Transcript Entire List for U.S. - Stanford University

Perspectives on Tax Reform
SIEPR Tax Policy Conference
Stanford, California
January 18, 2013
Michael J. Boskin
Tully M. Friedman Professor of Economics
Senior Fellow, Hoover Institution
Stanford University
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Five Tests for Tax Reform
1. Will tax reform improve the performance of the economy?
2. Will tax reform affect the size of government?
3. Will a new federal tax structure affect federalism?
4. Will a new tax structure likely endure?
5. Over time, will tax reform contribute to a prosperous, stable
democracy?
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Some Fiscal Arithmetic
 Government long-run budget constraint:
PV of future taxes = PV of future spending + national debt (net of assets)
 for spending, taxes, financial crises, inflation and therefore
economic growth
 Evolution of the debt depends on:
 primary budget position (budget net of interest payments)
 interest rate on government bonds minus the growth rate
 Tax/transfer systems:
 Necessary tax rate depends upon (product of)
 Dependency ratio (benefit recipients/taxpayers)
 Replacement rate (average benefits/average wages)
(ECB President Mario Draghi, “the European social model is
already gone”)
 The harm from higher tax rates rises with the square of the rates
 The same economic activity is often taxed multiple times: e.g. wages by
federal, state, and local income taxes and payroll taxes; saving by federal,
state and local income taxes and possibly corporate and/or estate taxes
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* Estimates based on gross debt in parentheses.
** Central estimate of effect on GNP in 2037 (range - 3.5% to more negative than -21%), from CBO alternative fiscal scenario.
*** Cobb Douglas, constant returns, one-third capital, two-thirds labor.
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How High Would Tax Rates Go?
1. To cover the recent deficits, all federal taxes must be 30-40% higher; if just
income taxes, they would need to be 60+% higher
2. To finance projected spending on entitlement growth, marginal tax rates would
exceed 70% for many, higher still at the top
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Political Economy Issues

Percentage of population paying (positive) income taxes declining
 49% in 2009 (JCT)

Percentage of population receiving transfers from the government rising
 51% in 2010

Between 1985 and 2009, US adult population increased by 48 million, the
number of tax returns filed increased by 39 million, the number with zero or
negative tax liability rose by 40 million

Dependency ratio rising from 1:3.2 to 1:2 in coming decades
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Potential Benefits from Stylized Tax Reform
(Broad Base, Low Rate(s), Consumption Tax)

Several studies show income gain of 6+% from comprehensive broad
based low rate(s) consumption tax reform

About 1/5 of the difference in per capita income between U.S. and
western Europe
 What fraction of that difference is due to higher European tax rates,
bloated welfare state, debated by economists, from under half to
100%
 So tax reform can be an important effective complement to
spending control
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Distributional Issues

Latest federal income tax data (2010 SOI):
Share of :
AGI
Income taxes
Ave. tax rate
1%
18.9%
37.4%
23.4%
10%
45.2%
70.6%
18.5%
10-25%
22.4%
16.5%
8.7%
Bottom 50%
11.7%
2.4%
2.4%
Top:

OECD: U.S. tax system most progressive
(n.b. larger public sectors financed with VAT in many countries)

Since 1980:

AGI share of top increased substantially; of bottom, fell considerably. Income tax
shares rose, and fell, considerably, respectively; average tax rate fell somewhat for all
income groups, as income tax share of GDP fell
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Key Decisions For Design Of Tax System
1. Tax base(s): income, consumption, hybrid; people or
transactions
2. Tax rate(s): flat, progressive, levels
3. Unit(s) of account: family, individual, transactions
4. Time period(s) of account: transaction, annual, longerhorizon
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The Impact of Taxes on Saving, Investment, and
Economic Growth

Real per capita income grows with productivity, which in turn rises with the growth
rate of capital (private and effective public) per worker and the growth rate of
technology

Taxes affect the capital stock by affecting saving and investment

Taxes may also affect hours of work, choice of occupation, fertility, and human
capital investment

Taxes, and some government spending, may affect the rate of advance in
technology

Tax effects on human investment and/or technology can permanently affect the
growth rate of the economy

Taxes on saving and investment affect the level of future income and hence the
interim growth rate; whether they permanently alter the growth rate depends upon
whether investment affects the rate of technical change, on which economists
disagree

At the very least, we should strive for neutrality in the tax code toward saving and
investment, especially given the anti-saving policies of exploding public debt and
rapidly rising social insurance transfers to the elderly

Taxes also affect many dimensions of labor supply and thus income
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Tax Treatment of Capital Income
1.
Business firms earn the before-tax return to private investment; firms then pay
corporate taxes on these profits, at tc, the effective marginal corporate tax rate;
2.
Suppliers of the capital receive the before-personal-tax return to savers, and
then pay personal taxes on their returns (interest, dividends, capital gains) at
rate tp, the marginal effective personal income tax rate on capital income
Thus a “wedge”, or distortion, is created between the before-tax return to
private businesses on their investment and the after-tax returns to savers
supplying the capital for the investment
The tax wedge = tc + tp
The “excess burden” of tax goes up with square of tax rate (tc + tp )2
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
“Corporate income taxes are found to be the most
harmful to economic growth, followed by personal
income taxes and then consumption taxes”

Organization for Economic Cooperation

and Development (OECD),

2008
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Tax Neutrality Toward Saving And Investment
1. Pure income tax: double taxation of saving
2. Pure consumption / consumed income tax: neutral
3. Add corporation income tax = third tax on saving
 Combination of tax rate, interest deductions on debt and PV of
depreciation allowances determines effect on investment (I)
 Tax income but allow true economic depreciation of equity financed
investment (no debt) => neutrality among types of investment.
4. Consumption tax: consumption (C) = income (Y) – investment (I)
 Neutral with respect to types of investment
 Neutral between investment / saving and consumption
 Immediate expensing (first year write-off)
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Tax Neutrality Toward Saving and Investment
5. Think of a football field
 Pure income tax level sideline-to-sideline, but saving (S) and
investment (I) running uphill
 Pure consumption tax – level sideline-to-sideline (among types of
I) and goalpost-to-goalpost (between S and C)
6. Debt raises the potential of negative effective tax rates (subsidies) on
investment
 The case for subsidizing investment
 The treatment of housing
7. Estate tax can be third or fourth tax on saving
8. Taxes and human capital investment
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Human Capital Investment
Types:
Education (50%), On the job training (30%), Mobility, Health (20%)
Note:
Virtually all on the job training (ojt) and sizeable fraction of higher
education and some fraction of mobility and health costs are foregone
earnings, which ARE NOT TAXED
Example: Early years of work and informal ojt (Heckman estimates 1/3 of
time)
So a $60,000 per year worker is actually “paid” $90,000 at annual
rate: $60,000 is cash and $30,000 is ojt
The in-kind ojt is not taxed. This is economically equivalent to
including it in income and then giving an immediate deduction
(expensing)
So a flat rate tax does not distort the bulk of human investment decisions. However,
a progressive rate structure does do so, as the human capital investment raises
earnings and drives people into higher tax brackets
Other policies: from government finance of education, lending, government
spending, from Head Start to job training programs, etc., provide and/or finance
human capital programs (most evaluations of efficacy not encouraging)
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Single and Double Taxation of Saving
1. Ordinary saving: taxed twice under the income tax

Earn income = $1, pay tax t, save $(1-t)

Saving earns return r, is taxed at t, your net of tax return is r(1-t)

Thus, you end up with (1-t)(1+r(1-t))
2. IRAs, 401(k)s: saving taxed once, on withdrawal

Earn income = $1, save and deduct it, so saving = $1

Saving earns return r, no tax while builds up

On withdrawal pay tax t (can be higher or lower than tax rate
when contributed)

Thus, you keep (1+r)(1-t)
3. Roth IRA: backloaded, saving not deductible, so no tax at withdrawal

Earn income = $1, pay tax t, saving = $(1-t)

Earns return r, no tax on withdrawal

So you keep (1+t)(1+r)
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Long-Term Effects of Taxes on Saving and
Investment
(real future value of $1 invested earning 10% before tax when taxed at 0% and 40%)
year 1
year 20
(1)
no capital tax
1.10
6.73
(2)
capital income tax
tc + tp = 40%
1.06
3.21
96%
48%
(2)/(1)
Tax rate on capital income = tc + tp
So, while a “small” capital income tax may not be too distortionary between
consumption today and consumption next year, it is very distortionary between
consumption today and consumption many years in the future.
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The Effects Of Taxes On Saving
4. Even very modest (substitution) effects of capital income taxes imply
very large costs to society from the tax distortions between
consumption and saving (future consumption)
 Nobel laureate Professor Robert Lucas, in his research and 2002
Presidential address to the American Economic Association,
concludes that removing the tax distortions to saving and
investment are by far the most important avenue for improving
economic well-being of any potential public policy reform
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Tax Reform
I.
Partial
Lower rates, broader base
Simplification
Expanded tax deferred saving
Corporate tax integration
II.
Comprehensive
Consumed income tax
National retail sales tax
Value added tax
Flat tax
perhaps with modest
additional income tax at
high incomes
N.B. income averaging? unit of account? non-payers: minimum tax?
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Consumption Taxes
(arguments for)
Equity
 People should be taxed on what they take out of the system, not
what they contribute
 Taxing life-cycle income (leaving aside bequests and
inheritances) is equivalent to taxing consumption
 Consumption may be a better measure of permanent income
than is current income
 A consumption-based tax can be progressive
Efficiency
 Eliminate distortion of saving decision and hence discrimination
against the patient vs. the impatient, and effects on growth.
 Taxes all saving equivalently
Simplicity
 A lot of the complexity of the tax code arises from capital
income taxation and avoidance
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Consumption Taxes
(arguments against)
Equity
 Income better measure of ability-to-pay (at least in an annual tax
with limited time horizons)
 Avoids differentiating capital and labor income
 Transactions based consumption taxes ineffective way of
differentiating by ability
 Transition unfair to elderly
Efficiency
 Intertemporal distortion not so severe; time horizons not so long
 In practice, may wind up subsidizing saving, investment (e.g., debt
finance and interest deductions unlikely to be limited in practice)
Simplicity
 Transition not simple
 Personal, business tax likely complex around saving, investment
definition
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Tax Reform and the Transition to a New Tax System
1.
Tax reforms => capital gains and losses if the taxation of capital is
involved
2.
We not only must compare the new tax or tax system to the old
one, we also have to pay attention to transition issues
3.
Most major tax reforms involve transition rules
a. For a while, there are parallel tax systems:
i. The old one, phasing out and
ii.
The new one, phasing in
b. Transitions impose costs, complexity
4.
Important to evaluate actual tax systems before, after and during
(transition), not just two theoretical systems
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Conclusion

The two routes to reform
1. Replace the current corporate and personal income taxes with an
integrated consumed income tax, e.g. with personal rates of 10%,
20% and 30%, a corporate rate of 30%; phase out most deductions
other than charity and mortgage interest; include super-IRAs;
simplify, eliminate, combine other aspects of the code
 Simultaneously, reduce subsidies to the well-off in government
benefit programs
2. Replace the income taxes with more fundamental reform, such as
the Hall-Rabushka flat income tax or a national retail sales or valueadded tax;

The political economy of the sales and VAT taxes raise fundamental
concerns of federalism and potential growth of government
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Conclusion: Policy Priorities

Medium-run fiscal consolidation, a la Simpson-Bowles, enacted NOW, and
difficult to reverse, but phasing in gradually as economy recovers

Long-run entitlement and tax reform: maintain strong incentives while reducing
subsidies to the well off
 Social Security: indexing, retirement age
 Medicare: age, competition, premium support a la Rivlin, Wyden-Ryan
 Tax: transition to broad based consumed income tax with lowest rates
possible to raise necessary revenue; corporate tax: broad base, lower rate,
territorial system (ideally integrated with personal tax)

Budget reform: making programs more effective by eliminating, consolidating
and modernizing; process reform; fiscal constraints

Monetary policy; human capital policy (education and training), trade, regulation

Make fiscal and monetary policy much more predictable and permanent,
eliminate endless use of temporary features
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