Transcript Tax - Iret.org

JEC Macroeconomic Conference
RETURN TO PROSPERITY: CREATING THE
STRONGEST ECONOMY OF THE 21ST CENTURY
Presentation of
Stephen J. Entin
Institute for Research on the Economics of Taxation
February 23, 2010
IRET • 1710 Rhode Island Ave., NW, 11th floor, Washington, DC 20036
(202) 463-1400 • www.iret.org
Policy Targets And Policy Tools
Two Policy Targets:
 Stable Prices And A Sound Dollar
 Vibrant Economy -- High Real Output,
Income, Employment
Two Policy Weapons:
 Monetary Policy (Federal Reserve) – Best Used To Keep
Prices Stable
 Fiscal Policy -- Taxes & Govt. Spending (Congress, Mainly) –
Can Facilitate Growth If Used Properly
 Reversing The Roles Leads To Trouble
Two Strategies:
 Shoot The Right Weapon At The Right Target
And You Might Hit Both.
 Shoot The Shotgun At The Elephant
And The Elephant Gun At The Quail
And You Will Get Gored And Go Hungry.
Policy Assignments:
Nixon/Ford/Carter Years:
 Set Monetary Policy To Promote Real Growth And
Reduce Unemployment With Easy Money While ...
 Congress Spent Like Crazy And Let Inflation Raise
Taxes, Growing The Public Sector And Restricting
The Private Sector.
Result: Stagflation.
Kennedy/Reagan/Clinton(Gingrich) Years:
 Set Monetary Policy To Promote Stable Prices While ...
 Congress Restrained Spending To Shrink The Public
Sector And Cut Taxes In A Pro-Growth Manner.
Result: Strong Private Sector Growth Without Inflation.
Inflation, Unemployment, And Interest Rates, 1965 - 1988
P e r c e n t
12
10
GNP Price Deflator *
10.8
10.0
(Percent Change from Year Earlier)
8
5.7
6
5.7
4
3.7
4.1
2
3.6
3.0
0
1965
2.1
1970
1975
1980
1985
1988
P e r c e n t
12
10.8
Civilian Unemployment Rate **
10
9.0
8
5.7
6
4.6
4
5.3
3.4
2
0
1965
1970
1975
1980
P e r c e n t
18
16
3-Month Treasury Bill Rate **
15.5
1985
1988
16.3
14
12
10.5
10
8.8
7.9
8
8.1
6
7.0
4
2
0
1965
7.1
5.2
4.4
3.5
3.2
1970
1975
1980
1985
1988
Does Fiscal Policy Have Demand Effects?
 The Keynesian Focus On Managing Demand Is Misguided
According To Friedman. Tax Cuts And Govt Spending Do Not
Stimulate Demand, Because The Govt Must Fund Them Through
Borrowing OrOffsetting Taxes/Spending Cuts.
 With Rare Exceptions, Govt Spending Takes Resources From The
Private Sector And Shrinks Real Output By Putting Them To
Inferior Uses.
 Tax Cuts Don't Work By Giving People Money To Spend (Raising
"Disposable Income" Or "Aggregate Demand"). Unless Matched By
Spending Cuts, The Tax Cuts Are Borrowed Back By The Treasury.
 If The Federal Reserve Buys The Added Debt With New Money,
Demand Will Rise, But The Likely Effect Is Higher Prices,
Not Higher Output.
Or Must We Rely On Incentives To Supply?
 Tax Cuts Can Boost Output By Creating Incentives To
Produce; Only Those Tax Cuts That Affect These Incentives
Have A Pro-Growth Effect.
 Tax Cuts That Simply Redistribute Income Do Not Increase
Work, Saving, Or Investment; They Do Not Increase
Employment, Productivity, Output, Or Income. They Probably
Reduce Them By Rewarding Non-Work.
 Tax Cuts That Improve After-Tax Rewards At The Margin For
Additional Work, Saving, Investment, Production, Raise
Output, Employment, Income.
 There Are No "First Order Income Effects" From A Tax Cut.
A Tax Cut Raises Income Only As It Encourages Supply. As
Supply Increases, People Get Paid For Their Productive
Services, And Only Then Does Demand Rise. (Says' Law,
Not Keynes' Claptrap).
Price
Imposition Of A Tax
Supply
(With Tax)
Supply
(No Tax)
Reduction in Value of
Economic Output =
E1
Pc
Loss to Consumer
Tax
E0
+
P0
Loss to Producer
Pp
Resources
Redirected
to other
Activities
Q1
Q0
Demand
Quantity
Laffer Curve
Government revenue maximized,
but tax rate too high because it's
hurting growth.
Tax Revenue
B
Optimum tax
rate: value of
government
services equals
revenue and
growth costs
that taxes
impose on
society.
0%
A
Normal
Range
C
Prohibitive
Range
Tax Rate
Tax rate much
too high. It's
hurting growth
and lowering
government
revenue.
100%
Tax Increases Reduce Economic Activity
Long Before They Reduce Tax Revenues
A
Dollars
Economic
Output
B
Optimal Tax
Rate
0%
Revenue
Maximizing
Tax Rate
Govt
Revenues
Tax Rate
100%
Effect of Tax On Labor
Wage
Labor
Supply
Gross Wage
Marginal
Product of Labor
(Demand)
Tax
Net Wage
Drop
in
Labor
L1
MPL would
rise if labor
had more
capital to work
with, and fall if
capital
formation
lagged.
L0
Hours Worked
Effect of Tax On Desired Capital Stock
Return to Capital
Gross Return
Tax
Required Return
to Capital (Supply)
Net Return
Drop in
Capital
Marginal Product of
Capital (Demand)
K1
K0
Desired Amount of Capital
Wage
A Smaller Stock Of Capital Reduces Wages
Labor
Supply
W0
MPL (K0)
W1
MPL (K1)
N1 N0
Employment
Taxing Capital Hurts Labor
 Labor Bears The Economic Burden When
Taxes Drive Capital Offshore Or
Discourage It From Existing At All.
 Taxing Income Used For Consumption
Instead Of “Haig-Simons Income”
Would Raise After-Tax Wages And GDP.
 A 10% Rise In GDP And Wages Would
Benefit Workers And Families More
Than Misc. Tax Credits And Govt Jobs.
Marginal Vs. Average Tax Rates
Income = $50 K. Desired Tax Take = $10 K.
System 1: Tax All $50 K @ 20%.
Tax = $10 K.
Average Tax Rate = 20%.
Marginal Tax Rate = 20%.
Earn $100 More, Keep $80.
System 2: Exempt $25 K. Tax $25 K @ 40%.
Tax = $10 K;
Average Rate 20%
Marginal Rate 40%.
Earn $100 More, Keep $60
Under Which System Will People Be
More Eager To Earn Additional Income?
Weighted Marginal Individual Income Tax Rate
34%
33.2%
32.0%
32%
30.5%
30.1%
30%
29.5%
28.5%
28.5%
Percent
28.1%
28%
27.6%
27.7%27.8%
26.8%
26.5%
26.1%
26.1%
26%
25.3%
25.6%
25.4%
25.1%
25.2%
24.7%
24.2%24.3%
24%
23.3%23.4%23.3%
23.2%23.2%
25.6%
24.7%
23.2%
22.9%
22.3%
22%
20%
72 73 74 75 76 77 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Year
Data Source: Internal Revenue Service, Statistics of Income, Individual Income Tax Returns, various issues; Internal Revenue
Service, Statistics of Income Bulletin, various issues. (Data not published for 1978)
Cumulative Marginal Tax Rate For A Single
Taxpayer Earning $12,000 to $40,000 With 2 Children
50%
46.71%
Marginal Tax Rate
40%
30%
41.71%
Cumulative
Marginal Tax Rate
16.71%
EITC Phase-Out
(21.06%)
26.71%
20%
25.65%
Federal Income Tax
(10%, 15%)
10%
0%
Child Tax
Credit (-15%)
-4.35%
-10%
Payroll Tax (7.65%)
State Income Tax (3%)
-20%
12,000
16,000
20,000
24,000
28,000
Earned Income
32,000
36,000
40,000
The Phase-Out Of The Health Exchange Subsidy
Would Create A Huge Marginal Tax Rate Spike
Single Individual
Effective Marginal Tax Rate
70%
With Subsidy Phase-Out
60%
50%
40%
30%
Current Law (2009)
20%
10%
0%
13,000
23,000
33,000
43,000
Adjusted Gross Income (AGI)
Sources: CBO for estimates of Health Exchange Subsidy; and calculations by author,
based on Federal Income Tax, State Income Tax, Federal Payroll Tax, and Phase-Out of
Health Exchange Subsidy. See text for more details.
Tax Base Vs. Tax Rates
 The Tax Base -- What We Tax -Is At Least As Important As
The Tax Rates We Impose.
 The Income Tax Is Seriously Biased
Against Saving And Investment.
 All Tax Reforms Worthy Of The Name
Reduce Or Eliminate These Tax Biases.
 A Good Tax System Is
Saving/Consumption Neutral.
Multiple Taxation of Saving
One Tax on Consumption, Four Taxes on Saving
Layer 1– Tax on Earnings
Income is taxed when earned. If it is used for consumption, there is
usually no further federal tax.
Layer 2 – Personal Income Tax on Returns
If the income is saved, the returns are taxed as interest, dividends, capital
gains, or non-corporate business profits.
Layer 3 – Corporate Income Tax
If the saving is in corporate stock, the corporate tax hits the income before
it is either paid out to shareholders or reinvested to boost future earnings.
Layer 4 – Transfer (Estate and Gift) Tax
Another tax on already taxed assets.
(Similar taxes at the state and local levels increase the multiple taxation.)
Advantage Of Tax Deferred Saving
Over Ordinary (Biased) Tax Treatment:
Build-up Of $1,000 Saved per Year
$450
$400
Tax
Deferred
Assets (thousands of $)
$350
$300
$250
$200
$150
$100
Ordinary
(Biased)
Tax Treatment
$50
$0
20
25
30
35
40
45 50
Age
55
60
65
70
Saving from age 20 onward, under tax-deferred system and ordinary "double taxation"
(7.2% interest rate, 20% tax rate).
Multiple Taxation of Corporate Income
(a) Retained
Earnings,
Pre-2003 Act
(b) Dividend
Payout,
Pre-2001 Act
(c) Retained
Earnings and
Dividends,
2003 Act
1) Corporate Income
$1.00
$1.00
$1.00
2) Corporate tax at top rate
$0.35
$0.35
$0.35
3) After-tax corporate income:
Either retained, raising stock price
(columns (a), (c)), or paid as dividend (col.
(b), (c))
$0.65
$0.65
$0.65
$0.13
(tax rate 20%)
$0.2574
(tax rate 39.6%)
$0.0975
(tax rate 15%)
5) Total tax
$0.48
$0.6074
$0.4475
6) Total tax rate
48%
60.74%
44.75%
7) Income left to shareholder
$0.52
$0.3926
$0.5525
4) Individual income tax at top rate
(dividends as ordinary income, retained
earnings as capital gain)*
* Top corporate rate excludes corporate surtaxes, and top individual rate ignores phase-outs of exemptions and deductions and taxation of
Social Security, which may push effective top tax rates higher than statutory rates. Retained earnings are assumed to trigger a long-term
capital gain with a maximum rate of 20% or 15%. Short-term gains are taxed at ordinary tax rates.
Changes In GDP, Wages, and Capital If Capital Gains
and Dividends Tax Rates Increase
Changes in Billions of Dollars
Tax Rates Rise to 20%
GDP
Capital
Stock
Private
Sector
Wages
Tax Rates Rise to 28%
GDP
Capital
Stock
Private
Sector
Wages
0
-500
-94
-194
-237
-489
-1,000
-1,029
-1,500
-2,000
-2,500
-2,549
-3,000
Changes In GDP, Wages, and Capital If Capital Gains
and Dividends Tax Rates Increase
Changes in Percent
Tax Rates Rise to 20%
GDP
Capital
Stock
Private
Sector
Wages
Tax Rates Rise to 28%
GDP
Capital
Stock
Private
Sector
Wages
0%
-2%
-4%
-1.4%
-1.4%
-3.8%
-3.4%
-3.5%
-6%
-8%
-10%
-9.5%
Static Versus Dynamic Federal Budget Effects
Of Capital Gains And Dividend Tax Changes
In Billions
100
Tax Rates Rise to 20%
Tax Rates Rise to 28%
77.5
80
60
40
30.7
20
0
-20
-28.3
-40
-19.9
-17.4
-60
-50.0
-80
-46.0
-73.5
-100
Static
Gain
Income
Tax
Loss
Other
Net
Budget Federal
Effects Budget
Impact
Static
Gain
Income
Tax
Loss
Other
Net
Budget Federal
Effects Budget
Impact
Present Value of Current Law Capital Consumption Allowances per
Dollar of Investment Compared to Expensing (First-Year Write-Off)
3
Yrs
Asset lives:
5
yrs
7
yrs
10
yrs
15
yrs
20
yrs
27.5
yrs
39
yrs
Present value of firstyear write-off of $1 of $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00
investment:
Present value
of current law
write-off of $1 if
inflation rate
is:
0%
$0.96 $0.94 $0.91 $0.88 $0.80 $0.74 $0.65 $0.55
3%
$0.94 $0.89 $0.85 $0.79 $0.67 $0.59 $0.47 $0.37
5%
$0.92 $0.86 $0.81 $0.74 $0.60 $0.52 $0.39 $0.30
Assumes a 3.5 percent real discount rate, 3-20 year assets placed in service in first quarter of the year, 27.5 - 39
year assets placed in service in January.
Expensing Versus Depreciation: Depreciation Overstates Taxable
Income and Depresses Return on Capital
Expensing (Full Cost Recovery)
Depreciation
Revenues from
machine, present value
$115
Revenues from machine,
present value
$115
Full cost of machine
$100
Full cost of machine
$100
Actual profit
$15
Actual profit
$15
Full cost write-off
for tax purposes
(expensing)
$100
Allowable depreciation
write-off, present value
$85
Taxable profit =
Actual profit
$15
Taxable profit exceeds
actual profit
$30
Tax
$5
Tax
$10
Actual after-tax income
$10
Actual after-tax income
$5
Rate of return
10%
Rate of return
5%
Marginal Tax Rates On Estates And
Income Contributed To Estates, 2009
90%
81%
80%
GST
70%
Marginal Tax Rate
70%
60%
50%
85%
GST
GST
Estate Tax
Estate Tax
45%*
Payroll Tax
40%
State Income Tax
State Income Tax
Federal
Income
Tax
30%
20%
Estate Tax
Estate Tax
Federal
Income
Tax
Estate Tax
Estate Tax and
Generation
Skipping Trust
Tax on a Dollar
of Interest
Left in an Estate
10%
0%
* 45% Estate Tax Rate became effective in 2007.
Assumes married couple in 33% tax bracket, who are self-employed, with a 6% state income tax.
Computed prior to Estate Tax Repeal, which is now scheduled for 2010.
Tax on a Dollar
of Wages (self-employed)
Left in an Estate
Effect Of Estate Tax Alternatives On
Gross Domestic Product And Labor income
150
100
Billions of $
50
0
-50
GDP
Labor Income
-100
-150
-200
Pre-2001 Law 35% Top Rate; 15% Top Rate; Repeal Estate
$5 Million
$5 Million
Tax
Exemption
Exemption
Calculations by Author
Revenue Effects Of Estate Tax Reform:
Static Versus Dynamic Revenue Estimates
30
25
Revenue Effect: Static Analysis
20
Revenue Effect: Dynamic Analysis
Billions of $
15
10
5
0
-5
-10
-15
-20
35% Top Rate; $5
Million Exemption
Calculations by Author
15% Top Rate; $5
Million Exemption
Repeal Estate Tax
STEPS TOWARD NEUTRALITY:
ALL SAVING GETS DEFERRAL
OR RETURNS EXEMPT EQUIVALENT;
EXPENSING OF INVESTMENT;
NO DOUBLE TAX OF CORPORATE INCOME;
NO ESTATE AND GIFT TAX.
TAX BASES OF FOUR NEUTRAL TAXES &
POINTS OF COLLECTION
NRST -- INCOME LESS SAVING = CONSUMPTION
(NOT IMPOSED ON INVESTMENT GOODS).
TAXED AT POINT OF SALE.
VAT -- INCOME LESS SAVING = CONSUMPTION
(INVESTMENT EXPENSED). CAPITAL AND LABOR
INCOME TAXED AT BUSINESSES, IN STAGES.
CASH FLOW TAX -- INCOME LESS SAVING =
CONSUMPTION. TAXED ON INDIVIDUAL TAX FORM.
FLAT TAX -- INCOME LESS INVESTMENT = CONSUMPTION.
CAPITAL INCOME ON BUSINESS OR PROPRIETOR TAX FORM
(INVESTMENT EXPENSED); WAGES ON INDIVIDUAL TAX
FORM.
The Kennedy and Reagan Tax Cuts
The Kennedy rate cuts were roughly the same percentage rate reductions
across the board, but rewards rose most where rates were highest:
Top tax rate cut from 91% to 70%.
After-tax reward rose from 9% to 30%, up 230%.
Bottom tax rate cut from 20% to 14%.
After-tax reward rose from 80% to 86%, up 7.5%.
Similarly for the Reagan Tax cuts:
Top tax rate cut from 70% to 50%.
After-tax reward rose from 30% to 50%, up 67%.
Bottom tax rate cut from 14% to 11%.
After-tax reward rose from 86% to 89%, up 3.5%.
In both cases, a greater response by upper-income taxpayers raised the
total share of taxes they paid.
The Kennedy and Reagan Tax Cuts, cont.
Kennedy also cut the corporate tax rate, introduced the ITC, and
accelerated depreciation.
Reagan (1981) also accelerated depreciation, increased the ITC, and
enhanced saving incentives.
Both altered business taxes as well as individual tax rates.
While Marginal Tax Rates Have Fallen,
High Earners' Income Tax Shares Have Risen
50%
1981
2006
39.9%
Income Tax Share (%)
40%
30%
24.2%
20.3%
20.2%
20%
17.5%
17.9%
15.5%
12.9%
10.7%
10%
10.7%
7.4%
3.0%
0%
Bottom
50%
50% - 75% 75% - 90% 90% - 95% 95% - 99%
Taxpayers in AGI Range
Top 1%
Marginal Individual Income Tax Rates Under Old Law
And 2001 / 2003 Tax Acts
If Congress
1986 Tax
1990 Tax
1993 Tax
Reform Act*
Act
Act
1988 - 1990
1991 - 1992
1993 - 2000
2001
2002
2003 - 2010‡
2011 -
---
---
---
10%†
10%
10%
---
15%
15%
15%
15%
15%
15%
15%
28%
28%
28%
27.5%
27%
25%
28%
33%**
31%
31%
30.5%
30%
28%
31%
28%
---
36%
35.5%
35%
33%
36%
---
---
39.6%
39.1%
38.6%
35%
39.6%
2001 / 2003 Tax Act s
Lets Tax
Cuts Sunset
* 1986 Tax Reform Act had transition rate for 1987, fully effective in 1988.
** The 5% surtax recaptured the "benefit" of the initial 15% rate, creating the 33% "bubble"; marginal rate returned to 28% after
taxpayer had lost all "benefit" from the 15% rate.
† Rebate in 2001 equivalent to 10% rate.
‡ 2001 / 2003 Tax Acts sunset at end of 2010. Old rates return in 2011 in the absence of further legislation.
Other 2001-2003 Tax Changes That Affect Growth
 Enhanced Saving Incentives (2001)
 Phase-Out Of Estate Tax (2001-2010)
 Reduction Of Tax Rates On Dividends And Capital Gains (2003)
1,100
340
1,050
320
1,000
950
2002 Tax
Cut
2003 Tax
Cut
2001
Tax
Cut
300
Equipment
and Software
<-- Left Axis
280
260
900
240
Nonresdidential
Structures
Right Axis -->
850
800
2000
220
200
2001
2002
2003
2004
2005
Quarter
Data Source: BEA, National Income and Product Accounts, Table 5.3.6, accessed via www.bea.gov.
Billions of Dollars (2000 $)
Billions of Dollars (2000 $)
Real Private Investment
And 2001, 2002, and 2003 Tax Cuts
Rebates Did Not Boost Consumption
Billions of Dollars
11,000
10,500
Disposable
Personal
Income
10,000
9,500
Personal
Consumption
Expenditures
9,000
J F M A M J J A S O N D J F M A M J J A S O
2007
2008
Data Source: U.S. Bureau of Economic Analysis <http://www.bea.gov>. Based on John B. Taylor, "Why
Permanent Tax Cuts Are the Best Stimulus,' Wall Street Journal, Nov. 25, 2008.
Interim Steps -What Works And What Doesn't
 Pro-Growth Tax Provisions:
End/Reduce Death Tax
Augment Expensing (At The Margin)
Lower Cap Gains, Dividend Tax Rates
Lower Corporate Tax Rate
Expand IRAs, Pensions (At The Margin)
Lower Marginal Personal Tax Rates (Especially In Top Brackets)
 Social Tax Cuts:
They Have Their Role, But Do Not Create Jobs
Or Boost Investment, Wages, Or Output.
E.g. Child Credits, Personal Exemptions, Standard Deductions.
Don't Meddle, Don't Distort
 Distorting Provisions Hurt:
Targeted Credits/Taxes That Favor Or
Penalize One Activity Over Another
Grow One Area But Shrink Another, And
Reduce Total Output And Welfare. e.g.,
Green Credits, Excises, Housing Breaks.
 You Can't Raise GDP, Income, And The
National Welfare By Making People Do
Things The Hard Way. e.g., Locking Up
Cheap Energy And Favoring Sources
That Cost More And Deliver Less.
Recovery Assignments:
Who Does What?
 Never Rely On The Federal Reserve To Create Real Growth
With Easy Money.
 The Best The Fed Can Do For Growth Is Focus On Price
Stability, Because Inflation Raises Taxes On Investment And
Kills Growth Of Jobs And Output.
 It Is The Job Of Congress To Aid The Growth Of The Real
Economy. That Is Best Done By Curbing Government, Leaving
Productive Resources For Private Sector Uses.
 Tax Rates And Regulations That Drive Up Costs Are Barriers
To Production And Hiring That Must Be Kept Under Control.
Final Thoughts
 People who do not learn from history are
condemned to repeat it.
 When governments do not learn from history,
the people are condemned to repeat it.
 Economics is not the dismal science, if you have
a morbid sense of humor.
Final Thoughts, cont.
 There is hope: we have in the past, and we can again, adopt
policies that set the people free to flourish and prosper.
 We even know what those policies are.
 They do not require sacrifice by the people.
 They require sacrifice by Washington.