Chapter 25 Fundamental Tax Reform © 2007 Worth Publishers Public Finance and Public Policy, 2/e,...

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© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Fundamental Tax Reform

25.4 The Flat Tax

25.3 Consumption Taxation

25.2 The Politics and Economics of Tax Reform

25.1 Why Fundamental Tax Reform?

Chapter 25

25.5 Conclusion

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Why Fundamental Tax Reform?25 . 1

tax compliance Efforts to reduce the evasion of taxes.

tax evasion Illegal nonpayment of taxation.

Improving Tax Compliance

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Theory of Tax Evasion

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Evidence on Tax Evasion

Tax evasion is pervasive in the United States and around the world. In the United States, the most recent estimates place the “tax gap” between taxes owed and taxes paid at $280 billion.

Why Should We Care About Tax Evasion?

There are three reasons why we should care about tax evasion and want to reduce it:

The first is efficiency.

The second is vertical equity.

Finally, tax evasion is one of the clearest violations of horizontal equity that we have discussed.

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Making the Tax Code Simpler

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Improving Tax Efficiency

Changing the tax rate changes tax revenues through five channels:

1. Direct effect: A higher tax rate raises revenues on a fixed base of taxation.

2. Indirect effects: A higher tax rate that lowers the size of the revenue base on which taxes are levied.

a. Gross income effect: A higher tax rate may reduce gross income generated by lowering the amount of labor supplied, the savings undertaken, or risk taking.

b. Reporting effect: For a given level of gross income, a higher tax rate will cause individuals to reclassify income in ways that are not subject to a tax.

c. Income exclusion effect: For a given reported income, a higher tax rate will cause individuals to take more advantage of the deductions and exclusions from gross income that are used in defining taxable income.

d. Compliance effect: Finally, higher tax rates may reduce revenues through increased tax evasion.

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Evidence on the Revenue Consequences of Higher Tax Rates

It wasn’t until the late 1980s that economists began to assess the overall impact of taxes on revenues.

Since that time, a large number of studies have modeled the impact of changes in individual tax rates on the tax revenues collected from those individuals.

These studies have provided several clear messages about how tax revenues respond to tax rates.

First, the indirect effects we listed do offset the direct effect of raising tax rates to a significant degree.

Second, most of this response comes from the indirect effects of reporting, income exclusion, and compliance, and not from the indirect effect of gross income earning.

Third, most if not all of this response comes from the rich.

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Summary: The Benefits of Fundamental Tax Reform

Fundamental tax reform such as a flat tax, or even the system put in place by the Tax Reform Act of 1986, helps address all three of the tax reform goals (increasing tax compliance, simplifying the tax code, and improving tax efficiency).

By expanding the tax base and lowering tax rates, fundamental tax reform improves tax compliance and tax efficiency.

By ending large numbers of detailed exemptions and deductions from taxation, and taxing different forms of income at the same rate, fundamental tax reform also makes tax filing simpler.

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The Politics and Economics of Tax Reform25 . 2

Political Pressures for a Complicated Tax Code

Political pressures for policy changes are strongest when the winners from these changes are concentrated, well-organized, and have much to gain, and the losers are diffuse and don’t lose much per person.

A particularly strong pressure for tax code complication is the perception of politicians that naïve voters are opposed to new government spending programs but support the same goal when financed by a tax expenditure, despite identical budget implications.

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Economic Pressures Against Broadening the Tax Base

tax shelters Activities whose sole reason for existence is tax minimization.

Background: Tax Shelters

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Economic Pressures Against Broadening the Tax Base

tax capitalization The change in asset prices that occurs due to a change in the tax levied on the stream of returns from that asset.

Transitional Inequities

transitional inequities from tax reform Changes in the treatment of similar individuals who have made different decisions in the past and are therefore differentially treated by tax reform.

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Grandfathering in Virginia

A P P L I C A T I O N

Near the end of 2003, the state of Virginia began the political process of transforming its tax system, in an effort to put its shaky financial house back in order.

One particularly costly feature of the system was the automatic $12,000 annual deduction that every Virginian 65 or older received on his or her state income taxes, regardless of wealth or income.

When Democratic governor Mark Warner proposed eliminating that deduction, he made sure to include in his plan a clause that allowed seniors currently over 65 to keep the deduction, a true “grandfather” (and grandmother) clause.

Virginia’s politicians agreed at the time that the so-called senior subtraction was largely untouchable, even though immediate repeal would bring nearly $300 million annually into the state’s coffers.

The tax reform eventually passed, with the grandfather clause intact, in April 2004.

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The Conundrum

Political and economic pressures are significant barriers to moving to a broad-based system.

Political forces are constantly pushing for the use of the tax code to deliver benefits to particular groups, at the cost of potentially inefficient and inequitable holes in the tax base.

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TRA 86 and Tax Shelters


TRA 86 closed many of the egregious tax shelters that had emerged in the wake of the 1981 tax reform.

A straightforward means of doing so would have been to eliminate the tax shelters directly, by stopping the special treatment of oil and gas investments.

This reform would have increased equity and efficiency, and would have made the tax code simpler.

Congress addressed the shelter problem indirectly, by dividing income into three categories: ordinary (earned) income, investment income, and passive income.

Passive income was defined as income in which the individual did not take an active role, such as tax shelters or real estate income.

These changes were largely effective at ending the most egregious use of tax shelters, but they came at a cost: they made the tax code more complicated.

One clear lesson is that both goals can be served if politicians take more direct routes to improving the tax code, such as simply removing tax shelters, rather than indirect routes, such as those pursued by TRA 86.

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Consumption Taxation25 . 3

taxing consumption Taxing individuals based not on what they earn but on what they consume (such as through a sales tax).

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Why Might Consumption Make a Better Tax Base?

Improved Efficiency

A single-rate sales tax could reduce many of the inefficiencies associated with the current tax system.

A particular source of inefficiency in our current tax system is the lack of a “level playing field” across investment choices.

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Fairer Treatment of Savers and Less Distortion to Savings Decision

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Simplicity

Another advantage of the consumption tax is simplicity.

In principle, it is much more straightforward to simply tax individuals on their purchases than on a complicated definition of income.

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Why Might Consumption Be a Worse Tax Base?

Vertical Equity

The efficiency, horizontal equity, and simplicity advantages of consumption taxation are offset by five disadvantages.

Asymmetric Information

Transition Issues

Compliance

Cascading

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Designing a Consumption Tax

Value-Added Tax

value-added tax (VAT) A consumption tax levied on each stage of a good’s production on the increase in value of the good at that stage of production.

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Designing a Consumption Tax

Expenditure Tax

expenditure tax A consumption tax levied on yearly consumption rather than on specific sales.

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Backing Into Consumption Taxation: Cash-Flow Taxation

cash-flow tax A tax on the difference between cash income and savings.

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The Flat Tax25 . 4

Consider the tax described in the example that opened this chapter, the flat tax, which was first popularized by economists Robert Hall and Alvin Rabushka in 1981. Their plan has several features:

1. Corporations pay a flat-rate VAT on their sales, but also get to deduct wage payments to workers from their VAT tax base. There is no corporate income tax.

2. Individuals pay a tax on labor income only, not capital income, at that same flat rate.

3. All tax expenditures would be eliminated (health insurance expenditures would be treated like wage payments, charitable contributions and home mortgage interest would no longer be deductible, and so on) and would be replaced by a single family-level exemption.

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The Flat Tax25 . 4

There are several major advantages of a flat tax.

The most important are the efficiency gains from having one flat rate on a broad income definition.

The flat tax would have enormous benefits in terms of simplicity.

Compliance would also likely improve because the simpler tax system would make it harder to find ways to evade taxes; for almost all taxpayers, their entire tax bill could be collected through withholding from earnings.

Advantages of a Flat Tax

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The Flat Tax25 . 4

The problems with the flat tax are similar to those raised with consumption taxation.

First, while a flat tax can be made fairly progressive for low- and middle-income earners, it will be much less progressive for high-income earners than our current system.

Second, there are difficult transition issues raised by the flat tax.

Problems with the Flat Tax

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The 2005 Panel on Tax Reform


In January, 2005, President Bush appointed the President’s Advisory Panel on Federal Tax Reform, charging them to recommend options that would make the tax code “simpler, fairer, and more conducive to economic growth.”

This panel issued a series of recommendations on November 1, 2005. In particular, the panel proposed several fundamental changes to the structure of the tax code: Move to a broader definition of income and flatter tax rates, simplify and condense complicated aspects of the tax code, and reduce capital taxation.

The Tax Panel therefore proposed the following changes:

► Replace the mortgage interest deduction with a flat 15% credit for all taxpayers for mortgage payments up to the mean home price in the area.

► Allow a deduction for charitable giving for all taxpayers who give more than 1% of their income (with the goal of subsidizing marginal, rather than inframarginal, gifts to charity).

Continued

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The 2005 Panel on Tax Reform (continued)


► Limit the exclusion of health insurance premiums from taxation to premiums below the national average level of premiums (for example, employer-provided insurance payments of more than $11,500 for a family would be taxed like wage income).

► Remove the deductibility of state and local tax payments.

► Move from the current system of six brackets to three or four brackets.

Despite fears that this report would be highly partisan, these recommendations were generally bipartisan and followed the recommendations that economists of all types have been making for tax reform for years.

The panel was equally criticized for going too far (by those opposed to reducing capital taxation on equity grounds) and for not going far enough (by those in favor of a pure consumption tax).

The one consistent complaint about the analysis was that this plan claimed to be revenue neutral, raising the new revenues necessary to pay for reduced capital taxation and the removal of the AMT.

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Conclusion25 . 5

Complaints about the taxation of income in the United States abound.

The complications, economic distortions, and redistribution inherent in the U.S. system of income taxation leave many unhappy with the income tax as the nation’s primary source of revenue raising.

Fundamental reform of the income tax is not easy.

Moving to fundamental reform, such as replacing income taxation with consumption taxation or a flat tax, raises difficult issues about the appropriate trade-off between efficiency and equity in our tax code.

Chapter 25 Fundamental Tax Reform © 2007 Worth Publishers Public Finance and Public Policy, 2/e,...

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