Fundamental Tax Reform

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 35

Fundamental Tax Reform

25.1 Why Fundamental Tax Reform?

25.2 The Politics and Economics of Tax Reform

25.3 Consumption Taxation

25.4 The Flat Tax

25.5 Conclusion


Why Fundamental Tax Reform?

• Increase tax compliance

• Make tax code simpler

• Improve tax efficiency

Main Arguments for Fundamental Tax Reform


C H A P T E R 2 5 ■ F U N D A M E N T A L T A X R E F O R M

25.1


tax compliance Efforts to reduce the evasion of taxes.

tax evasion Illegal nonpayment of taxation.

Improving Tax Compliance



25.1


APPLICATIONTax Evasion The distinction between tax

avoidance and tax evasion is a fine one and there is a large community of tax lawyers and judges who struggle daily with this distinction. Nevertheless, clear instances of outright taxevasion do exist:

1. In November 2008, Manhattan financier Stanley S.Tollman pleaded guilty to one count of tax evasion. The total amount that Tollman

owes the federal government is $105,093,638, not counting interest.

2. For years, taxpayers wanting to claim tax exemptions for dependents were required only to fill in the names of their dependents on tax forms. When the 1986 Tax Reform Act required filers to list as well the Social Security numbers of dependents over the age of five, six million dependents suddenly disappeared from the tax rolls!

3. Tax evasion is particularly common among workers who are paid in cash, which is harder for the IRS to trace.



25.1



Theory of Tax Evasion



25.1



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 $345 billion.

Why Should We Care About Tax Evasion?

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

1. Efficiency.

2. Vertical equity.

3. It is one of the clearest violations of horizontal equity that we have discussed.



25.1


APPLICATIONThe 1997 IRS Hearings and Their Fallout for Tax Collection In September 1997, the Senate Finance Committee held a week of hearings to

investigate abuses of taxpayers by the Internal Revenue Service:

As a result of these hearings, political pressure for IRS reform grew rapidly.

In 1998 President Clinton signed the Taxpayer Bill of Rights, which protected taxpayers and created a congressional watchdog agency.

Two facts have become clear in the years since the original hearings:

The testimony that made the IRS seem abusive and out of control actually painted a skewed and perhaps deliberately dishonest picture of the agency’s operations.

Constrained by a lack of financial resources and new obligations under the Taxpayer Bill of Rights, the IRS’s enforcement capacities have been severely impaired.

Though the Senate hearings fueled popular resentment of the IRS and the subsequent moves to restrain its powers, the pendulum may be swinging back in the opposite direction. Evidence of corporate tax evasion in particular has Americans calling once again for fairness in the tax system, rather than mere protection.



25.1


Making the Tax Code Simpler



25.1


Improving Tax Efficiency

direct effect of tax changes A higher tax rate that raises revenues on a fixed base of taxation.

indirect effects of tax changes 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.



25.1





25.1



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:

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

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.

Most if not all of this response comes from the rich.



25.1


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.



Political Pressures for a Complicated Tax Code

25.2

The Politics and Economics of Tax Reform

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.



Economic Pressures against Broadening the Tax Base

25.2


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

Background: Tax Shelters



Economic Pressures against Broadening the Tax Base

25.2


Transitional Inequities

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 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.



The Conundrum

25.2


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.



25.2


APPLICATIONTRA 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.



25.3

Consumption Taxation

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



25.3




Why Might Consumption Make a Better Tax Base?

25.3


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.




25.3


Fairer Treatment of Savers and Less Distortion to Savings Decision

The top panel of the table shows the impact of an income tax on Homer, who consumes all of his income when he earns it, and Ned, who saves some of his income. Ned has a higher present discounted value (PDV) of taxes than Homer under the income tax, since Ned is taxed on both his labor and interest income. When the government moves to a consumption tax in the second panel of the table, both Ned and Homer have the same PDV of taxes.




25.3


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.



Why Might Consumption Be a Worse Tax Base?

25.3


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

Vertical Equity

The primary concern with consumption taxation is a reduction of vertical equity.

Asymmetric Information

The government has only imperfect measures of ability.

Transition Issues

By some estimates, the entire efficiency gain from a consumption tax over the first several generations would be used up if extra taxes had to be raised to make transition payments to existing generations.



Why Might Consumption Be a Worse Tax Base?

25.3


Compliance

It is much harder to track consumption expenditures than it is to track income earned, where withholding from paychecks can solve compliance problems for the vast majority of the population.

Cascading

Businesses often pay sales taxes on their inputs and then again when they sell their outputs, so that a cascading problem develops.



Designing a Consumption Tax

25.3


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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Consumption Taxation25 . 3

Designing a Consumption Tax

Expenditure Tax

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

Backing Into Consumption Taxation: Cash-Flow Taxation

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

-Difficult to include progressivity



25.4

The Flat Tax

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.



25.4

The Flat Tax

Advantages of a Flat Tax

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.



25.4

The Flat Tax

Problems with the Flat Tax

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

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.

There are difficult transition issues raised by the flat tax.



25.5

Conclusion

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.

Fundamental Tax Reform

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