Objectives of Tax Reform

REFORMING TAXATION:

ADVANTAGES OF A SAVING-

CONSUMPTION NEUTRAL TAX BASE,

AND PRINCIPLES TO GUIDE REFORM

Stephen J. EntinInstitute for Research

on the Economics of Taxation

Objectives of Tax Reform

Neutrality (Growth)

Simplicity

Fairness

Visibility

2

Choose a better tax base.

Consumption versus Income.

(Better put: a Neutral Tax Base vs.

Income.)

How to Achieve Objectives

3

Income Income is the earned reward for providing

labor and capital to produce goods and services that other people value.

Income is proportional to effort. So the fairest tax is proportional to income, i.e., one flat rate.

Exempting the very poorest is a kindness, but it is fair for everyone who can to pay something toward the cost of government.

4

Income is revenue less the cost of earning revenue.

Deductions for costs are necessary to measure income properly.

Income is a Net Concept

5

No saving => no interest, no dividends.

You can't have your principal and eat it too.

Therefore, the best measure of income is consumption. We should tax what we spend.

Saving Is a Cost of Earning Income

6

Do not fall more heavily on saving and investment than on consumption,

Are unbiased against growth,

Are simpler than the income tax, and

Are fair and straightforward.

Neutral Taxes:

7

Hits saving and investment harder than consumption by taxing saving and its earnings, encouraging consumption by penalizing saving (a tax base error).

Compounds the damage by taxing people more heavily the more they work, save, and produce by imposing graduated tax rates (a tax rate error).

By Comparison the Income Tax:

8

Desired Amount of Capital

Ret

urn

to

Cap

ital

Effect of Tax On Desired Capital Stock

Net Return

Gross Return

Required Return to Capital (Supply)

Tax

Drop in Capital

K1

Marginal Product of Capital (Demand)

K0

9

Hours Worked

Wag

eEffect of Tax On Labor

Labor Supply

Net Wage

Gross Wage Marginal Product of Labor

(Demand)Tax

Dropin

Labor

L1

MPL would rise if labor had

more capital to work with, and

fall if capital formation lagged.

L0

10

Savers can always switch to consumption, which is nice for them.

But when they do, investment slumps, and workers lose their jobs.

Taxing Capital Income Hurts Workers

11

Employment

Wag

e

Labor

MPL (K0)

W0

N1

MPL (K1)

W1

N0

A Smaller Stock Of Capital Reduces Wages

12

Multiple Taxation of SavingOne Tax on Consumption, Four Taxes on Saving

Layer 1– Initial tax on EarningsIncome is taxed when earned. If it is used for consumption, there is usually no further federal tax.

Layer 2 – Personal Income Tax on Returns on Already-Taxed SavingIf the income is saved, the returns on the already-taxed saving are taxed as interest, dividends, capital gains, or non-corporate business profits.

Layer 3 – Corporate Income TaxIf the saving is invested in corporate stock, the corporate tax hits the returns before they are either paid out to shareholders or reinvested.

Layer 4 – Transfer (Estate and Gift) TaxAnother tax on already-taxed assets.

(Similar taxes at the state and local levels increase the multiple taxation.)

13

Step 1. Treat all saving and investment as a

cost of earning income.

Step 2. End double taxation of corporate

income.

Step 3. Kill the Death Tax.

Steps Toward a Fair, Flat, Unbiased Neutral Tax

14

Treat all saving like pensions and IRAs: either

defer tax until the saving is spent, or tax the

saving up front and not tax the returns.

Immediately expense all investment; do not

drag out depreciation over time. (This still tax

above normal profits, which is OK.)

Step 1. Treat Saving and Investment as a Cost of Earning Income

15

Neutral Tax Effect on Saving Vs. Consumption; Contrast With Ordinary Income Tax

Tax Treatment No Tax Sales Tax Income Tax

Pretax earnings to be spent or saved $100 $100 $100

Tax on spending 0If spent: 20

If saved: 0Saved or spent: 20

Amount spent or saved 100If spent: 80

If saved: 10080

If saved, is interest on inside build-up taxed?

No, 7.2% reinvested

No, 7.2% reinvested

Yes, 5.76% reinvested

Savings after 10 years 200 200 140

Tax due on future spending 0 40 0

After-tax spendable balance 200 160 140

Ratio of saving to spend later to spending now 2 to 1 2 to 1 1.75 to 1

Illustration assumes 7.2% pre-tax interest rate, 25% sales tax rate, 20% income tax rate.16

Equivalence Of Saving Deferred And Returns Exempt TaxOn Saving; Contrast With Ordinary Income Tax

Tax Treatment Saving Deferred Returns ExemptOrdinary Income

Tax

Pretax earnings to be saved $100 $100 $100

Tax on saving 0 20 20

Amount saved 100 80 80

Is interest on inside build-up taxed?

No, 7.2%

reinvestedNo, 7.2% reinvested

Yes, 5.76% reinvested

Account after 10 years 200 160 140

Tax due on withdrawal 40 0 0

After-tax spendable balance 160 160 140

Cost to saver of ordinary vs. neutral tax treatment

(same as sales tax) (same as sales tax)20 (= 160 – 140)

(1/3 of the interest)

Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment. 16

Tax-advantaged saving in an IRA, 401(k), or pension yields about two-thirds more income in retirement than ordinary saving!

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

20 25 30 35 40 45 50 55 60 65 70

Age

Ass

ets

(th

ou

san

ds

of

$)

Saving from age 20 onward, under tax-deferred system and ordinary "double taxation" (assume 7.2% interest rate, 20% tax rate).

TaxDeferred

Ordinary (Biased)

Tax Treatment

Advantage Of Tax Deferred SavingOver Ordinary (Biased) Tax Treatment:

Build-up Of $1,000 Saved per Year

17

Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing (First-Year Write-Off)

Asset lives:3Yrs

5yrs

7yrs

10yrs

15yrs

20yrs

27.5 yrs

39yrs

Present value of first-year write-off of $1 of investment:

$1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00

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.

18

A neutral tax would not tax corporate income twice.

It would tax it either at the corporate level or the shareholder level, but not both.

Step 2. End Double Taxation of Corporate Income

19

Multiple Taxation of Corporate Income

Retained Earnings, Pre

2003 Act

Dividend Payout, Pre

2001 Act

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 value, or paid as dividend

$0.65 $0.65 $0.65

4) Individual income tax at top rate (retained earnings as capital gain,dividends as ordinary income)*

$0.13(tax @ 20%)

$0.2574(tax @ 39.6%)

$0.0975(tax @ 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* 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.

20

A neutral tax would not tax estates because

estates are accumulated saving that has

already been taxed or will be subject to an

heir's income tax.

Step 3. Kill the “Death Tax"

21

22

Marginal Tax Rates On Estates And Income Contributed To Estates, 35% Estate Tax Rate

73%

78%

58%

35%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Estate Tax Estate Tax andGeneration

Skipping Trust

Tax on a Dollarof Interest

Left in an Estate

Tax on a Dollarof Wages (self-employed)

Left in an Estate

Mar

gin

al T

ax R

ate

State Income Tax

Estate Tax

Estate Tax

Estate Tax

Estate Tax

Payroll Tax

Federal Income

Tax

Federal Income

Tax

State Income Tax

GSTGST

GST

* A 35% Estate Tax Rate, with a $5 million exclusion, became effective in 2011 through 2012. It will revert to 55% in 2013, with a $1 million exclusion, without further legislation.Assumes married couple in 33% tax bracket, who are self-employed, with a 6% state income tax

*

23


81%85%

70%

45%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%


Skipping Trust


Left in an Estate


Left in an Estate

Mar

gin

al T

ax R

ate

State Income Tax

Estate Tax

Estate Tax

Estate Tax

Estate Tax

Payroll Tax

Federal Income

Tax

Federal Income

Tax

State Income Tax

GST

GST

GST

* 45% Estate Tax Rate, with a $3.5 million exclusion, became effective in 2007. The tax was repealed for 1 year in 2010.Assumes married couple in 33% tax bracket, who are self-employed, with a 6% state income tax.

*

22


87% 90%

80%

55%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%


Skipping Trust


Left in an Estate


Left in an Estate

Mar

gin

al T

ax R

ate

State Income Tax

Estate Tax

Estate Tax

Estate Tax

Estate Tax

Payroll Tax

Federal Income

Tax

Federal Income

Tax

State Income Tax

GSTGST

GST

* A 55% Estate Tax Rate, with a $675,000 exclusion, preceded the Bush 2001 tax cuts.Assumes married couple in 33% tax bracket, who are self-employed, with a 6% state income tax.

*

Personal Expenditure tax (on income less

saving, i.e., saving is tax-deferred).

Flat tax (no deferral, returns are exempt).

Sales tax (on income spent, not saved).

Value Added Tax (on output less investment;

which equals income less saving or sales tax).

Four Types of Neutral Taxes:

28

All treat saving neutrally vs. consumption.

All employ expensing instead of depreciation.

All are territorial.

All have the same basic tax base.

Differ mainly as to point of collection.

Elements of Neutral Taxes

29

History tells us that:

When we have moved toward a neutral tax with lower rates, the economy has boomed.

When we have increased tax biases the economy has faltered.

When we have wasted tax cuts on non-growth-related rebates, nothing good has happened.

Why it Matters

25

Tax Reform The Good, the Bad, and the Ugly

35

JFK ERTA 1981(+TEFRA’82&DEFRA’84) Tax Reform Act of 1986 Bowles-Simpson Deficit Commission Wyden-Coats

7.7%

-3.2%

1.0% 1.0%

2.8%

10.2%

-0.9% -0.5%

-2.1%

1.2%

8.0%

-3.4%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Kenned

y

Johnso

n

Nixon

Ford

Carte

r

Reagan

(I)

Reagan

(II)

GHW B

ush

Clinto

n (I)

Clinto

n (II)

GW B

ush

Obama

Change in GDP Due To Tax Law Changes During Presidential Administrations

Source: Calculations by author

800

850

900

950

1,000

1,050

1,100

2000 2001 2002 2003 2004 2005Quarter

Bil

lio

ns

of

Do

lla

rs (

20

00

$)

200

220

240

260

280

300

320

340

Bil

lio

ns

of

Do

lla

rs (

20

00

$)

Data Source: BEA, National Income and Product Accounts, Table 5.3.6, accessed via www.bea.gov.

Real Private InvestmentAnd 2001, 2002, and 2003 Tax Cuts

2002 Tax Cut

2001TaxCut

2003 Tax Cut

Equipment and Software<-- Left Axis

Nonresdidential StructuresRight Axis -->

0.66%

-1.40%

-3.20%

-0.37%

-4.32%-5%

-4%

-3%

-2%

-1%

0%

1%

Wyden-Coats: Percentage ChangeIn GDP By Provisions And For Total Bill

Indiv Rate Bracketand Std

DeductionChanges

CorporateRate andCap Gain/DividendChanges

DepreciationChange

InterestDeductionLimitation

CombinedEffect

0

5

10

15

20

25

30

35

40

45

1975 1980 1985 1990 1995 2000 2005

Year

0

1

2

3

4

5

6

7

8

Rea

lize

d G

ain

s as

Per

cen

t o

f G

DP

Capital Gains Realizations Rise When The MaximumTax Rate on Long-Term Gains Falls, 1976 - 2007M

axim

um

Tax

Rat

e o

n L

on

g-T

erm

Gai

ns

Top Tax Rate on Long-Term Gains

Realized Gains as Percent of GDP

Data from U.S. Treasury

27

Tax reform is about:

Getting the tax base right. Setting rates that cover the amount of government

that people want to have. Raising revenue with less damage to the economy. Informing voters of the price they pay for govern-

ment so that they can make informed decisions about how much government activity to support.

Cut spending to pay for it. THWRN,TBWSECTR

Recap

34

Neutral taxation is best for growth. It can yield:

More saving, investment, and growth. Potentially:

o Trillions of dollars of added capital.

o Millions of added jobs and higher wages.

o Thousands of dollars in added family income.

U.S. would become a jobs and investment magnet.

Objective: Neutrality/Growth

30

Neutral taxes are much simpler, even if collected on individual tax forms:

No double taxation.

No limits on savings plans. One universal plan, not dozens.

No separate taxation of capital gains.

No depreciation schedules.

No foreign tax and tax credit.

No phase-outs of exemptions, credits, deductions.

Objective: Simplicity

31

Consumption is a fairer tax base than income; it respects the effort of people who work and save.

Neutral taxes can be made progressive to shelter the poor.

There is no need to tax saving and investment more harshly than consumption to achieve progressivity.

The simpler, clearer neutral tax would be seen to be fair.

Objective: Fairness

32

Only people pay taxes.

Businesses and things don't pay tax.

Taxes are best levied on individuals.

Voters need to see what government costs.

Everyone who can do so should pay something toward the cost of government.

Simplicity is no excuse for dropping tens of millions of people from the tax rolls.

Objective: Visibility

33

Please consider:

Economics is not the dismal science --

if you have a morbid sense of humor --

and a large tru$t fund.

39

On the other hand ---

(Sorry, I’m an economist, it’s our mantra) ----

40

Political science (sic) is rather depressing, --

and actual politics is surely the

Great Dismal swamp!!! 40

Objectives of Tax Reform

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