Americas Changing Role in the World Economy

Why We Need Tax Reform and Why We Probably Wont Get ItRobert Coen

Professor Emeritus of EconomicsNorthwestern University

Womans Athletic ClubChicago, ILJanuary 23, 2013

The Changing Personal Income TaxSingle Taxpayer 1st bracket Top bracket Number of ------------------------- ---------------------------YearBracketsRateIncome

19552420%$16,74591%$1,674,475

1988215%33,85628%33,856

2007610%8,46835%378,435Income levels are adjusted for inflation and stated in 2011 dollars.

In each of these years, tax revenue = 9.7% of personal income

Source: The Tax Foundation

Effective Personal Income Tax Rates by Household Income, 2007AverageShare ofIncomeEffectivepre-taxpre-taxShare ofquintiletax rateincomeincometaxesLowest-6.818,4004-3

Second-0.442,50080

Third3.364,500135

Fourth6.294,1001913

Highest14.4264,7005686

All9.396,000100100

Top 1%19.01,873,0001940

Source: Congressional Budget Office

Why Are Effective Rates Much Lower Than Statutory Rates?Some types of income not subject to tax:Employer-provided health insuranceContributions to retirement programsInterest on state-local bonds

Basic income level exempted from tax:Personal exemptionsStandard deduction

Some uses of income deductible:Charitable contributionsMedical expensesState-local income, property taxes

Tax credits for some uses of income:Energy-efficient windows, appliances, heating

Refundable tax credits =negative tax:Earned income tax credit (1975)Child tax credit (1998)

Some types of income taxed lightly:Capital gainsShortcomings of Tax LoopholesHidden form of spending tax expendituresAlternative is direct expenditure (subsidy),regularly reassessedOpen-ended costDifficult to get rid of, may outlive usefulness

Incentive effects vary (undesirably?) across taxpayers

Invite creative behavior to avoid taxesConvert ordinary income to capital gainSubstitute home equity loan for other consumer borrowingAbuse and verification issues

Erosion of tax base requires higher, distorting tax rates

Waste of (limited!) human talent in legal and accounting professions

Direct Spending and Tax Expenditures by Category, 2011Billions of dollarsDirectTax

National Defense and Veterans Benefits832.813.1International Affairs45.736.3General Science, Space, and Technology29.510.3Energy, Natural Resources and Environment57.713.3

Agriculture, Commerce and Housing8.1418.3Transportation93.06.0Community and Regional Development23.84.3Education, Training, Employment, Social Services101.2167.7

Health and Medicare858.2202.6Income Security597.4198.4Social Security730.831.0General Government 25.572.8

Total outlays 3,603.11,175.5

Sources: Office of Management and Budget, Joint Committee on TaxationStrengths of Tax Loopholes Allow private preferences to allocate subsidies

Income Tax Reform of 1986GoalsReduce tax rates to improve economic efficiency and growthMaintain tax revenue by eliminating some tax expenditures Personal TaxReduced number of brackets from 15 to 2Reduced top rate from 50 to 28 percentEliminated deduction for interest paid, except on home mortgagesEliminated deduction for state-local sales taxesEliminated favored rates for long-term capital gains

Corporate TaxReduced top rate from 46 to 34 percent Repealed tax credit for equipment investmentTightened depreciation rules

Undoing of 1986 Reforms1991Top personal rate raised from 28% to 31%, Brackets increased from 2 to 31993Top rate personal rate raised to 39.6%Brackets increased from 3 to 5 Top corporate rate raised to 35%Capital gains rate reduced to 28%1997Refundable child tax credit of $500 Capital gains rate reduced to 20%2001 Personal rate to fall gradually from 39.6% to 35% Brackets to increased from 5 to 6 Child credit raised to $1KEstate tax reduced, to be eliminated in 20102003 Accelerated reductions in top rates Dividends and KG rates reduced to 15%

Numerous grants of accelerated depreciationNumerous new tax credits biofuels, etc. Alternative Proposals for Tax (Re)ReformRomney: Personal tax cuts1st bracket from 10% to 8%Top bracket from 35% to 28%Eliminate taxes on capital income Reduce corporate rate from 35% to 25% Pay for by eliminating unspecified tax expenditures TPC estimated 2015 cost at $480b

Estimated Cost of 10 Largest Personal Tax ExpendituresBillions of dollarsAnnual average2010-14

Exclusion of employer contributions for health care131.9Deduction of mortgage interest96.8Reduced tax rates on capital gains and dividends80.6Exclusion of pension contributions defined benefit plans60.6Earned income credit53.8

Deduction of state-local taxes47.5Exclusion of pension contributions defined contribution plans42.4Exclusion of capital gains at death38.4Deduction of charitable contributions36.5Exclusion of untaxed social security and railroad retirement34.6

Total of largest 10 623.1

Source: U.S. Congress, Joint Committee on TaxationEstimated Cost of 10 Largest Corporate Tax ExpendituresBillions of dollarsAnnual average2010-14

Deferral of income of controlled foreign corporations14.1Exclusion of interest on state-local debt9.1Deduction of income from domestic production activities8.6Inventory property sales source rule exception7.6Accelerated depreciation of equipment7.4

Inclusion of income from business debt discharged by reacquisition5.8Tax credit for low-income housing5.4Expensing of R&D expenditures5.1LIFO inventory accounting4.0Reduced tax rate for first $10mil of taxable income3.2

Total of largest 10 70.3

Source: U.S. Congress, Joint Committee on Taxation

Alternative Proposals for Tax (Re)ReformObamas Deficit Commission (Simpson-Bowles, Dec. 2010):Reduce personal rates to 12%, 22%, 28%Cut corporate tax cut to 28%Pay for by:Taxing dividends and capital gains like other incomeEliminating personal and corporate tax expenditures, except:Child and earned income creditsMortgage interest (within limits)Employer-provided health insurance (with cap)Charitable giving (>2% of income, 12% refundable creditExclusion of state-local bond interestRetirement savingsIncreasing gas tax to 15 per gallon

Alternative Proposals for Tax (Re)Reform Simply reduce or eliminate specific tax expendituresUse increased revenue to reduce budget deficit

Adopt a flat taxPopular with conservatives, e.g., Steve Forbes, Paul RyanSingle rate for individuals and businessesSimplified base for each Ultimate in simplification postcard tax return

The Postcard Tax Return for IndividualsSee The Flat Tax, by R. Hall and A. Rabushka

The Postcard Tax Return for BusinessesSee The Flat Tax, by R. Hall and A. Rabushka

Flat Tax Is a Consumption Tax, Not an Income Tax!Sources of income:Wages and salariesGross capital incomeGross business revenue wages and salaries purchasesUses of income:ConsumptionInvestment

Wages and salaries + Gross capital income Investment = Consumption Base of personalBase of business flat tax flat tax

Should we have a consumption tax?More popular form is value-added taxConsumption tax is regressive need to consider entire tax system Effective Federal Tax Rates by Household Income, 2007PersonalSocialCorporateAllIncomeIncomeInsuranceIncomeExciseFederalQuintileTaxTaxesTaxTaxesTaxes

Lowest-6.88.80.41.64.0

Second-0.49.50.51.010.6

Third3.39.40.80.814.3

Fourth6.29.51.10.717.4

Highest14.45.74.60.425.1

All9.37.43.00.620.4

Top 1%19.01.68.80.129.5Source: Congressional Budget Office

Impact of All Federal Taxes on the Distribution of Household Income, 1979 and 2007

Income19792007 QuintilePre-TaxAfter-TaxPre-TaxAfter-TaxLowest6745

Second111289

Third16171314

Fourth22221920

Highest45425653

Top 1%981917

Source: Congressional Budget Office

Why Is Tax Reform So Difficult?Its really expenditure reform, tax expenditures become entrenched

Growing income inequality leads to more lobbying for tax expendituresLegislators prefer to hide subsidies in lost revenue

Many tax expenditures support worthy goals child care, reduction of poverty, education, energy conservation, research, risk taking

Emphasis on reducing tax rates is out of touch with fiscal needs Taxes as Percent of GDP, 2010Denmark48 Sweden46 Italy43 Norway43 France43 Netherlands39 Germany36 UK35 Canada31 Switzerland28 Japan28 US25 Source: OECD Annual GDP Taxes as Growth Rate Percent of GDP 20001-11 2010Sweden2.446 Canada1.931 Switzerland1.828 UK1.735 US1.625 Norway1.543 Netherlands1.339 France1.243 Germany1.236 Denmark0.748 Japan0.628 Italy0.443 Source: OECDEND