U.S. Federal Tax Reform: Prospects and Possibilities

James Poterba

MIT & NBER

CCER-NBER Meeting, 26 June 2012

The U.S. “Fiscal Cliff”: 1/1/2013

Expiration of 2001 and 2003 Tax Cuts End of 2011-12 Payroll Tax Relief (2

Percentage Point Reduction: 12.4 to 10.4%) Sequester of Federal Spending Associated

with 2011 Debt Limit “Compromise” JUST BEYOND THE CLIFF: Early 2013 New

Debt Limit Increase is Needed

Expiring 2001 and 2003 Tax Laws

Tax Provision Current Rate “Reversion” Rate

Top Rate on Ordinary Income

35% 39.6%

Other Rates on Ordinary Income

10, 25, 28, 33 15, 28, 31, 35

Rate on Long-Term Capital Gains

15% 20%

Tax Rate on Dividend Income

15% Ordinary Income – Up to 39.6%

Phase Out of Itemized Deductions and Exemptions

Eliminated in Current Law

Will Return

3

Broader Background CBO Projects Deficit Reduction of 5.1% of GDP

(2013 vs. 2012) Under “Current Law”: Growth Drops from 4.4% to 0.5% for 2013

Taxes Rise for 83% of Households (avg $3701) Political Tension over Relative Priority to Assign

to Fiscal Consolidation and Fiscal Stimulus U.S. Long-Term Treasury Interest Rates

Remain at Remarkably Low Levels (1.6% for 10-year Bonds)

Political Economy of Deficit Reduction

Two Leading Options: “Kicking the Can Down the Road”: Near-Term

Agreement that Sidesteps Long-term Issues “Grand Compromise”

Unlikely that Any Sustainable Long-Term Solution will not Involve Tax Reform and Tax Increases

Options for Increasing Tax Revenues Raise Income Tax Rates Broaden the Income Tax Base Raise Other Existing Taxes (Gasoline Tax?) Introduce New Taxes: VAT

Federal Personal Income Tax

2010: Individual Income Tax Revenue = $944.5B (6.5% of GDP)

Tax Credits & Personal Exemption Have Reduced the Fraction of Households Paying Taxes

143M Tax Returns in 2010, 84.5M with Income Tax Liability

Note: Virtually All Wage-Earners Pay Payroll Taxes (7.65% on Workers, Firms)

Federal Income Tax Data, 2010

AGI Level Taxable Returns

Taxable Income

Federal Income Tax

< $30K 23.1% 4.6% 1.7%

$30-50K 22.0 10.0 5.0

$50-100K 33.5 26.4 17.7

100-250K 18.3 30.1 30.0

> $250K(2.73M ret)

3.2 28.8 45.6

Top Income Tax Returns, 2007-10

AGI Level 2007 2008 2009 2010

>$200K 4.520M 4.376M 3.924M 4.258M

> $500K 1.039M 899K 729K ----

> $ 2M 155K 121K 85K ----

Effective Federal Tax Rates: CBOFederal Individual Income Tax Rate

Total Effective Federal Tax Rate

2000 2005 2000 2005

Lowest Quintile -4.6 -6.5 6.4 4.3

Second Quintile 1.5 -1.0 13.0 9.9

Middle Quintile 5.0 3.0 16.6 14.2

Fourth Quintile 8.1 6.0 20.5 17.4

81-90% 11.3 8.7 23.4 20.3

96-99% 18.0 15.2 28.1 25.7

99-99.5 23.1 19.4 31.8 29.7

99.5-99.9 25.2 20.7 33.6 31.2

99.90-99.99 25.6 19.9 34.2 32.1

Top 0.01% 22.1 17.0 32.0 31.5

Revenue Option 1: Raising Top Tax Rates Doubling Tax Collected from Taxpayers with

AGI > $250K Yields About 3% of GDP Doubling Tax for >$1M Yields 1.2% of GDP BUT Reported Taxable Income Would

Decline as Marginal Rates Rise (ETI of 0.3?) Example: Raising τ from .35 to .50 Could

Reduce Taxable Income by 8%: Instead of 43% Increase, Get 32%

Rate Increases Raise Efficiency Cost of Tax System (Square of Marginal Tax Rate)

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“Taxable Income Elasticity” - Amsterdam, 1600s

Revenue Option 2: Broadening the Tax Base Eliminate or Scale Back Deductions (Caps,

Lower Rates, Phase-Outs) Some Policies Would Increase Efficiency Challenges:

Interest Group Politics Current Beneficiaries Don’t Consider these

“Benefits”: 60% of Lifetime Learning Credit and Home Mortgage Interest Deduction Users Say “No Use of Government Benefits”

Cost of Tax Expenditures (% of GDP) Exclusions:

Employer Provided Health Insurance: 1.0% Pension Contributions & Earnings: 0.9%

Deductions: Mortgage Interest: 0.8% Lower Rates on Dividends and Capital Gains: 0.5% State/Local Taxes: 0.3% Charitable Giving: 0.3%

Taxing Employer-Provided Health Insurance (EHI) Effect on After-tax Price Can Exceed 35%

Reduction with Payroll Tax; Affects Demand Firm-Level Responses Matter: Elasticity of

Demand -0.7 (Gruber-Lettau) Including EHI on Individual Tax Returns

Requires Valuing Person-Specific Value of Corporate Insurance Purchases

How to Handle Age- and Location-Related Cost Differences?

Gruber (2011) Estimates of Change in Insurance Coverage from Taxing EHI Currently 156M households with EHI, 49M

without Insurance Estimated Effect with Repeal of Income and

Payroll Tax Exemption: 15M more uninsured Repeal Income Tax Exemption Only: 9M

additional uninsured

Could Imputed Rent on Owner-Occupied Homes be Taxed? Limiting Mortgage Interest Deduction (MID)

vs. Taxing “Imputed Rent” Current MID Reduces Average “Marginal”

User Cost About 7% (Poterba-Sinai) How Could Imputed Rent be Taxed? Set

Rent as Fixed Percentage of House Value? Amount of Net Imputed Rent Depends on

Depreciation Assumption Ultimately Similar to a Property Tax

Distribution of Benefits from Current Tax Treatment of Housing

Income Range User Cost (2003)

< $40K 6.8%

$40-75K 5.9

$75-125K 5.4

$125-250 5.0

$250K+ 4.6

New Revenue Sources

Value Added Tax “Money Machine” vs. Burden on Low-Income

Households 1% VAT Would Yield About $50B/Year (3%

VAT = 1% of GDP) (N.B. Personal Consumption Spending = $10.9T in 2011)

Environmental Taxes 2009 Budget Projected $80B/Year from

Auctioning Greenhouse Gas Permits Gasoline Tax: $1/gallon yields $140B/year

“Efficiency” of VAT (IMF)Country VAT

Efficiency“Policy Gap”

Compliance Gap

France 51% 45% 7%

Germany 54 37 14

Italy 41 44 27

Sweden 55 43 4

U.K. 48 44 15

Retail Gasoline Prices (IEA, 1/12)

Country Retail Price Tax

France $7.54/gal. $4.22/gal.

Germany 7.44 4.44

U.K. 7.83 4.71

U.S. 3.38 0.41

What Lies Ahead?

Politics Will Dominate Economics “Grand Bargain” vs. Incremental Changes Fiscal Consolidations Do Happen