objectives of tax reform
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REFORMING TAXATION: ADVANTAGES OF A SAVING- CONSUMPTION NEUTRAL TAX BASE, AND PRINCIPLES TO GUIDE REFORM Stephen J. Entin Institute for Research on the Economics of Taxation. Neutrality (Growth) Simplicity Fairness Visibility. Objectives of Tax Reform. 2. How to Achieve Objectives. - PowerPoint PPT PresentationTRANSCRIPT
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
Marginal Tax Rates On Estates And Income Contributed To Estates, 45% Estate Tax Rate
81%85%
70%
45%
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
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
Marginal Tax Rates On Estates And Income Contributed To Estates, 55% Estate Tax Rate
87% 90%
80%
55%
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 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
38
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
40