Do we really want a tax system
with a broad base and low rates?
James R. Hines Jr.
University of Michigan and NBER
London
December 9, 2014
The answer, it seems, is obvious.
• Many people think they want a tax system with a
broad base and low rates.
• Why? Low tax rates are attractive. Everybody
likes low tax rates. Low rates mean low burdens.
• Furthermore, is it not the case that an efficient
tax system has low tax rates? Well, no.
• It is certainly inefficient to have an arbitrarily
differentiated tax base with random tax rates.
• But an efficient – and equitable – tax system has
a rather narrow base and rather high rates.
Therein lies the rub.
Haven’t we been told that a broad
tax base is better?
• Yes, we certainly have.
• Robert Murray Haig (1921) and Henry Calvert Simons
(1938) sketched what is now known as Haig-Simons
taxation.
• Haig-Simons taxation is very inclusive taxation: its
taxable income is the sum of consumption expenditure
plus the change in an individual’s net worth.
• Haig-Simons taxation taxes every source of income,
including unrealized capital gains (on your home, for
example) and gift receipts.
• No deductions, credits, or exemptions.
• Simons defended it on the basis of its “aesthetics.”
What have we been told recently?
• Much of the political discourse suggests that we can
solve our fiscal problems by broadening the tax base.
• The common narrative is the following:
▫ There is base erosion attributable to unwarranted tax
breaks for special interests.
▫ Eliminate these tax breaks, and there will be tax revenue to
fund government programs and/or reduce tax rates.
▫ Furthermore, eliminating these tax breaks makes the
economy more efficient by reducing tax-motivated
activities.
• How many unwarranted tax breaks are there in the
United States and the United Kingdom? It is hard to say.
Tax expenditures
• There is something called the “tax expenditure budget.”
• The concept – which dates back to Stanley Surrey 40
years ago – is to measure the extent of special tax
preferences, and treat them as though they were
government spending programs.
• Consider the case of charitable deductions:
▫ If taxpayers are permitted to deduct charitable
contributions from their taxable incomes, the government
implicitly subsidizes charities.
▫ Surrey would treat this as though the government collected
tax without permitting the deduction, then took the money
and spent it directly on charity.
Charitable contributions
• Consider a taxpayer with income of $100,000, who faces a 40
percent tax rate.
• If the taxpayer does not contribute to charity, he pays tax of
$40,000 (40 percent of $100,000), and has after-tax income of
$60,000.
• If the taxpayer gives $10,000 to charity, and is permitted to deduct
the contribution from taxable income, then he has taxable income of
$90,000, and pays tax of $36,000 (40 percent of $90,000).
• The taxpayer then has after-contribution disposable income of
$54,000: $100,000 pretax income minus $36,000 tax minus
$10,000 charitable contribution.
• Contributing $10,000 to charity costs only $6,000 if contributions
are deductible at a 40 percent tax rate.
• The result: the tax system encourages charitable contributions.
• And the tax expenditure budget treats the $4,000 of foregone tax
revenue as a “tax expenditure” by the government.
Other tax expenditures
• There are many other tax expenditures, including…
▫ Child tax credits.
▫ Earned income credits for low-income workers.
▫ Non-taxation of the imputed rental income on owneroccupied housing.
▫ Deferred taxation of value accumulation in employerprovided pension plans.
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What counts as a “tax expenditure”?
Anything that is a deviation from “normal taxation.”
What is that? It is rather in the eye of the beholder.
The notion is that Haig-Simons taxation is a normal tax
system, and any deviation is an expenditure.
Are there many tax expenditures?
• Yes.
• The United States was the first country to produce a tax expenditure
budget, but now many countries do so.
• Since tax expenditures are rather subjective, different countries
define them differently, so the tax expenditure budgets are not quite
comparable.
• It is nonetheless interesting to see how very large these tax
expenditure budgets are.
• And the answer is: large. In the case of the United States, annual
income tax expenditures are about $1.4 trillion, or roughly equal to
the size of total income tax collections.
• It is not quite correct to say that if we eliminated all the tax
expenditures we could cut all tax rates in half, but something close
to that is correct.
Composition of U.S. tax
expenditures
• Most U.S. tax expenditures are tax breaks for
individuals, not corporations.
• The biggest U.S. tax expenditure is the non-taxation of
employer provided health benefits.
• Many of the other large U.S. tax expenditures concern
the taxation of capital income:
▫ Favorable taxation of capital gains.
▫ Favorable treatment of retirement plans.
▫ Favorable treatment of owner-occupied housing.
• The recent growth of tax expenditures is largely
attributable to expanded social programs, such as the
child credit and the Earned Income Tax Credit.
U.S. Income Tax Expenditures
Top 15 US Tax Expenditures, 2015.
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Exclusion of employer provided health care
Capital gains (including owner-occupied homes)
Employer retirement plans
Deductibility of state/local taxes
Exclusion of imputed rental income on homes
Deferral of foreign income
Deductibility of home mortgage interest
Charitable contributions
Exclusion of interest on state/local bonds
Social security for retired workers
Treatment of qualified dividends
Child credit
Exclusion of interest on life insurance saving
Individual retirement accounts
Lifetime learning tax credit
$ 207 billion
$ 158
$ 129
$ 83
$ 80
$ 76
$ 74
$ 57
$ 35
$ 30
$ 27
$ 24
$ 23
$ 17
$ 15
U.S. Tax Expenditure Growth
International comparisons
• As mentioned, it is not really right to compare tax
expenditures across countries, since each defines the
concept differently.
• In addition, it is not right to add the tax expenditures
together, because they interact with each other.
▫ U.S. example: $80 billion for excluded imputed rental on
homes, plus $74 billion for deduction of mortgage interest.
▫ But if we actually taxed the imputed rental income on
homes, we would give a deduction for mortgage interest.
• That said, it is of course interesting to do some
international comparisons.
• Countries seem to differ, with the U.K. possibly a world
leader in tax expenditures.
• Note: relatively little goes to specific industries.
Numbers of Tax Expenditures
Income Tax Expenditures
All Tax Expenditures
Income Tax Expenditures
Advantages of reducing or
eliminating tax expenditures.
• Generates revenue that can be used to reduce tax
rates.
• Reduces economic distortions attributable to some
activities receiving favorable tax treatment.
• Produces a more equitable distribution of tax
burdens.
• Prevents governments from excessive meddling in
the private affairs of its citizens.
• It would indeed be remarkable for a single set of
potential tax reforms to produce so many
advantages.
Costs of reducing or eliminating
tax expenditures.
• Produces a less equitable distribution of tax burdens.
• Makes the economy less efficient.
• Therefore makes it harder to raise revenue. It is very
difficult for governments to impose taxes that are
inefficient and widely viewed as inequitable.
• If the United States were to adopt a Haig-Simons income
tax, the only tax policy role of Congress would be to
choose tax rates.
• Should we worry about what Congress might do with all
the extra time?
Equity and U.S. tax expenditures.
• The United States offers a child tax credit, which reduces
the tax burdens of families with children compared to
otherwise-similar families without children.
• Is that a good thing to do? The political system has
decided that it is.
• And it is certainly true that a family with two children
and an income of $50,000 is less well-off than a family
without children and an income of $50,000.
• People choose to have children, so should we permit
them to have a tax reduction on this basis?
• Reasonable minds might differ on this question, but the
majority feels that the answer is yes.
More tax expenditure equity.
• The United States offers a casualty loss deduction.
• Taxpayers can deduct losses (above a minimum amount)
from fire, theft, storms, shipwreck, etc. from their
taxable incomes.
• Example: your employer pays you $500 (gross) at the
end of the week.
• You take the check to the bank, ask for cash, and on the
way out of the bank are robbed at gunpoint (this
happens all the time in America; have you seen the
movies?)
• You are permitted to deduct the theft loss from taxable
income, so need not pay taxes on the wages.
• But this deduction is considered a “tax expenditure.”
Are all tax expenditures of this ilk?
• There is enormous variation.
• Many tax expenditures have the effect of reducing the taxation of
capital income.
• If I loan you $100 for a year, and you pay me $5 interest, I get to
spend $105 next year in return for waiting.
• Is it equitable to tax me on the $5?
• All that has happened is that you consumed the $100 this year
instead of me, and the $5 is the amount you are willing to pay (and I
am willing to accept) for the deal.
• Many argue that it is equitable not to tax the payment for waiting to
consume. There is extensive debate over this question.
• The issue of whether or not to tax capital income is entirely separate
from the issue of how progressive to make a tax system; a tax system
that does not tax capital income can be made very progressive,
indeed possibly more progressive, than a tax system that does.
Tax expenditures and efficiency.
• Would eliminating all tax expenditures make the
economy more efficient?
• Surely not.
• The most inefficient taxes are thought to be those on
capital income, because such taxes compound over time
and across income sources.
• At an interest rate of 5%, a 40% tax rate reduces the
after-tax rate of return to 3%.
• This reduces the total return on a 25-year investment
from 239% (pretax, at 5%) to 109% (after tax, at 3%),
which is a wedge of 54 percent.
• In addition to discouraging saving and investing, capital
income taxes discourage labor supply directed at earning
income to be saved for later consumption.
More efficiency.
• But would it make the tax system more efficient to eliminate, say,
the charitable deduction and use the additional tax revenue to lower
statutory tax rates?
• No; not if the charitable deduction is there for a (good) reason.
• Consider the taxpayer in a 40 percent tax bracket who gives 10
percent of his income to charity.
• He is now effectively taxed at 36 percent on his labor income,
bearing in mind that he will devote some of it to charity.
• If the government were to eliminate the charitable deduction and
reduce the top tax rate to (say) 38 percent, then the tax rate on this
taxpayer’s marginal labor income would actually go up.
• The actual effects will vary across taxpayers, but the general point is
that incentives to earn income depend not only on the statutory tax
rate, but also on deductions, credits, and other tax benefits
associated with what one plans to do with additional income.
Marginal tax rates.
• There is a much broader point: that a revenue-neutral
tax reform MUST increase some marginal tax rates.
• It is tempting to think that a revenue-neutral tax reform
that eliminates some tax deductions or credits, using the
additional revenue to reduce statutory tax rates, creates
greater incentives to earn income.
• But this is wrong. Why?
• Because it is IMPOSSIBLE to reduce some marginal tax
rates, leave others unchanged, and still have a revenueneutral tax reform. Reducing marginal rates means that
you get less tax revenue (except in the very unusual case
that tax rates are above the peak of the Laffer curve).
Other efficiency considerations
• Activities that create significant benefits for others, and
are therefore otherwise undersupplied, are good
candidates for favorable tax treatment.
• These are “Pigouvian subsidies.” Examples:
▫ Tax deduction for charitable contributions.
▫ Research tax credits.
• The flip side is that activities that create significant
harms to others, and are therefore otherwise
oversupplied, are good candidates for additional
taxation. These are “Pigouvian taxes.” Examples:
▫ Taxes on environmental pollutants.
▫ The London congestion charge.
• This leads to a highly differentiated tax system, a stark
departure from Haig-Simons taxation.
Efficient and inefficient taxation
• All taxation is inefficient:
▫ Income taxation discourages income production.
▫ Corporate income taxation discourages investment.
▫ Value added taxation discourages production of value
added.
• The challenge is to find the most efficient way of raising
revenue with a fair distribution of burdens.
• It is particularly inefficient to offer arbitrary tax benefits
to selected individuals, industries, and activities, if that is
what tax expenditures do. (Is that what they do?)
• But there is no presumption that all income should be
taxed at the same rates. The inevitable distortions are
minimized by taxing some activities, and some
individuals, at lower rates than others.
What else?
• Highly elastic economic activities – those that respond
most sharply to taxation – should be taxed at lower rates
than less elastic activities.
• For example, tax rates on international commerce are
optimally lower than tax rates on less-elastic domestic
activities.
▫ Put a heavy tax on international shipping and it just sails
away.
• Similarly, different individuals should be taxed to
differing degrees.
Efficient income taxation.
• Efficient taxation entails “tagging”: adjusting tax
burdens, and tax rates, to individual situations, rather
than applying the same system to everyone.
• For example, a 30-year-old usually has greater earning
potential than a 70-year-old, so the tax system might
offer extra breaks to 70-year-olds.
• We do this for two reasons:
▫ The 70-year-olds are poorer.
▫ Income production by 70-year-olds may be more responsive to
taxation: they can retire and spend down their savings.
• As a general matter, adjusting tax burdens by age makes
the system better tailored.
• But age-specific tax breaks can be described, and are
usually crafted to look like, narrowing the tax base.
Efficient taxation (2).
• Age is just one example.
• Efficient taxation uses information beyond
reported income to adjust tax burdens.
• Taller people earn more than shorter people;
men earn more than women; college graduates
earn more than others.
▫ These are no more than average tendencies.
▫ Is it right to adjust tax burdens on the basis of
criteria such as these?
▫ It has been shown that efficiency improves if the
system (properly) treats taxpayers differently.
Another example: business meals
• Should the costs of business meals be deductible?
• Yes, if they are really business expenses; no, if they are personal
expenses.
• Taxpayers differ in the extent to which these meals are work v.
pleasure.
• The tax system applies a single rule (US: 50 percent deductible),
which is usually wrong (in both directions).
• How should the rule be chosen? It should be sensitive to the extent
to which it creates incentives for too many, or too few, business
meals. This is a function of whether those who like, or hate,
business meals are more apt to vary their behavior in response to
tax incentives.
• Note: there is no presumption that reducing or eliminating the
business meal deduction enhances efficiency. Efficiency requires
balancing the costs of too many and too few tax deductions for
business meals.
Four reasons to deviate from
comprehensive income taxation.
• Tailoring taxes to individual situations (e.g., child tax
credit or age-based taxes).
• Imposing taxes on less-elastic activities and not on
highly elastic activities (e.g., exemption of foreign
income of multinational firms).
• Avoiding tax compounding (e.g., favorable tax treatment
of pensions and other saving for retirement).
• Pigouvian subsidies for efficiency-enhancing activities
(e.g., research tax credits).
Can politicians handle tax complexity?
• Some feel that it is better to stick with the story line that a broadbased, low-rate tax system is better than the alternatives.
• The concern is that once we acknowledge the truth that efficient
taxation is highly differentiated, it will be open season for special
interests to claim that they are (all) worthy of favorable tax
treatment.
• If the political process delivers tax breaks to special interests that
lobby effectively, the product can be a very inefficient tax system.
• There is another possibility: that the political system works
reasonably well, and that major tax reforms that lower rates and
broaden tax bases are customarily followed by higher tax rates and
more narrow bases because the tax system is actually better that
way.
• Do it really improve policy to push a line that is inconsistent with
the theory of taxation as we understand it?
U.S. Income Tax Expenditures
How taxpayers feel
• Voters say they want:
▫ Tax simplicity. Makes the system easier to understand, and
prevents others from getting unwarranted tax breaks.
▫ Lower tax rates.
• But that said, many specific tax breaks (in the US,
owner-occupied housing; charitable contributions;
employer provided health care and pensions; state/local
taxes;…) have considerable political appeal.
• Governments need revenue, and it is never going to be
popular to get that revenue through taxation.
• But our history suggests that governments are aware of
the need for tax policies that are sensitive to individual
situations and economic conditions.
Where does this leave us?
• There is no principle of efficiency or (non-tautological) equity that
implies that the best tax system taxes a very broad definition of
income at relatively low rates.
• Far from it: the prevailing theory is that taxation should be highly
differentiated and individualized. The most efficient and equitable
system has a relatively narrow tax base with relatively high tax rates.
• Proposals (and there are some) to cap all tax deductions, or reduce
all tax deductions by a fixed fraction (say, by letting people claim
only 80 percent) look odd through this lens.
• The truth is messy, good policy is messy, and we have no choice but
to rely on governments to make it for us.
• That they have done so with many tax credits, deductions, and
exemptions is not necessarily a bad thing. These governments may
have much clearer appreciation of the nature of the tax problem
than that with which we often credit them.