Advantages of a Saving-Consumption Neutral Tax Base

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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
Objectives of Tax Reform
 Neutrality (Growth)
 Simplicity
 Fairness
 Visibility
2
How to Achieve Objectives
 Choose a better tax base.
 Consumption versus Income.
 (Better put: a Neutral Tax Base vs.
Income.)
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 a Net Concept
Income is revenue less the cost of
earning revenue.
Deductions for costs are necessary
to measure income properly.
5
Saving Is a Cost of Earning Income
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.
6
Neutral Taxes:
 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.
7
By Comparison the Income Tax:
 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).
8
Effect of Tax On Desired Capital Stock
Return to Capital
Gross Return
Tax
Required Return to
Capital (Supply)
Net Return
Drop in Capital
Marginal Product of
Capital (Demand)
K1
K0
Desired Amount of Capital
9
Effect of Tax On Labor
Wage
Labor
Supply
Gross Wage
Marginal Product
of Labor
(Demand)
Tax
Net Wage
Drop
in
Labor
L1
MPL would rise
if labor had
more capital to
work with, and
fall if capital
formation
lagged.
L0
Hours Worked
10
Taxing Capital Income Hurts Workers
 Savers can always switch to consumption,
which is nice for them.
 But when they do, investment slumps, and
workers lose their jobs.
11
Wage
A Smaller Stock Of Capital Reduces Wages
Labor
W0
MPL (K0)
W1
MPL (K1)
N1
N0
Employment
12
Multiple Taxation of Saving
One Tax on Consumption, Four Taxes on Saving
Layer 1– Initial tax on Earnings
Income 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 Saving
If 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 Tax
If 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) Tax
Another tax on already-taxed assets.
(Similar taxes at the state and local levels increase the multiple taxation.)
13
Steps Toward a Fair, Flat,
Unbiased Neutral Tax
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.
14
Step 1. Treat Saving and Investment
as a Cost of Earning Income
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.)
15
Neutral Tax Effect on Saving Vs. Consumption;
Contrast With Ordinary Income Tax
Tax Treatment
No Tax
Sales Tax
Income Tax
$100
$100
$100
0
If spent: 20
If saved: 0
Saved or spent: 20
Amount spent or saved
100
If spent: 80
If saved: 100
80
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
0
40
0
200
160
140
2 to 1
2 to 1
1.75 to 1
Pretax earnings to be
spent or saved
Tax on spending
Tax due on future
spending
After-tax spendable
balance
Ratio of saving to spend
later to spending now
Illustration assumes 7.2% pre-tax interest rate, 25% sales tax rate, 20% income tax rate.
16
Equivalence Of Saving Deferred And Returns Exempt Tax
On Saving; Contrast With Ordinary Income Tax
Saving Deferred
Returns Exempt
Ordinary Income
Tax
$100
$100
$100
Tax on saving
0
20
20
Amount saved
100
80
80
No, 7.2%
reinvested
No, 7.2%
reinvested
Yes, 5.76%
reinvested
Account after 10 years
200
160
140
Tax due on withdrawal
40
0
0
160
160
140
(same as sales tax)
(same as sales tax)
20 (= 160 – 140)
(1/3 of the interest)
Tax Treatment
Pretax earnings to be
saved
Is interest on inside buildup taxed?
After-tax spendable
balance
Cost to saver of ordinary
vs. neutral tax treatment
Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment.
16
Advantage Of Tax Deferred Saving
Over Ordinary (Biased) Tax Treatment:
Build-up Of $1,000 Saved per Year
$450
$400
Tax
Deferred
$350
Assets (thousands of $)
Tax-advantaged
saving in an
IRA, 401(k), or
pension yields
about two-thirds
more income in
retirement than
ordinary saving!
$300
$250
$200
$150
$100
Ordinary
(Biased)
Tax Treatment
$50
$0
20
25
30
35
40
45
50
55
60
65
70
Age
Saving from age 20 onward, under tax-deferred system and ordinary "double
taxation" (assume 7.2% interest rate, 20% tax rate).
17
Present Value of Current Law Capital Consumption Allowances per
Dollar of Investment Compared to Expensing (First-Year Write-Off)
Asset lives:
3
Yrs
5
yrs
7
yrs
10
yrs
15
yrs
20
yrs
27.5
yrs
39
yrs
Present value of firstyear write-off of $1 of
investment:
$1.00
$1.00
$1.00
$1.00
$1.00
$1.00
$1.00
$1.00
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
Present value
of current law
write-off of $1
if inflation
rate is:
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
Step 2. End Double Taxation of
Corporate Income
 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.
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
$0.13
$0.2574
$0.0975
(tax @ 20%)
(tax @ 39.6%)
(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
4) Individual income tax at top rate
(retained earnings as capital gain,
dividends as ordinary income)*
* 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
Step 3. Kill the “Death Tax"
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.
21
Marginal Tax Rates On Estates And Income
Contributed To Estates, 35% Estate Tax Rate
100%
90%
78%
Marginal Tax Rate
80%
73%
GST
70%
GST
60%
58%
50%
GST
40%
Estate Tax
35% *
Estate Tax
Payroll Tax
State Income Tax
State Income Tax
Federal
Income
Tax
Tax on a Dollar
of Wages (self-employed)
Left in an Estate
30%
20%
Estate Tax
Estate Tax
Federal
Income
Tax
Estate Tax
Estate Tax and
Generation
Skipping Trust
Tax on a Dollar
of Interest
Left in an Estate
10%
0%
* 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
22
Marginal Tax Rates On Estates And Income
Contributed To Estates, 45% Estate Tax Rate
100%
90%
85%
81%
Marginal Tax Rate
80%
GST
70%
70%
60%
50%
GST
Estate Tax
GST
Estate Tax
45% *
Payroll Tax
40%
State Income Tax
State Income Tax
30%
Estate Tax
Estate Tax
Federal
Income
Tax
Federal
Income
Tax
Estate Tax
Estate Tax and
Generation
Skipping Trust
Tax on a Dollar
of Interest
Left in an Estate
Tax on a Dollar
of Wages (self-employed)
Left in an Estate
20%
10%
0%
* 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.
23
Marginal Tax Rates On Estates And Income
Contributed To Estates, 55% Estate Tax Rate
100%
87%
90%
Marginal Tax Rate
GST
70%
60%
GST
80%
80%
GST
Estate Tax
55% *
Estate Tax
50%
Payroll Tax
40%
30%
90%
Estate Tax
State Income Tax
State Income Tax
Federal
Income
Tax
Federal
Income
Tax
Tax on a Dollar
of Interest
Left in an Estate
Tax on a Dollar
of Wages (self-employed)
Left in an Estate
Estate Tax
20%
10%
0%
Estate Tax
Estate Tax and
Generation
Skipping Trust
* 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.
22
Four Types of Neutral Taxes:
 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).
28
Elements of Neutral Taxes
 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.
29
Why it Matters
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 nongrowth-related rebates, nothing good has
happened.
25
Tax Reform
The Good, the Bad, and the Ugly
 JFK
 ERTA 1981(+TEFRA’82&DEFRA’84)
 Tax Reform Act of 1986
 Bowles-Simpson Deficit Commission
 Wyden-Coats
35
Change in GDP Due To Tax Law Changes During
Presidential Administrations
12%
10.2%
10%
8.0%
7.7%
8%
6%
4%
2.8%
1.2%
1.0% 1.0%
2%
0%
-0.9% -0.5%
-2%
-2.1%
-4%
-3.2%
-3.4%
Fo
rd
C
ar
te
R
r
ea
ga
n
R
(I)
ea
ga
n
(II
G
H
)
W
B
us
C
h
lin
to
n
(I)
C
lin
to
n
(II
G
)
W
B
us
h
O
ba
m
a
on
N
ix
n
so
hn
Jo
K
en
ne
dy
-6%
Source: Calculations by author
1,100
340
1,050
320
1,000
950
2002 Tax
Cut
2003 Tax
Cut
2001
Tax
Cut
300
Equipment
and Software
<-- Left Axis
280
260
900
240
Nonresdidential
Structures
Right Axis -->
850
800
2000
220
200
2001
2002
2003
2004
2005
Quarter
Data Source: BEA, National Income and Product Accounts, Table 5.3.6, accessed via www.bea.gov.
Billions of Dollars (2000 $)
Billions of Dollars (2000 $)
Real Private Investment
And 2001, 2002, and 2003 Tax Cuts
Wyden-Coats: Percentage Change
In GDP By Provisions And For Total Bill
1%
0.66%
0%
-0.37%
-1%
-1.40%
-2%
-3%
-3.20%
-4%
-4.32%
-5%
Indiv Rate
Bracket
and Std
Deduction
Changes
Corporate
Rate and
Cap Gain/
Dividend
Changes
Depreciation
Change
Interest
Deduction
Limitation
Combined
Effect
45
8
Top Tax Rate on
Long-Term Gains
40
35
7
6
30
5
25
4
20
3
15
2
10
Realized Gains as
Percent of GDP
5
0
1975
1
Realized Gains as Percent of GDP
Maximum Tax Rate on Long-Term Gains
Capital Gains Realizations Rise When The Maximum
Tax Rate on Long-Term Gains Falls, 1976 - 2007
0
1980
Data from U.S. Treasury
1985
1990
1995
2000
2005
Year
27
Recap
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 government so that they can make informed decisions
about how much government activity to support.
 Cut spending to pay for it. THWRN,TBWSECTR
34
Objective: Neutrality/Growth
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.
30
Objective: Simplicity
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.
31
Objective: Fairness
 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.
32
Objective: Visibility
 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.
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
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