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25
25.1 Why Fundamental Tax Reform
25.2 The Politics and Economics of Tax Reform
25.3 Consumption Taxation
25.4 The Flat Tax
25.5 Conclusion
Fundamental Tax Reform and Consumption Tax
25
Introduction
In 2011, Republican Presidential candidate hopeful Herman Cain proposed the “9-9-9” plan for fundamental tax reform.
Replaces all current taxes with a 9% corporate tax, 9% personal income tax, 9% payroll tax.
Eliminates all tax deductions.
Example of a “flat tax.”
Eliminates any double taxation of a tax base.
25
Introduction
While popular with the public, however, Cain’s plan was met with opposition on both the right and left of the political spectrum.
Conservatives worried that granting the federal government the right to levy a broad sales tax, which currently is only found at state and local levels, would enable future presidential administrations to enact crippling tax policy.
Liberals objected to the inequitable redistribution of the tax burden that would result from this proposal. Lower-income individuals consume a much higher share of their income than do richer individuals, and the current progressive tax structure would be replaced with flat tax rates on all.
25
Introduction
Although Herman Cain suspended his campaign on December 3rd, 2011, the support for his tax policy illustrated the people’s dissatisfaction with the fundamental structure of the U.S. income tax.
There is no shortage of criticism of the existing income tax: Many claim the tax system is unfair to the poor or to the rich; it is unfair to single people or to married couples; it is too easy to evade, or that the government spends too much time harassing honest taxpayers; that it doesn’t do enough to promote savings or that it provides too many loopholes for savings; and so on.
As a result, fundamental reform of the income tax has become a centerpiece of public debate in recent decades.
25.1
Why Fundamental Tax Reform
Improve tax compliance.
Tax compliance: Efforts to reduce the evasion of taxes.
Tax evasion: Illegal nonpayment of taxation.
Tax avoidance: Legal action to reduce tax burden.
Make the tax code simpler.
Improve tax efficiency.
25.1
APPLICATION: Tax Evasion
The distinction between tax avoidance and tax evasion is often a fine one, but not always.
Stanley S. Tollman hid $100 million in profits from the IRS but eventually paid $105 million in taxes, interest, fraud, and lawsuits.
Once filers had to list Social Security numbers as well as names to claim exemptions for dependents, six million dependents disappeared from the tax rolls.
Greek property taxes are assessed on self-reported value, so in one town only 300 residents report having a pool, while about 20,000 actually have one.
25.1
Theory of Tax Evasion
The theory of tax evasion emphasizes the trade-offs involved:
Save money on unpaid taxes if not caught.
Penalties or jail if caught.
Higher taxes increase the benefit of avoidance without increasing the cost, increasing evasion.
Increased penalties decrease the cost of evasion and therefore reduce it.
C
B
A
Marginal cost and benefit of nonreported income, in dollars
Amount of
nonreported income,
in dollars
0
E1
E2
E3
0.50
$0.60
Effect of increased penalties
Effect of increased tax rate
Marginal cost, MC1
MC2
MB2 (marginal tax rate = 60%)
Marginal benefit, MB1 (marginal tax rate = 50%)
Theory of Tax Evasion
25.1
The marginal benefit of evading taxes is the tax payment saved per dollar of evasion. Optimal evasion occurs when these costs and benefits are equal at E1.
C
B
A
Marginal cost and benefit of nonreported income, in dollars
Amount of
nonreported income,
in dollars
0
E1
E2
E3
0.50
$0.60
Effect of increased penalties
Effect of increased tax rate
Marginal cost, MC1
MC2
MB2 (marginal tax rate = 60%)
Marginal benefit, MB1 (marginal tax rate = 50%)
Theory of Tax Evasion
25.1
If the penalties or odds of getting caught rise, the marginal cost curve shifts left and tax evasion falls from E1 to E2. On the other hand, if the tax rate increases, the marginal benefit curve shifts up and evasion rises from E1 to E3.
25.1
Evidence on Tax Evasion
Tax evasion is pervasive in the United States and around the world.
U.S. “tax gap” between taxes owed and taxes paid is $450 billion, 10.5% of tax revenue.
Similar to Sweden’s 10% in 2008.
Worse in developing countries: 69% tax gap in Pakistan.
Evidence that evasion increases with tax rates, decreases with threats of audits.
25.1
APPLICATION: The 1997 IRS Hearings and Their Fallout For Tax Collection
1997 Senate hearings detailed abuses of taxpayers by the IRS, creating strong pressure for IRS reform.
In 1998, Taxpayer Bill of Rights passed.
But the hearings painted a skewed, possibly deliberately misleading picture of the IRS.
The IRS’s enforcement capacities have been severely impaired by the Bill of Rights, so audits have fallen.
The IRS has identified $30 billion in unpaid taxes, but cannot afford the $2 billion up-front price to collect it.
25.1
Why Should We Care About Tax Evasion
Efficiency
Tax evasion narrows the base, reducing efficiency.
Vertical equity
The wealthy can evade more easily, reducing their tax burden at the expense of poorer Americans.
Especially: horizontal equity
A tax evader with the same income as a non-evader clearly has a lower tax burden.
25.1
Making the Tax Code Simpler
At the end of 2014, the IRS sent taxpaying individuals a packet with instructions for completing their Form 1040. The IRS estimated that it would take about 16 hours to complete the tax forms.
In 2000, tax payers spent 3.2 billion hours and $18.8 billion filling out tax forms, an average of 26.4 hours and $209 per filer.
Reducing exemptions or deductions would simplify the tax code.
But this may increase reporting requirements, with an unclear total impact on simplicity.
25.1
Making the Tax Code Simpler
The number of pages of instructions that come with the basic individual tax form, the 1040. This has risen from 2 pages in 1940 to 207 pages in 2013!
25.1
Improving Tax Efficiency
Efficiency of the tax code depends on elasticity of revenues with respect to the tax rate.
Tax code changes have two effects on revenue:
Direct effect of tax changes: A higher tax rate that raises revenues on a fixed base of taxation.
Indirect effects of tax changes: A higher tax rate that lowers the size of the revenue base on which taxes are levied.
25.1
Indirect Effects of Tax Changes on Efficiency
Tax changes can have four indirect effects:
Gross income effect: A higher tax rate reduces gross income by lowering labor supply, savings, or risk taking.
Reporting effect: For a given level of gross income, a higher tax rate causes people to report less income to avoid additional taxes.
Income exclusion effect: For a given reported income, a higher tax rate causes people to take more deductions and exclusions.
Compliance effect: Finally, higher tax rates may reduce revenues through increased tax evasion.
25.1
Changes in the Tax Base as Tax Rates Rise
When the tax rates rise, Bob reduces earnings, gives more to charity, substitutes health insurance for wages, and stops reporting some income. His taxable income falls. Only 40% more is collected in tax revenues despite doubling the tax rate.
25.1
Evidence on the Revenue Consequences of Higher Tax Rates
A large, growing literature explores how taxable income responds to tax rates.
Central estimate: 4% decline in the base of taxable income for each 10% rise in tax rates.
Most of this response comes from the indirect effects of reporting, income exclusion, and compliance, and not from the indirect effect of gross income earning.
Most, if not all, of this response comes from the rich.
25.1
Summary: The Benefits of Fundamental Tax Reform
Fundamental tax reform helps address all three of the tax reform goals:
Improves tax compliance and tax efficiency by expanding the tax base and lowering tax rates.
Simplifies tax filing by ending many detailed exemptions and deductions, and taxing different forms of income at the same rate.
25.2
The Politics and Economics of Tax Reform
TRA 86 broadened the base and reduced rates, representing a “victory” for tax reform.
But this victory was short lived.
In 1993, top tax rates rose.
1997 Taxpayer Relief Act gave many new credits.
Tax reforms in 2001 and 2003 continued to complicate the tax code.
Why is it so hard to maintain a simple, broad-based tax code
25.2
Political Pressures for a Complicated Tax Code
Political pressures are strongest when the winners are concentrated and have much to gain, and the losers are diffuse and don’t lose much per person.
Continuation of Bush tax cuts would save 3% of Americans $810 billion.
Na ve voters may oppose explicit government spending but support tax expenditures.
Clinton’s educational tax credits.
25.2
Economic Pressures Against Broadening the Tax Base
Any attempt to broaden the base may simply encourage additional tax shelters, undoing the base increase.
Tax shelters: Activities whose sole reason for existence is tax minimization.
Tax shelters have real economic costs but save the shelters’ creator money by reducing her tax burden.
25.2
Economic Pressures Against Broadening the Tax Base
Action Result
Invest $100,000 in oil venture
Sell oil venture for $90,000 Lose $10,000 in value
Deduct $60,000 from income Save $30,000 in taxes
Deduct $10,000 loss Save $5,000 in taxes
Net effect Make $25,000
This tax shelter exploits deductibility of investments and losses to turn a $10,000 loss into a $25,000 gain.
25.2
Transitional Inequities
Because of tax capitalization, eliminating tax shelters can create large transitional inequities.
Tax capitalization: The change in asset prices that occurs due to a change in the tax levied on the stream of returns from that asset.
Transitional inequities from tax reform: Changes in the treatment of similar individuals who have made different decisions in the past and are therefore differentially treated by tax reform.
25.2
APPLCATION: Grandfathering in Virginia
In 2003, Virginia began to transform its tax system.
The reform eliminated the $12,000 annual deduction Virginians 65 or older received on their state income taxes.
To make the law politically palatable, it included a true “grandfather” (and grandmother) clause that exempted current seniors.
25.2
The Conundrum
Political and economic pressures are significant barriers to moving to a broad-based system.
Political forces are constantly pushing for the use of the tax code to deliver benefits to particular groups, at the cost of potentially inefficient and inequitable holes in the tax base.
25.2
APPLICATION: TRA 86 and Tax Shelters
TRA 86 closed many tax shelters.
Politically infeasible to just close the shelters, though it would have increased equity, efficiency, and simplicity.
Instead, distinguished between ordinary income, investment income, and passive income, including tax shelters or real estate income.
Losses from one type cannot offset losses from others.
These changes ended the worst use of tax shelters, but they made the tax code much more complicated.
25.3
Consumption Taxation
Consumption taxation is a radical reform preferred by many economists.
Taxing consumption: Taxing individuals based not on what they earn but on what they consume (such as through a sales tax).
Used by state and local governments, and many governments around the world.
25.3
Consumption Taxation in OECD Nations
Of this set of comparable industrialized nations, the United States raises the smallest share of total national tax revenue from consumption taxation.
25.3
Improved Capital Allocation
The current tax system encourages some kinds of investment over others.
Real estate favored through tax-exempt status.
A particular source of inefficiency in our current tax system is the lack of a “level playing field” across investment choices.
Better allocation improves economic efficiency.
25.3
Consumption Taxes Treat Savers More Fairly and Distorts the Savings Decision Less
Income Tax Consumption Tax Homer Ned Homer Ned
Period 1 Income 100 100 100 100
Taxes 50 26.19 50 50
Consumption 50 26.19 50 25.51
Savings 0 47.62 0 24.39
Period 2 Interest 0 4.76 0 2.44
Taxes 0 26.19 0 1.22
Consumption 50 26.19 0 25.61
PDV of Taxes 50 50 50 51.11
25.3
Consumption Taxes Are Simple
Another advantage of the consumption tax is simplicity.
In principle, it is much more straightforward to simply tax individuals on their purchases than on a complicated definition of income.
25.3
Why Might Consumption Be a Worse Tax Base
Consumption taxes reduce vertical equity.
Rich people save more, so consumption taxes are regressive.
Net lifetime savings are bequests, so an estate tax might help, but estate taxes are very unpopular.
A progressive expenditure tax could correct this, but would introduce other complications.
25.3
Why Might Consumption Be a Worse Tax Base
Differences Between Savers and Non-Savers
Taxing savings might help tax high-ability people.
Transition Issues
Seniors could be devastated by the transition.
Compliance
Harder to measure consumption than income.
Cascading
One business’s output is another’s input, making it difficult to avoid double taxation.
25.3
Designing a Consumption Tax: Value-Added Tax
A value-added tax addresses cascading and compliance.
Value-added tax (VAT): A consumption tax levied on each stage of a good’s production on the increase in value of the good at that stage of production.
VATs are widely used around the world.
Since one firm’s tax burden is another’s tax burden, VATs encourage reporting.
25.3
Value-Added Tax in Practice
Agent Purchase Price Sale Price Value Added Tax Paid (20% VAT)
Logger $0 $25 $25 $5
Manufacturer 25 75 50 10
Retailer 75 100 25 5
Total tax paid 20
When the logger adds $25 in value through producing the wood, she pays $5 in VAT. The manufacturer then adds $50 in value and pays a VAT of $10. Finally, the retailer pays $5 in VAT on her $25 in value added.
25.3
Design a Consumption Tax: Expenditure Tax
An alternative to a VAT is an expenditure tax.
Expenditure tax: A consumption tax levied on yearly consumption rather than on specific sales.
It is straightforward to make an expenditure tax progressive, making the consumption tax system more vertically equitable.
Difficult to track expenditures throughout the year, however.
25.3
Backing into Consumption Taxation: Cash-Flow Taxation
Cash-flow taxation is a third alternative.
Cash-flow tax: A tax on the difference between cash income and savings.
Effectively taxes consumption and can be based on year-end total consumption.
The United States has features of this system, through tax-deferred savings accounts, 401(k)s and IRAs.
25.4
The Flat Tax
Hall and Rabushka proposed the Flat Tax in 1981:
Corporations pay a flat-rate VAT on their sales but deduct wages. No corporate income tax.
Individuals pay a tax on labor income only, not capital income, at that same flat rate.
All tax expenditures would be eliminated and replaced by a single family-level exemption.
VAT-like system, but income tax + exemption makes it progressive.
25.4
Advantages of a Flat Tax
Efficiency gains from having one flat rate on a broad income definition.
Enormous simplicity.
Compliance improvements:
The simpler tax system would make it harder to find ways to evade taxes.
For almost all taxpayers, their entire tax bill could be collected through withholding from earnings.
25.4
Problems with the Flat Tax
The problems with the flat tax are similar to those raised with consumption taxation:
While a flat tax can be made fairly progressive for low- and middle-income earners, it will be much less progressive for high-income earners than our current system.
There are difficult transition issues raised by the flat tax.
25.4
Distributional Implications of the Flat Tax
Income Current Tax Code Hall-Rabushka Flat Tax
$25,000 1.2% 0%
$50,000 6.9 9.5
$100,000 13.0 14.3
$300,000 24.2 17.4
$1,000,000 31.7 18.5
They propose a flat tax rate of 19% and an exemption level of $25,000. For families earning $25,000, the tax burden falls under a flat tax relative to today’s tax system. For most other families earning under $100,000, however, tax burdens rise, while for most families with incomes over $100,000, tax burdens fall.
25.4
APPLICATION: The Camp Tax Reform Proposal
The challenges facing tax reformers were recently illustrated during the debate over the fundamental tax reform proposed by former Congressman Dave Camp of Michigan. Overall recommendation:
Lower tax rates for individuals and corporations while reducing loopholes.
Simplify and condense complicated aspects of the tax code.
25.5
Conclusion
The complications, economic distortions, and redistribution inherent in the U.S. system of income taxation leave many unhappy with the income tax as the nation’s primary source of revenue raising.
Fundamental reform of the income tax is not easy.
Moving to fundamental reform, such as replacing income taxation with consumption taxation or a flat tax, raises difficult issues about the appropriate trade-off between efficiency and equity in our tax code.

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