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FUNDAMENTAL TAX REFORM:
TAXES ON CONSUMPTION AND WEALTH
Chapter 21
How a Value-Added Tax Works
Producer Purchases Sales Value Added VAT at 20 Percent Rate
Farmer $ 0 $400 $ 400 $ 80
Miller 400 700 300 60
Baker 700 950 250 50
Grocer 950 1,000 50 10
Total $2,050 $3,050 $1,000 $200
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Efficiency and Equity of Personal Consumption Taxes
Efficiency issues
An income tax and saving and labor supply decisions
A consumption tax and saving and labor supply decisions
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Efficiency and Equity of Personal Consumption Taxes
Equity issues
Progressiveness
Ability to pay
Annual versus Lifetime Equity
A numerical example
A formal model
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Annual versus Lifetime Equity – A Numerical Example
Parameters
Income tax rate = 50% Consumption tax rate = 50% Interest rate = 10% Mr. Grasshopper Ms. Ant
Income tax Consumption tax Income tax Consumption tax
Income period 0 $1,000 $1,000 $1,000 $1,000
Consumption period 0 $500 $500 $0 $0
Taxes period 0 $500 $500 $500 $0
Income period 1 $0 $0 $50 $100
Consumption period 1 $0 $0 $525 $550
Taxes period 1 $0 $0 $25 $550
Present Value of taxes paid $500 $500 $523 $500
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Annual versus Lifetime Equity – A Formal Model
Parameters Income tax rate = t Consumption tax rate = tc Interest rate = r Income Tax
Mr. Grasshopper Ms. Ant
Income period 0 I0 I0
Consumption period 0 c0G c0A
Taxes period 0 tI0 tI0
Income period 1 r(I0 – c0G) r(I0 – c0A)
Taxes period 1 tr(I0 – c0G) tr(I0 – c0A)
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Annual versus Lifetime Equity – A Formal Model
Parameters
Income tax rate = t
Consumption tax rate = tc
Interest rate = r Consumption Tax
Mr. Grasshopper
Ms. Ant
Present Value of Lifetime Income I0 = c0G + c1G/(1 + r) I0 = c0A + c1A/(1 + r)
Present Value of Lifetime Tax Liability RcG = tcc0G + tcc1G/(1 + r) =
tcI0 RcA = tcc0A + tcc1A/(1 + r) =
tcI0
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Retail Sales Tax
General sales tax
Percent of own-source revenue from sales taxes
State: 34.7%
Local: 10.0%
Selective sales tax (excise tax or differential commodity tax)
Forms of a sales tax
Unit tax
Ad valorem tax
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Rationalizations for Sales Taxes
Ease of administration
Defining the tax base
Tax evasion
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Efficiency and Distributional Implications of States Sales Taxes
Differential versus uniform tax rates
How to set rates
Efficiency goal only
Equity goal
Externalities
Sales taxes as substitutes for user fees
“Sin” taxes
Information requirements for differential tax rates
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A National Retail Sales Tax
Arguments in favor
Simplicity
Ease of compliance
Arguments Against
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Value-Added Tax
How a value-added tax works
VAT as an alternative method for collecting retail sales tax
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Implementation Issues
Treatment of investment assets
Consumption-type VAT
Collection procedure
Invoice method
Rate structure
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A VAT for the United States
Desirability of VAT depends on…
What tax (or taxes) it will replace
How revenues will be spent
Political implications of VAT’s revenue raising prowess
International implications
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Hall-Rabushka Flat Tax
Business tax
Tax base = Sales – purchases from other firms – payments to workers
Pay flat tax rate on final amount
Individual Compensation tax
Tax base = Payments received by individual for their labor services
No additional deductions
Apply selected tax schedule
Why is H&R tax a consumption tax
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Cash-Flow Tax
How a cash-flow tax works
How to compute annual consumption
Cash-flow basis
Qualified accounts
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Income versus Consumption Taxation
No need to measure capital gains and depreciation
Fewer problems with inflation
No need for separate corporation tax
Administrative problems
Transitional issues
Gifts and bequests
Advantages
Disadvantages
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Problems with Both Systems
Defining consumption
Choosing the unit of taxation
Choosing the rate structure
Valuing fringe benefits
Determining method for averaging over time
Taxing home production
Discouraging incentive to participate in underground economy
Real world versus ideal tax systems
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Wealth Taxes
Justifications for taxing wealth
Large accumulations of wealth should be taxed
Correct problems with administration of income tax
Higher wealth implies higher ability to pay
Reduces the concentration of wealth
Payment for benefits received from government
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Estate and Gift Taxes
Rationales
Payment for services
Reversion of property to society
Incentives
Recipient versus donor behavior
Work
Saving
Form of bequest
Relation to personal income tax
Income distribution
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Gross Estate
All decedent’s assets at time of death, including real property, stocks, bonds and insurance policies, plus gifts made during decedent’s lifetime
Typically valued at market value at date of death; valuation may be set 6 months later if value of estate declines
Closely held businesses and farms are valued at “use value.”
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Provisions of the Unified
Transfer Tax
Gross Estate
Charitable Contributions
Funeral Expenses
Costs of Settling Estate (lawyer’s fees)
Outstanding Debts
Lifetime Exemption
Qualified Transfers to Spouse
Annual Gift Exclusion
Taxable Estate
* tax rate
Tax
0
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Problems & Potential Reforms
Problems with Estate and Gift Taxes
Policy Perspective: Death of the Death Tax
Jointly held property
Closely-held businesses
Avoidance strategies
Insurance trust
Gifts of stock
Reforming Estate and Gift Taxes
Integrate with personal income tax
Accessions tax
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Chapter 21 Summary
Arguments for substituting the income tax with a personal consumption tax include the elimination of double taxation, promotion of lifetime equity, promotion of efficiency, adjustability for progressiveness and administrative ease.
Arguments against the substitution point out that it has transition problems, it violates the of ability-to-pay rule, it is administratively burdensome, it can lead to excessive concentration of wealth, and it is regressive in nature
Sales taxes are important sources of revenues for state and local governments
The VAT is popular in Europe but not used in the U.S.
Wealth taxes are controversial. They are not a major source of revenue and little is known about the incentive effects or incidence of these taxes
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