Tax reform State and local governments

1. Tax reformState and local governments Today: Some ideas on how to reform taxes; How do state and local governments affect behavior?

2. Today • More topics that affect behavior • Can taxes be reformed so as not to distort behavior as much? • How do state and local governments affect everyday lives?

3. Tax reform • Economic waste due to taxation is estimated to be as much as $1 trillion per year • Note that $1 trillion is about 8% of annual GDP • How can this be changed?

4. Tax reform • Current tax codes seriously distort behavior • People work less (labor tax) • Sub-optimal investment decisions (lock-in effects due to the capital gains tax) • Some people advocate a tax system that reduces waste

5. What about a consumption tax? • Taxes on consumption have some appeal • Vary tax rates based on externalities • Encourage consumption of goods and services with positive externalities • Discourage consumption with negative externalities • Progressiveness issue is probably not justified • Lifetime sales taxes paid (as a % of lifetime income) is about the same for each income bracket • Easy to administrate • International competitiveness could increase for the US

6. What about a consumption tax? • Some negative aspects of a consumption tax • Confusion about how much each good should be taxed • Example: The “snack tax” in California • Taxed: Wrapped slices of pie • Not taxed: A slice of pie served on a plate • Tax evasion due to smuggling and underground economies • What happens when you change the tax system? • Those that saved over the years get increased tax burden • Those that borrowed over the years get decreased tax burden

7. What are some ways to tax consumption? • National retail sales tax • To replace federal taxes, a federal retail tax of about 35% would be required • Problem: Tax evasion could become a serious problem once the sales tax rate exceeds 10% • Many states already have a sales tax about 6-8%

8. What are some ways to tax consumption? • Value-added tax (VAT) • Popular in Europe • Mostly consumption-based • Capital investments are not part of the taxable base • Involves taxing the additional value at each stage of production • See Figure 21.2, p. 487

9. Problems with consumption taxes • Distortions still occur • Consumption taxes will not solve all of the trade problems in the US • Household labor is still sheltered from taxation

10. Summary: Tax reform • Many people would like to see more consumption taxation and less labor taxation • Substantial evasion of a national retail sales tax would be possible if the tax completely offset personal income taxes • A value-added tax has appeal, but has its own disadvantages

11. State and local governments • State and local governments are playing a bigger role in taxation • 1960: 12.2% of state tax collections were from individual income taxes • 2002: 35% • Marginal income tax rates are still small compared to federal government • Highest bracket in 2006: Vermont (9.5%) • California not far behind: Highest bracket is 9.3% • Single taxable earnings above $44,814 in 2007

12. Centralization in the US • Centralization • Centralization ratio = Central government expendituresTotal government expenditures • In the US, the centralization ratio is less than one-half

13. State and local governments • How do people alter their behavior based on state and local governments? • The Tiebout model • Vote with your feet within your home country • Public education • Property taxes • Grants between different levels of government

14. The Tiebout model • People rarely leave the US due to government policy • Mobility in the US due to government policy is substantial • Tiebout makes many assumptions in his model • Not a perfect description of the real world • Gives a good idea of how people decide what community to live in

15. Tiebout’s assumptions • Government activities generate no externalities • Individuals are completely mobile • People have perfect information with respect to each community’s public services and taxes • There are enough different communities so that each individual can find one with public services meeting her demands • The cost per unit of public services is constant so that if the quantity of public services doubles, the total cost also doubles • Public services are financed by a proportional property tax • Communities can enact exclusionary zoning laws—statutes that prohibit certain uses of land

16. Advantages with the Tiebout model • Tailoring outputs to local taxes • Each person or family lives in a community they like • One size does not fit all • Tastes and preferences differ from person to person • Fostering intergovernmental competition • People in government generally want people to live in their community

17. Advantages with the Tiebout model • Experimentation and innovation in locally provided goods and services • States and cities can try new programs • These studies often result in quasi-experimental studies by economists • The analyzed results lead to good information for governments throughout the nation

18. Efficiency issues with the Tiebout model • Externalities • Both negative and positive • Many public goods are not at the local level • Scale economies in provision of public goods • Per-person cost often decreases as the number of users increases • Inefficient tax systems • Different states and cities often compete to get large businesses to locate in their area • Scale economies in tax collection

19. Public education • For families, voting with their feet often involves finding a good elementary and secondary education for their children • You often must live within a certain area to be able to go to a particular school

20. Recall: Quality of public education • Quality of education is hard to quantify • Besides the obvious aspects of class size and total spending, there are different criteria that affect education • Unionization of teachers • Parents’ choices of their kids’ curriculum • Size of school • School-sponsored sports and activities

21. What about low-income areas? • Local governments typically raise money for education through property taxes • Many families with lower incomes would not want as much spent on schooling • Additional K-12 funding provided by the Department of Education • Money helps to “level the playing field” • About $20 billion in 2003 to special education and “disadvantaged” • California and some other states also provide district power equalization grants to “level the playing field”

22. Property taxes • Property taxes are based on an assessed value • Assessed value is the value assigned to a piece of land or property for tax purposes • How does a land tax affect behavior? • See Figure 22.2, p. 522 • Effective rate depends on the assessed value relative to the actual value of the property • Example: Proposition 13 (Prop 13) in California

23. Prop 13 • In June 1978, California voters limited the amount that the assessed value could go up, as long as ownership did not change • Prop 13 also required a 2/3 majority for additional state and local property taxes • Why? • When housing prices go up significantly, some owners were forced out of their homes since they could no longer afford the property tax

24. What about structures? • Land taxes are capitalized in the price of land • Recall Chapter 14, p. 320 • Property taxes typically tax both land and structures • How does a tax on structures affect behavior? • Example with perfectly elastic supply curve for structures • See Figure 22.3, p. 523

25. Final topic: Intergovernmental grants • Matching grants from a state or the federal government has become commonplace • Requires cost sharing between different levels of government • How is behavior affecting by nonmatching grants? • See Figure 22.6, p. 533 • …matching grants? • See Figures 22.4 and 22.5, p. 530 and 532, respectively

26. Summary: State and local governments • The Tiebout model predicts that people “vote with their feet” within their home country • Public education is extensively financed through the state and local levels of government • Property taxes provide much of the funding for public education • Prop 13 has limited the ability to tax property in CA • Grants from the federal government are used to encourage certain projects within states and cities