Tax Reform: Theory and Evidence

1. Tax Reform:Theory and Evidence Professor John A. Spry, Ph.D University of St. Thomas jaspry@stthomas.edu The views expressed herein are solely those of the author and do not necessarily represent the views of the State of Minnesota or the University of St. Thomas. All errors are my own.

2. Revenue-Neutral Tax Reform • The goal is to increase the size of the economy while meeting the needed revenue goal • Reduce reliance on costly inefficient taxes • Increase reliance on less distortionary taxes • Generally, • avoid high tax rates with narrow tax bases that are highly responsive to tax rates • use low tax rates on broad bases that are less responsive to tax rates

3. The inefficiency of a tax increases with the square of the tax rate “Marginal distortions associated with the tax code tend to rise with the square of the tax rate, so that as the tax rate gets into higher and higher territory, the marginal dead-weight losses tend to grow rapidly. Going from a 30 percent to a 40 percent marginal tax rate, for example, doesn’t increase the marginal efficiency cost of taxation by a factor of 1.33, but by the ratio of 16 over 9—close to 75 percent.” Source: Professor James Poterba, MIT and NBER

4. A Tax Theorist’s Guide to Spotting “Better” and “Worse” Taxes for Economic Growth • “Better” Taxes for Growth • Minimally reduce gains from trade • An inelastic tax base • Small tax rate wedge (from combine federal and state rates) • Low administrative costs • Low compliance burden • “Worse” Taxes for Growth • Large distortions in the decisions of people and businesses • Multiple ways for creative individuals to change behavior • A large tax rate wedge (from combine federal and state rates) • A highly mobile tax base • High administrative costs • Large compliance burden

5. Minnesota is a Small Open Economy • Minnesota has 0.08% of the world population. • Minnesota GDP is about 0.33% of world GDP. • We should compare our taxation of capital internationally, as capital is highly mobile today. • We should compare our taxation of labor and savings nationally, because high human capital workers are very mobile today. How does Minnesota compare Internationally? What decisions face huge combined Minnesota and federal tax rates?

7. Minnesota is a Small Open Economy -but Minnesota has a Tax Code Designed for a Closed Economy • Minnesota’s 41.4% combined statutory federal and state corporate income tax rate is 50% higher than the OECD average of 27.6%. • Original idea - place the burden of the state corporate income tax on the owners of capital invested in Minnesota • Minnesota taxes intended to fall on capital miss in an open economy • Minnesota workers, consumers, and land owners get hit by taxes designed to burden owners of capital • How we tax Minnesota source-based capital determines how much capital is invested in Minnesota - but not the world rate of return on capital. • The pre-tax rate of return hurdle for investments in Minnesota is higher because competition in the capital market equalizes after tax rates of return across jurisdictions adjusting for risk.

8. Specifically, how do we learn what are “better” and “worse” taxes for economic growth and prosperity? • Even an ideal tax system would create some extra tax burden in excess of tax receipts to meet our need revenue target. • Analysis should be grounded in the economic theory of taxation • Rely on the serious, scholarly empirical research on the effects of taxes on economic decision making and economic performance

9. Specific problems caused by the Minnesota Corporate Franchise Tax • A high rate (41.4% ) even before considering the double taxation of corporate income • Strong disincentive for C-corp investment in Minnesota -Foreign Direct Investment in a state falls one percent for every one percent increase in the state corporate income tax rate. Source: Prof. Claudio A. Agostini, Public Finance Review, 2007 -” ... the effective corporate tax rate has a large adverse impact on aggregate investment, FDI, and entrepreneurial activity. For example, a 10 percent increase in the effective corporate tax rate reduces aggregate investment to GDP ratio by 2 percentage points. Corporate tax rates are also negatively correlated with growth, and positively correlated with the size of the informal economy. –Prof. Andrei Shleifer, et. al, Harvard University • It doesn’t collect much revenue for a tax with a 9.8% rate.

10. Specific problems caused by the Minnesota Corporate Franchise Tax • “The domestic distortions that the corporate income tax induces are large compared with the revenues that the tax generates…Overall, on the basis of a survey of estimates derived from published corporate tax studies, Gravelle concludes that the combined cost of the first five domestic inefficiencies discussed in this chapter could exceed the total amount of corporate tax revenues collected. – CBO, 2005 “Corporate income taxes appear to have a particularly negative impact on GDP per capita. This is consistent with the previously reviewed evidence and empirical findings that lowering corporate taxes raises TFP growth and investment. Reducing the corporate tax rate also appears to be particularly beneficial for TFP growth of the most dynamic and innovative firms. Thus, it seems that corporate taxation affects performance particularly in industries and firms that are likely to add to growth. Source: OECD Tax and Economic Growth

11. Specific problems caused by the Minnesota Corporate Franchise Tax • It distorts firms’ decisions between equity and debt finance • It has the highest administrative cost for the DOR per dollar raised • It is a regressive and probably highly regressive tax that falls on in-state consumers and workers. Perhaps shockingly, the current Minnesota CFT, or any heavily sales apportioned state income tax, acts to place a hidden, and somewhat arbitrary form of sales tax on everything sold in the state by corporations, including food, prescription drugs, clothing, and other goods that may be popularly thought to be tax free. “in the long-run a $1 increase in the tax bill tends to reduce real wages at the median by 92 cents.” Source: Oxford University Centre for Business Taxation “The Direct Incidence of Corporate Income Tax on Wages”

12. The State Corporate Income Tax and Sales Tax Bases are Becoming More Elastic Source “On The Relative Distortions of State Sales and Corporate Income Taxes” Profs. Donald Bruce, John Deskins, and William Fox. Paper to be presented at the 2008 Annual Conference of the National Tax Association

14. Specific problems caused by the Minnesota Personal Income Tax on Wages • Minnesota’s has a 40.1% current combined statutory top federal and state personal income tax rate. • The original idea is to place the burden of the state personal income tax on households with high personal income in Minnesota as if Minnesota was a closed economy. • A large disincentive to supply additional hours of effort • Iceland’s Natural Experiment • A large disincentive to invest in education and on-the-job-training • A large disincentive to take risky, disagreeable jobs that receive a compensating wage premium for less pleasant working conditions • A strong incentive to take compensation in tax preferred forms (perks, exotic business trips, benefits, ect.)

15. Specific problems caused by the Minnesota Personal Income Tax on Wages • Labor mobility of highly skilled individuals ”The evidence presented in this paper supports the basic theoretical presumption that state and local governments cannot redistribute income. Since individuals can avoid unfavorable taxes by migrating to jurisdictions that offer more favorable tax conditions, a relatively unfavorable tax will cause gross wages to adjust until the resulting net wage is equal to that available elsewhere. The current empirical findings go beyond confirming this long-run tendency and show that gross wages adjust rapidly to the changing tax environment. Thus, states cannot redistribute income for a period of even a few years. The adjustment of gross wages to tax rates implies that a more progressive tax system raises the cost to firms of hiring more highly skilled employees and reduces the cost of lower skilled labor. A more progressive tax thus induces firms to hire fewer high skilled employees and to hire more low skilled employees. Since state taxes cannot alter net wages, there can be no trade-off at the state level between distribution goals and economic efficiency. Shifts in state tax progressivity, by altering the structure of employment in the state and distorting the mix of labor inputs used by firms in the state, create deadweight efficiency losses without achieving any net redistribution.” Source: Professors Feldstein and Wrobel, Journal of Public Economics, 1998.

16. Specific problems caused by the Minnesota Personal Income Tax on Wages? • Labor mobility of highly skilled individuals “This paper examines the responsiveness of the rich to state income taxes. We use Major League Baseball free agents who were named All-Stars at some point in their career and who signed with a U.S. team for the 1991 through 2002 seasons. This data set overcomes some of the previous difficulties encountered in similar studies but also has limitations representing the general rich population. We find evidence that the wages of this subset of players do adjust to offset the burden of state income taxes, specifically a 1% decrease in net-of-tax rate leads to a 3.3% increase in salary.” – Professors Ross and Dunn, Contemporary Economic Policy, 2008 • High combined state and federal tax rates leads to a high marginal cost of public funds, even without considering labor mobility. “An across-the board increase in personal tax rates involves a deadweight loss of 76 cents per dollar of revenue and collects only about two-thirds of the revenue implied by a “static’ calculation.” –Feldstein, “The Effects of Taxes on Efficiency and Growth.” Tax Notes, 2006.

17. Specific problems caused by the Minnesota Personal Income Tax on Saving • The effective combined effect of federal and state taxes and inflation results in a tax rate on saving through banks or bonds can easily exceed 100% annually! • “Taxing capital involves taxing income twice: once when you receive it, before you save it, and then once again when you get the return on the savings. It gives a bias toward consuming now rather than consuming later and depresses capital accumulation.” Source: Nobel Prize Winner Professor Robert Lucas, in the Region Magazine from the Minneapolis Federal Reserve Bank

18. Tax and Economic Growth -OECD Conclusions “The analysis in this (OECD) paper suggests some general policy options that could be considered: − The reviewed evidence and the empirical work suggests a “tax and growth ranking” with recurrent taxes on immovable property being the least distortive tax instrument in terms of reducing long-run GDP per capita, followed by consumption taxes (and other property taxes), personal income taxes and corporate income taxes. − A revenue neutral growth-oriented tax reform would be to shift part of the revenue base from income taxes to less distortive taxes… In practical policy terms, a greater revenue shift could probably be achieved into consumption taxes.”

19. References Professor James Poterba on taxation: http://woodrow.mpls.frb.fed.us/pubs/region/08-06/poterba.pdf Tax and Economic Growth, OECD Working Paper 620 Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF Hodge, Scott. "U.S. States Lead the World in High Corporate Taxes" The Tax Foundation, Fiscal Fact No. 119. March 18, 2008. http://www.taxfoundation.org/publications/show/22917.html Claudio A. Agostini, "The Impact of State Corporate Taxes on FDI Location," Public Finance Review 2007; 35; 335. http://pfr.sagepub.com/content/abstract/35/3/335 Congressional Budget Office, “Corporate Income Tax Rates: International Comparisons.” http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf

20. References Professors Sineon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, "The Effect of Corporate Taxes on Investment and Entrepreneurship," National Bureau of Economic Research, Working Paper 13756, January 2008. http://www.nber.org/papers/w13756 “On The Relative Distortions of State Sales and Corporate Income Taxes” Donald Bruce, John Deskins, and William Fox. Paper to be presented at the 2008 Annual Conference of the National Tax Association http://web.utk.edu/~dbruce/bruce.deskins.fox.distortions.pdf Professors Feldstein and Wrobel, Journal of Public Economics, 1998 http://ideas.repec.org/p/nbr/nberwo/4785.html Professors Ross and Dunn, Contemporary Economic Policy, 2008 http://econpapers.repec.org/article/blacoecpo/v_3A25_3Ay_3A2007_3Ai_3A4_3Ap_3A639-648.htm Professor Feldstein, “The Effects of Taxes on Efficiency and Growth.” Tax Notes, 2006. May 8, 2006.