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Perspectives on Tax Reform. SIEPR Tax Policy Conference Stanford, California January 18, 2013. Michael J. Boskin Tully M. Friedman Professor of Economics Senior Fellow , Hoover Institution Stanford University. Five Tests for Tax Reform.

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Perspectives on Tax Reform

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    1. Perspectives on Tax Reform SIEPR Tax Policy Conference Stanford, California January 18, 2013 • Michael J. Boskin • Tully M. Friedman Professor of Economics • Senior Fellow, Hoover Institution • Stanford University 1

    2. Five Tests for Tax Reform • Will tax reform improve the performance of the economy? • Will tax reform affect the size of government? • Will a new federal tax structure affect federalism? • Will a new tax structure likely endure? • Over time, will tax reform contribute to a prosperous, stable democracy? 2

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    6. Some Fiscal Arithmetic • Government long-run budget constraint: PV of future taxes = PV of future spending + national debt (net of assets) • for spending, taxes, financial crises, inflation and therefore economic growth • Evolution of the debt depends on: • primary budget position (budget net of interest payments) • interest rate on government bonds minus the growth rate • Tax/transfer systems: • Necessary tax rate depends upon (product of) • Dependency ratio (benefit recipients/taxpayers) • Replacement rate (average benefits/average wages) (ECB President Mario Draghi, “the European social model is already gone”) • The harm from higher tax rates rises with the square of the rates • The same economic activity is often taxed multiple times: e.g. wages by federal, state, and local income taxes and payroll taxes; saving by federal, state and local income taxes and possibly corporate and/or estate taxes 6

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    10. * Estimates based on gross debt in parentheses. ** Central estimate of effect on GNP in 2037 (range - 3.5% to more negative than -21%), from CBO alternative fiscal scenario. *** Cobb Douglas, constant returns, one-third capital, two-thirds labor. 10

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    12. How High Would Tax Rates Go? • To cover the recent deficits, all federal taxes must be 30-40% higher; if just income taxes, they would need to be 60+% higher • To finance projected spending on entitlement growth, marginal tax rates would exceed 70% for many, higher still at the top 12

    13. Political Economy Issues • Percentage of population paying (positive) income taxes declining • 49% in 2009 (JCT) • Percentage of population receiving transfers from the government rising • 51% in 2010 • Between 1985 and 2009, US adult population increased by 48 million, the number of tax returns filed increased by 39 million, the number with zero or negative tax liability rose by 40 million • Dependency ratio rising from 1:3.2 to 1:2 in coming decades 13

    14. Potential Benefits from Stylized Tax Reform (Broad Base, Low Rate(s), Consumption Tax) • Several studies show income gain of 6+% from comprehensive broad based low rate(s) consumption tax reform • About 1/5 of the difference in per capita income between U.S. and western Europe • What fraction of that difference is due to higher European tax rates, bloated welfare state, debated by economists, from under half to 100% • So tax reform can be an important effective complement to spending control 15

    15. Distributional Issues • Latest federal income tax data (2010 SOI): • OECD: U.S. tax system most progressive (n.b. larger public sectors financed with VAT in many countries) • Since 1980: • AGI share of top increased substantially; of bottom, fell considerably. Income tax shares rose, and fell, considerably, respectively; average tax rate fell somewhat for all income groups, as income tax share of GDP fell 16

    16. Key Decisions For Design Of Tax System • Tax base(s): income, consumption, hybrid; people or transactions 2. Tax rate(s): flat, progressive, levels • Unit(s) of account: family, individual, transactions 4. Time period(s) of account: transaction, annual, longer-horizon 17

    17. The Impact of Taxes on Saving, Investment, and Economic Growth • Real per capita income grows with productivity, which in turn rises with the growth rate of capital (private and effective public) per worker and the growth rate of technology • Taxes affect the capital stock by affecting saving and investment • Taxes may also affect hours of work, choice of occupation, fertility, and human capital investment • Taxes, and some government spending, may affect the rate of advance in technology • Tax effects on human investment and/or technology can permanently affect the growth rate of the economy • Taxes on saving and investment affect the level of future income and hence the interim growth rate; whether they permanently alter the growth rate depends upon whether investment affects the rate of technical change, on which economists disagree • At the very least, we should strive for neutrality in the tax code toward saving and investment, especially given the anti-saving policies of exploding public debt and rapidly rising social insurance transfers to the elderly • Taxes also affect many dimensions of labor supply and thus income 18

    18. Tax Treatment of Capital Income • Business firms earn thebefore-tax return to private investment; firms then pay corporate taxes on these profits, at tc, the effective marginal corporate tax rate; • Suppliers of the capital receive the before-personal-tax return to savers, and then pay personal taxes on their returns (interest, dividends, capital gains) at rate tp, the marginal effective personal income tax rate on capital income Thus a “wedge”, or distortion, is created between the before-tax return to private businesses on their investment and the after-tax returns to savers supplying the capital for the investment The tax wedge = tc + tp The “excess burden” of tax goes up with square of tax rate (tc+ tp)2 19

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    20. “Corporate income taxes are found to be the most harmful to economic growth, followed by personal income taxes and then consumption taxes” • Organization for Economic Cooperation • and Development (OECD), • 2008 21

    21. Tax Neutrality Toward Saving And Investment • Pure income tax: double taxation of saving • Pure consumption / consumed income tax: neutral • Add corporation income tax = third tax on saving • Combination of tax rate, interest deductions on debt and PV of depreciation allowances determines effect on investment (I) • Tax income but allow true economic depreciation of equity financed investment (no debt) => neutrality among types of investment. • Consumption tax: consumption (C) = income (Y) – investment (I) • Neutral with respect to types of investment • Neutral between investment / saving and consumption • Immediate expensing (first year write-off) 22

    22. Tax Neutrality Toward Saving and Investment • Think of a football field • Pure income tax level sideline-to-sideline, but saving (S) and investment (I) running uphill • Pure consumption tax – level sideline-to-sideline (among types of I) and goalpost-to-goalpost (between S and C) • Debt raises the potential of negative effective tax rates (subsidies) on investment • The case for subsidizing investment • The treatment of housing • Estate tax can be third or fourth tax on saving 8. Taxes and human capital investment 23

    23. Human Capital Investment Types: Education (50%), On the job training (30%), Mobility, Health (20%) Note: Virtually all on the job training (ojt) and sizeable fraction of higher education and some fraction of mobility and health costs are foregone earnings, which ARE NOT TAXED Example:Early years of work and informal ojt (Heckman estimates 1/3 of time) So a $60,000 per year worker is actually “paid” $90,000 at annual rate: $60,000 is cash and $30,000 is ojt The in-kind ojt is not taxed. This is economically equivalent to including it in income and then giving an immediate deduction (expensing) So a flat rate tax does not distort the bulk of human investment decisions. However, a progressive rate structure does do so, as the human capital investment raises earnings and drives people into higher tax brackets Other policies: from government finance of education, lending, government spending, from Head Start to job training programs, etc., provide and/or finance human capital programs (most evaluations of efficacy not encouraging) 24

    24. Single and Double Taxation of Saving • Ordinary saving: taxed twice under the income tax • Earn income = $1, pay tax t, save $(1-t) • Saving earns return r, is taxed at t, your net of tax return is r(1-t) • Thus, you end up with (1-t)(1+r(1-t)) 2. IRAs, 401(k)s: saving taxed once, on withdrawal • Earn income = $1, save and deduct it, so saving = $1 • Saving earns return r, no tax while builds up • On withdrawal pay tax t (can be higher or lower than tax rate when contributed) • Thus, you keep (1+r)(1-t) 3. Roth IRA: backloaded, saving not deductible, so no tax at withdrawal • Earn income = $1, pay tax t, saving = $(1-t) • Earns return r, no tax on withdrawal • So you keep (1+t)(1+r) 25

    25. Long-Term Effects of Taxes on Saving and Investment(real future value of $1 invested earning 10% before tax when taxed at 0% and 40%) Tax rate on capital income = tc + tp So, while a “small” capital income tax may not be too distortionary between consumption today and consumption next year, it is very distortionary between consumption todayand consumption many years in the future. 26

    26. The Effects Of Taxes On Saving • Even very modest (substitution) effects of capital income taxes imply very large costs to society from the tax distortions between consumption and saving (future consumption) • Nobel laureate Professor Robert Lucas, in his research and 2002 Presidential address to the American Economic Association, concludes that removing the tax distortions to saving and investment are by far the most important avenue for improving economic well-being of any potential public policy reform 27

    27. Tax Reform I.Partial Lower rates, broader base Simplification Expanded tax deferred saving Corporate tax integration II.Comprehensive Consumed income tax National retail sales tax Value added tax Flat tax N.B. income averaging? unit of account? non-payers: minimum tax? perhaps with modest additional income tax at high incomes 28

    28. Consumption Taxes(arguments for) Equity • People should be taxed on what they take out of the system, not what they contribute • Taxing life-cycle income (leaving aside bequests and inheritances) is equivalent to taxing consumption • Consumption may be a better measure of permanent income than is current income • A consumption-based tax can be progressive Efficiency • Eliminate distortion of saving decision and hence discrimination against the patient vs. the impatient, and effects on growth. • Taxes all saving equivalently Simplicity • A lot of the complexity of the tax code arises from capital income taxation and avoidance 29

    29. Consumption Taxes(arguments against) Equity • Income better measure of ability-to-pay (at least in an annual tax with limited time horizons) • Avoids differentiating capital and labor income • Transactions based consumption taxes ineffective way of differentiating by ability • Transition unfair to elderly Efficiency • Intertemporal distortion not so severe; time horizons not so long  • In practice, may wind up subsidizing saving, investment (e.g., debt finance and interest deductions unlikely to be limited in practice) Simplicity • Transition not simple • Personal, business tax likely complex around saving, investment definition 30

    30. Tax Reform and the Transition to a New Tax System • Tax reforms => capital gains and losses if the taxation of capital is involved • We not only must compare the new tax or tax system to the old one, we also have to pay attention to transition issues • Most major tax reforms involve transition rules a.For a while, there are parallel tax systems: i. The old one, phasing out and ii. The new one, phasing in b. Transitions impose costs, complexity 4.Important to evaluate actual tax systems before, after and during (transition), not just two theoretical systems 31

    31. Conclusion • The two routes to reform 1.Replace the current corporate and personal income taxes with an integrated consumed income tax, e.g. with personal rates of 10%, 20% and 30%, a corporate rate of 30%; phase out most deductions other than charity and mortgage interest; include super-IRAs; simplify, eliminate, combine other aspects of the code • Simultaneously, reduce subsidies to the well-off in government benefit programs 2.Replace the income taxes with more fundamental reform, such as the Hall-Rabushka flat income tax or a national retail sales or value-added tax; • The political economy of the sales and VAT taxes raise fundamental concerns of federalism and potential growth of government 32

    32. Conclusion: Policy Priorities • Medium-run fiscal consolidation, a la Simpson-Bowles, enacted NOW, and difficult to reverse, but phasing in gradually as economy recovers • Long-run entitlement and tax reform: maintain strong incentives while reducing subsidies to the well off • Social Security: indexing, retirement age • Medicare: age, competition, premium support a la Rivlin, Wyden-Ryan • Tax: transition to broad based consumed income tax with lowest rates possible to raise necessary revenue; corporate tax: broad base, lower rate, territorial system (ideally integrated with personal tax) • Budget reform: making programs more effective by eliminating, consolidating and modernizing; process reform; fiscal constraints • Monetary policy; human capital policy (education and training), trade, regulation • Make fiscal and monetary policy much more predictable and permanent, eliminate endless use of temporary features 33