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An Economic Analysis of the Income Tax in Wisconsin Presentation to the Special Symposium Steering Committee on Income T

An Economic Analysis of the Income Tax in Wisconsin Presentation to the Special Symposium Steering Committee on Income Tax, Madison, WI, September 6, 2012. Andrew Reschovsky Professor of Public Affairs and Applied Economics Robert M. La Follette School of Public Affairs

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An Economic Analysis of the Income Tax in Wisconsin Presentation to the Special Symposium Steering Committee on Income T

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  1. An Economic Analysis of the IncomeTax in WisconsinPresentation to the Special Symposium Steering Committee on Income Tax, Madison, WI, September 6, 2012 Andrew Reschovsky Professor of Public Affairs and Applied Economics Robert M. La Follette School of Public Affairs University of Wisconsin-Madison reschovsky@lafollette.wisc.edu

  2. Presentation Outline • A primer on the questions economists ask when analyzing tax policy • How do income taxes effect the actions of individuals and businesses • What economic theory tells us • What we can learn from the empirical evidence • Why is the Wisconsin income tax so complex? • Recommendations for reforming Wisconsin’s individual income tax

  3. What Role Do Income Taxes Play in Wisconsin? • It provides revenue to finance public services • 52.1% of GPR taxes FY2012 • 24.8% of state and local taxes FY2009 • The state income tax system is designed to encourage some activities and to influence who pays taxes • Tax breaks to encourage entrepreneurial activity • Tax credits to encourage farmland preservation • Tax breaks to reduce taxes paid by the elderly, by farmers, by the poor

  4. Income Taxes as a % of Total State and Local Taxes, FY2009

  5. Two Important Principles in Thinking About Tax Policy • Any tax policy proposal should always be analyzed in a balanced budget context • The analysis of a tax proposal that reduces state revenues should include the analysis of the impacts of offsetting cuts in state spending or increases in alternative sources of revenue • Analysis should be done in the context of the entire tax system • A tax change that increases taxes on one group, e.g. the elderly should be analyzed in the context of how the entire tax system treats that group • The progressivity of the income tax should be evaluated in the context of the incidence of the other taxes paid by Wisconsin residents

  6. What Questions Do Economists Ask When They Analyze Changes in Tax Policy? • The efficiency of the tax • How does the income tax effect the behavior/actions of individuals and businesses? • The distribution of tax burdens (i.e. taxes relative to income) • Do reform proposals raise taxes on those with low incomes and reduce taxes on those with high incomes, or visa versa? • Distribution of tax burdens by taxpayer age, or other categories of interest • Do taxpayers with similar incomes pay widely divergent amounts of taxes • Simplicity and administrative feasibility • Do policy proposals complicate (and raise the cost) of tax administration? • Do policy reforms increase the time and effort taxpayers face in complying with the income tax? • Revenue growth and volatility • Will tax revenues grow as the economy grows? • How volatile is revenue over the course of a business cycle?

  7. Making Tax Policy • Legislating tax policy often requires making tradeoffs • An income tax policy that encourages job growth may reduce tax progressivity • Economists attempt to quantify the impact of tax changes on desired outcomes, predict changes in tax progressivity, and estimates of compliance costs • Policymakers are responsible for making the often difficult tradeoffs

  8. Income Taxes and Economic Efficiency • Taxes raise revenue, but they also have the potential to influence the actions of individual and businesses • Do lower income taxes lead people to work more? • Do lower income taxes encourage businesses to locate or expand their operations in Wisconsin? • Do higher taxes discourage people from saving? • Do lower taxes on capital gains encourage more business startups in Wisconsin? • Answers to these questions are important in determining what type of income tax reform might “improve economic growth…in the State of Wisconsin.”

  9. Assessing the Impact of Income Taxeson Taxpayer Behavior • What can we learn from economic theory? • What does the evidence show about the size/magnitude of the economic effects?

  10. Income Tax Theory • The income tax, like all taxes, has the potential to influence the actions of individuals and businesses • These influences can be detrimental to society, e.g. discourage investments or work • Larger increases in tax rates are likely to lead to exponentially larger impacts • This is a major reason why nearly all economists would support a revenue neutral and distributionally neutral tax reform that expands the tax base by eliminating exclusions, deductions, exemptions, and credits, and lowers marginal tax rates

  11. What Can Be Learned fromEconomic Theory? • Does a decrease in income taxes lead people to work more hours? • Economic theory does not provide an answer • While a higher after-tax wage rate may encourage more work, a higher after-tax income might discourage additional work effort • Do lower tax rates on savings lead people to increase the amount they save? • Economic theory provides no clear answer • Higher after-tax rates of return may lead to additional savings, but larger savings balances may discourage extra savings • The bottom line: the answer to these questions must come from studying the empirical evidence

  12. What Does the Evidence Say About Income Tax Rates and Work Effort? • Most research based on individuals response to (much higher) federal income tax rates • Based on many studies, there is a broad consensus among economists that income tax rates have very little influence on hours worked • Hours worked by second workers in a family (traditionally women) are more sensitive to income tax rates

  13. What Does the Evidence Say About Income Tax Rates and Savings Behavior? • Research somewhat more mixed, but the majority of evidence suggests: • Reduced rates on savings, e.g. IRAs, generates very little additional savings • Reduced rates on realized capital gains has very small impact on long-run capital gains realization • No evidence that lower state income tax rates on capital gains result in net job creation

  14. What Does the Evidence Say About the Role of the Individual and Corporate Income Tax in Influencing Business Firms to Expand, Increase Jobs, Move to Lower Tax States? • A question addressed by many studies • Both surveys and statistical studies indicate that business expansion in any given location depends on a wide range of factors including: • Access to customers • Availability of a skilled labor force • Easy access to network of suppliers • Spatial concentrations of firms in related industries • Cost of utilities • Taxes • Good public services, especially road, public safety, quality public education

  15. Research on Taxes andEconomic Development • Approach used by most economists is to conduct statistical (econometric) studies that explain variations across states in income growth, job creation, business expansions, or relocations by accounting for a complete list of factors that are known to influence economic development • These studies ask the question: what is the impact of taxes on economic development once we “control” for other factors that influence economic development • There exist several good summaries of the statistical literature, one of the most comprehensive is by Michael Wasylenko (Syracuse University) • “Taxation and Economic Development: The State of the Economic Literature,” New England Economic Review, March/April 1997.

  16. Wasylenko’s Conclusion • “Taxes do not seem to have a substantial effect on economic activity among states.” • He finds that in any given state, if there are no changes in state and local public services in that state and no changes in taxes and services in other states, then a tax reduction will have a small impact on business investment or job creation • If these conditions hold, then a 10% reduction in business income taxes would result in a 1 to 2% increase in business investment • Finds that public services have a positive impact on job creation • Actual tax cuts are usually combined with service cuts, so net impact is unclear

  17. Standards of Evidence • Evidence about the impact of taxes on job creation or economic growth must simultaneously consider the impact of other factors • Simple correlations should never be the basis of policy making • They ignore all the non-tax reasons that motivate businesses and individual • By choosing how to define variables, or the time period studied, it is not hard to use correlations to support any point of view • These flawed studies are used by all sides in debates about taxes

  18. Tax Simplification • It is hard to argue against simplification, at least in principle • Complexity of the income tax makes tax compliance more onerous • It takes more time and costs more money • Especially large burden for small businesses filing individual returns • Complexity also raise the cost to DOR of administering the income tax • Complexity makes tax evasion easier

  19. Sources of Complexity • A profusion of tax credits • About 40 credits are available to individuals • Form 1 is three pages long, yet there is room on the form for only 11 credits • Additional credits require multiple additional schedules-some are taken before the calculation of the AMT • Others, after calculation of the AMT • And finally some “other” credits are refundable

  20. The Effectiveness of Credits • Almost none of them have been subject to a cost-benefit analysis • In most cases we don’t know whether they have achieved their desired goals, and if so, at what cost • Question is whether individuals would have undertaken the subsidized activity in the absence of the credit • e.g. Historic Rehabilitation Credit—how many taxpayers would have undertaken home maintenance projects without the 25% credit, and what is the public benefit of more home maintenance in historic districts?

  21. Sources of Complexity (cont.) • Deviations from federal Adjusted Gross Income • There are over 50 “additions” and “subtractions” from federal AGI

  22. Multiple Rates Do Not Create Complexity • 5 or 10 rates is no more complex than a single rate • Tax liabilities are determined from a simple look-up tax table, or are calculated automatically by a computer program, e.g. Turbo Tax

  23. Income Tax Policy Recommendations • Expand the tax base by eliminating most tax credits • Measure the extent to which each credit actually changed behavior in the desired way, and determine the costs of incentivising these changes • Align the Wisconsin tax base more closely with federal AGI • End 30% capital gains exclusion • End exclusions that are unrelated to taxpayers’ ability to pay, e.g. Social Security benefits

  24. Income Tax Policy Recommendations (cont.) • Additional revenue from base expansion could be used to— • Reduce tax rates • Provide funding for compelling state government needs

  25. Why End Wisconsin’s Capital Gains Exclusion • Most states tax 100% of realized capital gains • Most capital gains are not associated with WI businesses • Most are gains on globally-traded stocks and mutual funds • Much investment in WI businesses comes from entities not subject to the income tax, e.g. banks, pension funds, corporations, non-profit organizations • Reduces tax progressivity--over 50% of benefit to richest 5% of taxpayers • Adds to complexity — requires extra lines on Form 1 plus additional schedules

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