FUNDAMENTAL TAX REFORM: TAXES ON CONSUMPTION AND WEALTH CHAPTER 21 FUNDAMENTAL TAX REFORM: TAXES ON CONSUMPTION AND WEALTH

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

Efficiency and Equity of Personal Consumption Taxes Equity issues Progressiveness Ability to pay Annual versus Lifetime Equity A numerical example A formal model

Retail Sales Tax General sales tax Selective sales tax (excise tax or differential commodity tax) Forms of a sales tax Unit tax Ad valorem tax

State and Local Sales Tax Revenues by Source ($billions) General sales tax $197.9 $46.9 Motor fuel 33.8 1.2 Alcoholic beverages 4.6 0.4 Tobacco 12.3 0.3 Public utilities 10.7 Percent of own-source revenue from sales taxes 36.7% 10.1% Source: US Bureau of the Census [2006]. Figures are for 2003-2004.

Rationalizations Ease of administration Defining the tax base Tax evasion

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

A National Retail Sales Tax Arguments in favor Simplicity Ease of compliance Arguments Against

Value-Added Tax How a value-added tax works VAT as an alternative method for collecting retail sales tax

Implementation Issues Treatment of investment assets Consumption-type VAT Collection procedure Invoice method Rate structure

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

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?

Cash-Flow Tax How a cash-flow tax works How to compute annual consumption Cash-flow basis Qualified accounts

Income versus Consumption Taxation Advantages Disadvantages 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

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 Policy Perspective: President’s Advisory Panel on Federal Tax Reform

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

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

Provisions of the Unified Transfer Tax 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

Special Problems 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

Prospects for Fundamental Tax Reform Broad versus piecemeal changes

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;” this can reduce estate value by up to $770,000

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 period 0 $1,000 Consumption period 0 $500 $0 Taxes period 0 Income period 1 $50 $100 Consumption period 1 $525 $550 Taxes period 1 $25 Present Value of taxes paid $523

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 Consumption period 0 c0G c0A Taxes period 0 tI0 Income period 1 r(I0 – c0G) r(I0 – c0A) Taxes period 1 tr(I0 – c0G) tr(I0 – c0A)

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

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 950 250 50 Grocer 1,000 10   Total $2,050 $3,050 $1,000 $200

Policy Perspective: President’s Advisory Panel on Federal Tax Reform Simplified Income Tax (SIT) Growth and Investment Tax (GIT)

Policy Perspective: President’s Advisory Panel on Federal Tax Reform Common features Eliminate individual and corporate alternative minimum tax Replace standard deduction, personal exemption, earned income tax credit, and child tax credit with “Family Credit” and “Work Credit” Replace mortgage interest deduction with mortgage tax credit Reduce tax preference for employer-sponsored health insurance eliminate deductibility of state and local taxes Reduce number of tax brackets Reduce maximum tax rate to 33% under SIT and 30% under GIT Create savings plans (Save at Work, Save for Retirement, Save for Family) GIT allows business to expense investments, lowers tax rates on business, and imposes single, low tax rate on dividends, interest and capital gains