Institute for Research on the Economics of Taxation (IRET) REFORMING TAXATION: ADVANTAGES OF A SAVING- CONSUMPTION NEUTRAL TAX BASE, AND PRINCIPLES TO GUIDE REFORM Stephen J. Entin Institute for Research on the Economics of Taxation

Institute for Research on the Economics of Taxation (IRET) Objectives of Tax Reform  Growth,  Simplicity,  Fairness, and  Visibility 2

Institute for Research on the Economics of Taxation (IRET)  Choose a better tax base.  Consumption versus Income. How to Achieve Objectives 3

Institute for Research on the Economics of Taxation (IRET) Income  Income is the earned reward for providing labor and capital to produce goods and services that other people value.  Income is proportional to effort.  Therefore, the fairest tax is proportional to income. 4

Institute for Research on the Economics of Taxation (IRET)  Revenue less the cost of earning revenue.  Deductions for costs are necessary to measure income properly. Income is a Net Concept 5

Institute for Research on the Economics of Taxation (IRET) No saving => no interest, no dividends. You can't have your principal and eat it too. Therefore, the best measure of income is consumption. We should tax what we spend. Saving Is a Cost of Earning Income 6

Institute for Research on the Economics of Taxation (IRET)  Do not fall more heavily on saving and investment than on consumption,  Are unbiased against growth,  Are simpler than the income tax, and  Are fair and straightforward. Neutral Taxes 7

Institute for Research on the Economics of Taxation (IRET)  Taxes people more the more they work, save, and produce by imposing graduated tax rates.  Hits saving and investment harder than consumption.  Encourages consumption by penalizing saving. By Comparison the Income Tax 8

Institute for Research on the Economics of Taxation (IRET) Multiple Taxation of Saving One Tax on Consumption, Four Taxes on Saving Layer 1– Tax on Earnings Income is taxed when earned. If it is used for consumption, there is usually no further federal tax. Layer 2 – Personal Income Tax on Returns If the income is saved, the returns are taxed as interest, dividends, capital gains, or non-corporate business profits. Layer 3 – Corporate Income Tax If the saving is in corporate stock, the corporate tax hits the income before it is either paid out to shareholders or reinvested to boost future earnings. Layer 4 – Transfer (Estate and Gift) Tax Another tax on already taxed assets. (Similar taxes at the state and local levels increase the multiple taxation.) 9

Institute for Research on the Economics of Taxation (IRET)  Savers can always choose consumption, which is nice for them.  But when they do, investment slumps, and workers lose their jobs. Taxing Capital Income Hurts Workers 10

Institute for Research on the Economics of Taxation (IRET) Step 1. Treat all saving like pensions and IRAs. A tax that is neutral between saving and consumption would either defer tax until the saving is spent, or tax the saving up front and not tax the returns. Steps Toward a Fair, Flat, Unbiased Neutral Tax 11

Institute for Research on the Economics of Taxation (IRET) Advantage Of Tax Deferred Saving Over Ordinary (Biased) Tax Treatment; Build-up Of $1,000 Saved per Year 12

Institute for Research on the Economics of Taxation (IRET)  A neutral tax would not tax corporate income twice.  It would tax it either at the corporate level or the shareholder level, but not both. Step 2. End Double Taxation of Corporate Income 13

Institute for Research on the Economics of Taxation (IRET) A neutral tax would not tax estates because estates are accumulated saving that has already been taxed or will be subject to an heir's income tax. Step 3. End the “Death Tax" 14

Institute for Research on the Economics of Taxation (IRET)  Saving deferred tax (on income less saving).  Flat tax (no deferral, returns exempt).  Sales tax (on income spent, not saved).  Value Added Tax (on output less investment; which equals income less saving). Four Types of Neutral Taxes: 15

Institute for Research on the Economics of Taxation (IRET)  All treat saving neutrally vs. consumption.  All employ expensing instead of depreciation.  All are territorial.  All have the same basic tax base.  Differ mainly as to point of collection. Elements of a Neutral Tax 16

Institute for Research on the Economics of Taxation (IRET) Neutral taxation is best for growth. It can yield:  More saving, investment, and growth. Potentially: o Trillions of dollars of added capital. o Millions of added jobs and higher wages. o Thousands of dollars in added family income.  U.S. would become a jobs and investment magnet. Objective: Growth 17

Institute for Research on the Economics of Taxation (IRET) Neutral taxes are much simpler, even if collected on individual tax forms:  No double taxation.  No limits on savings plans. One universal plan, not dozens.  No separate taxation of capital gains.  No depreciation schedules.  No foreign tax and tax credit.  No phase-outs of dozens of exemptions, credits, deductions. Objective: Simplicity 18

Institute for Research on the Economics of Taxation (IRET)  Consumption is a fairer tax base than income, because it respects the effort of people who work and save.  Neutral taxes can be made progressive to shelter the poor.  There is no need to tax saving and investment more harshly than consumption to achieve progressivity.  The simpler, clearer neutral tax would be seen to be fair. Objective: Fairness 19

Institute for Research on the Economics of Taxation (IRET)  Only people pay taxes.  Businesses and things don't pay tax.  Taxes are best levied on individuals.  Voters need to see what government costs.  Everyone who can should pay something toward the cost of government.  Simplicity is no excuse for dropping tens of millions of people from the tax rolls. Objective: Visibility 20

Institute for Research on the Economics of Taxation (IRET) Tax reform is about-  Getting the tax base right  Setting rates that cover the amount of government that people want to have.  Raising revenue while doing less damage to the economy, and  Informing the voting public what it is paying for government so that they can make informed decisions about how much government activity to support. Conclusion 21

Institute for Research on the Economics of Taxation (IRET) Appendix 22

Institute for Research on the Economics of Taxation (IRET) Equivalence Of Saving Deferred And Returns Exempt Tax On Saving; Contrast With Ordinary Income Tax Tax TreatmentSaving DeferredReturns Exempt Ordinary Income Tax Pretax earnings to be saved $100 Tax on saving020 Amount saved10080 Is interest on inside build- up taxed? No, 7.2% reinvested Yes, 5.76% reinvested Account after 10 years Tax due on withdrawal4000 After-tax spendable balance Cost to saver of ordinary tax treatment 20 (= 160 – 140) (a third of the interest) Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment. 23

Institute for Research on the Economics of Taxation (IRET) Multiple Taxation of Corporate Income (a) Retained Earnings, Pre 2003 Act (b) Dividend Payout, Pre 2001 Act (c) Retained Earnings and Dividends, 2003 Act 1) Corporate Income$1.00 2) Corporate tax at top rate$0.35 3) After-tax corporate income: Either retained, raising stock price (columns (a), (c)), or paid as dividend (col. (b), (c)) $0.65 4) Individual income tax at top rate (dividends as ordinary income, retained earnings as capital gain)* $0.13 (tax rate 20%) $ (tax rate 39.6%) $ (tax rate 15%) 5) Total tax$0.48$0.6074$ ) Total tax rate48%60.74%44.75% 7) Income left to shareholder$0.52$0.3926$ * Top corporate rate excludes corporate surtaxes, and top individual rate ignores phase-outs of exemptions and deductions and taxation of Social Security, which may push effective top tax rates higher than statutory rates. Retained earnings are assumed to trigger a long-term capital gain with a maximum rate of 20% or 15%. Short-term gains are taxed at ordinary tax rates. 24

Institute for Research on the Economics of Taxation (IRET) Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing (First-Year Write-Off) Asset lives: 3 Yrs 5 yrs 7 yrs 10 yrs 15 yrs 20 yrs 27.5 yrs 39 yrs Present value of first- year write-off of $1 of investment: $1.00 Present value of current law write-off of $1 if inflation rate is: 0%$0.96$0.94$0.91$0.88$0.80$0.74$0.65$0.55 3%$0.94$0.89$0.85$0.79$0.67$0.59$0.47$0.37 5%$0.92$0.86$0.81$0.74$0.60$0.52$0.39$0.30 Assumes a 3.5 percent real discount rate, 3-20 year assets placed in service in first quarter of the year, year assets placed in service in January. 25

Institute for Research on the Economics of Taxation (IRET) NIPA Table 5.3.6, line 9 26