FIVE KEY THINGS How Economics Can Inform Tax Policy Design Thomas A. Barthold Joint Committee on Taxation National Tax Association & Office of Tax Policy Research University of Michigan Washington, D.C. September 29, 2006

My Five Keys Economic incidence, not statutory incidence rules. Short-run incidence may be different from long-run incidence. The economic burden of a tax generally is different from the tax’s revenue yield. Time value matters. Some costs are sunk and some costs are variable.

1. Economic incidence, not statutory incidence, rules Demand and supply determine the gross price of exchange for goods, labor, and capital. A tax creates a wedge between the gross price and the net receipt on an exchange of goods, labor, and capital. How buyers and sellers respond to changes in the gross price or net receipt determines a new market outcome and who bears the tax.

-Implications Depending upon the elasticity of supply and demand, it can be a fool’s errand to try to place a burden on a specific party in the market.  Is the burden of the payroll tax half on the employee and half on the employer? Creating the appearance of imposing “the burden” on the statutorily designated party can create inefficiency from increased administrative and compliance burdens.  Could the administration of and compliance costs of the credits for hybrid vehicles have been significantly eased if it were a manufacturer’s credit?

2. Short-Run Incidence and Long- Run Incidence May Differ In wake of sharp increases in gasoline prices after Hurricane Katrina, several policy makers called for a temporary repeal of federal motor fuels excise taxes. If the hurricane’s damage resulted in a reduced and virtually immutable short-run supply of oil, the proposed policy would have increased the profits of suppliers with no change in price at the pump. However, over longer periods, economists generally estimate that motor fuel taxes are borne largely by consumers. Incidence is all about “elasticity,” behavioral response.

-Implications Policies may have different outcomes in the long run than in the short run. The adage “an old tax is a good tax” need not be valid as market conditions change.

3. Economic burden generally does not equal revenue yield In addition to using resources to pay a tax, market participants lose value from making choices they would not have made in the absence of the tax. The new choice is always inferior to the pre-tax choice. Economic burden is the sum of resources transferred to the government and the value of distorted behavior. The greater the behavioral response to a price change, the greater the economic burden, regardless of the revenue yield.

-Implications Revenue is the wrong measure to look at when assessing the burden and the distribution of the burden of a tax.  A low average tax rate does not necessarily mean a tax does little economic harm.  A high average tax rate does not necessarily mean a tax does great economic harm. Because burden results from loss of resources transferred to the government and changed behavior, revenue gained with little behavioral change is better than revenue gained with greater behavioral change.

4. Time value matters A dollar today is more valuable than a dollar tomorrow. True in real terms, more important in the presence of inflation. Well-known concept, many times not honored in tax policy design.

-Implications(1) Creates difficulty in defining income for the tax base, particularly if the intent is to tax real income.  E.g., Appropriate cost recovery schedules.  E.g., Realized capital gains.  E.g., Application of NOL, GBC, FTC carryforwards.

-Implications (2) Seemingly different policies can create identical economic incentives.  E.g., traditional vs. Roth IRA.  E.g., ITC vs accelerated depreciation. Subsidies delivered through Code cannot be of equal value to all taxpayers unless:  Refundable, or  Deferred with interest.

5. Some costs are sunk and some costs are variable A sunk cost is inframarginal, it does not affect behavior going forward. A tax change may affect the value of an existing asset (sunk cost), but generally not its supply. Where an expense is variable, a tax change may affect supply.

-Implications Policy makers spend significant time considering transition relief.  For sunk investments such relief has no effect on the economy.  Such relief is generally about perceptions of fairness. Providing transition relief for sunk investments can mean higher tax rates and more distortion of variable investments.