ARE TAX CUTS SELF-FINANCING? Presentation at the CEPOS conference on ”Tax Cuts, Employment and Growth” June 12, 2006 by Professor Peter Birch Sørensen University of Copenhagen, EPRU and CESifo Chairman of the Danish Economic Council

THE LAFFER CURVE Tax rate Tax revenue 0% 100%

DID LAFFER INVENT THE LAFFER CURVE? ● Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: ”It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.” ● John Maynard Keynes, Collected Writings: ”Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”

THE WELFARE GAIN FROM HIGHER EMPLOYMENT 1. Gain: Increase in output ≈ pre-tax wage rate: W 2. Loss: Welfare cost of additional work ≈ after-tax wage rate: W(1-t) 3. Net gain to society = 1.– 2.= marginal tax rate ● pre-tax wage rate = tW

TAX REVENUE AND WELFARE Suppose that a tax cut increases total labour supply by the amount ΔL. Then: Net welfare gain = tW● ΔL = increase in tax revenue = ”dynamic effect” Insight: The ”dynamic effect” on tax revenue is an indicator of the welfare gain from the tax cut. If we want to maximize the gain in economic welfare, we should cut taxes where the expected dynamic effect (the degree of self-financing) is the greatest.

THE DYNAMIC EFFECT The degree of self-financing (D): ε = elasticity of tax base, t = tax rate. Assume ε = 0.2 Example 1: Initial tax rate t = 50% → D = 20% Example 2: Initial tax rate t = 75% → D = 60% Insight: D is higher, the higher the initial tax rate Intuition: In Example 1 a 10 percentage point cut in the tax rate increases after-tax income by 20%; in Example 2 a similar tax cut increases after-tax income by 40%

WHO SHOULD GET THE TAX CUTS? THE CONCLUSION SO FAR If we care about economic efficiency rather than equity, it seems that we should start by cutting the highest tax rates (from the top of the income distribution) but things are not that simple

TWO DIMENSIONS OF LABOUR SUPPLY Hours worked (”effort”) are influenced by the marginal tax rate Labour force participation is influenced by the (sum of the) average tax rate on labour income and the replacement rate (net benefits relative to wages) Evidence from the US and the UK: Participation is more sensitive to economic incentives than hours worked

A TWO-CLASS ECONOMY: AN EXAMPLE Hypothetical tax schedule: 30% tax rate on the first 100 units of income, 50% tax rate on all income above 100 High-income earner 1. Pre-tax labour income After-tax labour income Potential transfer income in case of non-employment Incentive to work = 2. – Low-income earner 1. Pre-tax labour income After-tax labour income Potential transfer income in case of non-employment Incentive to work = 2. – 3. 30

THE EFFECTS OF TAX REFORM ON WORK INCENTIVES Reform 1: Switch to flat 30% tax Revenue cost = 20% of 100 = 20 No increase in work incentive for low-income earner Work incentive of high-income earner increases from 80 to 100 = 25% Reform 2: In-work benefit = 20% of earnings with cap at 20 and gradual phase-out at earnings between 100 and 200 Revenue cost = 20% of 100 = 20 (note: no benefit to high-income earner) No increase in work incentive for high-income earner Work incentive of low-income earner increases from 30 to 50 = 67% Insight: When labour force participation is sensitive to taxation but hours worked are not, it is more efficient to concentrate tax cuts at the bottom of the income distribution

TAX CUTS: DEGREES OF SELF-FINANCING Type of tax cut % change in progressivity Degree of self-financing (%) Increase in Earned Income Tax Credit (beskæftigelsesfradrag) Cut in payroll tax (arbejdsmarkedsbidrag) Cut in medium tax rate (mellemskat) Cut in top tax rate (topskat) Note: All tax cuts are designed to have the same effect on long-run fiscal sustai- nability. The estimates do not include effects on educational effort and migration Source: Danish Economic Council, The Danish Economy, Fall 2004.

CAVEATS The degree of self-financing varies across population groups; Laffer-effects may occur for some groups and some types of tax cut So could tax cuts be self-financing after all? Mind the words of John Maynard Keynes: ”Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.” Morale: Timing is essential. Don’t cut taxes in expectation of Laffer effects when the economy works at full capacity.

DYNAMIC EFFECTS: AN ALTERNATIVE PERSPECTIVE While tax cuts are generally not self-financing, the introduction of mandatory individual savings accounts to finance a part of social transfers is likely to be self-financing Motivation for introducing individual accounts: ● 74% of the taxes levied to finance Danish social transfers are paid back to the taxpayer himself over the life cycle ● Many social transfers imply little redistribution of lifetime income from rich to poor

A DESIGN FOR SOCIAL INSURANCE BASED ON INDIVIDUAL SAVINGS ACCOUNTS For each taxpayer an individual account (IA) is established A mandatory social security contribution is credited to the IA; the contribution replaces part of the taxpayer’s labour income tax Receipts of certain social transfers are debited to the IA Interest is added to or subtracted from the balance on the IA Any surplus on the IA at the date of retirement is converted into an annuity which is added to the public pension. Persons with a negative IA balance receive the public pension

Properties of the IA system Insurance properties ● Liquidity insurance ● Lifetime income insurance Incentive properties ● Reduced marginal tax rate ● Reduced replacement rate (selective tax and benefit cut for those with positive IA balances at retirement)

An IA system for Denmark (DEC proposal) Transfer programs included in IA system: ● Short-term unemployment benefits ● Early retirement benefits ● Education benefits in higher education ● Sickness benefits (up to a limited number of sickness days) ● Child benefits ● Parental leave benefits The payroll tax is cut by 7.9 percentage points and replaced by a mandatory contribution to the IA

Effects of the IA system on income distribution: Summary statistics Gini coefficients ● Lifetime factor income: ● Lifetime disposable income, current system: ● Lifetime disposable income, DEC proposal: Redistribution of lifetime income Current system: (0.253 – 0.127)/0.253 = 49.8 % DEC proposal: (0.253 – 0.133)/0.253 = 47.4 %

EFFECT ON THE PUBLIC BUDGET Even with moderate labour supply elasticities, the DEC proposal improves the public budget. The reason is that the proposal involves ● a cut in the marginal labour income tax rate combined with ● a cut in the replacement rate in the transfer programs included in the scheme Note: Effectively the replacement rate is cut by 100 percent, but the cut is felt at a stage in the life cycle where the taxpayer can more easily afford it.

CONCLUSIONS ● Mandatory saving accounts for (part of) social insurance can offer liquidity insurance and lifetime income insurance in a more efficient manner than the current tax-transfer system ● An IA system is likely to be self-financing. It therefore has the potential to generate a welfare gain for the majority of the population without making anybody worse off and without significantly increasing the inequality of lifetime income distribution