1. FUNDAMENTAL TAX REFORM: TAXES ON CONSUMPTION AND WEALTH
Chapter 21

2. 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

3. 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

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

5. 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

6. 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)

7. 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) =

8. Retail Sales Tax General sales tax
Percent of own-source revenue from sales taxes
State: 34.7%
Local: 10.0%
Selective sales tax (excise tax or differential commodity tax)
Forms of a sales tax
Unit tax
Ad valorem tax

9. Rationalizations for Sales Taxes
Ease of administration
Defining the tax base
Tax evasion

10. 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

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

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

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

14. 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

15. 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?

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

17. 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

18. 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

19. 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

20. 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

21. 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.”

22. 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

23. Problems & Potential Reforms
Problems with Estate and Gift Taxes
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

24. Chapter 21 Summary
Arguments for substituting the income tax with a personal consumption tax include the elimination of double taxation, promotion of lifetime equity, promotion of efficiency, adjustability for progressiveness and administrative ease.
Arguments against the substitution point out that it has transition problems, it violates the of ability-to-pay rule, it is administratively burdensome, it can lead to excessive concentration of wealth, and it is regressive in nature
Sales taxes are important sources of revenues for state and local governments
The VAT is popular in Europe but not used in the U.S.
Wealth taxes are controversial. They are not a major source of revenue and little is known about the incentive effects or incidence of these taxes