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Tax Reform: Lessons from Economic Theory

Tax Reform: Lessons from Economic Theory. V. V. Chari University of Minnesota and Federal Reserve Bank of Minneapolis. Reproduction or quotation of this material is expressly forbidden without the consent of the Author. Principles of Public Finance. Essentially all taxes distort decisions

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Tax Reform: Lessons from Economic Theory

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  1. Tax Reform:Lessons from Economic Theory V. V. Chari University of Minnesota and Federal Reserve Bank of Minneapolis Reproduction or quotation of this material is expressly forbidden without the consent of the Author.

  2. Principles of Public Finance • Essentially all taxes distort decisions • Key margins • How much to work • How much to save • Budget necessarily balanced in a present value sense

  3. Lessons from Public Finance • Desirable to tax final goods and primary inputs: Consumption, labor income, existing capital income • Presumption that uniform taxes desirable • Income from current and future investments should not be taxed

  4. Lessons from Public Finance • Similar goods should be taxed at similar rates • Capital income taxation equivalent to taxing future consumption at ever-growing rates • High taxation of initial capital income together with low future capital income taxes desirable. Creates time inconsistency problems

  5. Lessons from Public Finance Do Consumption Taxes have to be linear? Absolutely not! Arbitrarily High Levels of Progressivity possible

  6. Special Preferences • Health insurance: $130 billion • Child exemptions: $ 30 billion Fertility rate not a problem in the United States • Home mortgage interest deductibility: $70 billionTrue tax break is failure to tax imputed consumption from housing • Charitable deductions: $30 billion Decentralized giving may be better than government provision of public goods but strained argument

  7. Chari’s Ideal Tax System Progressive Consumption Tax implemented as follows: Households: • Income defined in same way as currently, except that employer-provided fringe benefits are included • Universal Savings Accounts. Annual contributions cannot exceed income (or some fraction thereof) • Taxable Income (which is basically the same as consumption) = Total Income + Withdrawals from USAs – Contributions to USAs • Progressive tax rates on consumption

  8. Businesses: Do not have to tax them. May be good for administrative ease • Taxable Income = Revenues – Payments to employees – Payments to other businesses for goods and services • Note: Definition of taxable income has expensing of investment, so intertemporal decisions are not distorted

  9. Why is this desirable? • Eliminates intertemporal distortions • Similar to current system • Allows for desired level of progressivity • No windfall gain to holders of old capital

  10. Why is Tax Reform Difficult? • We ask tax system to achieve multiple goals • Pretty much all “preferences” serve some social good • Public’s job is to revisit many of these arguments

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