Tax Reform: Theory and Evidence

1. Tax Reform:Theory and Evidence Professor John A. Spry, Ph.D University of St. Thomas jaspry@stthomas.edu The views expressed herein are solely those of the author and do not necessarily represent the views of the State of Minnesota or the University of St. Thomas. All errors are my own.

2. Revenue-Neutral Tax Reform The goal is to increase the size of the economy while meeting the needed revenue goal Reduce reliance on costly inefficient taxes Increase reliance on less distortionary taxes Generally, avoid high tax rates with narrow tax bases that are highly responsive to tax rates use low tax rates on broad bases that are less responsive to tax rates

3. Source: http://woodrow.mpls.frb.fed.us/pubs/region/08-06/poterba.pdf Source: http://woodrow.mpls.frb.fed.us/pubs/region/08-06/poterba.pdf

4. A Tax Theorist’s Guide to Spotting “Better” and “Worse” Taxes for Economic Growth “Better” Taxes for Growth Minimally reduce gains from trade An inelastic tax base Small tax rate wedge (from combine federal and state rates) Low administrative costs Low compliance burden “Worse” Taxes for Growth Large distortions in the decisions of people and businesses Multiple ways for creative individuals to change behavior A large tax rate wedge (from combine federal and state rates) A highly mobile tax base High administrative costs Large compliance burden

5. Minnesota is a Small Open Economy  Minnesota has 0.08% of the world population. Minnesota GDP is about 0.33% of world GDP. We should compare our taxation of capital internationally, as capital is highly mobile today. We should compare our taxation of labor and savings nationally, because high human capital workers are very mobile today. How does Minnesota compare Internationally? What decisions face huge combined Minnesota and federal tax rates? Source for 2007 World GDP (PPP dollars): http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP_PPP.pdf Source for 2007 Minnesota GDP: http://www.bea.gov/scb/pdf/2008/08%20August/D-Pages/0808dpg_i.pdf Source for World Population: http://www.census.gov/ipc/www/popclockworld.html Source for Minnesota Population: http://quickfacts.census.gov/qfd/states/27000.html Minnesota has 0.08% of the world population. Minnesota GDP is about 0.33% of world GDP. 1 of every 301 dollars of value produced in the world is produced in Minnesota. Source for 2007 World GDP (PPP dollars): http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP_PPP.pdf Source for 2007 Minnesota GDP: http://www.bea.gov/scb/pdf/2008/08%20August/D-Pages/0808dpg_i.pdf Source for World Population: http://www.census.gov/ipc/www/popclockworld.html Source for Minnesota Population: http://quickfacts.census.gov/qfd/states/27000.html Minnesota has 0.08% of the world population. Minnesota GDP is about 0.33% of world GDP. 1 of every 301 dollars of value produced in the world is produced in Minnesota.

6. Source: Tax and Economic Growth, OECD Working Paper 620 Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF Source: Tax and Economic Growth, OECD Working Paper 620 Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF

7. Minnesota is a Small Open Economy -but Minnesota has a Tax Code Designed for a Closed Economy Minnesota’s 41.4% combined statutory federal and state corporate income tax rate is 50% higher than the OECD average of 27.6%. Original idea - place the burden of the state corporate income tax on the owners of capital invested in Minnesota Minnesota taxes intended to fall on capital miss in an open economy Minnesota workers, consumers, and land owners get hit by taxes designed to burden owners of capital How we tax Minnesota source-based capital determines how much capital is invested in Minnesota - but not the world rate of return on capital. The pre-tax rate of return hurdle for investments in Minnesota is higher because competition in the capital market equalizes after tax rates of return across jurisdictions adjusting for risk. Source: Hodge, Scott. "U.S. States Lead the World in High Corporate Taxes" The Tax Foundation, Fiscal Fact No. 119. March 18, 2008. The original idea was to place the burden of the state corporate income tax on the owners of capital invested in Minnesota as if Minnesota was a closed economy. Minnesota’s high tax on capital doesn’t mean we don’t have capital investments in Minnesota. The pre-tax rate of return hurdle for investments in Minnesota is higher because competition in the capital market equalizes after tax rates of return across jurisdictions adjusting for risk. Source: Hodge, Scott. "U.S. States Lead the World in High Corporate Taxes" The Tax Foundation, Fiscal Fact No. 119. March 18, 2008. The original idea was to place the burden of the state corporate income tax on the owners of capital invested in Minnesota as if Minnesota was a closed economy. Minnesota’s high tax on capital doesn’t mean we don’t have capital investments in Minnesota. The pre-tax rate of return hurdle for investments in Minnesota is higher because competition in the capital market equalizes after tax rates of return across jurisdictions adjusting for risk.

8. Specifically, how do we learn what are “better” and “worse” taxes for economic growth and prosperity? Even an ideal tax system would create some extra tax burden in excess of tax receipts to meet our need revenue target. Analysis should be grounded in the economic theory of taxation Rely on the serious, scholarly empirical research on the effects of taxes on economic decision making and economic performance Review the exciting scholarly empirical research on the effects of taxes on economic decision making and economic performance -This literature uses rigorous panel data not only on the aggregate performance of state or national economies but studies the effects of taxes on individual and individual firms.Review the exciting scholarly empirical research on the effects of taxes on economic decision making and economic performance -This literature uses rigorous panel data not only on the aggregate performance of state or national economies but studies the effects of taxes on individual and individual firms.

9. Specific problems caused by the Minnesota Corporate Franchise Tax A high rate (41.4% ) even before considering the double taxation of corporate income Strong disincentive for C-corp investment in Minnesota -Foreign Direct Investment in a state falls one percent for every one percent increase in the state corporate income tax rate. Source: Prof. Claudio A. Agostini, Public Finance Review, 2007 -” ... the effective corporate tax rate has a large adverse impact on aggregate investment, FDI, and entrepreneurial activity. For example, a 10 percent increase in the effective corporate tax rate reduces aggregate investment to GDP ratio by 2 percentage points. Corporate tax rates are also negatively correlated with growth, and positively correlated with the size of the informal economy. –Prof. Andrei Shleifer, et. al, Harvard University It doesn’t collect much revenue for a tax with a 9.8% rate. Sources: Claudio A. Agostini, "The Impact of State Corporate Taxes on FDI Location," Public Finance Review 2007; 35; 335. http://pfr.sagepub.com/content/abstract/35/3/335 Sineon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, "The Effect of Corporate Taxes on Investment and Entrepreneurship," National Bureau of Economic Research, Working Paper 13756, January 2008. http://www.nber.org/papers/w13756 -” ... the effective corporate tax rate has a large adverse impact on aggregate investment, FDI, and entrepreneurial activity. For example, a 10 percent increase in the effective corporate tax rate reduces aggregate investment to GDP ratio by 2 percentage points. Corporate tax rates are also negatively correlated with growth, and positively correlated with the size of the informal economy. The results are robust to the inclusion of controls for other tax rates, quality of tax administration, security of property rights, level of economic development, regulation, inflation, and openness to trade.” – NBER Working Paper 13756 Sources: Claudio A. Agostini, "The Impact of State Corporate Taxes on FDI Location," Public Finance Review 2007; 35; 335. http://pfr.sagepub.com/content/abstract/35/3/335 Sineon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, "The Effect of Corporate Taxes on Investment and Entrepreneurship," National Bureau of Economic Research, Working Paper 13756, January 2008. http://www.nber.org/papers/w13756 -” ... the effective corporate tax rate has a large adverse impact on aggregate investment, FDI, and entrepreneurial activity. For example, a 10 percent increase in the effective corporate tax rate reduces aggregate investment to GDP ratio by 2 percentage points. Corporate tax rates are also negatively correlated with growth, and positively correlated with the size of the informal economy. The results are robust to the inclusion of controls for other tax rates, quality of tax administration, security of property rights, level of economic development, regulation, inflation, and openness to trade.” – NBER Working Paper 13756

10. Specific problems caused by the Minnesota Corporate Franchise Tax “The domestic distortions that the corporate income tax induces are large compared with the revenues that the tax generates…Overall, on the basis of a survey of estimates derived from published corporate tax studies, Gravelle concludes that the combined cost of the first five domestic inefficiencies discussed in this chapter could exceed the total amount of corporate tax revenues collected. – CBO, 2005 “Corporate income taxes appear to have a particularly negative impact on GDP per capita. This is consistent with the previously reviewed evidence and empirical findings that lowering corporate taxes raises TFP growth and investment. Reducing the corporate tax rate also appears to be particularly beneficial for TFP growth of the most dynamic and innovative firms. Thus, it seems that corporate taxation affects performance particularly in industries and firms that are likely to add to growth. Source: OECD Tax and Economic Growth Sources: http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF Sources: http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF

11. Specific problems caused by the Minnesota Corporate Franchise Tax It distorts firms’ decisions between equity and debt finance It has the highest administrative cost for the DOR per dollar raised It is a regressive and probably highly regressive tax that falls on in-state consumers and workers. Perhaps shockingly, the current Minnesota CFT, or any heavily sales apportioned state income tax, acts to place a hidden, and somewhat arbitrary form of sales tax on everything sold in the state by corporations, including food, prescription drugs, clothing, and other goods that may be popularly thought to be tax free. “in the long-run a $1 increase in the tax bill tends to reduce real wages at the median by 92 cents.” Source: Oxford University Centre for Business Taxation “The Direct Incidence of Corporate Income Tax on Wages” Sources: http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf The tax incidence of a CFI with 100% sales apportionment depends on factors like whether certain individuals tend to consume goods whose production is finance by debt or equity.Sources: http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf The tax incidence of a CFI with 100% sales apportionment depends on factors like whether certain individuals tend to consume goods whose production is finance by debt or equity.

12. Source “On The Relative Distortions of State Sales and Corporate Income Taxes” Profs. Donald Bruce, John Deskins, and William Fox. Paper to be presented at the 2008 Annual Conference of the National Tax Association Source: “On The Relative Distortions of State Sales and Corporate Income Taxes” Donald Bruce, John Deskins, and William Fox. Paper to be presented at the 2008 Annual Conference of the National Tax Association http://web.utk.edu/~dbruce/bruce.deskins.fox.distortions.pdf Source: “On The Relative Distortions of State Sales and Corporate Income Taxes” Donald Bruce, John Deskins, and William Fox. Paper to be presented at the 2008 Annual Conference of the National Tax Association http://web.utk.edu/~dbruce/bruce.deskins.fox.distortions.pdf

13. Source: Tax and Economic Growth, OECD Working Paper 620 Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF Source: Tax and Economic Growth, OECD Working Paper 620 Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF

14. Specific problems caused by the Minnesota Personal Income Tax on Wages Minnesota’s has a 40.1% current combined statutory top federal and state personal income tax rate. The original idea is to place the burden of the state personal income tax on households with high personal income in Minnesota as if Minnesota was a closed economy. A large disincentive to supply additional hours of effort Iceland’s Natural Experiment A large disincentive to invest in education and on-the-job-training A large disincentive to take risky, disagreeable jobs that receive a compensating wage premium for less pleasant working conditions A strong incentive to take compensation in tax preferred forms (perks, exotic business trips, benefits, ect.) Source: http://ideas.repec.org/a/aea/aecrev/v91y2001i5p1564-1579.html “The move to a pay-as-you-earn income tax system in Iceland in 1987-1988 made income earned in 1987 tax-free. Using a sample of 9,274 individuals for the years 1986, 1987 and 1988, we calculate the labor-supply response of this change and find that total labor supply rose by 6.7% in 1987 over the average of 1986 and 1988 when we correct for entry in 1988. This consists of an 8.6% increase in weeks supplied by those already in the labor market in 1986 and a 1.9% decline due to entry/exit. The elasticity of weeks worked to the rise in after-tax wages was 0.41 for men and 0.11 for women.” “Iceland’s Natural Experiment in Supply-Side Economics” American Economic Review, 2001Source: http://ideas.repec.org/a/aea/aecrev/v91y2001i5p1564-1579.html “The move to a pay-as-you-earn income tax system in Iceland in 1987-1988 made income earned in 1987 tax-free. Using a sample of 9,274 individuals for the years 1986, 1987 and 1988, we calculate the labor-supply response of this change and find that total labor supply rose by 6.7% in 1987 over the average of 1986 and 1988 when we correct for entry in 1988. This consists of an 8.6% increase in weeks supplied by those already in the labor market in 1986 and a 1.9% decline due to entry/exit. The elasticity of weeks worked to the rise in after-tax wages was 0.41 for men and 0.11 for women.” “Iceland’s Natural Experiment in Supply-Side Economics” American Economic Review, 2001

15. Specific problems caused by the Minnesota Personal Income Tax on Wages Labor mobility of highly skilled individuals ”The evidence presented in this paper supports the basic theoretical presumption that state and local governments cannot redistribute income. Since individuals can avoid unfavorable taxes by migrating to jurisdictions that offer more favorable tax conditions, a relatively unfavorable tax will cause gross wages to adjust until the resulting net wage is equal to that available elsewhere. The current empirical findings go beyond confirming this long-run tendency and show that gross wages adjust rapidly to the changing tax environment. Thus, states cannot redistribute income for a period of even a few years. The adjustment of gross wages to tax rates implies that a more progressive tax system raises the cost to firms of hiring more highly skilled employees and reduces the cost of lower skilled labor. A more progressive tax thus induces firms to hire fewer high skilled employees and to hire more low skilled employees. Since state taxes cannot alter net wages, there can be no trade-off at the state level between distribution goals and economic efficiency. Shifts in state tax progressivity, by altering the structure of employment in the state and distorting the mix of labor inputs used by firms in the state, create deadweight efficiency losses without achieving any net redistribution.” Source: Professors Feldstein and Wrobel, Journal of Public Economics, 1998. Source: http://ideas.repec.org/p/nbr/nberwo/4785.htmlSource: http://ideas.repec.org/p/nbr/nberwo/4785.html

16. Specific problems caused by the Minnesota Personal Income Tax on Wages? Labor mobility of highly skilled individuals “This paper examines the responsiveness of the rich to state income taxes. We use Major League Baseball free agents who were named All-Stars at some point in their career and who signed with a U.S. team for the 1991 through 2002 seasons. This data set overcomes some of the previous difficulties encountered in similar studies but also has limitations representing the general rich population. We find evidence that the wages of this subset of players do adjust to offset the burden of state income taxes, specifically a 1% decrease in net-of-tax rate leads to a 3.3% increase in salary.” – Professors Ross and Dunn, Contemporary Economic Policy, 2008 High combined state and federal tax rates leads to a high marginal cost of public funds, even without considering labor mobility. “An across-the board increase in personal tax rates involves a deadweight loss of 76 cents per dollar of revenue and collects only about two-thirds of the revenue implied by a “static’ calculation.” –Feldstein, “The Effects of Taxes on Efficiency and Growth.” Tax Notes, 2006. Sources: http://econpapers.repec.org/article/blacoecpo/v_3A25_3Ay_3A2007_3Ai_3A4_3Ap_3A639-648.htm Feldstein, “The Effects of Taxes on Efficiency and Growth.” Tax Notes, 2006. May 8, 2006. Sources: http://econpapers.repec.org/article/blacoecpo/v_3A25_3Ay_3A2007_3Ai_3A4_3Ap_3A639-648.htm Feldstein, “The Effects of Taxes on Efficiency and Growth.” Tax Notes, 2006. May 8, 2006.

17. Specific problems caused by the Minnesota Personal Income Tax on Saving The effective combined effects of federal and state taxes and inflation results in a tax rate on saving through banks or bonds can easily exceed 100% annually! “Taxing capital involves taxing income twice: once when you receive it, before you save it, and then once again when you get the return on the savings. It gives a bias toward consuming now rather than consuming later and depresses capital accumulation.” Source: Nobel Prize Winner Professor Robert Lucas, in the Region Magazine from the Minneapolis Federal Reserve Bank Source: http://www.minneapolisfed.org/pubs/region/93-06/int936.cfm The effective combined effects of current federal and state taxes and inflation results in a tax rate on saving through equity investments that pyramids with the length of the savings horizon and can approach 100% for 30 years. “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas “A worker with a backhoe makes more than a worker with a shovel.” –Professor Chris Phelan, University of Minnesota, Department of Economics Source: http://www.minneapolisfed.org/pubs/region/93-06/int936.cfm The effective combined effects of current federal and state taxes and inflation results in a tax rate on saving through equity investments that pyramids with the length of the savings horizon and can approach 100% for 30 years. “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas “A worker with a backhoe makes more than a worker with a shovel.” –Professor Chris Phelan, University of Minnesota, Department of Economics

18. Tax and Economic Growth -OECD Conclusions Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas

19. References Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas “A worker with a backhoe makes more than a worker with a shovel.” –Professor Chris Phelan, University of Minnesota, Department of Economics Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas “A worker with a backhoe makes more than a worker with a shovel.” –Professor Chris Phelan, University of Minnesota, Department of Economics

20. References Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas “A worker with a backhoe makes more than a worker with a shovel.” –Professor Chris Phelan, University of Minnesota, Department of Economics Source: http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF “Many people have estimated, and this is not an original remark or observation of mine, that the U.S. capital stock could be 30, 40, 50 percent higher than it is now under a tax structure that doesn't penalize capital accumulation with this double taxation. It's an important issue.” – Professor Robert Lucas “A worker with a backhoe makes more than a worker with a shovel.” –Professor Chris Phelan, University of Minnesota, Department of Economics