Tax Reform: Principles and Implementation Supply, Demand, and Deadlines October 17, 2006

1. Tax Reform: Principles and Implementation Supply, Demand, and Deadlines October 17, 2006 V. V. Chari University of Minnesota and Federal Reserve Bank of Minneapolis

2. Takeaways ___________________________________________  Consumption taxes better than income taxes  Commitment to stable, predictable rules critical in fiscal policy  Simplification is a red herring

3. Principles of Public Finance ____________________________  True burden of taxation is government spending Not current tax revenues  Timing issues second order  In practice, pretty much all taxes distort decisions  Finance Minister’s problem: How to raise given amount of revenue while minimizing distortions

4. Principles of Public Finance (continued) ____________________  People pay taxes  Businesses and corporations are a veil  Taxing business to business transactions isn’t good way to raise revenue  Should tax similar goods at similar rates  Should tax inelastic factors heavily

5. Key Margins ___________________________________________  How much to work  How much to save

6. Key Margins (continued) _________________________________  Sources of revenue Labor income taxes  Capital income taxes  Consumption taxes  Only two margins: So all tax systems equivalent to system with, for example,  Labor income taxes  Consumption taxes  Initial capital income

7. What do Positive Capital Income Taxes Mean ________________  Higher taxes on future consumption than current consumption  In most economic models, current and future consumption similar  So should tax at similar rates  So positive capital income taxes bad idea

8. Temptation to Tax Capital Income ________________________  Today’s capital is result of past investment decisions  Cannot be changed much  Good idea to tax it heavily  When tomorrow comes . . .

9. Tradeoff Between Equity and Efficiency ____________________  Little bit of a red herring  Equity concerns can be accommodated pretty easily in efficient tax system

10. Bottom-Line Lessons from Public Finance __________________  Tax rates on labor and consumption should be roughly constant  Capital income should not be taxed, intertemporal decisions should not be distorted  Fiscal policy has time inconsistency problem Institutions to solve this problem are desirable

11. Solving the Time Inconsistency Problem _________________  Fed independence key for good monetary policy  Would an independent institution help for fiscal policy?  Base Closing Commission analogy: Government’s proposal voted up or down by Congress

12. Special Preferences ____________________________________  Health insurance: Health care is not that special  Child Exemptions: Fertility rate not a problem in the United States  Home mortgage interest deductibility: True tax break is failure to tax imputed housing income  Charitable deductions: Decentralized giving may be better than government provision of public goods

13. Chari’s Ideal Tax System _______________________________ Progressive Consumption Tax implemented as follows: Households:  Income defined in same say 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

14. Businesses:  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

15. Why is this desirable? 1. Eliminates intertemporal distortions 2. Similar to current system 3. Allows for desired level of progressivity 4. No windfall gain to holders of old capital

16. Takeaways ___________________________________________  Consumption taxes better than income taxes  Commitment to stable, predictable rules critical in fiscal policy  Simplification is a red herring

17. Advisory Panel on Tax Reform __________________________  President establishes panel on January 7, 2005  Panel to raise same revenues as current system  Bipartisan with two distinguished economists  Panel submits recommendation on November 1, 2005

18. Proposals ___________________________________________  Two plans: Simplified Income Tax Plan Growth and Investment Tax Plan  Panel also discusses Progressive Consumption Tax Plan

19. Key Features of Both Plans _____________________________ Household Income Tax  Reduce top marginal tax rates  Repeal Alternative Minimum Tax  Replace mortgage interest deduction with tax credit  Limit health insurance deduction  Consolidate retirement, education, and health savings plans  Provide incentives for low income taxpayers to save

20. Key Features _________________________________________ Corporate Income Tax Simplified Plan  Dividends excluded at household level  Simplified depreciation schedules  Territorial Tax System for Interest and Income Growth and Income Plan  Dividends received by households taxed at 15%  Expensing of new investment  Destination-based system

21. Claimed Advantages of Proposals ________________________  Simplification  Base broadening  Lower tax rates  Closer to a consumption tax