A few of my favorite things. James Hines, University of Michigan

1. A few of my favorite things.James Hines, University of Michigan • Paying taxes is not the same as bearing tax burdens. • Capital taxes are the most distortionary of all. • Efficient tax policies make everyone better off. • Markets work; the economy is in general equilibrium. • Broad-based, low-rate tax systems are not optimal.

2. 1. Paying taxes is not the same as bearing tax burdens. • Why the difference? Because taxes affect prices, and price movements impose burdens. • Hence, for example, sellers bear part of the burden of a sales tax increase if it forces them to reduce their prices. • The extent to which tax burdens are shifted depends on supply and demand throughout the economy. • Example: Social Security taxes – are they really paid half by employers and half by employees? Well, no. And the burden on employees would be completely unaffected if the employer instead paid 75 percent or 100 percent of the Social Security taxes (with compensating adjustment in the benefit schedule).

3. Implications. • The distributional effects of taxes may look very different than how they are commonly conceived and measured. The actual tax burden is not a function of who remits money to the government. • For example, the burden of a source-based capital income tax in an open economy falls entirely on fixed factors (primarily labor). This effect is quite real, even though it is invisible to any single individual or company.

4. 2. Capital taxes are the most distortionary of all. • The effects of capital taxes compound over time, making these taxes extremely costly. • Even a low rate of capital tax imposes a huge wedge between consumption now and consumption 30 years from now. • No other tax has this compounding feature. There is something deceptive about the real burden in a setting with compounding. • The cost is greatest in an open economy, since the supply of capital is so elastic.

5. Implications. • If the goal is to impose greater tax burdens on the rich than on other income groups, then capital income taxation is a terribly inefficient way to achieve this goal. • Much better would be to adopt sharply progressive consumption taxes, for example. • If the goal is to impose greater tax burdens on foreigners, then capital income taxes will not achieve that goal. Instead, capital income taxes significantly reduce local incomes by distorting the economy and thereby reducing the productivity of local labor and other productive factors.

6. 3. Efficient tax policies make everyone better off. • Efficient tax policies minimize distortions to resource allocation. • Often there are apparent conflicts between efficiency objectives and distributional objectives. • These conflicts can be real, but may be misplaced in evaluating particular taxes, since there is more than one way to redistribute income. • Generally speaking, governments should redistribute income in the most efficient manner, and not by any possible means and with every available tax.

7. Implications. • For example, taxes that might be attractive because they help to protect the environment or correct other problems may be undesirable on distributional grounds. • The distributional consequences of environmental taxes can be remedied in other ways, notably, through changes in income tax schedules. • An efficient system is one that pursues every goal efficiently, which then offers more for everyone, including more effective pursuit of efficiency and distributional objectives.

8. 4. Markets work; the economy is in general equilibrium. • All markets clear in general equilibrium, which implies that everything affects everything else. • There is evidence that not all markets work perfectly all of the time, but these deviations from market efficiency – which are of great interest to academics – tend to be very small.

9. Implications. • Economic adjustments, including bankruptcies and plant closings, can be signs of economic health. When some firms close, others open using the freed resources. • This is progress; this is why we are not all still farmers. • Practical applications of general equilibrium: • Imposing a much higher tax on gasoline reduces consumer purchases in Detroit, and thereby reduces state sales tax collections in Michigan. • The principle that markets work – the “law of one price” - implies that VAT border adjustments do not stimulate greater exports.

10. 5. Broad-based, low-rate tax systems are not optimal. • Many bad tax systems share the attribute of having narrow bases and high rates. • It does not, however, follow that broad-based, low-rate systems are optimal. (Though they may be better than various bad alternatives.) • Economic theory indicates that price-insensitive activities should be taxed at higher rates than price-sensitive activities. And economic theory calls for low capital tax rates. There is no theoretical case for broad-based low-rate tax systems.

11. Implications. • The idea that all income should be taxed at the same rate may have political or other practical appeal, but such policies are costly in economic terms. • One might want to distinguish: • Capital and labor income. • Domestic and foreign income. • Capital gains and ordinary income. • Other forms of income that differ in their price sensitivities.