FUNDAMENTAL TAX REFORM: TAXES ON CONSUMPTION AND WEALTH

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

2. How a Value-Added Tax Works

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

6. Annual versus Lifetime Equity – A Formal Model

7. Annual versus Lifetime Equity – A Formal Model

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 • 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 Advantages Disadvantages

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. 0 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