5. Tax Reform in Practice

1. 5. Tax Reform in Practice 5.1 Micro-Simulation of Tax Reform 5.2 Flat Tax Reform: The Case of Germany 5.3 Literature

2. Taxation Economics: Short Account of Tenth Lecture • Strict convexity of the relative concentration curve in terms of q (Theorem 2); this comes up to an elasticity expression of taxation as a functionof q by way of the inverse distribution function. A graph illustrated. • Strict convexity of the relative concentration curve in terms of p (Theorem 3); elasticity expression in terms of p by way of the inverse of the first moment distribution function minus the derivative of the inverse of the first moment distribution function. A graph illustrated. • Discrete versions of these curves for empirical investigations. • Definitions of greater tax progression. • Equivalence between the shapes of relative concentration curves and curve differences. • Problem of greater tax progression with nonconvex or nonconcave relative concentration curve. • Statistics of international and intertemporal comparisons of tax progression. • Comparisons of the respective graphs for six concepts of the comparison of tax progression between Germany and USA for the year 2000.

3. Does money provide the decisive incentives? There are other examples, for instance Diogenes. John William Waterhouse (1849-1917), Diogenes, 1882, Art Gallery of New South Wales, Sidney, Australia.

4. 5.1 Micro-Simulation of Tax Reform Micro-simulation models use household data to infer consequences of the tax-and-transfer system and its changes. In particular, this concerns the impact effects of tax and transfer incidence and the change of the distribution of net incomes. Micro-simulation models are based on the data set of a sample of households. The evaluation of the overall effects require an inference from the sample data to the universe of households according to the weights of the different household types in the sample. We have two types of micro-simulation models: Static micro-simulation models: These models are based on cross-section data, usually household income and expenditure data. The data refer to one particular time period of data collection. Whenever they are used for later periods, the data have to be adapted, e.g. to allow for inflation, changes in the legal system which have meanwhile occurred, changes in the composition of the universe, etc. [See Merz (1991), Harding (1993, 1996), Gupta and Kapur (2000)]. These models by and large analyze impact effects, i.e., they do not assume that the individuals react to changes in the parameter values. [One can introduce behavioral functions, but the are more related to the analyst’s imagination.]

5. Dynamic micro-simulation models: These micro-simulation models are based on panel data, i.e., household data are continuously reported for the same households for a sequence of periods [see O’Donoghue (2001)]. Such data allow time series analyses of the behavior of households. They capture births, death, marriage, divorce, disease. These models use probabilities concerning demographic and socio-economic processes and allow thus inferences about the behavior of the universe. Missing or deficient data: sample data suffer from incomplete data bases. There are household types which are not in the sample [e.g. in Germany people in old-age nurseries; soldiers], not all data of interest are included in the questionnaire [e.g. in Germany entrepreneurial profits which are withdrawn from the enterprise], some households may refuse to supply some data, because of ignorance, default, or mistrust, some households may supply defective data. Hence, several procedures were developed to deal with incomplete data. 1) Methods to deal with missing data: a) Ignore missing data and exclude the households for the respective analyses. Might cause biased results. b) Exclude households with missing data. Advisable if not too many units would be excluded. c) Change the weights for the households with the respective entries; causes a multitude of weights.

6. 2) Statistical methods of data completion. All these methods take the missing or deficient data from another data file. The data files have to be similar to apply this technique. a) Completion by the mean: the missing data is completed by the mean or median of the valid values. b) Apply regression methods; problem is the use of point estimates for this method (neglect of data dispersion). c) Hot deck techniques: the missing or deficient data are replaced by randomly drawn data from the valid data. d) Doubling: take a similar household with complete data instead of the household with deficient data. e) Use maximum likelihood methods. f) Use Bayesian methods for the estimation of missing data. 3) Deductive methods of data completion: Use logical methods to make plausibility inferences.

7. Micro-simulation models consist of many equations. Many models are programmed in BASIC. The user usually gets a screenshot with results and possibilities to change certain parameters. Then the results are shown. Usually, the user cannot change the shape of the equations without access to the model (which is in often not disclosed to the user) There is a micro-simulation model for Russia [DARTS = Distributional Analysis of the Russian Tax and Transfer System] built by André Decoster [Louvain] and Anthony Shorrocks for WIDER in Helsinki. [WIDER has also micro-simulation models for several African countries online.] This model is available online from the WIDER homepage. [SEE CD!] Micro-simulation models are particularly valuable for the analysis of the effects of taxation and social policy in a country. They can inform about the distributional effects of changes in tax regimes and social security regimes [i.e., who pays and who benefits?], and they can inform on the revenue effects of tax and social security reforms [i.e., can the reform be financed?]. Recall that these are the impact effects. Micro-simulation models cannot objectively inform about the behavioral reactions to the changed set of parameters of the tax regime and the social security regime. All respective assumptions are speculations which result from the imagination of the analyst. They are as good as the prophetical power of the analyst.

8. 5.2 Flat Tax Reforms: Comprehensive Tax and Social Security Reform in Germany: A Flat Tax with a Social Component

9. The most important practical tax reforms in many countries are flat tax reforms. Flat taxes according were adopted by Estonia in 1994 (26%), by Lithuania in 1994 (33%), by Latvia in 1997 (25%), by Russia in 2001 (13%), by the Ukraine in 2003 (13%), by Slovakia in 2004 (19%), by Georgia in 2005 (12%), by Romania in 2005 (16%), and by Macedonia in 2007 (12%). Serbia had introduced a constant marginal tax rate on labor income, but applies a kind of surtax on the sum of income from all sources exceeding a certain limit. Keen et al. (2006, 3, footnote 2, and 5, footnote 5) report that Bolivia (13%) and Paraguay (10%) introduced a flat tax, but mainly as an instrument to improve the compliance of the value added tax, and that Jersey and Guernsey (20%) and Jamaica (25%) had introduced a flat tax. Hong Kong SAR allows taxpayers the choice between a 16% flat tax (with a narrow range of deductions) and a progressive tax schedule. Some subnational governments, such as Illinois, Indiana, Massachusetts, Michigan, and Alberta, also levy a regional flat tax; Pennsylvania has a proportional flat tax. Recently three more countries joined the flat tax community, viz. Iceland (36%), the Czech Republic (15%), and Albania (10%). Interestingly enough, The Washington Post reported on November 2, 2003, that the U.S. Administrator of Iraq, L. Paul Bremer, had imposed a flat tax on Iraq (15%). Most flat taxes are flat taxes with personal allowances, i.e., taxation of income at a flat tax starts only after a threshold determined by the personal allowance. We will, however mostly concentrate on true flat taxes, i.e., truly proportional taxes.

10. Advantages of True Flat Taxes Optimality: Luce (1959) and Young (1988) showed that a logarithmic utility function of income is a plausible hypothesis. Combining a logartihmic utility function of income with the principle of equal absolute sacrifice yields a proportional tax schedule [Young (1988)]. Deadweight loss of impost: Feldstein (1999), among others showed that the deadweight loss of impost is in proportion to the square of the marginal impost rate. In other words: when the marginal impost rate increases from 30% to 45%, then the excess burden of impost does not increase by 50%, but by 125%! A proportional tax schedule with lump-sum social security contributions minimizes the deadweight loss of the tax and social security system. Work incentives: the marginal impost rate affects work incentives. Given the average tax burden, then work incentives are less impaired the smaller is the marginal impost rate. Tax arbitrage: when all components of income are taxed at a uniform proportional tax rate, then all incentives for tax arbitrage are eliminated.

11. Elimination of the splitting boon:in Germany the income tax of a married couple is computed as the application of the tax schedule to the mean income and the tax is computed by doubling this tax. For a progressive tax schedule with nondecreasing marginal tax rates this means a lower tax burden than the sum of the taxes on the incomes of the individual spouses. This splitting boon disappears under a proportional tax. Tax compliance:Hindriks, Keen and Muthoo (1999) showed that a proportional tax with a tax rate equal to the probability of a tax audit and a fine amounting to the evaded income, multiplied with the acceptance of the tax return without audit, is evasion-proof, corruption-proof and revenue maximizing. Administrative simplification:A proportional tax schedule is a functional equation, i.e., the tax on the sum of all income components equals the sum of the taxes on all income components. This allows tax collection by deductions at source without asking the taxpayer for an additional tax return in most cases. Taxation at source curbs tax evasion and tax avoidance: For the United States it was shown that taxes which are withheld at source and reported by third parties have a close to 100% tax compliance. Sources of income which are neither withheld nor reported by third parties have the lowest tax compliance. [See Gale and Holtzblatt (2002). Social security contributions are collected as lump-sum payments.

12. The Achilles’ Heel of a Flat Tax Reform: Income Distribution Using micro-simulation models one easily finds that a flat tax leads to a very unequal post-tax income distribution [for Germany see Fuest, Peichl and Schaefer (2006), for Denmark see Larsen (2006)]. In case of a true flat tax all relative income inequality measures do not change for pre-tax income and post-tax income. In case of a flat tax with personal allowances the lower income strata will win (as compared to a graduated income tax) and the highest income strata will win (because of the low rate of the flat tax). If the switch to a flat tax should be revenue neutral, then the middle income strata will inevitably be higher burdened. But the median voter is usually in the middle income strata, and (s)he will oppose such reforms. This explains why flat tax reform proposals have hardly any chance in highly democratic countries with established progressive income tax schedules. They are not politically sustainable. Hence, if we want to make use of the advantages of flat taxes, we have to supplement the tax régime by devices which work in the direction of a more equal income distribution. The integration of the social security framework into the tax reform allows to reach such a goal.

13. Germany: The sick man of Europe?

14. Tax Base versus Tax Schedule • German Finance Ministers such as Hans Eichel and Peer Steinbrück have argued in defence of high German tax rates in that the tax base in Germany is narrower than in other countries. • However, what international investors understand and compare are national tax schedules rather than tax bases. Tax bases are more opaque and more likely to stealthy manipulations than the tax schedule. – Just have a look at the changes of the German income-tax legislation in the period 1998-2006 [see Bhatti (2006)]! • Moreover, the jointoperation of taxation and social security contributions makes Germany a high-impost country, in particular as compared with the new EU member countries.

17. Tax Burden on Profits of Joint Stock Companies in the New EU Member States and in Germany Source: Jacobs et al., Company Taxation in the New EU Member States, Frkf-Mannheim 2004

18. High cost of labor in Germany • German workers and employees have since long been pampered by high gross wages/salaries. • High standards of social security (high pensions, early retirement, high rates of social welfare, good health care) led to high social security contributions and high taxes. • All that boosted labor costs in Germany and depressed net wages at the same time: The ratio of labor cost and net wage is about 3!

19. Structure of total cost of labor: Labor cost per full-employed worker/employee in productive Sectors (Germany West) Sonderzahlungen: Urlaubs- und Weihnachtsgeld; Bonuszahlungen; Beiträge zur Vermögensbildung Vergütung arbeitsfreier Tage: bezahlter Urlaub; Lohnfortzahlung bei Krankheit; Arbeitsentgelt für Feiertage; Arztbesuche während Arbeitszeit Aufwendungen für Vorsorgeeinrichtungen: Arbeitgeberbeiträge zur Kranken-, Pflege-, Arbeitslosen-, Unfall- und Rentenversicherung; Aufw. für betr. Altersversorgung und für sonstige Vorsorgeeinrichtungen des Arbeitgebers Sonstige Nebenkosten: Abfindungen; Kurzarbeitergeld; Familienunterstützungen; etc. First 6 lines in percentages; last line in €. Trade ist similar to workers; Germany East labor costs lower by some 40%. Source: Arbeitskostenerhebung 2000 des Statistischen Bundesamtes

21. Consequences: Firms move to low-wage and low-tax countries and jobs in Germany vanish • Therefore, high unemployment in Germany, concentrated among low-skilled labor force. • Older workers are less productive (electronics) and are more expensive, due to seniority wage scales. Hence, they are laid off and take early retirement. • This means heavy federal subsidies for old age pensions [PAYG-system in Germany]. • Moreover, there are high public expenses for social welfare, due to high benefit rates and large numbers of needy people.

22. Federal subsidy for old age pensions in Germany

23. Social welfare [Arbeitslosengeld II] (incl. lodging subsidy; in €; W/E; children 7-14 y.)

24. These high social welfare payments can be afforded only in conjunction with extremely high marginal withdrawal rates as own labor income is earned. They amount to 85% and more an can even reach 100% for some income intervals. Hence, it does not pay to work for the recipients of social welfare as hardly anything is left from their own labor income. Thus, whereas countries like the United States and Great Britain (since Mrs.Thatcher) have the “working poor” among the low qualified workforce, Germany has the “nonworking poor”. The difference is that the working poor care for themselves, whereas the maintenance costs of the nonworking poor boost public expenses and, consequently, the taxes and the social security contributions. Moreover, the ratchet effect on wages exerted by the high social welfare payments attracts immigration of low qualified labor force. For them, the social welfare payments are considered as a rather good salary as compared to what they can earn at home. As the domestic low qualified labor force refuses to work for wages even somewhat higher than the level of social welfare payments, low qualified immigrants (who have not yet acquired a claim to social welfare) are attracted by this wage level which the consider as very attractive. Hence, Germany attracts low qualified immigrants, who may later on, when they have acquired claims to social welfare, augment the army of the nonworking poor. Owing to these circumstances, Germany has high unemployment rates among the low qualified labor force. Moreover, their maintenance incurs heavy cost.

25. Taxation Economics: Short Account of Eleventh Lecture • Micro-simulation models: static versus dynamic models • Missing or deficient data • Flat tax reforms in various countries • Advantages of flat taxes • Problem of flat taxes: unequal income distribution • Tax and cost situation in Germany • Labor cost and tax burden • Subsidy for old age pensions in Germany • Level of social welfare • Immigration of unskilled workers to Germany

26. Past Reforms of the German Income Tax Schedule: A Case for Window-Dressing • German Finance Minister Peer Steinbrück told members of the Frankfurt Chamber of Commerce in January 2006 that the German income tax rates are at a historical low. • A look at the development of lowering the German income tax schedule shows that the cognitively spectacular parameters (minimum and maximum tax rates) have been lowered without impairing the area under the marginal income tax schedule (= tax revenue) too much. • Moreover, lowering the tax schedule has been partly counterbalanced by broadening the tax base, primarily for higher incomes and irregular incomes [see Bhatti (2006)]. • This means that the lower income strata have gained more from lowering the tax schedule than they lost from broadening the tax base.

27. Der bundesdeutsche Marginalsteuertarif: Reform Dezember 2003

28. The Dilemma of Tax Reforms • Because of economic facts, the average burden of taxation and social security contributions cannot be much reduced. • As the deadweight loss of impost is governed by the marginal impost rate, all that can be done to eliminate distortions is to reduce marginal tax rates and marginal social security contributions and to broaden their base in order to prevent the revenues from falling. Also lump-sum payments may well fit in. • Now, given the history of German income tax reforms, all reform proposals focusing on income tax reform only cannot circumvent broadening the tax base for lower income strata relatively more than for higher income strata (simply because possibilities of broadening the tax base for the high income strata have partly been exhausted, partly to prevent inducing them to leave the country). • This means that all proposals for income tax reform imply that scale invariant measures of income inequality (e.g., Gini, Theil, Atkinson) increase. • As to absolute tax reductions, either many taxpayers gain – then the reform cannot be financed [CDU, FDP, Kirchhof], or many lose – then the reform cannot attract a majority of the electorate [SVR II].

29. Source: Bach and Steiner 2006 Change in income tax revenue in billions of EURO Change in income tax revenue per head

30. Source: Bach and Steiner 2006

31. Source: Bach and Steiner 2006 % Winners % Loosers

32. Reform of Social Security • Recall that Germany has peak rates of social security contributions. They cannot be further increased. • Reduction of social security benefits: were either effectuated or are on their way [stagnation of pensions; reduction of medical services; reduction of unemployment doles;…] • Many proposals suggest to incorporate incomes beyond employee incomes. This increases excess burden of social security contributions. Moreover, it would also increase the number of persons entitled to benefits (increases expenses). • Other proposals fail to collect the required revenue and propose to increase taxes instead.

33. A perfect régime for Germany: a flat tax with a social component.

34. An Escape: A Flat Tax with a Social Component • All sources of domestic income B are taxed at a porportional rate of  (tax for most incomes deducted at source). • Social component S: consists of (1) subsistence level E [700 € for first adult; 350 € for other adults; 300 € for a child]; (2) social security contributions; (3) investment in human capital [fees for kindergarten, school, university]. • Social compensation: The excess of S over the rate  of worldwide income B* is subsidized by public funds: max{0, (S-A-B*}. [A=alimony] • Thus the reform proposal is driven by two parameters: the proportional tax rate, , and the proportion of income considered to be shouldered by a household, .

35. The computation of net income where: N...….net income B……gross domestic income S…….social component E……subsistence level A…….alimony B*…..gross worldwide income TA……foreign taxes ……..tax rate ……proportion of worldwide income to be shouldered by the household Note that most East-European countries have introduced some variety of proportional taxation.

36. Other parts of the reform concept • The employer’s share of social security contributions is paid out along with the wage/salary and is subject to tax. • All social security contributions (except unemployment insurance) are done by lump sum contributions: • Old age pensions: the mandatory part is 600 € per month and household; switch to a funded system with individual (and portable) capital accounts [3,124 Billions €; 5% for replacement and 3% interest yield 250 Billions € per year; this is the running sum for pensions inclusive of federal subsidies, which are no longer needed for a funded system]. • Health insurance: Lump sum contribution of 190.80 € per adult and 78.44€ per child and month. • Nursing insurance: Lump sum contribution 25 € per adult and month. • Unemployment insurance: remains as it is. • Many other measures will prove to become necessary to prevent misuse of the system. (People who want to draw on the advantages of the system without having participated in its financing. In other words, the benefit principle should be observed as far as possible.)

37. Two varieties of the Social Component N • Social Component A: all wages are negotiated as hourly wages for real work only. Wages are increased by another 40% (68% in total), but the worker/employee carries all cost of social fringe benefits. [Social fringe benefits did not go at the expense of profits, but at the expense of wage/salary increases.] • Social Component E: Investments in human capital are not borne by the people, but are covered by public funds. This means higher taxes and higher incomes of the well-to-do, but can more easily be compared with the status quo. Our model calculations are carried out only for Social Component E. • The reform concept should also abolish business tax and corporation tax.

38. Check of Financing the Reform • We start from the data of the German Income and Expenditure Survey 1998 (EVS 98). • The data are updated to 2005 and processed in micro-simulation m. KiTs. • The data are transformed from EVS to the items used by the reform concept [See Seidl (2006)]. • For the social component E, the social compensation is max{0,(E+soc.sec.contr.-B*)}. Assuming that B=B* and TA=0, we have: N=(1-)B-(soc.sec.contr.)+max{0,(E+soc.sec.contr.-A-B)}+A • Theminimum pensions are fully taxed; only 17% of excess pensions are liable to tax (because they result from contributions out of taxed income). • Calculations show that we need the parameter values =0.3 and =0.35. • The next table shows in its upper part that aggregate net income (disposable income) is higher under the reform concept. This is largely due to alimonies received which are considered as incomes under the reform concept. • In its lower part, this table assumes, first, that income tax revenue and social security contributions are used to finance social expenses (data taken from the social security statistics in the table after the next). This gives a deficit for the status quo. Using also the revenues of business tax and corporation tax to cover the deficit leads to a surplus just a bit smaller than the surplus of the reform concept. However, the reform concept – as it renounces business and corporation taxes – leaves 46.5 Billions € in the private sector.

39. Collected equally from all income strata Benefits the low income strata: Hence, substantial income transfers to low income strata. a Inclusive of transfer income, distributed profits, exclusive non-distributed profits; for reform: inclusive of employers’ share of social security contributions and inclusive of alimonies and gifts received. b For status quo: exclusive of employers’ share of social security contributions and inclusive of premiums for private health insurance.

40. a Old age pension can be reduced by some 25% because of social compensation of reform concept. b Inclusive of expenditure of private health insurance companies. c Unemployment benefit and related expenses; no unemployment help. d Not all rehabilitation expenses for disabled persons might be covered by the reform concept.

41. Distributional Effects of the Reform • In the following tables, households are arranged according to income intervals, for Germany as a whole and for three types of households [singles with 2 or more children; married couples with 2 children, both spouses working; married couples without children, both spouses working]. • We observe that incomes are accumulated among the middle income strata, reflecting widespread progressive transfers. There are also transfers in the direction of households with children. • Income inequality is measured according to the Theil coefficient and the Gini coefficient. These measures decrease for all income intervals: The Theil coefficient diminishes partly by up to one half, the Gini coefficient by up to one third [Table 8]. • Households where both spouses work lose under the reform concept. This reflects their higher income. Age cohorts between 45 and 64 lose, the age cohorts 45-54 because of their higher incomes, the age cohorts 55-64 also because children have already left the household. Age cohorts 65 and older gain because of low pension incomes.

42. Income strata with more aggregate income under reform concept. Income strata with less aggregate income under reform concept. Germany: Intervals of disposable household income

43. Income strata with more aggregate income under reform concept. Income strata with less aggregate income under reform concept. Single with 2 or more children

44. Income strata with more aggregate income under reform concept. Income strata with less aggregate income under reform concept. Married couple with 2 children (both spouses working: husband 70% of household income; wife: 30%)

45. Income strata with more aggregate income under reform concept. Income strata with less aggregate income under reform concept. Married couple without children (both spouses working: husband 70% of household income; wife: 30%)

48. Absolute and Relative Tax Burden for Various Household Types • We check the absolute and relative tax burden for four household types [singles with 2 children; married couple, both working, with 2 children; married couple, both working, without children; old-age pensioner couple]. • No one is more burdened under the reform concept. • Moreover, we show how the two parameters govern the tax-cum-transfer system: higher  shifts the net income curve down and the curve of average burden up; higher  makes the tax-cum-transfer system more progressive for the lower and middle income strata.

49. Single with two children

50. Married couple (both spouses working 70%/30%) with 2 children