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THE CHALLENGE OF TAX REFORM AND EXPANDING THE TAX BASE

THE CHALLENGE OF TAX REFORM AND EXPANDING THE TAX BASE. Geary Lecture - ESRI James Poterba, MIT & NBER 28 May 2009. THE REVENUE IMPERATIVE. Near-Term Government Deficit > 10% of GDP Goal of Sharp Deficit Reduction by 2013 Upcoming Report of Commission on Taxation

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THE CHALLENGE OF TAX REFORM AND EXPANDING THE TAX BASE

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  1. THE CHALLENGE OF TAX REFORM AND EXPANDING THE TAX BASE Geary Lecture - ESRI James Poterba, MIT & NBER 28 May 2009

  2. THE REVENUE IMPERATIVE • Near-Term Government Deficit > 10% of GDP • Goal of Sharp Deficit Reduction by 2013 • Upcoming Report of Commission on Taxation • Only Two Ways to Raise Revenue: Raise Rates or Broaden Tax Base

  3. BASE BROADENING vs. RATE RAISING • Efficiency Cost of Taxation Rises With Square of Tax Rate • Taxpayer Behavior Responds to Changes in Marginal Tax Rates • Eternal Trade-Off: Distribution vs. Efficiency

  4. TAX EXPENDITURES • Deductions or Credits that Narrow the Tax Base • Omissions from Tax Base • Often Could be Replaced with Government Expenditure Program • Sometimes Criticized as “Camouflaged” Expenditure

  5. EXAMPLE TAX EXPENDITURES • Mortgage Interest Relief • U.S.: No Limit on Duration of Relief; Loan May Not Exceed $1,000,000 • Ireland: Loan Qualifies for Seven Years; Interest ceiling €10,000 FTB, €3,000 non-FTB; Allowable at 15% non-FTB, 25-20% FTB • Contributions to Retirement Saving Programs • Deduction for Health Insurance Premiums and Medical Costs • U.S.: Health Insurance Untaxed, High Limit for Medical Deduction • Ireland: Insurance Costs Deducted at 20% Rate

  6. ESTIMATED COST OF TAX EXPENDITURES (2005) • Total Income Tax Revenue: €11340 Million • Medical Insurance Relief: €230 M • Loans Related to Principal Private Residence: €280M • Supplementary Pension Provisions: €2900 M (for 2006)

  7. DISTRIBUTION OF INCOME TAX BURDENS: IRELAND & U.S. • Ireland: Top 6.5% of Income Earners Pay 50% of Income Tax • U.S.: Top 4% Pay 50% of Income Tax • Ireland: Top 20% of Taxpayers Pay 77% of Income Tax • U.S.: Top 20% of Taxpayers Pay 84% of Income Tax (71%, Income & Payroll Tax) • Tax Expenditures are Also Concentrated

  8. U.S. PRESIDENT’S ADVISORY PANEL ON TAX REFORM – 2005 • Charge: Recommendations to make individual and corporate income taxes simpler, fairer, and more pro-growth • Recognize importance of homeownership and charity in American society • Propose revenue neutral options at least one of which preserves the income tax

  9. THE PANEL’S RECOMMENDATIONS • Repeal the Individual & Corporate AMT • Two Reform Proposals: • Simplified Income Tax • Growth and Investment Tax • Proposals Have Received Almost No Serious Discussion

  10. TAX EXPENDITURE ANALYSIS: TAX PANEL REPORT • Concerns about Equity of Current Deductions • Identified Limited Analysis of Costs vs. Benefits for Most Tax Expenditures • Efficiency Question: Which Households are Best at Supporting the Targeted Areas (Charity Example) • Interest Group Opposition to Modifying Existing Tax Expenditures

  11. REFORMING TAX TREATMENT OF HEALTH INSURANCE (U.S.) • Appeal: High-Income Households Face Full Cost of Health Insurance Purchase • Distribution of Benefits Shifts Away from High-Income Group • Disadvantage: Higher Taxes on Some Groups • Reduction in Private Insurance Coverage: Treasury estimates increase in number of insured by approximately 1.6 million people

  12. TAX RATES AND TAXPAYER BEHAVIOR • Documenting Responses is Essential to Measuring Tax Distortions • To Avoid Placing High Tax Rates on Highly Responsive Behaviors, Empirical Work Must Identify These Activities

  13. INGREDIENTS FOR MEASURING RESPONSES • Economically Meaningful Variation in Tax Rates • Variation Across Households or Firms • Variation Over Time • Gold Standard: Variation Across Time for Same Households or Firms • Exogenous Tax Variation • Reliable Measures, Aggregate or Disaggregate, of Household or Firm Activity

  14. ILLUSTRATIONS OF TAXPAYER RESPONSIVENESS • Labor Supply • Taxable Income • Capital Gain Realizations • Corporate Dividend Policy Rates

  15. LABOR SUPPLY AND TAXES • Theory is Ambiguous on Effect of Taxes • Labor Supply is Difficult to Measure; Hours May Not Capture Key Responses • Two Reforms Provide Useful Evidence: • Tax Reform Act of 1986 in US (TRA86) • Swedish Income Tax Reform of 1989 • Irish Evidence: Participation Effects, Hours Effects, Migration Effects

  16. LARGEST CHANGES IN AFTER-TAX WAGE: w*(1-τ) • Sweden 1990-91: 24.6% Increase • U.S. 1941-42: 8.8% Decrease • Sweden 1989-90: 6.9% Increase • U.S. 1940-41: 6.2% Decrease • U.S. 1947-48: 6.1% Increase • U.S. 1943-44: 5.4% Decrease • U.S. 1986-87: 4.8% Increase • Decreases Ahead?

  17. LABOR FORCE PARTICIPATION OF MARRIED WOMEN, PRE- & POST-TRA86 (EISSA STUDY)

  18. LABOR SUPPLY RESPONSE TO SWEDISH TAX REFORM 1989-90 • Compare Earned Income For Same Households in 1994 and 1989 • Control for Business Cycle, Region of Country, Place in Income Distribution • Elasticity of Labor Earnings With Respect to Marginal “Keep Ratio” (1-t): 0.36 to 0.39 • Implication: Reducing Marginal Tax Rates Raises Labor Income

  19. CAPITAL GAINS TAXATION AND GAIN REALIZATION • One of the Most Elastic of Potential Behaviors • TRA86: Pre-Announced Tax Rate Increase on Long-Term Gains from 20 to 28 Percent • Differential Tax Burden on Short-Term and Long-Term Gains (Short Term Taxed at Higher Rates): Encourages Holding Gains Until Qualify as Long-Term

  20. HISTORICAL CAPITAL GAIN REALIZATIONS, 1965-1994

  21. EMPIRICAL EVIDENCE ON REALIZATION PATTERNS • Cross-Section of Tax Returns: Realizations and Tax Rates Negatively Correlated • Is This Selective Timing? • Panel Data on Asset Sales and Tax Rates: PERMANENT Tax Rate Variation Has Much Smaller Effect than TRANSITORY Change in Tax Rate • Burman-Randolph Study: Permanent Elasticity -0.18, Transitory Elasticity -6.42. • Differences Across Households in Elasticities?

  22. PROMOTING EFFICIENCY • Low Rates Applied to Broad Base • Substantial Growth Penalty from Taxing Capital Income • Avoid Distortions Across Sectors: • Housing vs. Other Assets • Debt vs. Equity • Dividends vs. Capital Gains • VAT on Different Goods • Equity-Efficiency Tradeoff: High Income Households Receive Most Capital Income

  23. DISTRIBUTING TAX BURDENS FAIRLY • Adam Smith: “the subjects … ought to contribute … in proportion to their respective abilities.” • Defining Fairness is Difficult – Ultimately Political Factors Determine What is Feasible • U.S. Tax Panel, 1986 Reform: “Distribution Neutrality”

  24. TRANSITION RELIEF • Avoid Short-term Disruptions • Recognize Actions that Impose Unfair Burdens on Some Taxpayers, For Example by Offering Relief for Existing Debt Contracts and Depreciation on “Old” Assets • Tradeoff: Generous Transition Relief Reduces Efficiency Gains

  25. WHAT ROLE FOR TAXING CARBON EMISSIONS? • Transition Relief is a Central Concern • Challenge: Offsetting Distributional Impacts • U.S. Policy Debate: How Much Potential Revenue Will Be Given Away as “Grandfathering Provisions?”

  26. WAYS TO MONITOR TAX EXPENDITURES • Encourage Routine Oversight – Cost Benefit Analysis of Every Provision Each Five Years? • Review Tax Base: Housing Example • Sunset Provisions for Deductions & Credits • “PAYGO” For New Tax Expenditures – Same Basis as Spending Programs

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