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Why We Need Tax Reform – and Why We Probably Won’t Get It

Why We Need Tax Reform – and Why We Probably Won’t Get It. Robert Coen Professor Emeritus of Economics Northwestern University Woman’s Athletic Club Chicago, IL January 23, 2013. The Changing Personal Income Tax Single Taxpayer.

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Why We Need Tax Reform – and Why We Probably Won’t Get It

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  1. Why We Need Tax Reform –and Why We Probably Won’t Get It Robert Coen Professor Emeritus of Economics Northwestern University Woman’s Athletic Club Chicago, IL January 23, 2013

  2. The Changing Personal Income TaxSingle Taxpayer 1st bracket Top bracket Number of ------------------------- --------------------------- Year Brackets Rate Income< Rate Income> 1955 24 20% $16,745 91% $1,674,475 1988 2 15% 33,856 28% 33,856 2007 6 10% 8,468 35% 378,435 Income levels are adjusted for inflation and stated in 2011 dollars. In each of these years, tax revenue = 9.7% of personal income Source: The Tax Foundation

  3. Effective Personal Income Tax Rates by Household Income, 2007 Average Share of Income Effective pre-tax pre-tax Share of quintile tax rate income income taxes Lowest -6.8 18,400 4 -3 Second -0.4 42,500 8 0 Third 3.3 64,500 13 5 Fourth 6.2 94,100 19 13 Highest 14.4 264,700 56 86 All 9.3 96,000 100 100 Top 1% 19.0 1,873,000 1940 Source: Congressional Budget Office

  4. Why Are Effective Rates Much Lower Than Statutory Rates? Some types of income not subject to tax: Employer-provided health insurance Contributions to retirement programs Interest on state-local bonds Basic income level exempted from tax: Personal exemptions Standard deduction Some uses of income deductible: Charitable contributions Medical expenses State-local income, property taxes Tax credits for some uses of income: Energy-efficient windows, appliances, heating Refundable tax credits =“negative tax”: Earned income tax credit (1975) Child tax credit (1998) Some types of income taxed lightly: Capital gains

  5. Shortcomings of Tax Loopholes Hidden form of spending – “tax expenditures” Alternative is direct expenditure (subsidy),regularly reassessed Open-ended cost Difficult to get rid of, may outlive usefulness Incentive effects vary (undesirably?) across taxpayers Invite “creative behavior” to avoid taxes Convert ordinary income to capital gain Substitute home equity loan for other consumer borrowing Abuse and verification issues Erosion of tax base requires higher, distorting tax rates Waste of (limited!) human talent in legal and accounting professions

  6. Direct Spending and Tax Expenditures by Category, 2011Billions of dollars Direct Tax National Defense and Veterans Benefits 832.8 13.1 International Affairs 45.7 36.3 General Science, Space, and Technology 29.5 10.3 Energy, Natural Resources and Environment 57.7 13.3 Agriculture, Commerce and Housing 8.1 418.3 Transportation 93.0 6.0 Community and Regional Development 23.8 4.3 Education, Training, Employment, Social Services 101.2 167.7 Health and Medicare 858.2 202.6 Income Security 597.4 198.4 Social Security 730.8 31.0 General Government 25.5 72.8 Total outlays 3,603.1 1,175.5 Sources: Office of Management and Budget, Joint Committee on Taxation

  7. Strengths of Tax Loopholes Allow private preferences to allocate subsidies

  8. Income Tax Reform of 1986 Goals Reduce tax rates to improve economic efficiency and growth Maintain tax revenue by eliminating some tax expenditures Personal Tax Reduced number of brackets from 15 to 2 Reduced top rate from 50 to 28 percent Eliminated deduction for interest paid, except on home mortgages Eliminated deduction for state-local sales taxes Eliminated favored rates for long-term capital gains Corporate Tax Reduced top rate from 46 to 34 percent Repealed tax credit for equipment investment Tightened depreciation rules

  9. Undoing of 1986 Reforms 1991 Top personal rate raised from 28% to 31%, Brackets increased from 2 to 3 1993 Top rate personal rate raised to 39.6% Brackets increased from 3 to 5 Top corporate rate raised to 35% Capital gains rate reduced to 28% 1997 Refundable child tax credit of $500 Capital gains rate reduced to 20% 2001 Personal rate to fall gradually from 39.6% to 35% Brackets to increased from 5 to 6 Child credit raised to $1K Estate tax reduced, to be eliminated in 2010 2003 Accelerated reductions in top rates Dividends and KG rates reduced to 15% Numerous grants of accelerated depreciation Numerous new tax credits – biofuels, etc.

  10. Alternative Proposals for Tax (Re)Reform Romney: Personal tax cuts 1st bracket from 10% to 8% Top bracket from 35% to 28% Eliminate taxes on capital income Reduce corporate rate from 35% to 25% Pay for by eliminating unspecified tax expenditures TPC estimated 2015 cost at $480b

  11. Estimated Cost of 10 Largest Personal Tax ExpendituresBillions of dollars Annual average 2010-14 Exclusion of employer contributions for health care 131.9 Deduction of mortgage interest 96.8 Reduced tax rates on capital gains and dividends 80.6 Exclusion of pension contributions – defined benefit plans 60.6 Earned income credit 53.8 Deduction of state-local taxes 47.5 Exclusion of pension contributions – defined contribution plans 42.4 Exclusion of capital gains at death 38.4 Deduction of charitable contributions 36.5 Exclusion of untaxed social security and railroad retirement 34.6 Total of largest 10 623.1 Source: U.S. Congress, Joint Committee on Taxation

  12. Estimated Cost of 10 Largest Corporate Tax ExpendituresBillions of dollars Annual average 2010-14 Deferral of income of controlled foreign corporations 14.1 Exclusion of interest on state-local debt 9.1 Deduction of income from domestic production activities 8.6 Inventory property sales source rule exception 7.6 Accelerated depreciation of equipment 7.4 Inclusion of income from business debt discharged by reacquisition 5.8 Tax credit for low-income housing 5.4 Expensing of R&D expenditures 5.1 LIFO inventory accounting 4.0 Reduced tax rate for first $10mil of taxable income 3.2 Total of largest 10 70.3 Source: U.S. Congress, Joint Committee on Taxation

  13. Alternative Proposals for Tax (Re)Reform Obama’s Deficit Commission (Simpson-Bowles, Dec. 2010): Reduce personal rates to 12%, 22%, 28% Cut corporate tax cut to 28% Pay for by: Taxing dividends and capital gains like other income Eliminating personal and corporate tax expenditures, except: Child and earned income credits Mortgage interest (within limits) Employer-provided health insurance (with cap) Charitable giving (>2% of income, 12% refundable credit Exclusion of state-local bond interest Retirement savings Increasing gas tax to 15¢ per gallon

  14. Alternative Proposals for Tax (Re)Reform Simply reduce or eliminate specific tax expenditures Use increased revenue to reduce budget deficit Adopt a “flat tax” Popular with conservatives, e.g., Steve Forbes, Paul Ryan Single rate for individuals and businesses Simplified base for each Ultimate in simplification – postcard tax return

  15. The Postcard Tax Return for IndividualsSee The Flat Tax, by R. Hall and A. Rabushka

  16. The Postcard Tax Return for BusinessesSee The Flat Tax, by R. Hall and A. Rabushka

  17. “Flat Tax” Is a Consumption Tax, Not an Income Tax! Sources of income: Wages and salaries Gross capital income Gross business revenue – wages and salaries – purchases Uses of income: Consumption Investment Wages and salaries + Gross capital income – Investment = Consumption Base of personal Base of business flat tax flat tax Should we have a consumption tax? More popular form is value-added tax Consumption tax is regressive – need to consider entire tax system

  18. Effective Federal Tax Rates by Household Income, 2007 Personal Social Corporate All Income Income Insurance Income Excise Federal Quintile Tax Taxes Tax Taxes Taxes Lowest -6.8 8.8 0.4 1.6 4.0 Second -0.4 9.5 0.5 1.0 10.6 Third 3.3 9.4 0.8 0.8 14.3 Fourth 6.2 9.5 1.1 0.7 17.4 Highest 14.4 5.7 4.6 0.4 25.1 All 9.3 7.4 3.0 0.6 20.4 Top 1% 19.01.68.8 0.1 29.5 Source: Congressional Budget Office

  19. Impact of All Federal Taxes on the Distribution of Household Income, 1979 and 2007 Income 1979 2007 Quintile Pre-Tax After-Tax Pre-Tax After-Tax Lowest 6 7 4 5 Second 11 12 8 9 Third 16 17 13 14 Fourth 22 22 19 20 Highest 45 42 56 53 Top 1% 9 819 17 Source: Congressional Budget Office

  20. Why Is Tax Reform So Difficult? It’s really expenditure reform, tax expenditures become entrenched Growing income inequality leads to more lobbying for tax expenditures Legislators prefer to hide subsidies in lost revenue Many tax expenditures support worthy goals – child care, reduction of poverty, education, energy conservation, research, risk taking Emphasis on reducing tax rates is out of touch with fiscal needs

  21. Taxes as Percent of GDP, 2010 Denmark 48 Sweden 46 Italy 43 Norway 43 France 43 Netherlands 39 Germany 36 UK 35 Canada 31 Switzerland 28 Japan 28 US 25 Source: OECD

  22. Annual GDP Taxes as Growth Rate Percent of GDP 20001-11 2010 Sweden 2.4 46 Canada 1.9 31 Switzerland 1.8 28 UK 1.7 35 US 1.6 25 Norway 1.5 43 Netherlands 1.3 39 France 1.2 43 Germany 1.2 36 Denmark 0.7 48 Japan 0.6 28 Italy 0.4 43 Source: OECD

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