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Public Finance

by: Madie Schinner

Public Finance ECN 131

Madie Schinner
GPA 3.57


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This 10 page Class Notes was uploaded by Madie Schinner on Tuesday September 8, 2015. The Class Notes belongs to ECN 131 at University of California - Davis taught by Staff in Fall. Since its upload, it has received 65 views. For similar materials see /class/191900/ecn-131-university-of-california-davis in Economcs at University of California - Davis.


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Date Created: 09/08/15
Chapter 25 Fundamental Tax Reform jonathan Gruber Public Finance and Public Policy Introduction I The tax code today is nothing more th cesspool of legalized corruption and special interest legislation We sho lace this monstrosity with a slmple flat tax for all Americans I Steve Forbes during his1996 presidential Campaign I His p atform reflects some of the Widespread dissahsfaction mtl the current tax system Introduction I At certan hmes this dissahsfaction has led to achon I The 1986 Tax Reform Act reduced 15 tax brackets ranging from 11 to 50 to Just three ranging from 15 to 33 I It owered rates and taxed a broader base ofincome I Subsequent legislation has added complexity to the tax code and greater opportunity for tax avoidance and evasio Introduction I This final lesson discusses fundamental tax reform I What are the motivations for moving to a lowrrate broad based tax system I What are the political and economic barriers to such re orm I What would be the effects of a consumption tax I What are the effects ofa flat income tax WHY FUNDAMENTAL TAX REFO RM I There are three ma or argumene for fundamental tax reform I Increase tax compliance I Make the code simple I Improve ef ciency Why fundamental tax reform Improving tax compliance l The rst motivation for fundamental tax reform relates to compliance l Tax compliance are efforts to reduce the evasion of taxes I Tax evasion is illegal nonpayment oftaxation I This differs from tax avoidance which are legal means such as givmg to charity to lower one s tax bill Q mm Tax evaSIon l The dishnchon between evasion and avoidance is sometimes a ne one hut it is not always the nch who evade taxes I For example for many years taxpayers Wanting to aim tax exemptions for dependene were only reqmred to 511 in their name on the tax form I TRA1986 also required the Social Security number for dependents over age five a mi im dependents suddenly aysappeareal iw quot Tax evasion F I In 1988 the tax law started requiring that the Social Security nurnhers of child care providers be listed before a worker could claim the child care creth 26 mils child Cate pnwl39dets aysappeareal Why fundamental tax reform Improving tax compliance I The simplest theory of evasion weighs the mar henefie from underreporung iii income evasion against the marginal cose I The marginal benefit is the saved tax 1 I Th arginai cost is the marginal penalty per dollar evaded rnuiupiied by the probability of getung caug t I Figure 1 iiiustrates this 2 i a lncreaslng enforcement ralsesthe marginal cust and lowers EVaSlun l l r H A M02 e marginal benefit and raises evasiu Evasiun level 53W ere M52 MC1 Dullars Evasiun Why fundamental tax reform Improving tax compliance I In this case as the marginal tax rate nses the marginal bene t curve shifts upward and more evasion occurs I As the expected penalty uses either the penalty per dollar or the probability of getung caught the marginal cost curve shifts upward and iess evasion occurs Why fundaInental tax reform Improving tax compliance The most recent evidence in the US sugg ests that the tax gap is 280 billion or 163 of tax revenue before e ither threatening audit or appealing to people s consciences to be honest In an interesung experiment Slemrod Blumenthal and Chrisuan 2001 randomly sent letters to taxpay taxes were du l The audit threats increased reported income for low and middle income tax They lowered reported income arriong upper ciass tarniiies who perhaps believed the ietter was an opening round in a negotiation and their reported income was a quotfirst offer wot 0 The 1997 IRS hearings on The 1997 IRS hearings V and their fallout for tax collection M V and their fallout for tax collection M I in September 1997 the senate Finance committee I As a result of this 1egis1auon the lRS s enforcement held a week of heanngs to mveshgate IRS abuses capabilities have been severely impaired l The committee heard all sorts Ofdamning testimony I Number offield examiners fell by tworthirds much ofwhich actually painted a skewed picture of I Number ofcollection cases fell by onerhalf the IRS Ope at ons I Number ofevasion cases pursued fell by tworthirds I In 1998 President c1inton signed the Taxpayer Bin I And rates for selfremployed fell from 4 to 2 ofRights which created some protections for l IRS has identi ed 30 billion in underp taxpayers ayments but does not have the resources to pursue h m The 1997 IRS hearings 39 Why fundaInental tax reform w NV and their fallout for tax collection Improvmg tax comphance I sentiment may now be tumin in the opposite I Why should we care about tax evasiongt Couldn t direction perhaps as a result of corporate scandals we raise taxes to offset this evasion l The latest IRS commissioner has vowed to make I First such a po1icy would 1ower uvan Ef ciency enforcement a Pmmy is increased by broadening the base and 1owering the rates Moreover since cheating rises with higher rates it is partially sel defeating I The damage may be done because 17 of Americans beheve cheating on their taxes is acceptabie up from 11 in 1999 I Second evasion harms imamaging because upper income households have greater scope for evasion I Third evasion is a very clear violation oflronzontz 29mg Why fundaInental tax reform Making the tax code simpler l The second motivation for fundamental tax reform relates to S mpl cw Wage income I The IRS estimates that it takes 1344 hours to complete Form 1040 assuming most i me came from wages and there were no complicated investment activities or itemized deducti I itemizing takes another 6 hours and reporting sma11 business activity takes 11 hours Use income tax schedule Multiply by 20 I Reporting capita1 gains is estimated to take 8 hours I This Complication motivates a simpier tax p1an such as Steve s flatetax proposal I This is illustrated in Table 1 Why fundamental tax reformgt Why fundamental tax reformgt Malnng the tax code slmpler Improving tax ef clency I Slmphclty ls an admnable goal and often conmeme l The thud menyanen fox fundamental tax teenn telntes to wlth o e ef aency and equlty goal xmpmvmgux uency l The eeet Dfxmsmgux antes mcludes an enhxe may of I Yet someworthwhlle goals aremconslstentwlth behmml stm 5 s mph m These mclude Inhaxsupply sayings naketalnng chdd cue me I For Exmple lnoludlng employeteptomded health md ehantahle gmng msumnce ot penslon contxlbutlons ls conastent with I The key questlm heeeme how does ehangmgthe tux my the Hageslmons amnmon change xvmuer Thexe ate bmh dues mdlnduect I They substantlally lnaease the reponm g burdm of 95quot employm I Diuch almx chmgu means nhlghex tan ante xmses xevenues en n xedbzse Dfuxmun Why fundamental tax refonngt Improving tax ef clency I The indirecre ecu aim chmgmmem a l39nghex me lowers the slze ufthe tevenue base on lil39 ch taxes axe levled I These effects lnclude omhwyn the Mann menseanh mama an supply ee Ram we The neennyee n techsme mean n any am an M my natsuhlectta tax suuh n Planang ennlayemealth lnenmee lam Wan yn manna a an gleamamnge at mm m m exclmmns fmmgmss henna n aeanngnxaale mcamzsur1h as man canmhmam Undenhehl hevlaxvme the Cw xmw 97m The maxezse m eman a inlixhzln g lndlvldualtakessame lnmme n I FigureZshmm an example of thxxevenue can be x dedudlhlemvm andalsae des nffectedby xmsmgthe tan utes quotWquot 1 quotW5 Why fundamental tax reformgt Why fundamental tax reformgt Improving tax ef clency Improving tax ef clency I In Figure 2 Wlth the loyet tax rate of10 n the I Empmczl mmanggeata that the elzshclty ufux xevenue lndmdual tepolts all ofhls lnoomewhoh conslsts mth xespecttuuxutes la nppmmmnte of 45000 otwagelnoome and 5000 of addmonal 7 5 tampon mntmphes slgm cmtdumxghtlm lnoome ttom lawn mowing I The mdaxect etteete Dfxepumng nenne enelunen and He PM 55000 m mg eemphanee not gloss mcume eammg dnve Lhs espouse I When thetax rate uses the person mahtaxataon by 39 Mm BMquot m N c 5 wh an em not tepomng thean moylnglnoome and 11147th taxataon by substatmang health lnsutanoe forwages 39 Fmd mmt m Mm m dhelp mh th gods and gmng to ohanty Dumphmce almplelty anneaseleney H s taxable mme 5 new 535000 My he mg I Yet lt ls dlf cult te aehleye ths xefuun fuxvnnuus puhhcal 57000 m taxes mdecunurmc xezsuns THE POLITICS AND ECONOMICS OF TAX REFORNI I TRA 1986 moved the U 3 toward a simpler tax code hut it was largely undone by subsequent legislahon I Why is it so hard to maintain a simple broadrbased I There are both political and economic explanations The politics and economics of tax reform Political pressures for a complicated tax code I There are political pressures for policy changes when I The Wlnners ofsuch changes are concentrated well organized and have much to gain an I The losers are diffuse and don t lose much per person I The is also a percepnon of politicians that voters oppose new government spending hut vviu support the same goal when financed through tax expenditure The politics and economics of tax reform Political pressures for a complicated tax code I For example President Clinton came into office promlsmg to shift federal spending to education and 0b tramng but ended up using targeteo tax cue l The minute we proposed any kind of tax cut everybody started sahvaung e Adviser to President Clinton e hues and eeononues oftax reform Economic pressures against broadening the tax hase I Economic considerations also come into play I Tax shelters are acnvines whose sole reason for eXistence is tax minimizauon I These were popular in the mid719805where some assee received very favorable tax treatnent e g through depreciation etc I Some tax shelters generated paper losses while actually turning a profit for their investors I Ari example of this is illustrated in Table 2 lusses the tax savings Tax shelters kllun Result Invest l in nil venmre Sal nil vmmre lur LusE l in value Deduel suuuu rum this yeal s ineume save auuuu un taxes Deduel l Iuss rum next year39s ineume save 5uuu un taxes N21 efleel MakE 25 I Even a load investnent 7 buying an asset for 100000 and selling it a year later for 90000 turns profitable under this tax shelter I This occurs heeause ofa 60 NC and offsetting the capital loss against the following years income e hues and eeononues oftax reform Economic pressures against broadening the tax hase l The existence oftax shelters runs in Opposmon to the three benefits of fundamental tax reform they make evasion easier make the code more complicated and reduce ef clency l Yet the value of such tax shelters is capitalized into an assefs value I Taxcapimlizani39nn is the change in asset prices that occurs due to a change in the tax on the stream of returns from that I I E e iminaung tax shelters can severely punish their owners and can cause large horizontal inequities The polincs and economics of tax reform Economic pressures agalnst broademng the tax hase I To illustrate tlus honzontal meqmty consider two aparunent complexes 7 one worth 100000 in a lowrlncome neighborhood hecause it cannot cover its costs with rent and the other worth 15200000 because it can I suppose an lTC or special depreciation schedule allowed the first owner substantial tax bene ts raising the market value from 100000 to 200000 That is the pretax value of the stream of tax bene B is equal to 100000 e litics and economics of tax reform Economic pressures agalnst broadenmg the tax hase I If a person buys the apartnent in the low income nelghborhood at 200000 expecting the stream of tax henefie that person will suffer if the breaks are eliminated I Ehmmatmg the tax shelter immediately lowers the market value of the apartnent back dovm to 100000 The polincs and economics of tax reform Economic pressures agalnst broademng the tax hase l T mnm ni39onalinequj ni39es from tax relbrm are changes in the treatment of simllar indimduals who have made different decisions in the past and are therefore differentially treated by tax reform I These meqmues are a natural feature of any tax reform whlch by definmon will create winners and losers I Feldsteln 1976 suggested that such tax reforms he infrequent and slowly phased in to minimize sudden changes in asset puces e litics and economics of tax reform Economic pressures agalnst broadenmg the tax hase I one solution is grandmangeletnng those who made decisions under the old tax rules to conunue to benefit from those rules I This is often ineqmtable welleoff individuals usually benefit from such grandfathenng rules an mef clent I But such compensation may he necessary to implement tax reform miw quot 6r andfa rhering in Virginia I one recent example of such a grandfathenng rule is in the state of Virginia I The state income tax system gave a 512000 annual deduction in everyone over the age of 65 regardless of income or we I In ehmmahng the deducuon Governor Mark Warner allowed seniors currently over 65 to keep the deduction I The legislauon passed in Apnl 2004 hivv quot TRA 3986 and Tax shelters I TRA1986 closed many of the most egregious tax shelters that had emerged as a result of the 1981 tax reform I Removin the tax shelte ouiIight would have an red many powerful constitu nts Instead M1986 created three groups ofincome eordinary earned income investment income and passive income I The shelter income was passive income I Income losses in one group could not offset income in another grou l The AMT rules for income also excluded many of the tax shelter rules I The tax shelters were eliminated but at the cost ofa more complicated tax code CONSUMPTION TAXATION 712Tquot I A mote tadoal tetonn tayoted by many F quot5 eoonomtsts as moymg ttom 2n moometax to a oonsumptaon ax nus not 39 I at am am I ngcnniurnpnnn means taxtng andyaduals m 12 av 1 Mquot 39 based not on what they eam but on what th oonsume such as through a sales tax shows that taxmg oonsumptaon as Fi e 3 telatayely smau m the u s oompated wath othet oountnes consumptaon taxatton consumptton taxatton Xhy mtght oonsumptaon make a bettet tax basegt Xhy mtght oonsumptaon make a bettet tax basegt I Consxdmmumzl ales 2mg we 35 uf lpuxchms I A oonsumptaon tax would also temoye the quotptoe xaLhexthan an mcume tax What axe the advantages of movmgm a cmsumpnm taxhasea cY oonsumptaonquot bus m the out tent system and Ef cxzn potentaauy motease Julmg Maze savings and faaxextxeamnz afsavexs I Constdet Homet and Ned m Table 3 Samghcxty I Such atax wuuldxmpxme q7mmyb2cause meet utthe elastanty utthe taxbase unh aspect to tax avenue anses because omules m the taxsystem Faxzxamgle the nantaxatam atmeame Padmthe nme fungabenz ts I Suehtaxayuadanee acnvmes desappeamath anatmnalsales tax consunpnon taxauo n Why might consumption make a better tax basegt 3 Intome Tax versus Consumption Tax unmet n Inmme fax 013739 I undet an moome tax Ned who as mote panent and s yes totthe next penod pa s mo Homet eyen though 2561 Savmwm Pznnd n xntenst Eamlnqs n Pamd 2 me n Pamd 2 E E a E ad s mcomels taxed both as labot mcome and mtetest tncome I That as hels taxed 50 on has taxed 1 22 on has 244ottnt I Hometwho con 100 of eammgs and etest mme munmun m Perm1 2 sumes all of has mcome m the rst PM n has penod does not have tntetest mme and avoxds that pan ofthe mcome tax Wan an ncametax Ned ts Penahzed 9m mung bwlawvg Mme nteae lTh mc us thexels a quotptoeoonsumptaonquot bus an the ome tax code Consumptton taxatton Why rmght consumptton make a better tax basegt I Under a consumpuon tax then tax payments are the same I Interest mcome 1 not taxed only consumption I Ned saves more m thxs example but m reahty lower taxes could lead to elther an mcrease or decrease m savmgs l The svntch m consumpnon taxanon removes the proeconsumpuon hras m the tax system and removes the honzontauy meqmtable treatment of those who choose to save I It may lead 391 hlgher savmgs as wen and a more producuve economy Consumptton taxatton Why rmght consumptton make a better tax basegt l The nal advantage ofsuch a consumpuon tax 1s mapmg I It 1s ease to 51m 1 tax mdmduals on thexr purchases than on a comphcated de nmon of Income I There are some dlsadvantzges ofa consumpnon tax owever I Smallextax base I Verucal equrty I Tonsmon rssues I Comphance I cascadmg Consumptton taxatton Why rmght consumptton be aworse tax basegt I Sam1mm bum A tax on consumpuon ls essenuauy a tax on hfehme labor mcome I It therefore removes the tax on savmgs shnnkmg the tax base I Thus the consumpnon tax rate would have m be hlgher than the mcome tax rate Consumptton taxatton Why mlght consumptton be aworse tax basegt I Ven zmeqmgy A centra1 fact about consumpuon ls that the share ofmcome devoted to consumpuon falls WJth mcome I That rs the nch save a 1arger proporuon of then mcome throughout then hves I consumpuon taxes are therefore regresslve I Pohcy prescnpuons e hke taxmg staple goods at 1ower rates 7 goes m the opposlte oarecuon of the Ramsey model Consumptton taxatton Why rmght consumptton be aworse tax basegt I Trumtz mn mm The current mrdoleeaged and elderly are mayor1osers from such a transmon I They have a1ready pald most of then mcome taxes dunng then workmg years and now get h1t w1th a hr h tax on then purchases that come from accumulated savmgs I Pohucauy there would almost certamly have to be some compensauon for semors yet thJs mlght use up the enure ef clency gam from the transmon Consumption taxation Why might consumption be aworse tax basegt I Campmm such ahigh sales tax might create a thnvmgquotb1ack market to eyade the sales tax I It is much harder to track consumption expenditures than it is to track income eamed I Canaamg There is also a problem With taxing h s uts I ln pnnciple the sales tax should only he on retail sales not husmess inputs ln practice many husmesses buy their inputs at the retail leyel I Businesses often pay sales taxes when they buy mpue and then again when they sell output Consumption taxation I Different forms of consumption taxation can address the concerns Iajsed by the sales tax approach These include I The yalueeadcled tax I An expenditure tax I The valueaddedrax VAT1s a consumption tax leyied on each stage of a good s production on the increase in yalue of the good at that stage of production I Table 4 illustrates the VAT in pracuce the value added uhly Value Added Tax in Practice Purchase price Sale price Value added Tax paid 25 Total taxes paid than the sales prlEE Consumption taxation Designing a consumption tax I The VAT addresses both the compliance and cascading problems I The tax is Wipemag mth each parucipant in the production chain haying a strong mcentiye to make sure that the other participants report correctly I An attempt to reduce the Value of a transacnon raises the tax hills of other parucipane I It also allows rms to deduct from taxahon the pnce they pay for inputs Consumption taxation Designing a consunlption tax I In practice the VAT is not quite as simple I Multiple rates I complicated exemptions I costly to administer I Exemptions torbusinesses doing less than 80000 in commerce I An eaquencbme taxls a consumption tax leyied on yearly consumpuon rather than on speci c sales I Thus it can be used to meet the progressiyity needs in a way es tax cannot I There are still compliance problems and complex informational requirements It is difficult to track expenditures Consumption taxation Backing into consumption taxation Cashr ow taxation l Taxing consumpnon at the point of producnon leads to progressiyity concerns thle taxln expenditure is admmistrauyely infeasible l A cashflow tax is a tax on the difference between cash income and sayings I This would qumre the least change to our current system of taxanon The main dif culty would he yenfying sayings THE FLAT TAX l The at tax was rst popularized by economists Robert Hall and Alvm Rabushka in 1981 1 features include I Corporation pay a atrrate VAT on sales minus purchases from other firms minus wage payments to workers l Indiyiduais pay a tax on labor income only at the me at rate I All tax expenditures would be eliminated like the exemption for employer health insurance and replaced with a familyrlevel exemption THE FLAT TAX I Although this is SImJlaI to a VAT hy taxing wage Income and offering a family deduchon we can introduce progressimty mm the tax system I Hall and Rahushka proposed a 19 at rate and a 525000 exemption l The advantages of a at tax include I EmCiency gains om haying one flat rate on a broad de nition of income I Simplicity and improved compliance The at tax Problems with a at tax I The key problem With the at tax sun is progressivity I Although it can he made fajrly progressive for 10w and mlddlermcome eamers it is much less progressive for higheiheeme earners than the current system I see Table 5 Distributional implications of a flat tax Household innit quottamed runpie mu lwn Maren a sum it mm i mam runequot tax ml 2am e nth WEIuld be the blg Winner underthe Halle Rabushka attax plan The at tax Problems with a at tax l The sizable reduchon in Verhcal eqmty would be problemahc for many Voters I In addmon there are transmon issues With a at tax I Horizontal inequities would anse for exampie remomng t e taxesubsidy to homeownership This could lead to a large drop in home values I There would also be disruption to the health insurance market 7 as many as 20 miiiion people could lose their health insurance ifthe exclusion from income was eliminated


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