ARE TAX CUTSSELF-FINANCING?

Presentation at the CEPOS conference on ”Tax Cuts, Employment and Growth”

June 12, 2006

by

Professor Peter Birch Sørensen

University of Copenhagen, EPRU and CESifo

Chairman of the Danish Economic Council

THE LAFFER CURVE

Tax rate

Tax revenue

0% 100%

DID LAFFER INVENT THE LAFFER CURVE?

● Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: ”It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.”

● John Maynard Keynes, Collected Writings: ”Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”

THE WELFARE GAIN FROMHIGHER EMPLOYMENT

1. Gain: Increase in output ≈ pre-tax wage rate: W

2. Loss: Welfare cost of additional work ≈ after-tax

wage rate: W(1-t)

3. Net gain to society = 1.– 2.=

marginal tax rate ● pre-tax wage rate = tW

TAX REVENUE AND WELFARE

Suppose that a tax cut increases total labour supply

by the amount ΔL. Then:

Net welfare gain = tW● ΔL = increase in tax revenue

= ”dynamic effect”

Insight: The ”dynamic effect” on tax revenue is an

indicator of the welfare gain from the tax cut. If we

want to maximize the gain in economic welfare, we

should cut taxes where the expected dynamic effect

(the degree of self-financing) is the greatest.

THE DYNAMIC EFFECT

The degree of self-financing (D):

1

tD

t

ε = elasticity of tax base, t = tax rate. Assume ε = 0.2

Example 1: Initial tax rate t = 50% → D = 20%

Example 2: Initial tax rate t = 75% → D = 60%

Insight: D is higher, the higher the initial tax rate

Intuition: In Example 1 a 10 percentage point cut in the tax rate increases after-tax income by 20%; in Example 2 a similar tax cut increases after-taxincome by 40%

WHO SHOULD GET THE TAX CUTS?THE CONCLUSION SO FAR

If we care about economic efficiency rather than

equity, it seems that we should start by cutting

the highest tax rates (from the top of the income

distribution)

but

things are not that simple

TWO DIMENSIONS OF LABOUR SUPPLY

Hours worked (”effort”) are influenced by themarginal tax rate

Labour force participation is influenced bythe (sum of the) average tax rate on labourincome and the replacement rate (net benefitsrelative to wages)

Evidence from the US and the UK: Participation is more sensitive to economic incentives than hours worked

A TWO-CLASS ECONOMY: AN EXAMPLE

Hypothetical tax schedule: 30% tax rate on the first 100 units of

income, 50% tax rate on all income above 100

High-income earner

1. Pre-tax labour income 200

2. After-tax labour income 120

3. Potential transfer income in case of non-employment 40

4. Incentive to work = 2. – 3. 80

Low-income earner

1. Pre-tax labour income 100

2. After-tax labour income 70

3. Potential transfer income in case of non-employment 40

4. Incentive to work = 2. – 3. 30

THE EFFECTS OF TAX REFORM ON WORK INCENTIVES

Reform 1: Switch to flat 30% tax

Revenue cost = 20% of 100 = 20

No increase in work incentive for low-income earner

Work incentive of high-income earner increases from 80 to 100 = 25%

Reform 2: In-work benefit = 20% of earnings with cap at

20 and gradual phase-out at earnings between 100 and 200

Revenue cost = 20% of 100 = 20 (note: no benefit to high-income earner)

No increase in work incentive for high-income earner

Work incentive of low-income earner increases from 30 to 50 = 67%

Insight: When labour force participation is sensitive to taxation but hours

worked are not, it is more efficient to concentrate tax cuts at the bottom

of the income distribution

TAX CUTS: DEGREES OF SELF-FINANCING

Type of

tax cut

% change in

progressivity

Degree of

self-financing (%)Increase in Earned

Income Tax Credit

(beskæftigelsesfradrag)

4.6 50.1

Cut in payroll tax (arbejdsmarkedsbidrag)

-1.1 54.1

Cut in medium tax rate

(mellemskat)

-10.1 46.4

Cut in top tax rate

(topskat)

-10.7 45.3

Note: All tax cuts are designed to have the same effect on long-run fiscal sustai-nability. The estimates do not include effects on educational effort and migrationSource: Danish Economic Council, The Danish Economy, Fall 2004.

CAVEATS

The degree of self-financing varies across population groups;Laffer-effects may occur for some groups and some types oftax cut

So could tax cuts be self-financing after all?

Mind the words of John Maynard Keynes: ”Nor should the argument seem strange that taxation may be so high as todefeat its object, and that, given sufficient time to gather thefruits, a reduction of taxation will run a better chance than anincrease of balancing the budget.”

Morale: Timing is essential. Don’t cut taxes in expectation ofLaffer effects when the economy works at full capacity.

DYNAMIC EFFECTS:AN ALTERNATIVE PERSPECTIVE

While tax cuts are generally not self-financing, the introduction

of mandatory individual savings accounts to finance a part of

social transfers is likely to be self-financing

Motivation for introducing individual accounts:

● 74% of the taxes levied to finance Danish social transfers are paid back to the taxpayer himself over the life cycle

● Many social transfers imply little redistribution of lifetime income from rich to poor

The redistribution index for Danish transfer programs

Transfer program

Annual Income

Lifetime Income

Percentage share of total spending on

social transfers (2004)

Social assistance 0.70 0.47 6.2

Housing benefits 0.35 0.39 4.4

Disability benefits 0.14 0.39 13.8

Supplementary retirement benefits 0.37 0.19 n.a.

Sickness benefits 0.19 0.18 8.3

Unemployment benefits 0.09 0.11 9.7

Child benefits 0.13 0.10 8.0

Education benefits 0.68 0.04 5.3

Early retirement benefits 0.00 0.04 10.8

Parental leave benefits 0.22 0.02 0.1

Basic retirement benefit 0.22 0.00 28.1*

* Sum of basic and supplementary retirement benefits. Source: Danish Economic Council.

A DESIGN FOR SOCIAL INSURANCE BASED ON INDIVIDUAL SAVINGS ACCOUNTS

• For each taxpayer an individual account (IA) is established

• A mandatory social security contribution is credited to the IA; the contribution replaces part

of the taxpayer’s labour income tax• Receipts of certain social transfers are debited

to the IA• Interest is added to or subtracted from the

balance on the IA• Any surplus on the IA at the date of retirement is

converted into an annuity which is added to the public pension. Persons with a negative IA balance receive the public pension

Properties of the IA system

Insurance properties

● Liquidity insurance

● Lifetime income insurance

Incentive properties

● Reduced marginal tax rate

● Reduced replacement rate

(selective tax and benefit cut for those with

positive IA balances at retirement)

An IA system for Denmark (DEC proposal)

Transfer programs included in IA system:

● Short-term unemployment benefits

● Early retirement benefits

● Education benefits in higher education

● Sickness benefits (up to a limited number of sickness days)

● Child benefits

● Parental leave benefits

The payroll tax is cut by 7.9 percentage points and replaced by a mandatory contribution to the IA

The DEC proposal: Average payments to and from the individual accounts and account balances at the time of retirement across lifetime income deciles1

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 Average

Lifetime income (index) 62 79 86 92 97 102 107 113 121 141 100

Accumulated payment into account in percent of accumulated withdrawal from account

34 56 72 84 97 109 123 141 161 210 100

After-tax account balance at retirement2 in percent of accumulated lifetime disposable income3

0.1 0.4 0.7 0.9 1.2 1.4 1.8 2.2 2.5 3.3 1.6

Percent of adult population with positive account balance

7.2 17.1 27.7 36.3 43.0 51.2 57.2 65.8 71.0 79.7 45.6

1. The estimates assume a zero growth-adjusted real interest rate and unchanged behaviour. 2. Average account balance across the entire sample population, where negative account balances have been set to zero. 3. Accumulated income up until the official retirement age of 65; average across the entire sample population Source: Danish Economic Council, The Danish Economy, Spring 2005.

Effects of the IA system on income distribution: Summary statistics

Gini coefficients

● Lifetime factor income: 0.253

● Lifetime disposable income, current system: 0.127

● Lifetime disposable income, DEC proposal: 0.133

Redistribution of lifetime income

Current system: (0.253 – 0.127)/0.253 = 49.8 %

DEC proposal: (0.253 – 0.133)/0.253 = 47.4 %

EFFECT ON THE PUBLIC BUDGET

Even with moderate labour supply elasticities, the DECproposal improves the public budget. The reason is thatthe proposal involves

● a cut in the marginal labour income tax rate

combined with

● a cut in the replacement rate in the transfer programs included in the scheme

Note: Effectively the replacement rate is cut by 100 percent, but the cut is felt at a stage in the life cycle where the taxpayer can more easily afford it.

CONCLUSIONS

● Mandatory saving accounts for (part of) social insurance can offer liquidity insurance and lifetime income insurance in a more efficient manner than the current tax-transfer system

● An IA system is likely to be self-financing. It therefore has the potential to generate a welfare gain for the majority of the population without making anybody worse off and without significantly increasing the inequality of lifetime income distribution