What Makes a Good Tax Structure

7/27/2019 What Makes a Good Tax Structure

1/16

E S S A Y

ADVANCING LIBERTY

WITH RESPONSIBILITY

BY PROMOTING

MARKET SOLUTIONS

FOR MISSOURI

PUBLIC POLICY

OCTOBER 2013

What Makes

A Good

Tax Structure?By Joseph H. Haslag and Haleigh Albers

1. INTRODUCTION

Have you ever looked at Chapter 143o itle X o the Missouri RevisedStatutes? Tis chapter applies toindividual and corporate incometaxes. Rather than go through a listo each subsection, we collecteddata on the number o subsectionsin Chapter 143 rom 1973 through2012. We plotted the number oeective subsections or each yearin Figure 1. Clearly, things havechanged over time, with the numbero subsections increasing rom 54 in1973 to 154 in 2012.1

Te next question is, why have thenumber o subsections in Chapter143 o itle X increased? Severalpossible answers apply. For onething, no law is ever written perectlythe rst time. So, new subsectionsrene things, such as loopholes that

were not evident when the law wasinitially written and to redenewhat income is subject to taxation.2

Additionally, the state assemblysees opportunities to use tax lawsthat seek to stimulate economic

development by changing theamount o income subject to thestate income tax. By implementingsuch changes, the carrot-and-stickapproach aims to modiy peoplesbehavior so that the Missourieconomy will grow aster.3

Tird, i we started rom scratch,would we implement the same seto subsections? Te calls or tax

reorm are based on the notion thattax code becomes unnecessarilycomplicated over time. Te view isthat the number o laws that adjusttaxable income changes over timecomplicate things by altering the

FIGURE 1: Effective Subsections per Year

2012


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ESSAY I SHOW-ME INSTITUTE

2

SHOW-ME INSTITUTE I ESSAY

2

The purpose

of this essay

is to focus on

the economics

of taxation.

Specically, we

are interested in

characterizing

those principles

that implement

taxes that do the

least harm to

people.

set o deductions, exclusions, and creditsthat apply to taxpayers.4 Each ler mustkeep up in order to comply. Each newsubsection adds a layer o new questionsthat taxpayers conront when ling theirtaxes. Do I qualiy or the new tax credit?

Does the new deduction apply to me? Onthe other hand, the ler risks either notcomplying or paying too much in taxes ihe ignores new tax laws.

We have moved systematically throughthree questions. At the end, there is acase to be made or tax reorm, i nothingelse, to reduce the complexity and savepeople time. ax reorm, however, is notlimited to dealing with the complexity

issue. Indeed, it is also a good time to ask,what kind o taxes do the least harm toMissourians?

Te purpose o this essay is to ocus onthe economics o taxation. Specically,we are interested in characterizing thoseprinciples that implement taxes thatdo the least harm to people. In orderto accomplish this goal, we study twospecic policy prescriptions. As we

examine each policy, one will see a singledoctrine that accomplishes two goals: ithelps us see how taxes are harmul andthereore, why more desirable tax policiesdo less harm. In each policy prescription,we avoid the problem o deciding howmuch the government will spend. Weassume that the spending decision isalready made so we only need to examinewhich set o taxes will provide the

necessary revenue and do the least harm.Te guiding idea is that doing theleast harm means creating the smallestdistortions. Because tax increases aectater-tax prices, the smallest distortionsoccur when the elasticity o eitherdemand or supply is smallest. At the endo the day, the elasticity principle serves as

the overarching guide or choosing the tpolicies that are the least harmul.

Te policy prescription starts with thepremise that income must be taxed. Wethen ask whether all sources o income a

the same. In this case, we ollow the wothat Christophe Chamley (1986) andKen Judd (1985) conducted separately.Independently, both authors derived thesame result. Tey started by dividingincome according to its source. Laborincome is paid or the work eort thata person puts orward. Capital incomeis paid to people or the resources theyprovide so that companies can purchasebuildings and machines used to produce

goods and services.5 Chamley and Juddasked i there should be dierent taxrates to these two dierent sources oincome. Each ound that the best policyis to set the tax rate equal to 0 on capitaincome and that the tax rate on laborincome is high enough to generate all thgovernments revenue.

Recently, we saw a state implementincome tax reorms that are similar to

what Chamley and Judd suggested. In2012, Kansas implemented reormsthat eliminated taxes on incomepaid to owners o sole partnerships,limited liability corporations, and Scorporations as long as the income ispass-through and not paid as wages.We will discuss the dierences betweethe Kansas income tax changes andthe Chamley-Judd prescription. In

addition, we consider a numericalillustration that supposes the incometaxes in Missouri i it implemented thChamley-Judd prescription.

Te key insight rom Chamley andJudd is really an application o a moregeneral principle that Nobel LaureatesPeter Diamond and James Mirrlees put


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OCTOBER 2013

3

Labor income

is paid for the

work effort that

a person puts

forward. Capital

income is paid

to people for

the resources

they provide so

that companies

can purchase

buildings and

machines used

to produce goods

and services.

orward. In their amous 1971 paper,the principle o elasticity was developed.Diamond and Mirrlees demonstratedthat the taxes that did the least harm wereones that were applied to the least elasticitems. Here, the term elasticity reers to

the percentage change in the quantity othe good or service or a given percentagechange in the tax rate.6 Chamley andJudd showed that capital is extremelyelastic because it is mobile. In the longrun, a higher tax rate on capital will lowerthe return and result in capital feeing to alower tax jurisdiction.

Our second illustration considersextending the principle o elasticity to

its logical conclusion. Land is an itemthat is completely inelastic; you cannotremove a parcel o land rom one state toanother. Tereore, land value constitutesa tax base that is inelastic and warrantsconsideration as a taxable item that doesthe least harm to Missourians. We usethe best data available to determine thetax rate that would apply in Missouri i itsought to implement a land-value tax.

Te outline o the paper is as ollows: InSection 2, we lay out the economy thatChamley and Judd studied. In doing so,we oer a more precise denition o whatwe mean by the phrase least harm. Weconduct our numerical experiment orthe Missouri economy in Section 3. Werelax the assumption that income mustbe taxed in Section 4, proposing a taxon land value as an alternative. Section 5

oers a brie summary o our ndings.

2. The Model Economy

A model captures the key eatures othe actual economy. Here, three maintradeos are captured: (1) peoplemake decisions within each yearbetween working, which is costly, and

consuming, which requires, in part,the income rom working; (2) peoplemake decisions about consuming thisyear versus consuming in the uture;and (3) rms decide how intensivelyto use capital and labor. Clearly, this is

not an exhaustive list o decisions, butit embodies key dimensions that matteror economic well-being. In particular,item 2 is a airly straightorward way tocapture the dynamic eects associatedwith peoples consumption-savingdecision. People look into the uture toproperly capture this tradeo.

We begin by describing how thiseconomy works. For example, we need to

describe who lives in the economy, howlong they live, and what kind o thingsthey want to buy and sell.

How long does this economy last? Weonly need two periods in order to getthe consumption-saving decision to beoperational. In order to get a sense othe long run, however, we think o thiseconomy as lasting or a long time. Tislength o time is divided into periods. For

our purposes, each period is a year. Whenwe get to the analysis, the nice thing isthat the decisions are easily characterizedas i it is about consumption this year andconsumption next year. So, any graph hasonly two dimensions.

Who lives in the economy? Te number opeople is very large so that no one personpossesses any market power. Put anotherway, each person takes prices as i they are

given and cannot implement any unilateraldecision that will aect those prices. We donot need to have an exact number, becausewe will assume that people are identical,at least with respect to their decisionsregarding current consumption (this period)and uture consumption (next period). Inaddition, everyone lives or two periods.


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In 2012, Kansasimplemented

reforms that

eliminated taxes

on income paid

to owners of sole

partnerships,

limited liabilitycorporations, and

S corporations

as long as the

income is pass-

through and not

paid as wages.

What goods exist in this economy? Westart with an economy that has threegoods: a consumption good that spoilseach year, leisure, and capital. Tere aremore than three goods in the world, butthis approach allows us to capture some

key elements without keeping track oall the variety. For the consumptiongood, spoilage simply means thatwhatever consumption goods areproduced in a given year must eitherbe consumed or turned into capital.Otherwise, the consumption goodrots and people derive no happiness urther known as utility romconsuming rotten goods. Oten, a

persons avorite ruit is used as ametaphor or the consumption good.Fruit ripens and then spoils. In thisparable, the ruits ripe phase coincideswith the length o a period.

Leisure is time spent enjoying lie. Eachperson is allotted one unit o time eachperiod. Te unit could be 24 hours, oneweek, one month, one quarter. Again,the length o the period does not matter

and will not aect the results o ouranalysis. Rather, the length is convertedinto a xed length and then normalizedto one. Tat amount o time is dividedbetween working and time o. Bycreating leisure, we can consider thetradeo each period between consumingand working. Working means that wegive up leisure so working is costly.However, consumption is tied to laborincome, so i our person does not work,

he will suer less consumption. Whendecisions are made, the balancing act isbetween the cost o giving up a little othe consumption good and the beneto enjoying a little more leisure.

In order to consider the tradeo betweenconsuming this year and consuming nextyear, we need an asset that allows us to

store value across years. Here, that good icapital. Capital serves two purposes: it is input into the production process and thmeans o saving or uture consumption.We assume that the consumption goodcan be converted into the capital good.

o build on the ruit-as-consumption-good metaphor, beore the ruit spoils,it can be planted. Te seed matures inthe uture, yielding more consumptiongood. Likewise, the consumption goodis converted into the capital good wherethe latter good returns quantities o next-year consumption goods. We assume theconversion rate o the consumption goodto the capital good is one-or-one. It does

not have to be so, but the assumptionsimplies the math. Across time, thedecision must balance the cost o givingup a little bit o the consumption goodthis year against the benet o being ableto aord a little more o the consumptiongood next year because productionexpanded with the capital stock.

Next, we describe the process thattransorms capital and labor into the

current-period consumption good. Titechnology is called the productionunction. Production combines laborand capital to generate the consumptiogood. As we previously wrote,capital is created by converting theconsumption good into capital; morespecically, beore the consumptiongood spoils, a person can change thisyears consumption into capital that isused in next years production. When

combined with next years labor, we getthe quantity o the consumption goodspecied by the production unction.Te market allows savers to rent theircapital to companies while people areemployed. o extend the consumptiongood-as-ruit analogy, a person savespart o the ruit and plants it. Next yea


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OCTOBER 2013

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We start with an

economy that has

three goods: aconsumption good

that spoils each

year, leisure, and

capital.

new ruit is available and by applyinglabor to harvest, new ruit is available orconsumption. Additional inputs yield

additional output. We urther assumethat the gains rom additional inputsoccur at a decreasing rate, or each inputexhibits diminishing marginal product.

he inal piece involves a speciicationo what people want. We assume thateach person has a utility unctionwhich describes the relationshipbetween happiness and the quantitieso the consumption good and leisure.

More is preerred to less so thathappiness increases, or example,with an increase in the quantity othe consumption good. Similarly,happiness increases, or example, withan increase in leisure. he rate atwhich happiness increases, however,diminishes with additional quantitieso the consumption good and leisure.

You may ask why people do not get

happiness rom capital. Capital isnot consumed; rather, it is a stand-inor uture consumption. hereore,happiness is indirectly tied to capitalquantities. With a description o thetime, length o lie and goods andservices together with the endowments,the technology, and peoplespreerences, we have a complete

description o the things that make thisan economy.

Figure 2 provides an overview o the

connections that exist between decisionsacross two dierent dates. In the currentperiod, a person decides between laborto oer and capital to rent. Payments toeach o these two actors result in incomethat is then divided between currentconsumption and saving. Te amount aperson saves is used to create additionalcapital, also known as investment. Nextperiod, the amount o capital brought

orward rom the current period is used,along with labor to generate income. Tisprocess continues ad innitum.

One can use Figure 2 to characterizehow decisions are made each year andhow those decisions aect outcomesacross years. In the letmost purple box,people decide how to allocate their time,assuming that any one persons decisiondoes not aect the wage they are oered.

Based on this knowledge o prices, theperson decides how much to work andhow much to enjoy leisure (the boxesjust to the right). Now with their laborincome and the capital income generatedby capital accumulated last year, eachperson knows their income, which is thenext box. Te income is divided intohow much to consume and how much to

FIGURE 2: What Decisions People Make and How Those Decisions

Are Linked Across Time

Year 1 Year 2 Time


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Suppose that

we have to tax

income. The

decision is

whether there

is an important

difference betweenlabor income and

capital income.

save. Here, saving is the act o adding tothe capital stock that will be carried overto next year and used in the productionprocess. Tis is where we jump rom oneyear to the next, indicated by the boxeschanging rom purple to blue. And the

decision process repeats.

Overall, Figure 2 depicts a decisionprocess that has two key elements. First,there is the decision each year about howmuch to work and how much to enjoyleisure. Tis decision aects income thisperiod. Second, there is the decisionabout how much to consume and howmuch to save. Te second decisionaects income next period through the

accumulation o additional capital thisyear, which generates income next year.So, both elements bear on income andon consumption. Working more resultsin more current-year income, but meansorgoing leisure. o save more, we see anincrease in next-year income, but thismeans orgoing this years consumption.ogether, these two elemental decisionsare the driving orces that aect a persons

lietime welare.2.1 What Income Should We ax?

Suppose that we have to tax income. Tedecision is whether there is an importantdierence between labor income andcapital income. I no, then the case canbe made that we want to tax both typesat the same rate. However, i there is animportant dierence, we at least want to

consider whether the tax rates on the twotypes should be dierent.

We begin by considering a tax rate ap-plied to labor income and capital income.When income is the tax base, the un-derlying assumption is that both laborincome and capital income are taxed atthe same rate. Following Judd (1985) and

Chamley (1986), we relax the assumptiothat both types o income are taxed at thsame rate, asking what rate, or combination o rates, is best.

o do this analysis, we use the economy

described earlier. Both Judd and Chamldid this. Te objective is to choose thepolicy combination o labor income taxrates and capital income tax rates that wresult in the highest welare level or ourtypical person. Troughout this paper, wadopt the idea that maximum welare iswhat we mean by best when reerringto tax policy. Equivalently, the welare-maximizing policy is the one that does

the least harm.

Suppose a government has access to twdistinct tax bases: capital income andlabor income. Each can have its own tarate. Capital income is the return thata person gets rom renting capital tocompanies. Examples o capital incomeinclude proprietors income, rental in-come, corporate prots, and net interepayments. More concretely, payments

are made to people providing resourcesto companies that are used in the pro-duction o market goods and services.Frequently, these resources are acquiredthrough sales o bonds, loans, and sell-ing ownership to people. Tereore, wemeasure the fow o payments on debtand equity that is, interest paymentand dividends as compensation orthe resources oered to companies. Inthe case o sole proprietorships, it isreasonable to think o the nancing thowner oers as renting capital to thecompany. Te prots rom the companare the fow o payments that the capitgenerates. Labor income is the paymenmade or work eort that is employedin the production o goods and serviceWe are most amiliar with labor incom


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OCTOBER 2013

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Suppose a

government has

access to two

distinct tax bases:

capital income

and labor income.

Each can have itsown tax rate.

because the majority o peoples incomeis derived rom applying their labor andearning a paycheck.

In this analysis, we assume the govern-ment spends a xed amount. So, what

is the best way to nance these expendi-tures? As we mentioned previously, thedenition o best is the set o taxes thatmaximizes welare. Start with the obser-vation that both the labor income tax andthe capital income tax aect the ater-taxprices o labor and capital. For example,an increase in the labor income tax ratemeans that or a given pre-tax wage, theater-tax return to labor declines. With a

smaller ater-tax income, people wouldbe able to aord less o the consumptiongood. Because more is preerred to less,the bottom line is that welare declines.So, we are looking or the tax rates thatdo the least harm to people.

We have the question that Judd and Cham-ley asked and the methodology they usedto answer the question. Tey separatelyound the same answer: in the long run, the

best tax policy is to set the tax rate on laborincome to raise exactly the revenues thegovernment sets. Te implication is that thetax rate on capital income is 0.

Principle 1: Given an income tax, thewelfare maximizing policy sets the taxrate on labor and the tax rate on capitalso that the marginal cost of an incre-mental increase in the tax rate is equalfor each income tax rate.

Principle 1 gives us the guide or settingtax rates. Suppose you raise the laborincome tax rate by 1/100th o a percentagepoint and a persons welare decreases by10 units. Consider an increase in the cap-ital income tax rate equal to 1/100th o apercentage point, which results in welare

decreasing by 50 units. Which tax policywill do the least harm? In this example, abenevolent government would raise thelabor income tax. Judd and Chamley areessentially doing this comparison whenthey nd that collecting revenue rom

labor taxes only is the policy that does theleast harm to people.

Why? In the long run, capital is mo-bile, which means that a small changein its price causes a very large changein the quantity o capital employed inan economy. Economists use the termelasticity to reer to the responsiveness inthe quantity to a given change in price. In

other words, the long-run supply o capi-tal is very elastic. o see how this works,we need to know that the relevant returnto capital is the ater-tax return. More-over, in the long run, the ater-tax returnis inversely related to the capital tax rate.So, i the tax rate on capital increases, orexample, the ater-tax return goes down.Even a minimal increase in the capitalincome tax rate means that people dra-matically decrease the amount o capital

they are willing to supply to the market.Indeed, the decline in the capital incometax base is sharp enough that a policythat chooses between labor income taxesand capital income taxes will choose onlylabor income taxes.

Because this concept is central to the eco-nomic principle o taxation, we go a littleurther to provide the intuition behindJudds and Chamleys result. Each persondecides how much labor to oer and howmuch capital to use in the productionprocess. By raising the tax rate rom 0 to10 percent on labor income, the laborsupply is reduced because the ater-taxwage has decreased and leisure has be-come cheaper. So people opt or moreleisure. Te eect that the tax-rate change


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8

In a 2010 Show-Me

Institute Essay,

Casteel and

Haslag conducteda numerical

analysis studying

the effects of a

state income tax

versus a state

sales tax.

has on the quantity o labor measures thesocial marginal cost o the labor tax. Inthe case o a change in the capital incometax rate rom 0 to 10 percent, the declinein capital supply is much larger than thedecline in labor supply. Te social mar-

ginal cost o raising the tax rate on capitalis greater than the social marginal cost oraising the tax rate on labor. (Social mar-ginal cost measures the change in the costthe entire society bears or a given changein the tax rate.) Following Principle 1,the best policy chooses the tax policy thatminimizes the social marginal cost. Tesocial marginal cost o an increase in thecapital income tax rate is simply always

greater than the marginal cost o raisingthe labor income tax. Tereore, we alwaysopt or raising the labor income tax andavoid raising the capital income tax.

2.2 Sales ax vs. Income ax

In a 2010 Show-Me Institute Essay,Casteel and Haslag conducted a numeri-cal analysis studying the eects o a stateincome tax versus a state sales tax. Speci-

cally, Casteel and Haslag asked whetherthe average person would preer to raisestate revenues using only a sales tax or thecurrent combination o income taxes andsales taxes.

Te results indicated that the sales tax-only option would result in greater hap-piness. Casteel and Haslag used a slightlydierent model economy to generate

these results. Te intuition is the same,however. Te sales tax was preerred overthe current policy o combined sales andincome tax because the income tax wasapplied to capital. Te numerical results,thereore, provide quantitative support orthe conclusions that Judd and Chamleyreached. Capital income taxes do moreharm than good.

2.3 Why Is It Hard o Get Rid OfCapital Income axes?

Measurement issues complicate the 0 rapolicy on capital income. When measuing capital income, there is the unam-biguous part: rental income, corporateprots, and net interest income matchwell with the concept o capital incomeas developed in the models. Te value oland and inventories are lumped into thmodels notion o capital. Data on landvalues and inventories are included inthe Flow o Funds accounts. One stickyissue, however, is how to treat Propri-etors income. Small business owners, o

instance, are almost always materially involved in the business operations; that ithey work. Tere is no neat way to divitheir compensation into a labor part anan owners part.

Some apportionment o proprietors in-come must be designated as labor incomand the remainder as capital income. Sua one-size-ts-all approach is not very appealing. One could try to ask the taxpay

what their two types o income are. Youcan expect that the share will depend onthe dierential between the labor incomrate and the capital income rate.

2.4 Te Kansas Approach

In 2012, Kansas implemented changesto its state income tax laws. Specicallyincome that sole proprietors, partner-

ships, limited-liability corporations, anS corporations report are not subject tostate income taxes. Tese types o busi-nesses are more closely associated withindividual or a small group o owners.Te net income o businesses organizedunder these legal headings is passedthrough to the owners and are subjectto taxation under the individual incom


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OCTOBER 2013

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Casteel and

Haslag asked

whether the

average person

would preferto raise state

revenues using

only a sales tax

or the current

combination of

income taxes and

sales taxes. Theresults indicated

that the sales tax-

only option would

result in greater

happiness.

tax laws. In contrast, C corporations willdeclare their net income and be subjectto corporate income taxation.

Essentially, Kansas implemented a lawthat allows business owners under these

our legal headings to choose their owndivision o income. Suppose there is atwo-person law rm in Kansas that is setup as a partnership. Te rm generates$500,000 in revenues and has expensesequal to $200,000. Te partners split, orpass-through, the $300,000 equally. Eachpartner then les his individual incometax orm and the $150,000 income is notsubject to Kansas state income taxes. I

instead, each partner paid himsel a sal-ary equal to $150,000, then each personwould receive a W-2 rom their partner-ship and those wages would be subject toKansas income taxes. Which option doyou think the two partners will choose?

Te point is that Kansas has eectivelyimplemented the 0-capital-tax-rate policy,but only on a portion o capital income.According to Principle 1, there are two

shortcomings to the Kansas income taxlaw. One is that it dierentially treatscapital income that C Corporationsgenerate and capital income paid to othertypes o business organizations. As such,the new Kansas income tax does not ap-ply Principle 1 in the best possible way.Principle 1 does not distinguish betweentypes o business organizations, speciyingthat the capital income tax rate should be0 across the board.

Second, Kansas ailed to make any provi-sion or labor income that owners o theour special types o business organi-zations earn. According to Principle 1,labor income taxes are not as harmul ascapital income taxes. By allowing ownersto choose the income classication

whether they earn labor income or not means the individual income tax baseis smaller than what economic theorysuggests. In our attorney partnershipexample, each partner is applying someeort to produce legal services. Accord-

ingly, Principle 1 would seek to identiythe appropriate amount o payment toeach lawyers work eort and apply thelabor income tax to that amount. oimplement the optimal income tax policy,we need to properly assign the paymentto labor. O course, this assignment cre-ates a measurement problem that requiresthought to solve.

Tere also is a strategic considerationthat Kansas law unleashed. It may beonly a theoretical curiosity, but thereis an incentive or each person to ormhis own business. Imagine that you candeclare yoursel a sole proprietorship andthat you consult with the company orwhich you work. Suppose you negotiatethe same compensation package, benetsand all, with the company so that you areindierent between being an employee

or being a sel-employed consultant.7 So,with everything else being equal, a soleproprietor could declare compensationas pass-through income and avoid pay-ing taxes. We are not predicting wide-scale shits in the Kansas labor orce, butincentives matter.

Overall, we speciy a model o the econ-omy and use it to compare the eects odierent tax rates. I the choice is betweenlabor income and capital income taxes,the least harmul option is to tax labor in-come only. Te deeper point is that leastharm means that the least elastic items aretaxed. In other words, nd items/tax basesthat do not respond very much, or not atall, to changes in prices that changes intax rates induce.


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10

We consider a

numerical example

in which we ask

what it would look

like if Missouri

were to implement

a modication

to its individual

income tax.

3. What If Missouri ImplementedA No-Capital-Income Tax Rate?

Here, we consider a numerical examplein which we ask what it would looklike i Missouri were to implement amodication to its individual incometax. Specically, suppose state lawdistinguished between labor income andcapital income. Further, suppose the statechose the tax rate on labor income sothat revenues are neutral; that is, moniesthe new income tax policy raises areequal to those the existing individualincome tax raises.

3.1 axing All Labor Compensation

Missouris General Revenue Fundreceived $5.986 billion rom individualincome tax in 2012, the last calendaryear or which we have data.8 Tisgure is the net receipts so reunds arealready subtracted. We use this amountas the target level o receipts that thelabor-income-only state income taxneeds to generate.

Missouris Gross Domestic Product(GDP) measures the total paymentsmade to both capital and labor that areemployed within Missouris borders.In 2012, Missouri GDP was $258.832billion. Next, we need to break out thetotal payments into the labor portionand the capital portion. Using data romcompensation sources, researchers havesettled on payments to labor typicallyaccounting or 60 to 70 percent o totalactor payments. I we choose 60 percent,we are eectively making the labor-income tax base as small as possible. Wecompute the product o Missouri GDPand 60 percent $258.832x0.6 which equals $155.299 billion. For thisindirect analysis, we use $155.299 billionas the labor-income tax base. Note that

this measure o labor income includes aorms o compensation or hours workeincluding benets. We start with thisbroad measure and later conduct ouranalysis with just wage-and-salary, ortake-home, pay.

Te last step is to solve or the rate thatwould yield the same level o individuaincome tax as Missouri collected in 201Te calculation involves computing theratio o Missouris individual incometax receipts to Missouris labor-incometax base. In this case, = 0.0385.In other words, Missouri could set thelabor-income tax rate at 3.86 percent an

generate the same tax receipts as it doesunder the current individual income tax

Suppose the goal is to replace the rev-enues rom individual and corporateincome taxes that Missouri collects. In2012, net receipts were $6.424 billion.Following the same procedure as we didearlier, the rate would be = 0.041Tus, the numerical example indicatesthat Missouri could replace its current i

come tax law with a tax on labor incomonly and the rate equal to 4.14 percentwould achieve revenue neutrality.10

We used a conservative estimate o thelabor income value in Missouri. Ournumerical analysis shows that a labor-income tax could replace the currentincome tax structure. Te tax rate onlabor income set at 4.14 percent wouldyield the same revenue as currentindividual and corporate income taxstructure. Alternatively, i labor incomaccounts or 70 percent o the paymenmade to Missouri workers, then thetax base increases to $181.182 billion.Correspondingly, the tax rate is= 0.0355. Te tax rate is 3.55 percent labor income in Missouri accounts or


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OCTOBER 2013

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Missouris General

Revenue Fund

received $5.986

billion from

individual income

tax in 2012, the

last calendar year

for which we have

data.

70 percent o GDP. What should notbe lost in these calculations is Principle1; the typical person has higher welareunder the labor-income tax-only policythan under the general income taxpolicy. By ridding the state o the highly

distortionary capital-income tax, eco-nomic well-being increases.

3.2 axing ake-Home Pay Only

Here, we start with a labor-income mea-sure that corresponds to gross take-homepay. Tings such as pension contributionsrom a company or 401(K) contributionsthat are not subject to current taxes are

excluded rom this labor-income measure.

For people working in Missouri, totalwage and salary disbursements was$121.33 billion in 2012. With wageand salary disbursements as the labor-income tax base, the rate that wouldgenerate $6.424 billion is obtained bycomputing = 0.0529. Because thetax base is smaller when we limit it tojust wage and salary disbursements, the

tax rate must increase. Te rate is 5.29percent on wage-and-salary disburse-ments in order to raise enough staterevenues to oset the amount that theindividual and corporate income taxescurrently generate.

Overall, our numerical examples demon-strate that the tax base matters. Even withthe smallest measure o the labor-income

tax base that we consider, the marginalincome tax rate on labor income is lowerthan the rate currently implemented onindividual and corporate income, whichis 6 percent. Tus, the rate on labor-in-come only is lower than the current mar-ginal income tax rate, is less distortionary,and is welare improving.

4. Is There A Better Way?

So ar, we have limited ourselves to tax-ing income. I that is the restriction, it isbetter to tax labor income than capitalincome. But the elasticity principle that

lies behind this result means there may beother tax bases that would be even better.

o reiterate, the elasticity tax principletells us that we should seek to tax items inwhich the quantity changes are the leastresponsive to changes in tax rates. By ol-lowing this principle, we will nd the seto taxes that are the least distortionary interms o aecting quantities, and there-ore, do the least harm in terms o reduc-

ing peoples welare.

One item that satises the inelasticityprinciple could serve as a tax base. Tevalue o unimproved land is a tax basewhere the quantity o the good is com-pletely invariant to changes to tax rates.I tax rates on land values were to in-crease rom 0 to 1 percent, or example,the ater-tax returns to the land woulddecline. By the logic o basic asset-pric-ing ormula, the price o the land woulddecline. In terms o the distorting eecton the quantity o land, there is none.Te supply o land within the statesborders is xed.

Tis is the major dierence betweenland and capital. When you tax physicalcapital, the decline in the value o physi-cal capital means that it simply moves to

where it is more highly valued. Capitalmobility explains why capital taxation isso harmul. In contrast, there is no wayto move land. Consequently, the absenceo land mobility means it is a good assetto tax. Instead o resulting in distortingchange in the quantity o land, the usageo the land changes. Suppose the land iscurrently used as a parking lot. By taxing


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the land value, the returns to the parkinglot owner are reduced. Te opportunityarises to use the land or other purposes.Perhaps a builder sees an opportunity toconstruct an apartment complex on theland. In the absence o the land-value

tax, the inertia is to keep the land as aparking lot. By implementing the land-value tax, there is now an incentive toput the land to its most highly valueduse. Te tax rate change instigates adynamic adjustment rom current use tothe lands more highly valued use.

In order to get an idea about the landvalue tax in Missouri, we present the

results rom a simulation o the landvalue. Data on land values are theoreti-cally available rom the county asses-sor. Current law states that the as-sessed value o the property is dividedbetween its land component and itsimprovement component, where thelatter includes all improvements addedto the land, such as buildings. Im-provements, thereore, all under thecategory o capital. Because taxes are

applied against land and improvementsat the same rate, greater care is takento calculate the assessed value with lesseort devoted to the division o valueso the two components.

o construct our simulation, we use datarom the United States Department o

Agriculture (USDA). In their 2012 re-port, Missouris total land area is listedas 43,974,900 acres. O that amount,39,776,900 acres are rural, leaving4,197,765 acres o urban land. Supposethe government owns 1 percent o the

total land.11 We urther assume that the 1percent is divided between rural and urbasettings, leaving privately owned land in trural area at 39,379,131 acres and privateowned urban land at 4,155,787 acres.Next, we need estimates o price data.Te USDA reports that in 2012, theaverage price o rural land in Missouriwas $2,900 per acre.12 We compute thproduct o privately owned rural land

by its average price, yielding a marketvalue equal to $114.2 billion. Urbanproperty is more challenging becausewe could not nd data on the averagevalue per acre. I, or example, you pria new lot in a city subdivision in SaintLouis, Kansas City, or Springeld, theprice can easily be $30,000 or more.And there are our to six lots per acre.For starters, we apply a conservativeestimate and assume the value o urban

land is $30,000 per acre. Under this assumption, the value o privately ownedurban land is $124.7 billion. Te resulis that the total value o Missouris pri-vately held land is $238.9 billion.

We also compute value o privatelyowned urban land at $75,000 per acre.

Missouris GrossDomestic Product

(GDP) measures

the total payments

made to both

capital and labor

that are employed

within Missourisborders. In 2012,

Missouri GDP was

$258.832 billion.

Table 1: Results from Land Value Tax Simulations

Land Value

$238,873,089,900

$425,883,531,150

Net StateGeneral Revenues

$7,340,600,000

$7,340,600,000

Implied Land-Value

Tax Rate

3.72 %

1.72 %

Case

Urban value = $30,000 per acre

Rural land = $2,900 per acre

Urban value = $75,000 per acreRural land = $2,900 per acre


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In this case, the value o privately ownedurban land is $311.7 billion. Add thevalue o privately owned rural land toobtain $425.9 billion.

able 1 reports the total land or Mis-

souri or the two dierent assumptionsregarding urban land values. In addition,able 1 reports the net general revenuevalue or Missouri in scal year 2012,which ended in June 2012. By divid-ing the Net General Revenue gure bythe total land value, we can computethe tax rate on land value that wouldbe revenue neutral; that is, the tax rateon land would generate state revenue

equal to that obtained rom all the othertaxes that the state government currentlycollects. As able 1 shows, Missouricollected $7.3 billion in revenues, ateraccounting or reunds, rom individualincome taxes, sales and use taxes, cor-porate income taxes, and others. In thelow-value urban assumption, the taxrate would be 3.72 percent. In the high-value urban assumption, the tax rate onland value is 1.72 percent.

Te chie benet o the land-value tax isthat it applies the inelasticity principle.Te tax is applied to land and the quan-tity o land is not responsive to move-ments in the ater-tax price o land. Oneproblem associated with the land-valuetax is the quality o data that is used tostudy the tax. So, on theoretical grounds,the land-value tax is useul, but withoutbetter measurement, we cannot tell whatthe tax rate would be.

5. Summary

In this paper, we consider two classeso tax structures. In the rst class, weask whether all income should be taxedequally. Te economic literature provides

one answer; i the elasticity o capital isvery high because o its mobility, then theleast harmul income tax would set the taxrate on capital income equal to 0 and relyon labor income taxes to pay or govern-ment spending. Te second class relaxesthe assumption that we must tax income.We consider a land-value tax because itapplies the principle o doing the leastharm to citizens; the quantity o land isnot distorted because its supply is xed.

Te more general point is that once weknow what the government spendinglevel is, we ought to seek taxes that dothe least harm to people. In general, theleast harm is associated with taxes, whichaect prices, that create the smallestdistortions to the quantities o goods andservices that people want to consume.Our starting point is that the current taxstructure does not apply the inelasticityprinciple. Tereore, there are opportu-nities to improve the tax structure andpeoples welare by creating thoughtultax reorm.

Joseph Haslag is the chief economist andHaleigh Albers is an intern at the Show-MeInstitute, which promotes market solutionsfor Missouri public policy.

For people

working in

Missouri, tota

wage and salary

disbursements

was $121.33 billion

in 2012


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So far, we havelimited ourselves

to taxing income.

If that is the

restriction, it is

better to tax labor

income than

capital income.

REFERENCESCasteel, Grant, and Joseph Haslag. Income axes vs. Sales

axes: A Welare Comparison. Show-Me Institute Essay.December 2010.

Chamley, Christophe. Optimal axation o Capital Income in

General Equilibrium with Innite Lives. Econometrica, 54:3(May 1986): 607-622.

Diamond, Peter A., and James A. Mirrlees. Optimal axationand Public Production II: ax Rules.American EconomicReview61, no. 3 (1971): 261-278.

Ishmael, Patrick, and Michael Rathbone. Cutting the ies

that Bind: End Missouris Corporate Income ax. Show-Me

Institute Essay, November 2012.

Judd, Kenneth L. Redistributive axation in a Simple Perect

Foresight Model.Journal of Public Economics28 (1985): 59-83.

NOES1 Te term eective is used to mean that this number

represents the total number o subsections enacted less theones that are repealed. Rather than eective you may want

to substitute the word net subsections in order to recognize

that repealed subsections are deleted rom this count. Sixsubsections have been repealed between 1973 and 2012.

2 Subsection 127 is a good example. It recognizes that survi-vors o Nazi persecution receive restitution. Subsection 127

stipulates that such restitution is not subject to Missouri state

income taxes and is allowed to be deducted rom the lers

adjusted gross income.

3 Subsection 173 is an example o modiying behavior. It

allows small business owners to deduct an amount rom theiradjusted gross income. Te subsection makes this deduc-

tion possible provided the small business owner pays a high

enough wage and hires enough people above that wage foor.

4 An Internal Revenue Service report states that the complex-

ity o the tax code is the most serious problem acing taxpay-ers and is the largest source o compliance burdens. See

http://www.irs.gov/pub/irs-utl/08_tas_arc_msp_1.pd.

5 Basically, it is OK to think o capital as everything that acompany uses that is not land or people when producing

goods and services.

6 Diamond and Mirrlees (1966) were even more general.

Teir principle o taxation was to set tax rates on commodi-

ties so that the elasticity was equated. Te corollary to thatstatement is that i there is a good that is completely inelastic,

the tax rate should be applied to only that good. Tere is no

distortionary eect because there is no change in the quantitythat people enjoy.

7 For the purposes o this illustration, ignore the risks that arrom job separations when you are employee and when you

a consultant. Tese are important and may explain why som

people would not opt or the sole proprietorship.

8 Te data are obtained or calendar year series on individual

income taxes rom http://eparc.missouri.edu/publications/hist_tax/sec02/orp12t14.pd.

9 Note that we would be lowering the tax rate on labor incom

rom 6 percent to 3.86 percent.

10 I Missouri eliminated the corporate income tax and all tax

credits, the amount o net general revenue lost would be ap-proximately slightly less than $5.986 billion because the reven

generated rom the corporate income tax is slightly less than

the tax credits redeemed. See Ishmael and Rathbone (2012) odetailed comparisons o the economic development tax credit

relative to the corporate income tax revenues. I we collect

enough revenues to oset the sum o individual and corporateincome less tax credits, then = 0.0493, or 4.93 percent

the labor income tax rate.

11 Tere are no data on the acreage that state and local gover

ments own. So, the 1 percent value is an assumption. Tisincludes state parks, roads, government buildings, etc.

12 Te report divided rural land into cropland and pastureland

but we do not have any measurements o the acreage under ea

category and the distinction almost assuredly changes romyear-to-year. We opted or the average price per acre o rural

land. Source: http://www.nass.usda.gov/Publications/odays_

ports/reports/land0812.pd.


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