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

Robert Coen 

Professor Emeritus of EconomicsNorthwestern University

Woman’s Athletic ClubChicago, IL

January 23, 2013

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Effective Personal Income Tax Rate, 1947-2011

Ratio of Personal Income Tax Revene to Personal Income (%)P

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Year

Average (red line) = 9.7

Source data: Commerce Department, National Income Accounts

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% 378,435Income 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

Effective Personal Income Tax Rates by Household Income, 2007

Average Share ofIncome Effective pre-tax pre-tax Share ofquintile tax rate income income taxesLowest -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 19 40

Source: Congressional Budget Office

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 exemptionsStandard deduction

Some uses of income deductible: Charitable contributionsMedical expensesState-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

Shortcomings of Tax Loopholes

Hidden form of spending – “tax expenditures”Alternative is direct expenditure (subsidy),regularly reassessedOpen-ended costDifficult to get rid of, may outlive usefulness

Incentive effects vary (undesirably?) across taxpayers

Invite “creative behavior” to avoid taxesConvert ordinary income to capital gainSubstitute home equity loan for other consumer borrowingAbuse and verification issues

Erosion of tax base requires higher, distorting tax rates

Waste of (limited!) human talent in legal and accounting professions

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

Strengths of Tax Loopholes

Allow private preferences to allocate subsidies

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Effective rate Staturtory rate

Effective and Statutory Corporate Income Tax Rate, 1948-2011

Ratio of Corporate Income Tax Revenue to Corporate Profits (%)P

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Year

Source data: Commerce Department, National Income Accounts

Income Tax Reform of 1986

GoalsReduce tax rates to improve economic efficiency and growthMaintain tax revenue by eliminating some tax expenditures

Personal Tax

Reduced number of brackets from 15 to 2Reduced top rate from 50 to 28 percentEliminated deduction for interest paid, except on home mortgagesEliminated deduction for state-local sales taxesEliminated favored rates for long-term capital gains

Corporate TaxReduced top rate from 46 to 34 percent Repealed tax credit for equipment investmentTightened depreciation rules

Undoing of 1986 Reforms

1991 Top personal rate raised from 28% to 31%, Brackets increased from 2 to 31993 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 20102003 Accelerated reductions in top rates Dividends and KG rates reduced to 15%

Numerous grants of accelerated depreciationNumerous new tax credits – biofuels, etc.

Alternative Proposals for Tax (Re)Reform

Romney: Personal tax cuts1st 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

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 death38.4

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

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

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 incomeEliminating personal and corporate tax expenditures, except:

Child and earned income creditsMortgage interest (within limits)Employer-provided health insurance (with cap)Charitable giving (>2% of income, 12% refundable

creditExclusion of state-local bond interestRetirement savings

Increasing gas tax to 15¢ per gallon

Alternative Proposals for Tax (Re)Reform

Simply reduce or eliminate specific tax expendituresUse increased revenue to reduce budget deficit

Adopt a “flat tax”Popular with conservatives, e.g., Steve Forbes, Paul RyanSingle rate for individuals and businessesSimplified base for each Ultimate in simplification – postcard tax return

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

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

“Flat Tax” Is a Consumption Tax, Not an Income Tax!

Sources of income:Wages and salariesGross capital income

Gross business revenue – wages and salaries – purchases

Uses of income:ConsumptionInvestment

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 taxConsumption tax is regressive – need to consider entire tax system

Effective Federal Tax Rates by Household Income, 2007

Personal Social Corporate AllIncome Income Insurance Income Excise FederalQuintile 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% 19.0 1.6 8.8 0.1 29.5Source: Congressional Budget Office

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-TaxLowest 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 8 19 17

Source: Congressional Budget Office

Why Is Tax Reform So Difficult?

It’s really expenditure reform, tax expenditures become entrenched

Growing income inequality leads to more lobbying for tax expendituresLegislators 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

Taxes as Percent of GDP, 2010

Denmark 48

Sweden 46

Italy 43

Norway 43

France 43

Netherlands 39

Germany 36

UK 35

Canada31

Switzerland 28

Japan 28

US 25 Source: OECD

Annual GDP Taxes as Growth Rate Percent of GDP 20001-11 2010

Sweden 2.4 46

Canada1.9 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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