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REFORMING TAXATION: ADVANTAGES OF A SAVING- CONSUMPTION NEUTRAL TAX BASE, AND PRINCIPLES TO GUIDE REFORM Stephen J. Entin Institute for Research on the.

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Presentation on theme: "REFORMING TAXATION: ADVANTAGES OF A SAVING- CONSUMPTION NEUTRAL TAX BASE, AND PRINCIPLES TO GUIDE REFORM Stephen J. Entin Institute for Research on the."— Presentation transcript:

1 REFORMING TAXATION: ADVANTAGES OF A SAVING- CONSUMPTION NEUTRAL TAX BASE, AND PRINCIPLES TO GUIDE REFORM Stephen J. Entin Institute for Research on the Economics of Taxation

2 Objectives of Tax Reform  Neutrality (Growth)  Simplicity  Fairness  Visibility 2

3  Choose a better tax base.  Consumption versus Income.  (Better put: a Neutral Tax Base vs. Income.) How to Achieve Objectives 3

4 Income  Income is the earned reward for providing labor and capital to produce goods and services that other people value.  Income is proportional to effort. So the fairest tax is proportional to income, i.e., one flat rate.  Exempting the very poorest is a kindness, but it is fair for everyone who can to pay something toward the cost of government. 4

5  Income is revenue less the cost of earning revenue.  Deductions for costs are necessary to measure income properly. Income is a Net Concept 5

6  No saving => no interest, no dividends.  You can't have your principal and eat it too.  Therefore, the best measure of income is consumption. We should tax what we spend. Saving Is a Cost of Earning Income 6

7  Do not fall more heavily on saving and investment than on consumption,  Are unbiased against growth,  Are simpler than the income tax, and  Are fair and straightforward. Neutral Taxes: 7

8  Hits saving and investment harder than consumption by taxing saving and its earnings, encouraging consumption by penalizing saving (a tax base error).  Compounds the damage by taxing people more heavily the more they work, save, and produce by imposing graduated tax rates (a tax rate error). By Comparison the Income Tax: 8

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11  Savers can always switch to consumption, which is nice for them.  But when they do, investment slumps, and workers lose their jobs. Taxing Capital Income Hurts Workers 11

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13 Multiple Taxation of Saving One Tax on Consumption, Four Taxes on Saving Layer 1– Initial tax on Earnings Income is taxed when earned. If it is used for consumption, there is usually no further federal tax. Layer 2 – Personal Income Tax on Returns on Already-Taxed Saving If the income is saved, the returns on the already-taxed saving are taxed as interest, dividends, capital gains, or non-corporate business profits. Layer 3 – Corporate Income Tax If the saving is invested in corporate stock, the corporate tax hits the returns before they are either paid out to shareholders or reinvested. Layer 4 – Transfer (Estate and Gift) Tax Another tax on already-taxed assets. (Similar taxes at the state and local levels increase the multiple taxation.) 13

14 Step 1. Treat all saving and investment as a cost of earning income. Step 2. End double taxation of corporate income. Step 3. Kill the Death Tax. Steps Toward a Fair, Flat, Unbiased Neutral Tax 14

15  Treat all saving like pensions and IRAs: either defer tax until the saving is spent, or tax the saving up front and not tax the returns.  Immediately expense all investment; do not drag out depreciation over time. (This still tax above normal profits, which is OK.) Step 1. Treat Saving and Investment as a Cost of Earning Income 15

16 Neutral Tax Effect on Saving Vs. Consumption; Contrast With Ordinary Income Tax Tax TreatmentNo TaxSales TaxIncome Tax Pretax earnings to be spent or saved $100 Tax on spending 0 If spent: 20 If saved: 0 Saved or spent: 20 Amount spent or saved 100 If spent: 80 If saved: If saved, is interest on inside build-up taxed? No, 7.2% reinvested Yes, 5.76% reinvested Savings after 10 years Tax due on future spending 0400 After-tax spendable balance Ratio of saving to spend later to spending now 2 to to 1 Illustration assumes 7.2% pre-tax interest rate, 25% sales tax rate, 20% income tax rate. 16

17 Equivalence Of Saving Deferred And Returns Exempt Tax On Saving; Contrast With Ordinary Income Tax Tax TreatmentSaving DeferredReturns Exempt Ordinary Income Tax Pretax earnings to be saved $100 Tax on saving 020 Amount saved Is interest on inside build- up taxed? No, 7.2% reinvested No, 7.2% reinvested Yes, 5.76% reinvested Account after 10 years Tax due on withdrawal 4000 After-tax spendable balance Cost to saver of ordinary vs. neutral tax treatment (same as sales tax) 20 (= 160 – 140) (1/3 of the interest) Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment. 16

18 Tax-advantaged saving in an IRA, 401(k), or pension yields about two-thirds more income in retirement than ordinary saving! 17

19 Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing (First-Year Write-Off) Asset lives: 3 Yrs 5 yrs 7 yrs 10 yrs 15 yrs 20 yrs 27.5 yrs 39 yrs Present value of first- year write-off of $1 of investment: $1.00 Present value of current law write-off of $1 if inflation rate is: 0%$0.96$0.94$0.91$0.88$0.80$0.74$0.65$0.55 3%$0.94$0.89$0.85$0.79$0.67$0.59$0.47$0.37 5%$0.92$0.86$0.81$0.74$0.60$0.52$0.39$0.30 Assumes a 3.5 percent real discount rate, 3-20 year assets placed in service in first quarter of the year, year assets placed in service in January. 18

20  A neutral tax would not tax corporate income twice.  It would tax it either at the corporate level or the shareholder level, but not both. Step 2. End Double Taxation of Corporate Income 19

21 Multiple Taxation of Corporate Income Retained Earnings, Pre 2003 Act Dividend Payout, Pre 2001 Act Retained Earnings and Dividends, 2003 Act 1) Corporate Income$1.00 2) Corporate tax at top rate$0.35 3) After-tax corporate income: Either retained, raising value, or paid as dividend $0.65 4) Individual income tax at top rate (retained earnings as capital gain, dividends as ordinary income)* $ %) $ %) $ %) 5) Total tax$0.48$0.6074$ ) Total tax rate48%60.74%44.75% 7) Income left to shareholder$0.52$0.3926$ * Top corporate rate excludes corporate surtaxes, and top individual rate ignores phase-outs of exemptions and deductions and taxation of Social Security, which may push effective top tax rates higher than statutory rates. Retained earnings are assumed to trigger a long-term capital gain with a maximum rate of 20% or 15%. Short-term gains are taxed at ordinary tax rates. 20

22 A neutral tax would not tax estates because estates are accumulated saving that has already been taxed or will be subject to an heir's income tax. Step 3. Kill the “ Death Tax " 21

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26  Personal Expenditure tax (on income less saving, i.e., saving is tax-deferred).  Flat tax (no deferral, returns are exempt).  Sales tax (on income spent, not saved).  Value Added Tax (on output less investment; which equals income less saving or sales tax). Four Types of Neutral Taxes: 28

27  All treat saving neutrally vs. consumption.  All employ expensing instead of depreciation.  All are territorial.  All have the same basic tax base.  Differ mainly as to point of collection. Elements of Neutral Taxes 29

28 History tells us that:  When we have moved toward a neutral tax with lower rates, the economy has boomed.  When we have increased tax biases the economy has faltered.  When we have wasted tax cuts on non- growth-related rebates, nothing good has happened. Why it Matters 25

29 Tax Reform The Good, the Bad, and the Ugly 35  JFK  ERTA 1981(+TEFRA’82&DEFRA’84)  Tax Reform Act of 1986  Bowles-Simpson Deficit Commission  Wyden-Coats

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34 Tax reform is about:  Getting the tax base right.  Setting rates that cover the amount of government that people want to have.  Raising revenue with less damage to the economy.  Informing voters of the price they pay for govern- ment so that they can make informed decisions about how much government activity to support.  Cut spending to pay for it. THWRN,TBWSECTR Recap 34

35 Neutral taxation is best for growth. It can yield:  More saving, investment, and growth. Potentially: o Trillions of dollars of added capital. o Millions of added jobs and higher wages. o Thousands of dollars in added family income.  U.S. would become a jobs and investment magnet. Objective: Neutrality/Growth 30

36 Neutral taxes are much simpler, even if collected on individual tax forms:  No double taxation.  No limits on savings plans. One universal plan, not dozens.  No separate taxation of capital gains.  No depreciation schedules.  No foreign tax and tax credit.  No phase-outs of exemptions, credits, deductions. Objective: Simplicity 31

37  Consumption is a fairer tax base than income; it respects the effort of people who work and save.  Neutral taxes can be made progressive to shelter the poor.  There is no need to tax saving and investment more harshly than consumption to achieve progressivity.  The simpler, clearer neutral tax would be seen to be fair. Objective: Fairness 32

38  Only people pay taxes.  Businesses and things don't pay tax.  Taxes are best levied on individuals.  Voters need to see what government costs.  Everyone who can do so should pay something toward the cost of government.  Simplicity is no excuse for dropping tens of millions of people from the tax rolls. Objective: Visibility 33

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41 Please consider: Economics is not the dismal science -- if you have a morbid sense of humor -- and a large tru $ t fund. 39

42 On the other hand --- (Sorry, I’m an economist, it’s our mantra)

43 Political science (sic) is rather depressing, -- and actual politics is surely the Great Dismal swamp!!! 40

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