Presentation on theme: "Presentation of Stephen J. Entin President and Executive Director Institute for Research On The Economics of Taxation The Cayman Finance Summit May 6,"— Presentation transcript:
Presentation of Stephen J. Entin President and Executive Director Institute for Research On The Economics of Taxation The Cayman Finance Summit May 6, 2010
Taxes have two purposes: To fund government; To inform citizen/voters what they pay for government. Taxes should be structured: To be highly visible to citizen/voters; To minimize economic damage.
TAXES REDUCE OUTPUT A tax drives a wedge between what the buyer pays and the supplier receives, reducing the amounts supplied and demanded. TAXES CREATE DEADWEIGHT LOSS Resources are shifted to other uses, but the lost output is of greater value than the resources saved. The difference is the deadweight loss.
RATE VS. REVENUE Raising tax rates does not always raise revenue. The higher the tax rate, the greater the deadweight loss. As the tax base shrinks, revenues rise by a smaller percent than the tax rate increases, then level off, then fall.
COST OF GOV’T INCLUDES DEADWEIGHT LOSS The true cost of government spending includes the deadweight loss of the taxes imposed to raise the money. If a government employee costs $100,000, and the tax imposed reduces national income by another $100,000, then the cost of the employee to the nation is $200,000. The optimal tax rate (from the people's perspective, if not the government's) is well under the revenue maximizing rate.
The amount of deadweight loss depends on supply and demand. If the item taxed is sensitive to tax, the drop in output is large. If insensitive, the drop is small. If demand is elastic, buyers go elsewhere, and local suppliers suffer. If supply is inelastic, suppliers bear the tax. Labor supply is moderately inelastic. Labor bears nearly all of the burden of taxes on labor. Employment falls modestly.
If supply is elastic, buyers bear the tax. Capital supply is very elastic. Income can be used for consumption instead of investment. Users of capital can avoid the tax by using less, or putting it in a lower tax jurisdiction. The capital stock falls sharply.
WORKERS BEAR THE TAX ON CAPITAL Less capital reduces the demand for labor. Wages are less than otherwise. Adam Smith told us almost 235 years ago that small region faces a much higher elasticity of supply of capital and a higher elasticity of demand for its labor services than a large region. It can easily chase capital away and reduce demand for its work force.
TAX INCOME OR TAX CONSUMPTION? Direct (income) taxation in major nations damages their economies and makes for international friction. Income and capital taxes hit hardest the factor of production most likely to shrink. Income tax systems of major nations may reduce GDPs ten percent or more, a huge loss suffered for no good purpose.
Chart 7 Multiple Taxation of Saving One Tax on Consumption, Four Taxes on Saving Layer 1– 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 If the income is saved, the returns are taxed as interest, dividends, capital gains, or non-corporate business profits. Layer 3 – Corporate Income Tax If the saving is in corporate stock, the corporate tax hits the income before it is either paid out to shareholders or reinvested to boost future earnings. 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.)
STEPS TOWARD NEUTRALITY: All saving gets deferral Or returns exempt equivalent; Expensing of investment; No double tax of corporate income; No estate and gift tax.
TO FIX THE BASIC DOUBLE TAX: Either tax income when earned and forego taxes on returns, or -- Defer taxes on income that is saved, until it is withdrawn for consumption. For direct investment, this requires expensing instead of depreciation.
Chart 8 Equivalence Of Saving Deferred And Returns Exempt Tax On Saving; Contrast With Ordinary Income Tax (Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment) Tax TreatmentSaving DeferredReturns Exempt Ordinary Income Tax Pretax earnings to be saved $100 Tax on saving020 Amount saved10080 Is interest on inside build-up taxed? No, 7.2% reinvested Yes, 5.76% reinvested Account after 10 years Tax due on withdrawal4000 After-tax spendable balance Cost to saver of ordinary tax treatment (= 160 – 140) (a third of the interest)
Chart 9 Multiple Taxation of Corporate Income (a) Retained Earnings, Pre 2003 Act (b) Dividend Payout, Pre 2001 Act (c) 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 stock price (columns (a), (c)), or paid as dividend (col. (b), (c)) $0.65 4) Individual income tax at top rate (dividends as ordinary income, retained earnings as capital gain)* $0.13 (tax rate 20%) $ (tax rate 39.6%) $ (tax rate 15%) 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.
Chart 10 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.
Chart 11 Expensing Versus Depreciation: Depreciation Overstates Taxable Income and Depresses Return on Capital Expensing (Full Cost Recovery)Depreciation Revenues from machine, present value $115 Revenues from machine, present value $115 Full cost of machine$100Full cost of machine$100 Full cost write-off for tax purposes (expensing) $100 Allowable depreciation write-off, present value $85 Real profit = Taxable profit $15 Taxable “profit” (exceeds real profit) $30 Tax$5Tax$10 After-tax income$10After-tax income$5 Rate of return10%Rate of return5%
FOUR NEUTRAL TAXES There are four major types of saving- consumption nuetral taxes: Retail sales tax; VAT; Hall-Rabushka "Flat Tax"; Consumed income (or cash flow) tax.
TAX BASES OF FOUR NEUTRAL TAXES & POINTS OF COLLECTION SALES TAX -- INCOME LESS SAVING/INVESTMENT = CONSUMPTION (NOT IMPOSED ON INVESTMENT GOODS). POINT OF SALE. VAT -- INCOME LESS SAVING/INVESTMENT = CONSUMPTION (INVESTMENT EXPENSED). AT BUSINESSES, IN STAGES. CASH FLOW TAX -- INCOME LESS SAVING = CONSUMPTION. INDIVIDUAL TAX FORM. FLAT TAX -- INCOME LESS INVESTMENT = CONSUMPTION. CAPITAL INCOME ON BUSINESS OR PROPRIETOR FORM (INVESTMENT EXPENSED); WAGES ON INDIVIDUAL FORM.
NEUTRAL TAXES: BETTER, NOT BENIGN Neutral taxes do less damage to growth than income taxes. However, taxing consumption does not “discourage consumption and encourage saving, investment, and growth.” These taxes equally punish the earning of income for consumption or for saving.
Neutral taxes still have deadweight losses and favor leisure over labor. They do less damage than the non-neutral income tax, and are to be preferred if taxes must be levied and raised. But even a neutral tax does more harm than cutting spending that is not worth its full cost.
COMPARING NEUTRAL TAXES A VAT is roughly equivalent to tariffs on imports plus a tax on labor income at a similar tax rate. Adopting a VAT in the Cayman Islands would be like adding a payroll tax on domestic labor.
For investment with normal returns (no special economic "rent"), the investment just earns back in present value what the asset cost. In that case, the VAT with expensing and a tax on the returns to the capital is equivalent to not deducting the cost and not taxing the returns. That is, over time, it is a tax only on the labor income.
A retail sales tax not imposed on intermediate goods is roughly equivalent to a VAT in which investment is expensed. It is collected at fewer points (final sales). A cash flow tax on individuals is imposed on income less saving and direct investment (= consumption). The "Flat Tax" is imposed on labor on individual tax forms, and on capital income as treated in a VAT, at the business level.
Visibility and ease of collection differ among neutral taxes. Tariffs are hidden taxes embedded in prices, and are not visible to the consumers. Their advantage, for an island, is that they can be collected efficiently at one point of entry (barring smuggling).
The VAT is often hidden in prices, and is not visible to the consumer. It is imposed on all businesses up through the supply chain, and involves significant paperwork. It can be mandated that the VAT at the consumer level be shown at the bottom of the sales slip, on top of the net-of-VAT price.
The retail sales tax involves less paperwork, and is normally seen on the sales slip. But like the VAT, consumers won’t know their total yearly tax payments unless they tally up the sales slips.
The cash flow tax is the most visible to the taxpayer/voters, showing the taxpayer the full amount owed over the year. All must file, but the form can be fairly simple. The Flat Tax requires all businesses and individuals to file. It hides the tax on capital from the taxpayers. Unlike the rest, it disallows deductions for education, taxes, and transfers to others. It is otherwise the same tax base as the other neutral taxes.
CAYMAN TAXATION The Cayman Islands have wisely avoided direct taxation. Direct taxes are distorting, and depress GDP and employment. Tariffs are imposed on all but essential foodstuffs and a few other goods; the system resembles a fairly broad goods tax. The tax does not generally reach domestic labor services.
Taxes on tourism reach domestic services, but may double up on tariffs on goods consumed by tourists. Taxes (licenses, fees) on the financial sector reach services there. Work permit fees are a form of tax on wages paid to guest workers. Competition from other jurisdictions may urge that these taxes and fees not be increased.
The Cayman spending surge and resulting deficits have created pressure to raise revenue, and a VAT has been talked about. To reiterate: spending restraint is preferable to tax increases unless the value to the people of the additional government outlays exceeds the direct cost of the outlays and the indirect deadweight losses on the population as the taxes restrict the rest of the economy.
If Cayman were to adopt additional taxes, they must fit in with the existing system, or the existing system would need to be altered. One could approximate a VAT by adding a payroll tax while keeping the existing tariff system. If a payroll tax were adopted, it would be necessary to modify or end the work permit fees. If a VAT were adopted, it would be important to eliminate the existing tariffs.
The Cayman property transfer tax affects land and buildings when sold. It is not a terrible tax, but may impede transfers and development. It might be reasonable to shift from a property transfer tax to an annual property tax at a reduced rate, imposed on the land value rather than the value of the land and the buildings on it.
Land, and any special value due to its location, are in inelastic supply, and would not be diminished by the tax. Buildings are in more elastic supply. Taxing buildings would discourage development. Taxing the land alone would encourage development to earn money to pay the land tax and discourage leaving land idle. But it would require annual assessments to estimate market value.
Any significant new tax would involve additional collection and compliance costs, limiting net revenue growth. Even the least distorting taxes would tend to increase the size of government and shrink the private sector.
INTERNATIONAL TENSION Taxation of income by major nations makes them eager to track down the foreign earnings of their citizens. In a tax system based on consumption or consumed income, there would be no such concerns.
VAT and sales tax are territorial taxes that stop at the border. A nation relying exclusively on a VAT or sales tax would not tax financial transactions or earnings, and would not care about interest and dividends earned by its citizens abroad. It would tax their imported purchases (which would have had foreign consumption taxes rebated on export).
Even the cash flow tax can be made territorial. The cash flow tax would defer tax on domestic saving, and tax it later on withdrawal for consumption. To avoid needing information on earnings of saving and investment located abroad, the cash flow tax could tax saving leaving the country as a withdrawal, and ignore the subsequent foreign earnings.
There is international pressure for sharing of tax information only because governments are trying to squeeze more revenue out of their citizens by double and triple taxing saving, to the detriment of all. Capital flees high tax rate jurisdictions that punish saving for places that do not impose punitive direct taxation. Don't blame the jurisdictions to which the capital flees, blame the countries with the biased, confiscatory tax systems.