Tax reform State and local governments Today: Some ideas on how to reform taxes; How do state and local governments affect behavior?

Today More topics that affect behavior  Can taxes be reformed so as not to distort behavior as much?  How do state and local governments affect everyday lives?

Tax reform Economic waste due to taxation is estimated to be as much as $1 trillion per year  Note that $1 trillion is about 8% of annual GDP How can this be changed?

Tax reform Current tax codes seriously distort behavior  People work less (labor tax)  Sub-optimal investment decisions (lock-in effects due to the capital gains tax) Some people advocate a tax system that reduces waste

What about a consumption tax? Taxes on consumption have some appeal  Vary tax rates based on externalities Encourage consumption of goods and services with positive externalities Discourage consumption with negative externalities  Progressiveness issue is probably not justified Lifetime sales taxes paid (as a % of lifetime income) is about the same for each income bracket  Easy to administrate  International competitiveness could increase for the US

What about a consumption tax? Some negative aspects of a consumption tax  Confusion about how much each good should be taxed Example: The “snack tax” in California  Taxed: Wrapped slices of pie  Not taxed: A slice of pie served on a plate  Tax evasion due to smuggling and underground economies  What happens when you change the tax system? Those that saved over the years get increased tax burden Those that borrowed over the years get decreased tax burden

What are some ways to tax consumption? National retail sales tax  To replace federal taxes, a federal retail tax of about 35% would be required  Problem: Tax evasion could become a serious problem once the sales tax rate exceeds 10% Many states already have a sales tax about 6-8%

What are some ways to tax consumption? Value-added tax (VAT)  Popular in Europe Mostly consumption-based Capital investments are not part of the taxable base  Involves taxing the additional value at each stage of production  See Figure 21.2, p. 487

Problems with consumption taxes Distortions still occur Consumption taxes will not solve all of the trade problems in the US Household labor is still sheltered from taxation

Summary: Tax reform Many people would like to see more consumption taxation and less labor taxation Substantial evasion of a national retail sales tax would be possible if the tax completely offset personal income taxes A value-added tax has appeal, but has its own disadvantages

State and local governments State and local governments are playing a bigger role in taxation  1960: 12.2% of state tax collections were from individual income taxes  2002: 35% Marginal income tax rates are still small compared to federal government  Highest bracket in 2006: Vermont (9.5%)  California not far behind: Highest bracket is 9.3% Single taxable earnings above $44,814 in 2007

Centralization in the US Centralization  Centralization ratio = Central government expenditures Total government expenditures  In the US, the centralization ratio is less than one- half

State and local governments How do people alter their behavior based on state and local governments?  The Tiebout model Vote with your feet within your home country  Public education  Property taxes  Grants between different levels of government

The Tiebout model People rarely leave the US due to government policy Mobility in the US due to government policy is substantial Tiebout makes many assumptions in his model  Not a perfect description of the real world  Gives a good idea of how people decide what community to live in

Tiebout’s assumptions Government activities generate no externalities Individuals are completely mobile People have perfect information with respect to each community’s public services and taxes There are enough different communities so that each individual can find one with public services meeting her demands The cost per unit of public services is constant so that if the quantity of public services doubles, the total cost also doubles Public services are financed by a proportional property tax Communities can enact exclusionary zoning laws—statutes that prohibit certain uses of land

Advantages with the Tiebout model Tailoring outputs to local taxes  Each person or family lives in a community they like One size does not fit all Tastes and preferences differ from person to person Fostering intergovernmental competition  People in government generally want people to live in their community

Advantages with the Tiebout model Experimentation and innovation in locally provided goods and services  States and cities can try new programs  These studies often result in quasi-experimental studies by economists  The analyzed results lead to good information for governments throughout the nation

Efficiency issues with the Tiebout model Externalities  Both negative and positive  Many public goods are not at the local level Scale economies in provision of public goods  Per-person cost often decreases as the number of users increases Inefficient tax systems  Different states and cities often compete to get large businesses to locate in their area Scale economies in tax collection

Public education For families, voting with their feet often involves finding a good elementary and secondary education for their children  You often must live within a certain area to be able to go to a particular school

Recall: Quality of public education Quality of education is hard to quantify Besides the obvious aspects of class size and total spending, there are different criteria that affect education  Unionization of teachers  Parents’ choices of their kids’ curriculum  Size of school  School-sponsored sports and activities

What about low-income areas? Local governments typically raise money for education through property taxes Many families with lower incomes would not want as much spent on schooling  Additional K-12 funding provided by the Department of Education Money helps to “level the playing field” About $20 billion in 2003 to special education and “disadvantaged”  California and some other states also provide district power equalization grants to “level the playing field”

Property taxes Property taxes are based on an assessed value  Assessed value is the value assigned to a piece of land or property for tax purposes How does a land tax affect behavior?  See Figure 22.2, p. 522 Effective rate depends on the assessed value relative to the actual value of the property  Example: Proposition 13 (Prop 13) in California

Prop 13 In June 1978, California voters limited the amount that the assessed value could go up, as long as ownership did not change  Prop 13 also required a 2/3 majority for additional state and local property taxes Why?  When housing prices go up significantly, some owners were forced out of their homes since they could no longer afford the property tax

What about structures? Land taxes are capitalized in the price of land  Recall Chapter 14, p. 320 Property taxes typically tax both land and structures  How does a tax on structures affect behavior? Example with perfectly elastic supply curve for structures  See Figure 22.3, p. 523

Final topic: Intergovernmental grants Matching grants from a state or the federal government has become commonplace  Requires cost sharing between different levels of government  How is behavior affecting by nonmatching grants? See Figure 22.6, p. 533  …matching grants? See Figures 22.4 and 22.5, p. 530 and 532, respectively

Summary: State and local governments The Tiebout model predicts that people “vote with their feet” within their home country Public education is extensively financed through the state and local levels of government  Property taxes provide much of the funding for public education Prop 13 has limited the ability to tax property in CA Grants from the federal government are used to encourage certain projects within states and cities