Why We Need Tax Reform – and Why We Probably Won’t Get It Robert Coen Professor Emeritus of Economics Northwestern University Woman’s Athletic Club Chicago, IL January 23, 2013

The Changing Personal Income Tax Single Taxpayer 1 st bracket Top bracket Number of YearBracketsRateIncome %$16,74591%$1,674, %33,85628%33, %8,46835%378,435 Income 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 AverageShare of IncomeEffectivepre-taxpre-taxShare of quintiletax rateincomeincometaxes Lowest-6.818, Second-0.442,50080 Third3.364, Fourth6.294, Highest , All9.396, Top 1%19.01,873, 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 exemptions Standard deduction Some uses of income deductible:Charitable contributions Medical expenses State-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 reassessed Open-ended cost Difficult to get rid of, may outlive usefulness Incentive effects vary (undesirably?) across taxpayers Invite “creative behavior” to avoid taxes Convert ordinary income to capital gain Substitute home equity loan for other consumer borrowing Abuse 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, 2011 Billions of dollars DirectTax National Defense and Veterans Benefits International Affairs General Science, Space, and Technology Energy, Natural Resources and Environment Agriculture, Commerce and Housing Transportation Community and Regional Development Education, Training, Employment, Social Services Health and Medicare Income Security Social Security General Government Total outlays 3,603.11,175.5 Sources: Office of Management and Budget, Joint Committee on Taxation

Strengths of Tax Loopholes Allow private preferences to allocate subsidies

Income Tax Reform of 1986 Goals Reduce tax rates to improve economic efficiency and growth Maintain tax revenue by eliminating some tax expenditures Personal Tax Reduced number of brackets from 15 to 2 Reduced top rate from 50 to 28 percent Eliminated deduction for interest paid, except on home mortgages Eliminated deduction for state-local sales taxes Eliminated favored rates for long-term capital gains Corporate Tax Reduced top rate from 46 to 34 percent Repealed tax credit for equipment investment Tightened depreciation rules

Undoing of 1986 Reforms 1991Top personal rate raised from 28% to 31%, Brackets increased from 2 to 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% 1997Refundable 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 Accelerated reductions in top rates Dividends and KG rates reduced to 15% Numerous grants of accelerated depreciation Numerous new tax credits – biofuels, etc.

Alternative Proposals for Tax (Re)Reform Romney: Personal tax cuts 1st 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 Expenditures Billions of dollars Annual average Exclusion of employer contributions for health care131.9 Deduction of mortgage interest96.8 Reduced tax rates on capital gains and dividends80.6 Exclusion of pension contributions – defined benefit plans60.6 Earned income credit53.8 Deduction of state-local taxes47.5 Exclusion of pension contributions – defined contribution plans42.4 Exclusion of capital gains at death38.4 Deduction of charitable contributions36.5 Exclusion of untaxed social security and railroad retirement34.6 Total of largest Source: U.S. Congress, Joint Committee on Taxation

Estimated Cost of 10 Largest Corporate Tax Expenditures Billions of dollars Annual average Deferral of income of controlled foreign corporations14.1 Exclusion of interest on state-local debt9.1 Deduction of income from domestic production activities8.6 Inventory property sales source rule exception7.6 Accelerated depreciation of equipment7.4 Inclusion of income from business debt discharged by reacquisition5.8 Tax credit for low-income housing5.4 Expensing of R&D expenditures5.1 LIFO inventory accounting4.0 Reduced tax rate for first $10mil of taxable income3.2 Total of largest 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 income Eliminating personal and corporate tax expenditures, except: Child and earned income credits Mortgage interest (within limits) Employer-provided health insurance (with cap) Charitable giving (>2% of income, 12% refundable credit Exclusion of state-local bond interest Retirement savings Increasing gas tax to 15¢ per gallon

Alternative Proposals for Tax (Re)Reform Simply reduce or eliminate specific tax expenditures Use increased revenue to reduce budget deficit Adopt a “flat tax” Popular with conservatives, e.g., Steve Forbes, Paul Ryan Single rate for individuals and businesses Simplified base for each Ultimate in simplification – postcard tax return

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

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

“Flat Tax” Is a Consumption Tax, Not an Income Tax! Sources of income: Wages and salaries Gross capital income Gross business revenue – wages and salaries – purchases Uses of income: Consumption Investment Wages and salaries + Gross capital income – Investment = Consumption Base of personalBase of business flat tax flat tax Should we have a consumption tax? More popular form is value-added tax Consumption tax is regressive – need to consider entire tax system

Effective Federal Tax Rates by Household Income, 2007 PersonalSocialCorporateAll IncomeIncomeInsuranceIncomeExciseFederal QuintileTaxTaxesTaxTaxesTaxes Lowest Second Third Fourth Highest All Top 1% Source: Congressional Budget Office

Impact of All Federal Taxes on the Distribution of Household Income, 1979 and 2007 Income QuintilePre-TaxAfter-TaxPre-TaxAfter-Tax Lowest6745 Second Third Fourth Highest Top 1% 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 expenditures Legislators 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 Denmark48 Sweden46 Italy43 Norway43 France43 Netherlands39 Germany36 UK35 Canada31 Switzerland28 Japan28 US25 Source: OECD

Annual GDP Taxes as Growth Rate Percent of GDP Sweden2.446 Canada1.931 Switzerland1.828 UK1.735 US1.625 Norway1.543 Netherlands1.339 France1.243 Germany1.236 Denmark0.748 Japan0.628 Italy0.443 Source: OECD

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