Tax Freedom Day

Who Pays?

 Taxes

Why Taxes?

1.

2.

3.

Not everyone agrees with all three.

Tax Classifications and Tax Incidence

What is a tax?

Economist’s definition:  an involuntary payment to the government by an individual or firm that does not entitle the payer to a quid pro quo benefit or to an equivalent value of goods and services in exchange.  Example: 

Tax vs. a User Fee:

Example:   

Taxes and user fees are polar cases; some payments to the government are a mixture of both tax and user fee. 

Example: 

Closely related is a benefit tax: 

Example: 

Classifying Taxes

First Classification:  Who Pays Them:  the oldest and most popular way to classify taxes.

This can include the classification of individual vs. business.  Although, it is always people who pay taxes.

A related classification is between direct taxes and indirect taxes.

Direct taxes: 

Example: 

Characteristics:

·         Are not anonymous, the tax paid depends upon the personal characteristics of the taxpayers.

·         Also, the tax base (the amount subject to the tax) of a direct tax usually includes the amount of the tax (a tax-inclusive base).  Example:  the income tax is determined by a % of gross income then paid out of that amount.

·         People usually know how much they pay.

Indirect taxes:  

Example: 

Characteristics:

·         By their nature, are anonymous, so all taxpayers pay the same rate of tax.

·         The tax base of an indirect tax usually excludes the amount of the tax (a tax-exclusive base).  Example:  a sales tax is determined by a % of a sale price then added to the sale price.

·         Sometimes “hidden” because they are included in the prices of goods, so the taxpayers may be unaware of the amount of tax they are paying.  (VAT)

Again, ultimately it is people who pay taxes, whether they are direct or indirect or levied on persons or businesses.

This is why most economists prefer to classify taxes according to the economic activity on which the tax is levied.

Second Classification:  Economic Activity – preferred by economists.

With few exceptions, taxes are levied on market activities like incomes and sales. 

Therefore the government taxes either productivity or consumption.

Typically economists will compare any tax with a tax that is NOT levied on economic activity – the head tax; also known as the poll tax or lump-sum tax.

A head tax or lump-sum tax:

    Incentives:

Tax incidence: 

Examples:

Tax Shifting: 

Different Measures of Tax Incidence

Because of its complexity, and political implications – there’s a lot of disagreement about how to measure tax incidence.

Economic incidence of the tax, which takes into account not only the taxes paid by different groups in the economy, but also the effect on real incomes caused by changes in wages and prices when the tax is levied.  A group’s real income is its money income adjusted for changes in the cost of living.

This is the Key:  A tax not only moves income from people to the government, it can change people’s behavior, resulting in resource allocation changes – which in turn can change the economic performance of a country.

Economic incidence is difficult to analyze:  we need an economic theory of how prices and rewards are affected by the tax.  This involved assumptions – and the outcome of the theory will rest upon the assumptions made.  It is often difficult to get empirical data as well.

Arbitrary assumptions are often made about tax shifting. 

The People Who Bear The Tax Burden

Remember:   Only people – not goods or organization – can bear the burden of a tax.

Typically economists examine tax burdens on identifiable groups of people.  People are grouped according to some relevant characteristic such as their income, where they live, or how old they are.

Tax Incidence by Income Group

What is equitable?

The income incidence of the tax: 

Progressive:

Regressive:

Proportional:

Note:  progressive does not simply mean that people with more income pay more taxes.  It means that people with more income pay a higher percentage of their income in taxes.

Example:  Taxpayer A makes $25,000 and pays $5,000 in taxes.

Taxpayer B makes $50,000 and pays $10,000 in taxes.  Taxpayer B pays more taxes.  Is this progressive, regressive or proportional?

Both pay 20% -- it is proportional even though taxpayer B pays more taxes.

Tax Incidence by Other Household Groupings

Regional Incidence: 

Examples: 

Generational Incidence: 

The lifetime burden of a tax on a person or group of people is equal to the present value of taxes paid over the lifetime, which is the sum of the discounted values of the future annual tax burdens.  Taxes paid later in a person’s life cause a smaller burden per dollar than taxes paid earlier in life – they could have invested taxes paid earlier in life and earned interest on the balance.

General incidence measures the distribution of lifetime tax burdens across different generations.  That is, will one generation pay more over their lifetime than another?

This has become more interesting to economists because of the large and persistent federal budget deficits – which many people believe shift the burden of taxes to future generations.

One famous study (Auerbach, Gokhale and Kotlikoff) says that people born after 1995 will have a net tax rate of 49.2 percent – very high.  This is because the current fiscal policy is “not sustainable” – present taxes are not high enough to fund government spending, interest payments on the debt, social security, and other transfer programs at current levels over the long run.

The Federal Personal Income Tax 

Progressive

The Excess Burden of an Income Tax vs. Lump Sum Tax

Because a tax on income makes work more expensive relative to leisure, the income tax lowers labor supply relative to a lump sum tax.  A lump sum tax would not change the relative price between labor and leisure, but the income tax does.  (Assumes substitution effect outweighs the income effect).

Effects of the Income Tax on Personal Saving

This is a major policy concern.  The fraction of income saved by Americans has fallen.

  Source:  Bureau of Economic Analysis

This has been blamed on many things: 

1.

2.

3.

etc.

Some economists argue that the income tax system in the United States discourages savings.

The income tax affects the level of savings by reducing the return on saving.  The return on savings includes interest on savings in bank accounts or invested in bonds, and dividends and capital gains on savings invested in stocks.  The effect of taxing this form of income is to decrease the amount invested.  It increases the cost of forgone consumption (future consumption) and makes present consumption relatively cheaper.  Because present consumption is made relatively cheaper, the taxpayer has an incentive to substitute present for future consumption.

Alternatives to the Existing Income Tax

Given that the federal tax system raises vast sums of revenue – any politically feasible alternatives to the income tax all take the form of broad-based taxes. 

The Flat Tax

Better described as a flat rate tax (or proportional tax).  There are different versions of this plan.  The Hall/Rabushka (Stanford professors) plan - income above a certain level, around $35,000 for a family of four, would be taxed at the same tax rate, rather than according to a graduated tax rate schedule.

This is a far more radical change in the tax system than the elimination of the tax brackets.  For one thing, many of the tax expenditures in the existing tax system, such as the mortgage interest and charitable donations deductions and the exemption of employer-paid fringe benefits like medical insurance, would be eliminated.

Also, the flat tax applies only to wages, salaries, and pension income, and leaves income from savings, such as interest, dividends, and capital gains, untaxed.

The flat tax significantly changes the way business income is taxed.  Most business tax expenditures (deductions) are eliminated, and the investment spending is deducted as a cost of doing business in the year the expenditures are made.  Deductions for depreciation and interest paid on business debt are eliminated.  The redefined business income is taxed at the same rate applying to households.  There is no double taxation of investment income.

What would the rate be?  Studies indicate anywhere from 11 to 17% will raise the same income as the current system, depending upon how broadly income is defined (and other assumptions made).

Advantages of a Flat Rate Tax

The current system uses high marginal rates on a narrow tax base.  This type of tax undermines economic productivity in two ways: 

1)       Total outputs will be lower than is efficient because of the way high marginal tax rates reduce the incentive to supply labor and capital. 

The flat tax rate would not avoid this altogether, but a lower marginal rate would reduce the magnitude of the disincentive effects significantly.

2)       High tax rates on a narrow base reduces productivity by inducing taxpayers to channel part of their incomes into non-taxed forms – when people would choose differently without the tax. 

A flat tax on a broad measure of income would also diminish this problem (although it would probably be impossible to define income so broadly that it would be eliminated altogether).

In addition to these efficiency advantages:

3)       The flat rate tax is simpler.  All the taxpayer would have to do is multiply their income by the rate to determine their tax.  Therefore, this would save taxpayers the cost of tax preparation.  It would also save taxpayers money in that the size of the IRS could be radically reduced.

4)       Some would argue that the flat tax is also more equitable.  Currently, taxpayers with the same real incomes bear different tax burdens because of special provisions that some taxpayers can utilize more fully than others.

5)       Or – some view the progressive income tax system inequitable because it taxes those who produce more than those who don’t.

6)       Indexing with inflation would not be needed to guard against bracket creep.

7)       There would be a public choice advantage.  With a graduated tax rate “a majority is allowed to set the rates that fall exclusively on the minority.”  With a flat tax rate, everyone would face the same rate – there would much less political bickering over how to reform the tax and redistribute the burden.

In short, proponents claim that, compared to the present income tax, a flat tax rate on a broad base will be simpler, more efficient, more equitable, more inflation-proof, and a politically more responsible.

Disadvantages of a Flat Rate Tax

Those against the flat tax rate would argue:

1)       Special concessions should be granted to certain types and uses of income (buying health insurance, for example).  By getting rid of the deductions, you get rid of the incentives to “buy” certain things over others. 

2)       Substituting a flat tax rate for the present progressive tax will alter the distribution of the tax burden; it will increase tax burdens on low- and middle-income taxpayers and reduce tax burdens on upper-income taxpayers.  Whether this change is considered undesirable is largely a matter of whether the income tax is viewed as a redistributive mechanism.  However, the flat rate tax would not get rid of redistribution of wealth.  The poorest households would continue to receive three times as much in transfers as they pay in all taxes combined.  Lower and middle income household would, however, see a larger tax bill (in many cases).  Would a stronger economy make up for this?

The National Retail Sales Tax (NRST)

Again, there are different proposals.  Under the Schaefer-Tauzin proposal, the federal personal and corporate income tax, the estate and gift tax, and most excise taxes would be abolished, along with the IRS.

The federal government would collect its revenue from a retail sales tax modeled on those levied by state governments. 

The tax is levied on the gross revenue businesses receive from selling goods and services to households and exempts business to business sales.

To lighten the sales tax burden on low-income families, each family would receive a rebate equal to the tax rate times the official poverty level of income for a family of the same size.

Example:  if the official poverty level for a family of four persons is $17,000, and the NRST were levied at 17%, all such families would receive an annual rebate of $2,890.

Some proposals would also exempt certain items from the tax (such as milk, bread, eggs) and also gives retailers a percentage of the taxes collected to pay for their added expenses of having to collect and turn over the taxes.

Some economists argue that if the tax rate is 17% (revenue would be neutral), prices, over the longer term, would not go up that much.  That is because, since productivity is no longer being taxed, it will increase.  More productivity will drive down the prices of goods and services and increase the wages of workers.  How much any given price would increase in the long run would depend upon these changes.

Policy Issues in Taxing Consumption or Are Consumption Taxes More Efficient?

Many economists argue that taxing consumption is more efficient than taxing incomes.  The reason is that consumption taxes, unlike income taxes, do not distort the choice between present and future consumption – the price of saving would decline under consumption.  The increase in savings would increase the amount of capital per worker and increase productivity and growth.

However, it might be argued that a tax on consumption distorts the labor/leisure trade-off.  If consumers have to pay higher prices, this reduces the real wage from labor, making leisure more attractive.  Therefore, people would work less, decreasing productivity.

Which would decrease productivity the most is hard to determine and depends on many factors.

Would the consumption tax be regressive?

How regressive it would be is arguable.  For one thing, saved income does not escape tax altogether under a consumption tax; the saved income is taxed in the future when it is consumed.  Annual incidence ignores these future taxes.

Also, most people are not locked into a particular income rank all of their lives.  Many people move from level to level over the course of their lives.  So perhaps the lifetime tax would be a better measure of the true incidence of any tax. 

Universal Rebate:  To mitigate this regressivity, advocates propose that the tax be coupled with a Universal Rebate.  The Universal Rebate is a lump-sum transfer given to every family that is equal to the NRST tax rates times the official poverty income level for a family of given size (as explained above).  In theory this would remove the tax burden from families below poverty level. 

The rebate then, however, would decrease the simplicity of the NRST, one of its advantages.  Still need a government bureau to administer the rebate.  It would also mean the tax rate would have to be higher in order to finance the rebate. 

Another major change in the tax system would be to eliminate the advantages some have due to tax deductions – homeowners would no longer have an advantage over renters (with respect to taxes) for example.  With a change, people who assumed large mortgages would be hurt relative to those who are renting or who have paid off their mortgages.

Administrative and Compliance Costs

The high administrative and compliance cost of the existing income tax system is one of the major motives for fundamental tax reform. 

No system would be free of these costs – but some might be better than others.  In general, there are reasons to believe that consumption can be taxed with lower costs than income.  The major reasons for the high administrative and compliance cost of the income tax system lie in the taxation of various forms of capital income and the taxation of corporate income.  Under a properly designed consumption tax, there is no need to tax capital income, and the business tax system can be drastically simplified.

Although businesses would need to comply with the increased demands of a national sales tax, they would not longer need to comply with the far more complicated corporation income tax system.

Of course tax accountants and lawyers would be out of luck! And this could be a good thing.  (Commentary)