Blogs review: The gains from fundamental tax reforms

What’s at stake: Greg Mankiw recently highlighted a John Diamond study, which finds that a base-broadening, rate-reducing, Romney type tax plan would increase GDP relative to baseline by 5.4 percentage points over the next decade.  While the specifics of this study are prone to discussion, similar simulations support similar findings – recognizing that the income tax systems of most countries are a complex, inefficient, and costly way of raising revenues to finance government expenditures. Looking beyond the headline numbers, however, reveals that these large efficiency gains often rely on the political feasibility of (1) making a majority of the population worse off, (2) raising burdens on older people, and/or (3) taxing imputed rents from housing.

Squaring the circle: John Diamond analysis and that of the Tax Policy Center

John Diamond simulates the economic effects of enacting a sketch of the Romney Tax Plan, which is similar in nature to the tax reform plan proposed by the National Commission on Fiscal Responsibility and Reform (2010). The key components of the reform proposal being analyzed are a significant reduction in individual and corporate income tax rates in the United States, coupled with the elimination of a wide variety of business and personal tax expenditures. The reform is revenue neutral across periods, with individual marginal rate reductions financed by base broadening under the income tax and corporate rate reductions financed by the elimination of business tax expenditures.

Jim Tankersley has a useful interview with John Diamond that helps bridge the gap between the result of this paper and the severe assessment we documented in a previous review (see here) that the US blogosphere made of Romney’s economic plan. Diamond also said he “can’t argue” with the basic conclusions reached by an independent group of economists who found that Romney’s plan would necessarily cut taxes on the wealthy but raise them on lower-income Americans (it is that progressivity goal that three economists at the Tax Policy Center judged earlier this month to be more or less impossible to reach under Romney’s plan). But Diamond also said that the conclusions paint an incomplete picture of the benefits that lower-income Americans would receive from the Romney plan, such as greater employment opportunities and lower lifetime tax burdens.

The large potential gains from cutting distortions in the tax code

A 2001 AER paper by David Altig, Alan Auerbach, Laurence Kotlikoff, Kent Smetters and Jan Walliser uses a large-scale, dynamic life-cycle simulation model to compare the welfare and macroeconomic effects of transitions to five fundamental alternatives to the U.S. federal income tax. "Fundamental tax reform" means different things to different people. The definition adopted in the paper is the simplification and integration of the tax code by eliminating tax preferences and taxing all sources of capital income at the same rate.

·         The Proportional Income Tax option applies a single tax rate to all labor and capital income, with no exemptions or deductions. This reform increases medium run output by 4.4% by encouraging labor supply and capital accumulation. However, the benefits are not widely shared – the bottom two-thirds of the population have lower lifetime utility (since some now face higher marginal tax rates and others lose from eliminating deductions such as the standard deduction).

·         The Proportional Consumption Tax option differs from the proportional income tax by permitting 100-percent expensing of new investment. This reform increases output by nearly twice as much as a proportional income tax in the long run (and by roughly 45% more in the medium run).

·         David Bradford’s X-Tax option is a modification of the flat tax option – which differs from the proportional consumption tax by including a standard deduction against wage income and by exempting implicit rental income accruing from the ownership of housing and consumer durable – that address some of the distributional concerns with a progressive subsidy to wages.

Each of the reforms broadens the tax base, permitting reductions in statutory marginal tax rates on labor supply and saving. The consumption and X-tax reform impose an implicit tax on existing wealth by introducing full expensing. “The expensing of new capital effectively eliminates the taxation of capital income at the margin. However, unlike the simple elimination of capital-income taxes, this tax reduction is available to new capital only, and, consequently, reduces the value of existing capital relative to that of new capital in a manner equivalent to that of a one-time tax on their wealth. As discussed in Auerbach and Kotlikoff (1987), this capital levy is crucial to both the efficiency and long-run welfare gains from switching to consumption taxation. It permits a permanent reduction in distortionary marginal tax rates and shifts the burden of paying for government spending from young and future generations to middle age and older initial wealth owners.”

Implications for feasible tax plans

The lesson from these fundamental tax reform simulations is that efficiency gains can be large, but they often require politically difficult steps regarding intergenerational burdens, the treatment of housing, and progressivity. Modifications that mitigate adverse transition and distributional effects are possible, but also can substantially reduce the long-run gains.

Base-broadening corporate tax reform

Both candidates have roughly similar corporate tax plans that broaden the base and lower the rate (while protecting the R&D credit). Governor Romney proposes reducing the corporate rate to 25% and President Obama proposes a slightly smaller reduction to 28%.

While lower rates and broader bases are often praised by tax analysts, some including Larry Summers have been skeptical in the past. A primary concern is that leveling the playing field – that is lowering rates of corporate taxation by getting rid of deductions such as accelerated depreciation – can put more of the burden on new investments rather than existing capital, which can reduce the attractiveness of new investment.

But Alan Auerbach recently offered a proposal for a modern corporate tax that overcomes these concerns and still raises revenue from the corporate sector. Auerbach’s proposal has full expensing, which means that any cash flows coming into a business are taxed unless they go to fund investment. Hence, although Auerbach gets rid of deductions, it manages to make new investment attractive.

Should we tax capital? Lessons from the optimal taxation literature

Economists have been reconsidering the idea that capital shouldn’t be taxed as documented by this recent Free exchange column in the printed edition of The Economist. Previously, the work of Chamley–Judd and Atkinson & Stiglitz suggested that capital taxes are superfluous.

Chamley & Judd logic: Compounding exacerbates distortions due to the difference between pre- and post-tax interest rates. For instance, getting 5% post tax returns instead of 7% pretax on a $100 investment costs $2 in one period but almost $10 after four periods. This growing intertemporal wedge discourages socially beneficial long-term investments, so an optimal tax system should limit the difference between pre- and post- tax returns especially since it is amplified overtime.

New thinking on capital income taxation:

·         Capital market imperfections: If financial markets aren’t perfect and people face borrowing constraints, taxing capital lets governments reduce tax burdens on wage income. Lower wage income taxes may help young, constrained borrowers more than future capital taxes will hurt them later in their lives.  Juan Carlos Conesa, Sagiri Kitao and Dirk Krueger point out in a 2009 AER paper that capital taxation can serve as a form of insurance and conclude that taxing capital is “not a bad idea after all!”

·         Bequests: Thomas Piketty and Emmanuel Saez argue that inequality comes not just from differences in ability, but also from differences in inheritances. Unlike the Atkinson & Stiglitz model, in which non-labor income taxes were superfluous because labor income uniquely determines lifetime resources, their model with inheritances suggests capital should be taxed.

·         Distinguishing capital and labor income: Taxing labor and capital at different rates encourages income shifting. For those who can shift their incomes, not taxing capital is equivalent to not taxing labor income. The optimal gap between labor and capital tax rates should shrink with the ease of shifting forms of income.

Peter Diamond and Emmanuel Saez cover these issues in more depth in this paper.