institute for research on the economics of taxation (iret) reforming taxation: advantages of a...

Institute for Research on the Economics of Taxation (IRET)

REFORMING TAXATION:

ADVANTAGES OF A SAVING-

CONSUMPTION NEUTRAL TAX BASE,

AND PRINCIPLES TO GUIDE REFORM

Stephen J. EntinInstitute for Research

on the Economics of Taxation


Objectives of Tax Reform

Growth,

Simplicity,

Fairness, and

Visibility

2


Choose a better tax base.

Consumption versus Income.

How to Achieve Objectives

3


Income

Income is the earned reward for providing labor and capital to produce goods and services that other people value.

Income is proportional to effort.

Therefore, the fairest tax is proportional to income.

4


Revenue less the cost of earning

revenue.

Deductions for costs are necessary

to measure income properly.

Income is a Net Concept

5


•No saving => no interest, no dividends.

•You can't have your principal and eat it

too.

•Therefore, the best measure of income is

consumption. We should tax what we

spend.

Saving Is a Cost of Earning Income

6


Do not fall more heavily on saving and

investment than on consumption,

Are unbiased against growth,

Are simpler than the income tax, and

Are fair and straightforward.

Neutral Taxes

7


Taxes people more the more they work, save, and produce by imposing graduated tax rates.

Hits saving and investment harder than consumption.

Encourages consumption by penalizing

saving.

By Comparison the Income Tax

8


Multiple Taxation of SavingOne Tax on Consumption, Four Taxes on Saving

Layer 1– Tax on EarningsIncome is taxed when earned. If it is used for consumption, there is usually no further federal tax.

Layer 2 – Personal Income Tax on ReturnsIf the income is saved, the returns are taxed as interest, dividends, capital gains, or non-corporate business profits.

Layer 3 – Corporate Income TaxIf 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) TaxAnother tax on already taxed assets.

(Similar taxes at the state and local levels increase the multiple taxation.)

9


Savers can always choose consumption,

which is nice for them.

But when they do, investment slumps, and

workers lose their jobs.

Taxing Capital Income Hurts Workers

10


Step 1. Treat all saving like pensions and IRAs.

A tax that is neutral between saving and

consumption would either defer tax until the

saving is spent, or tax the saving up front and

not tax the returns.

Steps Toward a Fair, Flat, Unbiased Neutral Tax

11


Advantage Of Tax Deferred Saving Over Ordinary (Biased) Tax Treatment;Build-up Of $1,000 Saved per Year

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

20 25 30 35 40 45 50 55 60 65 70

Age

Ass

ets

(th

ou

san

ds

of

$)

Saving from age 20 onward, under tax-deferred system and ordinary "double taxation" (assume 7.2% interest rate, 20% tax rate).

TaxDeferred

Ordinary (Biased)

Tax Treatment

Advantage Of Tax Deferred SavingOver Ordinary (Biased) Tax Treatment:

Build-up Of $1,000 Saved per Year

12


A neutral tax would not tax corporate income twice.

It would tax it either at the corporate level or the shareholder level, but not both.

Step 2. End Double Taxation of Corporate Income

13


A neutral tax would not tax estates because

estates are accumulated saving that has

already been taxed or will be subject to an

heir's income tax.

Step 3. End the “Death Tax"

14


Saving deferred tax (on income less saving).

Flat tax (no deferral, returns exempt).

Sales tax (on income spent, not saved).

Value Added Tax (on output less investment;

which equals income less saving).

Four Types of Neutral Taxes:

15


All treat saving neutrally vs. consumption.

All employ expensing instead of depreciation.

All are territorial.

All have the same basic tax base.

Differ mainly as to point of collection.

Elements of a Neutral Tax

16


Neutral taxation is best for growth. It can yield:

More saving, investment, and growth. Potentially:

o Trillions of dollars of added capital.

o Millions of added jobs and higher wages.

o Thousands of dollars in added family income.

U.S. would become a jobs and investment magnet.

Objective: Growth

17


Neutral taxes are much simpler, even if collected on

individual tax forms:

No double taxation.

No limits on savings plans. One universal plan, not dozens.

No separate taxation of capital gains.

No depreciation schedules.

No foreign tax and tax credit.

No phase-outs of dozens of exemptions, credits, deductions.

Objective: Simplicity

18


Consumption is a fairer tax base than income, because it

respects the effort of people who work and save.

Neutral taxes can be made progressive to shelter the poor.

There is no need to tax saving and investment more

harshly than consumption to achieve progressivity.

The simpler, clearer neutral tax would be seen to be

fair.

Objective: Fairness

19


Only people pay taxes.

Businesses and things don't pay tax.

Taxes are best levied on individuals.

Voters need to see what government costs.

Everyone who can should pay something toward the cost

of government.

Simplicity is no excuse for dropping tens of millions of

people from the tax rolls.

Objective: Visibility

20


Tax reform is about-

Getting the tax base right

Setting rates that cover the amount of government that people want to have.

Raising revenue while doing less damage to the economy, and

Informing the voting public what it is paying for government so that they can make informed

decisions about how much government activity to support.

Conclusion

21


Appendix

22


Equivalence Of Saving Deferred And Returns Exempt TaxOn Saving; Contrast With Ordinary Income Tax

Tax Treatment Saving Deferred Returns ExemptOrdinary Income

Tax

Pretax earnings to be saved

$100 $100 $100

Tax on saving 0 20 20

Amount saved 100 80 80

Is interest on inside build-up taxed?

No, 7.2% reinvested No, 7.2% reinvested Yes, 5.76% reinvested

Account after 10 years 200 160 140

Tax due on withdrawal 40 0 0

After-tax spendable balance

160 160 140

Cost to saver of ordinary tax treatment

20 (= 160 – 140)

(a third of the interest)

Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment.

23


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 $1.00 $1.00

2) Corporate tax at top rate $0.35 $0.35 $0.35

3) After-tax corporate income:

Either retained, raising stock price (columns (a), (c)), or paid as dividend (col. (b), (c))

$0.65 $0.65 $0.65

4) Individual income tax at top rate (dividends as ordinary income, retained earnings as capital gain)*

$0.13

(tax rate 20%)

$0.2574

(tax rate 39.6%)

$0.0975

(tax rate 15%)

5) Total tax $0.48 $0.6074 $0.4475

6) Total tax rate 48% 60.74% 44.75%

7) Income left to shareholder $0.52 $0.3926 $0.5525

* 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.

24


Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing (First-Year Write-Off)

Asset lives:3Yrs

5yrs

7yrs

10yrs

15yrs

20yrs

27.5 yrs

39yrs

Present value of first-year write-off of $1 of investment:

$1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $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, 27.5 - 39 year assets placed in service in January.

25


800

820

840

860

880

900

920

940

960

980

2000 2001 2002 2003 2004

Quarter

Bil

lio

ns

of

Do

lla

rs (

20

00

$)

Data Source: BEA

Real Private Investment - Equipment And SoftwareAnd 2001, 2002, and 2003 Tax Cuts

2002 Tax Cut, 30% Expensing

2001TaxCut

2003 Tax Cut, 50% Expensing

NIPA Table 5.3.6, line 9

26

institute for research on the economics of taxation (iret) reforming taxation: advantages of a...

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