Eric M. Zolt, UCLA School of Law

December 6 and 7, 2016

UN ESCAP Meeting of Expert Group on Tax Policy and Public Expenditure Management for Sustainable Development Tax Policy to Reduce Inequality

Overview of presentation

• Growing levels of inequality throughout the world, including Asia

• How successful has tax and spending policies been in reducing levels of inequality?

• What role does the personal income tax play in reducing inequality?

• What has changed in the last 20 years?

• Potential for wealth taxes in developing countries

Possible explanations for growing inequality

• Globalization, leading to increases in imports and greater outsourcing of US jobs

• Changes in labor market institutions, such as declining power of unions, erosion of real minimum wage and “flexible” policies on terminating workers

• Skill-biased technical change generating greater returns to education

• Demographic factors, such as aging population, increase in numbers of individuals living alone, immigration and increase in number of single-parent households

• Growth in financial innovation and changing compensation packages for executives.

• Geographical dispersion (Galbraith) as can explain a large portion of the increase in inequality by focusing on just 15 of the 3,150 counties in the US

Key Questions

• What role can or should the income tax system play in redistributing income and wealth in developed and developing countries?

• How successful have tax systems been in redistributing income?

• How confident can we be in determining the incidence of specific taxes, the tax system in general, and the benefits from government operations?

• Should differences between developed and developing countries influence decisions as to the redistributive role of the tax system?

Four Propositions (Bird & Zolt 2005)

• Personal income tax has done little, if anything, to redistribute income or reduce inequality in developing countries

• It is not costless to pretend to have a progressive personal income tax system

• Given the ineffectiveness of the personal income tax, if countries want to use the fiscal system to reduce poverty, increase economic mobility, or reduce inequality, there are alternative approaches that merit consideration

• What matters is the aggregate effect of a government’s tax and spending policies, not just the progressivity of the tax system

Fiscal Programs and Inequality (Chu, Davoodi & Gupta (2000)

• Before redistributive tax and spending programs, inequality is, on average, greater in developed countries than developing countries

• In developed countries, taxes and spending programs significantly reduce the level of inequality (mainly due to spending programs -perhaps 1/3 due to taxes)

• In developing countries, neither taxes nor spending programs have contributed to meaningful reductions in the level of inequality

Source: OECD Data extracted on 7 Sept 2016 from stats.oecd.org

Limitations on the Ability of the Personal Income Tax To Redistribute Income

• Personal income taxes play a relatively small role in the tax systems of developing countries

• Personal income tax is primarily a wage withholding tax on labor in the formal sector

• Little effective taxation of income from capital for both political and administrative reasons

Small Role of Personal Income Tax: Developed v. Developing Countries

Income Tax Individual Income Tax Income Tax Individual Income Tax

Developed Countries 38.6% 25.0% 10.6% 7.2%

Developing Countries 24.3% 9.1% 4.5% 1.9%

Percentage of Total Taxes Percentage of GDP

Relative Share of Personal and Corporate Income Tax Revenue (percent of GDP)

Country Income Tax Revenue1 Personal Income Tax Corporate Income Tax

Brazil 7.4 0.5 3.5

Indonesia 5.3 1.0 4.3

Malaysia 10.9 2.3 8.6

Philippines 6.2 2.1 3.7

Singapore 5.8 2.0 3.8

Thailand 7.4 2.1 5.3

United States 12.0 9.8 2.2

1 As a percent of GDP for Year 2013 (IMF source)

Effectiveness of Increasing Tax Rates on Reducing Inequality

• Hypothetical exercise (Gale, Kearney, and Orsag 2015) • Increase the top marginal personal tax rate from 39.6% to 50%

• Assume all the additional revenue is distributed to those in lowest quintile (about $95 billion of additional revenue resulting in a transfer of $2,650 to everyone in the bottom quintile)

• Changes in Gini coefficients • Before tax income .610

• After tax income current law .574

• After tax income 50% rate .560

Differences Between Developed and Developing Countries

• Tax incidence assumptions

• Costs of redistribution

• Relative size of the informal economy

• Relative tax burdens

• Relative use of different tax instruments

Tax Incidence: Developed and Developing Countries

• Developed countries • Income tax (progressive)

• Corporate tax (progressive or proportional)

• General consumption taxes-VAT (regressive)

• Trade taxes (regressive)

• Payroll taxes (ambiguous)

• Urban property tax (regressive/progressive)

Source: Shah and Whalley, The Redistributive Impact of

Taxation in Developing Countries (1991)

• Developing countries • Income tax (ambiguous)

• Corporate tax (progressive)

• General consumption taxes-VAT (progressive)

• Trade taxes (progressive)

• Payroll taxes (ambiguous/progressive)

• Urban property tax (progressive)

Costs of Redistribution

• Especially in developing countries, higher tax rates contribute to:

• More informal work arrangements

• More activity in the informal sector

• More capital invested outside the country (particularly portfolio investment held in the U.S. and other tax haven countries)

Relative Priorities for Fiscal Policy

• Tax and spending policies can be used to:

• Reduce inequality

• Reduce poverty

• Increase economic mobility

• One’s tolerance for relatively high levels of inequality are influenced by levels of poverty and economic mobility

• Relative weights given to these priorities will influence design of fiscal policies

• Countries with the largest levels of social spending have generally more regressive tax systems

• I believe the US needs more regressive taxes to support more progressive spending programs

Fiscal Contract and Fiscal Contracting

• Fiscal Contracts (Timmons 2005) • Governments raise revenue by trading goods and services for taxes

• Those who pay most of the taxes will receive most of the benefits • Governments with more progressive taxes spend more on protection of property

rights

• Governments with more regressive taxes spend more on social programs

• Fiscal Contracting (Bird & Zolt 2015) • Fiscal contracting is the process whereby different interest groups

participate to a differing extent over time in shaping the tax and expenditure policy

• Size of welfare programs in developed countries is path dependent on adoption of taxes on the middle class and the poor (Kato 2003)

• Countries with strong left-wing governments and strong labor unions rely heavily on regressive consumption taxes to fund social programs

What has changed since Bird & Zolt 2005

• Tax levels have increased slightly and social spending programs have become more effective in many countries

• Tax administration has improved • The improvements in tax capacity from the VAT makes it easier to improve tax

capacity for improving personal income taxes

• Economic environment has changed • Reduction in poverty levels

• Growing middle class

• Political environment has changed • Greater political awareness of growing inequality

• Perhaps opportunities for new fiscal contract or bargain

Some Observations

• Tax and spending policies will differ depending on relative priorities for reducing inequality, reducing poverty and increasing economic mobility

• Taxes played a relatively minor in causing increased inequality and will likely play a relatively minor role in reducing inequality

• Challenge is how to improve the distribution of income before considering the effects of transfers and taxes (market income)

• Key to reducing poverty, increasing economic mobility or reducing inequality lies in larger and better targeted and designed social spending programs

Wealth taxes in developed and developing countries

• Common arguments for wealth taxation

• Types of wealth taxes

• Design issues

• Current trends

• What has changed to make wealth taxes more attractive?

Thomas Piketty’s Global Wealth Tax Proposal

• Annual wealth tax of 1% for net worth of 1 to 5 million euros

• 2% wealth tax for net worth between 5 million to 1 billion euros

• Some higher rate (perhaps 5-10%) above 1 billion euros

Donald Trump’s 1999 Wealth Tax Proposal

• In a prior bid for the presidential nomination,

Donald Trump proposed a one time 14.25% wealth tax on the net worth of households with over $10 million of net assets.

• The projected revenues of $5.7 trillion would have been used to pay off the national debt.

Common Arguments for Wealth Taxation

• Equity: in determining relative ability to pay, wealth taxes are needed to supplement income taxes as wealth confers additional taxable capacity

• Efficiency: wealth taxes may encourage more productive use of assets

• Improve progressivity and reduce inequality: wealth taxes can reduce income and wealth inequality

• Administrative considerations: information from wealth taxes can prove useful in administering other types of taxes

• Political considerations: important signal that the government is concerned that all individuals pay their fair share

How persuasive?

• Equity: probably greater payoff from improving the income taxation of capital than adopting a new wealth tax

• Efficiency: uncertain economic consequences from adopting a wealth tax, but will change investment behavior of the rich and may reduce levels of savings and investment

• Improve progressivity and reduce inequality: at politically acceptable rates, a wealth tax will have a very small effect on levels of inequality

• Administrative considerations: developing countries face significant challenges in taxing income from capital and taxing real property, uncertain whether many countries could successfully administer a wealth tax

• Political considerations: wealth and property taxes are extremely unpopular even among those who will likely never have to pay them

Types of Wealth Taxes

• Wealth taxes are imposed on the holding, transfer, or appreciation of assets • Holding of assets:

• Annual wealth taxes

• Property taxes

• Transfer of assets: • Estate and gift taxes

• Stamp taxes and financial transactions tax

• Appreciation of assets: • Capital gains taxes (more effective if treat transfers by gift and inheritance as a taxable event)

Role in Tax System

• Three major bases for taxation: income, consumption or wealth

• Use wealth taxes to supplement existing taxes • Retain current taxes on income and consumption but use wealth tax to supplement existing

tax instruments

• Use revenues from a wealth tax to reduce marginal tax rates under the income tax

• Tax certain investment assets on a presumptive basis

• Use wealth tax as a minimum tax for income tax purposes (for individuals and corporations)

• Use wealth taxes to replace existing taxes • Combine a progressive consumption tax with an annual wealth tax to replace the income tax

• De-link the taxation of income from labor and income from capital, and consider using a wealth tax to tax income from capital (perhaps including mark-to-market taxation)

• Retrospective tax on capital (Auerbach 1991; Kwak 2016)

Example of Wealth Tax as Part of Income Tax: Netherlands Tax on Portfolio Income

• In 2001, the Netherlands adopted a scheduler approach in their personal income tax system: • Box 1: taxable income from labor and homeownership (progressive tax rates)

• Box 2: taxable income from substantial business interest (flat rate)

• Box 3: taxable income from portfolio investments (presumptive tax rate)

• Box 3 presumptive tax rate • Assumes net assets generate a return of 4% and are subject to a 30% tax rate

• Equivalent to a wealth tax of 1.2%

Assets Included in Wealth Taxes

• Assets • Cash and cash equivalents

• Corporate stock

• Corporate and government debt

• Privately-held businesses

• Owner-occupied housing

• Real estate other than personal residences

• Collectibles

• Retirement assets

• Life insurance

• Liabilities • Home mortgage loans

• Debt incurred to purchase securities and real estate

• Personal loans

• Contingent liabilities

Design Issues in Adopting a Wealth Tax

• Scope of tax • Individuals, households, families, or entities covered

• Assets included in the wealth tax

• Identification and disclosure of assets

• Valuation of assets

• Treatment of liabilities

• Liquidity concerns

Personal assets (including homes)

Closely- held stock

Bonds, mortgages, notes

Real estate

Retirement assets

Publicly traded stock

Life insurance, mutual funds

Noncorporate businesses, partnerships and non-traditional financial assets

Cash equivalents

Assets included in Wealth Tax: Where to draw the Line?

Possible factors: valuation challenges, challenges in identifying assets, political resistance, effectiveness in taxing ultra-wealthy

Identification and Disclosure Issues

• Challenges in identifying all assets of taxpayer • Physically hide assets (gold, diamond, paintings)

• Many techniques to obfuscate ownership (shell corporations, trusts, foundations, family partnerships)

• Disclosure • Many types of assets already are registered (real property tax registries and

financial asset registries )

• Adopt penalties for failure to disclose assets (high penalties for failure to disclose or impose higher rates of transfers under either capital gains taxes or inheritance taxes)

Potential Consequences of Adopting Wealth Taxes

• Different strategies for rich to deploy assets • New types of investment instruments, trusts, and partnerships to make

identification and valuation more difficult

• Transfers of assets among family members and from individuals to entities

• Increase in transfers of assets to private foundations

• Encourages transfers of assets outside the country

• Economic consequences • Taxes on wealth may reduce levels of savings and investments which will reduce

returns to labor

• If investors are target savers, then taxes on wealth may increase levels of savings and investment

Trends Against Increased Use of Wealth Taxes

• While several countries use wealth taxes, many countries have discontinued their use • Current wealth taxes: e.g. Argentina, Spain, Norway, Switzerland, Italy

• Abolished wealth taxes: e.g. Austria, Denmark, Finland, and Luxembourg

• Similar treads for abolishing or reducing inheritance taxes

• Revenue considerations • Even where the administration is relatively efficient, the tax revenues generated

from net wealth taxes, property taxes, and inheritance taxes are relatively small

What has Changed?

• Greater political awareness of high levels of income and wealth inequality

• Greater political awareness of tax avoidance and tax evasion strategies of multinational corporations and high net worth individuals

• Technological advances makes its easier to identify and value assets

• Greater information available to tax authorities • From reporting requirements imposed on domestic financial institutions

• From automatic exchange of information from other countries

Developing Countries: Political Economy Considerations

• Substantial political challenges in increasing tax burden on the rich

• Ineffective taxation of capital under personal income tax systems • In many developed countries, wages and salary income constitutes roughly 70%

of total revenue under the personal income tax

• In many developing countries, wages and salary income constitutes roughly 90-95% of total revenue under the personal income tax

• The so-called global, comprehensive, progressive, personal income tax system is neither global nor comprehensive, nor progressive nor personal, and often not even a tax on income

• How revenue is raised influences how government spend their money • Fiscal contracts (Timmons 2004) and fiscal contracting (Bird & Zolt 2014)

• Need creditable commitment by government on spending programs to achieve support for new or additional taxes

Developing Countries: Factors That May Argue in Favor of a Wealth Tax

• Current ineffective taxation of capital • Little taxation of income from capital under personal income tax system

• Ineffective taxation of property under property tax regimes

• Good access to information about assets held by taxpayers • From domestic financial institutions

• From automatic exchange provisions (requires satisfying concerns about safeguarding information)

• Sufficiently robust capital and real estate markets to allow for valuation of non-publicly traded assets

• High levels of income and wealth inequality and low levels of intergenerational economic mobility

• Political support for wealth taxes

Conclusion

• Cost/benefit analysis: • Costs: political, economic, and administrative costs of adopting a wealth tax

• Benefits: revenue and political benefits from adopting a wealth tax

• Perhaps greater revenue gains from improving existing domestic taxes for taxing the rich • Income taxes

• Property taxes

• But even if do not adopt a wealth tax, can use similar approaches to improve the income tax • Wealth taxes as minimum taxes

• Netherland’s presumptive tax approach for income from portfolio assets

• Global wealth tax regime is not likely in the short-term but still large potential revenue gains from access to information through information exchanges with other countries