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ECON-825 (Prof. Klein) Tony Quain “Tax Reform Options” 1 Tax Reform Options Presented by Tony Quain ECON-825 Professor Klein October 24, 2006

ECON-825 (Prof. Klein) Tony Quain “Tax Reform Options” 1 Tax Reform Options Presented by Tony Quain ECON-825 Professor Klein October 24, 2006

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Page 1: ECON-825 (Prof. Klein) Tony Quain “Tax Reform Options” 1 Tax Reform Options Presented by Tony Quain ECON-825 Professor Klein October 24, 2006

ECON-825 (Prof. Klein)Tony Quain

“Tax Reform Options” 1

Tax Reform OptionsPresented by Tony Quain

ECON-825 Professor KleinOctober 24, 2006

Page 2: ECON-825 (Prof. Klein) Tony Quain “Tax Reform Options” 1 Tax Reform Options Presented by Tony Quain ECON-825 Professor Klein October 24, 2006

ECON-825 (Prof. Klein)Tony Quain

“Tax Reform Options” 2

1. Introduction 3-62. The Federal Income Tax 7-113. Five Tax Reforms 12-284. Efficiency Comparison 29-325. Equity Expectations 33-376. Administration, Intrusion, Compliance, Evasion 38-427. Transition Issues 43-478. Political Viability 48-519. Recommendation 52-5310. References 54-58

Contents

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Our Inquiry What are the main problems with the current federal income tax? What are some tax reform alternatives to the federal income tax? How do these tax reform options compare in the following aspects?

1) Efficiency2) Equity3) Administration, Intrusiveness, Compliance, and Evasion4) Transition Issues5) Political Viability

Which type of tax reform is most desirable, given the relative advantages and political viability?

Introduction

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Assumptions During our discussion, we will use the following assumptions:

1) Reform would be limited to U.S. federal government revenue2) Reform would eliminate federal taxes on personal income and corporate income,

but not payroll taxes, excise taxes, estate taxes, customs, or other miscellaneous taxes

3) Income taxes were $1.205 trillion in 2005 ($927 bln. Individual, $278 bln. Corporate), or 56% of all U.S. federal taxes

4) Reform must be revenue neutral, i.e. it must replace the 56% of federal revenues or indicate what part of the income tax would remain in place

Introduction

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Five Tax Reforms The five types of tax reform to be examined will include (in order of the degree

of change, least radical to most):1) Flat Tax2) Retail Sales Tax (RST)3) Value-Added Tax (VAT)4) Geo-Rent Tax (GRT)5) Head Tax

All of these have many variations; I will use the most simplified (or popular) variation where possible, but will explain other significant variations

Introduction

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Tax-inclusive and Tax-exclusive Rates For consistency, all rates will be quoted as tax-inclusive unless specified Tax-inclusive: the tax rate is the percentage of the tax base given up in taxes;

the tax is “carved out” Tax-exclusive: the tax rate is a percentage of the tax base added to the base;

the tax is “added on” Example:

1) A 15% tax-inclusive sales tax rate on a sale of $2,000 yields a tax of $300 and a total sale price of $2,000; the equivalent tax-exclusive rate is 17.65% (of $1,700)

2) A 15% tax-exclusive sales tax rate on a sale of $2,000 yields a tax of $300 and a total sale price of $2,300; the equivalent tax-inclusive rate is 13.04% (of $2,300)

Tax-exclusive rates are always higher than the equivalent tax-inclusive rate Income taxes and VAT taxes are usually quoted as tax-inclusive rates Sales taxes are usually quoted as tax-exclusive rates

Introduction

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Problems with the Federal Income Tax1. Economic Inefficiency

Provisions in the tax code cause distortions in economic decision-makinga) The income tax creates an “excess burden” beyond the tax itself by making

people substitute untaxed activities for taxed activities (Slemrod 2005)

$200 bln. annually (est.); 17% of revenues (Jorgenson 2001)

30%-50% of revenues (Slemrod 2005)

Particularly damaging distortions include: (Hubbard 1997)

Saving and investment decisions Inter-sectoral and Inter-asset distortions (corporate vs. non-corporate; owner-occupied

housing vs. business capital) Financial distortions (corporate debt/equity structure; dividend decisions)

b) Tax expenditures: losses of revenue due to deductions and carve-outs $945 bln. (FY2006 est.); 78% of revenues (Hungerford 2006)

The Federal Income Tax

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Problems with the Federal Income Tax (contd.)c) Tax avoidance: the elasticity of taxable income, not simply labor supply, responds to

the income tax rate; as a result, tax revenues experience diminishing (and possibly negative) returns to increases in tax rates (Slemrod 2005)

$284 bln. annually for individual income tax alone (Feldstein 1999)

2. Inequitya) Equity only seen as a problem by those who disagree with current progressivityb) Progressive tax rates transgress Adam Smith’s principle of proportionality; they

violate “vertical equity” (proportional tax: the more you get, the more you pay) and replace it with “ability to pay” redistribution (Hall 1995)

Six individual tax brackets: 10%, 15%, 25%, 28%, 33%, 35% Eight corporate tax brackets: 15%, 25%, 34%, 39%, 34%, 35%, 38%, 35%

c) Tax expenditures (“targeted” tax provisions) and widespread evasion violate “horizontal equity” (people in similar circumstances should bear equal tax burdens) (Hall 1995)

The Federal Income Tax

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Problems with the Federal Income Tax (contd.)3. Administration and Enforcement

a) Enforcement costs are high due to complexity and evasion: $10.2 bln. (FY2005) to fund enforcement by the IRS (ERP 2006)

4. Intrusivenessa) Inhibitions of personal and business privacyb) Costly measures taken to avoid intrusiveness

5. Complexity and Compliancea) Complexity: income taxes are inherently complex because of (1) complicated

timing rules for capital expensing and (2) inflation distortions of interest payments (McClure 1995)

Complexity causes taxpayers, the IRS, and tax experts to make errors (CHC 2003)

b) Compliance: represents deadweight losses of productive capacity $200 bln. annually in direct and opportunity costs of compliance (CHC 2003)

The Federal Income Tax

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Problems with the Federal Income Tax (contd.)6. Evasion

a) Evasion includes non-filing, underreporting, and underpayment IRS claims the “Tax Gap” for income taxes is $230 bln. annually: $197 bln.

(individual), $33 bln. (corporate) (IRS 2004)

7. Rent-seekinga) Lobbyists spend society’s resources obtaining tax expenditures

The Federal Income Tax

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Adam Smith’s Four Taxation Maxims1. Proportionality (“The subjects of every state ought to contribute to the support

of the government … in proportion to the revenue which they respectively enjoy”) (Smith 1981) Federal Income Tax fails (see (2) Inequity)

2. Certainty (“The tax which each individual is bound to pay ought to be certain, and not arbitrary”) (Smith 1981) Federal Income Tax fails (see (5) Complexity)

3. Timeliness (“Every tax ought to be levied at the time, or in the manner in which it is most likely to be convenient for the contributor to pay it”) (Smith 1981) Federal Income Tax fails (does not permit immediate expensing of capital)

4. Unobtrusiveness: (Smith 1981)

a. No excess enforcement Federal Income Tax fails (see (3) Enforcement)b. No excess burden Federal Income Tax fails (see (1) Inefficiency)c. No excess evasion Federal Income Tax fails (see (6) Evasion)d. No intrusion Federal Income Tax fails (see (4) Intrusiveness)

The Federal Income Tax

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1. Flat Tax – How it Works The variant I use is the Hall-Rabushka Flat Tax, introduced in 1981 The Flat Tax is a reform of the income tax system that eliminates tax

expenditures (itemized deductions, credits, etc.) and tax brackets; individuals and businesses would both be subject to one “flat” rate

Businesses would be subject to a “Business Tax”:1) Taxable income would be gross revenue minus “Allowable Costs”:

Purchases of goods, services, and materials Wages, salaries, and pensions Purchases of capital equipment, structures, and land

2) Note that for purposes of this tax businesses would use cash accounting; there would be immediate write-off of investment (with a carry-forward provision)

Five Tax Reforms

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1. Flat Tax – How it Works (contd.) Individuals would be subject to an “Individual Wage Tax”:

1) Total compensation includes wages and salary plus pension and retirement distributions

2) Personal allowances deducted from total compensation: Personal allowance for filer:

1. Single: $12,800 (H-R: $9,500)2. Married filing jointly: $25,600 (H-R: $16,500)3. Head of household: $19,200 (H-R: $14,000)

Allowance for each dependent (not incl. spouse): $6,000 (H-R: $4,500)

3) Interest, dividends, and capital gains would not be taxed4) Non-wage earners (sole proprietors, etc.) would file a Business Tax only, unless

they paid themselves a wage Variant A: no personal allowances

Five Tax Reforms

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1. Flat Tax – Problems Retains the income tax: leaves open the possibility of returning to a more

complicated and graduated system over time Foreign goods bias: domestic goods for export are taxed while foreign goods

for import are not; this puts domestic goods at a disadvantage Government bias: while government workers are subject to the wage tax,

government enterprise (such as USPS) is not subject to the business tax

Five Tax Reforms

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1. Flat Tax – Factfile

Five Tax Reforms

Revenue neutral rate: 17.25%(Hall 1995) adjusted

Ideology: free-market political establishment; bargainers; those who are resigned to keeping the income tax but want to eliminate the inefficiencies and inequities of tax expenditures and tax brackets

In Operation:Estonia 26% (1994-)Lithuania 27% (1995-)Latvia 25% (1996-)Russia 13% (2001-)Ukraine 13% (2003-)Iraq 15% (2004-)Slovakia 19% (2004-)Romania 16% (2005-)Illinois 3%Indiana 3.4%Massachusetts 5.3%Michigan 3.9%Pennsylvania 2.9%

Endorsements:Arthur LafferBruce BartlettMilton FriedmanSteve Forbes

Dick Armey

Arnold SchwarzeneggerAliases: Yield-Exemption Tax

Origins: Income tax introduced by Pitt the Younger in 1798

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2. Retail Sales Tax – How it Works The Retail Sales Tax is assessed on retail (final) sales only; wholesale

producers do not pay the tax; it is added on to goods at the point of final sale To avoid “cascading” (whereby businesses pay the tax on investment

purchases that are sold again and therefore taxed again), businesses would be able to recover taxes paid on goods purchased for resale

Government purchases and investments are subject to the tax, to avoid economic distortions

Businesses would collect the tax, but incidence falls on consumers Individuals would not file tax returns Exports are excluded; imports sold domestically are included Variant A: “FairTax” includes a rebate to poverty level income for all Variant B: lower rate or exclusion of certain goods or services

Five Tax Reforms

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2. Retail Sales Tax – Problems No current experience of use at the national level Unlike the VAT, enforcement of a sales tax at the necessary percentage

would be onerous due to lack of audit trail; evasion would be a crucial problem (Slemrod 2005)

Five Tax Reforms

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2. Retail Sales Tax – Factfile

Five Tax Reforms

Revenue neutral rate: 13% (tax-incl)(Edwards 2005) adjusted

Ideology: abolitionists (sixteenth amendment must be repealed); nativists (sales taxes as “American” practice)

In Operation:45 U.S. states California highest (7.25% tax-excl)9 Canadian provinces PEI highest (10.6% tax-excl)

Endorsements:Stephen MooreLaurence KotlikoffGrover NorquistWayne AngellPaul RubinVernon SmithJohn Linder

Aliases: FairTax,National Sales Tax

Origins: Spain introduced a sales tax in 1342;Kentucky was first state in 1934

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3. Value-Added Tax – How it Works The Value-Added Tax is assessed on every business as a fraction of each

sale, net of purchases made by that business; in this sense it taxes the “value added” at each stage of production, rather than only the final value sold at retail; nevertheless, the same percentage of a retail and a value-added tax should theoretically net the same revenue

Businesses would collect the tax, but incidence falls on consumers Individuals would not file tax returns Exports are excluded, except for that (wholesale) portion which is transacted

between businesses within the U.S.; imports are taxed on any value added by American wholesalers/retailers

Variant A: lower rate or “zero rate” of certain goods or services

Five Tax Reforms

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3. Value-Added Tax – Problems Coordination with state retail sales tax schemes is fraught with major

complications; states would need to change their sales tax schemes to a VAT piggy-back (Mack 2005) (McClure 1995)

Since it is somewhat hidden from the retail consumer (it can be stated but is nevertheless absorbed in the price), it obscures the cost of government (Slemrod 2005)

Five Tax Reforms

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3. Value-Added Tax – Factfile

Five Tax Reforms

Revenue neutral rate: 13% (tax-incl)(Edwards 2005) adjusted

Ideology: Mainstream economists; Euro-philes; “Big-government” conservatives

In Operation:25 EU nations U.K. 17.5% France 19.6% Germany 19% Sweden 25%39 other nations Australia 10% China 17% Mexico 15%All Canadian provinces 6%-14%Michigan 1.9% (1975-2009)

Endorsements:Bruce BartlettBill Thomas

Aliases: Goods and Services Tax (GST),Single Business Tax (SBT),Business Transfer Tax (BTT)

Origins: Invented by French economist Maurice Lauré in 1953

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The Flat Tax, RST, and VAT as Consumption Taxes The Flat Tax, RST, and VAT call themselves consumption taxes since saving

and investment are not taxed The Hall-Rabushka Flat Tax is actually a modification of a classic Value-Added

Tax: (Slemrod 1997)

From the Hall-Rabushka Flat Tax:1. Eliminate the personal and dependent exemptions in the personal income tax2. Abolish the personal income tax3. Disallow the deductibility to business of payments to labor and pensions= The traditional consumption-based Value-Added Tax

Macroeconomic identities show that various consumption taxes are equivalent: (Auerbach 1997)

Consumption = Income – Savings = Wages + Returns to Capital – Investment

RST = USA Tax = VAT or Flat Tax

Five Tax Reforms

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4. Geo-Rent Tax – How it Works The Geo-Rent Tax is a tax on the implicit rental value of land, exclusive of the

value of improvements; “land” includes all surface area (including water), airway corridors, and the electro-magnetic spectrum

The tax would apply to all owners of land, including household, commercial, and government-owned real estate; taxing government land adds pressure to manage, maintain, and retain an efficient amount of public land

Land values would be assessed as they are presently for property taxes, which usually distinguish between site and improvement value

Assessment would be done either by adapting existing state/local assessment systems or by a national revenue collection agency

Five Tax Reforms

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4. Geo-Rent Tax – Problems Insufficient revenue: Even if geo-rents are taxed at 100%, the revenue raised

would not be sufficient to replace income taxes (Foldvary 2005)

Assessment: Valuation is inexact and subject to manipulation; land site values can only be determined in the exchange of the market (Rothbard 1957)

Five Tax Reforms

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4. Geo-Rent Tax – Factfile

Five Tax Reforms

Revenue neutral rate: 69%(Tideman 2002) adjusted

Ideology: Progressives;Environmentalists (“we all own the world”)Geo-libertarians (libertarians who believe

in the private possession of land but not land as private property)

In Operation:EstoniaTaiwanSingaporeHong KongSydney, AustraliaCanberra, AustraliaFairhope, AL

Arden, DE

Endorsements:Adam SmithJohn Stuart MillMilton FriedmanThomas PaineWilliam F. Buckley, Jr.Albert Jay NockSun Yat Sen

Winston Churchill

Ralph NaderAliases: Land Value Tax, Site Value Tax

Origins: Invented by American political economist Henry George in 1879 (but the idea of taxing the non-labor value of land has been around since John Locke)

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5. Head Tax – How it Works The Head Tax is a tax of a nominal dollar amount assessed to every

individual over a certain age (for our example, over 18) It is not based on income, or consumption, or any economic activity; since the

amount of tax paid does not vary due to economic choices, it has no impact on economic activity

Businesses would not be assessed a tax Individuals who are citizens or residents would be assessed a tax Variation A: No age limitation (include children) Variation B: Exclude the insane, the infirm, or the incarcerated Variation C: Tax amount is based on age (to attempt to coincide with lifetime

income stream), with young paying lower

Five Tax Reforms

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5. Head Tax – Problems Insolvency: some people simply would not be able to pay (not in the normal

sense of “I must pay for food, shelter, cable first”, but in the sense that they would not actually have enough money at all); a “carry forward” provision could ameliorate but not solve this

Five Tax Reforms

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5. Head Tax – Factfile

Five Tax Reforms

Revenue neutral rate: $5,407 (annual)

Ideology: Libertarian academics

In Operation:Not presently in operation anywhereRecent trials:England/Wales (1990-92)Scotland (1988-92)

Endorsements:Steven LandsburgKeith JosephMargaret Thatcher

Aliases: Poll Tax; Lump-sum Tax

Origins: Assessed by John of Gaunt in England in 1380

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Taxes and Incentives The effects of the five tax reforms on economic activity:

1) Income taxes discourage work, investment, and entrepreneurial activity2) Consumption taxes (RST, VAT) discourage consumption3) Geo-Rent Taxes arguably do not discourage anything (sprawl?)4) Head taxes are non-contingent and do not discourage anything (is this true?)

Is complete elimination of tax incentivization desired? Is any economic activity good in itself (positive externalities or ethical merit)?

Work? Saving? Is any economic activity bad in itself (negative externalities or vice)?

Consumption? Work?

Efficiency Comparison

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Consumption Taxes and Labor Supply Because of inter-temporal substitution, there is no long-term effect on labor

supply arising from the shift in taxation from income (work) to consumption (Auerbach 1997)

However, the reduction of tax rates at the margin (whether on income or on consumption) and the investment potential in deferred consumption should result in an increase in labor supply (Auerbach 1997)

Any consumption tax would increase labor supply by 6% initially, then decline eventually to original level (Jorgenson 1997)

The Flat Tax would add 4% more work hours and 3% total output to GDP (Hall 1995)

The Retail Sales Tax would add 5% more work hours initially, eventually to diminish to 1% in 20 years (Kotlikoff 1995)

Efficiency Comparison

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Consumption Taxes and Saving Consumption taxes eliminate the inter-temporal consumption distortion that

arises from taxing savings (Metcalf 1995(1))

If the savings elasticity with respect to the interest rate is positive, a consumption tax should increase the savings rate (Metcalf 1995(1))

The Flat Tax would raise the ratio of capital stock to GDP from 5.0 to 6.2; this would result in a 3% increase in GDP; interest rates would fall by 20% to reflect a new after-tax rate similar to a tax-free rate (Hall 1995)

The Retail Sales Tax would raise the capital stock by 8%; this would result in a 6% increase in GDP; interest rates would fall by 8% (Moore 1995)

Efficiency Comparison

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GRT and Head Tax Efficiency GRT:

While the improvement value of land has some supply elasticity, the site value of land (which GRT taxes) is theoretically completely supply inelastic

The demand for land, however, could shift to alternatives (e.g., internet over brick-and-mortar) and would change the use and development of land

Head Tax: The Head Tax is theoretically completely non-contingent, and thus completely

efficient Caveats:

1) The age breakpoint and carry-forward rules may influence behavior in light of borrowing constraints

2) Decisions of American residency and citizenship may be influenced

Efficiency Comparison

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Measuring Distribution Taxation per dollar of annual income is traditional distributional measure Distribution measures (progressivity/regressivity) and taxes that target them:

1) Taxation per dollar of wealth (GRT)2) Taxation per dollar of income3) Taxation per dollar of consumption (Flat Tax; RST; VAT)4) Taxation per dollar of benefits5) Taxation per person (Head Tax)

Distribution timeframes:1) Annual timeframe (politician view; affects political viability)2) Lifetime timeframe (economist view; true equity)

Distribution adjusted for evasion:1) Measured by how much tax is owed (this is used)2) Measured by how much tax is paid

Equity Expectations

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Annual and Lifetime Measurement Distinction between annual income and lifetime income makes consumption

taxes appear proportional with respect to income (Metcalf 1995(2)) Two caveats: (Metcalf 1995(2))

1) Non-taxed consumption (leisure): to the extent that the income elasticity of leisure exceeds one, leisure is not taxed and consumption taxes are progressive; however, evidence shows that income elasticity of leisure is one or less

2) Non-taxed bequests: to the extent that the income elasticity of bequests is less than one, bequests are not taxed and consumption taxes are regressive; however, bequests may be implicitly taxed in the sense that the value is reduced

Equity Expectations

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Distribution Estimation Flat Tax (B+) is income and consumption progressive, due to personal

deductions RST (A-) and VAT (A) are income regressive and consumption flat on an

annualized basis, but are both income and consumption flat over a lifetime GRT (A-):

Adherents claim that all of the incidence is on present landowners Realistically, incidence falls on land users, whether renter or owner Businesses which use land push incidence onto consumers On an annual basis, GRT is probably loosely income and consumption

progressive, since renters use less land per dollar of income than owners On a lifetime basis, GRT is probably loosely income and consumption regressive,

since differences in lifetime income will not be wholly captured by land use Head Tax (D) is income and consumption regressive

Equity Expectations

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Tax Distribution Elasticity Matrix

▲ = Tax increases more than proportionally with increases in measure (“progressive”)▬ = Tax increases in proportion with increases in measure (“flat”)▼ = Tax increases less proportionally (or decreases) with increases in measure (“regressive”)

Equity Expectations

Annual Lifetime StockIncome Cons Benefit Income Cons Benefit Wealth Person

Current Income Tax ▲ ▲ ▼ ▲ ▲ ▼ ▼ NA

Flat Tax ▲ ▲ ▼ ▲ ▲ ▼ ▼ NA

RST ▼ ▬ ▼ ▬ ▬ ▼ ▼ NA

VAT ▼ ▬ ▼ ▬ ▬ ▼ ▼ NA

GRT ▲ ▲ ▼ ▼ ▼ ▼ ▬ NA

Head Tax ▼ ▼ ▼ ▼ ▼ ▼ ▼ ▬

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Distribution Flexibility Flat Tax can extend progressivity by augmenting the personal deductions or

introducing new deductions RST and VAT can introduce progressivity by reduced-rating or zero-rating of

low-income goods and services or by rebates or consumption credits to all adults

Head Tax can reduce annual regressivity by varying with age

Equity Expectations

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Administration and Enforcement Costs Current income tax (C): $10.2 bln. annually (ERP 2006)

Flat Tax (B): higher than VAT or RST because of individual returns, less than current income tax

RST (B+): $12 bln. annually (1% of revenues); this is a credit to cover costs, not an estimate of costs (Burton 1997)

VAT should be more expensive to administer than RST because more information is collected and audited (Bickley 2004)

VAT (B+): $1.8 bln. annually (Metcalf 1995)

GRT (A-): assessment formulas and property registration; should be low Head Tax (A-): some enforcement difficulties but otherwise easy; should be

very low

Administration, Intrusion,Compliance, Evasion

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Intrusion Current income tax (C): heavy intrusion on personal and business privacy Flat Tax (B): intrusion on business transaction privacy and on individuals, but

limited RST (A-): intrusion on retail business, but less than VAT or Flat Tax VAT (B+): intrusion on business transaction privacy, but limited GRT (A): no intrusion Head Tax (A): no intrusion

Administration, Intrusion,Compliance, Evasion

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Compliance Costs The most dramatic gains over the current system are in compliance costs Current income tax (C): $200 bln. annually (CHC 2003)

Flat Tax (B): no estimate; while individuals would need to comply, compliance costs would be similar to other consumption taxes because business would bear the overwhelming majority of compliance costs in tracking credits

RST (B+): $6 bln. annually (0.5% of revenues); this is a credit to cover costs, not an estimate of costs (Burton 1997)

VAT (B): $5 bln. annually (Bickley 2006)

GRT (A-): no estimate; record-keeping of property transactions; should be very low as property does not turnover as quickly as general consumption

Head Tax (A): no estimate; since only individuals comply, and computation and record-keeping are not necessary, costs should be extremely low

Administration, Intrusion,Compliance, Evasion

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Tax Evasion Evasion is higher the higher the tax rate; there will be more total evasion with

a 20% tax on either sales or income than with a 10% tax on each For most taxes, there is a tax rate above which avoidance and evasion result

in lower tax revenues Current income tax (C): 23% of collected revenue (IRS 2004)

Flat Tax (B+): since under-reporting of non-wage income is the largest problem of current evasion, this would substantially diminish evasion

RST (C):1) Estimate of state evasion: 13%; likely to be higher if rates are higher (Due 1994)

2) Since the high rate would apply to the total sale and is paid completely by retailers, the incentive for evasion is higher than Flat Tax or VAT

3) Shorter audit trails than Flat Tax or VAT facilitates evasion

Administration, Intrusion,Compliance, Evasion

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Tax Evasion (contd.) VAT (B+):

1) Reduced evasion compared to a national sales tax: (Mack, 2005)

Demand for input credits creates self-enforcement mechanism and paper trail Reduced tax liability for each business (includes retailers, wholesalers, producers)

2) European estimates of evasion are generally under 10% (Bickley 2006)

United Kingdom 2%-4%; France 3%; Netherlands 6%; Belgium 8%; Italy 40%

GRT (A): Land can not be hidden; taxes on land are extremely difficult to evade

Head Tax (B): Head taxes are theoretically difficult to evade, since proof of compliance can be tied

to any government service (driver’s license, benefits, etc.) Nevertheless, there is a very strong incentive for evasion and many people may be

able to go “underground”

Administration, Intrusion,Compliance, Evasion

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Out with the Old: Tax-preferred vehicles Saving and investment vehicles:

1) Retirement accounts $125 bln. (FY2006) (Hungerford 2006)

Savings are not taxed under any reform; tax would not be paid on distributions2) Tax-exempt municipal bonds $26 bln. (FY2006) (Hungerford 2006)

Interest rates would be higher for these projects but lower for other bonds; eliminates excessive local government debt financing

Housing deductions:1) Mortgage financing $69 bln. (FY2006) (Hungerford 2006)

Eliminates excessive property inflation

Health care financing:1) Elimination of employer deduction of health care expenses $91 bln. (FY2006)

(Hungerford 2006) (one step towards correcting America’s ailing health sector!)

Transition Issues

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Out with the Old: Current System Parasites Tax professionals: not all would go (the replacement tax and other taxes still

need due attention), but a majority cover federal income taxation1) Tax collectors (35,010) (BLS 2006)

2) Tax preparers (58,850) (BLS 2006)

3) Tax accountants4) Tax attorneys5) Tax lobbyists

Should they be compensated or retrained (GI Bill)? Compensation opens itself up to fraud; retraining is debatable

Depending on transition period to new tax, retraining may be unnecessary

Transition Issues

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In with the New Consumption Taxes:

1) Double taxation of wealth: switching from income to consumption taxation entails double taxation of all existing wealth and inventory, since it was taxed once as income (in the old scheme) and will be taxed again when it is used for future consumption (in the new scheme); this is the biggest transition issue Possibility of a large consumption binge before transition Should existing holders of wealth be compensated? Public finance theorists are split,

but the case (on both efficiency and equity grounds) for not compensating is compelling (Metcalf 1995(2))

2) Price changes: businesses will either “pass forward” the new tax in the form of higher prices, or reduce the cost of factor inputs (wages) If higher prices, people and businesses with money instruments suffer a real loss If lower wages, businesses and individuals with inventories suffer a real loss Generally, it is expected that higher prices will occur and nominal wages will stay the

same (Hall 1997); monetary policy would make a one-time adjustment (Bradford 1995)

Transition Issues

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In with the New (contd.)3) Depreciation: businesses with existing depreciation balances will need to be able

to write-off the remaining balance; this will cost $108 bln. a year in lost revenue for 5 years (Hall 1995)

4) Interest deductions: individuals with mortgages or other deductible interest may ask for relief; but then the interest should become taxable to the lender (Hall 1995)

5) Housing: to avoid the distortion between the purchase of new and existing housing, new housing should be taxed upon first sale and existing housing should be taxed upon first sale after tax enactment (Metcalf 1995(2))

Transition Issues

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Transition Summary Flat Tax (B): 1-2 years; works within existing tax system; transition would be

similar to Tax Reform Act of 1986 RST (C): 5 years (Burton 1997); new at the federal level VAT (D): more time to implement than RST, since it is new (Bickley 2004)

GRT (F): 20 years; compensation of existing landowners would require a very gradual phase-in (Foldvary 2005)

Head Tax (A-): depends on equity issues

Transition Issues

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The Equity Problem The equity problem is perhaps the largest political issue for tax reform All other arguments (efficiency, compliance, etc.) in favor of tax reform may

not be able to overcome the opposition created by the equity problem All consumption taxes (Flat, RST, VAT) and the Head Tax are vulnerable to

attack on the grounds that they are less progressive than the current income tax system, and thus “favor” the rich and harm the poor

The change from progressivity to a “flat” treatment per dollar of consumption (or per head) is in fact one of the intended goals of all four of these reforms

The reduction of vertical inequity (generally considered unfair) is somewhat ameliorated by the reduction of horizontal inequity (considered more fair)

The Flat Tax is less vulnerable on these grounds because the personal allowances retain some progressivity; in effect, the low-income and high-income earners are better off and middle-income earners worse off

Political Viability

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Flat Tax Popularity The Tax Foundation asked over 2,000 adults the following question in 2005

and 2006: “If you could choose one plan to collect all federal taxes, of these listed, which federal tax plan would you prefer?”

2005 20061) A flat-rate income tax with no deductions 37% 33%2) A national sales tax 19% 20%3) The current graduated income tax with deductions 19% 21%4) Unsure 25% 26%(Chamberlain 2006)

This shows the continued popularity of the Flat Tax over both the current system and a national Retail Sales Tax; note that personal and dependent deductions were not even mentioned for the Flat Tax

Political Viability

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Passage Hurdles All five tax reforms can be enacted by Congressional passage of a law,

signed by the President Some notes:

1) VAT: States with RSTs should pass legislation to change to VAT2) RST: States with RSTs may need legislation to better combine with federal RST3) GRT: As this is not an indirect tax, it may require a constitutional amendment4) Head Tax: Constitutional amendment repealing Amendment XXIV should not be

necessary (only applies to taxes on voting) All except the Flat Tax should pass a constitutional amendment to repeal

Amendment XVI, which gave Congress the authority to tax income

Political Viability

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Political Challenge Flat Tax (A-): popular in Congress; has decade of somewhat positive

exposure outside the beltway; easily understood RST (B): more popular in Congress than the Flat Tax; gaining momentum

recently; evasion problems raised by opponents VAT (C+): difficult to explain; European flavor suppresses support; not well-

known in the United States; opposed by right-wing as “money machine” GRT (B-): esoteric; unknown; could easily garner support from left and right;

will be vehemently opposed by land owners Head Tax (F): very radical; scary; equity concerns a killer; political

Armageddon; hated in Canada, Britain, and elsewhere

Political Viability

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Grand Comparison

The current income tax baseline grade is a “C” in all categories (except Transition)

Recommendation

Flat Tax RST VAT GRT Head Tax

Efficiency B+ B+ B+ A- AEquity B+ A- A A- DAdministration B B+ B+ A- A-Intrusion B A- B+ A ACompliance B B+ B A- AEvasion B+ C B+ A BTransition B C D F A-Politics A- B C+ B- F

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Flat Tax All reforms appear better than the current income tax The Hall-Rabushka Flat Tax is recommended because:

1) It is competitive with other reforms in all aspects of reform, including efficiency, equity, administration, intrusiveness, compliance, and evasion

2) It has the easiest and fairest transition route of all reforms, and is thereby the least risky reform

3) It appears the least radical way to a consumption tax; and thus,4) It is the most politically viable

The Geo-Rent Tax is a powerful and attractive idea that should be tested at the state level to assess the revenue, incidence, and equity implications

Recommendation

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A-CAuerbach, Alan J. "The Future of Fundamental Tax Reform." The American Economic Review 87.2

(1997): 143-46.Bartlett, Bruce. "Flat-Tax Comeback." National Review Online, 2003.Bickley, James M. A Value-Added Tax Contrasted with a National Sales Tax. Washington, DC:

Congressional Research Service, Library of Congress, 2004.---. Value-Added Tax: A New U.S. Revenue Source? Washington, DC: Congressional Research Service,

The Library of Congress, 2006.Boskin, Michael J., ed. Frontiers of Tax Reform. Hoover Institution Press, 1995.Bradford, David F. "Consumption Taxes: Some Fundamental Transition Issues." Frontiers of Tax

Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 123-50. Burton, David R. and Mastromarco, Dan R. Emancipating America from the Income Tax: How a National

Sales Tax Would Work. Washington, D.C.: The Cato Institute, 1997.Cato Handbook for Congress. Washington, DC: The CATO Institute, 2003.Chamberlain, Andrew. 2006 Annual Survey of U.S. Attitudes on Tax and Wealth. Washington, DC: Tax

Foundation, 2006.

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D-HDue, John F., and John L. Mikesell. Taxation. 3rd ed. Washington, DC: Urban Institute Press, 1994."The Economic Report of the President." Ed. Council of Economic Advisers: U.S. Government Printing

Office, 2006. 1-410.Edwards, Chris. Options for Tax Reform. Washington, D.C.: The Cato Institute, 2005.Feldstein, Martin. "Tax Avoidance and the Deadweight Loss of the Income Tax." The Review of

Economics and Statistics 81.4 (1999): 674-80."Flat Tax." Wikipedia.Foldvary, Fred E. "Geo-Rent: A Plea to Public Economists." Econ Journal Watch 2.1 (2005): 106-32.Hall, Robert E. "Potential Disruption from the Move to a Consumption Tax." The American Economic

Review 87.2 (1997): 147-50.Hall, Robert E. and Rabushka, Alvin. The Flat Tax. Second ed: Hoover Institution Press, 1995.Hubbard, R. Glenn. "How Different Are Income and Consumption Taxes?" The American Economic

Review 87.2 (1997): 138-42.Hungerford, Thomas L. Tax Expenditures: Trends and Critiques. Washington, D.C.: Congressional

Research Service, Library of Congress, 2006.

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I-MIRS Strategic Plan, 2005-2009. Washington, DC: Internal Revenue Service, 2004.Jorgenson, Dale W. "The Long-Run Dynamics of Fundamental Tax Reform." The American Economic

Review 87.2 (1997): 126-32.Jorgenson, Dale W. and Yun, Kun-Young. Investment Volume 3: Lifting the Burden: Tax Reform, the

Cost of Capital, and U.S. Economic Growth. Cambridge, MA: MIT Press, 2001.Kies, Kenneth J., et al. Discussion of Issues Relating To "Flat" Tax Rate Proposals. Washington, D.C.:

Joint Committee on Taxation, U.S. Congress, 1995.Kotlikoff, Laurence J. "Saving and Consumption Taxation: The Federal Retail Sales Tax Example."

Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 160-80.

"List of Soc Occupations". Washington, DC, 2006. Bureau of Labor Statistics, Department of Labor. 10/12/06. <http://www.bls.gov/oes/current/oes_stru.htm#13-0000>.

Mack, Connie III, et al. Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System. Washington, D.C.: The President's Advisory Panel on Federal Tax Reform, 2005.

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M-PMcClure, Charles E. Jr. and Zodrow, George R. "A Hybrid Approach to the Direct Taxation of

Consumption." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 70-90.

McGeveran, William A. Jr., ed. The World Almanac and Book of Facts 2006. New York, NY: World Almanac Books, 2006.

McNulty, John K. "Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United States: A Tax Policy Discussion of Fundamental Tax Reform." California Law Review 88.6 (2000): 2095-185.

Metcalf, Gilbert E. "The Role of a Value-Added Tax in Fundamental Tax Reform." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 91-109.

---. "Value-Added Taxation: A Tax Whose Time Has Come?" The Journal of Economic Perspectives 9.1 (1995): 121-40.

Moore, Stephen. "The Economic and Civil Liberties Case for a National Sales Tax." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 110-20.

"Poll Tax." Wikipedia.

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R-ZRothbard, Murray. The Single Tax: Economic and Moral Implications. Irvington-on-Hudson, NY:

Foundation for Economic Education, 1957.Slemrod, Joel. "Deconstructing the Income Tax." The American Economic Review 87.2 (1997): 151-

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Indianapolis, IN: Liberty Fund, 1981.Tait, Alan A. Value Added Tax: International Practice and Problems. International Monetary Fund,

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