FUNDAMENTAL TAX REFORM:TAXES ON CONSUMPTION AND WEALTH

Chapter 21

How a Value-Added Tax Works

Producer Purchases SalesValue Added

VAT at 20 Percent Rate

Farmer $ 0 $400 $ 400 $ 80Miller 400 700 300 60Baker 700 950 250 50Grocer 950 1,000 50 10 Total $2,050 $3,050 $1,000 $200

21-2

Efficiency and Equity of Personal Consumption Taxes

• Efficiency issues– An income tax and saving and labor supply

decisions– A consumption tax and saving and labor supply

decisions

21-3

Efficiency and Equity of Personal Consumption Taxes

• Equity issues– Progressiveness– Ability to pay– Annual versus Lifetime Equity• A numerical example • A formal model

21-4

Annual versus Lifetime Equity – A Numerical Example

Parameters

Income tax rate = 50%Consumption tax rate = 50%

Interest rate = 10%

Mr. Grasshopper Ms. AntIncome

taxConsumption

taxIncome

taxConsumption

tax

Income period 0 $1,000 $1,000 $1,000 $1,000Consumption period 0 $500 $500 $0 $0

Taxes period 0 $500 $500 $500 $0Income period 1 $0 $0 $50 $100

Consumption period 1 $0 $0 $525 $550Taxes period 1 $0 $0 $25 $550

Present Value of taxes paid

$500 $500 $523 $500

21-5

Annual versus Lifetime Equity – A Formal Model

ParametersIncome tax rate = t

Consumption tax rate = tcInterest rate = r

Income TaxMr.

GrasshopperMs. Ant

Income period 0 I0 I0

Consumption period 0

c0G c0

A

Taxes period 0 tI0 tI0

Income period 1 r(I0 – c0G) r(I0 – c0

A)Taxes period 1 tr(I0 – c0

G) tr(I0 – c0A)

21-6

Annual versus Lifetime Equity – A Formal Model

Parameters

Income tax rate = t

Consumption tax rate = tc

Interest rate = r

Consumption Tax

Mr. Grasshopper Ms. Ant

Present Value of Lifetime Income

I0 = c0G + c1

G/(1 + r) I0 = c0A + c1

A/(1 + r)

Present Value of Lifetime Tax Liability

RcG

= tcc0G + tcc1

G/(1 + r) =

tcI0

RcA = tcc0

A + tcc1A/(1 + r) =

tcI0

21-7

Retail Sales Tax

• General sales tax– Percent of own-source revenue from sales taxes• State: 34.7%• Local: 10.0%

• Selective sales tax (excise tax or differential commodity tax)

• Forms of a sales tax– Unit tax– Ad valorem tax

21-8

Rationalizations for Sales Taxes

• Ease of administration• Defining the tax base• Tax evasion

21-9

Efficiency and Distributional Implications of States Sales Taxes

• Differential versus uniform tax rates• How to set rates– Efficiency goal only– Equity goal

• Externalities• Sales taxes as substitutes for user fees• “Sin” taxes• Information requirements for differential tax rates

21-10

A National Retail Sales Tax

• Arguments in favor– Simplicity– Ease of compliance

• Arguments Against

21-11

Value-Added Tax

• How a value-added tax works• VAT as an alternative method for collecting

retail sales tax

21-12

Implementation Issues

• Treatment of investment assets– Consumption-type VAT

• Collection procedure– Invoice method

• Rate structure

21-13

A VAT for the United States?

• Desirability of VAT depends on…– What tax (or taxes) it will replace– How revenues will be spent

• Political implications of VAT’s revenue raising prowess

• International implications

21-14

Hall-Rabushka Flat Tax

• Business tax– Tax base = Sales – purchases from other firms – payments

to workers– Pay flat tax rate on final amount

• Individual Compensation tax– Tax base = Payments received by individual for their labor

services– No additional deductions– Apply selected tax schedule

• Why is H&R tax a consumption tax?

21-15

Cash-Flow Tax

• How a cash-flow tax works• How to compute annual consumption– Cash-flow basis– Qualified accounts

21-16

Income versus Consumption Taxation

• No need to measure capital gains and depreciation

• Fewer problems with inflation

• No need for separate corporation tax

• Administrative problems

• Transitional issues• Gifts and bequests

Advantages Disadvantages

21-17

Problems with Both Systems

• Defining consumption• Choosing the unit of taxation• Choosing the rate structure• Valuing fringe benefits• Determining method for averaging over time• Taxing home production• Discouraging incentive to participate in underground

economy• Real world versus ideal tax systems

21-18

Wealth Taxes

• Justifications for taxing wealth– Large accumulations of wealth should be taxed– Correct problems with administration of income

tax– Higher wealth implies higher ability to pay– Reduces the concentration of wealth– Payment for benefits received from government

21-19

Estate and Gift Taxes

• Rationales– Payment for services– Reversion of property to society– Incentives• Recipient versus donor behavior• Work• Saving• Form of bequest

– Relation to personal income tax– Income distribution

21-20

Gross Estate

• All decedent’s assets at time of death, including real property, stocks, bonds and insurance policies, plus gifts made during decedent’s lifetime

• Typically valued at market value at date of death; valuation may be set 6 months later if value of estate declines

• Closely held businesses and farms are valued at “use value.”

21-21

Provisions of the Unified Transfer Tax

Gross Estate- Charitable Contributions- Funeral Expenses- Costs of Settling Estate (lawyer’s fees)- Outstanding Debts- Lifetime Exemption- Qualified Transfers to Spouse- Annual Gift Exclusion Taxable Estate* tax rate Tax

21-22

Problems & Potential Reforms

• Problems with Estate and Gift Taxes– Policy Perspective: Death of the Death Tax?– Jointly held property– Closely-held businesses– Avoidance strategies

• Insurance trust• Gifts of stock

• Reforming Estate and Gift Taxes– Integrate with personal income tax– Accessions tax

21-23

Chapter 21 Summary• Arguments for substituting the income tax with a personal

consumption tax include the elimination of double taxation, promotion of lifetime equity, promotion of efficiency, adjustability for progressiveness and administrative ease.

• Arguments against the substitution point out that it has transition problems, it violates the of ability-to-pay rule, it is administratively burdensome, it can lead to excessive concentration of wealth, and it is regressive in nature

• Sales taxes are important sources of revenues for state and local governments– The VAT is popular in Europe but not used in the U.S.

• Wealth taxes are controversial. They are not a major source of revenue and little is known about the incentive effects or incidence of these taxes

21-24