Tax reformState and local governments

Today: Some ideas on how to reform taxes; How do state and local governments affect behavior?

Today

More topics that affect behavior Can taxes be reformed so as not to distort

behavior as much? How do state and local governments affect

everyday lives?

Tax reform

Economic waste due to taxation is estimated to be as much as $1 trillion per year Note that $1 trillion is about 8% of annual GDP

How can this be changed?

Tax reform

Current tax codes seriously distort behavior People work less (labor tax) Sub-optimal investment decisions (lock-in effects

due to the capital gains tax) Some people advocate a tax system that

reduces waste

What about a consumption tax? Taxes on consumption have some appeal

Vary tax rates based on externalities Encourage consumption of goods and services with

positive externalities Discourage consumption with negative externalities

Progressiveness issue is probably not justified Lifetime sales taxes paid (as a % of lifetime income) is

about the same for each income bracket Easy to administrate International competitiveness could increase for

the US

What about a consumption tax? Some negative aspects of a consumption tax

Confusion about how much each good should be taxed Example: The “snack tax” in California

Taxed: Wrapped slices of pie Not taxed: A slice of pie served on a plate

Tax evasion due to smuggling and underground economies What happens when you change the tax system?

Those that saved over the years get increased tax burden Those that borrowed over the years get decreased tax burden

What are some ways to tax consumption? National retail sales tax

To replace federal taxes, a federal retail tax of about 35% would be required

Problem: Tax evasion could become a serious problem once the sales tax rate exceeds 10% Many states already have a sales tax about 6-8%

What are some ways to tax consumption? Value-added tax (VAT)

Popular in Europe Mostly consumption-based Capital investments are not part of the taxable base

Involves taxing the additional value at each stage of production

See Figure 21.2, p. 487

Problems with consumption taxes Distortions still occur Consumption taxes will not solve all of the

trade problems in the US Household labor is still sheltered from

taxation

Summary: Tax reform

Many people would like to see more consumption taxation and less labor taxation

Substantial evasion of a national retail sales tax would be possible if the tax completely offset personal income taxes

A value-added tax has appeal, but has its own disadvantages

State and local governments State and local governments are playing a

bigger role in taxation 1960: 12.2% of state tax collections were from

individual income taxes 2002: 35%

Marginal income tax rates are still small compared to federal government Highest bracket in 2006: Vermont (9.5%) California not far behind: Highest bracket is 9.3%

Single taxable earnings above $44,814 in 2007

Centralization in the US

Centralization Centralization ratio =

Central government expendituresTotal government expenditures

In the US, the centralization ratio is less than one-half

State and local governments

How do people alter their behavior based on state and local governments? The Tiebout model

Vote with your feet within your home country Public education Property taxes Grants between different levels of government

The Tiebout model

People rarely leave the US due to government policy

Mobility in the US due to government policy is substantial

Tiebout makes many assumptions in his model Not a perfect description of the real world Gives a good idea of how people decide what

community to live in

Tiebout’s assumptions

Government activities generate no externalities Individuals are completely mobile People have perfect information with respect to each

community’s public services and taxes There are enough different communities so that each

individual can find one with public services meeting her demands

The cost per unit of public services is constant so that if the quantity of public services doubles, the total cost also doubles

Public services are financed by a proportional property tax Communities can enact exclusionary zoning laws—statutes

that prohibit certain uses of land

Advantages with the Tiebout model Tailoring outputs to local taxes

Each person or family lives in a community they like One size does not fit all Tastes and preferences differ from person to person

Fostering intergovernmental competition People in government generally want people to

live in their community

Advantages with the Tiebout model Experimentation and innovation in locally

provided goods and services States and cities can try new programs These studies often result in quasi-experimental

studies by economists The analyzed results lead to good information for

governments throughout the nation

Efficiency issues with the Tiebout model Externalities

Both negative and positive Many public goods are not at the local level

Scale economies in provision of public goods Per-person cost often decreases as the number of

users increases Inefficient tax systems

Different states and cities often compete to get large businesses to locate in their area

Scale economies in tax collection

Public education

For families, voting with their feet often involves finding a good elementary and secondary education for their children You often must live within a certain area to be

able to go to a particular school

Recall: Quality of public education Quality of education is hard to quantify Besides the obvious aspects of class size

and total spending, there are different criteria that affect education Unionization of teachers Parents’ choices of their kids’ curriculum Size of school School-sponsored sports and activities

What about low-income areas? Local governments typically raise money for

education through property taxes Many families with lower incomes would not want as

much spent on schooling Additional K-12 funding provided by the Department of

Education Money helps to “level the playing field” About $20 billion in 2003 to special education and

“disadvantaged” California and some other states also provide district power

equalization grants to “level the playing field”

Property taxes

Property taxes are based on an assessed value Assessed value is the value assigned to a piece

of land or property for tax purposes How does a land tax affect behavior?

See Figure 22.2, p. 522 Effective rate depends on the assessed value

relative to the actual value of the property Example: Proposition 13 (Prop 13) in California

Prop 13

In June 1978, California voters limited the amount that the assessed value could go up, as long as ownership did not change Prop 13 also required a 2/3 majority for additional

state and local property taxes Why?

When housing prices go up significantly, some owners were forced out of their homes since they could no longer afford the property tax

What about structures?

Land taxes are capitalized in the price of land Recall Chapter 14, p. 320

Property taxes typically tax both land and structures How does a tax on structures affect behavior?

Example with perfectly elastic supply curve for structures See Figure 22.3, p. 523

Final topic: Intergovernmental grants Matching grants from a state or the federal

government has become commonplace Requires cost sharing between different levels of

government How is behavior affecting by nonmatching grants?

See Figure 22.6, p. 533 …matching grants?

See Figures 22.4 and 22.5, p. 530 and 532, respectively

Summary: State and local governments The Tiebout model predicts that people “vote with

their feet” within their home country Public education is extensively financed through the

state and local levels of government Property taxes provide much of the funding for public

education Prop 13 has limited the ability to tax property in CA

Grants from the federal government are used to encourage certain projects within states and cities