Slide 1 - ESRI

							THE CHALLENGE OF TAX REFORM AND EXPANDING THE TAX BASE
Geary Lecture - ESRI James Poterba, MIT & NBER 28 May 2009
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THE REVENUE IMPERATIVE
• Near-Term Government Deficit > 10% of GDP • Goal of Sharp Deficit Reduction by 2013 • Upcoming Report of Commission on Taxation • Only Two Ways to Raise Revenue: Raise Rates or Broaden Tax Base
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BASE BROADENING vs. RATE RAISING
• Efficiency Cost of Taxation Rises With Square of Tax Rate • Taxpayer Behavior Responds to Changes in Marginal Tax Rates • Eternal Trade-Off: Distribution vs. Efficiency

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TAX EXPENDITURES
• Deductions or Credits that Narrow the Tax Base • Omissions from Tax Base • Often Could be Replaced with Government Expenditure Program • Sometimes Criticized as “Camouflaged” Expenditure
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EXAMPLE TAX EXPENDITURES
• Mortgage Interest Relief
o U.S.: No Limit on Duration of Relief; Loan May Not Exceed $1,000,000 o Ireland: Loan Qualifies for Seven Years; Interest ceiling €10,000 FTB, €3,000 non-FTB; Allowable at 15% non-FTB, 25-20% FTB

• Contributions to Retirement Saving Programs • Deduction for Health Insurance Premiums and Medical Costs
o U.S.: Health Insurance Untaxed, High Limit for Medical Deduction o Ireland: Insurance Costs Deducted at 20% Rate
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ESTIMATED COST OF TAX EXPENDITURES (2005)
• Total Income Tax Revenue: €11340 Million • Medical Insurance Relief: €230 M • Loans Related to Principal Private Residence: €280M • Supplementary Pension Provisions: €2900 M (for 2006)
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DISTRIBUTION OF INCOME TAX BURDENS: IRELAND & U.S.
• Ireland: Top 6.5% of Income Earners Pay 50% of Income Tax • U.S.: Top 4% Pay 50% of Income Tax • Ireland: Top 20% of Taxpayers Pay 77% of Income Tax • U.S.: Top 20% of Taxpayers Pay 84% of Income Tax (71%, Income & Payroll Tax) • Tax Expenditures are Also Concentrated
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U.S. PRESIDENT’S ADVISORY PANEL ON TAX REFORM – 2005
• Charge: Recommendations to make individual and corporate income taxes simpler, fairer, and more pro-growth • Recognize importance of homeownership and charity in American society • Propose revenue neutral options at least one of which preserves the income tax

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THE PANEL’S RECOMMENDATIONS
• Repeal the Individual & Corporate AMT • Two Reform Proposals:
o Simplified Income Tax o Growth and Investment Tax

• Proposals Have Received Almost No Serious Discussion

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TAX EXPENDITURE ANALYSIS: TAX PANEL REPORT
• Concerns about Equity of Current Deductions • Identified Limited Analysis of Costs vs. Benefits for Most Tax Expenditures • Efficiency Question: Which Households are Best at Supporting the Targeted Areas (Charity Example) • Interest Group Opposition to Modifying Existing Tax Expenditures
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REFORMING TAX TREATMENT OF HEALTH INSURANCE (U.S.)
• Appeal: High-Income Households Face Full Cost of Health Insurance Purchase • Distribution of Benefits Shifts Away from HighIncome Group • Disadvantage: Higher Taxes on Some Groups • Reduction in Private Insurance Coverage: Treasury estimates increase in number of insured by approximately 1.6 million people

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TAX RATES AND TAXPAYER BEHAVIOR
• Documenting Responses is Essential to Measuring Tax Distortions • To Avoid Placing High Tax Rates on Highly Responsive Behaviors, Empirical Work Must Identify These Activities

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INGREDIENTS FOR MEASURING RESPONSES
• Economically Meaningful Variation in Tax Rates
o Variation Across Households or Firms o Variation Over Time o Gold Standard: Variation Across Time for Same Households or Firms

• Exogenous Tax Variation • Reliable Measures, Aggregate or Disaggregate, of Household or Firm Activity

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ILLUSTRATIONS OF TAXPAYER RESPONSIVENESS
• • • • Labor Supply Taxable Income Capital Gain Realizations Corporate Dividend Policy Rates

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LABOR SUPPLY AND TAXES
• Theory is Ambiguous on Effect of Taxes • Labor Supply is Difficult to Measure; Hours May Not Capture Key Responses • Two Reforms Provide Useful Evidence:
o Tax Reform Act of 1986 in US (TRA86) o Swedish Income Tax Reform of 1989

• Irish Evidence: Participation Effects, Hours Effects, Migration Effects
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LARGEST CHANGES IN AFTERTAX WAGE: w*(1-τ)
• • • • • • • • Sweden 1990-91: 24.6% Increase U.S. 1941-42: 8.8% Decrease Sweden 1989-90: 6.9% Increase U.S. 1940-41: 6.2% Decrease U.S. 1947-48: 6.1% Increase U.S. 1943-44: 5.4% Decrease U.S. 1986-87: 4.8% Increase Decreases Ahead?
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LABOR FORCE PARTICIPATION OF MARRIED WOMEN, PRE- & POST-TRA86 (EISSA STUDY)
Pre-TRA86 PostTRA86 Difference

High Income Husbands Not-soHigh Income Husbands

46.4%

55.4%

9.0%

68.7%

74.0%

5.3%

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LABOR SUPPLY RESPONSE TO SWEDISH TAX REFORM 1989-90
• Compare Earned Income For Same Households in 1994 and 1989 • Control for Business Cycle, Region of Country, Place in Income Distribution • Elasticity of Labor Earnings With Respect to Marginal “Keep Ratio” (1-t): 0.36 to 0.39 • Implication: Reducing Marginal Tax Rates Raises Labor Income
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CAPITAL GAINS TAXATION AND GAIN REALIZATION
• One of the Most Elastic of Potential Behaviors • TRA86: Pre-Announced Tax Rate Increase on Long-Term Gains from 20 to 28 Percent • Differential Tax Burden on Short-Term and Long-Term Gains (Short Term Taxed at Higher Rates): Encourages Holding Gains Until Qualify as Long-Term
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HISTORICAL CAPITAL GAIN REALIZATIONS, 1965-1994

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EMPIRICAL EVIDENCE ON REALIZATION PATTERNS
• Cross-Section of Tax Returns: Realizations and Tax Rates Negatively Correlated • Is This Selective Timing? • Panel Data on Asset Sales and Tax Rates: PERMANENT Tax Rate Variation Has Much Smaller Effect than TRANSITORY Change in Tax Rate • Burman-Randolph Study: Permanent Elasticity 0.18, Transitory Elasticity -6.42. • Differences Across Households in Elasticities?
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PROMOTING EFFICIENCY
• Low Rates Applied to Broad Base • Substantial Growth Penalty from Taxing Capital Income • Avoid Distortions Across Sectors:
o o o o Housing vs. Other Assets Debt vs. Equity Dividends vs. Capital Gains VAT on Different Goods

• Equity-Efficiency Tradeoff: High Income Households Receive Most Capital Income
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DISTRIBUTING TAX BURDENS FAIRLY
• Adam Smith: “the subjects … ought to contribute … in proportion to their respective abilities.” • Defining Fairness is Difficult – Ultimately Political Factors Determine What is Feasible • U.S. Tax Panel, 1986 Reform: “Distribution Neutrality”
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TRANSITION RELIEF
• Avoid Short-term Disruptions • Recognize Actions that Impose Unfair Burdens on Some Taxpayers, For Example by Offering Relief for Existing Debt Contracts and Depreciation on “Old” Assets • Tradeoff: Generous Transition Relief Reduces Efficiency Gains
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WHAT ROLE FOR TAXING CARBON EMISSIONS?
• Transition Relief is a Central Concern • Challenge: Offsetting Distributional Impacts • U.S. Policy Debate: How Much Potential Revenue Will Be Given Away as “Grandfathering Provisions?”

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WAYS TO MONITOR TAX EXPENDITURES
• Encourage Routine Oversight – Cost Benefit Analysis of Every Provision Each Five Years? • Review Tax Base: Housing Example • Sunset Provisions for Deductions & Credits • “PAYGO” For New Tax Expenditures – Same Basis as Spending Programs
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