May 16, 2009
Taxation by Joseph J. Minarik
Article From Library of Economics:
In recent years, taxation has been one of the most prominent and controversial topics in economic policy. Taxation has been a principal issue in every presidential election since 1980—with a large tax cut as a winning issue in 1980, a pledge of “Read my lips: no new taxes” in the 1988 campaign, and a statement that “It’s your money” providing an enduring image of the 2000 campaign. Taxation was also the subject of major, and largely inconsistent, policy changes. It remains a source of ongoing debate.
Economists specializing in public finance have long enumerated four objectives of tax policy: simplicity, efficiency, fairness, and revenue sufficiency. While these objectives are widely accepted, they often conflict, and different economists have different views of the appropriate balance among them.
Simplicity means that compliance by the taxpayer and enforcement by the revenue authorities should be as easy as possible. Further, the ultimate tax liability should be certain. A tax whose amount is easily manipulated through decisions in the private marketplace (by investing in “tax shelters,” for example) can cause tremendous complexity for taxpayers, who attempt to reduce what they owe, and for revenue authorities, who attempt to maintain government receipts.
Efficiency means that taxation interferes as little as possible in the choices people make in the private marketplace. The tax law should not induce a businessman to invest in real estate instead of research and development—or vice versa. Further, tax policy should, as little as possible, discourage work or investment, as opposed to leisure or consumption. Issues of efficiency arise from the fact that taxes always affect behavior. Taxing an activity (such as earning a living) is similar to a price increase. With the tax in place, people will typically buy less of a good—or partake in less of an activity—than they would in the absence of the tax.
The most efficient tax system possible is one that few low-income people would want. That superefficient tax is a head tax, by which all individuals are taxed the same amount, regardless of income or any other individual characteristics. A head tax would not reduce the incentive to work, save, or invest. The problem with such a tax, however, is that it would take the same amount from a high-income person as from a low-income person. It could even take the entire income of low-income people. And even a head tax would distort people’s choices somewhat, by giving them an incentive to have fewer children, to live and work in the underground economy, or even to emigrate.
Within the realm of what is practical, the goal of efficiency is to minimize the ways in which taxes affect people’s choices. A major philosophical issue among economists is whether tax policy should purposefully deviate from efficiency in order to encourage taxpayers to pursue positive economic objectives (such as saving) or to avoid harmful economic activities (such as smoking). Most economists would accept some role for taxation in so steering economic choices, but economists disagree on two important points: how well policymakers can presume to know which objectives we should pursue (e.g., is discouraging smoking an infringement on personal freedom?), and the extent of our ability to influence taxpayer choices without unwanted side effects (e.g., will tax breaks for saving merely reward those with the most discretionary income for actually saving little more than they would without a tax break?).
Fairness, to most people, requires that equally situated taxpayers pay equal taxes (“horizontal equity”) and that better-off taxpayers pay more tax (“vertical equity”). Although these objectives seem clear enough, fairness is very much in the eye of the beholder. There is little agreement over how to judge whether two taxpayers are equally situated. For example, one taxpayer might receive income from working while another receives the same income from inherited wealth. And even if one taxpayer is clearly better off than another, there is little agreement about how much more the better-off person should pay. Most people believe that fairness dictates that taxes be “progressive,” meaning that higher-income taxpayers pay not only more, but also proportionately more. However, a significant minority takes the position that tax rates should be flat, with everyone paying the same proportion of their taxable income. Moreover, the idea of vertical equity (i.e., the “proper” amount of progressivity) often directly contradicts another notion of fairness, the “benefit principle.” According to this principle, those who benefit more from the operations of government should pay more tax.
Revenue sufficiency might seem a fairly obvious criterion of tax policy. Yet the federal government’s budget has gone from enormous deficit to large surplus, and back again, in just ten years. Part of the reason for the deficit is that revenue sufficiency may conflict with efficiency and fairness. Economists who believe that income taxes strongly reduce incentives to work or save, and economists who believe that typical families already are unfairly burdened by heavy taxes, might resist tax increases that would move the federal budget toward balance.
Likewise, other objectives of tax policy conflict with one another. High tax rates for upper-income households are inefficient but are judged by some to make the tax system fairer. Intricate legal provisions to prevent tax sheltering—and thus make taxes fairer—would also make the tax code more complex. Such conflicts among policy objectives are a constant constraint on the making of tax policy.
The U.S. Tax System
At the federal level, total tax collections have hovered in a fairly narrow range around 19 percent of the gross domestic product (GDP) since the end of the Korean War, though the percentage was down sharply in 2003 (see Table 1). The individual income tax has provided just under half of that revenue over the entire period. The corporation income tax was the source of almost a third of total revenue at the beginning of the period, but it has declined dramatically to under 10 percent today. In mirror image, the payroll tax for Social Security began at just under 10 percent of total revenue but increased sharply to about 40 percent as the elderly population and inflation-adjusted Social Security benefits grew and as the Medicare program was added to the system. The relative contribution of excise taxes (primarily on alcohol, tobacco, gasoline, and telephone services) has declined significantly.
One little-recognized aspect of the development of federal taxes is the gradual decline of revenues other than those earmarked for the Social Security and Medicare programs. Although total federal taxes are a roughly constant percentage of GDP, the Social Security payroll tax has increased significantly while other taxes have been cut in approximately equal measure. The result has been that federal revenues available for programs other than Social Security and Medicare have been squeezed from almost 17 percent of GDP in 1954 to as little as 10 percent in 2003.
States rely primarily on sales taxes, but income taxes are becoming increasingly important. Local governments rely most heavily on property taxes. Contrary to what many believe, any explosion in taxation has been at the state and local levels. Unlike federal taxes, state and local taxes have increased substantially—from about 6 percent of GDP in 1954 to 9 percent in 2002 (see Table 2).
Thus, although the level of federal taxes has been relatively constant for nearly thirty years, total taxes have increased because state and local taxes have increased. (The data in Tables 1 and 2 are computed on different accounting years and procedures, and thus cannot be added together; the general picture they suggest is, however, accurate.) The increase in state and local taxes has added to the taxpayers’ burden and has limited the federal government’s ability to cut the federal deficit and to increase spending. It is true, though, that the federal government requires state and local governments to provide various government services.
Table 1 Federal Tax Revenues by Type of Tax, Percentages of GDP for Selected Fiscal Years
Year Individual Income Corporate Income Social Security Excise Other Total
1954 7.8 5.6 1.9 2.6 0.5 18.5
1959 7.5 3.5 2.4 2.2 0.6 16.2
1964 7.6 3.7 3.4 2.1 0.7 17.6
1969 9.2 3.9 4.1 1.6 0.9 19.7
1974 8.3 2.7 5.2 1.2 1.0 18.3
1979 8.7 2.6 5.6 0.7 0.9 18.5
1984 7.8 1.5 6.2 1.0 0.9 17.3
1989 8.3 1.9 6.7 0.6 0.9 18.3
1994 7.8 2.0 6.6 0.8 0.8 18.1
1999 9.6 2.0 6.7 0.8 0.9 20.0
2003 7.3 1.2 6.6 0.6 0.7 16.5
Source: Office of Management and Budget.
Table 2 State and Local Tax Revenues by Type of Tax, Percentages of GDP
Year Individual Income Corporate Income Property Sales Other Total
1954 0.3 0.2 2.5 1.7 1.1 5.8
1959 0.4 0.2 2.9 2.2 0.9 6.7
1964 0.6 0.3 3.3 2.5 0.9 7.5
1969 1.0 0.4 3.3 2.9 0.8 8.4
1974 1.4 0.4 3.3 3.2 0.8 9.1
1979 1.5 0.5 2.5 3.0 0.7 8.3
1984 1.7 0.5 2.5 3.1 0.8 8.6
1989 1.9 0.4 2.7 3.1 0.7 8.9
1994 1.9 0.4 2.8 3.3 0.7 9.1
1999 2.1 0.4 2.6 3.3 0.7 9.1
2003 1.9 0.3 2.8 3.1 0.7 8.8
Source: Department of Commerce, Bureau of Economic Analysis.
Note: Data are not comparable to those in Table 1.
Recent Tax Policy Changes
Much of the recent interest in tax policy has focused on the federal individual and corporate income taxes. Advocates of “supply-side economics” (most prominently, Arthur Laffer) believed that income taxes had severely blunted incentives to work, save, and invest and that the income tax burden had become excessive. Congress passed substantial income tax cuts in 1981, 2001, and 2003, which provided for substantial cuts in income tax rates along with significant tax inducements for business investment. In the face of a rapidly rising budget deficit, some of the 1981 tax cuts were partially repealed in 1982, 1990, and 1993.
An even more radical tax restructuring was passed in 1986. This law, like the 1981 law, also significantly reduced income tax rates. It was, however, radically different from the 1981 tax cuts in a more meaningful sense, in that all of the tax rate cuts were “paid for” by the elimination of tax incentives—including the remaining business investment inducements from 1981. While this tax “reform” simplified the tax law in some respects, it also included complicated provisions designed to prevent tax sheltering and provided significant tax relief for low-income taxpayers, especially families with children.
Tax scholars observed the experience of the 1980s closely to learn more about how taxes affect economic choices. While much controversy remains, certain results seem clear. First, as many economists expected, the two reductions of tax rates over the 1980s apparently did induce greater work effort, especially by married women. In 1988, according to Brookings Institute economists Barry Bosworth and Gary Burtless, men between the ages of twenty-five and sixty-four worked 5.2 percent more hours than they would have under the pre-1981 tax code; women aged twenty-five to sixty-four worked 5.8 percent more; and married women worked 8.8 percent more. These increased hours would translate into the equivalent of almost five million full-time jobs.
Second, household saving fell in the face of tax rate cuts and substantial targeted tax incentives for saving, strongly suggesting that taxes have a limited impact, at best, on saving. Studies by economists Steven F. Venti and David Wise (1987) suggest that individual retirement accounts (IRAs) were successful in encouraging new saving, but a study by William G. Gale and John Karl Scholz (1994) indicates that much of the IRA deposits came from households that had already accumulated considerable wealth and could simply transfer it into the tax-favored accounts. Subsequent papers by James Poterba, Venti, and Wise (1996) and by Eric Engen, Gale, and Scholz (1996) reinforced these contrary positions, while more recent work by Orazio Attanasio and Thomas DeLeire (2002) found very little positive impact of IRAs on saving. And finally, while business investment did increase after the 1981–1982 recession (as documented by Harvard’s Martin S. Feldstein), other economists (notably Barry P. Bosworth of Brookings) argue that this increase came primarily in assets (such as computers) that were not highly favored by the tax law. In fact, investment in equipment increased to a record percentage of GDP in the 1990s after the incentives were repealed in the 1986 tax reform, though Alan Auerbach and Kevin Hassett (1991) argue that it would have increased even more strongly if investment incentives had been continued.
Distribution of the Tax Burden
Many economists judge the fairness of the tax system largely on how the tax burden is distributed among different income groups. Further, some economists use the distribution of the tax burden as a major criterion of the success or failure of the tax changes of recent years. Despite considerable effort and innovative methods, however, estimates of the distribution of the tax burden are still limited by imperfect data and the differing perspectives of investigators.
Economists with the Congressional Budget Office have attempted to measure what percentage of overall income is paid in federal taxes of all kinds by various income groups. They assumed that all the corporate income tax is borne by owners of business capital and that the employer’s share of the Social Security payroll tax is borne by workers, through lower wages. With these assumptions, they reached two important findings, both summarized in Table 3. First, the higher a family’s income, the higher the percentage of income that family pays in federal taxes. In other words, the federal tax system as a whole is highly progressive. Second, between 1980 and 2000, the percentage of income paid in federal taxes of all forms decreased for the 80 percent of families with the lowest incomes taken as a group, and increased for the 20 percent with the highest incomes (see Table 3). The increases were small, with no identified group paying as much as one percentage point of their income more. Likewise, the declines among lower-income households were no more than two percentage points of income. Since 2000, there have been substantial new tax cuts, providing relatively more relief for upper-income households.
Although upper-income families paid a larger percentage of their income in tax in 2000 than they did in 1980, they received a much larger share of total taxable income by the end of the period. One reason the taxable income of upper-income families is higher is that changes in the tax law, particularly in 1986, caused many upper-income families to reallocate their portfolios from nontaxable instruments like municipal bonds to assets that yield taxable income. But there also is evidence that the distribution of income simply became less equal. The net result is that upper-income families now pay a larger share of the total tax burden, but also have much higher after-tax incomes. So, for example, the 1 percent of households with the highest incomes paid 14.2 percent of all federal taxes in 1980 and 25.6 percent in 2000—and still saw their share of after-tax income more than double, from 7.7 percent in 1980 to 15.5 percent in 2000.
Table 3 Federal Taxes as a Percentage of Family Income, 1980 and 2000
Quintile of Families (Ranked by Income) 1980 2000 Change
Lowest 7.7 6.4 −1.3
Second 14.1 13.0 −1.1
Third 18.7 16.7 −2.0
Fourth 21.5 20.5 −1.0
Highest 27.3 28.0 0.7
Top 10 percent 29.0 29.7 0.7
Top 5 percent 30.8 31.1 0.3
Top 1 percent 34.6 33.2 −1.4
All 22.2 23.1 0.9
Source: Congressional Budget Office.
Current Tax Issues
Tax policy remains controversial, and some economists continue to argue for large-scale revision of the federal tax system. Princeton’s David F. Bradford and Stanford’s Robert E. Hall have advocated slightly different forms of a flat-rate tax on labor income coupled with immediate deduction (“expensing”) of the cost of all investment for the corporate income tax. Some conservative economists, such as Charles E. McLure Jr., and some liberal ones, such as Alice M. Rivlin, argue for a broad-based federal tax on consumption, like the sales taxes imposed by the states or the value-added tax (VAT) widely used in Europe. A key issue to consumption-tax advocates is how the proceeds of the tax would be used. Some would insist that the money go to increase federal spending; some would demand that it be used to cut federal income taxes; and some would require that it reduce the deficit. Advocates argue that a tax on consumption would encourage saving; opponents claim that such a tax would unfairly burden low-income families.
In past years, some economists, including Princeton’s Alan Blinder, argued that the income tax should provide a comprehensive adjustment (“indexation”) for inflation to eliminate the inflationary mismeasurement of interest income and expense, depreciation of business investment, and capital gains. A few economists would maintain that indexation should be pursued today. However, an adjustment for inflation would be quite complex; and with inflation as low as 2 percent now, and with little short-term prospect of a substantial increase in inflation, many economists contend that the costs in complexity would exceed the benefits in precise measurement of income.
Some economists, including Martin S. Feldstein and R. Glenn Hubbard, argue for targeted tax cuts for capital gains (the profit from the sale of assets such as corporate stock or real estate) and dividends paid on corporate stock (to reduce or eliminate the so-called double tax on dividends, in which profits are taxed under the corporate income tax and then again when distributed to shareholders as dividends). Such initiatives are typically claimed to add to fairness (through attenuating “double taxation”) and to increase economic growth. Opponents, such as Brookings’s Henry J. Aaron, believe that they would be ineffective and would unduly benefit upper-income groups, who own the most capital assets and have the most discretionary income to save. The 2003 tax law cut the already reduced tax rates on capital gains and established similar reduced individual income tax rates for corporate dividend income. Because these provisions were both controversial and temporary, they will remain the subject of debate. Likewise, the general tax rate cuts enacted in 2001 and accelerated in 2003 remain temporary, expiring at the end of 2010.
Other, more conservative economists advocate greater incentives for household saving, such as allowing withdrawals of nondeductible deposits into designated savings accounts to be tax free. Advocates, such as Eric M. Engen, argue that greater freedom with respect to withdrawals from tax-favored savings accounts would encourage even people with modest incomes, who cannot risk “locking up” their limited funds until retirement, to save. Opponents, including Leonard E. Burman, William G. Gale, and Peter R. Orszag, fear that wealthy people would be able to shield past savings from taxation in perpetuity, thus increasing the federal deficit without undertaking any new saving.
The estate tax will be phased down until it is totally eliminated in 2010, only to return under its pre-2001 configuration in 2011. This provision has proved particularly controversial. Advocates of repeal, such as Council of Economic Advisers Chair N. Gregory Mankiw, argue that the estate tax, whose highest pre-2001 rate, at 55 percent, was significantly higher than the income tax, constituted double taxation and both discouraged effort and increased consumption on the part of older wealthy people. Advocates contend that successful small businesses and farms could be forced to shut down because of insufficient liquidity to pay the tax. Opponents, including William G. Gale, argue that efficiency concerns about the estate tax, whose exemptions were already so high as to excuse 98 percent of all decedents from any tax, were exaggerated. They maintain that much accumulated wealth (such as unrealized capital gains) might not be taxed at all upon death, that policies were already in place to postpone tax for estates with small businesses or farms that might have liquidity problems, and that the new law’s phase-down, repeal, and reinstatement of the estate tax would make sound financial planning virtually impossible.
With taxpayers enjoying tax reductions today that are scheduled to fade away entirely in 2011—and with a sizable and possibly enduring budget deficit—these tax issues will surely remain prominent in the public-policy debate.