Consistent Tax Bases for Broad-Based Reform
By Fiscal Associates, Inc.
Draft, September 2011
Interest in far-reaching tax reform will begin again as the nation confronts financing entitlement growth. There will be a need to simplify the tax system and to promote increased saving, investment, and growth. Tax reform fever will intensify during the 2012 Presidential election cycle because many contenders and others will be proposing some combination of spending cuts and tax changes to close future deficits.
Simply cutting spending and raising taxes is unlikely to succeed. As taxes are raised, growth will necessarily slow as the economy adjusts to a lower level of output. Lower output will mean lower tax revenues, setting off yet another round of spending cuts and tax increases. This vicious cycle will only end if the tax system becomes more efficient and growth-oriented.
If the past is any guide, proponents of various tax reform plans will jostle over which plan is fairer, flatter, or simpler. Often forgotten is that the first real hurdle in any tax reform debate is whether a plan meets the “scoring test”. If not deemed "revenue neutral", that is, able to replace what the current tax systembrings in, any tax reform plan faces the virtually insurmountable obstacle of appearing to exacerbate the budget deficit problem.
The revenue effects of a tax reform proposal depend on its tax base. The tax base sets out which sectors of the economy will be taxed, which activities within those sectors will be subject to the tax, and how much revenue will be generated by a tax on those activities. The tax base thus measures the amount of income that will be subject to the tax. From the tax base one can determine a tax rate that will be revenue neutral.
This paper computes the tax bases for the following three tax reform proposals: a business transactions tax; a comprehensive factor income tax (flat personal income tax); an expanded retail sales tax (Fair Tax). In this paper, we find the revenue neutral tax rate, assuming no growth effects, and assuming no exemptions, deductions or credits. Recognizing that relief for low income taxpayers will inevitably be part of any tax reform, we also estimate tax rates assuming that each plan will provide a refundable credit equal to the tax rate times the poverty level. (This amounts to subtracting the identical amount from each tentative tax base.) Finally, we will combine the three bases to examine four hybrid proposals that split the rate between each of the combined bases. Specifically we will examine a variant of the Laffer/Moore Tax that combines the business transactions tax and a flat personal income tax and a plan that combines all three bases.
The major tax reform proposals have at least two significant goals: (1) to simplify the tax system and (2) to promote U.S. saving, investment and growth. They also seek to replace the existing federal personal and corporate income taxes, estate and gift taxes, and payroll taxes.
With the public policy emphasis on balancing the budget, any proposal will have to demonstrate how much revenue it will raise compared to the current federal income tax system. If a proposal comes up short on revenue, either the proposal will have to be altered or government spending will have to be reduced.
Official revenue estimates are done on a static basis. Government forecasters first project a baseline of total economic activity over the next five to ten years. Revenue implications of proposed changes are then evaluated against that same baseline. In other words, a static forecast would not take into account any growth effects that might occur if a new tax system were implemented. (Government estimators reject the notion that their analysis is static, indicating that they make second-order adjustments while holding only total output constant. Despite protestations, output remains unchanged, that is, static.)
Static revenue forecasts will thus play a key role during the tax reform debate. They will be used to assess whether the tax rates are too high or too low, or whether the tax base needs to be broadened. In short, official static forecasts will shape the final form of any tax reform bill that might emerge from Congress.
This study provides a baseline for the tax bases that can be used to estimate revenues on a static basis for major tax reform proposals. The next section describes the national income and product accounts from which any tax base must be derived. Special attention is given to the imputation items, which are part of the accounts, including how they arise and whether or not they can be taxed.
The third section discusses the characteristics of each proposal including neutrality, static tax bases, and implied tax rates. The last section contains a summary and conclusions.
II. National Income and Product Accounts
All taxes must be paid out of current income. For instance, the corporate income tax is not a tax on corporations per se. Rather it is a tax on the income that would otherwise go to the shareholders who own the company. Similarly, property taxes, although nominally levied against physical assets, ultimately must be paid out of the income produced by those assets. Finally a “consumption tax” is not paid on goods and services but rather out of the income used to purchase those items. In sum, taxes on people, businesses, goods and assets are actually taxes on the income generated through current production.
To understand the tax base for any proposal, one must first understand how income arises. To do that we turn to a concept taught in introductory macroeconomics – basic national income and product accounting.
Any analysis of tax bases must start with the total amount of goods and services a nation produces, or its gross domestic product (GDP). There are several ways to view GDP. One is from the standpoint of what is produced, another is in terms of the legal form of the producer, and yet another is who produces it.
GDP as Output
Total GDP is the maximum size of the tax base available for any tax reform proposal. The Commerce Department valued the goods and services produced by the U.S. economy at $ 14.4 trillion in 2008.
The total output of the U.S. economy can be divided into the following four broad categories:
3. Government; and
4. The foreign sector.
As Table 1a reports, 70.3 percent of output went into goods and services for personal consumption in 2010. The next largest category was purchases of goods and services by government (20.0%) followed by private investment (14.6%). The foreign sector exerted a negative influence because the U.S. imported more than it exported (-4.9%).
Part of GDP does not arise through market transactions. The Commerce Department imputes the extent to which GDP would be higher if certain unmeasured activities were included. As Table 1b shows, the largest imputation is for the gross return to non-business capital which is comprised of owner-occupied residential structures and capital owned by nonprofit institutions (8.8%). Other imputations include the return to capital owned by general government, small amounts for farm products consumed on farms, and assumed mark-ups on owner-built housing. Because none are likely to be taxed under any system, they must be removed from the accounts used to construct tax bases. The imputation for the return to capital owned by government enterprises amounts to an accounting adjustment that reduces surpluses (profits) of these enterprises and puts them on a closer basis to private enterprise profits.
In the course of imputing non-business capital income, Commerce reclassifies the purchases of homes and the capital of nonprofits from consumption to investment. For our purposes, to measure the investment purchases made by businesses, this reclassification must be reversed. As Table 1c shows, removing the imputed items and reclassifying investment reduces total GDP from $14,396 billion to $12,966 billion, or about 9.8 percent. The biggest change is the 25 percent reduction in investment from $2,097 billion to $1,576 billion.
Commerce also rearranges interest payments made by consumers and received by depositors to measure the ancillary services they receive. Financial institutions channel funds from depositors to borrowers. In conducting these intermediation activities, institutions produce services for both parties. Part of the difference between the interest received on loans and the interest paid to depositors is used to pay for these included services. The imputation estimates the “consumption” of services which financial intermediaries furnish to persons without payment. The rate differential pays for the capital and labor services needed to produce the “free” services and, therefore, shows up as income. Because the consumption element does not appear as a market transaction, however, it will be difficult to tax directly as consumption. This will become important as we consider the retail sales tax that attempts to tax all personal consumption.
Finally, fringe benefits paid by employers count as part of personal consumption even though they are not directly purchased by individuals. These employer-related purchases amounted to $581 billion (4.5% of GDP) in 2008. Employer contributions for health and life insurance accounted for over 96 percent of these purchases. These expenditures must be specifically accounted for in the design of a retail sales tax or as much as 7 percent of the tax base could disappear. In this case the payments made by the employer must be deemed to have been paid by the employee to conform to taxing the purchases of individuals
GDP by Legal Form of Producer
Many tax proposals make distinctions in treatment based on different sectors of the economy. The proposals examined in this paper tax only business or only individuals or a combination of both. We will need to know GDP by the legal form of the producer because some sectors of the economy are not fully taxed. For example, as discussed above, it is unlikely that any reform proposal will levy a tax on the output of owner-occupied housing and tax-exempt institutional capital. As Table 2 shows, measured as rental value, the output of households and institutions makes up 5.1 percent of GDP without imputations. Taxing GDP originating in the general government sector presents similar problems.
General government services compose another 11.1 percent of GDP. While wages are taxed, income from capital is not and Commerce attributes no business income this sector. Similarly, Commerce measures the profits earned by government enterprises, such as the U.S. Postal Service, the Federal Housing Administration and the Tennessee Valley Authority, as surpluses, which again are not linked to capital income and would not be taxed.
That leaves the private business sector, which accounted for 82.4 percent of GDP in 2010, as the sole component of the business tax base and the major source of the labor tax base.
GDP by Factor Income
Another way to view GDP is in terms of the payments to the factors – capital and labor – that produce it. The total value of output is returned to the factors of production as payment for their services in the form of wages, profits, rents, recovery of capital, and so forth.
Factor payments are important from an accounting viewpoint because they are most closely aligned with what people normally think of as income. Table 3 reports that gross factor payments – the value of GDP less indirect business taxes plus subsidies – totaled $13.8 trillion in 2008. Labor received the largest share (56.1%) with gross capital income receiving the rest. Removing imputations increases labor’s share to 62.2 percent.
Not all factor payments flow back to individuals. For example, the employer portions of Social Security, Medicare and unemployment taxes go directly to government, as do indirect business taxes such as sales and property taxes. Factor payments that do flow back to people show up in the national accounts as personal income. As Table 4 shows, personal income in 2008 was $12.4 trillion, or 86 percent of GDP. The largest categories were wages and salaries (65.1%), transfer payments primarily from government (15.2%), and income from interest and dividends (17.0%).
Personal income, for the most part, is spent, saved or used to pay taxes and interest. Contributions for government social insurance are actually payroll taxes and personal current transfer payments are estate and gift taxes. In 2008, 81.5 percent of personal income went for consumption and 19.6 percent went for personal taxes (income, government social insurance, and estate). Personal saving was 3.6 percent.
Federal Tax Receipts
Scoring tax reform proposals requires an estimate of federal tax receipts under current law. As Table 5 shows, federal taxes amounted to about $2.5 trillion or 17.4 percent of GDP in 2008.
The tax reform proposals under consideration contemplate replacing the personal and corporate income taxes, estate and gift taxes, customs duties, and employer contribution for social insurance. These taxes, which totaled $2.3 trillion in 2008, account for roughly 92 percent of federal receipts. Taxes left in place would be excise taxes and user fees.
III. Three Broad-Based Tax Systems
One purpose of tax reform is to produce a tax system that is more favorable to U.S. saving and investment. Private saving is currently higher than the prior decade to recoup lost asset values, and investment after depreciation has not begun to recover from the dramatic downturn in 2008 and 2009.
One reason for this slow recovery is the threat of future increases in tax burden on saving and investment. Today an extra dollar earned by private business capital in the U.S. pays more than 55 cents in federal, state and local taxes. This marginal tax on business capital is about a quarter higher than the 44 percent collected on labor income. Repealing the lower individual rates on dividends and capital gains enacted in 2003 would jump the effective capital tax to the range of 65 cents on the dollar – almost 50 percent higher than the labor tax rate.
The way to improve future growth is to remove the existing bias against saving and investment in the current federal tax system. This bias arises because the current system taxes income from saving and investment twice. Taxation first occurs when the income that is to be saved or invested is initially earned. A second round of taxation occurs when the return on saving or investment is again taxed.
For saving or investment to occur, someone must postpone consumption. Savers and investors demand a reward, or return, for putting off consumption into the future. Taxing both the initial saving (postponed consumption) and its reward favors current consumption over future consumption.
Removing the bias against saving and investment means that income should be taxed only once. The two general ways this can be done are:
The three proposals under consideration are variations on the following three broad-based tax reforms:
If the initial saving or investment is made with aftertax dollars, the return on that saving and investment should not be taxed, referred to as Principle 1.
If the initial saving or investment is made with pretax dollars, the return on that saving and investment should be taxed, referred to as Principle 2.
A. a business transactions tax;
B. a comprehensive factor income tax; and
C. an expanded retail sales tax.
Although all three attempt to tax saving and investment only once, each uses a different tax base.
For this analysis, we first derive the broadest tax base for each type of reform. In other words, we assume no exemptions, deductions or credits. Doing so determines the lowest, single rate possible for each type of reform.
Relief for lower income taxpayers will inevitably be part of any tax reform. To illustrate the effect that progressivity could have on tax rates, we will later derive the rates needed to allow a refundable exemption equal to the poverty level of income. This is the same as a refundable credit equal to the tax rate times the poverty level of income. This simplifies the estimation as the aggregate poverty amount is just subtracted from the gross tax base for each proposal.
Table 6 shows the poverty thresholds and number of families by size of family for selected years 2000 through 2010. The poverty grant is the sum of the threshold times the number of families for each family size group. For example, the average family would receive an exemption of $14,764 in 2008, reducing the tax base of each proposal by $2.0 trillion.
A business transactions tax would radically broaden the base for businesses. Each business would pay tax on gross receipts less payments to other businesses. Allowing the subtraction of payments for intermediate goods yields the value added by the company. Subtracting investment as well yields a subtraction method value-added tax.
A. Business Transactions Tax
In keeping with the basic value-added structure, the tax is treated as border adjustable. That is, the tax is on a territorial basis and applies only to sales in the U.S. rather than the worldwide treatment under the current tax system. This approach exempts exports while subjecting imports to the tax.
Government, households, and institutions would be treated as “businesses” for the purpose of the tax. The tax base for each would be the gross compensation paid to employees.
The business transactions tax is neutral between consumption and saving and follows Principle 2 from above. Businesses would save and invest with pretax dollars because any investment is subtracted from the tax base. They would, however, pay tax on the returns.
To estimate the tax rate, we first derive the tax base and revenues. Because the tax is border adjustable, the first step is to subtract net exports from GDP. As Table 7 shows, this increases the tax base by 4.9 percent because imports exceed exports. Subtracting the imputed items that can not be taxed reduces the base to 95.2 percent of GDP. Current surplus of government enterprises and Federal Reserve System profits returned to the Treasury are also removed from the base. Subtracting business domestic investment to eliminate the double taxation of capital income produces a business tax base equal to 83.5 percent of GDP in 2008.
Replacing the revenues from individual income, corporate income as well as estate and gift taxes would require an individual tax rate of 19.2 percent in 2008. We will deal with the issue of exemptions and underreporting in a later section.
B. Comprehensive Factor Income Tax
A comprehensive factor income tax is what people usually mean when they talk about the "flat tax". Popularized by Professors Robert Hall and Alvin Rabushka, individuals would pay tax on labor income and businesses would pay tax on capital income.
This tax is neutral between saving and consumption. For individuals, it follows Principle 1 described above. Income that is saved would be taxed, but the returns from that saving would be free of tax. As a result, individuals would pay tax on their wages and salaries.
For businesses, it follows Principle 2. The business tax base is gross income less new investment. In other words, the initial act of investment is free of tax while the returns are taxed. Wages and salaries, which are taxed at the individual level, would be deducted from the business tax base as would taxes on output such as sales and excise taxes.
Table 8 derives the factor income tax base and rate. The business tax base deducts taxes on production and imports from GDP as well as the same imputations used in the business transactions tax. Because labor income is taxed at the personal level, wages, pensions and profit-sharing are deducted from the business tax base along with the current surplus of government enterprises, Federal Reserve System profits returned to the Treasury, and gross business domestic investment. The final estimated business tax base is 25.7 percent of GDP in 2008.
The individual tax base would amount to $6.6 trillion – the amount of wages and salaries paid to workers in the economy. The comprehensive tax base for businesses and individuals would amount to more than $10.2 trillion in 2008. The required tax rate would be 22.5 percent.
C. Sales Tax
A retail sales tax would impose a transactions tax on the sale of goods and services used for consumption. Purchases by businesses would be exempt. Instead of individuals and businesses paying taxes via returns, revenue would be collected at the cash register. This means that goods produced for export will not appear in the base and imported goods will be added.
A sales tax achieves neutrality between saving and consumption under Principle 2. By taxing final sales, but not the intermediate stages of production, a sales tax exempts initial saving and investment from tax. The tax occurs only when savers, investors, or workers use the returns they receive from either labor or capital to consume goods and services.
The starting point of a retail sales tax would be personal consumption expenditures, shown in Table 9 as $10.1 trillion in 2008. If it were possible to tax the entire amount, replacing the $2,304 billion in current taxes would require a 22.8 percent rate.
Some items which the Commerce Department imputes as part of personal consumption do not show up at the cash register, however. Subtracting out imputations such as the value of owner-occupied housing, the rental value of buildings owned by nonprofit institutions, the output of the nonprofit and government sectors, and an underreporting adjustment, the final value of the retail sales tax base would be $8.1 trillion in 2008.
Replacing the revenues from our selected taxes would require a retail sales tax rate of 28.6 percent on an income-tax equivalent basis (not shown on table). This means that out of every dollar spent, 28.6 cents is tax.
A retail sales tax, however, is normally expressed as an add-on rate to the before-tax price of the item. An income-tax equivalent tax rate of 28.6 percent means the pretax price of the item is 71.4 cents. To generate 28.6 cents in tax revenue, the stated, or add-on, sales tax rate would have to be 40.0 percent.
Exempting certain categories of expenditures from the sales tax would drive the rate even higher. Food, often a prime candidate for exemption, accounts for 14 percent of personal consumption expenditures, and medical care makes up almost 17 percent. Leaving both out of the tax base could raise the sales tax rate by one-half.
A More Comprehensive Variant
A more comprehensive variant of the retail sales tax is the so-called “Fair Tax” that adds several special taxes to increase the tax base. Largest is a special tax on the compensation of general government employees and, in some cases, government investment purchases (not considered here). Also subject to tax is compensation in the institution sector and the untaxed services provided by the financial sector.
As the bottom of Table 9 shows, these additions would bring the base up to the same levels as the business transactions tax. The tax rate comparable to the others would be 21.3 percent, 27.1 percent when expressed as an add-on sales tax.
VI. Combining the Three Systems
At this point we should observe that the three tax bases are roughly the same size. This should not come as a surprise since the base of the business transactions tax is all production, the sales tax base is the sales of those same products, and the factor income tax base is the proceeds of those sales distributed to those who produced the products. Remembering the circular flow chart from our first economics course, we know that what is sold is produced and the producers are paid the proceeds of those sales.
The differences arise from the fact that the business transactions tax includes indirect business taxes that do not flow through to the factors of production and would not be part of the sales tax base. Secondly an adjustment for exports less imports would not be in the factor income base but would be included in the sale tax base. In other words we should expect the business transactions tax base to be the largest, followed by the comprehensive sales tax, with the factor income tax being the smallest.
As a practical matter the effective tax rate applied to the production of output must be the same as we are raising the identical revenue from all three systems. It may appear that the smaller rate under the business transaction tax would mean a smaller rate on capital and labor, the truth is that the smaller rate is “grossed-up” by the amount of indirect and payroll tax that imbedded in the cost of each unit produced.
There may be administrative consideration for combining two of the broad base systems. We will show the three possible combinations as well as the combination of all three bases. This expands our original three systems to seven possible systems. As outlined above we will need to estimate the economic impact of only one of the systems to provide a gauge of how any of the system will affect the economy.
Tables 10a through 10c recap the major plans and combinations with required rates for the tax reform proposals just discussed. Table 10a recaps the unadjusted bases and rates. Table 10b incorporates an adjustment for likely underreporting under each of the plans. Table 10c includes a flat poverty grant in each of the plans.
The business transactions tax would have the largest base at about 83.5 percent of GDP. Untaxed GDP consists mainly of investment and untaxable imputations. Because labor compensation is not deductible, the labor income of workers in private businesses would be taxed at the business level. Labor compensation in other sectors, such as government, would be collected at the employer level. Exempting exports and taxing imports expands the base by nearly 3.5 percent of GDP. Having the largest base relative to GDP, this proposal has the lowest tax rate.
The comprehensive retail sales tax would have the next largest tax base – 75.2% of GDP.
The comprehensive factor income tax would cover about 71 percent of GDP. Investment and taxes on output would not be taxed. Because wages and salaries are deductible at the business level, they would appear only in the individual tax base subject to the same tax rate as businesses.
V. Economic Effects of Broad Reform
Table 11 shows the static and dynamic results of adopting one of the broad-based alternatives shown above. In the long run GDP would be nearly $2 trillion larger than the 2008 baseline or nearly 15% higher. The private business capital stock would be more than one-third higher. Hours worked would be 4.4% higher translating into 6 million more jobs. Not shown is that wage rates will be 10% higher. Total federal receipts would be nearly 15% higher. This means that rates could be reduced by another 4 percentage points while maintaining a constant level of federal revenues.
VI. Summary and Conclusions
The exact nature of tax reform proposals will change many times. Most important is to evaluate the revenue consequences of any proposal using the same ground rules. That means the starting point should be the same set of national income accounts and the amount of revenue to be raised should be comparable. Doing so will provide policy makers with valid comparisons.
This study has shown the lowest average tax rates possible for the three general types of reform currently under consideration assuming no growth effects. The decision of which reform to choose should be based on other than revenue considerations. Regardless of which plan is selected there is a great potential for increased welfare while holding federal revenues constant.
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