Economics of Policy Issues EC3060 Spring 2018

Transcription

1 Economics of Policy Issues EC3060 Spring 2018 Notes No. 4 Michael King 1

2 Readings 1. Public Finance and Public Policy (2009), Arye Hillman. 2 nd Edition. Chapter Elschner and Vanborren. (2009) Corporate Effective Tax Rates in an Enlarged Europe. European Commission Taxation Papers ents/taxation/gen_info/economic_analysis/tax_papers/ta xation_paper_14_en.pdf 3. Report of the Commission on Taxation (2009). 2

3 Optimal Taxation: Contents 1. Optimal taxation 2. Capital and other tax bases 3. Appendix: Commission on Taxation Report 3

4 Taxation has been present in public goods, externalities, social justice and entitlements and the laffer curve In each case, there was: a single tax rate a designated tax base one government We now look at the structure of tax rates and the choice of the tax base. 4

5 1. Optimal Taxation Optimal in achieving an appropriate balance or trade-off between efficient and socially just taxation 5

6 Efficient Taxes: Ramsey Rule Efficient taxes: Taxation that minimises the efficiency losses incurred through the excess burden of taxation. Ramsey rule for efficient taxation: Minimisation of excess burdens for a give R Frank Ramsey ( ) derived the rule in

7 Competitive goods markets A and B (can also be 2 ind s) Cross price elasticities are here zero Efficient taxation: tax rates should be inversely related to demand elasticities The rule is derived from: t t A B = e e Tax rate should be higher on the good that has the lower price elasticity of demand DB DA 1 1 Min D = e p q t + e p q t 2 2 st R= t PQ + t PQ 2 2 DA A A A DB B B B.. A A A B B B 7

8 Efficient taxation of personal incomes t t e = e 1 S 2 2 S1 The Ramsey rule ensures that public goods and entitlements are financed by efficient taxation The leaks in the bucket of redistribution are minimal. 8

9 For efficient taxation, the marginal losses due to the excess burdens of increases in different taxes should be equal The Ramsey rule can contradict social justice The Ramsey rule calls for high tax rates on necessities, low tax rates on luxuries In the traditional model of the family, the woman s labor-supply elasticity is greater than that of the man 9

10 Social injustice in taxes personal incomes Person 1 is independently wealthy but is prepared to work if paid enough Person 2 has no sources of income other than from work and has no choice but to work for a living ε S1 > ε S2 The Ramsey rule implies regressive income taxation The Ramsey rule introduces conflict between efficiency and social justice 10

11 Political decision makers in democracies are reluctant to use the Ramsey rule Economists study the Ramsey rule because of the importance of the social objective of efficiency 11

12 Types of Income Taxation Social justice in taxation is often associated with a progressive income tax schedule t A Total taxes paid R º = Total income earned Y t M R º Y A tax schedule is progressive if the average rate of taxation (or the marginal tax - generally) rate increases with pre-tax income. 12

13 Flat Income Tax in Dark Green 13

14 Progressive Tax Schedules Marginal tax rate is t M is given by the slope of the income tax schedule As the marginal tax rate increases so does the average tax rate Along the 45 o line the total taxes paid are equal to total pre-tax income At point 3, the slope of the tax schedule is 45 o, so the marginal tax rate is 100% 14

15 An income-tax schedule: Relationship between total taxes paid R and total pre-tax income Y. R= R( Y) 15

16 Income Tax Schedule with Tax Brackets The tax brackets for ranges of income end at points 1, 2 and 3 Tax brackets have constant marginal tax rates Taxation is progressive as the average rate of tax increases with income High marginal tax rates would have effects on efficiency through the substitution between work effort and leisure attempts to hide income from the government 16

17 17

18 Linear Tax Schedule: An Flat Tax with Transfers Y is market determined income, everyone receives G (government income transfer), t is a constant flat tax rate and R is the tax revenue individual pays to the government People with Y > Y 0 pay positive taxes R = - G + ty i i 18

19 The simplicity of the optimal linear tax There is a need to choose only one rate of taxation The rate of taxation t determines the income transfer G paid to everybody in the population, by determining the tax revenue R that is available for redistribution 19

20 The government s budget constraint Choice of the income subsidy G and the tax rate t are linked through the government s budget constraint n å t Y = ng i= 1 i 20

21 A complexity in solving for the optimal linear income tax where n ng = tåyi (, t G) Y i i= 1 = Y(, t G) Taxable earned income Y i depends on the tax rate and on the income transfer received from government The optimal solution for the tax and income transfer needs to be consistent with the supply of labor that provides that tax base on which the income tax is levied i 21

22 Moving from progressive to flat Conclusion from simulations: Progressive systems of income taxation can be replaced with a flat or proportional rate of income taxation of 20 to 25 percent to yield the same revenue as the progressive tax system in place 22

23 Taxation: Principles of Fairness Ability-to-pay Principle (as opposed to the benefit principle of taxation) People pay taxes based on their income not from the benefits they receive Two Important Points Horizontally equitable taxation Vertical equity in taxation 23

24 What do we mean by social justice? 1. Ex-post equality Achievable through appropriative taxation and equal redistribution (we have eliminated the excess burden of taxation) Do not wish to use ex-post equality as the definition of social justice as it is not overly realistic 2. Ability-to-pay principle Requires that people with higher incomes pay more in taxes Does not imply progressive income taxation Only requires that the marginal rate of taxation be positive, which is the case whether taxation is progressive or regressive or proportional 24

25 3. The equal-sacrifice principle of taxation John Stuart Mill in 1848: equality of taxation is equality of sacrifice Total utility loss should the same for everybody, no matter what a person s pre-tax income happens to be Marginal utility of income is declining and therefore the personal marginal sacrifice from paying taxes declines as income increases The equal-sacrifice principle is defined in terms of total taxes paid total personal utility lost Conclusions - need to take on face value very complex mathematics required 25

26 Basics of Equal Sacrifice Assume a common utility function to measure and compare taxpayers sacrifices from paying taxes No substitution effects on the work-leisure choice Y is pre-tax earned income With no efficiency effects of taxation, Y depends on neither the level of taxation nor the structure of taxes The total tax paid by a taxpayer is R(Y) The utility from post-tax income is U[Y - R(Y)] The sacrifice from paying taxes is S S = U [ Y ]-U [ Y - R(Y )] = c = constant 26

27 2. Capital and Other Tax Bases Taxation of income from capital The Ramsey rule for income from capital and labor t t L K = e e SK SL Mobility between tax jurisdictions If capital can readily leave, ε SK is high If labor cannot leave, ε SL is low If capital can freely leave, capital is not taxed The home bias in investment reduces ε SK Social justice and taxation of income from labor and capital Portfolio investment is more mobile than physical investment. 27

28 Residence-based taxation: Taxes are levied on income without regard for the locational origin of the income Time inconsistency ε SK = 0 after the investment has been made The Ramsey rule: Announce a low rate of taxation of income from capital before an investment is made After the investment is made apply a high rate of tax The announcement of a low tax rate will not be credible and there will be no investment Stable taxes eliminate uncertainty of having to predict future government tax policy 28

29 Corporate Taxation The corporate or company tax is a tax on the profits of firms The corporate tax allows governments to discriminate in their tax treatment of profits (and losses) of corporations and personal incomes Tax structures, as well as tax rates, in general differ between individuals and corporations Ireland has a flat 12.5% tax rate for corporations 29

30 Elschner and Vanborren. (2009) 30

31 Elschner and Vanborren. (2009) 31

32 Elschner and Vanborren. (2009) 32

33 Double taxation Because the profits earned by corporations ultimately belong to individuals, there is double taxation Perhaps there is no need for a separate corporate income tax If there is a corporate profits tax, individuals could receive tax credits for taxes paid on corporate profits 33

34 Expenditure Tax Similar to indirect sales taxes The tax structure can be progressive, just as with a personal income tax Compliance: A taxpayer reports personal wealth at the beginning of the year personal wealth at the end of the year personal income during the year Personal income consists of income from all sources The expenditure tax determines tax liability based on money spent The sources of a person s income are of no importance for the expenditure tax 34

35 Example 1: Personal wealth $100,000 at the beginning of the year $120,000 at the end of the year Personal income = $50,000 during the year Spending of $30,000 is taxed No taxes are paid on the $20,000 that was added to savings 35

36 Example 2: Income from a wage or salary = 0 Wealth = $500,000 at the beginning of the year Wealth = $450,000 at the end of the year Income from interest = $30,000 Personal expenditure during the year = $80,000 36

37 Social justice and Expenditure Taxes Is an expenditure tax socially just compared to an income tax? Taxation of personal spending rather than personal income is consistent with taxing the source of personal utility, which is consumption. 37

38 Efficiency and Expenditure Taxes Expenditure and income taxes have different substitution responses Income tax: The work-leisure decision Expenditure tax: In addition, the personal spending saving decision (the substitution response contracts the present tax and expands the future tax base) Economic growth is higher with an expenditure tax 38

39 Timing of taxation With the income tax, taxation occurs when income is earned With the expenditure tax, taxation takes place when income is spent A lifetime budget constraint Lifetime income is greater with the expenditure tax Compared to an income tax at the same rate, an expenditure tax increases economic growth and provides greater lifetime tax revenue from taxpayers 39

40 Problems with an expenditure tax 1. Concentrated spending 2. An expenditure tax needs to accommodate the timing of spending by allowing taxes to be spread over time to match the benefits over time 3. Tax evasion High-expenditure people could give tax-free gifts to lowexpenditure people and send them shopping 4. Expenditures often provide shared benefits (e.g., a number of people might use the same refrigerator) 40

41 No government has replaced an income tax with an expenditure tax Impediments to change Change to an expenditure tax from an income tax would be unjust for older people 41

42 Other Taxes Lotteries A lottery is an unfair gamble The unfair gamble can only be sustained when the lottery is a monopoly as competition will improve the odds Adam Smith: sole source of demand for lottery tickets is the vain hope of gaining some of the great prizes. Low-income people tend to spend more on lottery tickets Taxation through a lottery tends to be regressive 42

43 Wealth Taxes Taxes on wealth- a retroactive tax on income No excess burden if a surprise A recurring wealth tax is not a surprise Time inconsistency Incentives to hide wealth Wealth taxed at death Incentive is to consume rather than accumulate wealth Gift taxes prevent tax avoidance while alive. A tax on intergenerational altruism A tax on ignorance 43

44 Should indirect taxes accompany the optimal income tax? When consumption preferences differ, indirect taxes can target people who have particular preferences For example, tobacco products A case for indirect taxes to accompany optimal income taxes stereotypes people Direct taxes on income can be more readily evaded than indirect taxes 44

45 Tax Competition Tax competition and Ramsey Rule Taxes on mobile capital should be lower than taxes on immobile labour Returns to capital are equalised Mobile capital moves between jurisdictions seeking the highest return (adjusted for risk) Fixed amount of capital K indicated by distance O 1 O 2 is allocated through a competitive market between two jurisdictions O 1 is the origin for capital in jurisdiction 1 and O 2 for jurisdiction 2 45

46 K = K + K r = When there are no taxes on income from capital, the competitive market equilibrium is at point A determined by equality of the marginal products of capital at point E After the tax on capital in jurisdiction 1: Capital (AB) leaves jurisdiction 1, new equilibrium at point C The tax reduces the returns to capital in both jurisdictions Tax base contracts (similar to the leaky bucket) in the jurisdiction where the tax is imposed,expands in the jurisdiction without a tax AB capital produced BAED before tax AB produces ECBA after the tax Loss in output is area DEC r ( t )MP MP K1 K = K * * ( 1- t K1)r1 = r2 46

47 47

48 Tax revenue is R = tr K * 1 1. When the tax base is mobile capital, the leaky bucket that indicates efficiency losses from redistribution includes the contraction of the tax base because of exit of mobile capital 48

49 Residence principle of taxation and tax competition A tax on capital imposed by the government of the investor s home jurisdiction cannot be escaped by moving capital to another jurisdiction The investor could move along with the capital to escape the tax Double tax agreements Taxes paid in one jurisdiction can be deduced from tax obligations in another 49

50 Tax competition and tax coordination Government is best off when it has low taxes and adjoining government has high taxes Nash equilibrium is low tax despite the fact that both would be better if they choose high tax together 50

51 A race to the bottom in taxes on mobile capital Tax competition is avoided if taxes are based on residence. Indirect taxes A tax coordination problem between governments also arises for indirect taxes 51

52 The Commission Proposal on the CCCTB (March 2011) Common Consolidated Corporate Tax Base a single set of rules that companies operating within the EU could use to calculate their taxable profits. CCCTB would make it possible for companies or groups of companies to consolidate all profits and losses across the EU Consolidation means adding up all the profits and losses of a company / group of companies from different Member States, to arrive at a net profit or loss for the whole of its activity in the EU. This would then be used to decide the final taxable base of the company or group. Attributed to each member state on three equally-weighted factors (assets, labour and sales).

53 Under CCCTB, once the company s tax base is determined, it will then be shared out (apportioned) to all Member States in which the company is active on the basis of a fixed apportionment formula. This formula will be based on three factors, equally weighted: Assets: All fixed tangible assets, including buildings, airplanes and machinery will be covered. The costs incurred for R&D, marketing and advertising in the 6 years prior to a company entering the CCCTB will also be included as a proxy for intangible assets for 5 years. Labour: Two factors will be taken into account under the heading of labour: 50% payroll costs and 50% the number of employees. Sales: This will be calculated on the basis of where the goods are dispatched to / destined for. For services, this will be where the service is physically carried out.

54 The CCCTB would be optional, allowing companies that felt that they would truly benefit from this harmonised system to opt-in, while other companies could continue to work within their national systems. Consolidation would eliminate the need for the complex transfer pricing system that is currently in place for cross-border intra-group sales.

55 Appendix 55

56 4. Commission on Taxation: Introduction The Commission was established on 14 February 2008 to review the structure, efficiency and appropriateness of the Irish taxation system and with the intention that our work would help establish the framework within which tax policy would be set for the next decade at least 56

57 Starting Point: Programme for Government To keep the overall burden low and implement further changes to enhance rewards of work while increasing the fairness of the tax system Guarantee that the 12.5 corporation tax rate will remain Objective: Consider how best tax system can support economic activity, promote employment, encourage long term savings 57

58 Guiding Principles 1. Equity - Equity that is, taxing persons on their ability to pay. 2. Flexibility Adjusting in line with changes in society, markets, business practices, technology and economic conditions. 3. Tax neutrality - Tax system that does not create a bias that could influence a taxpayers to choose one course of action over another. 4. Simplicity - Tax rules are known and that liability is clear. 5. Evidence-based approach - Facts and appropriate benchmarks were used to support our analysis and conclusions. 6. Pragmatism - Focus on tax reform rather than tax design, due to time constraints (exceptions carbon tax and property taxation). 58

59 Selected Recommendations 1 1. The employee PRSI ceiling could be abolished (equity and revenue generation considerations) 2. Share-based remuneration should be subject to PRSI. 3. Gains attributable to inflation should be excluded from the charge to capital gains tax. 4. Stamp duty on ATM, credit and debit cards should be phased out in the interests of promoting a cash free society 5. The 183/280 days test for determining tax residence should be supplemented by additional criteria. 59

60 Selected Recommendations 2 6. The provision of an up-to-date valuation based for all property and land in Ireland should be a priority. 7. Provide for an annual property tax on all residential housing units 8. Stamp duty for purchasers of principal private residences should be zero. 9. Taxes on labour should be kept low to support economic activity 10.A carbon tax on fossil fuels should be introduced 60

61 Selected Recommendations 3 11.Retirement: The current relief for personal retirement provision should be replaced by a matching scheme 1 for every 1.60 contributed and 1 for 1 the first five years. 61

62 See Report of the Commission on Taxation (2009) t.asp for further details. 62