ECO 4113 FISCAL ECONOMICS

PRINCIPLES OF TAXATION 2: PRACTICAL PROBLEMS IN

TAX DESIGN

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CRİTERİA FOR TAX/REVENUE SYSTEM DESİGN

Taxes and nontax revenue sources have a number of different attributes.

Different taxes or revenue sources will score higher on some of these criteria and lower on others.

A good tax system will use a mix of taxes with different desired characteristics.

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EFFİCİENCY AND EQUİTY

Taxes that minimize unintended distortions of economic decisions in the private sector while steering taxpayers toward desired choices involving externalities are the foundation of a good revenue system.

Designing taxes that achieve both equity(ability to pay and benefit principle) and revenue objectives is also important to creating a good revenue system.

The criteria of efficiency and equity remain at the top of the list in selecting and designing both taxes and nontax revenue sources.

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ADEQUACY A revenue system has to generate adequate

funds to pay for the desired level of public services.

Unlike private markets ,public revenues and expenditures do not have a one-to-one correspondence in the form of payment for goods sold or services rendered.

In general, a revenue system needs to provide revenue growth that at least matches the increase in population and in the costs of inputs into providing public goods and services.

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The system may also need to keep pace with real income growth,because demand for public services as a complement to private consumption can be expected to increase as the standard of living rises.

Adequacy is more a property of a revenue system as a whole than of a particular tax or revenue source.

But some taxes contribute more to adequacy than others.

At least one tax with a broad base-income,retail sales,or property-is an essential part of the revenue system for each level of government in order to ensure adequacy.

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Special taxes - accomodations,admissions,severance,

alcohol, gasoline - make a contribution to adequacy.

These more narrowly based taxes score low on the adequacy criterion.

Ensuring and defending adequacy means that legislators must be sensitive to the dangers of base erosion.

Adding exemptions to the sales tax, increasing deductions on the income tax ,and using corporate income tax breaks to lure industry all exact a cost in terms of not just current revenue adequacy but also future revenue flows.

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STABİLİTY

Some of the revenue sources in the overall system need to offer a cushion of stability, particularly for state and local governments that must balance their budgets annually through recessions as well as periods of prosperity.

Stability means that the revenue flow is not unduly sensitive to fluctuations in economic activity.

Stability is not as important a criterion for the central government, which can run deficits during recessions and surpluses during prosperous years.

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For local governments,an important positive attribute of the property tax is its stability.

For the two major state taxes,the appropriate mesaure of stability is the short-run income elasticity of the tax base.

That is, does the tax base fluctuate more than,less than, or about the same as fluctuations in gross state product or state personal income?

Revenue from an income tax that is indexed,will fluctuate less in proportion to changes in personal income than one that is not.

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If the tax rate structure has any progressivity to it, the revenue will fluctuate more than the tax base even with indexing for two reasons.

First,all real incomes rise,people will find themselves in higher tax brackets during expansions;when real incomes decline, they will be lower in lower tax brackets during recessions.

Second,the exempt amount(personal exemptions and standard deductions),even after indexing ,becomes a smaller proportion of total personal or adjusted gross income during expansions and a larger proportion during recessions.

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Stability has a price. A tax or revenue source that is stable over the business cycle tends to be unresponsive to growth in population,income,or the price level(inflation).

For this reason, a stable tax is an important component of the revenue mix ,but it needs to be balanced with other taxes that are more responsive.

The retail sales tax is more stable than the individual income tax at both the state and national level but is moderately sensitive to income growth and somewhat more sensitive to population growth and inflation. 10

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SENSİTİVİTY TO GROWTH AND İNFLATİON

The mirror image of stability is sensitivity to growth and inflation,which allows government revenues and expenditures to keep pace with changing costs and needs.

Growth has three different components:(1)population growth(2)income growth(3)inflation.

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Growth needs to be seperated into these three components before evaluating the sensitivity of revenue sources to growth for two reasons.

First,some revenue sources are sensitive(or not) only to inflation,or only to population,or(more rarely) only to real income growth.

Second,demands for public expenditures react differently to each of these three components of nominal income growth.

As the population grows,revenue needs to grow in order to finance the additional services required by a growing population, although the correspondence is not necessarily one to one.

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Population growth may involve scale economies in the provision of some services,so that revenue does not need to grow quite as fast as population.

The additional revenue required to serve a growing population also depends on where the new residents are located(in-fill versus new development,rural versus urban,isolated versus clustered in subdivisions),what the age distribution of the new residents is ,and whether there is a concentration of special needs populations.

Any population growth in young families will create demand for more spending on the largest component of local government expense,public education.Older citizens typically have lower service demands.

Retail sales tend to be tied to population growth,particularly at younger ages,that is,a high birth rate will increase retail sales more than an influx of retirees. 13

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Inflation also impacts both the expenditure and revenue sides of government budgets.

Inflation drives up the cost of providing public services.

Prolonged periods of inflation result in increased demands for real property,especially houses and undeveloped land,as an inflation hedge(because their values tend to rise at least as fast as the general price level).

Property values tend to rise more rapidly than the overall inflation rate,increasing property tax revenues faster than the rate of inflation. 14

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With indexing,inflation has little or no effect on individual tax revenues ,although growth in real income does increase revenue.

Retail sales tax revenue tracks the inflation rate fairly closely if the inflation is spread broadly over the full range of goods and services.

When inflation is largely concentrated in such items as health care and housing ,both of which are not subject to retail sales taxes ,then sales tax revenue is more likely to lag behind the rate of inflation.

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Economists Sobol and Holcombe have also measured the sensitivity of the bases for the major state taxes to long-term income growth (which reflects all three kinds of growth,population,inflation,and real income)

Personal taxable income has a long run elasticity of 1.215,and adjusted gross income a long run elasticity of 0.945,again tracking income to some degree but perhaps growing a little faster than income.

Retail sales tax elasticity is quite low over the longer time frame with an elasticity of 0.66 and so is corporate taxable income(elasticity=0.670).

States that rely solely on sales taxes are at a disadvantage when trying to generate revenue to keep pace with long-term growth of population,inflation,and the demand for public services associated with real income growth.

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VİSİBİLİTY One of the more controversial attributes of a tax or tax

system is visibility,or how obvious the amount of tax being paid to taxpayers and others.

Value added taxes are typically low visibility because they are reflected in the quated prices of goods,while retail sales taxes are much more visible because they are added to the quated price at the time of purchase.

People are not very aware of how much they pay annually in retail sales taxes because this type of tax is collected frequently and in small amounts.

The painful visibility of income taxes ,likewise is reduced by weekly or monthly withholding.

Property taxes ,in contrast,are extremely visible because they are usually collected in a lump sum once a year.

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Is visibility desirable?

It depends on one’s perspective. Those who think that government is too large prefer that

taxes be highly visible so that the pain of paying taxes will be weighed carefully against the benefits from government services,especially at the margin.

Others argue that, because many government services are low visibility, taxes should be equally low in visibility in order to avoid limiting the size and scope of government activity to a level that is less than optimal.

In practice, the mix of taxes and revenue sources in the system ranges from high visibility (property taxes) to moderate visibility(sales taxes,payroll taxes) to low visibility(excise taxes included in the price).

Likewise ,government services range from high visibility (road repairs,trash pickup,schools) to moderate visibility(national defense,parks,prisons)to low visibility(building inspection,financial administration). 18

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Taxes can be made more visible in a variety of ways.

Referenda, usually on bond issues for schools and other capital expenses,give taxpayers a chance to directly weigh an increase in taxes against an increase in services.

Stating the retail sales tax seperately from the price, a practice in most states with retail sales taxes ,makes it more visible.

Posting the excise tax on the pump at gas stations is another way to try to make consumers more aware of how much of what they pay is for the product itself and how much is tax.

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COLLECTİON AND COMPLİANCE COSTS

There is an even more direct cost of transferring revenue from taxpayers to governments that does not get transferred into increased government services.

To collect taxes, bureaucracies must be created to interpret the tax laws and ensure that taxes are collected.

The cost of printing forms,processing and auditing returns,and assesing tax liabilities is the collection cost.

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Taxpayers also incur costs in addition to the excess burden.

They have to keep records,fill out forms, go through audits,and pay tax accountants to make sure that they are in compliance.

These costs that fall on the taxpayers are called compliance costs.

Some taxes are costly to administer but not to comply with,like the property tax,while others are burdensome on both the tax collector and the taxpayer,like the individual income tax.

In some cases, compliance costs fall on third parties ,such as employers who must keep the records and file the returns for Social Security taxes or retailers who must collect and remit the retail sales tax.

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The remaining tariffs imposed by the federal government probably win the “prize” in terms of collection costs,because they cost more to administer than tyey generate in revenue.

However ,these residual tariffs are not designed to raise revenue,but to protect certain industries from foreign competition.

Although compliance costs for property taxes are low,these taxes are quite expensive to administer because of the need to assess the market value of a variety of assests,and to handle disputes and appeals over the values assigned.

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A few rules of thumb can provide guidance in reducing costs.

ıt is cheaper in terms of collection costs to administer a tax centrally rather than locally,because each local government will need its own staff. Substantial economies of scale in tax administration result in counties collecting property taxes on behalf of municipalities and states collecting and distributing local sales taxes on behalf of their cities and counties.

It is also less expensive to administer a broad-based income tax than one with many exemptions,exclusions, and deductions.

For retail sales taxes ,it is less costly to administer and to comply with a tax that is broad based in terms of tangible goods, because neither the tax collector nor the retailer has to worry much about seperating taxable from nontaxable sales.

Expanding the tax to include services increases the costs of both collection and compliance because of the large number of very small firms that have to be included in the process.

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TARGETİNG İNDİVİDUALS,FİRMS,PRODUCTS,SERVİCES

Some taxes in the system,and features within those taxes ,score poorly on several, or sometimes all of the criteria just listed.

For example, consider the exemption of food from the retail sales tax; about two thirds of the states with retail sales taxes exempt food. Eliminating food from the base means that the retail sales tax produces less revenue(reducing adequacy) and is less stable over the course of the business cycle.

A retail sales tax without food in the base is also more costly to comply with and to collect,because the retailer (and the tax collector) must carefully distinguish between taxable and exempt items.

Although the food exemption is Routed as a way to help the poor, and it does appear to make the sales tax less regressive ,it is a relatively inefficient equity tool ,because the tax savings go to all income levels,not just the poor.

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So why is the exemption so popular?

Exemption is used because taxing food is highly visible ,which makes the exemptions small contribution to equity more visible and hence more politically popular.

This exemption is also in part a response to the notion of basic rights to food and shelter regardless of ability to pay ,an important cultural norm that may override the rather arid principles of good tax design.

Some provisions in the tax law are intentionally designed to encourage or discourage specific kinds of consumption or production activities.

Taxes on alcohol and tobacco ,also known as sumptuary taxes,are intended to discourage the consumption of harmful substances.

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TAX EXPENDİTURES When provisions are inserted into the tax law

to exempt certain taxpayers ,organizations,or activities from taxation,or to reduce their tax burden relative to others,a measurable loss of revenue results.(The loss of revenue depends on the tax rate,the amount of the activity prior to the exemption,and the responsiveness of the activity to the stimulus of the tax break).

That revenue forgone is more or less equivalent to a direct expenditure on the exempted good or service and is thus known as a tax expenditure.

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Many tax expenditures favor charitable organizations.

These nonprofit firms that meet certain tests are often exempt from paying state sales taxes and local property taxes,and contributions to such organizations are deductible for fedral and many state income tax purposes.

Their net income is considered”surplus”rather than a taxable “profit”and is not subject to income taxes at any level.

Tax expenditures have both advantages and drawbacks in comparison to either direct expenditures as a means of furthering a particular social goal. 27

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Tax expenditures are less visible and thus easier to enact,which is both an advantage and adrawback.

They are less likely to come up for annual review.

Because they create demand in the private sector for delivery of services ,they develop strong lobbying constituencies.

Finally,they create tax relief for activities that were already ongoing or would have been undertaken anyway,so that their marginal impact in offering incentives requires a fairly high expenditure over the total range of the target activity to achieve an often modest increase or decrease.

Perhaps it would be more efficient to target particular populations through a direct subsidy.

Tax expenditures remain a very popular policy tool, but they are not always the best way to attain a particular goal at the lowest possible cost.

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İMPLEMENTİNG AND RESİSTİNG CHANGE

Stability of the tax law and the revenue it generates is of important economic and political value.

The notion of Pareto optimality,or at least the compensation principle ,may well be better served by gradual rather than immediate implementation.

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VALUE OF STABLE TAX RULES

The tax code represents a part of the operating rules of a city,country,state,or nation,along with other structures and institutions such as contract law and penalties for misdemeanors and the right to attend public schools.

People make decisions and commitments based on the current tax code and the expectation that those tax rules will continue into the future.

When the rules change ,windfall gains and losses happen.

A rate increase,a lost deduction,a brodening of the tax base all change the rules to which taxpayers have become accustomed and that were factored into their financial planning.

Even if the tax code is imperfect,or inequitable,it is not clear that the gains from frequent alteration outweigh the cost of adjustments falling on taxpayers who made decisions on the basis of existing tax rules. 30

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GRADUAL OR RAPİD İMPLEMENTATİON

The impact of a change in the tax rules can be mitigated by phasing it in,or delaying its implementation.

Gradual implementation in changing tax policy or indeed in changing any policy has advantages,but good arguments can also be made for making changes quickly and decisively.

If the change in the tax rules was undertaken in order to raise more revenue and the change is implemented gradually,revenue will come in more slowly,and the total amount of revenue increase will be smaller by missing the immediate/short run effect when elasticities are very low. 31

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If the tax change was proposed in order to mitigate an inequity or provide desired incentives or disincentives ,the gradual or delayed implementation will mean that citizens have to live with a less optimal situation in terms of either efficiency or equity for a longer period of time.

Finally,tax changes should be no different from changes that take place suddenly in the market.

The signals of impending change are always there well in advance,whether the change is in market interest rates or federal income tax indexing.

Quick changes induce faster responses,and dynamic change is both a benefit and a cost of a market system. 32

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What are the advantages of gradual or phased implementation of tax changes?

The main advantage is an offshot of the value of stability itself.

If taxpayers cannot have stability in the tax rules that affect their economic and financial decisions,the next best thing is to have enough time to prepare for and adopt to changes in those rules.

By giving taxpayers advance notice,they can act to mitigate some of the windfall redistribution of income,wealth,and tax burdens resulting from a change in the tax rules.

At the state level,efficiency and equity take on additional dimensions.

State and local governments also have to consider equity and efficiency in a competitive context.

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EFFİCİENCY AND İNTERSTATE COMPETİTİON Interstate competition for industrial and

residential location can both enhance and reduce economic efficiency.

Some of the benefits of competition apply to states as well as to private firms.

If states are forced to be more efficient in the provision services in order to hold down taxes while satisfying residents’ demands ,then interstate competition is efficiency enhancing.

Interstate competition places some important constraints on the actions of legislators and city councils to reinforce the voters’ efforts to make them responsive in terms of both taxes and services.

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Interstate competition can also push governments from beyond optimal to below optimal levels of taxes and spending in attempting to make government lean and fsical surpluses attractive to new comers.

Given the rational ignorance of most voters, and the short term time horizon of most elected officials,success in holding down taxes and attracting industry and jobs may be more visible and more influential in voting decisions than in longer term decisions about maintaining infrastructure and providing quality public services.

This argument is particularly relevant when evaluating economic development incentives.

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EQUİTY AND İNTERSTATE COMPETİTİON

Tax incentives,whether for retirees(usually income and property tax relief) or industry(most often corporate income and property tax breaks),shift the burden of taxation to other groups.

Some of that increased burden may fall on existing industry,including commercial and service firms.

Often the tax burden falls more heavily on the state’s least mobile residents,who are likely to be lower to middle income groups.

Alternatively, the quality of public services may decline as the increase in residents and firms to be served is not matched with an increase in revenue to pay for the additional services.

In that case, the burden of providing such tax incentives falls on the existing population as a whole, both individual and industrial/commercial.

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TAX EXPORTİNG State and local governments are always alert to

opportunities to shift the burden of paying for government to nonresidents,also known as tax exporting.

The theoretical justification for such shifting is that nonresidents benefit from services that the state provides but make little if any contribution toward the cost .

States that attract large numbers of tourists,for example, incur high costs for extra infrastructure ,police and fire protection,solid waste disposal,and public recreational facilities for a transient and seasonal population.

These states can use accomodations taxes ,admissions taxes,and special fees of various kinds to recoup some of that cost.

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The pragmatic justification for tax exporting is that residents are more likely to vote than nonresidents.

If some of the pain of paying for public services can be shifted from likely voters to those who have no voice or vote, politicians will have a more contented citizenry and will be more likely to be reelected.

The opportunities for tax exporting are usually fairly limited.

For most goods and services, a single state is in ahighly competitive situation and is a price taker.

The exceptions occur where a state(or a city or county) has some limited degree of monopoly power.

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Monopoly power comes from two sources.

1. One is access to unique or exceptionally attractive tourist/business destinations-large cities,beaches,national parks,ski areas.

2. The other is natural resources such as oil,natural gas,coal,or various minerals.

Natural resource extraction is usually subject to a specific levy called a severance tax ,which is successfully shifted forward to the buyer because there are few good alternatives.

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TAXATİON İN A GLOBAL ECONOMY

State and local governments are not the only ones that are constrained by competition in designing revenue structures that are attractive and acceptable.

Even national governments have to take into consideration the effects of their tax structures on decisions by firms and individuals about where they live and work,where they locate their businesses and invest their financial assets,and where they make their purchases and sales.

Firms,resources,and individuals are increasingly mobile ,particularly in the electronic age.

The taxation of corporate net income has been a hotly contested issue.

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Firms tend to locate their headquarters where the terms of taxation are most favorable.

Some kinds of taxes on goods are rebated on export(value added taxes in particular),which may give an advantage to exporters from nations that rely more heavily on value-added than on income taxation.

Nations that are interested in attracting multinational firms and financial investors will structure their tax packages with the goal of offering an attractive fiscal surplus,sometimes at the expense of some fraction of their own citizens.

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