THE ECONOMICS OF TAXATION

Garett JonesBB&T Professor for the Study of CapitalismThe Mercatus CenterGeorge Mason Universityjonesgarett@gmail.com

Overview

1. The grim future of tax revenues2. Who pays federal taxes? 3. Ways to raise taxes4. How citizens will respond to #35. Taxes on Capital: A strong result.

Not your usual recession

In the aftermath of a typical financial crisis:

“Value of government debt tends to explode…an average of 86%.”

“The main cause…is the inevitable collapse in tax revenues…”

Source: CBO Director Elmendorf, 2/25/10

Who pays ALL federal taxes? (SS, too)

Source: CBO

Who pays federal taxes? (details)

YearLowest Quintile

Second Quintile

Middle Quintile

Fourth Quintile

Highest Quintile Top 10% Top 5% Top 1%

Average Pre-Tax Income for All Households, by Household Income Category, 2005

2005 15,900 37,400 58,500 85,200 231,300 339,100 520,200 1,558,500

Tax Rates, All Federal Taxes, percent

2005 4.3 9.9 14.2 17.4 25.5 27.4 28.9 31.2

Total Federal Taxes paid, dollars

2005 684 3,703 8,307 14,825 58,982 92,913 150,338 486,252

Source: Congressional Budget Office.Notes: Income equals pretax cash income plus all in-kind benefits (Medicare, Medicaid, food stamps, school lunches and breakfasts, etc.).

Who thinks they pay federal taxes? Gerald Prante, new George Mason Ph.D.

“Americans underestimate the share of taxes paid by the rich and overestimate the share paid by middle-income Americans.”

Prante’s explanation: “pride theory” + “class delusion”

Revenue Raisers: VAT? NRST?

Value Added Tax—a consumption tax “If economists were to vote for their favorite tax,

the...VAT…would surely be high on the list.”-Keen, Journal of Economic Literature, 2009

Gets people and businesses to think about future Easy to enforce honestly BUT: More exceptions=higher rate

National Retail Sales Tax States avoid high sales tax rates: Why?

My plan for when NRST becomes law.

One revenue raiser: Taxing Sin

Excise taxes Alcohol, Tobacco, Sugary-soda

Mercatus brief by Richard Williams/Katelyn Christ

Young people (12-17) respond more 10% rise in cigarette price 12% fall in purchases But for over-35’s: 10% rise in price 1.5% fall

(Grossman et al., “Alcohol and Cigarette Taxes,” 1993. Discourage consumption by young, raise money from

the old?

Tax Expenditures: Loopholes we love

Top 5 on personal side: Tax-free health, mortgage interest, charitable, state and local taxes, IRA/Pensions: ~$370B per year, ½ of total

A must-read: GAO, “Tax expenditures…” 2005

How people respond to tax changes

Survey of labor economists: Married Women (MW) respond more than men

MW:10% cut in tax rate5% more hours Men:10% cut in tax rate 1% more hours

Low-earners respond more: about 2X these numbers and high-earners respond less. Source: Fuchs, Poterba, Kreuger (1997, J. Econ Lit).

Note: Nobel Laureate Edward Prescott sees 10x bigger responsesSocial forces at work?

Taxes and the Rich: Taxable Income Games

For the rich, it’s not about “hours of work”

There’s taking an easy job (low wage, low stress) vs. taking a harder job (high wage, high stress)

There’s this year (low tax) vs. next year (high tax)

Little of this involves “hours of work.”

How much do the rich change their “taxable income” when taxes change? Martin Feldstein (Harvard, former NBER chief)

2 for 1 1% rise in take-home fraction 2% rise in income

Gruber (MIT) & Saez (Harvard) 0.6 for 1: Quite a bit smaller. 1% rise in take-home fraction 0.6% rise in income

Goolsbee (Chicago, Admin): Looking at 1993 tax increase 1 for 1 in short run (end-of-year tax games) 0.1 in long run (they work and work)

How real is the Laffer Curve?

Laffer, Time, 12/7/07:“I've never said all taxcuts pay for themselves.I never even saidReagan's tax cuts wouldpay for themselves.”

Brad Delong, Berkeley & Clinton Treasury:

“[R]educing the top tax ratefrom 70% to 50% is probablya revenue gainer and surelynot much of a loser.”

Taxing Capital Income in Theory

Shockingly robust: Taxing capital is a bad idea. (Chamley/Judd result (1986/1985))(In general, includes corporate income taxes, interest and profit taxes, and capital gains taxes. IRAs and 401K’s get us closer to zero tax.)

Key point: Capital tax causes lower wages in long run.

Future-minded workers would vote to tax themselves, not capital.

Really? How?

Higher tax on capital Lower long-term saving fewer machines to tax (An obvious point)

The subtle point: Fewer machines workers produce less Lower wages

Even if you take all capital tax revenue and gave it to workers, rational, patient workers would vote against capital tax.

Taxes, Capital, and Growth

Survey of top tax economists: Shift to pure consumption tax

Unlimited IRA and/or VAT and/or Sales tax

avg. answer: 0.2% faster growth unnoticeable 10% richer in long run

optimists: 0.5% faster growth Probably noticeable 25% richer in long run

Who pays the corporate income tax?

Answer: Unclear Part sales tax

Part capital tax

Part labor tax

Big economic idea: Only humans can pay taxes We just don’t know which humans are paying it

Conclusion

Revenue will likely be low for years Our tax system is progressive. Tax rates change amount of work and savings

And phasing out benefits for high earners raises tax rates

Capital taxation: Bad in theory.