Chapter 25: Fundamental Tax Reform and Consumption Taxation

Fundamental Tax Reform (Goals)

• Improve tax compliance.

• Make the tax code simpler.

• Improve tax efficiency

The "9-9-9" Plan

A plan for fundamental tax reform proposed by Herman Cain in 2011. It would replace all current taxes with a 9% corporate tax, a 9% personal income tax, and a 9% payroll tax. It is an example of a "flat tax".

Tax Reform Act of 1986 (TRA 86)

A significant tax reform that "broadened the base and reduced rates". The PDF notes this victory for reform was "short lived" as subsequent tax acts (1993, 1997, 2001, 2003) moved away from this structure.

Tax Shelters

Activities whose sole reason for existence is tax minimization.

Tax Capitalization

• The change in asset prices that occurs due to a change in the tax levied on the stream of returns from that asset.

• eliminating tax shelters can create large transitional inequities.

Transitional inequities from tax reform:

Changes in the treatment of similar individuals who have made different decisions in the past and are therefore differentially treated by tax reform

Tax Evasion

Illegal nonpayment of taxation

Tax Avoidance

Legal action to reduce tax burden

Tax Compliance

Efforts to reduce the evasion of taxes.

Theory of Tax Evasion

A theory emphasizing the trade-off involved in evasion: saving money on unpaid taxes if not caught, versus facing penalties or jail if caught. The theory suggests higher taxes increase evasion , while increased penalties reduce it.

The Tax Code – Making the Complex Code Simpler

• One of the goals of fundamental tax reform is to simplify the tax code.

• the complexity is costly, citing as evidence the rise in pages for Form 1040 instructions (from 2 in 1940 to 217 in 2017) and the fact that many taxpayers don't itemize even when it would save them money, due to the costs of doing so.

Tax Efficiency: Direct Effects

A higher tax rate that raises revenues on a fixed base of taxation.

Tax Efficiency: Indirect Effects

Tax changes can have four indirect effects on efficiency:

Gross income effect

A higher tax rate may reduce gross income (e.g., by lowering labor supply, savings, or risk taking).

Reporting effect

For a given level of gross income, a higher tax rate causes people to report less income.

income exclusion effect

For a given reported income, a higher tax rate causes people to take more deductions and exclusions

Compliance effect

Higher tax rates may reduce revenues through increased tax evasion.

Consumption Taxation (Consumption Tax)

A tax system that taxes individuals based on what they consume (or spend) rather than what they earn.

Consumption Tax – A Better Tax Base?

many economists prefer consumption taxation, why it might be a worse tax base, including transition issues for seniors , difficulty in measuring consumption (compliance) , and cascading.)

Value-Added Tax (VAT)

A consumption tax levied on each stage of a good’s production on the increase in value of the good at that stage of production.

VAT (Strengths)

It addresses the problem of cascading (double taxation) and improves compliance, as firms have an incentive to ensure other firms in the chain are honest.

VAT (Weaknesses)

In practice, VATs often have multiple rates (for progressivity or political reasons) and their administrative costs are similar to income tax systems.

Expenditure Tax

A consumption tax levied on yearly consumption rather than on specific sales. Its strength is that it can easily be made progressive, but its weakness is the difficulty in tracking yearly expenditures.

Cash-Flow Tax

A tax based on the cash flow of a household, which is defined as total income minus all savings (or plus all borrowing).

The Flat Tax

A tax system that would apply a single low tax rate to a broad income base. Herman Cain's "9-9-9" plan is cited as an example.