Tax Reform: Theory and Evidence

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Tax ReformTheory and Evidence

• Professor John A. Spry, Ph.D
• University of St. Thomas
• jaspry_at_stthomas.edu
• The views expressed herein are solely those of
  the author and do not necessarily represent the
  views of the State of Minnesota or the University
  of St. Thomas. All errors are my own.

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Revenue-Neutral Tax Reform

• The goal is to increase the size of the economy
  while meeting the needed revenue goal
• Reduce reliance on costly inefficient taxes
• Increase reliance on less distortionary taxes
• Generally,
• avoid high tax rates with narrow tax bases that
  are highly responsive to tax rates
• use low tax rates on broad bases that are less
  responsive to tax rates

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The inefficiency of a tax increases with the
square of the tax rate
Marginal distortions associated with the tax
code tend to rise with the square of the tax
rate, so that as the tax rate gets into higher
and higher territory, the marginal dead-weight
losses tend to grow rapidly. Going from a 30
percent to a 40 percent marginal tax rate, for
example, doesnt increase the marginal efficiency
cost of taxation by a factor of 1.33, but by the
ratio of 16 over 9close to 75 percent. Source
Professor James Poterba, MIT and NBER
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A Tax Theorists Guide to Spotting Better and
Worse Taxes for Economic Growth

• Better Taxes for Growth
• Minimally reduce gains from trade
• An inelastic tax base
• Small tax rate wedge
• (from combine federal and state rates)
• Low administrative costs
• Low compliance burden
• Worse Taxes for Growth
• Large distortions in the decisions of people and
  businesses
• Multiple ways for creative individuals to change
  behavior
• A large tax rate wedge
• (from combine federal and state rates)
• A highly mobile tax base
• High administrative costs
• Large compliance burden

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Minnesota is a Small Open Economy

• Minnesota has 0.08 of the world population.
• Minnesota GDP is about 0.33 of world GDP.
• We should compare our taxation of
• capital internationally, as capital is
• highly mobile today.
• We should compare our taxation of
• labor and savings nationally, because high
• human capital workers are very
• mobile today.
• How does Minnesota compare
• Internationally? What decisions face huge
• combined Minnesota and federal tax rates?

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Minnesota is a Small Open Economy -but Minnesota
has a Tax Code Designed for a Closed Economy

• Minnesotas 41.4 combined statutory federal and
  state corporate income tax rate is 50 higher
  than the OECD average of 27.6.
• Original idea - place the burden of the state
  corporate income tax on the owners of capital
  invested in Minnesota
• Minnesota taxes intended to fall on capital miss
  in an open economy
• Minnesota workers, consumers, and land owners get
  hit by taxes designed to burden owners of capital
• How we tax Minnesota source-based capital
  determines how much capital is invested in
  Minnesota
• - but not the world rate of return on capital.
• The pre-tax rate of return hurdle for investments
  in Minnesota is higher because competition in the
  capital market equalizes after tax rates of
  return across jurisdictions adjusting for risk.

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Specifically, how do we learn what are better
and worse taxes for economic growth and
prosperity?

• Even an ideal tax system would create some extra
  tax burden in excess of tax receipts to meet our
  need revenue target.
• Analysis should be grounded in the economic
  theory of taxation
• Rely on the serious, scholarly empirical research
  on the effects of taxes on economic decision
  making and economic performance

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Specific problems caused by the Minnesota
Corporate Franchise Tax

• A high rate (41.4 ) even before considering the
  double taxation of corporate income
• Strong disincentive for C-corp investment in
  Minnesota
• -Foreign Direct Investment in a state falls one
  percent for every one percent increase in the
  state corporate income tax rate.
• Source Prof. Claudio A. Agostini, Public
  Finance Review, 2007
• - ... the effective corporate tax rate has a
  large adverse impact on aggregate investment,
  FDI, and entrepreneurial activity. For example, a
  10 percent increase in the effective corporate
  tax rate reduces aggregate investment to GDP
  ratio by 2 percentage points. Corporate tax rates
  are also negatively correlated with growth, and
  positively correlated with the size of the
  informal economy.
• Prof. Andrei Shleifer, et. al, Harvard
  University
• It doesnt collect much revenue for a tax with a
  9.8 rate.

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Specific problems caused by the Minnesota
Corporate Franchise Tax

• The domestic distortions that the corporate
  income tax induces are large compared with the
  revenues that the tax generatesOverall, on the
  basis of a survey of estimates derived from
  published corporate tax studies, Gravelle
  concludes that the combined cost of the first
  five domestic inefficiencies discussed in this
  chapter could exceed the total amount of
  corporate tax revenues collected. CBO, 2005
• Corporate income taxes appear to have a
  particularly negative impact on GDP per capita.
  This is consistent with the previously reviewed
  evidence and empirical findings that lowering
  corporate taxes raises TFP growth and investment.
  Reducing the corporate tax rate also appears to
  be particularly beneficial for TFP growth of the
  most dynamic and innovative firms. Thus, it seems
  that corporate taxation affects performance
  particularly in industries and firms that are
  likely to add to growth.
• Source OECD Tax and Economic Growth

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Specific problems caused by the Minnesota
Corporate Franchise Tax

• It distorts firms decisions between equity and
  debt finance
• It has the highest administrative cost for the
  DOR per dollar raised
• It is a regressive and probably highly regressive
  tax that falls on in-state consumers and workers.
• Perhaps shockingly, the current Minnesota CFT,
  or any heavily sales apportioned state income
  tax, acts to place a hidden, and somewhat
  arbitrary form of sales tax on everything sold in
  the state by corporations, including food,
  prescription drugs, clothing, and other goods
  that may be popularly thought to be tax free.
• in the long-run a 1 increase in the tax bill
  tends to reduce real wages at the median by 92
  cents.
• Source Oxford University Centre for Business
  Taxation The Direct Incidence of Corporate
  Income Tax on Wages

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The State Corporate Income Tax and Sales Tax
Bases are Becoming More Elastic

• Source On The Relative Distortions of State
  Sales and Corporate Income Taxes Profs. Donald
  Bruce, John Deskins, and William Fox. Paper to
  be presented at the 2008 Annual Conference of the
  National Tax Association

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Specific problems caused by the Minnesota
Personal Income Tax on Wages

• Minnesotas has a 40.1 current combined
  statutory top federal and state personal income
  tax rate.
• The original idea is to place the burden of the
  state personal income tax on households with high
  personal income in Minnesota as if Minnesota was
  a closed economy.
• A large disincentive to supply additional hours
  of effort
• Icelands Natural Experiment
• A large disincentive to invest in education and
  on-the-job-training
• A large disincentive to take risky, disagreeable
  jobs that receive a compensating wage premium for
  less pleasant working conditions
• A strong incentive to take compensation in tax
  preferred forms (perks, exotic business trips,
  benefits, ect.)

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Specific problems caused by the Minnesota
Personal Income Tax on Wages

• Labor mobility of highly skilled individuals
• The evidence presented in this paper supports
  the basic theoretical presumption that state and
  local governments cannot redistribute income.
  Since individuals can avoid unfavorable taxes by
  migrating to jurisdictions that offer more
  favorable tax conditions, a relatively
  unfavorable tax will cause gross wages to adjust
  until the resulting net wage is equal to that
  available elsewhere. The current empirical
  findings go beyond confirming this long-run
  tendency and show that gross wages adjust rapidly
  to the changing tax environment. Thus, states
  cannot redistribute income for a period of even a
  few years. The adjustment of gross wages to tax
  rates implies that a more progressive tax system
  raises the cost to firms of hiring more highly
  skilled employees and reduces the cost of lower
  skilled labor. A more progressive tax thus
  induces firms to hire fewer high skilled
  employees and to hire more low skilled employees.
  Since state taxes cannot alter net wages, there
  can be no trade-off at the state level between
  distribution goals and economic efficiency.
  Shifts in state tax progressivity, by altering
  the structure of employment in the state and
  distorting the mix of labor inputs used by firms
  in the state, create deadweight efficiency losses
  without achieving any net redistribution.
• Source Professors Feldstein and Wrobel, Journal
  of Public Economics, 1998.

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Specific problems caused by the Minnesota
Personal Income Tax on Wages?

• Labor mobility of highly skilled individuals
• This paper examines the responsiveness of the
  rich to state income taxes. We use Major League
  Baseball free agents who were named All-Stars at
  some point in their career and who signed with a
  U.S. team for the 1991 through 2002 seasons. This
  data set overcomes some of the previous
  difficulties encountered in similar studies but
  also has limitations representing the general
  rich population. We find evidence that the wages
  of this subset of players do adjust to offset the
  burden of state income taxes, specifically a 1
  decrease in net-of-tax rate leads to a 3.3
  increase in salary. Professors Ross and Dunn,
  Contemporary Economic Policy, 2008
• High combined state and federal tax rates leads
  to a high marginal cost of public funds, even
  without considering labor mobility.
• An across-the board increase in personal tax
  rates involves a deadweight loss of 76 cents per
  dollar of revenue and collects only about
  two-thirds of the revenue implied by a static
  calculation. Feldstein, The Effects of Taxes
  on Efficiency and Growth. Tax Notes, 2006.

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Specific problems caused by the Minnesota
Personal Income Tax on Saving

• The effective combined effects of federal and
  state taxes and inflation results in a tax rate
  on saving through banks or bonds can easily
  exceed 100 annually!
• Taxing capital involves taxing income twice
  once when you receive it, before you save it, and
  then once again when you get the return on the
  savings. It gives a bias toward consuming now
  rather than consuming later and depresses capital
  accumulation.
• Source Nobel Prize Winner Professor Robert
  Lucas, in the Region Magazine from the
  Minneapolis Federal Reserve Bank

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Tax and Economic Growth -OECD Conclusions
The analysis in this (OECD) paper suggests some
general policy options that could be
considered - The reviewed evidence and the
empirical work suggests a tax and growth
ranking with recurrent taxes on immovable
property being the least distortive tax
instrument in terms of reducing long-run GDP per
capita, followed by consumption taxes (and other
property taxes), personal income taxes and
corporate income taxes. - A revenue neutral
growth-oriented tax reform would be to shift part
of the revenue base from income taxes to less
distortive taxes In practical policy terms, a
greater revenue shift could probably be achieved
into consumption taxes.
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References
Professor James Poterba on taxation
http//woodrow.mpls.frb.fed.us/pubs/region/08-06/
poterba.pdf Tax and Economic Growth, OECD
Working Paper 620 Source http//www.olis.oecd.org
/olis/2008doc.nsf/LinkTo/NT00003502/FILE/JT032488
96.PDF Hodge, Scott. "U.S. States Lead the World
in High Corporate Taxes" The Tax Foundation,
Fiscal Fact No. 119. March 18, 2008. http//www.ta
xfoundation.org/publications/show/22917.html
Claudio A. Agostini, "The Impact of State
Corporate Taxes on FDI Location," Public Finance
Review 2007 35 335. http//pfr.sagepub.com/cont
ent/abstract/35/3/335 Congressional Budget
Office, Corporate Income Tax Rates
International Comparisons. http//www.cbo.gov/ft
pdocs/69xx/doc6902/11-28-CorporateTax.pdf
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References
Professors Sineon Djankov, Tim Ganser, Caralee
McLiesh, Rita Ramalho, and Andrei Shleifer, "The
Effect of Corporate Taxes on Investment and
Entrepreneurship," National Bureau of Economic
Research, Working Paper 13756, January 2008.
http//www.nber.org/papers/w13756 On The
Relative Distortions of State Sales and Corporate
Income Taxes Donald Bruce, John Deskins, and
William Fox. Paper to be presented at the 2008
Annual Conference of the National Tax
Association http//web.utk.edu/dbruce/bruce.deski
ns.fox.distortions.pdf Professors Feldstein and
Wrobel, Journal of Public Economics,
1998 http//ideas.repec.org/p/nbr/nberwo/4785.html
Professors Ross and Dunn, Contemporary Economic
Policy, 2008 http//econpapers.repec.org/article/b
lacoecpo/v_3A25_3Ay_3A2007_3Ai_3A4_3Ap_3A639-648.h
tm Professor Feldstein, The Effects of Taxes on
Efficiency and Growth. Tax Notes, 2006. May 8,
2006.