ARE TAX CUTS SELF-FINANCING?

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ARE TAX CUTSSELF-FINANCING?

• Presentation at the CEPOS conference on Tax
  Cuts, Employment and Growth
• June 12, 2006
• by
• Professor Peter Birch Sørensen
• University of Copenhagen, EPRU and CESifo
• Chairman of the Danish Economic Council

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THE LAFFER CURVE
100
0
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DID LAFFER INVENT THE LAFFER CURVE?

• ? Ibn Khaldun, a 14th century Muslim
  philosopher, wrote in his work The Muqaddimah
  It should be known that at the beginning of the
  dynasty, taxation yields a large revenue from
  small assessments. At the end of the dynasty,
  taxation yields a small revenue from large
  assessments.
• ? John Maynard Keynes, Collected Writings Nor
  should the argument seem strange that taxation
  may be so high as to defeat its object, and that,
  given sufficient time to gather the fruits, a
  reduction of taxation will run a better chance
  than an increase of balancing the budget.

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THE WELFARE GAIN FROMHIGHER EMPLOYMENT

• 1. Gain Increase in output pre-tax wage rate
  W
• 2. Loss Welfare cost of additional work
  after-tax
• wage rate W(1-t)
• 3. Net gain to society 1. 2.
• marginal tax rate ? pre-tax wage rate tW

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TAX REVENUE AND WELFARE

• Suppose that a tax cut increases total labour
  supply
• by the amount ?L. Then
• Net welfare gain tW? ?L increase in tax
  revenue
• dynamic effect
• Insight The dynamic effect on tax revenue is
  an
• indicator of the welfare gain from the tax cut.
  If we
• want to maximize the gain in economic welfare, we
• should cut taxes where the expected dynamic
  effect
• (the degree of self-financing) is the greatest.

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THE DYNAMIC EFFECT

• The degree of self-financing (D)

e elasticity of tax base, t tax rate.
Assume e 0.2
Example 1 Initial tax rate t 50 ? D 20
Example 2 Initial tax rate t 75 ? D 60
Insight D is higher, the higher the initial tax
rate
Intuition In Example 1 a 10 percentage point cut
in the tax rate increases after-tax income by
20 in Example 2 a similar tax cut increases
after-tax income by 40
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WHO SHOULD GET THE TAX CUTS?THE CONCLUSION SO FAR

• If we care about economic efficiency rather than
• equity, it seems that we should start by cutting
• the highest tax rates (from the top of the income
• distribution)
• but
• things are not that simple

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TWO DIMENSIONS OF LABOUR SUPPLY

• Hours worked (effort) are influenced by the
• marginal tax rate
• Labour force participation is influenced by
• the (sum of the) average tax rate on labour
• income and the replacement rate (net benefits
• relative to wages)
• Evidence from the US and the UK
• Participation is more sensitive to economic
• incentives than hours worked

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A TWO-CLASS ECONOMY AN EXAMPLE

• Hypothetical tax schedule 30 tax rate on the
  first 100 units of
• income, 50 tax rate on all income above 100
• High-income earner
• 1. Pre-tax labour income 200
• 2. After-tax labour income 120
• 3. Potential transfer income in case of
  non-employment 40
• 4. Incentive to work 2. 3. 80
• Low-income earner
• 1. Pre-tax labour income 100
• 2. After-tax labour income 70
• 3. Potential transfer income in case of
  non-employment 40
• 4. Incentive to work 2. 3. 30

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THE EFFECTS OF TAX REFORM ON WORK INCENTIVES

• Reform 1 Switch to flat 30 tax
• Revenue cost 20 of 100 20
• No increase in work incentive for low-income
  earner
• Work incentive of high-income earner increases
  from 80 to 100 25
• Reform 2 In-work benefit 20 of earnings with
  cap at
• 20 and gradual phase-out at earnings between 100
  and 200
• Revenue cost 20 of 100 20 (note no benefit
  to high-income earner)
• No increase in work incentive for high-income
  earner
• Work incentive of low-income earner increases
  from 30 to 50 67
• Insight When labour force participation is
  sensitive to taxation but hours
• worked are not, it is more efficient to
  concentrate tax cuts at the bottom
• of the income distribution

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TAX CUTS DEGREES OF SELF-FINANCING
Type of tax cut change in progressivity Degree of self-financing ()
Increase in Earned Income Tax Credit (beskæftigelsesfradrag) 4.6 50.1
Cut in payroll tax (arbejdsmarkedsbidrag) -1.1 54.1
Cut in medium tax rate (mellemskat) -10.1 46.4
Cut in top tax rate (topskat) -10.7 45.3
Note All tax cuts are designed to have the same
effect on long-run fiscal sustai- nability. The
estimates do not include effects on educational
effort and migration Source Danish Economic
Council, The Danish Economy, Fall 2004.
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CAVEATS

• The degree of self-financing varies across
  population groups
• Laffer-effects may occur for some groups and some
  types of
• tax cut
• So could tax cuts be self-financing after all?
• Mind the words of John Maynard Keynes Nor
  should the
• argument seem strange that taxation may be so
  high as to
• defeat its object, and that, given sufficient
  time to gather the
• fruits, a reduction of taxation will run a better
  chance than an
• increase of balancing the budget.
• Morale Timing is essential. Dont cut taxes in
  expectation of
• Laffer effects when the economy works at full
  capacity.

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DYNAMIC EFFECTSAN ALTERNATIVE PERSPECTIVE

• While tax cuts are generally not self-financing,
  the introduction
• of mandatory individual savings accounts to
  finance a part of
• social transfers is likely to be self-financing
• Motivation for introducing individual accounts
• ? 74 of the taxes levied to finance Danish
  social transfers are paid back to the taxpayer
  himself over the life cycle
• ? Many social transfers imply little
  redistribution of lifetime income from rich to
  poor

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A DESIGN FOR SOCIAL INSURANCE BASED ON INDIVIDUAL
SAVINGS ACCOUNTS

• For each taxpayer an individual account (IA) is
  established
• A mandatory social security contribution is
  credited to the IA the contribution replaces
  part
• of the taxpayers labour income tax
• Receipts of certain social transfers are debited
  to the IA
• Interest is added to or subtracted from the
  balance on the IA
• Any surplus on the IA at the date of retirement
  is converted into an annuity which is added to
  the public pension. Persons with a negative IA
  balance receive the public pension

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Properties of the IA system

• Insurance properties
• ? Liquidity insurance
• ? Lifetime income insurance
• Incentive properties
• ? Reduced marginal tax rate
• ? Reduced replacement rate
• (selective tax and benefit cut for those with
• positive IA balances at retirement)

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An IA system for Denmark (DEC proposal)

• Transfer programs included in IA system
• ? Short-term unemployment benefits
• ? Early retirement benefits
• ? Education benefits in higher education
• ? Sickness benefits (up to a limited number of
  sickness days)
• ? Child benefits
• ? Parental leave benefits
• The payroll tax is cut by 7.9 percentage points
  and replaced by a mandatory contribution to the IA

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Effects of the IA system on income distribution
Summary statistics

• Gini coefficients
• ? Lifetime factor income 0.253
• ? Lifetime disposable income, current system
  0.127
• ? Lifetime disposable income, DEC proposal 0.133
• Redistribution of lifetime income
• Current system (0.253 0.127)/0.253 49.8
• DEC proposal (0.253 0.133)/0.253 47.4

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EFFECT ON THE PUBLIC BUDGET
Even with moderate labour supply elasticities,
the DEC proposal improves the public budget. The
reason is that the proposal involves ? a cut in
the marginal labour income tax rate combined
with ? a cut in the replacement rate in the
transfer programs included in the scheme
Note Effectively the replacement rate is cut by
100 percent, but the cut is felt at a stage
in the life cycle where the taxpayer can more
easily afford it.
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CONCLUSIONS

• ? Mandatory saving accounts for (part of) social
  insurance can offer liquidity insurance and
  lifetime income insurance in a more efficient
  manner than the current tax-transfer system
• ? An IA system is likely to be self-financing. It
  therefore has the potential to generate a welfare
  gain for the majority of the population without
  making anybody worse off and without
  significantly increasing the inequality of
  lifetime income distribution