L14: Fundamental Tax Reform and Consumption Taxation

Question 1

why tax capital income at the same rate as labour income?

Answer 1

we shouldn’t
- optimal taxation literature suggests that we shouldn’t tax capital income regardless of SWF
- under certain assumptions, progressive labour income tax cannot be improved upon by adding capital income tax

we want to
- propensity to save and to have capital income may be correlated with unobservable ability
- taxes on capital income provide insurance against risky outcomes

Question 2

how consumption taxes work

Answer 2

standard in the US - retail sales tax
- taxes consumption directly

standard everywhere else - value added tax
- easier to enforce since it is collected from all businesses, not just retailers
- at each stage of production, business is responsible for all taxes up to that point

Question 3

progressivity and consumption taxes

Answer 3

VAT Is a proportional tax on all consumption
- exempts certain elements of consumption that are necessities like food

inefficient approach since it distorts choice and subsidy goes mostly to the non-poor

better response to modify the VAT so it can vary by individual according to ability to pay

Question 4

economic benefits of shifting to progressive consumption taxation

Answer 4

greater economic efficiency
- no tax on saving, so greater capital accumulation
- taxation of consumption from existing wealth

simplification
- measuring capital income is complex, as is resulting tax avoidance
- makes tax system easier to enforce

Question 5

more traditional tax reform approaches

Answer 5

broadening the income tax base and lowering the income tax rate

when we only tax part of income, it isn’t a constant fraction which distorts decisions
- sensible tax expenditures in terms of design and aim can still increase tax complexity and compliance costs and make enforcement harder

cost of compliance
- taxpayers do not itemise although total deductions exceed standard deduction (itemising is costly and outweights tax benefit)

costs of enforcement
- when there’s a complicated tax system, it is difficult to enforce
- way to make the tax system more enforceable is to have fewer tax deductions for individuals and corporations

Question 6

politics and economics of tax reform - tax reform act of 1986

Answer 6

broadened the base and reduced rates, representing a victory for tax reform

but soon after, tax rates rose and subsequent reforms complicated the tax code

why the difficulty in maintaining a simple broad-based tax code?
- political pressures are strongest when winners are concentrated and have a lot to gain whereas losers are diffuse and don’t lose as much per person