Statutory and effective tax rates: Part 2

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Article Highlights

  • In an economy with a positive saving rate, capital income taxes generally penalize work.

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  • In the temporal economy, large additional gains can be achieved by eliminating capital income taxes.

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  • Replacing the income tax system with a progressive consumption tax would promote efficiency.

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STATUTORY AND EFFECTIVE TAX RATES: PART 2

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In the first article of this two-part series, I considered the incentive effects of income and consumption taxes in a hypothetical economy with no passage of time and therefore no savings.1 In that hypothetical economy, individuals chose how much to work and consume and which goods to consume, but had no choice about when to work or consume. I now extend the analysis to consider an economy that features the passage of time.

I explained in the first article that work disincentives in the hypothetical economy were not determined solely by the statutory tax rate on wages. Because people work in order to consume, work disincentives also depended on the taxation of the consumption financed by earning additional wages.Tax deductions and credits for specific consumer goods mitigated work disincentives, and general consumption taxes and excise taxes on specific consumer goods amplified work disincentives. As a result, tax reforms that left revenue and progressivity unchanged also left work disincentives roughly unchanged, even if they significantly altered statutory tax rates. I concluded that, considering the difficulty of reducing work disincentives, tax policy should instead focus on reducing other distortions, particularly by eliminating tax provisions that arbitrarily favor some consumer goods over others.Revenue-neutral reforms that lowered statutory income tax rates while limiting tax deductions and credits were likely to be desirable on those grounds, even though they generally did not reduce work disincentives.

The same basic principles hold in the temporal economy in this article. The primary difference is that because individuals can consume at different dates, work disincentives at each date depend on the tax treatment of past, current, and future consumption and work. Capital income taxes have interesting and surprising effects because of the manner in which they tax consumption and work at different dates. Capital income taxes generally impose work disincentives, but do not do so uniformly throughout an individual's life. Capital income taxes impose significant penalties on work done early in life, but impose smaller penalties on, or may even provide subsidies to, work done later in life.

As in the hypothetical economy considered in the first article, a misplaced focus on statutory tax rates leads to serious misconceptions about the effects of revenue-neutral tax reforms on work disincentives. A prominent fallacy holds that a revenue-neutral replacement of the income tax system with a consumptionor wage tax would aggravate work disincentives because the wage or consumption tax would need to impose higher statutory rates to offset the loss of capital income tax revenue. In reality, however, the reform would have little net effect on work disincentives, because it would leave effective tax rates on work roughly unchanged. The increased work disincentives arising from the higher statutory tax rates would be roughly offset by the removal of the work disincentives imposed by capital income taxation.

The fundamental policy implications in the temporal economy are similar to those in the hypothetical economy considered in the first article. A tax reform that leaves revenue and progressivity unchanged also leaves work disincentives roughly unchanged, even if it significantly alters statutory tax rates. Given the difficulty of reducing work disincentives, tax policy should focus on reducing other distortions. As in the hypothetical economy, one way to reduce distortions is to eliminate tax provisions that arbitrarily favor some consumer goods over others. In the temporal economy, though, large additional gains can be achieved by eliminating capital income taxes, which arbitrarily favor early consumption over late consumption and late work over early work. Replacing the income tax with a progressive consumption tax would yield efficiency gains by making the tax system neutral regarding the timing of consumption and work.  

Working and Consuming at Many Dates

In a temporal economy, as in the hypothetical economy considered in the first article, individuals work in order to consume. But, they now work and consume at more than one date. As a result, it is necessary to consider work disincentives at different dates; a tax system's penalty on earning additional wages at one date may differ from its penalty on earning additional wages at another date.

Individuals' abilities to work and consume at different dates also imply that the marginal dollar of wages earned at a particular date need not beused to finance consumption at that time. Part or all of the wages may be used to finance consumption at other dates. Alternatively, part or all of the wages may be used to finance a reduction in work at other dates, because the individual's receipt of additional wages on one date may reduce her need to earn income at other times.

Regarding individuals' reactions to expected taxes, those effects can pertain to the past or the future. For example, an individual planning her lifetime consumption can respond to an expected increase in earnings in 2020 by working less or consuming more in 2015. Of course, the individual cannot change her 2015 decisions in response to additional wages unexpectedly received in 2020; her response to unexpected 2020 events must be confined to 2020 and thereafter. As a result, expected and unexpected taxes have different incentive effects.

The effects of expected taxes on work disincentives at a specified date depend on how the individual would spend an additional dollar of expected wages earned at that date, including any changes in consumption or work at other dates. For example, consider an individual who lives for three periods. Suppose that the before-tax interest rate between periods is 100 percent, so that any amount saved in one period earns interest equal to the amount saved and therefore doubles in value by the next period. (The high interest rate reflects the fact that the interval between periods may encompass many years.) Suppose that in the no-tax economy, the individual responds to the expected receipt of $100 of additional wages in the middle period by earning $20 less wages and consuming $10 more in the first period, consuming $20 more in the middle period, and consuming $40 more in the last period.

It is worth confirming that those responses imply changes in saving that are consistent with the individual's budget. The changes in saving are crucial for understanding the work disincentive effects of capital income taxes. Because the individual earns $20 less in wages and consumes $10 more in the first period, she saves $30 less in that period. As a result, she earns $30 less interest and enters the middle period with $60 less wealth. She earns $100 of additional wages in the middle period, of which she consumes $20 and saves $80. At the end of the middle period, her wealth has risen by $20, as the $80 saved from the additional wages outweighs the $60 wealth reduction at the beginning of the period. She earns $20 of additional interest and enters the last period with $40 of additional wealth, which she consumes in that period.

Several tax provisions affect the individual's middle-period work disincentive. The wage tax imposed in the middle period has an obvious effect, as the individual is taxed on the $100 of additional wages at the statutory wage tax rate then in effect.However, that statutory tax rate is only one factor affecting the work disincentive.

As in the first article, work disincentives are also affected by the tax treatment of the consumption financed by the additional wages. Unlike in the first article, however, the effects do not depend solely on taxes imposed at a single point in time. Because earning additional expected wages in the middle period increases consumption in all three periods, a consumption tax imposed in each of the three periods penalizes work in the middle period.

Under the numerical values assumed in this example, consumption taxes in each of the three periods have equally powerful effects on middle-period work incentives. The equal effects arise because the $10 of additional consumption in the first period, the $20 of additional consumption in the middle period, and the $40 of additional consumption in the last period each have a $20 present value, as evaluated in the middle period. (With an interest rate of 100 percent per period, $1 in the first period is worth $2 in the middle period and $1 inthe middle period is worth $2 in the last period.) More generally, of course, the effects of consumption taxes at each date may differ depending on how an individual allocates consumption across different dates.

Another divergence from the first article's analysis is the relevance of the wage tax rate in the first period. The wage tax imposed in the first period reduces the middle-period work disincentive because the individual substitutes work in the first period for work in the middle period.The effects of wage and consumption taxes in the temporal economy are relatively straightforward. But the effects of capital income taxes are more complicated and merit a separate discussion.

Capital Income Taxes

One might think that capital income taxes do not affect work disincentives because they are imposed on savings rather than work. But that view is just as invalid as the assertion, rebutted in the first article, that consumption taxes do not affect work disincentives because they are imposed on consumption rather than work. Consumption taxes affect work disincentives because earning additional wages gives rise to additional consumption. Similarly, capital income taxes affect work disincentives because earning additional wages gives rise to changes in capital income. The effects of capital income taxation are more complex, however, because capital income can change in either direction in response to the earning of additional wages.

As outlined above, earning $100 of additional expected wages in the middle period reduces the individual's saving in the first period by $30, but it increases her saving in the middle period by $20. Middle-period work disincentives are therefore aggravated by any tax on the capital income earned on first-period saving and ameliorated by any tax on the capital income earned on middle-period saving.

While the numbers are purely illustrative, the basic pattern of the results is likely to apply quite broadly. Earning additional expected wages at a specified date generally reduces savings before that date and increases savings after that date as individuals spread the additional wages throughout their lives. Higher expected wages in 2020 reduce the need to save before that, as individuals increase consumption or reduce work in those earlier years. Higher wages in 2020 increase the opportunity to save after that, allowing individuals to increase consumption or reduce work in those later years. Because of that pattern of savings responses, a capital income tax imposed at a specified date generally penalizes work done at earlier dates and subsidizes work done at later dates.

A capital income tax imposed at a constant rate during an individual's life is not neutral regarding the timing of work. Given that work at each date is penalized by any capital income taxes imposed after that date and subsidized by any capital income taxes imposed before that date, a constant-rate capital income tax systematically treats earlier work more harshly than later work.

It is widely recognized that the savings penalty arising from capital income taxation constitutes a penalty on late consumption. It is less commonly recognized that the savings penalty also constitutes a penalty on early work, an effect that appears prominently in dynamic simulations of tax reform. Because savings and capital income arise when individuals consume later than they work, capital income taxes create incentives both to accelerate consumption and to delay work. Holding the timing of wages fixed, an individual who consumes later must save more and therefore pay more capital income tax. Holding the timing of consumption fixed, an individual who works earlier must save more and therefore pay more capital income tax. Surprisingly, the effects of capital income taxation on the timing of work have gone unmentioned in many tax policy discussions.2

If an individual starts working at the beginning of her economic life, a constant-rate capital income tax penalizes that work because all capital income taxes are imposed after that work. If an individual works until the very end of her economic life, a constant-rate capital income tax subsidizes that work because all capital income taxes are imposed before that work. In the more realistic case of an individual who stops working before the end of life and retires, a constant-rate capital income tax may not subsidize the last work done, because some capital income taxes are still imposed after that work. But a constant-rate capital income tax does treat that work more favorably than earlier work.

In an economy with a positive saving rate, capital income taxes generally penalize work. Positive savings arise because individuals generally consume later than they work. On balance, individuals also receive capital income later than they work. Because a tax on capital income at each date penalizes work done before that date, capital income taxes generally penalize work in that type of economy.Conversely, capital income taxes generally subsidize work in an economy with a negative saving rate. Of course, capital income taxes also raise negative revenue in that type of economy. It is hardly surprising that a tax policy that spends rather than raises revenue tends to subsidize economic activity.

The recognition that capital income taxation generally imposes work disincentives in those economies in which it raises revenue helps dispel a fallacy that has frequently appeared in discussions of tax reform. The fallacy, which I call the trade-off fallacy mistakenly asserts that a revenue-neutral replacement of the income tax system by a wage or consumption tax necessarily increases work disincentives.

The Trade-Off Fallacy

The argument behind the fallacy begins on a sound footing by correctly noting that in an economy with positive savings and positive capital income, consumption and wages are smaller than income. Holding fixed other relevant factors,3 replacement of the income tax system with a consumption tax or wage tax therefore represents a movement to a smaller tax base. To raise the same revenue, statutory tax rates need to be higher under the wage or consumption tax than under the income tax system. The increase in statutory tax rates is required to replace the revenue that the income tax system raises from capital income taxation. So far, so good.

Unfortunately, the argument goes astray (and becomes a fallacy) by concluding that the higher statutory tax rates of a wage or consumption tax necessarily inflict larger work disincentives. Drawing on that conclusion, proponents of the fallacy imagine that a revenue-neutral shift from income taxation to wage or consumption taxation poses a policy trade-off. They think that the shift aggravates work disincentives even as it eliminates the income tax's bias against future consumption, and they therefore conclude that the efficiency consequences of the shift depend on the relative sensitivities of work and saving to tax rates.4

The argument should set off alarm bells because it relies on the erroneous assumption that work disincentives are determined solely by statutory tax rates. The invalidity of the trade-off fallacy can best be understood by drawing on an analogy that I have used, in a slightly different form, in previous writings.5

Consider a timeless economy, similar to that in the first article, in which people work to buy apples and oranges, devoting half their wages to each fruit.The income tax rate is 20 percent, but oranges are subject to a 10 percent excise tax so that apples are taxed at 20 percent and oranges at 30 percent. Economists note that the excise tax inefficiently favors apples over oranges and propose a revenue-neutral reform that repeals the excise tax and raises the income tax rate to 25 percent. A critic acknowledges that the proposed reform eliminates the bias in favor of apples over oranges, but he contends that it aggravates work disincentives by raising the income tax rate from 20 to 25 percent. Perceiving a trade-off between increased efficiency in the fruit market and decreased efficiency in the labor market, the critic argues that the net efficiency consequences of the reform depend on the relative tax sensitivities of work and the choice between the two fruits.

The critic's objection is unfounded because it fails to recognize that the excise tax on oranges also creates a work disincentive. If the marginal dollar of wages is divided between apples and oranges in the same ratio as their shares of total spending, then the reform leaves the effective tax rate on work unchanged at 25 percent. The reform then promotes efficiency because it eliminates the distortion between apples and oranges without impairing work incentives. Of course, if taxing oranges really offered a ‘‘free lunch'' way to raise revenue without penalizing work, then it would indeed be problematic to replace the tax on oranges with wage taxation. But that is not the case.

The same logic applies to a switch from income taxation to wage or consumption taxation. If the marginal dollar of wages is divided between consumption at various dates in the same ratio as their shares of total spending, then the reform leaves the overall effective tax rate on work unchanged. The reform thus promotes efficiency because it eliminates the income tax's distortion between early and late consumption (and work) without impairing work incentives. The increased work disincentives arising from the higher statutory tax rates are offset by the removal of the work disincentives imposed by capital income taxation. Of course, if taxing capital income really offered a free-lunch way to raise revenue without penalizing work, then it would indeed be problematic to replace capital income taxation with wage or consumption taxation. But that is not the case.

Although the trade-off fallacy has been refuted by numerous economists,6 it continues to flourish. Despite their diametrically opposed conclusions, the trade-off fallacy and the fallacy that a switch from income to consumption taxation eliminates work disincentives are based on the same fundamental error of linking work disincentives solely to a statutory tax rate. The latter fallacy assumes that work disincentives depend only on the statutory tax rates on wages and income, which become zero when the income tax system is replaced by a consumption tax. The trade-off fallacy recognizes that the statutory consumption tax rate also affects work disincentives. But in its focus on that statutory tax rate, it neglects to consider the work disincentiv eeffects of capital income taxation.

In practice, a revenue-neutral switch from income taxation to wage or consumption taxation is unlikely to leave work disincentives exactly unchanged. If the marginal dollar of wages is divided between consumption at various dates in differentratios than overall consumption, then the tax switch can either aggravate or mitigate work disincentives. Although the analysis is complicated when work is done at many different dates, a switch from income taxation to wage or consumption taxation is likely to reduce work disincentives if saving for later consumption receives a larger share of the marginal dollar of wages than the share it commands in overall spending.

The incentive effects of the reform also depend on transition issues. Consideration of that factor suggests that a switch to consumption taxation will have more beneficial incentive effects than a switch to wage taxation.

As previously mentioned, unexpected tax policy changes have different incentive effects than expected tax policies. Although an unexpected capital income tax or consumption tax in 2020 may cause individuals to regret having worked and saved in earlier years, it cannot prevent them from having done the work and saving. That behavior has already occurred and cannot be undone. At any point in time, therefore, revenue can be raised without disincentive effects by imposing unexpected taxes on past behavior. Conversely, revenue can be lost without efficiency gains by unexpectedly removing taxes on past behavior.

A switch to consumption taxation imposes unexpected taxes on past saving while a switch to wage taxation unexpectedly removes taxes on past saving. Under the income tax system, savers expect to be taxed on the future returns earned on their past savings, but not on the principal of those savings. A switch to consumption taxation brings the principal into the tax base while a switch to wage taxation removes the future returns from the tax base. Because it raises additional revenue from past savings, the switch to consumption taxation is likely to have more favorable incentive effects. Of course, transition relief may diminish the effects.

Although space does not permit a full discussion of the question, it should be emphasized that it would be a mistake for the government to continually seek revenue by unexpectedly taxing past savings and other past behavior. Because any policy that is continually pursued can hardly hope to remain unexpected, such a policy is doomed to be self-defeating and pernicious.

Conclusion

The policy implications of this analysis are essentially the same as those in the first article's analysis of a hypothetical economy with no passage of time. Because tax reforms that leave revenue and progressivity unchanged also leave work disincentives roughly unchanged, it is not easy to find attractive ways to reduce work disincentives. Accordingly, it is probably sensible for tax policy to focus on reducing other distortions.

As in the hypothetical economy, distortions can be reduced by removing tax provisions that favor some consumer goods over others. In the temporal economy, however, large additional gains can be achieved by eliminating capital income taxes, which create distortions in favor of early consumption and late work. Replacing the income tax system with a progressive consumption tax, either a Bradford X tax or a personal expenditure tax, would promote efficiency by making the tax system neutral regarding the timing of consumption and work. 

Alan D. Viard is a resident scholar at AEI.

Notes

1Alan D. Viard, ‘‘Statutory and Effective Tax Rates: Part 1,'' Tax Notes, Aug. 20, 2012, p. 943, Doc 2012-16509, 2012 TNT 163-4.

2For an exception, see Steven E. Landsburg, ‘‘You Too Could Face 95% Taxation,'' The Wall Street Journal, Mar. 15, 2001, at A22. COMMENTARY.

3Of course, statutory tax rates also depend on the extent to which tax preferences are provided to specific consumer goods.Statutory tax rates might well decline if the current income tax system, which offers numerous tax preferences for specific consumer goods, were replaced by a consumption tax that offered fewer preferences, as envisioned in most proposals for fundamental tax reform. Nevertheless, the removal of tax preferences and the switch to consumption taxation are logically separate policy changes. The switch to consumption taxation, considered in isolation, would indeed require an increase in statutory tax rates to maintain revenue neutrality.

4For a partial list of sources that embrace the trade-off fallacy, see Robert Carroll and Viard, Progressive Consumption Taxation:The X Tax Revisited 181, n.1 (Washington: AEI Press, 2012).

5See Viard, ‘‘McMahon Off Base on Consumption Tax,'' Tax Notes, Apr. 10, 2006, p. 247, Doc 2006-6408, or 2006 TNT 69-22;Carroll and Viard, supra note 4, at 18-19.

6Refutations include Alan J. Auerbach, ‘‘The Future of Fundamental Tax Reform,'' 87 Am. Econ. Rev. 143 (May 1997); Joseph Bankman and David A. Weisbach, ‘‘The Superiority of an Ideal Consumption Tax Over an Ideal Income Tax,'' 58 Stanford L. Rev.1417 (Mar. 2006); Eric Toder and Kim Rueben, ‘‘Should We Eliminate Taxation of Capital Income?'' in Taxing Capital Income 103 (Washington: Urban Institute Press, 2007); Weisbach, ‘‘Commenton Toder and Reuben,'' in Taxing Capital Income 143-151; Daniel N. Shaviro, ‘‘Beyond the Pro-Consumption Tax Consensus,''60 Stanford L. Rev. 759 (Dec. 2007); see also Viard, ‘‘For Efficiency's Sake, Consider a Consumption Tax,'' Tax Notes, Jan.24, 2000, p. 559, Doc 2000-2516, or 2000 TNT 15-103; Viard, supra note 5; and Carroll and Viard, supra note 4, at 10, 18-19. 

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About the Author

 

Alan D.
Viard
  • Alan D. Viard is a resident scholar at the American Enterprise Institute (AEI), where he studies federal tax and budget policy.

    Prior to joining AEI, Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also been a visiting scholar at the US Department of the Treasury's Office of Tax Analysis, a senior economist at the White House's Council of Economic Advisers, and a staff economist at the Joint Committee on Taxation of the US Congress. While at AEI, Viard has also taught public finance at Georgetown University’s Public Policy Institute. Earlier in his career, Viard spent time in Japan as a visiting scholar at Osaka University’s Institute of Social and Economic Research.

    A prolific writer, Viard is a frequent contributor to AEI’s “On the Margin” column in Tax Notes and was nominated for Tax Notes’s 2009 Tax Person of the Year. He has also testified before Congress, and his work has been featured in a wide range of publications, including Room for Debate in The New York Times, TheAtlantic.com, Bloomberg, NPR’s Planet Money, and The Hill. Viard is the coauthor of “Progressive Consumption Taxation: The X Tax Revisited” (2012) and “The Real Tax Burden: Beyond Dollars and Cents” (2011), and the editor of “Tax Policy Lessons from the 2000s” (2009).

    Viard received his Ph.D. in economics from Harvard University and a B.A. in economics from Yale University. He also completed the first year of the J.D. program at the University of Chicago Law School, where he qualified for law review and was awarded the Joseph Henry Beale prize for legal research and writing.
  • Phone: 202-419-5202
    Email: aviard@aei.org
  • Assistant Info

    Name: Regan Kuchan
    Phone: 202-862-5903
    Email: regan.kuchan@aei.org

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