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TaxReformLecture

TaxReformLecture - Fundamental Tax Reform Outline Should...

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1 Fundamental Tax Reform: Outline Should the US Federal income tax be replaced with a consumption tax? Income v. consumption taxation Domar-Musgrave Model Distributional Issues Reform Options Retail Sales Tax VAT and variants (Hall-Rabushka, X-tax) Transition issues
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2 Haig-Simons Definition Income = Consumption + Net Increase in Wealth This defines the tax base for a given time period (e.g. one year) Income = “power to consume” i.e. net increases in wealth are included in “income” because they could have been used for consumption
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3 Income v. Consumption Taxation Income = Consumption + Net Increase in Wealth A “consumption tax” is any tax that has consumption as its base In effect, a consumption tax abandons the effort to measure and tax changes in wealth Restricts the tax base to actual , not potential, consumption
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4 Income v. Consumption Taxation Tax Base = Consumption + Net Increase in Wealth
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5 Income v. Consumption Taxation Tax Base = Consumption
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6 Fundamental Tax Reform As this term is typically used, it refers to the replacement of the current income tax system with some form of consumption tax Has been debated extensively among tax scholars since the 1970’s Recent Presidential Commission on Tax Reform
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7 Income v. Consumption Taxation Suppose you live for 2 periods Earn $100 of wages in period 1 Earn no wages in period 2 Spend $60 in period 1 Save $40 in period 1 at a 10% interest rate Receive $4 of interest income (+ $40 principal) in period 2; consume $44
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8 Income v. Consumption Taxation Type of Tax Income Tax Base Consumption Tax Base Period 1 100 60 Period 2 4 44
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9 Income v. Consumption Taxation The major difference between income and consumption taxes is in the timing of taxes But, this difference can have important efficiency consequences Example: Consider 2 individuals, A and B Each lives for 2 periods Each earns $100 of wages in period 1 Each earns no wages in period 2
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10 Income v. Consumption Taxation A: consumes all (after-tax) income in period 1; consumes zero in period 2 B: saves all (after-tax) income in period 1; invests at 10% rate of return; consumes principal + return in period 2 What is the present value of each individual’s tax liability?
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11 Period 1 Period 2 Tax Individual Income Cons Tax Income Cons Tax Income A 100 80 20 0 0 0 (20%) B 100 0 20 8 86.4 1.6 Consumption A 100 80 20 0 0 0 (20% of pretax cons) B 100 0 0 10 88 22
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12 Tax Individual PV of Tax Liability Income A 20 (20%) B 21.5 Consumption A 20 (20% of pretax cons) B 20
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13 Income v. Consumption Taxation Under an income tax, those who save (i.e.
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