Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin - - PowerPoint PPT Presentation

ECON 551: Lecture 7 1 of 43

Econ 551 Government Finance: Revenues Fall 2019

Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 7: Choosing a Tax Base

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Agenda

• 1. Equity Principles
• 2. (Schanz) Haig Simons Definition of Income
• 3. Exemptions and Deductions
• 4. Alternative Bases
• 5. The Optimal Tax Approach
• 6. Canada’s system

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Equity Principles

Q: Who should pay taxes? On what principle should we distribute the tax burden?

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Q: Who should pay taxes? Answer 1: Those who benefit from the spending. ..also known as ‘the benefit principle’ Answer 2: Those who have the ability to pay. …also known as ‘ability to pay principle’

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Benefit Principle

Long history back to at least Adam Smith (1776): “ […] The expence of government to the individuals of a great nation is like the expence of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. In the observation or neglect of this maxim consists what is called the equality or inequality of taxation.” Adam Smith, The Wealth of Nations, Book V, Chapter 2, Part 1.

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Benefit Principle

 Imagine we thought the current distribution of income was just. Then, it might make sense to tax only those who receive benefits, or else the just distribution would be disturbed.  Another way to think about it is voluntary exchange. If taxes exceed benefits, then people would not likely make this exchange voluntarily. Under this view, taxation is only possible through coercion.  Swedish economist Knut Wicksell went so far as to argue a unanimity rule: everyone must agree to an expenditure for it to be equitable.  But should we take an insurance view? Maybe we *would* have benefited in another state of the world.

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Ability to pay Principle

John Stewart Mill: Principles of Political Economy (1848), Book V, Chapter II.8 ‘On the general principles of taxation’ [link] “If we wanted to estimate the degrees of benefit which different persons derive from the protection

• f government, we should have to consider who would suffer most if that protection were

withdrawn: to which question if any answer could be made, it must be, that those would suffer most who were weakest in mind or body, either by nature or by position. Indeed, such persons would almost infallibly be slaves. If there were any justice, therefore, in the theory of justice now under consideration, those who are least capable of helping or defending themselves, being those to whom the protection of government is the most indispensable, ought to pay the greatest share of its price: the reverse of the true idea of distributive justice, which consists not in imitating but in redressing the inequalities and wrongs of nature.”

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Ability to pay Principle

 If we think the current distribution of resources is not just, we might want to adjust it for the reasons we have already discussed in a previous lecture.  Note that it ignores the spending side of the budget.

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Ability to Pay or Benefit Principle?

Now go back to Adam Smith… “ The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities;” ..next sentence…

“…that is, in proportion to the revenue which they respectively enjoy under the protection of the

state.” If you think of the state defending your right to keep your income, higher income people benefit more from the state. This mixes benefit and ability to pay principles.

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Vertical vs Horizontal Equity

Vertical equity: Definition: Tax burdens should be increasing in ability to pay. Horizontal equity: Definition: Those with equal ability to pay should have the same tax burden. Q: Are these actually distinct concepts?

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Indexing ability to pay How should we measure ‘ability to pay’? Any suggestions?

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Indexing ability to pay  Wealth  Income  Consumption  IQ  Natural endowment

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Agenda

• 1. Equity Principles
• 2. (Schanz) Haig Simons Definition of Income
• 3. Exemptions and Deductions
• 4. Alternative Bases
• 5. The Optimal Tax Approach
• 6. Canada’s system

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(Schanz)-Haig-Simons Definition of Income

This definition is most often associated with Haig and Simons, but German economist Georg von Schanz had an earlier claim… Robert Murray Haig in ‘The Federal Income Tax’, 1921. p. 27: “Income is the money value of the net accretion to one’s economic power between two points in time.” Henry C. Simons in ‘Personal Income Taxation’ 1938, p. 50: “Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question.”

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(Schanz) Haig Simons Definition of Income

Georg Schanz in “Der Einkommensbegriff und die Einkommensteuergesetze” FinanzArchiv 1896: [link] Wir wollen wissen, welche wirtschaftliche Leistungsfähigkeit einer Person,

• hne daß sie ihr Kapital aufzehrt oder Schulden macht, in einem

bestimmten Zeitabschnitt zukommt, über was sie so z. B. in einem bestimmten Jahr disponieren kann ; ob diese Summe wiederkehrt, wie sie sich zusammensetzt, ob sie der Wiederkehr fähig ist, ist für das betreffende Jahr gleichgültig. In English via Google translate: “We want to know which economic performance of a person without that it absorbs its capital or debt, makes plays in a given time period, about what they can, for example, dispose in any given year, whether this sum returns as composed, whether it is capable of repetition, no matter for that year.”

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S-H-S in math:

The H-S concept can be expressed algebraically as the sum of consumption and the change in the value of all assets. H-S income = C + A This definition has roots right back to Adam Smith in ‘The Wealth of Nations.” It is meant to measure the amount that one could consume over the time period, holding wealth

• constant. (It is not clear in principle why we should want to hold wealth constant, however.)

Q: Do you think this concept is a good measure of ‘ability to pay’?

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S-H-S example:

 Income 2018=$15K  House value 2017=$850K  House value 2018=$950K  Gain in value of assets = $100K  Pure H-S definition of income would include the $100K  To access this, however, Granny might have to sell her house!

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S-H-S implementation problems:

Valuing assets every period  This could be very difficult to do – think of stamp collections, other unique assets.  Even if unrealized, you would be taxed. Example of Granny in an appreciated house, but little cash income. Inflation  Consider a time when inflation is 10% annually.  If you have a return of 10% on your bond, your real return is 0%.  So, A=0, but a system that taxes nominal income would say A>0.

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Agenda

• 1. Equity Principles
• 2. (Schanz) Haig Simons Definition of Income
• 3. Exemptions and Deductions
• 4. Alternative Bases
• 5. The Optimal Tax Approach
• 6. Canada’s system

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Exemptions and deductions in S-H-S

H-S income = C + A How should we measure ‘C’?  Joe has income of $40K. He must pay $3,000 per year for insulin to stay alive.  Frank has income of $40K and spends it all on beer, cigarettes, and pizza. Q: Since they have the same income, should they be treated the same? Do they both have the same ‘ability to pay’? Another example:  Arthur has 10 children and an income of $40K.  George has income of $40K and lives on his own in a cool downtown condo sipping lattes and eating out at fancy restaurants.

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Three categories of ‘C’ that might deserve special treatment

1. Expenses necessary to earn income. Some things don’t bring utility to the household directly, but instead allow the household to generate income. Some examples:  Union dues or professional fees.  Tools, commuting expenses.  Childcare costs.  Moving expenses.  Interest paid on funds borrowed to make investments. What if these weren’t treated specially? In this case, it would bias the tax system against work

• utside the home.

Challenge: how far to go in defining these expenses. What about food? Clothing? Entertainment and hospitality?

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Three categories of ‘C’ that might deserve special treatment

2. Involuntary expenses. Some expenses result from bad luck or expenses that must be made without choice. Why should we include those expenses in our index of ability to pay? One could argue these are differences in need rather than a choice among gratifications.  Medical expenses.  Caregiver expenses.  Special treatment of children.  Basic living expenses. However, isn’t there really some choice involved in some of these – such as children? Also, how to limit things under this category. Wouldn’t umbrellas count? I don’t get gratification from buying an umbrella.

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Three categories of ‘C’ that might deserve special treatment

3. Correcting externalities: trying to change our behaviour. Some things receive special tax treatment because government wants to encourage them.  Charitable donations.  Children’s sports (was removed as of 2018….)

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Should these items have special tax treatment? Why?

 Charitable donations.  Toiletries.  Childcare expenses.  Tuition? (What about pottery classes?)  Medical expenses. (What about a single room? A TV?)  Viagra?  Commuting expenses (gasoline? Food for bicyclists?)

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Example: Wayne Scott the courier

Wayne Scott was a Toronto courier who won a court case in 1998 to have his food recognized as a business expense.

http://messarchives.com/foodasfuel.html Toronto Councilor Jack Layton presents Wayne Scott with award from the City

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Alternative view: Brooks (2016)

Separate the raising of revenue from the ‘spending’:  We raise revenue with the rates and brackets.  Any credits, deductions, or preferences are like spending. Evaluate redistribution.  Akin to “from each according to ability; to each according to need”. Example: Child Care Expense Deduction Traditional horizontal equity view: adjust tax base through deduction to account for cost of work. Brooks view: Why should we cut bigger cheques to high earners? If we’re going to spend on childcare, spend on childcare. Why this pattern for payouts? Necessary condition for this to work:  We need to be *very* comfortable with the ‘core’ tax base of the rates-brackets system.

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Agenda

• 1. Equity Principles
• 2. (Schanz) Haig Simons Definition of Income
• 3. Exemptions and Deductions
• 4. Alternative Bases
• 5. The Optimal Tax Approach
• 6. Canada’s system

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Alternative bases: Expenditure taxation

How can we avoid some of the problems with the H-S definition?  Primary focus: ‘double’ taxation of savings; heavier taxation of future consumption 𝑧 = 𝑑1 + (1 + 𝑠)𝑑2

C1 C2 U0 E0 U1 E1 Slope is −(1 + 𝑠) Slope is −൫1 + 𝑠(1 − 𝑢)൯

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Alternative bases: Expenditure taxation

John Stuart Mill, Nicholas Kaldor, and many others advocated expenditure tax. Expenditures = income - savings Kaldor: the income tax is based on what you put into society, while an expenditure tax would tax what you take out of society.  Avoids the real-world problems of taxing the returns to capital  Treats early and late consumers equitably, thus preserving one type of horizontal equity. Of course, there are also several objections to an expenditure tax.  The consumption of some people will escape taxation: Émigrés, miserly millionaires.  On a period basis, some with large capital income may escape taxation.  What of bequests, or wealth-for-wealth’s sake instead of consumption?

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Alternative bases: Dual Income Taxation

Separate the taxation of earned income from capital income.  Earned income at a progressive rate  Capital income at a lower, flat rate. Implemented in Sweden, Norway, Finland, Denmark in 1990s.  Other countries moving in that direction with flat taxation of dividends (e.g. Germany) Advantages:  Can tax the growing, less mobile earnings base progressively.  Lower tax on capital income to encourage saving, lower gain to avoidance. Disadvantages:  Opens gain to tax arbitrage: camouflage your earned income as capital income.  Self-employment—what is return to work; what is return to capital?

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Agenda

• 1. Equity Principles
• 2. (Schanz) Haig Simons Definition of Income
• 3. Exemptions and Deductions
• 4. Alternative Bases
• 5. The Optimal Tax Approach
• 6. Canada’s system

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The optimal tax approach: Mirrlees Review

In 2010-11, James Mirrlees led a broad review of the UK tax system.  Advocated a ‘welfarist’ approach instead of ‘ideal tax base’ approach. Banks and Diamond (2010) do a deep dive on the ‘ideal’ vs ‘optimal’ approach to the tax base. The core of their argument:  Ability to pay / budget set approach recognizes skill differences, but not preferences  Optimal tax clarifies objectives and constraints, sets out efficiency and distribution explicitly.

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The optimal tax approach: Mirrlees Review

Example: should we tax capital income?  What does theory say? Atkinson-Stiglitz theorem; differential taxation of C1 vs C2.  Key questions: are savings correlated with leisure? Who has high C2?  Mirrlees review used theory/empirics as guidance for the proposed treatment of capital income. Practical problems:  How to turn optimal tax formulas into action: heavy information requirement.  What social welfare function? What are relevant elasticities?

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Agenda

• 1. Equity Principles
• 2. (Schanz) Haig Simons Definition of Income
• 3. Exemptions and Deductions
• 4. Alternative Bases
• 5. The Optimal Tax Approach
• 6. Canada’s income tax system

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Brief overview of income taxation in Canada

The 1966 Royal Commission on Taxation (“Carter Commission”)  Advocated ‘comprehensive income’ concept.  Include capital gains; unemployment benefits, family allowance  View corporations as a ‘veil’; undo corporate tax at individual level through integration.  Elevated equity—measured by ability-to-pay/comprehensive income—to most important design priority.  Partially implemented in 1972 tax reform.

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Deductions vs. Credits

Deductions: lower taxable income before tax rates applied.  Value depends on marginal tax rate: higher for high income filers. Credits: lower tax liability. For non-refundable, can’t lower it below zero.  Value same for all taxable returns. Time permitting, we will take a tour of the tax forms available from the CRA here:

https://www.canada.ca/en/revenue-agency/services/forms-publications/tax-packages-years/general-income-tax-benefit-package.html

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Basic structure

[Income Items] LINE 150 TOTAL INCOME [Deductions before net income] LINE 236 NET INCOME [Deductions before taxable income] LINE 260 TAXABLE INCOME [Non-refundable credit items on Schedule 1 times credit rate of 15%] LINE 350 TOTAL NONREFUNDABLE CREDITS [Tax liability using brackets and rates. Subtract off non-refundable credits.] LINE 420 NET FEDERAL TAX

ECON 551: Lecture 7

ECON 551: Lecture 7

ECON 551: Lecture 7

ECON 551: Lecture 7

ECON 551: Lecture 7

ECON 551: Lecture 7