05/12/2010 1 pisani-ferry december 2010 1 Chapter 7 Tax policy Introduction At the core of politics and sovereignty "Taxation without representation is tyranny“ James Otis (1725-1783), US lawyer and politician at the time of the American Revolution «Pour l’entretien de la force publique, et pour les dépenses de l’administration, une contribution commune est indispensable; elle doit être également répartie entre les citoyens, en raison de leurs facultés ». Déclaration des droits de l’Homme et du Citoyen, Article 13, 1789 pisani-ferry december 2010 2
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Chapter 7 Tax Policy - JEAN PISANI-FERRY · Corporate income tax Personal income tax Structure of taxation by tax instrument, OECD (unweighted), 1965-2007 Source: OECD The case of
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05/12/2010
1
pisani-ferry december 20101
Chapter 7
Tax policy
Introduction
At the core of politics and sovereignty
"Taxation without representation is tyranny“
James Otis (1725-1783), US lawyer and politician at the time of the American
Revolution
« Pour l’entretien de la force publique, et pour les dépenses
de l’administration, une contribution commune est
indispensable; elle doit être également répartie entre les
citoyens, en raison de leurs facultés ».
Déclaration des droits de l’Homme et du Citoyen, Article 13, 1789
pisani-ferry december 2010 2
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pisani-ferry december 2010 3
Why taxation?
• Because governments seldom charge for their services –
hence the need for financing them through taxation
• Because taxes are instruments
– For allocative purposes – e.g. green taxes
– For distributive purposes – e.g. Income taxes
• Economic theory suggests tax policies should aim at
minimising distortions but this often conflicts with other
purposes – see Margaret Thatcher’s fall over the poll tax
• In few other fields are economics and politics as tightly
intertwined
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Outline
6.1 Issues
• What is taxation about?
• Which taxes?
• Redistribution and efficiency
6.2 Theories
• Tax incidence
• Social losses and distortions
• Optimum taxation
• Corrective taxation
• Taxation in open economies
6.3 Policies
• Efficiency
• Equity
• International coordination
pisani-ferry december 2010 5
6.1 Issues
• What is taxation about?
• Which taxes?
• Redistribution and efficiency
6.2 Theories
• Tax incidence
• Social losses and distortions
• Optimum taxation
• Corrective taxation
• Taxation in open economies
6.3 Policies
• Efficiency
• Equity
• International coordination
pisani-ferry december 2010 6
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What is taxation about?
The Musgravian trinity applies:
• Allocation
• Minimisation of distortions in the financing of public goods
• Correction of market failures
• Redistribution
• Tax policy is not the only instrument (an alternative is transfers)
but it contributes to achieving desired distribution of income and
wealth
• It is generally accepted that taxation should be either
proportional or progressive, but not regressive
• Stabilisation
• Tax policy contributes to automatic stabilisation (to an extent
that depends on income elasticities)
Some trade-offs (e.g. cigarettes)
pisani-ferry december 2010 7
How much?
pisani-ferry december 2010 8Source : OECD
15
20
25
30
35
40
45
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
% o
f G
DP
Canada
Japan
United States
EU15 unweighted
United Kingdom
Total tax revenues in selected countries, percentage of GDP, 1965-2007
Total tax revenues in EU countries, percentage of GDP, 2007
Source: European Commission
Who collects taxes?
pisani-ferry december 2010 10
0
5
10
15
20
25
30
35
40
45
50
De
nm
ark
Sw
ed
en
Be
lgiu
m
No
rwa
y
Fra
nce
Ita
ly
Fin
lan
d
Au
stri
a
Cy
pru
s
Ice
lan
d
Hu
ng
ary
Ge
rma
ny
Ne
the
rla
nd
s
Slo
ve
nia
Sp
ain
EU
27
…
Cze
ch
Po
rtu
ga
l
Luxe
mb
ou
rg UK
Ne
w Z
ea
lan
d
Po
lan
d
Ma
lta
Bu
lga
ria
Ca
na
da
Est
on
ia
Gre
ece
Ire
lan
d
Au
stra
lia
Latv
ia
Lith
ua
nia
Slo
va
kia
Ro
ma
nia
Sw
itze
rla
nd
Un
ite
d S
tate
s
Ko
rea
Turk
ey
Me
xico
% o
f G
DP
Social insurance funds
Local governments
State or regional governments
Central government
Distribution of tax revenues by level of government, selected countries, 2007
Source: OECD and European Commission
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Which taxes?
Direct taxesHouseholds
- Personal income tax
- Social security contributions
- Property taxes
- Inheritance taxes
- Wealth taxes
Companies
-Corporate income tax
- Local business taxes
- Social security contributions
Indirect taxes- VAT
– Excise taxes
– Energy taxes
– Environmental taxes
Atkinson (1977) : direct taxes are those that can be personalised (adapted to the
taxpayer’s characteristics)
Only direct taxes are to be used for redistribution purposes
Obvious? If so, why do we have two VAT rates?
Genuine taxes or social security
contributions? Bismarckian vs.
Beveridgian systems
11pisani-ferry december 2010
Which taxes? Evidence
pisani-ferry december 2010 12
0
5
10
15
20
25
30
35
40
45
50
De
nm
ark
Sw
ed
en
Be
lgiu
m
Fra
nce
Ita
ly
Fin
lan
d
Au
stri
a
Cy
pru
s
Hu
ng
ary
Ge
rma
ny
Ne
the
rla
nd
s
EU
27
un
we
igh
ted
Sp
ain
Cze
ch
Po
rtu
ga
l
Luxe
mb
ou
rg UK
Po
lan
d
Ma
lta
Bu
lga
ria
Est
on
ia
Slo
ve
nia
Gre
ece
Ire
lan
d
Latv
ia
Lith
ua
nia
Slo
va
kia
Ro
ma
nia
% o
f G
DP
Social insurance
contributionsIndirect taxes
Direct taxes
Breakdown of taxation by nature of revenues, EU countries, 2007
Who is
Bismackian?
Who is
Beveridgian?
Source: European Commission
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Changes over time
pisani-ferry december 2010 13
• Rise in VAT and social security contributions
• Decline in traditional consumption taxes and (since the 1980s) income taxes
0
10
20
30
40
50
60
70
80
90
100
1965 1975 1985 1995 2007
% o
f ta
x r
ev
en
ue
s
Other taxes (incl. green taxes)
Other consumption taxes
VAT and sales tax
Property taxes
Social insurance contributions
and payroll taxes
Corporate income tax
Personal income tax
Structure of taxation by tax instrument, OECD (unweighted), 1965-2007
Source: OECD
The case of developing countries
pisani-ferry december 2010 14
Developing countries generally exhibit lower taxation (e.g. 10 to 20% of GDP
in West Africa) and they rely much more on indirect taxes, especially customs duties
y = -0,0011x + 54,379R² = 0,2979
0
10
20
30
40
50
60
70
80
90
100
0 5 000 10 000 15 000 20 000 25 000 30 000 35 000
Indirect t
axe
s (%
of pu
blic
receip
ts)
National income per capita (PPP$)
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Redistribution and efficiency
Share of first decile in national
income, USA, 1917-2007 Zooming in: decomposition
pisani-ferry december 2010 15
Source: Atkinson, Piketty and Saez (2010)
Significant differences across countries
pisani-ferry december 2010 16
Taxation plays an important role in determining disposable income inequalities
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But the structure of income changes
pisani-ferry december 2010 17
Share of national income of the .1 per cent fractile, USA, 1916-2007
Source: Atkinson, Piketty and Saez (2010)
Graphique 7.10 – Variation (en %) de la part du revenu total en faveur du premier quintile derevenu
0
0,5
1
1,5
2
2,5
3
3,5
Allemagne Belgique France Italie Irlande Royaume-Uni
Prestations Impôts
Lecture : ce graphique indique la variation de la part cumulée dans le revenu du premier quintile de la population due aux impôtsprélevés et aux prestations distribuées.
Source : d’après Bourguignon (1998).pisani-ferry december 2010 18
Some countries redistribute more in spite of
having lower taxes
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VAT is a regressive tax
pisani-ferry december 2010 19
pisani-ferry december 2010 20
Redistribution vs. efficiency:
what matters?
Marginal tax rate T’(R)
Incentives
Efficiency
Average tax rate = T(R)/R
Redistribution
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Marginal tax rates are often highest at the bottom of
the income distribution, resulting in poverty traps
pisani-ferry december 2010 21
Marginal net tax rate for a single-worker couple with two children in France (2010)
• Goal is not to raise revenue but to correct incentives
• Pigouvian taxation an alternative to regulation
pisani-ferry december 2010 36
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What to do with the money?
• Pigouvian tax rate should be set in view of incentive objectives, not in view of revenues (optimal rate should be set in order to equalise marginal distortion across taxes)
• Solutions to dispense of revenues– Compensate taxpayers with lump-sum allowance (e.g.
grandfathering for CO2 emissions)
– Reduce other taxes (‘double dividend’), e.g. taxes on labour
– Finance public goods, possibly in the same field (e.g. research on climate change mitigation)
• Successful Pigouvian taxes are expected to shrink the tax base and therefore revenues, so double dividend approach may be self-defeating
pisani-ferry december 2010 37
Taxation in open economies and
tax competition
• Standard taxation models assume goods and factors are immobile
• Mobility (of labour; capital; and goods and services) raises issues of tax
competition
• Applies
– Across jurisdictions within countries (local taxation). Major issue for income taxes,
business taxes
– Across countries. Increasingly significant issue for income taxes, corporate income
taxes
• Tax competition can be viewed:
– A good thing if the government is considered a Leviathan (or just an inefficient government)
– A bad thing if the government is considered benevolent and efficient: reduced provision of
public goods, tax inequality arising from heavier taxation of less-mobile bases (low-skill labor)
pisani-ferry december 2010 38
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Tax competition models
pisani-ferry december 2010 39
Tiebout (1956) :
• N jurisdictions with different tax rates and government services
• Individuals ‘vote with their feet’ and move across jurisdictions. Two effects:
– Eliminates inefficient tax / government service combinations
– Makes room for diversity (individuals group according to preferences)
Zodrow et Mieszkowski (1986):
• If all jurisdictions have similar preferences, provision of government services under
such tax competition will be lower than its optimum
• Validates ‘race to bottom’ view
Bucovetsky et Wilson (1991):
• If capital is mobile and labour is immobile, taxation will fall on labour
Baldwin et al. (2003):
• Agglomeration generates rents that are taxable
• Tax competition a way for peripheral countries to compensate disadvantage
Tax competition in practice: The EU case
Corporate tax rate, 1990-2007 Standard VAT rate, 1982-2010
pisani-ferry december 2010 40
15%
20%
25%
30%
35%
40%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
Statutory EU15
Effective average EU15
Effective average NMS8
Statutory NMS10
18.0%
18.5%
19.0%
19.5%
20.0%
20.5%
21.0%
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
NMS10
EU15
Source: European Commission
05/12/2010
21
6.1 Issues
• What is taxation about?
• Which taxes?
• Redistribution and efficiency
6.2 Theories
• Tax incidence
• Social losses and distortions
• Optimum taxation
• Corrective taxation
• Taxation in open economies
6.3 Policies
• Efficiency
• Equity
• International coordination
pisani-ferry december 2010 41
Theory and policy
• Tax policy less influenced by economic theory than decisions
in other policy fields
• Examples:
– Bush tax cuts
– French VAT cut for restaurants
• Why?
– Some straightforward recommendations, but
– Other concerns (ex: ‘un vieil impôt est un bon impôt’)
– Tax theory concepts difficult to grasp (tax incidence)
pisani-ferry december 2010 42
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pisani-ferry december 2010 43
Efficiency
Equivalence principle
• where WP is real cost of labour for the employer, Ω is net real income for the employee
• Labour demand and supply elasticitities command the variations of Ω and W/P in response to changes in tax rates (tax incidence)
Ignores that VAT is also paid on capital income and pension income (but investment isexempted from VAT)
Equivalence only applies in the long run (in the short run rigidities matter)Example: Germany 2007 • Initially lowering of social security contributions and raise of VAT• Later on led to demands for wage increases
Special cases:• Minimum wage (in France, set in real terms net of social security contributions but
gross of VAT)• Open economy
P
W
tt
tt
VATSSC
PITSSC
)1)(1(
)1)(1(
1
2
++
−−=Ω
pisani-ferry december 2010 44
Case study: VAT vs social contributions
First step: Y = C
• the VAT base is Y ;
• if the share of labor in value added is 2/3, the social contribution base is 2Y/3 ;
• to raise receipts of Y/5, you need a 20% VAT rate or a 30% SC rate: VAT less distorsionary (Ramsey rule).
Second step: Y = C + I
• if the share of labor in value added is 2/3, the VAT base shrinks to 2/3 Y ;
• the social contribution base is still 2Y/3
• to raise receipts of Y/5, you need a 30% VAT rate or a 30% SC rate: the two levies are equivalent.
• this corresponds to the golden rule of growth where I/Y = rK/Y = 1- wL/Y
Third step: Y = C + I + X - QM
• unchanged VAT receipts if X = QM, higher receipts if X < QM (trade deficit) ;
• however foreign suppliers may reduce their export prices following a VAT
Conclusion: impact of a substitution of VAT for employers’ contributions
• short run: increased competitiveness, reduced purchasing power
• long run: increased net wages, no impact on competitiveness neither on purchasing power (except
incomplete pass-through from foreign suppliers and/or distributional effects across industries)
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In practice VAT increasingly popular
pisani-ferry december 2010 45
General consumption taxes in OECD countries, percentage of total
revenues, 2007
0
5
10
15
20
25
30H
un
ga
ry
Ice
lan
d
Ire
lan
d
Po
rtu
ga
l
Ne
w-Z
ea
lan
d
Po
lan
d
Gre
ece
Slo
va
k R
ep
.
De
nm
ark
Turk
ey
Me
xico
Ne
the
rla
nd
s
Fin
lan
d
Ge
rma
ny
Sw
ed
en
No
rwa
y
EU
15
un
we
igh
ted
OE
CD
un
we
igh
ted
Au
stri
a
UK
Cze
ch R
ep
.
Fra
nce
Be
lgiu
m
Sp
ain
Ko
rea
Luxe
mb
ou
rg
Ita
ly
Ca
na
da
Sw
itze
rla
nd
Au
stra
lia
Jap
an
% o
f to
tal
tax
re
ve
nu
es
Source: OECD
pisani-ferry december 2010 46
Case study: VAT vs sales taxAssumptions
• A producer of an intermediate input sells for EUR 100 to a producer of a final good
• The producer of the final good sells for EUR 150 to a final consumer
VAT 20%
• the intermediate input producer charges a EUR 20 VAT;
• the final good producer charges a EUR 30 VAT and recovers EUR 20 on his purchase of the
intermediate good;
• tax receipt: EUR 30.
Sales tax 20%
• the intermediate input producer does not charge any tax;
• the final good producer charges a EUR 30 sales tax;
• tax receipt: EUR 30.
Advantage of the VAT over the sales tax
• in case one producer in the value-added chain omits to declare VAT, the latter will be charged at
a later stage of the chain; there is an incentive for each firm to declare its purchases;
• however fraud on VAT is widespread (up to10% of the receipts in some Member states).
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pisani-ferry december 2010 47
Number of countries with VAT
pisani-ferry december 2010 48
Efficiency: the CIT case
Should firms’ profits be taxed?
•Useless is final incidence is on labor;
• Better tax capital income at the household level (less mobile than capital itself).
Justifications to CIT:
• Corporate income easier to track at the source than at the residence level;
• Try to tax only rents;
•The only way to tax foreign shareholders;
• Save the personal income tax (what if households become firms?);
• Political economy: firms don’t vote.
However the CIT raises some difficulties
• Source or residence principle? (how to tax affiliates’ benefits)
• Base: stock return (exemption of interests on debt), capital return (taxation of interests) or
just rents (exemption of interests and of « normal » dividends?
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pisani-ferry december 2010 49
Equity
progressive or flat tax ?
Bourguigon & Chiappori (1998,
France) : PIT, constant rate of
35% necessary to fund a
universal income of 4500 euros
for a single.
Georges W. Bush (2001, 2003,
USA): unfunded tax cuts
pisani-ferry december 2010 50
The flat tax
Flat tax adopted Personal income tax rates Corporate income
tax rate, after
reform
Change in basic
allowance After Before
Estonia 1994 26 16-33 26 Modest increase
Lithuania 1994 33 18-33 29 Substantial increase
Latvia 1997 25 25 and 10 25 Slight reduction
Russia 2001 13 12-30 37 Modest increase
Ukraine 2004 13 10-40 25 Increase
Slovak Rep. 2005 19 10-38 19 Substantial increase
Georgia 2005 12 12-20 20 Eliminated
Romania 2005 16 18-40 16 Increase
Note: Most countries do not apply pure flat tax systems since the flat rate does not apply to all tax bases. For
instance, social insurance contributions are levied separately. To the extent that these contributions exceed the
present value of future (contingent) social benefits, the system is not neutral, since labor and capital income are
not taxed equally. See OECD (2006).
Source: Keen et al. (2006).
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pisani-ferry december 2010 51
Example: the 2001 reform in Russia
Marginal and average tax rates before and after Russian tax reform
Equity: inter-temporal aspectsimpact of 2001-2006 tax cuts in the United States
Percentage change of after-tax income, in 2006
0
1
2
3
4
5
6
7
1st
quintile
2nd
quintile
3rd
quintile
4th
quintile
5th
quintile
Top 10% Top 5% Top 1% Top
0,5%
Top
0,1%
Source: Leiserson and Rohaly (2006).
Percentage change in after-tax income for various percentiles of the population, 2010
-20
-15
-10
-5
0
5
10
1st
quintile
2nd
quintile
3rd
quintile
4th
quintile
5th
quintile
Top 10% Top 5% Top 1% Top
0,5%
Top
0,1%
Source: Leiserson and Rohaly (2006).
No financing Lump-sum financing
Financing proportional to income Financing proportional to tax liability
Direct effect Accounting for financing
pisani-ferry december 2010 54
Horizontal equity: capital income
• Avoid double taxation (labor income, capital income) :
payment in full discharge, tax credit, dual tax (Sweden).
• Distortion between tax treatment of interests and dividends
(CIT)
• Distortion between physical and human capital
• Tax expenditure = 20% of tax receipts in France, 40% in Spain,
50% in the United States.
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pisani-ferry december 2010 55
Collection costs
Tax administration costs in percentage of net tax receipts, 1997
0
0,2
0,4
0,6
0,8
1
1,2
1,4
1,6
1,8
Unite
d Sta
tes
Swed
en
Ireland
Spain
Canad
aUK
Net
herla
nds
Italy
Fran
ce
Ger
man
y
Source: Lépine (1999).
United States:
For each dollar of
tax, 22 cents paid to
layers or advisers
(average, source
Hodge et al. 2005).
Alternative
minimum tax.
pisani-ferry december 2010 56
European tax coordination
• VAT: « transitory » regime (since1993) :
– Origin principle only for across-the-border purchases by households, mail-order selling and cars;
– Destination principle: general case (carrousel fraud ≅ 10% in some Member states).
• Taxation of personal capital income (January 2003) :
– « Tax package » = exchange of information (after a delay an conditional on agreements with tax heavens) + code of conduct (harmful practices)
• CIT
– « Mother-affiliate » directive against double-taxation of repatriated profits;
– Ruding report (1992): minimum tax rate
– Base harmonization and consolidation (October 2001). Enhanced cooperation? 2008.
• A European tax?
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pisani-ferry december 2010 57
Standard VAT rates in 2008
10%
12%
14%
16%
18%
20%
22%
24%
Den
mar
k
Swed
en
Finland
Polan
d
Belgium
Ireland
Portu
gal
Austri
aIta
ly
Bulga
ria
Hun
gary
Slove
nia
Franc
e
Ger
man
y
Gre
ece
Net
herla
nds
Cze
ch R
ep.
Rom
ania
Slova
kia
Eston
ia
Latvia
Lith
uania
Malta U
K
Spain
Luxe
mbo
urg
Cyp
rus
Source: European Commission (2008).
References
• Atkinson, A. (1977), “Optimal Taxation and the Direct versus Indirect Tax Controversy,” Canadian Journal of Economics, 10, pp. 590–606.
• Atkinson, A., T. Piketty and E. Saez (2010), “Top income in the long run of history”, mimeo, http://piketty.pse.ens.fr/fichiers/public/AtkinsonPikettySaez2010.pdf
• Baldwin, R., R. Forslid, P. Martin, G. Ottaviano, and F. Robert-Nicoud (2003), Economic Geography and Public Policy, Princeton University Press.
• Bourguignon, F., and D. Bureau (1999), “L’architecture des prélèvements obligatoires en France: état des lieux et voies de réforme,” Rapport pour le Conseil d’Analyse Economique, no. 17, Paris: La Documentation Française.
• Bourguignon, F., and P.-A. Chiappori (1998), “Fiscalité et redistribution,” Revue Française d’Economie, 13, pp.1–64.
• Bucovetsky, S., and J.D. Wilson, (1991), “Tax Competition with Two Tax Instruments,” Regional Science and Urban Economics, 21, pp. 333–50.
• Laffer A. (2004), “The Laffer Curve: Past, and Present Future,” Backgrounder no. 1765, Washington DC: The Heritage Foundation, available at www.heritage.org.
• Mirrlees, J. (1971), “An Exploration of the Theory of Optimal Income Taxation,” Review of Economic studies, 38, pp. 175–208.
• Olson, M. (1969), “The Principle of ‘Fiscal Equivalence’: The Division of Responsibilities among Different Levels of Government,” American Economic Review, 59, pp. 479–87.
• Salanié, B. (2003), The Economics of Taxation, MIT Press.
• Tiebout, Ch. (1956), “A pure theory of local expenditures,” Journal of Political Economy, 64, pp. 416–24.
• Zodrow, G., and P. Mieszkowski (1986), “Pigou, Tiebout, Property Taxation, and the Underprovision of Local Public Goods,” Journal of Urban Economics, 19, pp. 356–70.