Insights from a Tax-Systems Perspective - Joel Slemrod - Barcelona GSE Lecture


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Joel Slemrod (Ross School of Business, University of Michigan)
Barcelona GSE Lecture XXVIII
Barcelona Graduate School of Economics

Based on Prof. Slemrod's forthcoming book, Tax Systems, co-authored with Christian Gillitzer (MIT Press).

Video summary of the lecture included after the last slide.

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Insights from a Tax-Systems Perspective - Joel Slemrod - Barcelona GSE Lecture

  1. 1. Insights from a Tax-Systems Perspective Joel Slemrod University of Michigan Barcelona October 21, 2013 (Based on Tax Systems, co-authored with Christian Gillitzer, MIT Press forthcoming.)
  2. 2. Tax Phenomena • A new type of motorcycle with three wheels and long benches at the back seating up to eight passengers, and a redesigned panel truck with glass windows instead of wood panels and upholstered seats in the back— both designed to avoid high taxes on cars. • Income taxes based not on income but, for restaurants, the seating square footage and number of tables.
  3. 3. Tax Phenomena (2) • Simplified tax rules—or no tax at all— levied on businesses below a size threshold. • The IRS Commissioner testifying before its Congressional appropriations committee that an additional dollar added to its budget will generate $7.30 in additional tax revenue, and will therefore decrease, not increase, the deficit.
  4. 4. Tax Phenomena (3) • Tax experts declaring a value-added tax as a self-enforcing administrator’s dream, while deriding the textbookequivalent retail sales tax as not acceptable under usual standards of equity and intrusiveness. • In the United States the self-employed remit only 43% of their true tax liability, while wage and salary earners remit 99%.
  5. 5. Tax Phenomena (4) • U.S. corporations making substantial real investments in Puerto Rico in electronics, pharmaceutical, and high-fashion production, not generally considered activities in which Puerto Rico has a comparative advantage. • Standard tax analysis models struggle to illuminate these examples. Why?
  6. 6. The Modern Theory of Taxation • The modern theory of taxation, beginning circa 1970, represented a major breakthrough in how economics addressed the issue. • It provided a rigorous basis for analysis, which enables intellectual progress. • Like all models, the modern models of taxation are stylized; they emphasize certain aspects of taxation at the expense of others.
  7. 7. Limitations of the Standard Toolkit 1. Little attention paid to the administrative and compliance costs of taxation. (Exception: practical discussion of “tax handles”) 2. A focus on tax rates and, to a lesser extent, tax bases, to the relative exclusion of all other tax system instruments, such as enforcement tools (audits, evasion penalties, “loopholes,” public disclosure).
  8. 8. Limitations of the Standard Toolkit 3. A focus on what might be called real behavioral responses to taxation, to the relative exclusion of avoidance and evasion responses. (Mirrlees: labor supply only. Allingham & Sandmo introduce evasion.) 4. A recognition of the central role of asymmetric information between the government and private citizens, but extreme assumptions regarding what is measurable without cost and what is not measurable at any cost. (Mirrlees: can measure income, cannot measure ability or effort.)
  9. 9. Limitations of the Standard Toolkit 5. No meaningful role for firms. With constant returns to scale, firm size is indeterminate and irrelevant. 6. No concern with the details of tax remittance. Folk theorems about its irrelevance. I will argue this evening that a tax-systems perspective can provide insight into these, and other, important issues.
  10. 10. What Is a Tax System? A set of rules, regulations, and procedures that: 1. Defines what events or states of the world trigger tax liability (tax bases and rates). 2. Specifies who or what entity must remit that tax and when (remittance rules). 3. Details procedures for ensuring compliance, including information-reporting requirements and the consequences (including penalties) of not remitting the legal liability (enforcement rules). Standard analysis presumes that tax liability can be ascertained and collected costlessly, in which case statement 2 is irrelevant and statement 3 is unnecessary.
  11. 11. Tax-Systems Analysis Addresses: 1. Although some individuals may remit their tax liability dutifully, others view compliance as a tactical decision and will evade their liabilities if the odds of success seem favorable. 2. Taxpayers will re-arrange their affairs to legally reduce their tax liability, including efforts to reduce their tax liability without altering their real activities, which I will refer to as avoidance.
  12. 12. and… 3. Limiting avoidance and evasion is costly, and tax authorities have limited administrative resources. 4. Tax authorities have multiple, but limited, policy instruments. 5. Taxpayers (and tax policy makers) have cognitive limitations. 6. The world is complex, complicating the collection of non-capricious taxes. Some of the complication is manufactured by taxpayers to obfuscate their affairs, and some exists because the tax system is used to achieve specific social goals in addition to raising revenue.
  13. 13. Outline of What’s Next • Building Blocks of Tax Systems – Multiple behavioral responses – Multiple sources of cost – Multiple tax instruments – Tax base elasticity • Optimal Tax Systems – Standard tax instruments – New tax instruments – Implications of the information revolution
  14. 14. Multiple Costs--Administrative • Collecting taxes, especially noncapriciously, requires a costly bureaucracy. • One reason is the need for a payment and collection system. • For any given objective, there are more and less effective ways for a tax administration to operate.
  15. 15. Administrative Costs • For example, should a tax administration be organized by tax levy (e.g., corporate tax versus value-added tax), or by taxpayer segment (e.g., corporations versus high-income individuals)? How should it be organized to minimize corruption? • Important procedural differences across tax systems include the degree of self-assessment, the extent to which income withholding at source is used and the amount of arms-length information reporting of tax liabilities to the tax authority.
  16. 16. Administrative Costs (2) • Market (non-cash) transactions facilitate administration. A modified Coase assertion: equilibrium firm size is not optimal in a world with taxes. • AC is a function of the physical size, tangibility/visibility and mobility of the tax base (e.g., it is harder to tax diamonds than windows), whether there is a registration of the tax base (e.g., owners of cars), and the number of taxpayer units. • AC is an increasing function of the complexity and lack of clarity of the tax law, ceteris paribus. • They tend to be discontinuous and to have decreasing average costs with respect to the tax rate.
  17. 17. Multiple Costs―Compliance • Compliance costs, borne in the first instance by taxpayers, dwarf the administrative costs. For the U.S. income tax, CC =~10% of revenues, versus 0.6% for AC. • Burden may be shifted, as for tax liability. • Administrative costs also ultimately burden citizens, although they show up as government expenditures. • CCs have been generally measured using surveys. Biases going both ways: a survey is like a tax form, and some may want to express frustration.
  18. 18. Compliance Costs • How to value time spent? • Voluntary versus involuntary CCs—does it matter in measuring social cost? • Which costs are truly marginal is tricky, especially for businesses. What value, if any, does addressing one’s financial affairs provide? • Tradeoffs in administrative versus compliance costs: existing expertise, transparency, differing shadow cost.
  19. 19. Multiple Behavioral Responses: Evasion • Positive theoretical analysis has taken off since the deterrence model of Allingham and Sandmo (1972). Non-deterrence theories (e.g., duty, altruism, process) have proliferated, but without much empirical support to date. There is overwhelming support for deterrence. • Empirical analysis is challenging, and creativity is rewarded. (“You can’t measure the right-handside-variables, and you can’t measure the left-
  20. 20. Evasion There are, though, several promising developments: 1. Traces-of-income approach – Pissarides-Weber, Feldman-Slemrod, etc. 2. Randomized field experiments ― Slemrod et al. on income tax in Minnesota (USA), Kleven et al. in Denmark, Pomeranz on VAT in Chile, Fellner et al. on TV fees in Austria 3. Administrative data (mostly in Scandinavia) We may never be allowed to do randomized field experiments on tax rates or bases, but we can, and are getting, to do them for other tax instruments.
  21. 21. Multiple Behavioral Responses: Avoidance • What is it? “Taxpayer efforts to reduce their tax liability that do not alter their consumption basket other than due to income effects.” • Examples: paying a tax professional to search for deductions, tax arbitrage, slightly re-timing a transaction, slightly re-engineering a vehicle.
  22. 22. Avoidance • Much avoidance arises because what triggers tax liability is not real variables or Haig-Simons income. We rely instead on surrogate tax bases that may be justified on administrative/compliance cost grounds • Examples: taxes on realized capital gains; income shifting; arbitrary, incoherent treatment of financial transactions such as debt versus equity.
  23. 23. Interactions among Responses • Example: Income from real U.S. investment in Puerto Rico was subject to a low rate, and was not subject to any U.S. residual tax, thus making income shifting very attractive. • Result: Much U.S. investment in high-margin activities in P.R. (electronics, pharma, high-fashion) • The income-shifting was facilitated by real investment, thus providing an avoidance-facilitation implicit subsidy to real investment there. • Lesson: Tax-systems issuss matter for real behavior.
  24. 24. Interactions (2) • The notion of avoidance facilitation allows us to rethink Rosen (1976), where he interpreted the differential response of labor supply to lnw and ln(1-t) as tax illusion (“lack of salience” in modern terminology). • But, the effective price of a real decision depends on the avoidance/evasion technology; the tax can be “finessed,” but the pre-tax price cannot be. • Lesson #1: In general, one should not expect a homologous response to the pre-tax price and the netof-tax term, even with no illusion. • Lesson #2: Avoidance/evasion affects real decisions.
  25. 25. Tax Instruments: Withholding and Information Reporting • Withholding and information reporting: In the United States, the noncompliance rate is • 56% when “little or no” information reporting • 11% when “some” information reporting • 8% when “substantial” information reporting • 1% when both withholding and substantial information reporting • This suggests a central role of firms, discussed a bit later, and provides support for the deterrence theory.
  26. 26. Tax Instruments: Market Transactions • Basing tax liability on market transactions provides a natural check on accuracy, relies on betterdocumented data, and establishes arm’s-length prices. • But cash transactions are much more problematic. Compare Gordon-Li argument for subsiding relationships with financial institutions and the recent IRS 1099-K initiative. • Issues also arise with family firms, as examined by Kopczuk and Slemrod (2011).
  27. 27. Tax Instruments: Public Disclosure • Policy in the United States during the Civil War, and again in the 1920s and 1930s. • Current policy in Norway, Sweden, and Finland; it was policy in Japan from 1949-2004. • A serious proposal in Australia recently. • Supporters say it reduces tax evasion/avoidance and improves policy transparency, opponents decry the loss of privacy and the negative attention brought to the affluent. • What do we know about its consequences? • Discuss evidence from Japan in Hasegawa et al. (2012) and from Norway in Slemrod et al. (2013).
  28. 28. The Econometrics of Multiple Tax Instruments • Potential bias of omitting tax instruments; crosscountry data from the OECD is now available. • Example: Kawano and Slemrod (2012) examine the effect of corporate tax rate changes on corporate tax revenues, controlling for multiple non-rate instruments. Base and rate changes tend to happen together, but not always.
  29. 29. The Tax Base Elasticity • All behavioral responses to tax rates are symptoms of inefficiency. • Although traditionally economists focused on real responses, the same logic applies to avoidance and evasion responses, which are particularly important for sophisticated taxpayers—highincome individuals and multinational corporations—but also for self-employed people in cash businesses. • These responses are summarized by the tax base elasticity.
  30. 30. The Elasticity of Taxable Income • For an income tax, all the responses are summarized by the elasticity of taxable income, or ETI, to the netof-tax rate. • Much recent effort has gone into estimating the ETI. See Saez, Slemrod, and Giertz (JEL, 2012) for a critical summary of the empirical research. • Saez et al. suggest a longer-term ETI of between 0.12 and 0.40. • But these estimated ETIs must be adjusted for the fiscal externalities discussed next.
  31. 31. Caveats in Using TBE/ETIs For a TBE/ETI to be a sufficient statistic for measuring the marginal welfare cost of changing a tax rate: 1. Must consider income shifting across tax bases. Otherwise one will over-estimate the welfare-relevant behavioral response. 2. Must consider shifting across time and measure TBE in a present-value sense.
  32. 32. The Endogeneity of TBE/ETIs The TBE/ETI depends on: • Non-rate tax instrument choices made by the home government, including enforcement and base (as well as avoidance opportunities facilitated by other governments—e.g., tax havens). • Slemrod and Kopczuk (2002) argue that there is an optimal ETI.
  33. 33. Optimal Tax Systems • Changes answers to classic OT questions, such as optimal income tax progressivity and optimal commodity taxation. • Raises new questions, such as: – How many resources to devote to enforcement? • What is an optimal auditing structure? – How to collect information (e.g., through third-party information reports)? – What is the proper role of firms in remittance? – If higher top tax rates would induce taxable income flight offshore, should we abandon the attempt, or crack down on the flight itself?
  34. 34. Bringing Firms into Tax Theory: Remittance • Public finance textbooks assert a remittance irrelevance proposition: it doesn’t matter which side of a taxed transaction must remit. • This is wrong, though. Cup-at-the-counter metaphor. • Examples: predominance of firm remittance, VAT vs. RST, employer withholding, small business exemptions. • Evidence: see Kopczuk at al. (2012) on diesel fuel. • Note the recent French proposal that altered the remittance responsibility for the new top income tax rate from individuals to firms.
  35. 35. Why Exempt Small Businesses? • It violates the Diamond-Mirrlees injunction against production inefficiency. • But it economizes on collection costs. • This trade-off has not been closely addressed by the optimal tax literature. • One reason is that heterogeneous firms are absent from the theory of taxation, although they are ubiquitous in other fields of economics.
  36. 36. Taxes and the Missing Middle • Dharmapala, Slemrod, and Wilson (2011) identify conditions under which it is optimal to exempt small firms from taxation, and consider per-firm administrative costs. • These inefficiencies occur in part because some firms obtain the tax exemption by reducing their outputs to inefficiently low levels—below the tax net cutoff— creating a “missing middle” of intermediate-sized firms. • This production inefficiency is balanced against the cost savings from collecting revenue from, on average, larger firms.
  37. 37. Line Drawing Much real-world scuffling about taxation involves drawing and interpreting lines, yet analysis of this topic is almost completely absent from economic analysis. Why? • For example, optimal commodity tax theory allows an unlimited number of tax rates, but this is infeasible.
  38. 38. Tax-Driven Product Innovation • Drawing lines create "notches" in choice sets—a small change in some aspects of the taxed good creates a large change in tax liability. • This causes tax-driven product innovation, goods just slightly on the low-tax side of the line. • An example: car-like motorcycles in Indonesia and car-like panel trucks in Chile. • A more important example: equity-like finance that qualifies for (debt-like) interest deductibility.
  39. 39. Notches… …are everywhere. • Quantity notches, characteristic notches, time notches, border notches… • They can provide identification for estimating behavioral responses, a la Chetty and Saez. • Kleven and Waseem (2012) provide a methodology for jointly estimating behavioral response and the extent of “adjustment frictions.”
  40. 40. Future Directions: Information Revolution • Computerization of the tax collection process is the most visible example of the effects. • Can base tax liability on a wider range of information. – Finnish income-based speeding fines – Use of tags (even genome?) – Smart (tax) cards – But it works both ways. Note the existence of automatic sales suppression devices, known as “zappers,” that skim cash sales by excluding random transactions from the apparent electronic record.
  41. 41. Tax Phenomena Redux • New types of motorcycle and panel trucks are examples of tax-induced product innovation. • Presumptive income taxes substitute a more easily measured surrogate tax base that is correlated with income.
  42. 42. Tax Phenomena Redux (2) • Simplified tax rules—or no tax at all—levied on businesses below a size threshold economize on administrative costs at the expense of production efficiency, which may be optimal in spite of the injunction of Diamond and Mirrlees (1971). • That an additional dollar added to its budget will generate $7.30 in additional tax revenue, says nothing about the wisdom of increasing its budget.
  43. 43. Tax Phenomena Redux (3) • Over 150 countries levy a VAT, many at rates well above 10%, but none levies a retail sales tax at over 10%, testifying that the details of tax remittance matter. • With limited withholding and information reporting possible, the selfemployed, especially those operating in cash businesses—are the final frontier of tax compliance.
  44. 44. Tax Phenomena Redux (4) • U.S. corporations found real investments in Puerto Rico in electronics, pharmaceutical, and highfashion production attractive because income shifting to low-tax Puerto Rico is facilitated by having real operations there, lowering the true effective tax rate on real investment there.
  45. 45. Insights • The British economist Frank Hahn once wrote that “optimal tax formulas are either guides to action or nothing at all.” • As of now, these formulas mostly refer to a stylized world far from the reality of withholding, information reports, audits, tax havens and evasion, and where line drawing and notches lurk everywhere. • Tax-systems analysis applies rigorous economic analysis of taxation to issues that are prominent in the formulation and implementation of real-world tax policy.
  46. 46. Policy Contributions • Policymakers should recognize the interrelationship among tax rates, tax bases, enforcement, and administration. • There re may alternative ways to raise revenue, and many types of costs, some that show up in government budgets but most of which do not • The costs of using one tax instrument often depends on the setting of the others. • Recognizing that tax policy is really tax-system policy can ward off substantial policy errors, such as foregoing tax increases because the existing base is too narrow or too poorly enforced.
  47. 47. Key Challenges • • • • Integrating firms, with Coasean implications. Optimal observability. Multiple jurisdictions. Empirical analysis demands creative research designs. • Integrating horizontal equity.
  48. 48. Thank you!