This lecture explores how the consequences of policy options can be determined and why they should guide the reform effort. The Tax Foundation's Taxes and Growth Dynamic Tax Model will be demonstrated. Also discussed: the benefits and limitations of dynamic vs. static analysis and scoring of tax changes, which tax features harm growth the most, which potential reforms help the most, and which revenue offsets hurt the least. Differing views of how to predict the effects of tax changes on economic growth, how different models view the effect of the federal budget deficit and the Federal Reserve on the outcomes, and the proper role of monetary policy. Register for Tax Foundation University Online here: https://taxfoundation.org/tax-foundation-university-remote/#enroll

1. The Economics of Tax Policy
and How to Think About Tax Reform
Tax Foundation University 2017, Part 3
Stephen Entin
Tax Foundation
June 16, 2017

2. TODAY’S KEY POINTS
TWO COMPETING CONCEPTS OF INCOME
TIME VALUE OF MONEYAND PRESENT
VALUE
EXPENSINGVS. DEPRECIATION
HOW TO TAX INTEREST

3. INCOME CONCEPTS
CHANGE IN THE ABILITYTO CONSUME: Includes
current labor income,earnings on savings and investment, capital gains as
accrued, and assumes economicdepreciation. No adjustment for time value of
money. Proposed by Haig and Simons. Leads to income tax.
REVENUE LESS COST OF EARNING REVENUE:
Labor income, earnings on savings and investment after full, immediate
expensing of all costs (purchases of machines, buildings, materials;also tuition,
training). Reflects time value of money. Proposedby Fisher. Leads to
saving/consumptionneutral tax.

4. Taxes and Growth (TAG) Model
It works like the economy:
Cost of Capital
Cost of Labor
Amount of
Output (GDP)
& Income
Size of Capital Stock:
i.e. Tools, Equipment,
Buildings
Changes In: Determine:
Size of Labor Supply:
i.e. Hours worked, # of
People in the Workforce
Determine:

5. DEPRECIATION CONCEPTS
ECONOMIC DEPRECIATION: Loss of value year-to-year as asset
wears out or obsolesces.No adjustment for time value of money.
STRAIGHT LINE DEPRECIATION: Equal annual write-down.
Spreads cost over presumed asset life with no adjustment for time valueof money.
ACCELERATED DEPRECIATION: Greater write-downin early
years,less later. GAAP rules require reporting dollar-for-dollaroffsetting “deferred tax
liability”to warn of higher taxes due later, but do not discount the future taxes to reflect
time value of deferring them. So accelerationdoes not affect “bottom line.”
EXPENSING: Immediate write-off.Reflects time value of money as cost.

6. Profit (income) is revenue less the costs of earning the
revenue.
Sales are not profit. Costs must be subtractedto get profit.
That includes the cost of investment in plant, equipment, &
buildings.
Two approaches to cost recovery for capital assets are:
cash flow (expensing) and depreciation.
Should capital assets be counted as costs when theywere
bought, or should the costs be stretched over manyyears?

7. $-
$10
$20
$30
$40
$50
$60
$70
$80
$90
1 2 3 4 5
Year
Rationale for Straight Line Depreciation
EOY Resale Value of $100 5-year Machine
resale value loss during year

8. Depreciation vs. Expensing
The time value of money and inflation reduce the value of
depreciation allowances below the full cost of the asset.
Present Value of Cost Allowance per Dollar of Investment
3-year asset 7-year asset 39-year asset
Expensing $1.00 $1.00 $1.00
MACRS at 0%
inflation
$0.96 $0.91 $0.55
MACRS at 5%
inflation
$0.92 $0.81 $0.30
Assumes 3.5% real discount rate, plus inflation.

9. 200
190
181
173
165
100
120
140
160
180
200
220
Today Next Year 2 Years Out 3 Years Out 4 Years Out
Time Value Of Money
Present Value Of $200 Today Vs. $200 In Later Years
(Assume 5% Discount Rate)
Dollars

11. 100
180
160
140
120
100
0
20
40
60
80
100
120
140
160
180
200
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Switching From Straight Line Depreciation
To Expensing At Start Of Year 1
One 5-Year Asset Costing $100 Bought Each Year
Dollars
$80Depreciation
$40Deprec.
$20
Deprec.
$60Deprec.
$100Depreciation
$100Expensing
$100Expensing
$100Expensing
$100Expensing
$100Expensing
/
/
/
/

12. 100
20
40
60
80
100
0
20
40
60
80
100
120
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Switching From Expensing To
Straight Line Depreciation At Start Of Year 1
One 5-Year Asset Costing $100 Bought Each Year
Expense
Asset
Bought in
Year 0
Depreciate Assets Bought in Later Years
Dollars

15. Source: Tax Foundation Taxes and Growth Model (Oct. 2016)
Full Expensing Would Lead to Economic Growth
Static and Dynamic Revenue Estimates of Immediate Expensing of Capital Investment

17. Source: Tax Foundation Taxes and Growth Model (Oct. 2016)
A Corporate Rate Cut Would Lift GDP
Static and Dynamic Revenue Estimates of a 20% Corporate Tax Rate

19. Taxes and Growth (TAG) Model
It works like the economy:
Cost of Capital
Cost of Labor
Amount of
Output (GDP)
& Income
Size of Capital Stock:
i.e. Tools, Equipment,
Buildings
Changes In: Determine:
Size of Labor Supply:
i.e. Hours worked, # of
People in the Workforce
Determine:

20. Tax Treatment of Interest
Taxable interest where tax rates average 33%:
Pretax 6% Post-tax 4%
Pre-tax rate of 6% is 4% after-tax to the borrower after the tax deduction, and 4% after-tax to a
taxable lender. (Tax exempt lenders keep the full 6%.)
Interest that is not deductible and not taxable:
Pretax 4% Post-tax 4%
Pre- and post-tax interest rates are 4% for everyone.

21. Tax Treatment of Interest with Expensing
Capital returns are shared by borrower & lender,
but owners of assets get the cost recovery.
Some claim that deducting the cost and
deducting the interest is a double deduction
that results in negative taxes to the business.
This claim is false. It forgets the tax on the
lender.

22. Four Neutral Tax Types
National Retail Sales Tax
Value Added Tax
Flat Tax (Hall-RabushkaorArmey)
Personal Expenditure Tax (cash flowtax, consumed-income tax,
Bradford X-tax,Inflow-Outflowtax)

24. The deadweight loss (DWL)
from a tax rises with the
square of the rate.
Single rate sales taxes have
less DWL than multiple rate.
A 2% flat rate on all items
would have 4 units of DWL in
this diagram.
If half of items were taxed at
1% and half at 3%, the DWL
would be 9/2+1/2 units or 5
units of DWL.
1%
2%
3%
DEADWEIGHT LOSS FROM A TAX

25. Comparison of Sales Tax and Value Added Tax
Sales price Value added Sales tax
10%
Value Added
Tax 10%
Iron and coal $6,000 $6,000 None $600
Steel and parts $18,000 $12,000
(= $18,000- $6,000)
None $1,200
(=$1,800 - $600)
Automobile $27,000 $9,000
(= $27,000-
$18,000)
$2,700 $900
(= $2,700 - $1,800)
Final sale, total
value added
and total tax
$27,000 $27,000 $2,700 $2,700

26. Flat Tax
Business tax Personal tax
Value added
(sales less purchases
from other businesses)
$300,000 Labor income of
one worker
$54,000
Less labor contribution
(wages, salaries but
not fringe benefits)
-$200,000 Less large family
allowance (no other
deductions)
-$34,000
= Taxable income
(business share of
value added)
$100,000 = Taxable income
(worker share of
value added)
$20,000
Tax at 15% $15,000 Tax at 15% $4,000

27. Form 1040: Individual Tax Form, Inflow Outflow Tax
1. Sum of: Labor compensation, Pension receipts, Taxable Social security,
Transfer payments (from W-2 forms). $33,000
2. Net saving (+) or net withdrawals (-) (from Schedule B)
$ 3,000
3. If line 2 is net saving (+), subtract dollar amount from line 1; if net withdrawal
(-), add the dollar amount to line 1. $30,000
4. Other itemized deductions from Schedule A
$10,000
5. Subtract line 4 from line 3.
$20,000
6. Personal allowances (taxpayers and dependents): $5,000 x 2 =
$10,000
7. Subtract line 6 from line 5. This is your taxable income.
$10,000
8. Tax from table (or, line 7 times 20%).
$ 2,000
9. Withholding,from W-2, plus estimated tax payments.
$ 2,100
10. Amount due (+) or amount of refund (-) (line 8 less line 9).
-$100
Inflow Outflow Tax

28. Inflow Outflow Tax: Schedule A, Itemized Deductions
1. Sum of individual payroll tax (from W-2),
state and local income tax withheld (from W-
2) and estimated state and local tax less
refunds from previous year, and local
property taxes.
$ 5,000
2. Gifts, contributions. $ 1,000
3. Qualified tuition, training expenses. $ 4,000
4. Total. Enter on Form 1040, line 4. $10,000
Inflow Outflow Tax

29. Inflow Outflow Tax:Schedule B, Saving
List net saving (+) or withdrawals (-)
from financial institutions reported on
1099 forms:
First National Bank -
$1,000
Merrill Paine Schwab +$4,000
Total (if greater than zero, this is net
saving; if less than zero, a net
withdrawal). Enter on Form 1040, line 2.
$3,000
Inflow Outflow Tax

30. President’s Advisory Panel on Tax Reform, 2005
Simple, Fair, and Pro-Growth:
Proposals to Fix America’s Tax System
The Simplified Income Tax Plan with simplified
accelerated depreciation and Roth-type saving incentives,
graduated tax rates and most deductions replaced by credits
The Growth and Investment Tax Plan, with similar but
with expensing and interest removed from the tax system
Also discussed: a full-blown cash flow tax, VAT, and NRST

31. GUESS WHOSE TAX?
• A tax on wages and salaries of the lesser of 2% to 17% with
deductions, or a flat 15% on gross wages and salaries.
• No savings deductions, but no tax on dividends, capital
gains, or interest.
• Business tax rates: corporate 16.5%, non-corporate 15%.
Tax on rents 15%.
• Small stock transfer tax (0.2%).
• A few excise taxes (liquor, petroleum fuels, tobacco).
• No estate tax; no tariffs.

33. GUESS WHOSE TAX?
• AVAT (with expensing)for the majority of national government
revenue.
• Individual income tax rates 5% to 45%.
• Most interest and capital gains on stock trades are tax exempt.
• Corporate tax rate 25%, about OECD average.
• Dividends on home country stock are half exempt, reducing double
tax on corporations.
• No estate tax.
• Payroll taxes deductible, and benefits not taxed.

34. One Thousand Words From 1990
34

35. Another Thousand Words, A Generation Later
35

36. End of Part 3

37. GDP change 6.2% Weighted Average service
price
GDP, long-run change in annual level
(billions of 2016 $)
$225
Private business stocks (equipment,
structures, etc.)
17.3% Corporate -10.1%
Wage rate 3.9% Noncorporate -7.1%
Full-time Equivalent Jobs (thousands) 1,457 All business -9.2%
1962-1964 Kennedy Tax Cuts
Economic Effects

38. 1962-1964 Kennedy Tax Cuts
Revenue and EconomicImpact, 2016 Dollars
Bottomline, billions of 2016 dollars:
Static tax cuts (-$83.49) plusrevenue fromgrowth ($52.87) equalsnet revenue change (-$30.62).
Provision
Change in Static
Revenue (billions)
Change in GDP
(percent)
Change in Dynamic
Revenue (billions)
Create a minimum standard deduction
-$1.87 0.09% -$1.08
Create a business investment tax credit
-$7.63 1.35% $5.21
Move from Bulletin F to Guidelines
depreciation schedules
-$12.43 1.15% -$1.59
Lower marginal tax rates across the
board
-$52.37 2.51% -$32.64
Lower the corporate tax rate to 48%
from 52% -$9.18 1.09% -$0.52
TOTAL -$83.49 6.18% -$30.62

39. Economic Recovery Tax Act of 1981
Economic Effects
GDP change 8.00% Weighted Average service
priceGDP, long-run change in annual level
(billions of 2016 $)
$572
Private business stocks (equipment,
structures, etc.)
19.9% Corporate -8.6%
Wage rate 4.1% Noncorporate -10.9%
Full-time Equivalent Jobs ( thousands) 3250 All business -9.4%

40. Provision
Change in
Static (billions)
Change in
GDP (percent)
Change in
Dynamic (billions)
Deduction for lower-earning
spouses
-$1.06 0.17% $3.85
Move from ADR to ACRS for
depreciation schedules
-$23.64 2.69% $37.00
Increase investment tax credit -$6.29 0.52% $5.48
Cut marginal individual income
tax rates across the board
-$158.89 4.62% -$80.34
TOTAL -$189.88 8.00% -$34.01
Economic Recovery Tax Act of 1981
Revenue and Economic Impact, 2016 Dollars
Bottomline, billions of 2016 dollars:
Static tax cuts (-$189.88) plus revenuefrom growth ($155.87) equalsnet revenue change (-$34.01).

41. Tax Reform Act of 1986
Economic Effects
GDP change -0.23% Weighted Average service
priceGDP, long-run change in annual level
(billions of 2016 $)
-$19.2
Private business stocks (equipment,
structures, etc.)
-3.3% Corporate 5.5%
Wage rate -1.5% Noncorporate -1.1%
Full-time Equivalent Jobs ( thousands) 1190 All business 3.3%

42. Tax Reform Act of 1986
Revenue and Economic Impact, 2016 Dollars
Bottomline, billions of 2016 dollars:
Static tax cuts (-$9.38) lessrevenue fromcontraction (-$5.19) equalsnet revenue change (-$14.57).
Provision
Change in Static
Revenue (billions)
Change in GDP
(percent)
Change in Dynamic
Revenue (billions)
Treat capital gains as ordinary income $20.74 -2.59% -$39.26
Move frompost-1984ACRSto MACRS $15.67 -1.81% -$26.22
Repealinvestmenttax credit $45.13 -2.67% -$15.91
Expand personalexemptionand
standard deductions
-$52.00 0.56% -$35.81
Collapse the 16-bracketstructure to a
4-bracketstructure
$7.19 2.97% $79.28
Lowercorporate tax rate: 46% to 34% -$46.11 3.31% $23.36
TOTAL -$9.38 -0.23% -$14.57

43. Economic Growth and Tax Relief Reconciliation Tax Act of 2001
Economic Effects
GDP change 2.3% Weighted Average service
priceGDP, long-run change in annual
level (billions of 2016 $)
$380
Private business stocks (equipment,
structures, etc.)
4.6% Corporate -1.5%
Wage rate 0.8% Noncorporate -3.5%
Full-time Equivalent Jobs (in
thousands)
1668 All business -2.0%

44. Provision
Change in
Static (billions)
Change in
GDP (percent)
Change in
Dynamic (billions)
Deduction for lower-earning
spouses
-$1.06 0.17% $3.85
Move from ADR to ACRS for
depreciation schedules
-$23.64 2.69% $37.00
Increase investment tax credit -$6.29 0.52% $5.48
Cut marginal individual income
tax rates across the board
-$158.89 4.62% -$80.34
TOTAL -$189.88 8.00% -$34.01
Economic Growth and Tax Relief Reconciliation Tax Act of 2001
Revenue and Economic Impact, 2016 Dollars
Bottomline, billions of 2016 dollars:Static tax cuts (-$214.16) plusrevenue fromgrowth
($69.00) equalsnet revenue change ($-145.16).

45. Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)
Economic Effects
GDP change 3.4% Weighted Average service
priceGDP, long-run change in annual
level (billions of 2016 $)
$483
Private business stocks (equipment,
structures, etc.)
10.3% Corporate -8.3%
Wage rate 2.8% Noncorporate -1.1%
Full-time Equivalent Jobs (in
thousands)
637 All business -6.1%

46. Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)
Revenue and Economic Impact, 2016 Dollars
Bottom line, billions of 2016 dollars: Static tax cuts (-$44.25) plus revenue from growth
($93.07) equalsnet revenue change ($48.42).
Provision
Change in Static
Revenue (billions)
Change in
GDP (percent)
Change in
Dynamic Revenue
(billions)
Lower long-term capital gains
rates to 15% and 0%
-$18.54 0.34% -$9.05
Extend reduced capital gains
rates to qualified dividends
-$12.66 1.95% $41.54
50% bonus expensing on
capital investment
-$13.05 1.10% $16.33
TOTAL -$44.25 3.38% $48.82