Witness: Aldona Robbins
Testimony Date 04/13/2000
Body of Congress: House
Committee: Ways and Means
Subcommittee:
At the Request of: Chairman Bill Archer
Bill:
Testimony Subject:
Fundamental Tax Reform
Testimony:
Mr. Chairman and members of the Committee, I am Aldona Robbins, Vice President of Fiscal Associates and Senior Research Fellow at the Institute for Policy Innovation (IPI). Thank you for the invitation to appear at these important hearings on tax reform.
Calls for tax reform stem from growing dissatisfaction with record tax burdens, the complexity of the present code, and worries that Americans aren’t saving enough. As the Committee has heard during two days of testimony, there are a myriad of ways to implement fundamental tax reform. Some, like a national sales tax, represent a radical departure from the current system. Others, like a factor payment or generic business cash flow tax, are less so.
While fundamental tax reform proposals have important differences, they also have much in common. My remarks today will focus on some key similarities.
First, the tax bases of most reform proposals are basically the same. Someone will undoubtedly protest, wait a minute, a sales tax taxes consumption, a business tax taxes business, and an income tax taxes income. Those distinctions, however, really refer more to the point of collection than to what is ultimately being taxed.
Anyone who takes an introductory economics course usually goes through an accounting exercise called the circular flow describing the workings of a market economy. Businesses acquire the services of labor and capital from households to produce goods and services. Households exchange their labor and capital services for the goods and services produced by businesses. But, it is important to remember that the same people who make up households also own and operate the businesses. Labels merely serve to distinguish among economic activities.
Government gets its revenue by taxing the income going between households and businesses. Here it is important to note that the two flows – (1) the value of the goods and services that businesses produce and (2) the value of the labor and capital services provided by households – are made up of the same dollars. A tax on the sale of goods and services reduces the income that would otherwise be paid to labor and capital. A tax on factor income reduces what workers and owners of capital can buy. Because both flows measure the same thing, that is, total economic activity, all taxes can be viewed as being paid out of income earned by labor and capital.
A second area of commonality is the tax rate. To raise a given amount of revenue, and holding exemptions constant, most reform proposals should yield similar rates. What is more, those that look to replace federal revenues should likewise end up with average rates close to the current system.
Demonstrating these propositions requires some complex accounting to attribute all taxes to factor income. This requires rearranging the Commerce Department’s National Income and Product Accounts to better reflect taxes. Details will be forthcoming in a study by Gary and Aldona Robbins entitled Road Map for Tax Reform from the Institute for Policy Innovation this spring. Some taxes easily translate into this framework while others require more work. For example, people pay personal taxes on income received for labor and capital services in the form of wages, interest, dividends and so forth. The employer and employee shares of payroll taxes come out of labor compensation. Less obvious are taxes seemingly levied on business, but they, too, affect the dollars flowing to factors. For example, the corporate income tax reduces the pool of money available to pay dividends or other forms of capital compensation to shareholders. Even sales and excise taxes, which are seemingly levied on the purchases of goods and services, come out of factor income because they reduce the funds available to pay the factors.
Table 1 summarizes the average and marginal tax rates on labor and capital in private businesses. Accounting for three-fourths of the economy, the private sector pays close to 90 per cent of U.S. taxes. In 1999, private businesses produced 75.8 percent of the $9.3 trillion in GDP. Table 2 contains average and marginal rates for the rest of the economy. This includes federal, state and local government, government enterprises, domiciles (which is people employed in domestic service and the value of home ownership) and nonprofit institutions.
On average, taxes at all levels of government claim about a third of labor income in the private sector. Federal taxes amount to 25.9 percent and state and local taxes to 7.4 percent. Table 3 contains the components of labor income for 1999. Private business capital pays almost half its income in taxes. The average tax rate at the federal level is 27.6 percent and 21.6 percent for states and localities. Capital income is gross capital compensation less capital consumption allowance. Table3 contains the components of capital income for 1999.
Private business capital and labor pay even higher marginal tax rates. Out of the next dollar of income, labor pays 44.4 percent in taxes – 35.6 percent to the federal government and 8.8 percent to states and localities. The marginal rate on capital is 60.6 percent – 37.6 percent to the federal government and 23 percent to states and localities.
Combining capital and labor, taxes claim an average 38.5 percent of private business income. Federal taxes claim 26.5 percent while state and local taxes take 12.1 percent. That implies that any proposal aiming to replace all federal taxes would need a tax rate of somewhere between 25 and 30 percent on all U.S. income, depending on the level of personal exemptions.
Summarized below are tax rates for current law and two general approaches to tax reform – a comprehensive sales tax and a generic business cash flow tax, with and without border adjustment – which are assumed to replace all federal taxes. Average and marginal rates are expressed as a percent of private business income.
Because the tax bases for the three proposals are the essentially the same, the effective tax rates needed to raise the same amount of federal revenue as under current law also would be the same. Replacing all federal taxes would require an effective average rate on private business income of about 24 percent and a marginal rate of about 29 percent under either the sales tax or the business cash flow tax, with or without border adjustment. These effective rates are lower than the 26.5 percent under current law because the proposals have broader, more uniform tax bases.
Even though the rate is flat, the system is progressive. In this example, each family would receive a refundable credit equal to the poverty line. While families below the poverty line would face the same marginal rate as everyone else, they still would better off than under current law. Because they would get money back, their average tax rate would be negative, and they would not have to pay FICA taxes.
A last point about the summary table. The calculations assume that compliance would be the same as under current law. The effective tax rate would be the same regardless of what the stated rate may be. If the Joint Tax Committee says the required rate is 30% instead of 24%, it simply means that the current law rate must be higher than the 26.5% calculated in the table. Doing so would not change either the conclusions regarding effective rates or the relative comparisons.
I would like to close with some comments about economic effects. There are efficiency gains to be had in reform of the current system. First, both capital and labor pay higher rates on the next dollar of income than on the average dollar. Second, capital is presently taxed more heavily than labor. A single rate, which would treat capital and labor the same as well as lower marginal rates would encourage greater saving and investment, lead to a more efficient use of resources and result in increased output.
There are, to be sure, important differences among competing proposals for fundamental tax reform. But, we should not lose sight of the fact that the economic ramifications of proposals that broaden the base, remove the bias against capital and lower marginal rates are essentially the same.