Memo To: SSU Students
From: Jude Wanniski
Re: On Tax Rates, Incentives and Equities
With the House Ways & Means Committee taking up tax reform this year and the President eager for reform bringing about simplification of the tax system, I thought you might find it interesting to read an essay on the topic written more than 30 years ago by a giant in the field. The late Norman B. Ture was not only the technical expert who worked on the design and rationale of the Kennedy tax legislation of 1963-64, with Republicans in opposition, but was also Undersecretary of Treasury for Tax Policy in the Reagan Administration – responsible for the supply-side tax legislation, with Democrats in opposition. The Tax Foundation published the essay in “Essays on Taxation.” [New York, 1974]. Note throughout how Dr. Ture carefully distinguishes between tax “rates” and tax “revenues,” which is one of many differences between classical supply-side theory and the demand-side Keynesian approach that blurs the distinction. You will also see Ture discussing a flat tax in positive terms. I’ll divided the lesson into two parts, concluding this semester next week and then taking an SSU break before we have our usual summer lectures.
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Federal Income Tax Rates, Incentives, and Equities
By Norman B. Ture
It is a great pleasure for me to contribute this essay on the Federal Income tax rate structure to a volume honoring Colin Stam. No one more appreciated than Stam the fact that the rate structure of the income tax lies at the very heart of the issues of tax reform. Yet on those occasions in recent years when major changes have been made in the rate structure of the Federal income tax, these changes have been widely regarded as budgetary or fiscal policy matters, disassociated from the substantive concerns of tax reform. For example, in the 1969 tax reform legislation, rate reduction for individuals was introduced into the House Ways and means committee bill –H.R. 13270—at the last moment, while a 2 point rate reduction for corporate income taxpayers was proposed by the Treasury as a feature of the bill only as it was taken up by the Senate Finance Committee after passage by the House. One might infer, both from the last-minute attention to rate reduction and the very modest extent of the rate cuts for most taxpayers, individual and corporate, that rate reduction is generally deemed to warrant low priority on an income tax reform agenda. But I shall attempt to demonstrate in this discussion that, measured against the basic objectives of income tax reform, no aspect of tax reform is more important than the structure of the rates applied to taxable income in determining tax liability.
The questions “What is an appropriate rate structure in an income tax?” is of course, one of the principal, long standing concerns of public finance. While the issues are still to be resolved as far as scholars are concerned, in the world of practical affairs the decision in favor of steeply graduated rates appears to have been firmly established in tax policy. In the United States, at any rate, the history of the tax seems to show a far stronger tendency toward a higher level and steeper, more progressive graduation of rates than toward the reverse.
This discussion, however, is focused on the future, not the past. While history may instruct us, it need not imprison us. It might prove refreshing, therefore, re-examine critically the case for a progressive rate structure in the light of the criteria of tax policy.
Individual Income Tax
Let us consider first the individual income tax. It is, of course, in this context that the issues about the income tax, rate structure may be most clearly perceived. These issues, however, also must be dealt with in connection with the corporation income tax.
Although the equity criterion has long dominated tax policy discussions, the specifications of this policy objective still remain obscure. Generally, the equity goal is expressed a providing equal tax liabilities for equally situated taxpayers while properly differentiating the tax liabilities of taxpayers in dissimilar situations. But what are the relevant circumstances of taxpayers, the equality or inequality of which are to afford the guide in determining tax liabilities? And assuming we can answer that question, what guide should we rely upon for determining the “correct” difference in tax liabilities among unequally situated taxpayers?
Regarding the first questions, there is a broad consensus that “income” is by far the best measure of circumstance. It is, at best, an incomplete answer, since the definition of “income” itself is highly elusive as an analytical matter. As a practical matter, one need only weigh the Internal Revenue code to realize the imprecision of the income concept. But unless income is clearly and correctly defined and unless one can be sure that so defined it does indeed properly define the relevant circumstances of taxpayers, there can be no assurance that the horizontal equity criterion of equal treatment of equals will be observed. Apparent equality of treatment might, on the contrary, be highly discriminatory treatment, in fact, even under a flat-tax rate. And if steeply graduated tax rates are applied to an improperly defined tax base, the possibilities of violating this criterion may be greatly enhanced.
But disregarding the ambiguities in the concept of income, we still confront the problem of systematically differentiating tax liabilities among taxpayers with unequal incomes. What guides are we to use?
We can get little help in answering this question from notions of “ability to pay.” Income taxes are often characterized as the “best” taxes because they best reflect “ability to pay.” Whether this is an acceptable proposition depends first, on whether income can be properly defined and implemented as a tax base, and then on whether we know what we mean by “ability to pay.”
There are few economists today who are heroic enough to attempt to explain “ability to pay” in terms of utility functions associated with income, let alone to attempt to identify and to compare such utility functions as among taxpayers. In other words, a scientific or analytical definition of “ability to pay” is not available as the basis for determining the shape of the rate structure.
But what meaning, then, are we to attribute to “ability to pay?” while it is certainly true that the larger the “income” (whatever that may be), the larger the measured amount of financial resources the taxpayer is likely to have for paying taxes, no guide emerges from this observation for determining how much more taxes should be collected from Mr. A with $20,000 of “income” than from Mr. B with $10,000. A Canadian White Paper on “Proposals for tax Reform” sums this up quite simply. It explicitly notes, “There is no single or simple rule for increasing the tax rates up the income ladder that can be said to be the ‘right way.’ It is a matter of opinion, of judgment.”
This statement in the White Paper gets to the heart of the matter: rate graduation is a matter or opinion or judgment. On what propositions are such opinions or judgments to be based?
A frequent response to this question is the assertion that progressively graduated marginal tax rates are desirable and useful as a means for redistributing income from the affluent to the poor. The ethical virtue of such income redistribution is seldom challenged, but even if it were universally assumed, it is still fair to ask whether a progressive rate structure accomplishes the objective.
Analytically, there are solid grounds for questioning whether marginal rate graduation is materially effective in the long run in accomplishing any such income redistribution. The affirmative proposition depends upon unrealistic assumptions, never explicitly identified or examined, about the nature of production functions and about the elasticity of long-run supplies of factors or production. Apart from the analytics, the lack of any empirical demonstration of the income-redistributing effectiveness of a progressive-rate income tax should leave us highly skeptical on this score.
Sometimes the vertical equity argument for progressive rates turns to a “benefits” basis for support. Here the argument is that progressively graduated rates are a desirable reflection of the distribution of the benefits” basis for support. Here the argument is that progressively graduated rates are a desirable reflection of the distribution of the benefits of the government expenditures financed by taxes, assuming that the rich reap a disproportionately large share of such benefits. This assumption surely is subject to challenge. But even if it were proved correct, it could hardly be offered as universally applicable. What if we were to find at a future time that the poor benefit proportionately far more than the rich from government expenditures? Should we then insist on a regressive rate structure?
To recapitulate to this point, it is difficult to make a persuasive case for a graduated income tax rate structure by reference to the equity criterion of taxation. Most of the arguments for progression, in the light of this criterion, rest on shaky analytical and factual foundations. And at best, these arguments led to progression in average or effective tax rates, which may be attained without progressive graduation of the statutory, i.e. marginal rates of tax.
As a practical matter, neutrality is just as challenging a criterion of income taxation as equity. It is considerably easier to define, however. This criterion calls for reducing to a minimum the intrusion of the tax in the decisions of households and businesses concerning the amount ad the way in which income is to be earned and how income and wealth are to be used. Every tax has the effect of altering relative prices, to which taxpayers will respond, more or less, by altering their activities. The essence of the neutrality criterion is that a tax should have a minimum impact in changing the relative prices confronting taxpayers.
The neutrality criterion requires the imposition of the same affective rate of tax on the net returns per unit of every factor of production.
If we were to define income properly in line with the neutrality criterion, we would quite clearly have to forego graduation of marginal tax rates and rely on a flat-rate tax. For a graduated rate structure could be consistent with the neutrality requirement – that the same effective rate of tax is applied to the net returns per unit of every factor of production – only if all taxable entities had exactly equal amounts of factor endowments. Failing such a perfectly equal distribution, a graduated tax imposes varying effective tax rate on the net returns per factor unit, depending on the number of units of factors owned by the taxpayer.
In real life, of course, the definition of income used for tax purposed departs very far indeed from the concept required by the neutrality criterion. It is probably impossible to assess the major thrust of all the differentials built into the income tax in terms of their impact with respect to neutrality. There is, however, a widespread presumption that much of the inequality in the distribution of income, as we conventionally measure it, it attributable to the highly skewed distribution in the ownership of capital, both human and non-human. The graduated marginal rate structure, therefore, probably results in the application of differentially higher taxes rates to the returns to capital than to other factor returns and adds significantly to the total tax bias against private capital accumulation.
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