Proportional Tax Research Articles

Retirement Incomes: Private Savings versus Social Transfers

It has long been known, from the work of Samuelson and Aaron, that if (approximately) the sum of the population and real earnings growth rates exceeds the real interest rate, all individuals can be made better off by using a pay‐as‐you‐go pension scheme. The basic overlapping generations model that is typically used to examine such intergenerational transfers makes no allowance for labour supply responses to taxes and transfers, and so cannot be used to examine optimal tax and pension levels. The present paper allows for labour supply effects, whereby a tax imposed to finance current pensions introduces distortions to labour supply and a reduction in the tax base. The optimal proportional tax rate, and therefore the optimal combination of private savings and social transfers, is derived in terms of the time preference rate, the taste for leisure, real interest and productivity and population growth rates. It is found that the condition under which the optimal tax is positive is the same as the Samuelson–Aaron condition. A crucial ingredient in obtaining this result is an assumption that pension levels are adjusted in line with the growth of wage rates rather than, for example, being held constant in real terms. This in turn is found to imply that earnings grow at the same rate as the wage, so long as preferences are such that leisure can be expressed as a proportion of full income.

A two-class fiscal and monetary growth model

This paper extends the two-class monetary growth model by incorporating fiscal activity along the lines of Pasinetti (Cambridge J. Econ. 13, 25–36). Despite this extension, the Cambridge equation is found to be one of long-run equilibria. It is shown that Fiscal policy decreases the accumulation of capital, through an increase in the proportional tax on profits. An inflationary monetary policy has ambiguous effects, it can have positive, negative or no effect on the accumulation of capital and on the rate of profit.

Tax Policy and Entrepreneurial Entry

Many models of tax-policy evaluation abstract from decisions about entrepreneurship, such as entry, saving, and investment. Given recent emphasis on the significance of business ownership in explaining aggregate wealth accumulation and its distribution (see e.g., Gentry and Hubbard, 1999; Vincenzo Quadrini, 1999), such omissions are likely to be significant. In addition, entrepreneurs’ decisions may account for much of the responsiveness of taxable income to changes in marginal tax rates. We focus on impacts of tax rates and, in particular, tax progressivity on the decision to become an “entrepreneur.” While recent research has examined effects of marginal tax rates on investment decisions of entrepreneurial households (Robert Carroll et al., 1997), analysis of effects of taxation on entry is less often pursued. While a proportional tax with a full loss offset will not affect the entry decision for a risk-neutral individual, a progressive schedule with imperfect loss offsets can discourage entry. We find substantial evidence for this effect on entrepreneurship using variation in tax schedules faced by households in the Panel Study on Income Dynamics (PSID) over the period from 1979 to 1992. While progressive taxation could in principle encourage entry via insurance for risk-averse entrepreneurs through the tax system or through offering greater incentive to avoid taxes on self-employment income, we find no evidence to support such channels. Our empirical results imply a significant increase in entrepreneurial entry when tax rates are less progressive; whether such encouragement is efficient (that is, stimulating the most talented entrepreneurs) is a topic for future research. I. Tax Policy and Entrepreneurial Selection

Financial repression and external openness in an endogenous growth model

An endogenous growth model has been developed that extends Sidrauski (1967), Roubini and Sala-i-Martin (1992,1995) and Lucas (1988) by combining financial development, human capital investment, and external openness. Financial development and trade liberalization are shown to increase the economic growth rate by increasing the marginal benefits of human capital investment. Expansionary governments are, however, provided with an incentive to increase the money supply growth rate, to repress the financial sector, to close its economy, and to impose a high proportional income tax rate.

Labour supply in Italy: an empirical analysis of joint household decisions, with taxes and quantity constraints

This study applies an econometric framework which allows for complex non-convex budget sets, highly non-linear labour supply curves and imperfect markets with institutional constraints. A married couple's version of the model is estimated on Italian microdata. The empirical results show that male labour supply is rather inelastic while labour supply among females, especially participation, is considerably more elastic. The elasticities depend strongly on household income. The largest elasticities are found for females living in poor households. The results of the tax simulations suggest that there are only modest labour supply responses from replacing the 1987 system by proportional taxes. Copyright © 1999 John Wiley & Sons, Ltd.

Taxes and income distribution in Chile: some unpleasant redistributive arithmetic

This paper quantifies the direct impact of taxes on income distribution at the household level in Chile and estimates the distributional effect of several changes in the tax structure. We find that income distributions before and after taxes are very similar (Gini coefficients of 0.488 and 0.496, respectively). Moreover, radical modifications of the tax structure, such as raising the value added tax from 18 to 25% or substituting a 20% flat tax for the present progressive income tax affect the after-tax distribution only slightly. We present some arithmetic showing that the scope for direct income redistribution through progressivity of the tax system is rather limited. By contrast, for parameter values observed in Chile, and possibly in most developing countries, the targeting of expenditures and the level of the average tax rate are far more important determinants of income distribution after government transfers. Thus, a high-yield proportional tax can have a far bigger equalizing impact than a low-yield progressive tax. Moreover, a simple model shows that the optimal tax system is biased against progressive taxes and towards proportional taxes, with a bias that grows with the degree of inequality of pre-tax incomes. Our results suggest that to reduce income inequality, the focus of discussion should be on the amount to be redistributed, the targeting of public spending, and the relative efficiency of alternative taxes, and not on the progressivity of the tax system.

Would a Privatized Social Security System Really Pay a Higher Rate of Return?

Many advocates of social security privatization argue that rates of return under a defined contribution individual account system would be much higher for all than they are under the current social security system. This claim is false. The mistake comes from ignoring accrued benefits already promised based on past payroll taxes, and from underestimating the riskiness of stock investments. Confusion arises because three distinct reforms are muddled. By privatization we mean creating individual accounts (which could, for example, be invested exclusively in bonds). By diversification we mean investing in stocks, and perhaps other assets, as well as bonds; diversification might be undertaken either by individuals in their private social security accounts, or by the social security trust fund. By prefunding we mean closing the gap between social security benefits promised to date and the assets on hand to pay for them. Any one of these reforms could be implemented without the other two. If the system were completely privatized, with no prefunding or diversification, the social security system would need to raise taxes and/or issue new debt in order to pay benefits already accrued. If the burden were spread evenly across all future generations via a constant proportional tax, the added taxes would completely eliminate any rate of return advantage on the individual accounts. We estimate that the required new taxes would amount to about 3 percent of payroll, or about a quarter of all social security contributions, in perpetuity. Unlike privatization, prefunding would raise rates of return for later generations, but at the cost of lower returns for today's workers. For households able to invest in the stock market on their own, diversification would not raise rates of return, correctly adjusted to recognize risk. Households that are constrained from holding stock, due to lack of wealth outside of social security or to fixed costs from holding stocks, would gain higher risk-adjusted returns and would benefit from diversification. If this group is large, diversification would raise stock values, thus helping current stockholders, but it would lower future stock returns, thus hurting young unconstrained households. Overall, since the number of truly constrained household is probably not that large, privatization and diversification would have a much smaller effect on returns than reformers typically claim.

The impossibility of a progressive tax structure

When households are identical in all respects other than income, a non-decreasing average tax rate is both necessary and sufficient for post-tax incomes to be always at least as equal as pre-tax incomes. This paper investigates whether this well known result can be extended to households with different needs. A tax structure which never increases inequality (in the Lorenz sense) is shown to be unable to discriminate between household types. If, in addition, the tax structure never reduces the relative income of the poorest member of the neediest group of households, then the same proportional tax must be applied to all households, and redistribution is impossible either within or between groups of households with differing needs. A similar conclusion is reached using conventional equivalence scale arguments, and also applies when the parameters of the tax schedules are determined endogenously. We discuss the significance of this impossibility result and its implications for tax design.

Growth Effects of Taxation Under Altruism and Low Elasticity of Intertemporal Substitution

An increase in the tax rate on capital income may raise the rate of economic growth when the elasticity of intertemporal substitution is low and intergenerational transfers are absent. Since the strength of the bequest motive depends on tax rates, this paper provides conditions under which taxing capital income, and then reducing the labour income tax, is more growth enhancing than the classical policy of zero taxes on capital income, and vice versa. This paper analyses the effects of different taxes on the rate of economic growth. We consider an economy in which public spending is a fixed fraction of the GNP and the government can obtain revenues from proportional taxes on both labour and capital income. Obviously, the growth effects of these two instruments will depend on the assumptions made about the economic environment. In the standard overlapping generations (OLG) model with production (Diamond, 1965), an increase in capital income taxes allows a reduction in labour income taxes, and thus agents will enjoy more income when they are young. Since in the OLG model young agents must purchase the total stock of capital installed in the next period, and saving is increasing in young income, higher taxes on capital income may lead to faster capital accumulation. In order to complete the argument, we must ensure that the associated decrease in the after-tax interest rate does not lead to a reduction in saving which would outweigh the previous income effect. In other words, we need a sufficiently low elasticity of intertemporal substitution. The argument is thus similar to the one of Jones and Manuelli (1992), who have already pointed out that, if the technological environment makes sustained growth feasible, then taxing the old agents and subsidising the young ones may increase the rate of economic growth. However, the situation is completely different if we consider instead an economic environment in which the life-cycle considerations are absent. For instance, in endogenous growth models with a representative agent (or dynasty) and infinite life-span, an increase in the capital income tax rate typically translates into lower growth (see, for instance, Sato, 1967; Feldstein, 1974; Stiglitz, 1978; and the more recent contributions of Lucas, 1990; and Rebelo, 1991). A way to give a unified treatment to these two alternative models is by means

Insurance Premium Taxes: a Lump-Sum Proposal

All insurance companies in the United States are assessed state premium taxes based on percentages of written premiums. In this article, the authors argue that the proportional premium tax system is unfair to higher risk insureds because they must pay greater state premium taxes, even though they do not cause the state greater expenses. As an alternative, the authors propose a lump-sum premium tax system in which all insureds pay a fixed dollar tax that may or may not differ by risk classification. Although lump-sum taxes are widely recognized as Pareto dominant with respect to proportional taxes, the potential advantages of lump-sum taxes have not been explored in the premium tax context, in which random outcomes and the heterogeneity of risks play important roles. The authors compare the potential advantages of lump-sum premium taxes with their potential disadvantages in terms of administrative expenses, moral hazard, and adverse selection.

Rent Dissipation Through Electricity Prices of Publicly Owned Utilities

A public-choice model is presented in order to explain the fact that publicly owned electricity utilities rarely price at marginal cost in practice. It is shown that if (i) government revenues are raised through proportional taxes, (ii) median income is less than mean income, and (iii) the share of a consumer's spending on electricity decreases with income, then the price resulting from a majority rule and universal voting is below marginal cost. The determination of a fixed subscription fee is also considered. Empirical evidence of our results is obtained from pricing and consumption data for Hydro-Qu6bec.

Political-economic equilibrium when parties represent constituents: The unidimensional case

A political–economic environment is studied in which two parties, representing different constituencies of citizens, compete over a proportional tax rate to be levied on private endowments, to finance a public good. Although parties know the distribution of citizen traits (preferences and endowments), they are uncertain about the distribution of traits among the citizens who will turn up at the polls. This uncertainty engenders an endogenously derived function π(t 1, t 2) giving the probability that any one tax policy t 1 will defeat another t 2 in the election. Equilibrium existence theorems are proved, and the nature of equilibrium is compared with the equilibrium that exists when Downsian parties (ones whose objective is to maximize the probability of victory) face uncertainty. Both constituency-representing parties and uncertainty are needed to generate equilibria in which parties propose different policies.

On the optimality of the Nordic system of dual income taxation

In recent years the Nordic countries have introduced a so-called dual income tax which combines a proportional tax on capital income with progressive taxation of labour income. The paper argues that this asymmetric treatment of the two types of income can be defended on pure efficiency grounds, because the progressivity of the labour income tax serves to reduce the private return to human capital investment, thereby offsetting the tendency of a proportional comprehensive income tax to discriminate in favour of such investment. The analysis is based on an overlapping generations model of a small open economy where consumers face a trade-off between investment in human capital and investment in non-human capital. Extended versions of the model allow for liquidity constraints and an endogenous labour-leisure choice.

Unemployment Benefits and Redistributive Taxation in the Presence of Labor Quality Externalities

In this paper, a worker's productivity is assumed to depend on his own quality and on the average quality of other employed workers. In this setting, unemployment benefits that induce low quality workers to leave the labor force have important efficiency as well as equity implications. In addition to unemployment benefits, the authorities can use a proportional income tax and lump sum transfers. The desirability of tax and transfer policy is considered from the perspectives of a utilitarian social planner and of an electorate consisting of employed and unemployed workers. Employed workers may be in favor of unemployment benefits, even though they do not benefit directly. If unemployment benefits are financed by lump sum taxes, then relatively high unemployment benefits may be favored by a coalition of the unemployed and of high quality employed workers.

Labor Supply Responses and Welfare Effects of Tax Reforms

During the late 1 980s and early 1 990s, taxation of wage income has undergone a change towards a proportional tax regime in many countries. Our analysis shows that gradual tax reforms in Norway may have removed some of the distortions on worker behavior. Moreover, we find that proportional taxes may reduce the inequality in the distribution of disposable household income. Yet, when the distributional consequences are related to changes in individual welfare, we find that rich households may benefit far more than households at the other tail of the income distribution, because they earn more without any significant increase in effort.

Social insurance and taxation under sequential majority voting and utilitarian regimes

Abstract It is often argued that with a positively skewed income distribution (median less than mean) a majority voting over proportional tax rates would result in higher tax rates than those that maximize average welfare, and will accordingly reduce aggregate savings. We reexamine this view in a capital accumulation model, in which distorting redistributive taxes provide insurance against idiosyncratic shocks, and income distributions evolve endogenously. We find only small differences of either sign between the tax rates set by a majority voting and a utilitarian government, for reasonable parametric specifications. We show how these differences reflect a greater responsiveness of a utilitarian government to the average need for the insurance provided by the tax-redistribution scheme. These conclusions remain true despite the fact that the model simulations produce positively skewed distributions of total income across agents.

Coordinated action in local public goods models: The case of secession without exclusion

This paper investigates threats of coordinated exit (secession) when coalitions cannot choose their members by exclusion. This is modeled by a three-stage noncooperative game in which voters choose a proportional tax rate and the level of public services, and may choose to exit jointly. A modified Perfectly Coalition-Proof Nash concept is applied to rule out dynamically inconsistent threats and behavior by coalitions that is not self-enforcing. The major result is that cooption of potential seceding coalitions will not occur. This result relies on the assumption that seceding coalitions cannot exclude potential members.

POLITICAL CYCLES

A model of elections is put forth in which there are two parties, each representing a different constituency of voters (the poor and the rich). The political issue is the choice of a proportional tax rate on income, revenues from which are used to finance a public good. There is a stochastic element in which party wins the elections, due to party uncertainty concerning voter preferences, or due to uncertainty concerning which voters will show up at the polls. A political equilibrium in one period consists in a tax policy put forth by each party, and a probability that each party wins. A long series of elections is simulated (100 periods). Voter preferences for the public good change adversely as a function of length of time the incumbent party has been in power and the level of the public good in the last period. Thus, if the party in power funds high levels of the public good, preferences start to move against the public good. This model generates dramatic political cycles, and it is argued that these cycles are of fundamentally different origin from that discussed in the realignment literature.

A decentralized and informationally efficient mechanism realizing fair outcomes in economies with public goods

We present a decentralized mechanism (called Lindahl Egalitarian), which yields Pareto efficient and envy free allocations (i.e. fair outcomes). We show that the mechanism is informationally efficient in general production economies with an arbitrary, but finite, number of private and public goods, and a finite number of agents. The mechanism reduces to the Walrasian mechanism starting from equal wealth when no agent cares about public goods. We also prove that the set of Public Competitive equilibrium allocations (from equal endowments and proportional taxation), and the set of the Lindahl Egalitarian equilibrium allocations are the same.

An Analysis Of Alternative Methods Of Calculating Tax-Adjusted Awards

Abstract No abstract available.