The Advisory Panel's Tax Reform Proposals
The Advisory Panel’s Tax Reform Proposals
July 13, 2006
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
The Advisory Panel’s Tax Reform Proposals
In November 2005, the President’s Advisory Panel on Tax Reform presented
two potential reform proposals: a simplified income tax (SIT) and a direct
consumption tax proposal (the growth and investment tax, or GIT). Both proposals
would eliminate itemized deductions while allowing, for all taxpayers, a credit for
mortgage interest deductions and deductions for charitable contributions and health
insurance. Both proposals substitute credits for personal exemptions and standard
deductions. Both would allow greatly expanded tax-preferred savings plans. SIT
would eliminate taxes on dividends and most capital gains from corporate stock,
simplify depreciation and allow expensing (deducting costs immediately) for small
business, and alter the international tax regime. GIT, as a consumption tax, would
allow expensing of all investment. GIT also includes a tax on passive capital income
(dividends, interest, and capital gains).
Both proposals are stated to be both revenue and distributionally neutral.
Because the panel uses a baseline assuming the 2001 tax cuts are permanent, both
would lose revenue compared to the Congressional Budget Office (CBO) official
baseline, which has the tax cuts expire as provided by current law. An additional
revenue loss is expected in the long run because of the proposals for tax-deferred
savings plans. These measures also cause the income tax proposal to be slightly less
progressive than current law. The consumption tax proposal is likely to be
significantly less progressive than current law.
The plans would simplify tax filing for higher-income individuals and the self
employed; lower-income taxpayers could, in some cases, have more complicated
tax returns. Much simplification rests on the assumption that many minor provisions,
not actually discussed, will be eliminated, an unlikely event in the case of certain
provisions such as casualty losses and catastrophic medical expenses.
Both plans would likely increase efficiency in the allocation of capital, but these
effects would be quite small for SIT and lessened for GIT due to the tax on financial
income. The SIT may magnify distortions in the allocation of capital around the
world. The effects on overall economic growth would be negligible for SIT because
of the limited change in marginal tax rates. Although there would be a substantial
reduction in effective tax rates on new investment under GIT, the growth effects for
this plan are uncertain and may be quite modest. In any case, they are not large
enough to materially affect the budget outlook. The effects on economic efficiency
other than in the allocation of capital are mixed: a floor under charitable deductions
along with expansion to non-itemizers would contribute to efficiency, but the effects
on health markets are unclear.
Transition problems present difficulties; the main issue with the SIT would
probably be in the loss of deductions for homeowners with large houses and
mortgages. These transition problems in the SIT are minor, however, in comparison
with the significant problems in the GIT arising from the loss of depreciation
deductions, interest deductions, and deductions for the recovery of inventory. This
report will not be updated.
Description of the Proposals.........................................2
Changes in Basic Individual Tax Provisions (Both Proposals)...........2
Business and Capital Income Tax Treatment Under the Income Tax
Additional Modifications of Business and Capital Income Tax Treatment
Under the Pro-Growth Proposal (GIT).........................3
Fairness and Equity................................................6
Efficient Allocation of Capital and the Taxation of Capital Income...........9
Differential Taxes Across Asset Types............................11
The Debt Equity Distortion.....................................13
Distortions of Payout and Realization Decisions.....................16
Corporate Versus Non-corporate Business Distortions................16
Business versus Owner-Occupied Housing and Total Burden..........18
Effects on Savings, Labor Supply, Growth, and Output...................19
International Tax Treatment.........................................22
Other Tax Incentives..............................................23
Charitable Contributions .......................................25
State and Local Tax Deductions; Tax Exempt Bonds.................26
Appendix A: Calculating Effective Capital Income Tax Rates..............29
Appendix B: Discussion of the Macroeconomic Analysis of the Tax Reform
Plans by the Treasury Department................................30
List of Tables
Table 1. Differential Tax Rates Across Asset Types......................12
Table 2. Weighted Average Effective Corporate Firm Level Tax Rates
(Assuming No Debt) on Reproducible Capital......................13
Table 4. Effective Tax Rates on Alternative Business Forms...............17
Table 5. Effective Tax Rates on Reproducible Capital....................18
Table 6. Percentage Change in National Income, Treasury Study............20
The Advisory Panel’s Tax Reform Proposals
In early 2005, the President appointed a tax reform advisory panel to formulate
tax reform proposals. The report of the President’s Advisory Panel on Tax Reform,
issued in November 2005, recommended two reform plans to consider: 1) a revised
income tax, referred to as the simplified income tax (SIT); and 2) a consumption tax
coupled with a tax on financial income, referred to as the growth and investment tax
(GIT ). 1
The income tax proposal, or SIT, is an income tax reform proposal that broadens
the base and lowers the rates. The consumption tax, or GIT, is imposed as a direct tax
which includes a cash flow tax on businesses and a progressive tax on individual
wage income. A consumption tax of this type is often referred to by the generic term
“flat tax” when rates are flat, and as an “x-tax” when the tax on wages is progressive.
The GIT is not a pure consumption tax plan because it also includes a 15% tax on
financial income (interest, dividends, and capital gains); rather it is a consumption
tax, with a wage credit and an add-on tax on passive capital income at the individual
level. Few individuals are likely, however, to pay much of that capital income tax
because of the generous opportunities for tax-favored savings accounts.
The advisory panel’s report discussed and found some merit in considering
partial replacement of the income tax with a value added tax (VAT), but did not
propose such a tax. Finally, the report discussed but rejected a retail sales tax as a
replacement for the income tax, and also rejected full replacement of the income tax
with a VAT. Note, however, that there are several congressional proposals that
include value added taxes and retail sales taxes, as well as income tax and flat tax2
Currently, the reform proposals are being considered further by the Treasury
Department, which has recently released a dynamic analysis that discussed the two
tax reform proposals as well as a third proposal, a progressive consumption tax
(PCT) that modifies the GIT by eliminating the 15% financial income tax, and raising3
the top rate to 35%.
1 Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, November 2005,
which can be found at [http://www.taxreformpanel.gov/].
2 See CRS Report RL33443, Flat Tax Proposals and Fundamental Tax Reform, by James
3 Robert Carroll, John Diamond, Craig Johnson, and James Makie III, A Summary of the
Dynamic Analysis of the Tax Reform Options Prepared for the President’s Advisory Panel
on Federal Tax Reform, U.S. Department of the Treasury, Office of Tax Analysis, May 25,
2006, prepared for the American Enterprise Institute Conference on Tax Reform and
Dynamic Analysis, May, 2006.
This report describes the two formal proposals and analyzes them based on
revenue neutrality, simplicity and administrative feasibility, equity (distributional
effects), and a variety of economic effects. The section on economic effects
considers the effects on the allocation of capital, overall effects on growth, potential
consequences of the international tax rules, and effects of other tax incentives,
including health care, charitable contributions, and spending by state and local
governments. Some of these sections also include brief mention of the PCT, the
VAT, and the retail sales tax. The report concludes with a discussion of transition
Description of the Proposals
The tax reform plans have not been presented in legislative language, and
therefore details of the plans are not always clear. Many tax issues, such as the
treatment of casualty losses or alimony, or capital gains on owner-occupied housing,
are not directly addressed, but would presumably be addressed once specific4
legislative changes are contemplated. However, the major important features are
Changes in Basic Individual Tax Provisions (Both Proposals)
The proposals generally have similar provisions that relate largely to the current
individual income tax:
!Convert personal exemptions and standard deductions to credits.
!Replace the current rate structure (10%, 15%, 25%, 28%, 33%, and
35%) with four rates (15%, 25%, 30%, and 33%) in the SIT and
three rates (15%, 25%, and 30%) in the GIT.
!Repeal the alternative minimum tax (AMT).
!Increase the maximum earned income credit (EIC).
!Eliminate itemized deductions. Allow a 15% mortgage interest
credit for all taxpayers with the mortgage amount capped at the
average price of housing in the region. Allow a deduction for
charitable contributions in excess of 1% of income for all taxpayers.
(Note: deductions for state and local taxes would be eliminated).
!Allow a deduction for the purchase of health insurance to taxpayers
not covered by an employer plan, and cap employers’ deductions for
!Simplify the exclusion for social security benefits and index it.
!Eliminate the tuition tax credit and other education preferences.
!Significantly expand existing preferred savings accounts, such as
individual retirement accounts, by allowing two savings accounts,
4 Technically, the proposal appears to disallow casualty loss deductions, even though these
deductions were recently expanded for victims in the aftermath of Hurricane Katrina.
Current law also allows alimony to be deductible by the payor and taxable by the recipient,
and presumably many divorce settlements take into account this tax treatment. Many other
small tax provisions are not explicitly addressed in the proposal.
each with a limit of $10,000. No income restrictions would apply.
The “Save for Retirement” account would replace existing
individual retirement accounts with a current limit of $5,000. The
“Save for Family” account would replace education and health
savings accounts; funds could be used for education, health, and first
time home purchase. Simplify employer savings plans. All
individual savings plans would be converted to Roth- type plans (not
deductible up front) and, in the case of the GIT, 401(k) and similar
plans would be converted to Roth-type plans as well.
!Simplify employer savings accounts, and encourage and remove
barriers to automatic enrollment and growth of contributions.
Several provisions listed above would also have consequences for the taxation
of investments in assets. For owner-occupied housing, the changes in mortgage
interest and property taxes would affect the return on that investment. Tax burdens
on capital income would also be affected by the preferred savings accounts.
Business and Capital Income Tax Treatment
Under the Income Tax Proposal (SIT)
The simplified income tax plan would make major revisions in the current
treatment of capital income in addition to those affecting savings in preferred
accounts and investment in owner-occupied housing. As in the case of the
individual structural provisions, the treatment of some items is not entirely clear. For
example, although the research and experimentation credit would presumably be
repealed, the expensing of intangible investment in R&D would presumably
continue. The major changes are as follows:
!Eliminate taxes on dividends and reduce taxes on capital gains on
corporate stock to a more or less negligible level.
!Allow a significant amount of expensing of investment in equipment
as well as cash accounting for small businesses, and cash accounting
for medium sized businesses. Small businesses would be required
to have a separate business bank account.
!Repeal the corporate alterative minimum tax (AMT).
!Provide a new, simplified depreciation system.
!Eliminate most existing preferences.
!Eliminate the taxation of income from active business abroad, but
tax earnings from intangibles currently.
Additional Modifications of Business and Capital Income
Tax Treatment Under the Pro-Growth Proposal (GIT)
The GIT provides a cash flow tax at the business level so that the treatment of
investments that are currently expensed, such as intangible expenditures on research
and development, would continue.
!All investments and purchases are expensed (deducted when paid);
old depreciation deductions phased out.
!Interest would not be deductible by business and interest income
would not be taxable; deductions and payment of taxes on interest
on existing debt would be phased out.
!Taxes paid would be rebated at the border (similar to the treatment
of a value added tax).
!Financial capital income (dividends, capital gains, and interest)
would be taxed at 15%.
The progressive consumption tax (PCT) plan studied by Treasury would
eliminate the tax on financial capital (and obviate the need for savings accounts), and
would raise the top rate to 35%. The VAT would be similar to the PCT but would
not allow a deduction at the firm level for wages and would not tax wages to
individuals, and therefore would eliminate all of the features of the individual tax
including the mortgage credit and the deduction for charitable contributions for that
part of the tax. The VAT was discussed, however, as a partial replacement for the
One of the objectives of the proposal was revenue neutrality. How revenue
neutrality is measured depends on the baseline used, and the panel chose to use the
Administration baseline, which included the permanent extension of the 2001-2003
tax cuts. This baseline differs from the baseline used by the Congressional Budget
Office (CBO), which simply relies on the current tax law, and thus assumes that
temporary provisions, including the 2001-2003 tax cuts, will expire. Thus, revenues
raised under the administration baseline are smaller than those raised under the CBO
As a result, the revenues raised by the tax reform proposal are associated with
a substantial deficit — and one even more substantial given that there is a currently
a surplus in the Social Security account that will eventually disappear and become
a deficit. Over the period 2007-2016, in addition to the projected deficit of $0.8
trillion, the cost of making temporary tax provisions (except the AMT) permanent,
including debt service, is about $2.3 trillion.5 And these projections do not include
the possibility that discretionary spending will rise to keep pace with national
income, which would increase the deficit by $1.6 trillion.
Because the panel used the Administration baseline, any comparisons made in
the analysis are with current law incorporating the 2001-2003 tax reductions.
Nevertheless, some additional source of revenue must eventually be identified, which
means that tax rates might need to be increased or tax preferences reduced, and how
that revenue is made up would affect the analysis. Note also that there are some
smaller provisions that would be difficult to dispense with, as discussed below, and
if they were restored, an additional revenue shortfall would occur.
5 Based on data in CRS Report RS22045, Baseline Budget Projections Under Alternative
Assumptions, by Gregg Esenwein and Marc Labonte.
There is an additional reason that the proposals may not be truly revenue neutral
even within the context of the baseline used. The adoption of Roth-type savings
accounts reduces current losses from deductions in traditional accounts, but loses
revenue in the future. Such a loss could be significant. For example, some rough
estimates suggest that a similar proposal by the Administration that gained a small
amount of revenue in the budget horizon could eventually cost around $50 billion at
current income levels, an amount equal to about 4% of current income tax revenues.6
Both proposals contain many elements that would simplify tax compliance. The
elimination of itemized deductions would simplify tax filing. The proposal would,
however, add complexity to current non-itemizing returns, which account for 70%
of all returns, by allowing the charitable deduction, health insurance deduction, and
mortgage credit. Some non-itemizers do not give in amounts that exceed the
threshold for charitable deductions (1% of income), and either rent their homes
(about a third of the population rents) or have paid off their mortgages. But for those
who have either a mortgage payment or significant charitable deductions, or who
purchase health insurance, tax filing will be more complicated. Charitable
deductions, in particular, require record keeping, although floors may eliminate the
need of those with small contributions relative to income to do so.
The proposal, on its surface, also eliminates some itemized deductions that are
difficult to dispense with, such as the casualty loss deduction, the deduction for
extraordinary medical costs, and the deduction for miscellaneous items such as
employee and investment costs. Because the panel remained silent on these other
itemized deductions, there is no way to know how they would be treated. These
exemptions, all over a floor (except for casualty losses for hurricane victims in 2005),
are designed to allow offsets for unusually large costs relative to income. It is
difficult to imagine not allowing some deduction for these extraordinary costs, but
allowing the deductions for all taxpayers would significantly add to the complexity
of the tax form. Under current law, two factors limit the claiming of these deductions
to truly large costs: the floor, and the fact the deduction is itemized (so that low-
income individuals must have a significant dollar loss). Since itemized deductions
are no longer feasible, since there is no longer a standard deduction, restoring these
deductions would be complicated and undo much of the apparent simplification with
respect to itemized deductions.
There are also “above the line” deductions, such as those for alimony and for
moving expenses, as well as some credits that might be thought desirable (the child
care credit) whose retention might prove important. Given the extension of tax
benefits to non-itemizers, and the possibility of reintroducing some additional
deductions, it is not clear whether simplification for individual tax filers on the whole
is increased or decreased. A considerably simpler approach to reform would have
been to eliminate the state and local income tax deduction while leaving other
6 See CRS Report RL32228, Proposed Savings Accounts: Economic and Budgetary Effects,
by Jane G. Gravelle and Maxim Shvedov.
itemized deductions in place; calculations based on the public use file suggest that
change would have reduced the number of itemizers from 30% to about 20%.7
All taxpayers should experience simplification from the collapsing of
deductions, exemptions, and credits into a single family credit, and, for higher-
income taxpayers, from eliminating phaseouts and the AMT. Higher-income
taxpayers who save will also benefit from the simplified savings accounts.
Allowing cash accounting and expensing for small businesses under the income
tax would also significantly simplify their tax compliance, although much of this
benefit would be lost if state income taxes do not make similar adjustments. The
provision requiring small business bank accounts to be handled separately from
personal accounts could complicate the affairs of those with occasional small
amounts of self-employment income unless a de-minimus rule were adopted. (An
example would be a professional who receives a small consulting fee, but whose
major source of income is employment, or a skilled workman who occasionally
moonlights). Complications would also occur for those who use assets for both
business and personal use (e.g., homes and cars). Although there is some
simplification of the depreciation system for larger businesses, most of the current
complexities would remain, as would most of the challenges in allocating
international income for multinationals which cannot be eliminated. The elimination
of the production activities deduction is an important simplification, however.
On the whole, the income tax proposal appears to simplify the tax system for
higher-income taxpayers and the self-employed, while possibly complicating it for
lower- and middle-income wage earners. The consumption tax proposal should
achieve more simplification for business because all acquisitions would be expensed.
In this system, there is no need to keep depreciation accounts or inventories.
Fairness and Equity
Issues of tax equity may concern vertical equity (how effective tax rates rise as
incomes rise) and horizontal equity (how different taxpayers with similar
circumstances are treated). The discussion below suggests that the income tax
replacement has relatively small effects on either vertical or horizontal equity, and
indeed may increase inequities across family types. It is more difficult to characterize
the growth plan, which is essentially a consumption tax, but there is a case to be
made that such a tax would be much less progressive than the current income tax
system. In any case, the distributional method used in the panel’s study for their
progressive consumption tax is inconsistent with the one they suggest is appropriate
for another economically equivalent consumption tax — the VAT.
7 This information was provided by Maxim Shvedov of CRS based on simulations from the
Statistics of Income public use file.
A second objective of the panel was to maintain the current progressivity of the
tax system. The panel’s report shows both the SIT and the GIT to be distributionally
neutral, at least across broad income classes. (There is no detail about the extremely
high-income individuals at the top who constitute only a tiny fraction of taxpayers
but a large fraction of income). Note that this distributional comparison is with
respect to the assumption that the 2001-2003 tax cuts, which favored higher-income
individuals, are in place. Even so, there are questions about the distributional
neutrality of the plans.
Proposals to reduce taxes on capital income through reducing or eliminating
taxes on dividends, capital gains, and interest income, would likely shift the burden,
other things equal, away from high-income individuals to the middle class. The
commission’s distributionally neutral system is likely, in part, a temporary artifact of
the shift into back-loaded savings accounts (which can raise revenue from owners of
assets in the short run but lower it dramatically in the long run).8 The magnitude of
this effect is difficult to determine, but analysis of the President’s budget proposals
of this nature, which had less generous contribution limits and negligible revenue
effects in the budget window, suggested the long-run revenue loss could easily be
$50 billion or more at current income levels, an amount equal to 4% of FY2005
corporate and individual income taxes. This saving would accrue to individuals in
the higher income levels, as savings of any sort tends to be concentrated there.
Distributional issues are far more problematic in the case of the consumption
tax proposal. Although distributional tables are presented that also show
distributional neutrality, that conclusion is not clear. As in the case with the income
tax proposal, some of the overall effect reflects the effects of savings accounts, and
these effects are even more important in the GIT because all defined contribution
plans (such as 401(k)s) will be converted into backloaded plans. Moreover, because
dividends and capital gains are taxed under this proposal, the long-run sheltering of
income by high-income individuals may be even more important. The effects will
likely be larger than the effects in the SIT, which are already significant.
A second, and more important, problem with evaluating vertical equity under
the GIT is how to distribute the tax that is collected. One might propose to allocate
the tax according to consumption, along with a credit for wage tax reductions due to
graduated rates. Indeed, in discussing the VAT, which is also a consumption tax, the
study indicates that tax would be allocated according to consumption and would be
regressive, not progressive, requiring additional fixed-rate credits and, even in that
case, resulting in lower shares of tax paid by the highest-income individuals.
However, for the GIT, which is simply a VAT imposed in a different form with a
wage credit, a different distributional methodology was used. The business cash flow
tax is allocated according to income, and thus the tax is modeled as if it were an
8 See CRS Report RL32228, Proposed Savings Accounts: Economic and Budgetary Effects,
by Jane G. Gravelle and Maxim Shvedov, for an explanation of this budget effect.
A consumption tax is a tax on wage income and a lump sum tax on old capital
that is effectively collected over time as the assets are consumed. For very-high-
income individuals who indefinitely pass on assets in estates, that consumption may
never occur. If one distributed the tax on the basis of consumption, the tax would
decline as income rises despite the rate structure. The tax was, however, distributed
as if it were an income tax and thus the cash flow tax at the firm level (which is really
a lump sum tax on old capital that may or may not be translated into an effective tax
on consumption) is treated as if it is a tax on income and falls on high-income
To illustrate the importance of these approaches, consider a recent study that
compared the distributional effects of an “x tax” with a 15% and 30% rate and a
demogrant (rebate to lower-income individuals to offset the tax) under both
approaches.9 This plan is similar in many respects to the panel’s proposal. If
distributed according to consumption, the middle quintile has an effective tax rate
of 23.3%, the top quintile a tax rate of 12.1% and the top 1% a tax rate of 6.1%. If
distributed according to income, the tax rate is 11.4% for the middle quintile, 22.5%
for the top quintile, and 22.0% for the top 1%.
Distributing a consumption-based tax in the short run is tricky, and there is no
perfect answer because the cash flow tax is a tax that causes asset values (or their
purchasing power) to fall, but does not burden new investment which can be
purchased at a discount. However, in the long run the consumption tax base tends
to be similar to a wage tax base, except that it also favors higher-income people, even
in the long run, because they are less likely to consume all of their lifetime wage
income. Thus it is highly unlikely that the GIT is distributionally neutral; it makes
the tax system less progressive by largely exempting capital income from tax.
Horizontal equity refers to the equal treatment of those with similar
circumstances. There are three basic issues of horizontal equity that could be
considered: equal treatment of different family sizes, equity in the treatment of
different age cohorts, and equity in the treatment of taxpayers who vary in their
preferences for tax-favored activities.
A recent study used an equivalency index (similar to the poverty levels that vary
across family size) to compare tax burdens on families of different sizes.10 This
analysis suggested that in the lower-income levels, families with children tend to be
heavily favored compared to singles and childless couples with similar abilities to
pay, whereas the reverse is the case at the higher income levels. The tax reform plans
appear largely to preserve these features of the tax system. The benefits for families
with children at lower income levels arise from the earned income tax credit and
9 See Leonard Burman, Jane Gravelle, and Jeff Rohaly, Towards a More Consistent
Distributional Analysis, forthcoming in the Proceedings of the National Tax Association,
10 See Jane Gravelle and Jennifer Gravelle, “Horizontal Equity and Family Tax Treatment:
The Orphan Child of Tax Policy,” forthcoming, National Tax Journal, September, 2006.
child credits, which are maintained. At higher income levels families with children
are penalized because the adjustments for family size are not large enough; this
problem may be magnified by the converting of personal exemptions into credits, but
reduced by the repeal of the alternative minimum tax and phase-outs of deductions.
On the whole there appears to be no major change in this aspect of the tax system.
Consumption taxes, such as the GIT, inevitably shift the burden of the tax
towards the current older generation and away from young and future generations.
Essentially, those with assets who expect to consume out of these assets are subject
to a substantially higher tax. This shifting across the generations is relieved to some
extent by the transition rules that allow some recovery of depreciation, but this offset
is quite limited. That shift means that older people pay a higher lifetime tax than
younger or unborn generations.
The elimination of preferences for investment types, the most frequent type of
tax preference in the income tax, is generally not viewed as important to horizontal
equity in the long run, since capital and pre-tax returns shift to equate returns after
tax. The tax revisions continue to favor homeownership, although, as seen below,
to a lesser degree. The proposals eliminate the preferences for taxpayers in states
with higher taxes, and appear to reduce the benefits for those covered by employer
provided health care while allowing benefits for those not covered by employer plans.
Charitable contributions effects are mixed as the benefit is provided to non-itemizers,
but also subject to a floor. On the whole, the proposals appear to improve horizontal
equity as measured on this basis.
Efficient Allocation of Capital and the
Taxation of Capital Income
In the broadest terms, a tax reform can alter economic behavior by changing the
tax rates on labor and capital income. One of the most important ways in which the
tax reform proposals would affect the nature of the tax system is through changes in
the taxes on capital income. Indeed, the indications from a recent dynamic analysis
of the tax reform proposals suggest there is little or no change in either average or
marginal tax rates on labor income from the proposals. It is largely in the treatment
of capital income that the proposals have a potential effect.
Change in the treatment of capital income can improve economic efficiency if
they lead to a better allocation of capital to different uses. In general, more even
taxation of different types of assets is more efficient. If investors tend to equate
returns after tax on different investments, then more neutral taxation will more
clearly equate the pre-tax, or social, return, leading to a higher level of output and
well-being. A lower aggregate tax rate on capital income can also reduce distortions
and lead to a more optimal savings behavior.
The method for examining this issue begins with measuring the effective tax
rate on the returns to capital invested in different types of assets. In the absence of
external effects or other “market failures,” capital is allocated most efficiently when
all returns are taxed in at the same rate and when financial choices are not influenced
by the tax code.11 Effective tax rates can vary across physical assets (such as
equipment and structures), across organizational forms (corporate versus non-
corporate businesses), and financial form (corporate debt versus equity).
Effective tax rates presented in this section are estimated effective rates on
income from prospective investments; they take into account the timing of
deductions and the fact that a tax benefit received today is more valuable than a tax
benefit received in the future because of the time value of money (i.e., money
received today can be invested and yield more money in the future). (See Appendix
A for a more detailed explanation.) These effective tax rates can differ substantially
from average tax rates in the economy because the timing of deductions has a
different (and in the long run, more powerful) effect on tax burdens on new
investment than is reflected in average tax rate measures. Indeed, it is possible for
effective tax rates on new investments to be negative, while average tax rates are
positive. However, it is the effective tax rates on new investment that affect the
allocation and size of the capital stock. Aside from the statutory tax rate, the main
provision affecting the tax burden on new investment is how quickly the cost of the
asset is recovered via depreciation deductions.
When tax depreciation matches economic depreciation, the effect is to tax the
return to capital (investment income) in each period and the effective tax rate is the
statutory rate, when considering a firm’s tax burden. The same effect occurs as long
as the present discounted value of depreciation deductions is equal to the present
discounted value of economic depreciation deductions.12 Two opposing forces can
affect depreciation (and therefore effective tax rates). Because depreciation is based
on historical acquisition cost, the real value of depreciation deductions is undermined
by inflation. Thus, higher inflation means higher effective tax rates.13 This inflation
effect, other things equal, raises the effective tax rate more for shorter-lived
investments than for longer-lived ones. However, depreciation deductions are
generally allowed more quickly than the rate that would be justified by economic
decline, and that tendency is particularly pronounced in the case of equipment, which
increases the deductions’ value and leads to a lower effective tax rate. Under current
law, most equipment assets, for example, have their costs deducted in five to seven
years, although they last a much longer period of time. The Internal Revenue Code
specifies that buildings are deducted over 39 years (although residential structures are
deducted over 27.5 years).
11 Market failure is a technical term which indicates not that markets do not function, but
that they do not function perfectly so that prices represent true resource costs. In practice,
market failures are numerous, but in most cases are small, or cannot be easily determined
and quantified, and thus make effective government intervention difficult or capable of
worsening rather than improving the market failures.
12 The present discounted value is the value of a future dollar discounted by dividing it by
(1+r)t, where r is the interest rate and t is the time period. For depreciation, all of the values
are summed up.
13 Higher inflation can, however, benefit debt-financed investment if the tax rate of the
firm is higher than the tax rate of the creditor, because nominal rather than real interest is
The maximum acceleration of depreciation allows investments to be deducted
when incurred, and is a feature of the consumption tax (GIT) at the firm level. The
effective tax rate on new investment is zero.
Tax rates can be measured in different ways. The tax rate at the corporate level
on equity financed investment, which is calculated first, shows the effects of
depreciation rules across asset type (e.g., computing equipment, buildings). Effective
corporate tax rates can also be measured as the total tax at both the corporate and
personal level, which also reflects the deductibility of interest by corporations and the
imposition of individual income taxes on interest, dividends, and capital gains. This
measure indicates the change in the total burden on corporate investment. Tax rates
can also be separated into total rates on debt financed and equity financed
investment, to examine the degree of distortion that favors debt finance. The total tax
rate can also be compared with tax rates on non-corporate investment to measure the
differential between the total tax on investment in the corporate and non-corporate
sectors, as well as federal income taxes on owner-occupied housing (which tend to
be around zero). Tax rates also affect the dividend payout choice, arising from
differential treatment of retained earnings (which give rise to capital gains) and
dividends, and the realization of capital gains. Finally, the overall tax rate in the
economy, which requires weighting by asset type, can affect savings decisions.
Differential Taxes Across Asset Types
Table 1 shows the effective tax rates across different types of assets for the
corporate sector with a corporate level tax and shows how even the tax rates are.
Two different types of tax rates for current law are reported, one without and one
with the 9% production activities deduction enacted in 2004. The statutory rate
without the production activities deduction is 35%, and the effective statutory rate
with the production activities deduction is 31.85%, similar to the statutory rate of
31.5% in the panel’s income tax revision. The last column reports the effective tax
rates using the depreciation system in the panel’s income tax plan. Although the
corporate tax rate under the panel’s consumption tax plan is 30%, it is not really
relevant to the effective tax rate, since all investments are effectively subject to zero
Table 2 reports these tax rates aggregated across basic composite asset types,
and assumes a third of assets is eligible, under current law, for the production14
activities deduction. This table indicates that the panel’s income tax reform evens
out tax rates slightly and very slightly increases the effective tax rate (by a percentage
point). Essentially that plan does not differ much from current law. The
consumption tax reform, however, results in a zero effective corporate tax rate on all
14 See Jane G. Gravelle, CRS Report RL32099, Capital Income Taxes and Effective Tax
Rates, for data on the share of assets eligible. This report also contains data on the effective
tax rates before the 2001-2004 revisions and presents a more extensive discussion of
effective tax rates.
Table 1. Differential Tax Rates Across Asset Types
No With Panel’s
Office/Computing Equipment 312836
Construction Machinery 232127
Mining/Oilfield Equipment 282527
Service Industry Equipment 282527
Other Equipment 272425
General Industrial Equipment 252325
Metalworking Machinery 232123
Electric Transmission Equipment 333032
Communications Equipment 191722
Other Electrical Equipment 242122
Furniture and Fixtures 232022
Special Industrial Equipment 211921
Agricultural Equipment 211920
Fabricated Metal 292639
Engines and Turbines 363332
Ships and Boats 171513
Railroad Equipment 181617
Mining Structures 7620
Other Structures 403737
Industrial Structures 373434
Public Utility Structures 272424
Commercial Structures 343 132
Farm Structures 262323
Residential Structures 31NA30
Source: Congressional Research Service. See Appendix A for method of computation and
Table 2. Weighted Average Effective Corporate Firm Level Tax
Rates (Assuming No Debt) on Reproducible Capital
Asset TypeProductionIncome TaxConsumption Tax
DeductionReform PlanReform Plan
Equipment 25 27 0
Structures 30 31 0
Inventory 37 35 0
Total 29 30 0
Note: Structures reflect a weighted average of the last seven rows of Table 1. The remaining assets
Source: Congressional Research Service. See Appendix A for method of computation and
These comparisons across asset types indicate that the depreciation system in
the income tax reform plan is quite similar in its features to the current provision.
Equipment assets are slightly favored relative to structures and inventory, and tax
rates are reasonably close to their statutory rates. The income tax reform slightly
narrows these differentials, but, in general, is quite similar to current law. The
consumption tax reform plan is completely neutral across assets because all
investment is expensed, leading to a zero effective tax rate at the firm level (taxes15
may still be paid at the individual level, however).
The Debt Equity Distortion
Another issue is the differential tax treatment, within the corporate sector, of
debt-financed versus equity-financed capital. Debt is favored at the corporate level
under current income tax rules and under the income tax reform because corporations
deduct interest payments. If taxes applied only to real economic profits, the tax rate
on debt financed earnings would be zero and the tax rate on equity would be the
statutory rate, currently 35% for most corporate income. However, under current
law, debt is subject to a subsidy at the firm level, for two reasons. First, interest is
deducted at the statutory rate (adjusted for the production activity deduction, which
on average lowers the rate to 34%) whereas the income is taxed (as suggested above)
at a lower effective rate of 29% due to accelerated depreciation. Second, nominal
15 The beneficial treatment of mineral investment, largely in oil and gas, arises from
provisions that allow much of the cost, including unproductive tracts and wells, as well as
all intangible drilling costs (supplies, labor, etc.), to be deducted immediately. The
deduction of losses, while consistent with accounting rules, is a subsidy because the cost of
unproductive tracts and wells is part of the cost of finding productive ones and should be,
in theory, deducted over the useful life of productive properties. The calculations assume
that unproductive wells and tracts will continue to be deducted as losses under the income
tax reform option, but intangible drilling costs will be recovered, as will other costs, under
rather than real interest is deducted. Together these effects mean that debt, at the
firm level, enjoys a 32% subsidy, whereas equity has a 29% tax.16
These tax rates are increased and the differences are moderated, however,
because equity is favored at the individual level. Capital gains and dividend tax rates
are lower, and capital gains can be deferred until the stock is sold and are never paid
if shares are passed on at death. (Note that this calculation uses the lower rates on
capital gains and dividends adopted in 2003 and technically scheduled to expire in
2010; tax rates would be higher if these provisions expire.) Individual taxes on the
return to capital are also reduced because they are imposed on profits after the
corporate tax, and thus the corporate tax is effectively deductible from the individual
tax base. For an individual in the 30% tax bracket, for example, the tax on interest
income is 30% for a dollar of earnings, but the additional individual tax on equity is
only 20% (0.3 X (1-0.35)). The recent temporary revisions lowered the tax rate on
capital gains (for most recipients) from 20% to 15% and extended these lower tax
rates to dividends — a change favoring equity investment. There was also a
temporary benefit to debt finance, from the individual tax rate reductions.
These effects are shown in the first three rows of Table 3, which shows that the
tax reform plans narrow the differentials between the two types of finance. In fact,
the consumption tax reform results in slightly higher tax burdens for debt finance.
Under this plan, the only tax is at the individual level, and because of the preferential
treatment of capital gains (about half is effectively not taxed through deferral and
step up in basis at death), the effective burden on equity-financed investment is lower
than that on debt-financed investment.
The effective tax rate on debt vs. equity is, however, complicated by the
existence of tax-favored forms of individual investment, through pensions and IRAs,
where individual tax rates are effectively zero. If these effects are taken into account,
current tax rates are lower and the effect of changes in individual tax rates less
important. Since these pension funds and IRA account managers (whether or not self
directed) can also choose between debt and equity, the case with these effects
incorporated is probably more realistic.
Determining exactly what weight to assign to tax exempt assets is not entirely
clear. Although roughly half of interest and dividends are in funds where they are
eligible for exemption under current law, it is not clear whether half of the marginal
investments were exempt because some assets were in accounts where investment
was made up to the limit. The account limits reduce the share of investments that
were non-taxable at the margin. In addition, because of the restraints on these
investments, such as penalties for early withdrawal or lack of access to funds, assets
in tax exempt accounts at the margin also pay an implicit cost that offsets, to some
extent, the tax benefit.
16 With a 0.075 nominal interest rate and a 0.02 inflation rate, and with the production
deduction reducing the tax rate by 3%, the after-tax discount rate to the firm is 0.075*(1-
The real interest rate is 0.055 (0.075-0.02), so the difference of 0.0146 is 32% of the pre-tax
Table 3. Effective Tax Rates on Debt-Financed vs. Equity
Financed Corporate Investments
Tax Regime Debt Equity
Excluding Tax Exempt Forms
Current Law 937
Panel’s Income Tax Reform Plan 1633
Panel’s Consumption Tax Reform Plan1512
Including Tax Exempt Forms (50% or 100% exempt)
Current Law (50%)-1133
Panel’s Income Tax Reform Plan (50%)-331
Panel’s Consumption Tax Reform Plan (50%)86
Panel’s Income Tax Reform Plan (100%)-2330
Panel’s Consumption Tax Reform Plan (100%)00
Source: Congressional Research Service. See Appendix A for method of computation and
a ssump tio ns.
It is clear, however, that the share of investment financed from tax exempt
sources is likely to increase under the reform commission proposals, and for that
reason a case is shown that is financed 100% with tax exempt investment. These
plans increase the exemption levels to $10,000 and allow both a retirement account
and a savings account — where withdrawals may be made for health, education, or
purchase of a primary residence — to replace existing IRAs that are limited to
$5,000, as well as existing health and eduction savings plans that also tend to have17
smaller limits. Income limits would also be abolished. In addition, for the income
tax plan, the exemption of dividends and most of capital gains should allow more
interest-bearing assets to be placed into exempt accounts.
Once tax exempt forms are considered, and the exempt share is assumed to be
larger for the reform plans, it is no longer obvious that the income tax reform narrows
the debt-equity distortion compared to current law. In comparing tax rates with large
discrepancies, and particularly those with negative rates, a more meaningful
comparison is the tax wedge, or the excess by which the pre-tax return must exceed
a fixed after-tax return, which is measured by t/(1-t), where t is the tax rate. Thus
under current law without considering tax exempt forms effects, a debt-financed
17 Note that recent tax legislation allowing a one time rollover of assets in 2010, including
nondeductible traditional IRAs, without income limits effectively eliminates the income
limit for a few years. All individuals are eligible for non-deductible traditional accounts
which allow a deferral of income, and by opening those accounts in the next five years and
rolling them over into Roth IRAs, high-income individuals can effectively open tax exempt
return must exceed the after-tax return by 10% (0.09/(1-0.09)), whereas an equity-
financed return must exceed the after-tax return by 59% (0.37/(1-0.37)). The
difference between those is 49% of after-tax return. The difference between the
wedges for the income tax reform proposal is 30%. However, the difference between
the wedges for current law with 50% tax exempt finance is 59%, whereas the
difference for the tax reform proposal is 48% for 50% tax finance and 62% for 100%
tax finance. (The differences are negligible for the consumption tax plus tax on
financial income reform.)
These measures suggest that the income tax reform is likely to narrow the
differences between debt and equity finance, but perhaps not by very much, whereas
the consumption tax reform would eliminate virtually all of the differences.
Distortions of Payout and Realization Decisions
Under current law, the tax system favors the retention of earnings in
corporations and the delay in the realization of capital gains, because capital gains
that arise from retained earnings are not taxed until the asset is sold, and are never
taxed if held until death. As a result the effective tax rate on capital gains for taxable
investors is about half the rate of dividends, and the distortion is small (about an
eight percentage point differential) because most dividends and capital gains are
taxed at a flat 15% rate. There are no distortions for tax exempt investments. This
basic treatment is retained in the consumption tax reform provision, although the
share of tax exempt investment is likely larger. The income tax revision actually
reverses the relationship, because the tax rate on dividends is zero, but only 75% of
capital gains are excluded. That treatment creates an incentive to pay out earnings.
The magnitude of the distortion is probably less, however; the maximum capital
gains effective rate will be only about 8%.
Corporate Versus Non-corporate Business Distortions
Aside from the distortion between debt and equity, the corporate tax also
discourages investment in the corporate sector. Table 4 examines the total effective
tax rate in the corporate sector as compared with the non-corporate sector under the
different tax regimes.
Table 4. Effective Tax Rates on Alternative Business Forms
Lar g e Medium Small
Tax Regime CorporateNon-Non-Non-
Corporate Corporate Corporate
Excluding Tax Exempt Forms
Current Law 32202018
Panel’s Income Tax
Tax Reform Plan14 6 6 6
Including Tax Exempt Forms (50% or 100% exempt)
Current Law (50%)25161614
Panel’s Income Tax Reform
Panel’s Consumption Tax
Reform Plan (50%)7 333
Panel’s Income Tax Reform
Panel’s Consumption Tax
Reform Plan (100%)0000
Source: Congressional Research Service. See Appendix A for method of computation and
a ssump tio ns.
As in the debt vs. equity case, calculations are also done taking into account the
lower individual tax rates for pensions and IRAs. Since these entities would not
invest directly in unincorporated businesses (such as sole proprietorships and
partnerships), the non-corporate numbers consider only the case when the providers
of loans are not fully subject to tax. However, since non-corporate investment is not
a viable alternative for passive investment entities such as pension plans, the more
relevant measure may be the tax rates without incorporating these effects, since it is
among taxable accounts that choices might be made about investing directly in
businesses rather than financial instruments.
This table also considers the differential treatment of small businesses (which
are largely non-corporate). The smallest businesses (which account for most non-
corporate investment) are assumed to operate on a cash basis and expense equipment
investments, whereas the medium sized businesses would also be on a cash basis but
would depreciate equipment and buildings. Cash accounting produces a zero
effective tax rate on inventory investment. For current law, the calculations assume
that small non-corporate businesses would be able to expense investments in
equipment under current provisions of the tax law that allow expensing with a
As in the case of the debt equity choice, the income tax reform proposal appears
to narrow the differentials between corporate and non-corporate investment although
the reduction is generally small. The consumption reform significantly narrows the
Business versus Owner-Occupied Housing and Total Burden
Table 5 provides estimates of the total tax burden on business investment for
owner-occupied housing and for aggregate investment in the economy.
The income tax reform, in general, narrows the differences in tax rates between
business investment and owner-occupied housing, from a difference in tax wedges
of about 40% under current law to a difference of about 27%. The consumption tax
reform narrows the wedge to less than 15%. Thus both reforms would reduce the
distortions between business investment and housing.
A final rate shown in Table 5 is the overall marginal tax rate in the economy.
The income tax reform proposal keeps about the same effective tax rates if the same
assumptions are made about tax exempt finance, but it would be likely to slightly
lower the overall tax rate because of the increased amount of tax exempt finance.
The consumption tax proposal with the tax on financial income would lower overall
tax rates, and is likely to produce a negative overall tax rate. A negative tax rate
could occur when most investment comes from tax exempt forms (and thus there is
little or no tax on financial investment) and combines a virtually zero tax on business
investment with a negative tax on owner-occupied housing, due to the mortgage
credit. A negative tax rate on capital income, like a positive one, causes an
Table 5. Effective Tax Rates on Reproducible Capital
Ow ner- To t a l
Tax Regime BusinessInvestmentOccupiedEconomy
Excluding Tax Exempt Forms
Current Law 28-318
Panel’s Income Tax Reform Plan24317
Panel’s Consumption Tax Reform Plan11 0 7
Including Tax Exempt Forms (50% or 100% exempt)
Current Law (50%)22-1311
Panel’s Income Tax Reform Plan (50%)21-113
Panel’s Consumption Tax Reform Plan (50%)6- 81
Panel’s Income Tax Reform Plan (100%)17-69
Panel’s Consumption Tax Reform Plan (100%)0-17-6
Source: Congressional Research Service. See Appendix A for method of computation and
a ssump tio ns.
Effects on Savings, Labor Supply,
Growth, and Output
If tax rates on capital and labor income affect labor and savings and if they are
altered, output and growth rates in the near and intermediate term can change.18
Despite the presumption that lower tax rates will increase supply, such an outcome
is neither theoretically nor empirically certain. For both of these effects, there are
offsetting income and substitution effects. A rise in after-tax wage income can cause
work effort to decrease because the individual wishes to consume more of
everything, including leisure, offsetting the incentive to shift consumption from
leisure to other goods, with the outcome uncertain. Similarly, a rise in the after-tax
rate of return can allow individuals to achieve a target amount with smaller savings,
offsetting the effects of the incentive to save more to achieve a higher target. Simple
empirical evidence suggests that effects are small because labor supply and savings
responses are relatively small.19
Economists at the Treasury Department recently prepared a dynamic analysis
of the tax reform plans, and that analysis will be used to discuss the potential growth
effects.20 The Treasury study, in addition to examining the two reform plans, also
examined a personal consumption tax (PCT) that was similar to the panel’s
consumption tax (GIT), but excluded the 15% tax on financial income (interest,
dividends, and capital gains) and had a slightly higher top individual tax rate (35%
rather than 30%).
The Treasury used three different models to analyze the effects. One model is
a standard neoclassical growth model with fixed labor supply and an elasticity of
savings with respect to the rate of return equal to 0.4. The other two models used in
the Treasury study were the standard intertemporal models: the Ramsey model,
which depicts the economy as a single infinitely lived person; and the overlapping
generations model (OLG), which traces cohorts of individuals over time. These
intertemporal models were developed to bring the microeconomic foundations of
decisions regarding savings and labor supply into macroeconomic models. Although
more satisfying theoretically to many economists, these models have not been tested
empirically and are highly stylized in many ways.
Table 6 summarizes the effects on output of the various reform plans using the
three models in the first 10 years, in year 20, and in the long-run steady state. As the
18 In most growth models changes in savings rates and labor supply cannot affect the long-
run growth rate, which is determined by population growth and exogenous technological
change. There are models of endogenous growth, but the factors that drive those growth
rates are unlikely to be affected by the tax changes in the reform plan.
19 For a review of the empirical evidence see CRS Report RL31949, Issues in Dynamic
Revenue Estimating, by Jane G. Gravelle.
20 Robert Carroll, John Diamond, Craig Johnson, and James Makie III, A Summary of the
Dynamic Analysis of the Tax Reform Options Prepared for the President’s Advisory Panel
on Federal Tax Reform, U.S. Department of the Treasury, Office of Tax Analysis, May 25,
2006, prepared for the American Enterprise Institute Conference on Tax Reform and
Dynamic Analysis, May, 2006.
numbers in this table indicate, two results are clear. First, the income tax reform has
very small effects on growth in any of the model simulations, because it has little
effect on tax rates. None of the proposals had a significant effect on marginal and
average-wage tax rates, and only the consumption tax proposals had an effect on tax
rates on investment.21 Second, for those proposals that had a noticeable effect on the
capital income tax rate, the results vary significantly depending on the model used.
In the first 10 years, on average output increases by 1.9% for the Ramsey model,
1.5% for the OLG model, and 0.1% for the Solow model. In the long run, output is
larger respectively by 4.8%, 2.2%, and 1.4%.
Table 6. Percentage Change in National Income, Treasury Study
PlanSolow ModelOLG ModelRamsey Model
Simplified Income Tax (SIT)
Consumption Tax Plan (GIT)
Personal Consumption Tax (PCT)
Source: Treasury Department, Office of Tax Analysis.
21 The Treasury study reports the marginal and average income tax rates on labor income at
24% and 13% respectively. Under the income tax plan, these rates are estimated at 24% and
12.8%, whereas in the consumption tax plan they are 23.5% and 13.3% respectively. The
marginal and average rates go up slightly in their personal consumption tax plan (PCT), to
26.4% and 14.7%. For capital income, the Treasury study estimates a current marginal tax
rate of 13.9%. For the income tax reform, the rate falls slightly to 12.8% but for the
consumption plan (GIT), the reduction is much larger, to 1.1%. Their personal consumption
tax rate is -3.7%. The tax rates used in their analysis are similar to the ones calculated in
this study in Table 5.
Explaining the causes of these different results and evaluating the
reasonableness of the models is quite complicated, and the technical discussion is
contained in an appendix to this paper. However, the major conclusions suggested
in that appendix are as follows:
!Straightforward empirical evidence indicates that savings could rise
or fall and even in the model with the most modest results (the
Solow model) it is not clear that the effects would, indeed, be
positive, as some time-series elasticities are negative.
!The use of Roth-type IRAs and, in some cases, 401(k)s from
traditional IRAs would, according to the theory embedded in
intertemporal models, be less likely to induce savings as individuals
would no longer need to save the up-front tax reduction to pay future
taxes. This effect could be particularly pronounced in the GIT where
defined contribution pension plans will be converted to Roth style
plans, as substituting a Roth for a deductible plan should reduce
savings. These effects are not accounted for.
!Intertemporal models, while theoretically appealing in many ways,
involve some fairly heroic assumptions about the abilities of
individuals to make complex decisions and have not been
empirically tested. Much of the savings response reflects
intertemporal substitution of labor in response to interest rate
changes, where virtually no evidence of a response is available.
Alternative “rules of thumb” savings behavior may be more
consistent with individual savings behavior and tend to imply a zero
or negative elasticity. This view of behavior suggests that automatic
enrollment in employer retirement plans, facilitated by the proposals,
might increase savings, for which there is some direct evidence.
!The Ramsey model also suffers from some serious limitations, as it
requires some strict assumptions to achieve an internal solution (i.e.,
where there is general ownership of capital across many people, as
observed in the economy), including homogeneous preferences,
asexual reproduction, and a common tax rate, thereby making it
impossible to apply the model to a progressive tax rate structure, an
open economy, or to incorporate differential state tax rates.
!Even within the context of the intertemporal models, many of the
implicit elasticities are inconsistent with the empirical evidence,
including the labor supply elasticities and particularly the
intertemporal labor substitution elasticity, which empirical work
suggests is less than 0.2, but which is set at around 0.75 in the
Ramsey model and around 0.5 in the OLG model. Standard labor
supply elasticities also tend to be higher than most empirical
estimates, especially in the Ramsey model. Part of the reason for
these high elasticities is the somewhat arbitrary choice of hours
available for additional work.
!Even where the higher growth effects are expected, these effects are
quite modest compared to the normal growth of the economy. For
example, the largest growth is projected for the GIT by the Ramsey
model. In that simulation, over the 20-year period, output rises by
3.7%, for an average annual growth rate of less than 2/10 of a
percent. Normal growth is usually 2 to 3% and growth per worker
typically 1% or more. Growth induced by even a significant tax
change of this nature is not likely to materially affect the fiscal
outlook — that is, we cannot grow our way out of the deficit by
changing the shape of the tax system.
International Tax Treatment
The panel proposes a significant change in the tax treatment of foreign source
income in its income tax proposal, and proposes to treat taxes in its consumption tax
proposal (GIT) in the same manner as a VAT.
Under current income tax law, income of foreign subsidiaries of U.S. parents
is not taxed until repatriated as dividends, a treatment referred to as deferral. Income
of foreign branches of U.S. companies is taxed currently as is certain passive income
(Subpart F income) of subsidiaries that is easily subject to abuse. When income is
taxed, firms can take a credit against foreign taxes paid up to the amount of the U.S.
tax due, and these credits are aggregated across countries, so that unused credits for
taxes in high-tax countries can be used to offset U.S. tax due in low-tax countries.
This offsetting of credits across countries is referred to as cross-crediting. Certain
passive income is segregated into a separate foreign tax credit “basket.”
The international tax regime has several problems relating to economic
efficiency and tax compliance. First, because of deferral and cross-crediting, too
much of U.S. investment flows to low-tax countries (where its pre-tax return is too
low) and too little to the United States and high-tax countries. Deferral does not
produce as large a disincentive as outright exemption, but once income is earned
abroad there is an incentive to reinvest abroad to avoid the repatriation tax. Second,
the potential to reallocate profits from high- to low-tax jurisdictions complicates tax
administration and compliance. Profits may be reallocated by setting prices for
inter-company transactions and by assigning patent rights to operations in low-tax
countries. In addition, since companies control their tax liability through repatriation
decisions, they engage in complex planning to minimize their taxes, and, indeed, very
little tax is paid on foreign source income.
One reform approach would be to tax all income currently, which would
eliminate the repatriation issue. Also, if it were administratively feasible (although
there are claims that it is not), foreign tax credits could be separated into country
baskets, a treatment that would eliminate incentives for investment in low-tax
countries (although it would increase the disincentive to invest in high-tax countries).
But even with cross-crediting, a case can be made that this change would lead to
greater economic efficiency through eliminating much of the incentive to invest in
low-tax countries. Moreover, there would be less incentive to transfer income across
different countries. U.S. individual investors could avoid some of this current tax by
investing in foreign parents, and there would also be incentives for U.S. parents to
transform into foreign parent corporations (corporate inversion). The evidence
suggests that these effects would probably be small, and corporate inversions could
be discouraged with legislation. Revenue raised from this approach could be used
to reduce the corporate income tax rate and top income tax rates, if the distributional
effects are to be held constant.
An argument is sometimes made that this type of change would lead to an unfair
disadvantage to companies that must compete in low-tax countries with firms from
other countries who do not tax their subsidiaries’ income. It could lead to a smaller
presence abroad of U.S. firms, but, nevertheless, the investment that takes place in
the United States would earn a higher return and benefit the U.S. economy. That is,
from the point of view of U.S. society as a whole this is not so much an “unfair
competition” but rather a system that diverts resources to their best uses.
The panel did not choose current taxation of foreign source income, but rather
a complete exemption of active income, and current taxation of passive income
including royalties. This latter provision would eliminate the ability of companies
to shift income abroad through the use of royalties. This option suggests the panel
wanted to focus more on the international abuses and reduction of planning costs, as
this treatment eliminates the repatriation decision and reduces the opportunity to shift
income through royalties. The panel argues their plan on the basis of conforming to
what most other countries do and also invokes the “level-playing-field” argument
discussed above. They also suggest that the tax shelter problem is more severe than
the real allocation of capital. But the plan can be criticized as not only increasing real
asset allocation distortions but also giving up the opportunity to reduce transfer
pricing and expense allocation methods of shifting profits to low-tax jurisdictions.22
For the consumption tax plan, since the tax is no longer a corporate income tax,
all of these mechanics would be abandoned. Two approaches that are generally
equivalent for a uniform tax (and this tax is relatively uniform) are an origin basis tax
(where output is taxed where produced) and a destination basis tax (where output is
taxed where consumed). In the destination approach, as used in the VAT, taxes
would be rebated on exports and imposed on imports. The panel recommends a
destination basis because it eliminates the incentive to shift taxable sales into low-tax
Other Tax Incentives
The tax reform proposal eliminates a series of tax preferences, some of which
are discussed in the document and some of which are simply presumed to be
eliminated based on general statements. An analysis of this myriad of tax incentives
22 For a recent study which compares these systems, with a discussion of these profit-shifting
issues, see Harry Grubert and Rosanne Altshuler, “Corporate Taxes in the World Economy:
Reforming the Taxation of Cross Border Income,” presented at the James A. Baker III
Institute for Public Policy Conference, “Is It Time for Fundamental Tax Reform?: The
Known, Unknown, and Unknowable,” Houston, TX, April 27-28, 2006.
is beyond the scope of this report, although it is possible to argue that many of them
tend to distort the allocation of resources and many are simply accidents of history.23
Some provisions, however, are substitutes for what might be desirable spending
programs that are channeled through the tax system, and repealing them without
providing an alternative spending program may be questioned.
An example is the low-income-housing credit, for which a case may be made
that use of the tax system is inefficient, but where the goal (helping low-income
people obtain decent housing) may be laudable. Another example is the education
tax credit and deduction, which was aimed at making higher education more
affordable for the middle class and was phased out at higher incomes. The tuition
credits and deductions were criticized because a direct system for delivering aid was
already in place, and using the tax system simply made the system more complicated.
One can also debate the desirability of expanding aid to middle class, given the
extensive subsidies that already exist, but that is a debate about education, not tax,
policy. It is the case, however, that the proposal retained the subsidies for saving for
higher education through the “Save for Family” accounts, subsidies that are likely to
be more concentrated to higher-income families who can afford to save for a long
period of time.
As noted above, many of the provisions in current law affect the allocation of
capital investment, and the major ones are incorporated in the analysis of capital
income taxes. There are certain consumption items that are favored in a significant
way by the current tax law, and these will be discussed briefly in this section.
Perhaps the most significant, in terms of lost dollars of revenue, is the current
benefits for health care, and specifically for health insurance. Also discussed is the
subsidy for charitable giving and the effect on state and local governments (due to
the deductibility of state and local taxes and the exclusion of interest on tax exempt
bonds). The panel’s proposal would make changes in all of these areas. Although
a full analysis of these issues is beyond the scope of this report, some brief discussion
Some of the largest subsidies in the tax code accrue to health care, with forgone
revenues of $90.4 billion in FY2006 for the exclusion of health insurance benefits
from employees’ income. There is also a $3.8 billion loss for exclusion of health
insurance for the self-employed. Some part of spending for cafeteria plans, where
employees choose benefits, is associated with health care; these plans result in a
revenue loss of $27.9 billion. In addition to these benefits for private health
insurance, $7.5 billion is lost in itemized deductions for major health costs (those
over 7.5% of income). There are also some losses due to exclusion of employee
benefits and Medicare benefits, the latter being relatively costly.
23 For a brief discussion of each of the more than 100 tax expenditures, see U.S. Congress,
Senate Committee on the Budget, Tax Expenditures: Compilation of Background materials
on Individual Provisions, Prepared by the Congressional Research Service, S. Prt. 108-54,
There are reasons for government intervention into the health care market,
which is subject to adverse selection (differential premiums for people with poor
health histories) and moral hazard (encouraging too much spending on health care
due to insurance). In addition, our society does not wish to deny critical medical care
to people due to lack of ability to pay.
The revisions in the panel’s plan may reduce some of the problems but possibly
aggravate others. The exclusion of insurance for employer plans (and the self-
employed) can be criticized on the grounds that it adds to moral hazard (by
encouraging coverage of ordinary medical expenses) and is unfair because it does not
benefit employees of firms without plans. At the same time, employer plans, by
pooling individuals in the workplace, can address adverse selection. The proposal
to limit employer contribution deductions (it is not practical to tax this implicit
income to employees) might reduce moral hazard without interfering with the
benefits of offsetting adverse selection, and thus may be considered an efficient
reform. Allowing a deduction for health insurance premiums to those not covered
by employer plans has both desirable effects — it would be more equitable and
would improve coverage — and undesirable effects — it would increase moral
hazard and could undermine the employer system with its improvement of adverse
selection. In addition to including health-related fringe benefits, the plan would
eliminate the extraordinary medical expense deduction, a provision that allowed
relief for families with significant medical costs and one which might be difficult to
The panel’s proposals would restrict the current deduction for charitable
contributions to amounts over a floor equal to 1% of income, and would also extend
the benefits to all taxpayers, not just itemizers. The proposal would also permit
individuals to sell assets and donate the cash to charity without paying a capital gains
tax if the cash is donated within a short time frame, a provision that would eliminate
the tax benefits of donating property directly.
Charitable contributions are subject to a market failure in that, assuming
individuals benefit from the goods financed by charitable contributions, individuals
can “free-ride” on others’ contribution. Because of this “free-ride,” people count on
others to fund charities and do not give enough in the aggregate. Thus there is a
justification for a subsidy. The tax benefit is potentially subject to abuse as people
attempt to gain private benefits, overstate their deductions, and exaggerate values of
property donated. Even for taxpayers who are intending to be honest, valuation of
property is often difficult. This problem would be reduced to some extent by the
provision allowing the property to be sold and then donated.
The 1% floor would contribute to target efficiency, which focuses on how much
charitable contributions are increased for each dollar of revenue loss. Target
efficiency is often referred to as “bang for the buck.” The floor would also achieve
administrative simplicity by disallowing small deductions. Among itemizers, it
would reduce the overall incentives for giving (for those with contributions under the
threshold). According to calculations using the public use statistics of income file,
about 63% of itemizing contributors gave over 1% of income.24 These contributors
accounted for 95% of giving, with 18% under the floor and 77% above the floor.
These numbers suggest for itemizers that the floor will create a more target efficient
system without doing much to reduce giving, since 78% of the revenue gain from the
floor is associated with the loss deductions by those already over the threshold who
will retain an incentive to give at the margin.
The extension of the deduction to non-itemizers may offset the reduction in
coverage and also will be more efficient than a deduction without a floor. Thus,
overall this change is likely to lead to a more effective incentive for charitable giving.
State and Local Tax Deductions; Tax Exempt Bonds
The proposal eliminates the existing deductions for state and local taxes, which
include income, property, and, as a temporary alternative to income tax deductions,
sales tax deductions. The property tax deduction can be considered as part of the
general beneficial treatment to owner-occupied housing, as well. But, in general, the
argument against deducting state and local taxes is that these taxes pay for state and
local goods and services that are not taxed to the recipients; hence the deduction
encourages more expenditure on these goods. Of course, there is no close
relationship between taxes and services as there is for private spending or even fees
(such as those for national parks), so this argument is not entirely straightforward.
The deduction also encourages the use of deductible taxes (income and property, and,
temporarily, general sales taxes); some consider this effect to be an inappropriate
interference in choice, but others may support the encouragement to use more
progressive taxes, especially the income tax. Another argument for allowing a
deduction is that these taxes are not voluntary and reduce ability to pay, although the
deduction can also be criticized as favoring taxpayers in high-tax states. Whether the
deduction for state and local taxes is desirable or undesirable, therefore, is difficult
Another major subsidy in the tax system is the exemption of interest on state and
local bonds. On theoretical grounds, this benefit is questionable because there seems
no particular reason to favor spending on investment goods (which generally are the
purposes of these bonds). In addition, some of the subsidies go to investments which
are not really public goods through localities financing (for example) sports stadiums
and convention centers, or through the use of private activity bonds which are
permitted to benefit private investors with restrictions on the purposes and amounts.
Although there is no explicit elimination of the subsidy, the expansion of tax-favored
savings accounts in both plans will, however, diminish the tax benefit.
In any major tax revision, transition issues become difficult. In the case of the
income tax plan (SIT), these transition issues are likely to be most problematic for
24 These estimates were provided by Maxim Shvedov of CRS based on the Statistics of
Income public use file.
moderately high- and higher-income homeowners who have purchased homes with
values high relative to income, and will lose part of the value of their mortgage
deductions and their deduction for property taxes.
The transition problems are much more severe for the consumption tax proposal
and, indeed, may be severe enough to make adoption of such a proposal impossible.
In shifting from an income to a consumption base, businesses would normally lose
all of their recovery of costs of existing assets, including depreciation deductions,
basis in the sales of assets, and costs of goods sold when selling items in (or
produced from) inventory or intermediate purchases.
A consumption tax is, as noted above, equivalent to a wage tax and a lump sum
tax on capital income. Under a consumption tax without transition rules, the value
of assets falls because the full value of the asset will be taxed upon sale. Also,
because the consumption tax does not include financial assets in its base but does not
require a price accommodation (as might be the case for a VAT or a retail sales tax),
that lump sum tax on old assets falls on the equity share of capital. It should also be
reflected in stock market share values, where, absent adjustment costs, the imposition
of a 30% consumption tax should be expected, given that about one third of assets
is debt financed, resulting in a theoretically predicted fall in asset value of 45%
(20%/(2/3)).25 Taxpayers with heavily debt-financed assets not only would be unable
to deduct interest costs, as well as depreciation or costs of goods sold, but also could
suffer a significant burden if they wish to sell their business or major asset, with the
tax due on sale exceeding their cash proceeds.26 Examples of taxpayers who might
be adversely affected are individuals with substantial inventory going out of business
(and unable to deduct the cost of their goods sold) or individuals who own and wish
to sell a single piece of property, such as a building.
These effects are adjustment costs, and can be reduced by transition rules, but
transition rules for recovery of depreciation or inventory costs would be extremely
expensive. This lump sum effect would be offset in part if depreciation deductions
and recovery of old inventory costs were still allowed. However, without adjustment
costs, assets would still lose about half of their value because the present value of
depreciation deductions is less than the current value of the property.27
The panel’s transition rules are quite limited. There would be a four-year
phaseout of depreciation deductions and interest deductions — 80% in the first year,
60% in the second, 40% in the third, and 20% in the fourth. (Interest would be taxed
in the same proportions.) No other transitions are allowed, and sale of an asset would
terminate depreciation transitional rules and new financial contracts would terminate
interest deduction allowances.
25 These effects are smaller in the short run, if there are adjustment costs.
26 See CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales
Tax: Overview of the Issues, by Gregg A. Esenwein and Jane G. Gravelle for a further
27 See Leonard Burman, Jane Gravelle, and Jeff Rohaly, Towards a More Consistent
Distributional Analysis, forthcoming in the Proceedings of the National Tax Association,
Based on this transition rule, a taxpayer with a new nonresidential building
purchased before the tax was imposed would lose approximately 95% of scheduled
deductions on buildings, about 65% of deductions for equipment (for a typical seven
year asset), and all of the deductions for existing inventory (either goods for sale or
goods in process). The loss would be smaller in present value for the buildings and,
to some extent, for equipment, and smaller for older assets. But inventories would
bear virtually the full loss, and the loss is substantial. “Current inventories” for the
fourth quarter of 2004 were $1.7 trillion, thus, providing any sort of partial relief
would be extremely costly, as most inventories are turned over very quickly.
Taxpayers with outstanding debt would also lose a significant fraction of interest
deductions unless they can refinance. Not all bonds can be called. According to
bondmarket.com, out of $207.7 billion of corporate bonds with maturities of over a
year, over half, or $121.7 billion, are not callable.28 The average maturity of bonds
is approximately seven years.29 For a seven-year bond paying a coupon, taxpayers
would lose 71% of interest deductions. The loss would be greater for longer
maturities: 80% for a 10-year bond, 90% for 20-year bond, and 93% for a 30-year
Presumably all depreciation would be lost when an asset is sold and presumably
the basis of the asset would not be recovered (all proceeds taxed). Thus all
depreciation would be lost for these assets.
These transition problems impose a very significant barrier to the possibility of
adopting a consumption tax.
Of the two proposals presented by the panel, the income tax revision may be
more likely to have any chance of ultimate adoption. The consumption tax has gains
in efficiency (through the allocation of capital), possibly some gains in growth
(although the analysis in this report suggests these effects may be modest), and some
significant gains in simplicity, especially for business, that exceed those of the
income tax proposal. However, the analysis presented in the last section suggests
that the progressive consumption tax proposed by the panel would be very difficult
to implement. Moreover, the consumption tax is likely, when appropriate
distributional analysis is considered, to significantly reduce the progressivity of the
federal tax system.
These observations suggest a focus on the income tax proposal (SIT). There are
some important simplifications in the SIT, especially for businesses and high-income
individuals, although lower-income taxpayers may find their affairs more
complicated. In translating the income tax plan to a more detailed proposal that deals
with small, but important, deductions, however, some of these simplification gains
28 See [http://www.bondmarkets.com/story.asp?id=2234].
29 See [http://www.bondmarkets.com/story.asp?id=2235].
may be lost. The SIT faces revenue sufficiency problems that will require some taxes
to be increased in the future, and is probably not entirely distributionally neutral, but
shifts some of the burden away from high-income taxpayers. There are efficiency
gains in a number of areas, although probably little effect on growth, and the change
to international tax may increase inefficiency and even exacerbate tax sheltering.
There are also some transition problems, but they are small compared to the
Whether the gains from the changes under the SIT are worth the costs is unclear.
Historically, it has been difficult to make major changes to the tax code because of
the disruption in taxpayers’ affairs. Nevertheless, there are some limited aspects of
the proposals that do seem to have many advantages and few drawbacks. The
proposal for a floor on charitable deductions has a salutary effect on both target
efficiency and tax administration and simplification. Removing barriers to automatic
enrollment in employer retirement plans is, as well, a proposal that is likely to
facilitate savings. A ceiling on deductions by employers in health insurance plans
appears to preserve the benefits of reduced adverse selection in health insurance
markets while reducing both moral hazard effects and differential treatment of
taxpayers. It may be that the greatest contribution of the panel study is to identify
some possibilities for more limited reforms.
Appendix A: Calculating Effective Capital Income
The tax rates in this paper are calculated by first determining, given a required
after-tax return and an expected rate of decline in productivity of the asset due to
depreciation, how much the investment must initially produce in order for the sum
of profits after tax over time, discounted by the after-tax return, to equal the
individual investment outlay (i.e., to break even). Then all of the tax payments and
deduction are eliminated and the before profit flows are used to determine what pre-
tax discount rate would sum the flows to original cost. The effective tax rate is the
pre-tax rate of return minus the after-tax rate of return, divided by the pre-tax rate.
Discounting means dividing each flow by a discount factor; for a flow earned
a year from now, the discount factor is , for a flow earned two years from()1+r
now , for a flow three years from now , where r is the discount rate.()12+r()13+r
In practice, however, the analysis uses a continuous time method with continuous
compounding. The formula derived from this method is
where r is the pre-tax return, R is the after-tax discount rate of the corporation, d is
the economic depreciation rate, u is the statutory tax rate, and z is the present value
of depreciation deductions (discounted at , where is the inflation rate).R+ππ
The effective tax rate for equity at the firm level is . When including()rRr−/
individual level taxes and debt finance, the tax rate is measured by determining r as
above, where , where f is the share debt()()RfiufE=−−+−11π
financed, I is the nominal interest rate, and E is the real return to equity before
individual tax but after corporate tax. E is equal to D + g, where D is the dividend
rate and g is the growth rate. The after-tax real return, , isR∗
, where t is the effective individual tax()()()()fitfDtgc1111−−+−−+−π
rate and c is the effective capital gains tax rate. The total tax rate is .()rRr−∗/
For a more complete description of the methodology and data sources, including
useful lives for depreciation purposes, formulas for measuring z, and the allocation
of assets in the economy, see Jane G. Gravelle, The Economic Effects of Taxing
Capital Income, Cambridge, MA, MIT Press, 1994.
For purposes of this analysis, the following assumptions were made: the interest
rate is 7.5%, the inflation is 2%, and the real return to equity before individual taxes
is 7% , with a 4% return (or 57% of real profits) paid as dividends. The corporate
rate is 35%, the average individual marginal tax rate on investment income is 23%
(data consistent with calculations in the National Bureau of Economic Research
TAXSIM model). Statutory tax rates on dividends and capital gains are 15% under
current law and under the consumption alterative; taxes on gains are half the rates on
dividends to reflect exclusion and deferral at death. Under the income tax reform,
of the remainder is excluded because of the exemption rule, with the remainder taxed
Within businesses, the following asset shares apply: 62.2% in corporations,
5.3% in large non-corporate firms, 2.7% in medium non-corporate firms, and the
remainder in small non-corporate firms. Owner-occupied housing is 40% of total
Appendix B: Discussion of the Macroeconomic
Analysis of the Tax Reform Plans by the Treasury
The model that yields the smallest results in the dynamic analysis is the Solow
model, where labor supply is fixed, but savings is responsive to changes in the rate
of return. The savings response is based on a direct estimate of the savings elasticity
from time series evidence. Most evidence of labor supply is consistent with a
relatively unresponsive supply. This evidence reflects the historical stability of
participation and hours by prime-age men, cross section studies of labor supply, and
studies using contrived or natural experiments. Similarly, times series estimates of
saving tend to suggest a small response that is not surprising given the relative
constancy of the savings rate over time as well as the constancy of the capital output
ratio, despite significant changes in tax rates. These estimates may be positive or
negative but are close to zero, and the 0.4 elasticity estimate used in that model is
about at the upper range of estimates of savings supply response from time series
Although it is possible to construct an intertemporal model with a fixed labor
supply, a standard labor supply response is included in the two intertemporal models;
however, that standard response is only part of the effect that labor has in the model.
In addition to a potential permanent decrease or increase in the labor supply due to
within-period choices of leisure and consumption, there can be an intertemporal shift.
Indeed, this intertemporal shift in labor can play a major role in the short-run
response to a tax cut in capital income, as occurs in a shift to consumption taxes.
This effect comes about because of the desire to shift leisure from the present to the
future, so that the agent works more today, saves that income, and works less in the
future. In addition to these labor supply effects, there is the normal savings response
that would occur even in models with fixed labor supply, a savings response that
depends on the rate of return. This savings response tends to have a very small effect
on output in the short run, but can be significant in the long run.
There are several issues surrounding the use of these intertemporal models to
project the effects of tax changes. These issues are also discussed in considerable
detail in a CRS report on dynamic revenue estimating.31 However, three questions
may be raised about these intertemporal models.
The first question is how realistic such models are as a way of depicting how
people actually behave. These models are attractive to economists because they rest
on the basic micro-foundations of consumer behavior. Nevertheless, the Ramsey
model originated as a planning model rather than a description of how people
actually behave and can only be considered as a representation of economy-wide
behavior if strict assumptions are met. Since the model treats society as an infinitely
lived person, it requires asexual reproduction if dynasties are to be represented as an
infinitely lived person. And, in order to avoid reaching a “corner solution” where all
capital is owned by one group, it requires completely homogeneous tastes (i.e., all
individuals have the same preferences for present and future consumption), and
common marginal tax rates. Thus, the model cannot be used if there are differential
marginal tax rates either through progressivity in tax rates, or differential tax rates
across states of the United States, or differential rates across countries.
The overlapping generations (OLG) life-cycle model does not suffer from these
problems, and a planning horizon of 50 years or more provides significant savings
effects. In addition, because income is shifted from the old to the young, savings
may increase for that reason as well. Some economists doubt the appropriateness of
such a model because of the extreme complexity of the decision the individual is
making. The model presumes individuals to make optimal decisions choosing work
30 For a survey of evidence on labor supply see CRS Report RL31949, Issues in Dynamic
Revenue Estimating, by Jane G. Gravelle, cited above. For a brief survey on the savings
evidence, see Jane G. Gravelle, The Economics of Taxing Capital Income, Cambridge: MIT
Press, 1994. Further discussion of the historical evidence and savings response can be
found in CRS Report RL32517 Distributional Effects of Taxes on Corporate Profits,
Investment Income, and Estates, by Jane G. Gravelle.
31 CRS Report RL31949, Issues in Dynamic Revenue Estimating, by Jane G. Gravelle.
decisions, savings, and consumption for, typically, around a 55-year adult life.
Individuals may not be able to make these decisions because they do not have the
knowledge and skills to do so, or even the self control and freedom from
procrastination. An alternative model, sometimes referred to as a “bounded
rationality” model, suggests that people may make choices based on rules of thumb,
and the most common rules of thumb, a fixed fraction of income saved, or a target
retirement fund, imply zero or negative savings elasticities. There is some empirical
evidence to support this type of model, and, indeed, evidence on the importance of
defaults on savings in retirement plans is a justification for the automatic savings
provisions for employer plans included in the panel’s report.32 In addition, the life
cycle model is sensitive to many types of assumptions that may be made in an
arbitrary fashion, including how retirement occurs, how bequests are left, whether
there are precautionary as well as retirement savings, and many other characteristics.
The OLG model can also have outcomes that depend on specific model features.
However, the OLG model used by Treasury does avoid one troublesome problem in
some other OLG models: it has a fixed retirement age. That feature means that an
effect common in an OLG model with endogenous retirement, older people returning
to work in significant numbers due to the lump sum tax on older people’s assets
under a consumption tax, a phenomenon that seems unlikely given the adjustment
costs and health issues, does not occur.33
The second question is whether the models have been empirically tested, and
the basic answer to that question is no. Although relationships are based on certain
empirical estimates of substitutions across time, there are no estimates of substitution
elasticities across long periods of time. Basically, the models presume that the
substitutability across far-apart periods is the same as for close-together periods. In
addition, the models often predict very dramatic short-run changes in savings and
labor supply that are difficult to reconcile with the stability of these relationships over
The third question is how closely the models, given that structure, track those
empirical relationships that we can observe, and how those empirical relationships,
in turn, drive the model. There are actually four types of empirical relationships to
draw on: the substitution effect for the static labor supply response, the income effect
for the static response, the intertemporal substitution elasticity for consumption
bundles over time, and the intertemporal labor supply elasticity, and these in turn
govern the short run labor supply response, the initial savings response, and,
32 See CRS Report RL33482, Saving Incentives: What May Work, What May Not, by
Thomas Hungerford, for a discussion.
33 That phenomenon causes an OLG with endogenous retirement, such as that presented in
Alan Auerbach and Laurence Kotlikoff, Dynamic Fiscal Policy, Cambridge, Cambridge
University Press, 1987 to have larger effects in the short run than a Ramsey model. For a
discussion see Eric Engen, Jane Gravelle, and Kent Smetters, “Dynamic Tax Models: Why
They Do the Things They Do” National Tax Journal, vol. 50, September 1997, pp. 657-682.
In these simulations of a shift from a flat income tax to a flat consumption tax, the OLG
model increased labor supply by 3.8% compared to the 2.4% in the Ramsey (infinite
horizon) model, even though the time horizon for the Ramsey model is greater.
ultimately, the long run effect on the capital stock. Both labor supply and
consumption can be shifted over time due to changes in expected wages over time
or changes in the rate of return.
It is possible to sort out some of these effects, in a rough fashion, to compare
them with empirical estimates. Those empirical estimates include the static income
and substitution (compensated) elasticities of labor supply with respect to wage
changes, the intertemporal substitution elasticity (how consumption shifts across
time, with respect to the interest rate), and the intertemporal labor supply elasticity
(how labor supply shifts with respect to the wage rate).
The formula for percentage change in labor from a static model is34
l dt dtm a
HLa t tm a() ()()+ − −11
where l is hours of leisure, H is the time endowment, L is hours of labor, E is the
substitution elasticity between leisure and consumption, a is the ratio of non-labor
income to labor income, tm is the marginal tax rate, and ta is the average tax rate.
In the model, the share of the time endowment in leisure was 0.6 in the Ramsey
model and 0.5 in the OLG model, and the elasticities were 0.8 and 0.6 respectively.
Given the tax rate changes in the text, this effect suggests a reduction in labor for the
SIT of about -0.1% (because of the slight fall in the average tax on labor income,
whose income effect causes less work). For the GIT, where the marginal tax rate fell
and the average tax rate rose, both income and substitution effects led to a 0.5%
increase in the Ramsey model and a 0.4% increase in the OLG. In the full simulations
by the Treasury, in the Ramsey model, the labor supply fell in the first 10 years, on
average, by 0.1% in the SIT, but rose by 0.3% in the OLG model. These small
differences could have arisen because of some small amount of intertemporal shifting
and variations in income effects. For the GIT, however, labor supply rose in the first
10 years by 1.3% and 1.2% respectively. Moreover, while labor supply changes over
time stayed relatively constant for the SIT (-0.2% and 0.4% in year 20 for the Ramsey
and OLG, -0.3% and 0.4% in the long run), they show a significant decline in the
GIT. For the Ramsey model, the labor supply increase was 1.3% in the first 10 years,
1% in year 20, and 0.1% in the long run. For the OLG model, the labor supply
increase was 1.2% in the first 10 years, 0.7% in year 20, and 0.6% in the long run.
The intertemporal labor supply response also affects saving because the increase
in labor is for the purpose of saving to permit more leisure in the future. There was
additional savings as well in the GIT simulation, since, even as labor increased,
consumption fell. These calculations suggest that, at least in simulating the GIT
(and the PCT) that the intertemporal labor supply response is important.
Several empirical measures govern these responses. For labor, the static
responses imply a compensated elasticity (which captures the positive effect on
34 This formula is derived in CRS Report RL31949, Issues in Dynamic Revenue Estimating,
by Jane G. Gravelle, as are the remaining formulas in this appendix.
wages on labor supply and multiplies the marginal tax rate term in equation (1), with
the value of a ranging from zero to 0.2) of 0.48 to 0.53 and an income elasticity of
-0.56 to -0.6. For the OLG model the substitution elasticity is 0.3 to 0.33 and the
income elasticity is -0.45 to -0.5. The smaller elasticities in the OLG model reflect
the lower leisure share (0.6 in the Ramsey model versus 0.5 in the OLG model) and,
with respect to the compensated elasticity, because of the smaller intratemporal
substitution elasticity (0.8 in the Ramsey model and 0.6 in the OLG model). These
elasticities are likely to be high. Based on surveys of the evidence, the Congressional
Budget Office chose an uncompensated elasticity of 0.14 and an income elasticity of
-0.07, whereas the Joint Tax Committee chose an uncompensated elasticity of 0.18
and an income elasticity of -0.13.35 The CBO has recently increased their
elasticities.36 Yet, there is more of a justification for reducing them, because it is
likely that the response for women has decreased because of greater participation: for
participation, as for hours, the greater the labor supply the smaller the elasticity is
likely to be. A recent study suggested that elasticities of women’s labor supply had
decreased by about 50%.37
The second type of elasticity that can be compared with empirical evidence is
the intertemporal substitution of labor with respect to the wage rate. This elasticity
where is the share of total consumption spent on leisure, is theαγ
intertemporal substitution elasticity, and is the intratemporal substitution elasticityρ
between leisure and consumption. Although the elasticities vary, most of the
evidence suggests intertemporal labor supply elasticities that are quite small, in the
neighborhood of 0.2.38 The Treasury elasticities are higher than that value. For the
35 Congressional Budget Office, How CBO Analyzed the Macroeconomic Effects of the
President’s Budget, July 2003, p. 12; John W. Diamond and Pamela Moomau, “Issues in
Analyzing the Macroeconomic Effects of Tax Policy, National Tax Journal, Vol 56,
September 2003, p. 450. See also the discussion of labor supply elasticities in CRS Report
RL31949, Issues in Dynamic Revenue Estimating, by Jane G. Gravelle.
36 CBO apparently subsequently increased their labor supply elasticities, but did not report
a weighted average and did not provide the data to calculate such an average. See
Congressional Budget Office, Macroeconomic Analysis of a 10% Cut in Income Tax Rates,
May 2004. However, they indicated that they relied on a survey by Frank Russek which
reports a substitution elasticity of 0.2 to 0.4 and an income elasticity of -0.2 to -0.1.
37 Blau, Francine D. and Lawrence M. Khan, “Changes in the Labor Supply Behavior of
Married Women: 1980-2000” NBER Working Paper No. 11230 (2005).
38 See the review in CRS Report RL31949, Issues in Dynamic Revenue Estimating, by Jane
G. Gravelle. For a recent study that found no labor supply effect for middle income
individuals, and was not included in that review, see Adam Looney and Monica Singhal,
“The Effect of Anticipated Tax Changes on Intertemporal Labor Supply and the Realization
of Taxable Income,” Finance and Economics Discussion Series, 2005-44. This study that
used the loss of a dependent to identify an expected change in the marginal tax rate and
Ramsey model, the elasticity is estimated at 0.75, whereas for the OLG model it is
estimated at 0.49.39
These relatively high labor supply responses, particularly in the Ramsey model,
drive a lot of the short-run response in the GIT. One simple way of reducing these
elasticities to conform more closely with the empirical evidence, without disturbing
other parts of the model, is to reduce the time endowment available for labor. There
are some direct reasons to do so as well. For example, in the Ramsey model,
assuming 40 hours of work for a full time worker and eight hours to sleep would
result in a “leisure” of 64%, not much above the allowance in the Ramsey model.
But this ratio leaves no time to carry on the essential functions of modern life which
are really not leisure but simply necessary tasks, such as commuting, personal
grooming, eating and preparing food, shopping, and maintenance of home and
The intertemporal substitution elasticities, of 0.25 in the Ramsey model and 0.
35 in the OLG model, are consistent with the empirical evidence, suggesting the
intertemporal elasticity is below 0.5 and that the average is around 0.3.41
Note that there are really no studies that capture some of the other relationships
directly such as the labor supply response to a change in the rate of return, or
responses across long periods of time. It is these far-apart periods that drive much
of the models’ results because the savings elasticity with respect to the interest rate
is multiplied by the time period so that the savings response in the long run is very
large. In fact, in the Ramsey model, the long run steady state does not depend on the
intertemporal substitution elasticity as the savings elasticity is effectively infinite;
it merely determines the adjustment path. In the long run, in both models, it is the
increase in the capital stock that largely causes the increase in output.
Another important elasticity in both models for both the short run and the long
run is the factor substitution elasticity, which is set at one. Setting this value at one
is common in many models. Nevertheless there are some economists who have
found a change in labor income but not in labor supply (either in participation, or in hours
worked by existing participants). The study did find a curious increase in labor income of
men, which is not easily explained, although it is possible that there was a shifting of income
over time periods or a shift to fringe benefits, or perhaps an increase in work intensity.
39 In the Ramsey model, since leisure is 60% of total hours, the ratio of leisure to labor is
1.5; in the OLG model it is 50% of total hours and the ratio is 1. The intertemporal
substitution elasticity is 0.25 in the Ramsey model and 0.35 in the OLG model, while the
intratemporal elasticities are 0.80 and 0.60 respectively. CRS was unable to obtain the
estimate of the share of leisure in expenditure on leisure and consumption, but estimated the
leisure share assuming that consumption is 95% of output and labor is 75%, at 54% for the
Ramsey model (1.5*.75/(.95+1.5*.75) and 44% for the OLG model.
40 See the review in CRS Report RL31949, Issues in Dynamic Revenue Estimating.
studied this issue and argue that the elasticity is much lower, around 0.4.42 These
elasticities can make a great deal of difference. In a simulation study, lowering the
elasticity from 1.0 to 0.5 caused the output change to fall by 45%.43
Based on this survey of models and elasticities, it is unlikely that the GIT would
have as pronounced an effect on output, especially in the short run, as depicted in the
There is one final issue that makes the effects also likely to be overstated. In
these models, private saving is influenced by the timing of taxes. Thus, in a shift to
a consumption tax, that fact that taxes are higher in the retirement years as assets are
drawn down results in an increase in savings in the short run. The changes in IRAs
and 401(k)s, however, are moving in the opposite direction. Traditional IRAs with
deductions up front should cause greater private savings because individuals should
save their tax cut today to pay taxes on withdrawals in the future. For the Roth style
IRA, there is no up-front deduction, and substituting Roth IRAs for traditional IRAs
should cause savings to fall.
43 Eric Engen, Jane Gravelle, and Kent Smetters, “Dynamic Tax Models: Why They Do the
Things They Do” National Tax Journal, vol. 50, September 1997, pp.657-682.