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Congressional Testimony
April 11, 2000, Tuesday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 7880 words
HEADLINE:
TESTIMONY April 11, 2000 JOSEPH M. KAHN HOUSE WAYS AND MEANS
TAX OVERHAUL PROPOSALS
BODY:
Statement of Joseph M.
Kahn House Ways and Means Committee Hearings on Tax Reform April 11 - 13, 2000
Thank you for the opportunity to contribute to these hearings on replacing the
income tax. I am providing this statement on behalf of the Stanford University
Decisions and Ethics Center. From 1996 to 1997, I had the privilege of
coordinating a team of economic researchers within the Decisions and Ethics
Center analyzing the impact on households of a change from the current income
tax regime to the National Retail Sales Tax (NRST) proposed by the group
Americans for Fair Taxation. This proposal is now embodied in H.R. 2525. Herein,
I present the main findings of our study. The study was based on the 1996 income
tax code, and assumed that the tax regime change would take place in 1998.
Though the income tax code continues to change each year and the proposed date
of changeover to the NRST remains in the future, I would not expect any major
changes in the study's general conclusions. 1. Summary of Main Findings The
Decisions and Ethics Center at Stanford University investigated the impact on
households of a change from the current tax regime to the national retail sales
tax (NRST) proposed by Americans for Fair Taxation. Under this proposal, all
federal income and payroll taxes would be repealed, federal revenues would be
replaced by the NRST at a (tax-inclusive) rate of 23%, and all families would be
granted a rebate for the amount of taxes paid at the federal poverty line. Our
study focused on individual families over their remaining lifetimes rather than
statistical aggregates in a single year, Our analysis yielded several major
conclusions regarding the impact on families of a change to the NRST tax regime.
The current tax code is complex and there is probably no change which can
guarantee that everyone would be better off. However, we find that most families
would enjoy higher real lifetime consumption under the NRST than under the
current regime. This is due to several factors, including lower tax burdens on
many households, lower compliance costs, lower marginal tax rates, and increased
economic growth and efficiency. Some wealthier seniors may experience a
reduction in purchasing power under the NRST. However, their own financial
well-being may not be the only issue they consider in their decision to support
a particular tax regime. Other factors, such as the effect on their
grandchildren or on the poor, may take precedence in their decision. This
statement highlights the following points: - Incentives to work and to save tend
to be higher under the new regime-over 20% higher for many households. This is
primarily due to the replacement of high marginal income tax rates with a flat
rate on consumption. - Middle-class families tend to be financially better off
under the change. A combination of factors including lower compliance costs,
lower marginal tax rates, and increased economic growth and efficiency
contribute to improve their prospects. - Existing homeowners tend to benefit
under the change, despite the removal of the mortgage interest deduction. This
is because existing owner-occupied homes would increase in value, while existing
mortgages would become more affordable. - Low-income families tend to be
significantly better off financially under the change. They would effectively
pay none of the national sales tax under the change because they would receive
rebates which cover the amount of taxes paid at poverty level. In addition, any
federal benefits they receive would be indexed to match possible increases in
after-tax consumer prices. - Younger households tend to be financially better
off after the change, benefiting from improved economic conditions over their
entire careers. - Middle- and lower-income seniors tend to do better financially
under the change. Social security payments would be indexed to a tax-inclusive
price index, holding recipients harmless against any changes in after- tax
prices. Additionally, the NRST rebate would more than make up for any losses in
after-tax purchasing power of pension benefits for these seniors. - Some
wealthier seniors would tend not to benefit from the redistribution of the tax
burden. This is because wealthier seniors have a larger portion of financial
assets whose after-tax purchasing power may decline under the new regime.
However, for many seniors the removal of income taxes from asset earnings and
retirement account disbursements, the exclusion of their existing homes from the
NRST, and the repeal of the estate tax would more than make up
for any initial loss in asset values. - Considered over a lifetime, the
progressivity of the NRST would be similar to that of the current income tax
regime. The progressivity of the NRST would be achieved through use of a rebate
and replacement of regressive payroll taxes. 2. Study Methodology Our goal was
to translate the economic effects of a change in the tax regime into
understandable impacts on individual households. Traditional methodologies,
which examine statistical averages for a single year and aggregate very
different households, lack vital data and often do not reveal important and key
information. In our analysis, we focus on specific households, considering the
impact of the actual tax code. Further, we examined households over their entire
remaining lifetime rather than focusing on a single year. Examining a variety of
family profiles, we develop critical insights into the effects of a change in
the tax regime. We then varied individual household characteristics and economic
assumptions to ensure that our conclusions are robust. Taxes affect the
household either directly, or indirectly through the economy (see Figure I
below). Direct taxation on the household includes individual income
taxes'(including the earned income tax credit), propert7y taxes, and the
employee portion of payroll taxes. Indirect taxes are collected from businesses
(including corporate income taxes, the employer portion of the payroll tax,
sales and service taxes, excise taxes, and corporate property taxes). Businesses
serve as intermediaries between workers, investors, and consumers. So all
indirect taxes and other costs on business are ultimately paid by households:
through reduced wages and benefits, lower investment returns, and higher prices.
Economists cannot agree about how the indirect tax burden is allocated among
these three economic activities. However, it is certain that all indirect taxes
and other costs are ultimately paid by households. Figure 1. All Taxes Fall on
Households Figure 1 found on hardcopy In addition to the visible tax revenues
collected by government, there are several effects of taxation which are hidden,
or less visible. These include seigniorage (the inflation tax), compliance
burden of the tax code, economic distortions, and slower economic growth. Our
method accounted for the combination of direct, indirect, and hidden taxation in
an integrated framework. Differences in direct taxes were computed by applying
the tax code to a household's financial situation, directly affecting the finds
available for investment and consumption. Changes in indirect and hidden taxes
were distributed to household economic activities of work, investment, and
consumption. The taxes' magnitude and incidence result in changes to the
after-tax market prices, wages and investment returns available to the
household. Resulting changes in the household's annual finances lead to
different levels of real consumption and investment, which carry through to
affect the household's finances over its remaining lifetime. These changes are
then integrated to produce a summary measure of the effect on a household's
remaining real lifetime consumption. 3. Economic Assumptions We compared the
effects on real lifetime consumption of replacing the 1996 Federal Income Tax
code with the National Retail Sales Tax proposed by Americans for Fair Taxation
(AFT). Throughout, we attempt to match AFT's proposed tax rate of 23%
(tax-inclusive) * on all final goods and services, to exclude from taxation any
resale of existing consumer-owned housing, and to include a rebate to all
families based on federal poverty levels for a given family size. We have also
followed AFT's proposal that Social Security is indexed to a consumer price
index which includes the NRST. We should note that we analyzed only law-abiding
households, those attempting to comply with the actual tax code. Our conclusions
would not remain valid for households engaged in criminal enterprises, or
otherwise able to evade their current income taxes. Our base case economic
assumptions include a 3% inflation rate under the status quo (with nominal tax
brackets indexed for inflation), incidence of direct taxes entirely on the
household, employer payroll taxes incident on workers, corporate income taxes
incident on investors, an NRST distributed two-thirds to consumers and one-third
to factors of production (divided between workers and investors by their value
share in the economy), a 2% increase in economic efficiency (real purchasing
power) from lower compliance costs (i.e., significantly less resources used to
deal with filing complex income tax forms), a 1% increase in economic efficiency
from other economic effects such as lower marginal tax rates, and a minor 0.05%
increase in real wage growth under the NRST due to effects such as increased
investment. We tested variations in these base case assumptions to ensure the
robustness of our results. We found that perhaps the most significant change in
the level of improvement for many families is if the replacement tax rate is
changed. Replacing the current income tax with a consumption tax, one might
expect at least the modest macro-economic improvements mentioned above at any
revenue- neutral tax rate. However, at the time of this analysis there was some
uncertainty as to the rate. A lower or higher tax rate would obviously lead to
either a better or a more modest improvement (respectively) in most families'
real life-time consumption than is calculated at 23%. For low-income families,
any differences from the base case results tend to be small, as a
proportionately-changed rebate makes up for-any change in -the NRST tax over the
bulk of their expenditures. Differences would be more marked for middle and
higher-income families, though the shape of graphs and general conclusions that
we present would remain valid over a range of possible rates. - A tax-inclusive
rate is used for easier comparison with the current income tax rates, which are
for gross (tax- inclusive) income. A 23% tax rate on gross sales corresponds to
a 30% tax rate on net sales. The middle federal income tax bracket in 1996 was 3
1 % of gross income, corresponding to a 45% tax rate on net income. 4. Effects
on Typical Households We began our study with an analysis of the finances of a
typical middle-class family-the "Cleavers." The Cleavers are a married couple,
aged 40. They own their home and are struggling to meet their mortgage payments
while raising their two children (ages 10 and 11). Both parents are employed
outside of the home. Some key financial information about the Cleavers is shown
in Table I (below). Table 1 found on hardcopy In Figure 2 (below), we find that
families with the Cleavers' household profile would be financially better off
under the NRST regime. Even over a wide range of incomes - from poverty level,
about $16,000 per year for the Cleavers' family of four, to the higher income
levels families with this profile would be better off than under the current
income tax regime. A combination of factors including lower tax burdens, lower
compliance costs, lower marginal tax rates, and increased economic growth and
efficiency would allow middle-class families like the Cleavers to enjoy higher
real lifetime consumption under the NRST than under the federal income tax.
Effect on Homeowners One issue of concern to many middle-class households is the
effect of the change on the value of their homes. Because the sales tax would
apply only to new homes, the market value of owner-occupied homes would increase
under the new tax regime (to the point where newly constructed homes would not
be disadvantaged from the viewpoint of prospective home buyers). Also,
homeowners with fixed-rate mortgages would find it easier to make their mortgage
payments under the NRST regime. This is because if enough of the NRST falls on
consumers, after-tax consumer prices would rise to some "tent. So mortgages
could be paid off with less valuable dollars. Figure 2. Lifetime Improvement
under NRST for the Cleavers* Figure 2 found on hardcopy It is also possible that
mortgage interest rates would decline, which would further benefit existing and
prospective homeowners (though this effect is not included in our base case
analysis). Since many middle-aged families already own their homes and tend to
have substantial outstanding fixed-rate mortgages, they would be relatively
better off under the NRST regime. Figure 2 (above) illustrates the relative
improvement of current homeowners. 5. Variations with Income Low-income
Households A critical factor in examining low-income households is the status
and amount of government subsidies (including transfer payments) that they
receive. These include Supplemental Security Income and food stamps. The working
poor not receiving government subsidies tend to be better off under the NRST
regime. This enhancement of their financial condition is due to the rebate
system, which effectively exempts the working poor from paying any of the NRST.
The repeal of the payroll tax allows this group to take home their entire
paycheck and avoid the substantial payroll taxes (less earned income tax credit)
that they face under the current federal tax system. They are also relieved of
the indirect effects of replaced corporate income and payroll taxes that
currently decrease their wages and increase the prices they pay as consumers.
Figure 3 (below) illustrates the improvement that would be experienced by
low-income families with other characteristics similar to those of the Cleavers.
Chart found on hardcopy Cleavers' household career average gross wages (in 1996
dollars) Figure 3. Lifetime Improvement under NRST for Low-Income Cleavers
Figure 3 found on hardcopy Currently, most government transfer payments (such as
food stamps, Supplementary Security Income, and Medicaid) are indexed for
inflation. It is possible that these transfer payments would be indexed to an
after-tax consumer price indicator (CPI) that includes the NRST. If so, families
would receive both indexed transfer payments and the NRST rebate. Figure 4
(below) illustrates the improvement under the NRST for the "Lowes", a low-income
family with four children. The Lowe household receives enough government
subsidies each year to bring them to 100% of poverty line consumption (about
$22,000 annually for the Lowe family of six). A combination of rebate and full
indexing of benefits would lead to substantial financial improvement for
low-income families like the Lowes. In effect, indexing benefits to a CPI that
includes the NRST would over-compensate for the change, as the rebate alone
already reimburses the entire tax. Even if their subsidies were indexed to a CPI
that ofily partially or not at all included the national retail sales tax, the
rebate effectively exempts these families from the NRST, ensuring that they
would still be roughly even or financially better off. Under welfare reform that
occurred after this study took place, we expect that those families with
household gross wages averaging in the lowest range of figure 4 over their
entire remaining careers would be unusual cases. Figure 4. Lifetime Improvement
under NRST for a Low-Income Family Receiving Government Subsidies Figure 4 found
on hardcopy High-income Households Working households with higher incomes would
no longer be subject to progressively higher marginal income tax rates, and tend
to improve under the NRST regime. The top end of the Cleavers' graph in Figure 2
illustrates their improvement. 6. Variations with Age We found that age is an
important factor in determining the effect of the NRST on households. Young
Households Younger households, as illustrated by the "Juniors", tend to be
financially better off after the change. The Juniors are a married couple, aged
25. They both work, and hope to buy a home and start a family someday. They are
just now beginning their careers, and would experience most of their working
lives under the new regime. A combination of factors including lower compliance
costs, lower marginal tax rates, and increased economic growth and efficiency
would allow younger families like the Juniors to enjoy higher real lifetime
consumption under the NRST than under the federal income and payroll tax regime.
Figure 5 (below) illustrates the improvement in lifetime consumption for the
Juniors over a wide range of income levels. Juniors' household career average
gross wages (1 996 dollars) Figure 5. Lifetime Improvement under NRST for a
Young Family Figure 5 found on hardcopy Elderly Households The "Seniors"
represent at The Seniors represent a typical retired couple. We find that the
impact of the NRST depends critically on the amount and composition of their
savings. Because the sales tax applies only to new homes, the value of the
elderly's home equity tends to increase under the new tax regime. Also,
portfolios with a higher proportion of their wealth in tax-deferred status (such
as in IRAs and "401(k)" plans) and in unrealized capital gains would do
relatively better under the NRST, since these holdings would no longer be
subject to federal income tax. Some wealthier seniors would tend not to benefit
from the redistribution of the tax burden. This is because wealthier seniors
have a larger portion of financial assets whose after-tax purchasing power may
decline under the new regime. However, for many seniors the removal of income
taxes on asset earnings and retirement account disbursements, and the exclusion
of their existing homes from the NRST, along with the repeal of the
estate tax more than make up for any initial loss in asset values. Most
elderly couples with moderate or limited financial resources would be
significantly better off under the NRST (see figure 6). The rebate in place
would already cover all taxes on essentials (including some formerly hidden-
taxes built-in to today's prices). Provisions to fully index Social Security for
any increase in after-tax consumer prices would then more than compensate for
any loss on these families' modest savings. And for those households with
estates over $1,200,000, the removal of estate taxes could more than make up for
any loss of the estate's purchasing power. Figure 6 shows these effects on the
Seniors for a wide range of net worth (including home equity and private pension
funds). As a point of reference for this figure, the median family net worth for
a household whose head was between 65 and 74 years of age in 1992 was listed as
$103,600 (Federal Reserve Bulletin , October 1994). This suggests that the
majority of seniors are described in the lower range of wealth in figure 6, and
would experience considerable improvement under the NRST. Seniors' net worth (in
thousands of 1996 dollars) Figure 6. Lifetime Effect of NRST for the Seniors
under a Range of Financial Profiles at Retirement Figure 6 found on hardcopy
While some wealthier Seniors may experience a reduction in purchasing power,
their own financial well-being might not be the only issue they consider in
their decision to support a particular tax regime. Factors such as the effect on
their grandchildren or on the poor may take precedence in their decision. 7.
Effects on Marginal Tax Rates Under the NRST regime, marginal tax rates on work
and savings would be substantially lower for many households, increasing their
incentives to work and save. This is primarily due to the replacement of high
marginal income tax rates with a low flat rate on consumption. We measured the
incentives to work, computing the additional (after-tax) real goods and services
that a household could consume by working additional hours. For example, suppose
that the Cleavers are contemplating working an extra hour a year for each year
over the course of their remaining careers. And suppose that after all taxes
under the existing tax regime, they could purchase a total of 4 pairs of shoes
with their additional pay. If, under the NRST, they could instead purchase 5
pairs of shoes for that same extra work, then their marginal incentives will
have increased by 25%. Figure 7 (below) shows that although the marginal
incentives may decrease for some low-income households, a broad range of
households experience significantly increased incentives. Incentives to work
rise by over 20% for many families, depending on their earnings. On an economy-
wide level, these improved incentives would lead to higher economic growth and
efficiency. Cleavers' household career average gross wages(inl996dollars) Figure
7. Effect on Cleavers' Marginal Incentives to Work Figure 7 found on hardcopy 8.
Regressivity Analysis There is a common perception that consumption taxes are
regressive, which would be supported in a myopic single-year analysis of the tax
system. The argument is that: In a given year wealthy people save a higher
fraction of their income than poor people, so the wealthy would pay a lower
fraction of their income in consumption taxes. However, a lifetime analysis
reveals that most or all of the saved income of a household is eventually
consumed in retirement or by the heirs, at which time it is subject to the
consumption tax. So over a lifetime, a consumption tax-without a rebate-is
roughly flat across income categories. Under the NRST, a consumption tax is
combined with a rebate which refunds all taxes up to poverty-level consumption.
This clearly makes the NRST a progressive tax. 9. Conclusions Because the
combination of the current tax code and government subsidies is extremely
complex, there is probably no change that can guarantee everyone to be better
off. But under the National Retail Sales Tax proposed by Americans for Fair
Taxation, several factors would allow most families to enjoy higher real
lifetime consumption than under the current federal income and payroll tax
regime. These factors include: - a rebate which would keep the amount of taxes
paid by most households similar to or lower than the current income tax regime,
and would effectively exempt low- income households from the NRST, - indexing of
Social Security, which would effectively hold recipients harmless against
possible after-tax price increases, - lower compliance costs, - lower marginal
tax rates, and - increased economic growth and efficiency Some wealthier seniors
would tend not to benefit from the redistribution of the tax burden. However,
their own financial well-being might not be the only issue that wealthier
seniors consider in their decision to support a particular tax regime. Other
factors, such as the effect on their grandchildren or on the poor, may take
precedence in their decision. I would like to again thank the committee for-the
opportunity to contribute this testimony., Additionally, I should like to
recognize a number of individuals that were helpful in this effort. This
research has benefited from discussions with William W. Beach, Dale W.
Jorgenson, James M. Poterba, and Gary Robbins. David R. Burton and Laura D. Dale
have contributed a number of questions and valuable discussions. I am grateful
for the dedicated assistance of Roberto Szechtrnan and Ellynne T. Dec, along
with Decisions and Ethics Center research assistants J. Eric Bickel, William F.
Carone, Alexis G. Collomb, Jeffrey D. Cornwell, George K. Ferguson, Kenneth B.
Malpass, and Marcia F. Tsugawa. Our lifetime model and methodology are an
extension of work by Stephen M. Malinak, Frederick V. Giarrusso, and Jeffrey K.
Belkora, along with suggested improvements from Paul B. Skov, James M.
Knappenberger, Derek D. Ayers, and Michael M. Reeds. Special thanks to Elizabeth
C. Brierly for editing large portions of this report. Research guidance was
provided by Frederick V. Giarrusso and Center Director Ronald A. Howard. The
Decisions and Ethics Center gratefully acknowledges help from those volunteers,
and a gift from the National Tax Research Committee that enabled this research
effort. Sincerely, Joseph M. Kahn
LOAD-DATE: April 18,
2000, Tuesday 
