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The Economic Effects of Comprehensive Tax Reform July 1997

Proponents of comprehensive tax reform voice the sentiment that the federal income tax system is beyond repair. It is, they argue, too complicated and has too much influence on the economic decisions of households and businesses. The tax code makes so many distinctions among different types of income and expenses that people easily find ways to reduce the taxes they owe: for example, by rearranging their personal investments or postponing the sale of an asset.

At a more fundamental level, economists often voice concern about the effects of the income tax system on saving and investment. Any income tax tends to discourage saving and investment by taxing capital income. The present system also affects the types of investments undertaken and the allocation of that capital throughout the economy through special provisions in the tax code that treat some assets and types of businesses differently from others. For those reasons, many of the recent proposals for federal tax reform call for a switch to a comprehensive consumption-based tax--a tax that would exempt the expected return from capital and treat all forms of investment more uniformly.

Economists also focus attention on the effects of the tax system on whether and how much people choose to work. An income tax system includes a tax on earnings and thus can discourage people from working. A switch to a consumption-based tax system would not avoid that effect. But a switch to a broader-based tax, whether on income or consumption, might allow a lower tax rate on income from labor and encourage work compared with the present income tax system.

Thus, a broad-based tax on consumption would seem to be an attractive alternative to the present income tax system. For that reason, many of the recent proposals call for just that. Consumption-based tax replacements proposed by the Congress include the Gibbons value-added tax, the Armey-Shelby flat tax, and the Unlimited Savings Allowance (USA) tax. One proposal, the Gephardt 10 percent tax, calls for a switch to a broader-based income tax. That proposal is based on the principle that much of the benefit of fundamental tax reform might come from broadening the tax base and lowering tax rates.

Unfortunately, reform of the tax system is much easier in theory than in practice. Although a comprehensive consumption tax, once in place, might be simpler to administer and have a smaller effect on economic decisions than the current income tax system, getting there could prove to be immensely complicated.

Consider one issue: the switch from an income tax to a consumption tax would impose a tax on existing savings. That tax might be considered unfair, since it would be unexpected at the time the saving took place and difficult to avoid after the tax change. Thus, some of the proposals provide "transition relief" for existing assets. But the upshot of such relief would be added complexity, a narrower tax base, and higher tax rates, all of which could significantly reduce the economic benefits from tax reform.

Another issue is that although early versions of proposals would all broaden the tax base by eliminating many types of existing tax preferences, any such version is unlikely to be enacted. Thus, a consumption-based tax that survives the tax reform process is apt to retain many of the present system's special provisions and is therefore unlikely to produce the same level of economic benefits as the comprehensive versions examined in this study.
 

Capital Accumulation, Labor Supply, and Economic Output

A switch from income-based to consumption-based taxes could potentially boost household saving, which would be highly desirable in light of the low rate of national saving in the United States--the result of both increased deficits by the federal government and reduced saving by households and businesses. More saving would lead to higher investment, greater productivity, and more output in the long run. Yet how much additional saving would result from comprehensive tax reform depends in part on how much interest rates would change and how much people would increase saving because of a change in the net return from saving. The evidence suggests that household saving would be likely to rise under a consumption-based tax, although different economic models predict a broad range of possible increases. The current tax system already favors some types of saving, such as pensions and retirement accounts, and by so doing it tends to lower the expected magnitude of the saving response to tax reform. Granting transition relief to consumption from previously accumulated wealth would also be likely to reduce the saving response.

Moreover, a switch to consumption-based taxes would probably spur investment in physical capital. The cost of capital under a consumption-based tax would be less than under an income tax because consumption-based tax systems either remove the tax on capital income or make a provision for immediately writing off (expensing) investments. Moreover, a comprehensive consumption-based tax would remove the bias that now exists for certain types of investments over others. For example, investment in housing would no longer be tax-favored over investment in business capital, and the subsequent reallocation of resources could improve future productivity and output.

Moving to a flatter tax rate structure could spark other types of economic activity, such as the supply of labor. A consumption-based tax would continue to tax the returns from work either directly or indirectly as earnings were spent. If tax reform sufficiently broadened the tax base by eliminating various preferences, the tax rate on labor income could be reduced. Evidence suggests that even though the overall effect of decreased marginal tax rates on labor supply is likely to be small, some groups (in particular, married women) could increase their labor force participation and hours of work substantially. If tax reform does not sufficiently broaden the tax base, then with a switch to a consumption base, the tax rate on earnings must climb to maintain the same amount of revenues as the current system. In that case, labor supply could change in either direction. On the one hand, a consumption-based tax could make current consumption more expensive, which would diminish the incentive to work. On the other hand, a consumption-based tax would lower the relative price of future consumption, thereby encouraging people to work more now in order to consume more later.

In the short run, a switch to a consumption-based tax could cause labor supply to increase faster than capital stock, reducing real wages. In the long run, however, capital stock would expand, causing real wages to rise.

The probable hikes in capital stock, coupled with smaller changes in labor supply, indicate that the level of national output would rise in the long run as the economic growth rate increased temporarily. Most simulation models suggest increases on the order of 1 percent to 10 percent. The exact amount depends critically on assumptions about how responsive households and firms would be to the changes in returns from capital. Unfortunately, tax reform is unlikely to raise the growth rate of the economy permanently. Moreover, the increase in output would be greater than the increase in well-being, since higher output involves less leisure and also less consumption per unit of output.

A bevy of economic studies of tax reform have produced widely different estimates of the effects on interest rates. Because those studies focus on different measures of the interest rate, use different models of saving response, and make different assumptions in their calculations, confusion is often the outcome. Nonetheless, researchers agree on one point: comprehensive tax reform would lower the marginal product of capital (the amount of output produced by the last unit of capital invested) and would lift the after-tax return from saving. But the effects of reform on other rates of return--such as the market return from equity or the interest rate on corporate debt--remain uncertain.
 

Changes in the Allocation of Economic Resources

Although a switch to a consumption-based tax would probably yield modestly higher output in the economy as a whole, such a reform would more significantly affect the composition of the national economy. In other words, it would alter the mix of what is produced and how it is produced. Particular features of fundamental tax reform point to a number of types of reallocations.

First, current proposals would improve the coordination of business- and personal-level taxes and would "level the playing field" among different forms of financing and types of capital. The current income tax system favors financing through debt over equity, encourages retaining earnings over disbursing dividends, taxes noncorporate businesses and owner-occupied housing at lower rates than corporate businesses, and treats equipment and intangible capital more generously than other forms of capital. Most proposals for fundamental tax reform would remove, or at least substantially alleviate, those tax inequalities. The result would be a more economically efficient allocation of resources. In the short run, costs of capital for incorporated businesses that rely on equity would fall. In the longer run, the corporate share of production would be likely to increase and less investment would be made in previously tax-preferred forms of capital.

Second, the switch to a consumption-based tax would reduce the effective tax rate on capital income and encourage the use of capital in production. Although the current tax system gives preferential treatment to some forms of saving and investment, a switch to a consumption-based tax would reduce still further the taxation of capital. Thus, the switch would encourage investment and expansion of output for those firms and industries undertaking such investment. In the long run, industries that were able to employ capital-intensive production technologies would attract more investment, and the economy's capital-to-labor ratio would generally increase.

Finally, most fundamental tax reform proposals would remove many of the explicit tax preferences present in the current system, such as various itemized deductions, exclusions, and credits. Although those tax reductions may serve other policy objectives, they can induce people to engage more heavily in the favored activities, which may not be the best way to allocate society's economic resources.

Most proposals for fundamental tax reform would expunge nearly all of those preferences. For example, if the mortgage interest deduction was eliminated and owner-occupied housing services were taxed, the demand for owner-occupied housing would fall, and resources would be reallocated to rental housing or other forms of investment or consumption. Estimates based on simulation models suggest that in the short run the stock of housing would fall, although in the long run increased capital accumulation would drive up the overall quantity of housing. Reducing the supply of owner-occupied housing would dampen some of the depressing effect on housing prices. Removing other tax preferences--such as the deductions for state and local income and property taxes and charitable contributions, and the exclusion for employer-provided fringe benefits--would be likely to reduce the activities they finance as well. At the same time, some new preferences might be created in the switch to a consumption-based tax, if only because certain types of activities are more difficult to capture under a consumption tax.
 

Economic Efficiency

Changes in saving and investment, economic output, and the allocation of resources are not, of course, ends in themselves; they are instead avenues by which society as a whole may become better off. By mitigating the effects of taxation on relative prices and economic decisions, fundamental tax reform would enhance economic well-being (or "utility") and reallocate resources to more productive uses. Some people would lose, however, so whether society as a whole was better off--that is, whether "economic efficiency" would increase--becomes an empirical issue, depending on the size of gains to winners relative to the size of losses to losers. For the purposes of this analysis, general-equilibrium, utility-based models of taxation are used to estimate the potential magnitude of any gains in efficiency and the extent to which those gains result from each particular feature of fundamental tax reform.

Those models suggest that with a switch from the current income tax system to a comprehensive consumption-based tax, younger generations stand a greater chance of being better off, although the other side of the coin is that older generations could be worse off. More specifically, society as a whole (accounting for effects on all generations) is likely to gain. However, it is unlikely to gain by very much, and under some reasonable assumptions it could even experience a loss. The model used here indicates that the gain in social welfare, in terms of present value, is unlikely to be more than 1 percent of lifetime income, although other models suggest somewhat higher gains.

Simulations from those models also indicate that any form of relief during the transition period would lighten the tax burden on existing wealth and make a consumption-based tax more like a wage-income tax. The result would substantially reduce the gains in efficiency from fundamental tax reform. Switching to a progressive rather than a proportional consumption-based tax would not necessarily cut overall gains in efficiency, but the outcome depends on the way in which tax relief is given to lower-income households.

Comparing gains from a comprehensive consumption-based tax with those from a switch to a broad-based income tax reveals that the relative merits of a consumption-based tax would depend heavily on how sensitive consumers would be in their decisions about when to consume and about whether and how much to work within a period of time. In particular, if the timing of consumption does not respond much to the changes brought about by a revamped tax system, then switching from the current system to a more comprehensive income tax could improve social welfare just as much as a switch to a consumption-based tax.

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