Statement of Dale W. Jorgenson, Frederic Eaton Abbe Professor of Economics,
Harvard University, Cambridge, Massachusetts

Testimony Before the Subcommittee on Select Revenue Measures
 of the House Committee on Ways and Means

Hearing on the Extraterritorial Income Regime

May 9, 2002

EFFICIENT TAXATION OF INCOME

A NEW APPROACH TO FUNDAMENTAL TAX REFORM

Summary

1. Fundamental tax reform through the EFFICIENT TAXATION OF INCOME consists of two parts, an Efficient Capital Income Tax and a Proportional Labor Income Tax. Adjusted Gross Income for individuals and Corporate Income would be defined as in the existing tax code. The Proportional Labor Tax would tax labor income at a flat rate of 10.9%. The Efficient Capital Tax would tax capital income at an effective rate of 30.8%.

2. Since the definition of income would be unchanged and the rate structure for capital income would be preserved, the Efficient Capital Tax would introduce a system of Investment Tax Credits to equalize before-tax rates of return on all business assets. The average tax credits for the business sector would be:

            Corporate business: 3.9% on equipment, 18.9% on structures.

            Non-corporate business: 0.5% on equipment, 8.1% on structures.

To equalize before-tax rates of return on assets in the business and household sectors, new taxes on investments by households would be collected by car dealers, real estate developers, and other providers of investment goods to households at the rates:

            7.2% on equipment, 32.5% on structures.

Tax credits for businesses and taxes on household investments would apply only to new assets and would not apply to existing assets.

3. The welfare gains from this tax reform would be $4.90 trillion; by comparison GDP was $8.11 trillion and National Wealth was $25.38 trillion in 1997, the base year for our welfare comparison. The welfare gains would amount to 19.3% of our national wealth or 19.3 cents for every dollar of wealth.

Source: Dale W. Jorgenson and Kun-Young Yun, LIFTING THE BURDEN: Tax Reform, the Cost of Capital and U.S. Economic Growth, Cambridge, MA: The MIT Press, 2001

EFFICIENT TAXATION OF INCOME

Frequently Asked Questions

Question 1: Is this a good time to introduce EFFICIENT TAXATION OF INCOME?

Answer: The U.S. economy is just emerging from recession and investment is depressed, relative to the boom period in the 1990’s. Instituting investment tax credits, like those under EFFICIENT TAXATION OF INCOME, would stimulate investment, especially in the corporate sector.

Question 2: What about the long-run effects?

Answer: These are measured by the welfare gains. The welfare impact of $4.90 trillion is the answer to the question: How much additional wealth would be required to purchase the added consumption of goods and leisure made possible by tax reform? The welfare gains reflect more investment and faster economic growth.

Question 3. Is EFFICIENT TAXATION OF INCOME a tax on income or a tax on consumption?

Answer: As the name suggests, EFFICIENT TAXATION OF INCOME is a tax on income rather than consumption. Income would be defined in exactly the same way as in the existing tax code. 

Question 4: What about transition rules?

Answer: Since the definition of income would be unchanged, no transition rules would be required. EFFICIENT TAXATION OF INCOME could be enacted today and implemented tomorrow. All existing tax exemptions and deductions on capital income would be unaffected. This would include depreciation and interest deductions by businesses as well as mortgage interest and property tax deductions by existing homeowners.

Question 5: What about tax simplification?

Answer: The system of tax credits for businesses and taxes on household investments could be adjusted to preserve equality of before-tax rates of return on all assets whenever the tax code is altered. In short, there is no conflict between EFFICIENT TAXATION OF INCOME and simplification of the tax code.

Question 6. How would the tax rates under EFFICIENT TAXATION OF INCOME compare with rates under consumption taxes? The tax rates under EFFICIENT TAXATION OF INCOME would be

labor income tax          10.9%
effective capital income tax rate 30.8%

Key tax rates for some of the popular consumption tax proposals are:

            Hall-Rabushka Flat Tax

flat tax rate 27.6%
 average labor tax rate 15.3%

 Progressive National Retail Sales Tax (No Deductions; Exemptions like the Flat Tax)

marginal sales tax rate 40.1%
 average sales tax rate 29.6%

Proportional National Retail Sales Tax  (No Deductions, No Exemptions).

sales tax rate 28.5%

Question 7. How do the welfare gains from EFFICIENT TAXATION OF INCOME compare with gains from consumption taxes?

Answer: EFFICIENT TAXATION OF INCOME would have a larger impact than a Proportional National Retail Sales Tax and twice the impact of the popular Flat Tax proposal. Here are the numbers:

EFFICIENT TAXATION OF INCOME $4.90 trillion
Hall-Rabushka Flat Tax $2.06 trillion
Progressive National Retail Sales Tax $3.32 trillion
Proportional National Retail Sales Tax $4.69 trillion

Question 8: Does EFFICIENT TAXATION OF INCOME sacrifice progressivity?

Answer: Progressivity would result from differences between taxation of capital income and taxation of labor income, not from exemptions like those in the Flat Tax or a progressive rate structure like the current income tax.

Question 9: Why not introduce exemptions and/or a progressive rate structure?

Answer: The welfare gains would depend critically on lowering the marginal rates on both capital and labor income; these are the rates on the “last dollar” of income. Exemptions and progressive tax rates would increase the marginal rates and reduce the welfare gains.

Question 10: How would EFFICIENT TAXATION OF INCOME be affected by introducing exemptions like those in the Flat Tax?

Answer: The capital income tax rate would be unaffected, but the marginal labor income tax rate, the rate on the last dollar of income, would rise from 10.8% to 26.0%. As a consequence, the welfare gains would be sharply reduced to $2.02 trillion.

Question 11: What would happen to Social Security and Medicare contributions under EFFICIENT TAXATION OF INCOME?

Answer: These would be unchanged.

Question 12: What about contributions to private pension funds through 401(k)’s and similar provisions of the existing tax code?

Answer: These would also be unchanged.

Question 13: What would happen to property values for home owners?

Answer: Existing home owners would be deemed to have paid taxes on their property at the time they originally purchased it. They would be exempt from all future taxes on this property, including capital gains taxes when they eventually sell it. Property values would be protected by the reduction in future capital gains taxes and the taxes on new housing, so that home owners would share in the welfare gains from EFFICIENT TAXATION OF INCOME.

Question 14: How does this affect people thinking of becoming home owners?

Answer: By definition, these people are renters, not home owners, and they

would be made better off. They would find home ownership slightly more expensive and rental housing somewhat less expensive. In short, they would also share in the welfare gains from EFFICIENT TAXATION OF INCOME.

Question 15: What would happen to stock market values for corporate shareholders?

Answer: Since the new investment tax credits would reduce the cost of acquiring new assets after taxes, the value of existing assets would fall. However, this would be offset by an increase in the rate of return on these assets, so that stock market values would be largely unaffected.

Question 16: How would EFFICIENT TAXATION OF INCOME impact states and localities?

Answer: Most states use the same tax bases as federal corporate and individual income taxes. Since the tax bases would not change, state and local income taxes could be left unchanged. More likely, states and localities would follow the federal government in adopting EFFICIENT TAXATION OF INCOME. The tax rates given above assume that they would, so that these rates include federal, state, and local taxes.

Question 17: What about state sales and property taxes?

Answer: These would not be affected. Also, deductions of these taxes at the federal level would be preserved.

Question 18: What would happen to tax revenues?

Answer: EFFICIENT TAXATION OF INCOME is revenue-neutral, so that tax revenues at federal, state, and local levels would be unchanged.

Source: Dale W. Jorgenson and Kun-Young Yun, LIFTING THE BURDEN: Tax Reform, the Cost of Capital and U.S. Economic Growth, Cambridge, MA: The MIT Press, 2001