of Policy Issues EC3060b Spring 2011

Notes No. 4 Michael King

1 EC3060b Economics of Policy Issues Readings

1. Public Finance and Public Policy (2009), Arye Hillman. 2nd Edition. Chapter 9. 2. Report of the Commission on Taxation (2009). http://www.commissionontaxation.ie/Report.asp 3. Elschner and Vanborren. (2009) Corporate Effective Rates in an Enlarged Europe. European Commission Taxation Papers http://ec.europa.eu/taxation_customs/resources/docum ents/taxation/gen_info/economic_analysis/tax_papers/ta xation_paper_14_en.pdf

2 EC3060b Economics of Policy Issues Optimal Taxation: Contents

1. Optimal taxation 2. Capital and other tax bases 3. Fiscal federalism 4. Commission on Taxation Report

3 EC3060b Economics of Policy Issues • Taxation has been present in public goods, externalities, social justice and entitlements and the laffer curve • In each case, there was: – a single – a designated tax base – one government • We now look at the structure of tax rates, the choice of the tax base and fiscal federalism

4 EC3060b Economics of Policy Issues 1. Optimal Taxation

• Optimal in achieving an appropriate balance or -off between efficient and socially just taxation

5 EC3060b Economics of Policy Issues Efficient : Ramsey Rule

• Efficient taxes: Taxation that minimises the efficiency losses incurred through the excess burden of taxation. • Ramsey rule for efficient taxation: Minimisation of excess burdens for a give R – Frank Ramsey (1903–1930) derived the rule in 1929

6 EC3060b Economics of Policy Issues • Competitive goods markets A and B (can also be 2 ind’s) • Only considering substitution effects • Cross price elasticities are here zero • Efficient taxation: tax rates should be inversely related to demand elasticities t  A DB tB DA • The rule is derived from: 11 Min D p q t22 p q t 22D A A A A DB B B B

s.. t R tAAABBB P Q t P Q

• Tax rate should be higher on the good that has the lower price of demand 7 EC3060b Economics of Policy Issues • Efficient taxation of personal incomes t  12 S . t21 S • The Ramsey rule ensures that public goods and entitlements are financed by efficient taxation • The leaks in the bucket of redistribution are minimal

8 EC3060b Economics of Policy Issues • For efficient taxation, the marginal losses due to the excess burdens of increases in different taxes should be equal • The Ramsey rule can contradict social justice • The Ramsey rule calls for high tax rates on necessities, low tax rates on “luxuries” • In the traditional model of the family, the woman’s labor-supply elasticity is greater than that of the man

9 EC3060b Economics of Policy Issues • Social injustice in taxes personal incomes • Person 1 is independently wealthy but is prepared to work if paid enough • Person 2 has no sources of income other than from work and has no choice but to work for a living

εS1 > εS2 • The Ramsey rule implies regressive income taxation • The Ramsey rule introduces conflict between efficiency and social justice

10 EC3060b Economics of Policy Issues • Asymmetric information and the Ramsey rule • Labor-market intentions and opportunities are private information – Is a woman committed to her career or is she prepared to withdraw from the labor market at least temporarily to have children? • The Ramsey rule is subject to asymmetric information, since only people themselves know their labor-market supply elasticities – and their demand elasticities for different goods and services

11 EC3060b Economics of Policy Issues Small Diversion • Taxation of innate personal abilities is efficient taxation according to the Ramsey rule • Difficult to measure innate ability • Becomes a tax on preferences of people who voluntarily wish to forego high income to seek other sources of personal satisfaction in life • No incentive to show ability

12 EC3060b Economics of Policy Issues • Political decision makers in democracies are reluctant to use the Ramsey rule • Economists study the Ramsey rule because of the importance of the social objective of efficiency

13 EC3060b Economics of Policy Issues Social Justice in Taxation: Equal Sacrifice Principle • Progressive taxes • Socially justice in taxation is often associated with a progressive schedule Total taxes paid R t  = A Total income earned Y R t  M Y • A tax schedule is progressive if the average rate of taxation or the marginal tax rate increases with pre-tax income

14 EC3060b Economics of Policy Issues • To focus on social justice we make some assumptions: – No substitution responses to taxation – No laffer curve • What are the grounds for having a system in terms of social justice?

15 EC3060b Economics of Policy Issues • Ability-to-pay Principle (as opposed to the benefit principle of taxation) • People pay taxes based on their income not from the benefits they receive • Two Important Points – Horizontally equitable taxation – Vertical equity in taxation • We are still looking for a rationale of the social justice of progressive tax systems

16 EC3060b Economics of Policy Issues • A first place to look for possible justification for progressive income taxes: diminishing marginal utility of income • Intuitively suggests a rational for progressive taxation

17 EC3060b Economics of Policy Issues Income Tax Schedule

• Marginal tax rate is tM is given by the slope of the income tax schedule • As the marginal tax rate increases so does the average tax rate • Along the 45o line the total taxes paid are equal to total pre-tax income • At point 3, the slope of the tax schedule is 45o, so the marginal tax rate is 100%

18 EC3060b Economics of Policy Issues • An income-tax schedule: Relationship between total taxes paid R and total pre-tax income Y. RRY ()

19 EC3060b Economics of Policy Issues Income Tax Schedule with Tax Brackets • The tax brackets for ranges of income end at points 1, 2 and 3 • Tax brackets have constant marginal tax rates • Taxation is progressive as the average rate of tax increases with income • High marginal tax rates would have effects on efficiency through – the substitution between work effort and leisure – attempts to hide income from the government

20 EC3060b Economics of Policy Issues 21 EC3060b Economics of Policy Issues • The normative question about progressive taxation • To be socially just, does an income-tax structure necessarily have to be progressive? – Note again: We have neutralized efficiency considerations that affect a tax structure for simplicity

22 EC3060b Economics of Policy Issues • What do we mean by social justice? 1. Ex-post equality • Achievable through appropriative taxation and equal redistribution (we have eliminated the excess burden of taxation) • Do not wish to use ex-post equality as the definition of social justice as it is not overly realistic 2. Ability-to-pay principle • Requires that people with higher incomes pay more in taxes • Does not imply progressive income taxation • Only requires that the marginal rate of taxation be positive, which is the case whether taxation is progressive or regressive or proportional

23 EC3060b Economics of Policy Issues 3. The equal-sacrifice principle of taxation • John Stuart Mill in 1848: “equality of taxation” is “equality of sacrifice” • Total utility loss should the same for everybody, no matter what a person’s pre-tax income happens to be • Marginal utility of income is declining and therefore the personal marginal sacrifice from paying taxes declines as income increases • The equal-sacrifice principle is defined in terms of – total taxes paid – total personal utility lost • Conclusions - need to take on face value – very complex mathematics required – The equal-sacrifice principle cannot be used to justify progressive taxation – Nor can progressive taxes be justified on the basis of the equal- sacrifice principle

24 EC3060b Economics of Policy Issues Basic of Equal Sacrifice • Assume a common utility function to measure and compare taxpayers’ “sacrifices” from paying taxes • Focus on the most advantageous conditions for progressive taxation – no substitution effects on the work-leisure choice • Y is pre-tax earned income • With no efficiency effects of taxation, Y depends on neither the level of taxation nor the structure of taxes • The total tax paid by a taxpayer is R(Y) • The utility from post-tax income is U[Y - R(Y)] • The sacrifice from paying taxes is S S U Y  U Y  R(Y )  c  constant

• However utility functions with diminishing MU of income are consistent with equal-sacrifice tax functions that can be progressive, proportional, or regressive (see pages 680-682 if interested)

25 EC3060b Economics of Policy Issues Optimal Income Taxation

• The equal-sacrifice principle is based on people supplying labor without regard for reward (no substitution effects and no excess burden of taxation) • In the realistic circumstances, people’s effort and work decisions depend on the incentives of rewards – We reintroduce excess burdens of taxation – We return to the definition of social justice as achieved by maximizing a social welfare function • What is the structure of an income tax that maximizes social welfare when there are efficiency losses from taxation? – An “optimal income tax” schedule which takes into account the trade-off between efficiency and social justice.

26 EC3060b Economics of Policy Issues • Optimal income tax structure depends on the social welfare function that is chosen 1. A Bentham social function exhibits greatest sensitivity to inefficiency 2. A Rawls social welfare function exhibits no sensitivity to inefficiency except insofar as inefficiency reduces the utility of the worst- off person

27 EC3060b Economics of Policy Issues • A linear income tax • Y is market determined income, everyone receives G (government income transfer), t is a constant rate and R is the individual pays to the government Rii  G  tY

• People with Y > Y0 pay positive taxes

• If personal incomes are random, income tax provides social insurance

28 EC3060b Economics of Policy Issues • The progressivity of the linear income tax structure

• Person with Y1 pays R1 taA 1 Y1 • A linear income tax is progressive if people with higher incomes pay higher shares of their incomes as taxes • A linear income tax is progressive, although the marginal tax rate is constant • Although the tax structure is progressive, the flat rate of income taxation provides favorable incentives to work

29 EC3060b Economics of Policy Issues • The simplicity of the optimal linear tax • There is a need to choose only one rate of taxation • The rate of taxation t determines the income transfer G paid to everybody in the population, by determining the tax revenue R that is available for redistribution

30 EC3060b Economics of Policy Issues • Social insurance and taxation – Higher G provides more social insurance by providing more income support for the low- income population – Higher tax revenue R is required to finance the more generous income support – More tax revenue in turn results in a greater excess burden of taxation

31 EC3060b Economics of Policy Issues • The government’s budget constraint • Choice of the income subsidy G and the tax rate t are linked through the government’s budget constraint

n t Yi  nG i1

32 EC3060b Economics of Policy Issues • A complexity in solving for the optimal linear income tax n nG t Yi (,) t G i1 where

Yii Y(,) t G

• Taxable earned income Yi depends on the tax rate and on the income transfer received from government • The optimal solution for the tax and income transfer needs to be consistent with the supply of labor that provides that tax base on which the income tax is levied

33 EC3060b Economics of Policy Issues • Choice of the social welfare function for deriving the rate – Rawls’s social welfare function will require a higher income transfer G and higher value of the tax rate t – There is a greater efficiency loss through the higher excess burden of taxation.

34 EC3060b Economics of Policy Issues • The value of the optimal tax rate. Conclusion from simulations: – Progressive systems of income taxation can be replaced with a “flat” or proportional rate of income taxation of 20 to 25 percent to yield the same revenue as the progressive tax system in place

35 EC3060b Economics of Policy Issues • If A progressive tax structure can place the government on the wrong (or inefficient side) of the Laffer curve – Why do governments then retain progressive taxes?

36 EC3060b Economics of Policy Issues • The optimal linear income-tax schedule could be linear – The optimal linear income tax requires solving for the two variables t and G • In truth, finding the general structure of the optimal income tax schedule is very challenging – James Mirrless (Nobel Prize in 1996) helped set out the challenge by focusing on innate ability – He came to some interesting conclusions!

37 EC3060b Economics of Policy Issues • The tradeoff between progressive and regressive taxation • Progressive taxation is desirable because of the objective, in the social welfare function of ex-post (post- tax) equality • Regressive taxation because of – The Ramsey rule – The effects of taxation on the tax base • Under regressive taxation, there is a disincentive for low- income people to work • Under progressive taxation, there is a disincentive for high-income people to work at high levels of income

38 EC3060b Economics of Policy Issues • The solution for the Mirrlees optimal income tax indicates that: – The tax system should provide incentives for higher-ability people to reveal their ability by earning at least as much income as lower- ability people – The tax structure should not therefore discourage more able people from working more than less able people • Assumed Bentham social welfare function

39 EC3060b Economics of Policy Issues  The Mirrlees optimal income tax structure has zero marginal tax rates at the bottom and top of the income distribution – Regressive marginal tax rates approaching zero for the highest income earners encourage high-ability or high-income people to keep working and to provide income that expands the tax base – A zero marginal tax rate at the highest income is optimal because the highest-income person is not discouraged from working more

40 EC3060b Economics of Policy Issues • Mirrlees’ conclusions – No rationale for high tax rates for high income individuals – High marginal tax rates on low incomes were found to be consistent with an optimal tax schedule – Highest marginal tax rate should not exceed 30-35% • Mirrless analysis is very complex • General conclusions – If choice of utility function means that labour supply is quite inelastic, taxes do overly effect efficiency, the optimal tax can focus on achieving equality in post-tax income and can be quite progressive – If choice of utility function means that labour supply is quite elastic, optimal tax may be quite regressive

41 EC3060b Economics of Policy Issues Political and Social Objectives

• Why do governments choose progressive tax structures? • Taxes are decided through political processes

42 EC3060b Economics of Policy Issues • Governments can obtain the same tax revenue from simple low-rate linear income taxes as from complex less efficient progressive income-tax schedules • Are there political reasons why income taxes progressive? – Regressive schedules are very unpopular – Greater opportunity to selectively provide tax deductions – Consistent with aversion to inequality in incomes – Feeling of fairness of progressive taxes does not depend on how tax revenue is spent

43 EC3060b Economics of Policy Issues • Distributional consequences of • Hugh Dalton (1887-1962): There should be no change in the ranking of households in the income distribution

44 EC3060b Economics of Policy Issues 2. Capital and Other Tax Bases

• Taxation of income from capital • The Ramsey rule for income from capital and labor t  L  SK tK SL

• Mobility between tax jurisdictions

• If capital can readily leave, εSK is high • If labor cannot leave, εSL is low • If capital can freely leave, capital is not taxed

• The home bias in investment reduces εSK • Social justice and taxation of income from labor and capital • Portfolio investment is more mobile than physical investment.

45 EC3060b Economics of Policy Issues • Residence-based taxation: Taxes are levied on income without regard for the locational origin of the income • Time inconsistency

• εSK = 0 after the investment has been made • The Ramsey rule: – Announce a low rate of taxation of income from capital before an investment is made – After the investment is made apply a high rate of tax – The announcement of a low tax rate will not be credible and there will be no investment – Stable taxes eliminate uncertainty of having to predict future government

46 EC3060b Economics of Policy Issues Corporate Taxation

• The corporate or company tax is a tax on the profits of firms • The allows governments to discriminate in their tax treatment of profits (and losses) of corporations and personal incomes • Tax structures, as well as tax rates, in general differ between individuals and corporations • Ireland has a flat 12.5% tax rate for corporations

47 EC3060b Economics of Policy Issues Elschner and Vanborren. (2009) 48 EC3060b Economics of Policy Issues Elschner and Vanborren. (2009) 49 EC3060b Economics of Policy Issues Elschner and Vanborren. (2009) 50 EC3060b Economics of Policy Issues • • Because the profits earned by corporations ultimately belong to individuals, there is double taxation – Perhaps there is no need for a separate corporate income tax – If there is a corporate profits tax, individuals could receive tax credits for taxes paid on corporate profits

51 EC3060b Economics of Policy Issues Expenditure Tax

• Similar to indirect sales taxes • The tax structure can be progressive, just as with a personal income tax • Compliance: A taxpayer reports – personal wealth at the beginning of the year – personal wealth at the end of the year – personal income during the year • Personal income consists of income from all sources • The expenditure tax determines tax liability based on money spent • The sources of a person’s income are of no importance for the expenditure tax

52 EC3060b Economics of Policy Issues Example 1: • Personal wealth – $100,000 at the beginning of the year – $120,000 at the end of the year – Personal income = $50,000 during the year – Spending of $30,000 is taxed • No taxes are paid on the $20,000 that was added to savings

53 EC3060b Economics of Policy Issues • Example 2: – Income from a wage or salary = 0 – Wealth = $500,000 at the beginning of the year – Wealth = $450,000 at the end of the year – Income from interest = $30,000 – Personal expenditure during the year = $80,000

54 EC3060b Economics of Policy Issues • Social justice and Expenditure Taxes • Is an expenditure tax socially just compared to an income tax? – Taxation of personal spending rather than personal income is consistent with taxing the source of personal utility, which is consumption.

55 EC3060b Economics of Policy Issues • Efficiency and Expenditure Taxes – Expenditure and income taxes have different substitution responses – Income tax: The work-leisure decision – Expenditure tax: In addition, the personal spending – saving decision (the substitution response contracts the present tax and expands the future tax base) • Economic growth is higher with an expenditure tax

56 EC3060b Economics of Policy Issues • Timing of taxation – With the income tax, taxation occurs when income is earned – With the expenditure tax, taxation takes place when income is spent – A lifetime budget constraint – Lifetime income is greater with the expenditure tax – Compared to an income tax at the same rate, an expenditure tax increases economic growth and provides greater lifetime tax revenue from taxpayers

57 EC3060b Economics of Policy Issues • Problems with an expenditure tax 1. Concentrated spending 2. An expenditure tax needs to accommodate the timing of spending by allowing taxes to be spread over time to match the benefits over time 3. • High-expenditure people could give tax-free gifts to low- expenditure people and send them shopping 4. Expenditures often provide shared benefits (e.g., a number of people might use the same refrigerator)

58 EC3060b Economics of Policy Issues • No government has replaced an income tax with an expenditure tax • Impediments to change – Change to an expenditure tax from an income tax would be unjust for older people

59 EC3060b Economics of Policy Issues Other Taxes

Lotteries • A lottery is an unfair gamble • The unfair gamble can only be sustained when the lottery is a monopoly as competition will improve the odds • : sole source of demand for lottery tickets is the “vain hope of gaining some of the great prizes.” • Low-income people tend to spend more on lottery tickets • Taxation through a lottery tends to be regressive

60 EC3060b Economics of Policy Issues Wealth Taxes • Taxes on wealth- a retroactive tax on income – No excess burden if a surprise – A recurring is not a surprise • Time inconsistency • Incentives to hide wealth • Wealth taxed at death – Incentive is to consume rather than accumulate wealth – Gift taxes prevent while alive. – A tax on intergenerational altruism – A tax on ignorance

61 EC3060b Economics of Policy Issues Inflation and Financial Repression • Revenue by printing money • Financial repression to provide governments revenue • In both cases, a government obtains revenue by being a monopoly

62 EC3060b Economics of Policy Issues • Should indirect taxes accompany the optimal income tax? • When consumption preferences differ, indirect taxes can target people who have particular preferences – For example, tobacco products • A case for indirect taxes to accompany optimal income taxes stereotypes people • Direct taxes on income can be more readily evaded than indirect taxes

63 EC3060b Economics of Policy Issues 3. Fiscal Federalism

• Fiscal federalism describes a structure of multiple governments with designated taxation and spending responsibilities • Personal benefit from choice among governments • Two ways to change governments 1. Elections 2. Leave for another jurisdiction • Is fiscal federalism beneficial in facilitating efficiency and social justice?

64 EC3060b Economics of Policy Issues • Locally Adapted Public Goods – The Tiebout locational choice mechanism as a second-best solution when the Lindahl first-best is non-attainable • A centralized government can be expected to know less about preferences for public goods • Fiscal federalism is socially beneficial in solving the public-good problems of asymmetric information and free riding • Community values as public goods • Locational choice can avoid a clash of cultures and norms

65 EC3060b Economics of Policy Issues • Externalities among communities can be internalised by higher levels of government – Strict v’s liberal gun control/environmental standards in adjoining districts • Externalities underlies the rational for higher forms of government

66 EC3060b Economics of Policy Issues • Fiscal federalism allows efficiency when there is natural monopoly for a private good. Example: Water Supply • Total cost of single supply C(1 ) C( 2 )  C( 3 )  150 • For coalitions of two communities, the total cost is C(,)1 2 C(,) 2 3  C,) 3 1  180 • For all three communities sharing the costs, the total cost is C(1 , 2 , 3 )  150300 • Costs for any individual community are thus minimized by a coalition of two communities. Not stable as excluded community has incentive to offer 120 to encourage others into all inclusive deal C(,)C()1 2 3  180  150  330  300  C(,,) 1 2 3 • Natural monopoly is not sustainable by voluntary decisions of the individual communities.

67 EC3060b Economics of Policy Issues • Fiscal Federalism and Insurance – A fiscal federal system can redistribute income – Regional income pooling: Insurance through diversification – Recessions and natural disasters can be region specific – Fiscal system under threat when shocks are symmetric – Example: Greece’s public finance problem in 2010

68 EC3060b Economics of Policy Issues • Fiscal Federalism and Equal Opportunity – Centralization of taxation and public spending avoids unequal opportunity in different jurisdictions – A veil of ignorance regarding the jurisdiction or neighborhood into people will be born? – A fiscal-federal system can provide equal entitlements independently of location – Zoning and housing prices can create unequal entitlements by preventing relocation

69 EC3060b Economics of Policy Issues • Fiscal Federalism and Moral Hazard – The hold-up problem and revenue extraction – The local government spending the tax revenue is not accountable to taxpayers who have paid the taxes that are being spent (similar issue in foreign aid) – Misallocations: Local governments may spend the tax revenue on salaries and benefits of public school and public health-care administrators – and request more funds

70 EC3060b Economics of Policy Issues • Conclusions on Fiscal federalism – Enhances efficiency • Public goods • Externalities • Natural monopoly • A fiscal federal system can redistribute income • Regional income pooling: Insurance through diversification

71 EC3060b Economics of Policy Issues

• Tax competition and Ramsey Rule – Taxes on mobile capital should be lower than taxes on immobile labour • Returns to capital are equalised – Mobile capital moves between jurisdictions seeking the highest return (adjusted for risk) • Fixed amount of capital K indicated by distance O1O2 is allocated through a competitive market between two jurisdictions

• O1 is the origin for capital in jurisdiction 1 and O2 for jurisdiction 2

72 EC3060b Economics of Policy Issues KKK12

rr12 • When there are no taxes on income from capital, the competitive market equilibrium is at point A determined by equality of the marginal products of capital at point E • After the tax on capital in jurisdiction 1: 12 (1 tKKK1 )MP MP ** (1 tK1 )r 1 r 2 • Capital (AB) leaves jurisdiction 1, new equilibrium at point C • The tax reduces the returns to capital in both jurisdictions • Tax base contracts (similar to the leaky bucket) in the jurisdiction where the tax is imposed ,expands in the jurisdiction without a tax • AB capital produced BAED before tax • AB produces ECBA after the tax • Loss in output is area DEC

73 EC3060b Economics of Policy Issues 74 EC3060b Economics of Policy Issues * • Tax revenue is R tr11 K . • When the tax base is mobile capital, the leaky bucket that indicates efficiency losses from redistribution includes the contraction of the tax base because of exit of mobile capital

75 EC3060b Economics of Policy Issues • Residence principle of taxation and tax competition – A tax on capital imposed by the government of the investor’s home jurisdiction cannot be escaped by moving capital to another jurisdiction – The investor could move along with the capital to escape the tax • Double tax agreements – Taxes paid in one jurisdiction can be deduced from tax obligations in another

76 EC3060b Economics of Policy Issues • Tax competition and tax coordination • Government is best off when it has low taxes and adjoining government has high taxes • Nash equilibrium is low tax despite the fact that both would be better if they choose high tax together

77 EC3060b Economics of Policy Issues • A “race to the bottom” in taxes on mobile capital • Tax competition is avoided if taxes are based on residence. • Indirect taxes – A tax coordination problem between governments also arises for indirect taxes

78 EC3060b Economics of Policy Issues Political Behaviour

• Whether tax competition is advantageous or disadvantageous to taxpayers and citizens depends on whether there are political and bureaucratic principle agent problems – Whether government is spending in the interests of its citizens • If there are large principal agent problems then tax competition might be in the interests of tax payers

79 EC3060b Economics of Policy Issues • Decentralized government offers advantages for taxpayers through proximity to political decision makers and to the administrating bureaucracy – Asymmetric information and rational ignorance are reduced – Transparency of government and political accountability are greater with decentralized rather than centralized government

80 EC3060b Economics of Policy Issues • Rent seeking and fiscal federalism • How does decentralized government affect the social costs of rent seeking? – Rent seeking is more profitable carried out far from the prying eyes of taxpayers and voters – Decentralized government is less conducive to rent creation and rent seeking than centralized government – In decentralized jurisdictions, taxpayers are more sensitive to political decisions about taxes and spending

81 EC3060b Economics of Policy Issues • Voting and fiscal federalism – Compare the tax revenue problem in centralized and decentralized jurisdictions – We use simple majority voting – We consider pure public goods, which are a natural monopoly • Choice from among multiple governments avoids the tyranny of the majority

82 EC3060b Economics of Policy Issues • Majority voting and the common pool problem • Individual pre-tax benefits from public goods • Each group consists of three people who are also voters in 3 sub-jurisdictions of a larger jurisdiction • Only one of the projects is chosen in a jurisdiction • Costs are shared equally, each voter pays 100

Individual Pre-tax Benefits from Public Goods

83 EC3060b Economics of Policy Issues Individual post-tax benefits in a centralized jurisdiction

• The Condorcet winner is Y

84 EC3060b Economics of Policy Issues • Each taxpayer now pays tax of 300 to finance the chosen jurisdiction • All voters now have a post tax benefit of 700 Individual Post-tax Benefits in Decentralized Jurisdictions

85 EC3060b Economics of Policy Issues • Taxpayers in groups 1 and 3 are better off with decentralized government • Taxpayers in group 2 are better off under centralized government • Decentralized government is also efficient or equivalently maximizes Bentham social welfare • If group 2 can determine the decision, government will be centralized, to benefit from the common pool of tax revenue • Centralized government allows the group that determines collective choice through majority voting in the centralized jurisdiction to benefit from the taxes of other groups

86 EC3060b Economics of Policy Issues • Conclusions – Decentralized choice of public goods avoids the tyranny of the majority – Decentralized jurisdictions avoid the common pool problem of centralized tax revenue

87 EC3060b Economics of Policy Issues • We used the Condorcet winner and majority voting to illustrate the common pool problem of tax revenue • The conclusions about the common pool problem are the same when other voting procedures are used to determine political control over the common pool of tax revenue

88 EC3060b Economics of Policy Issues • Fiscal federalism and global government – Does a fiscal federal structure require global government to solve global externality problems and to oversee global social justice?

89 EC3060b Economics of Policy Issues 4. Commission on Taxation: Introduction • The Commission was established on 14 February 2008 to review the structure, efficiency and appropriateness of the Irish taxation system and with the intention that our work would help establish the framework within which tax policy would be set for the next decade at least

90 EC3060b Economics of Policy Issues Starting Point: Programme for Government • To keep the overall burden low and implement further changes to enhance rewards of work while increasing the fairness of the tax system • Guarantee that the 12.5 corporation tax rate will remain • Objective: Consider how best tax system can support economic activity, promote employment, encourage long term savings

91 EC3060b Economics of Policy Issues Guiding Principles 1. Equity - Equity that is, taxing persons on their ability to pay. 2. Flexibility – Adjusting in line with changes in society, markets, business practices, technology and economic conditions. 3. Tax neutrality - Tax system that does not create a bias that could influence a taxpayers to choose one course of action over another. 4. Simplicity - Tax rules are known and that liability is clear. 5. Evidence-based approach - Facts and appropriate benchmarks were used to support our analysis and conclusions. 6. Pragmatism - Focus on tax reform rather than tax design, due to time constraints (exceptions and property taxation). 92 EC3060b Economics of Policy Issues Selected Recommendations 1

1. The employee PRSI ceiling could be abolished (equity and revenue generation considerations) 2. Share-based remuneration should be subject to PRSI. 3. Gains attributable to inflation should be excluded from the charge to . 4. Stamp on ATM, credit and debit cards should be phased out in the interests of promoting a cash free society 5. The 183/280 days test for determining should be supplemented by additional criteria.

93 EC3060b Economics of Policy Issues Selected Recommendations 2

6. The provision of an up-to-date valuation based for all property and land in Ireland should be a priority. 7. Provide for an annual on all residential housing units 8. for purchasers of principal private residences should be zero. 9. Taxes on labour should be kept low to support economic activity 10.A carbon tax on fossil fuels should be introduced

94 EC3060b Economics of Policy Issues Selected Recommendations 3

11.Retirement: The current relief for personal retirement provision should be replaced by a matching scheme €1 for every €1.60 contributed and €1 for €1 the first five years.

95 EC3060b Economics of Policy Issues • See Report of the Commission on Taxation (2009) http://www.commissionontaxation.ie/Repor t.asp for further details.

96 EC3060b Economics of Policy Issues Questions?

97 EC3060b Economics of Policy Issues