Transition Costs of Fundamental Tax Reform Transition Costs of Fundamental Tax Reform Kevin A. Hassett and R. Glenn Hubbard The AEI Press Publisherfor the American Enterprise Institute WASHINGTON, D.C. 2001 Distributed to the Tmde by National Book Network, 15200 NBN Way, Blue Ridge Summit, PA 17214. To order call toll free 1-800-462-6420 or 1-717-794-3800. For all other inquiries please contact the AEI Press, 1150 Seventeenth Street, N.W., Washington, D.C. 20036 or call 1-800-862-5801. Library of Congress Cataloging-in-Publication Data Hassett, Kevin A. Transition Costs of Fundamental Tax Reform Kevin A. Hassett and R. Glenn Hubbard p. cm. Essays prepared for an AEI conference Includes bibliographical references ISBN 0-447-4111-6 (cloth : alk. paper)-ISBN 0-8447-4112-4 (pbk. alk. paper) 1. Taxation-United States-Congresses. 2. Taxation-Economic aspects-United States-Congresses. 3. Spending tax-United States- Congresses. I. Hubbard, R. Glenn. II. Title. HJ2381.H344 2001 336.2'05'0973--dc21 135 79108642 © 2001 by the American Enterprise Institute for Public Policy Research, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the American Enterprise Institute except in cases of brief quotations embod- ied in news articles, critical articles, or reviews. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not necessarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. The AEI Press Publisher for the American Enterprise Institute 1150 17th Street, N.W, Washington, D.C. 20036 Printed in the United States of America 00-029974 Contents CONTRIBUTORS 1x 1 INTRODUCTION Kevin A. Hassett and R. Glenn Hubbard 1 2 THE IMPACT Or TAx REFORM IN MODERN DYNAMIC ECONOMIES 5 Kenneth L. Judd COMMENTARY Alan J. Auerbach 54 3 ASSET PRICE EFFECTS OF FUNDAMENTAL TAX REFORM 58 Andrew B. Lyon and Peter R. Merrill COMMENTARY James R. Hines Jr 92 4 WILL A CONSUMPTION TAX KILL THE HOUSING MARKET? 96 Donald Bruce and Douglas Holtz-Eakin APPENDIX 110 COMMENTARY William G. Gale 115 INDEX TABLES 2-1 Consumption Tax Equivalents 13 2-2 Efficiency Costs of Various Policy Changes 19 2-3 Effective Total Tax Rates 25 2-4 Optimal Tax Rates 27 V vi CONTENTS 2-5 Welfare Gain 28 2-6 Initial Increase in Firm Value from a Wage Tax 31 2-7 Excess Burden of Taxation with Risky Assets 35 2-8 Elasticity of Long-Run Output to Net-of-Tax Rates 39 2-9 Disaggregated Effects of Small Tax Changes 42 2-10 Life Expectancy in AK Model and the United States 45 2-11 Major Tax Expenditures, 1998 47 3-1 Percentage Change in Asset Values under Switch to Consumption Taxation 67 3-2 Percentage Change in Asset Value from Loss of Depreciation Allowances for Three-Year, Five-Year, and Seven-Year Equipment 69 3-3 Percentage Change in Asset Value under Switch to Consumption Tax without Change in Pretax Value of Capital Services for Three-Year, Five-Year, and Seven-Year Equipment 71 3-4 Percentage Change in Asset Value under Switch to 20 Percent Consumption Tax with Immediate Decline in Pretax Value of Capital Services for Three-Year, Five-Year, and Seven-Year Equipment 74 3-5 Percentage Change in Asset Value under Switch to Consumption Tax with Increase in Discount Rate for Three-Year, Five-Year, and Seven-Year Equipment 76 3-6 Amortization under USA Tax 81 3-7 Transition Relief and Percentage Change in Asset Value under Switch to Consumption Tax without Change in Pretax Value of Capital Services for Three-Year, Five-Year, and Seven-Year Equipment 83 3-8 Transition Relief and Percentage Change in Asset Value under Switch to Consumption Tax Assuming Immediate Decline in Pretax Value of Capital Services for Three-Year, Five-Year, and Seven-Year Equipment 85 3-9 Transition Relief and Percentage Change in Asset Value under Switch to Consumption Tax with Increase in Discount Rate for Three-Year, Five-Year, and Seven-Year Equipment 86 4-1 Changes from Initial to New Steady States 103 4A-1 Parameter Values 112 4C-1 Effects on Housing Prices from Shift to a Consumption Tax 117 CONTENTS vii 4C-2 Value of Mortgage Interest Deduction, 1980 and 1995 120 FIGURES 2-1 Rule of Inverse Elasticity 11 2-2 Commodity Tax Equivalents of Taxation of Asset Income 12 2-3 Taxation and Monopolistic Competition 16 2-4 Revenue and Welfare Trade-Offs with Asset Taxation 3 4 3-1 Increase in Investment Demand under Consumption Tax without Adjustment Costs 6 2 3-2 Increase in Investment Demand under Consumption Tax with Adjustment Costs 6 3 4-1 Impact of Removing Deductions for Mortgage Interest and Property Taxes 104 4-2 Impact of Flat Tax 104 4-3 Removed Deductability: Low-Supply Response 106 4-4 Flat Tax: Low-Supply Response to Flat Tax 106 4-5 Worst-Case Scenario after Removal of Deductions 108 4-6 Worst-Case Scenario under Flat Tax 108 4-7 Interest Rate and Loan-to-Value Reductions under Flat Tax 109 INDEX 123 Contributors AIAN J. AUERBACH is the Robert D. Burch Professor of Economics and Law and the director of the Burch Center for Tax Policy and Public Finance at the University of California, Berkeley He is a research associate of the National Bureau of Economic Research. Mr. Auerbach taught at Harvard University and the University of Pennsylvania. He was a deputy chief of staff of the U.S. Joint Committee on Taxation in 1992. Mr. Auerbach is a fellow of the Econometric Society and of the American Academy of Arts and Sciences. DONALD BRUCE is a research assistant professor at the Center for Business and Economic Research and an assistant professor of economics at the University of Tennessee, Knoxville. He specializes in empirical research in public finance and labor economics, particularly the economic effects of taxation. His recent work includes an investigation of the effects of rapidly expanding electronic commerce on state sales tax revenue. WILLIAM G. GALE is a senior fellow and the Joseph A. Pechman Fellow in Economic Studies at the Brookings Institution. He is the coeditor of Economic Effects of Fundamental Tax Reform and of the Brookings-Wharton Papers on Urban Affairs. Mr. Gale was an assistant professor at the University of California, Los Angeles. He was a senior economist at the Council of Economic Advisers. He has written extensively on taxes, saving, and public finance. KEVIN A. HASSETT is a resident scholar at the American Enterprise Institute. He had been a senior economist at the Board of Governors of the Federal Reserve System and an associate professor of economics at the Graduate School of Business, Columbia University Mr. Hassett was a policy consultant to the Treasury Department during the Bush and the Clinton administrations. JAMES R. HINES JR. is a professor of business economics and the research direc- tor, Office of Tax Policy Research, at the University of Michigan Business School. He is also a research associate at the National Bureau of Economic Research. ix x CONTRIBUTORS DOUGLAs HOLTz-EAKIN is a professor and the chairman of the Department of Economics at Syracuse University; he is also the associate director of the Center for Policy Research at Syracuse. Mr. Holtz-Eakin is the editor of National Tax Journal and a member of the editorial board of Economics and Politics, Regional Science and Urban Economics, and Public Works Management and Policy. He has taught at Columbia and Princeton Universities. He was the senior staff econo- mist at the Council of Economic Advisers in 1989-1990 and was a member of the Economics Advisory Panel to the National Science Foundation from 1996 to 1998. Since 1985 he has been a faculty research fellow and research associ- ate of the National Bureau of Economic Research. R. GLENN HUBBARD holds the Russell L. Carson Professorship in Economics and Finance at Columbia University. At the National Bureau of Economic Research, he is a research associate in programs on public economics, corporate finance, industrial organization, monetary economics, and economic fluctuations. Mr. Hubbard is also a visiting scholar at the American Enterprise Institute. KENNETH L. JUDD is a senior fellow at the Hoover Institution on War, Revolution and Peace. He has taught at the Kellogg Graduate School of Management, Northwestern University, and at the University of Chicago. Mr. Judd researches taxation, imperfect competition, economic theory, and mathematical economics. ANDREW B. LYON is an associate professor of economics at the University of Maryland. He has served on the staff of the Council of Economic Advisers and of the Joint Committee on Taxation and was a visiting fellow at the Brookings Institution. His current research includes corporate investment, the effects of taxation on portfolio choice, and taxation with informational asymmetries. PETER R. MERRILL is the director of the National Economic Consulting Group for PricewaterhouseCoopers LLP, of which he is a principal. He is also respon- sible for the firm's Tax Technology Consulting, also in Washington, D.C. He had been the chief economist for the Joint Commmittee on Taxation of the U.S. Congress. Mr. Merrill had been a consultant to the National Economic Commission. He also was a lecturer at Harvard College. He has advised the governments of Poland, the former Yugoslavia, the for- mer Soviet Union, Bulgaria, and Russia on the reform and enactment of income and value-added taxes. His expertise includes international taxation and tax policy, financial services, electronic commerce, and energy and environmental tax policy.