Dimensions: 9'' x 6'' 140 pages AEI Press  (Washington) Publication Date: January 2001 Paperback ISBN: 0844741124 Price: $ 16.95 Add to Cart   Hardcover ISBN: 0844741116 Price: $ 34.95 Add to Cart   Examination Copies

The authors of this volume challenge the common perception that the removal of old distortions from the tax system would seriously harm segments of the economy. The three essays, each of which is followed by a commentary, discuss the understatement of benefits from fundamental reform, the perniciousness of the current tax system, the distribution of benefits from reform, and the effects of reform on the housing market and on stock prices.

Kevin A. Hassett is a resident scholar at AEI. R. Glenn Hubbard is a visiting scholar at AEI and the Russell L. Carson Professor of Economics and Finance at Columbia University; President Bush has nominated him to be chairman of the Council of Economic Advisers. The authors of the essays are Donald Bruce of the Center for Business and Economic Research at the University of Tennessee, Kenneth L. Judd of the Hoover Institution, Douglas Holtz-Eakin of Syracuse University, Andrew B. Lyon of the University of Maryland, and Peter R. Merrill of PricewaterhouseCoopers. The commentators are Alan J. Auerbach of the University of California, Berkeley; William G. Gale of the Brookings Institution; and James R. Hines of the University of Michigan. This summary is adapted from the editors’ introduction to the volume.

The Tax Reform Act of 1986 was a sweeping reform that lowered marginal tax rates and broadened the tax base. Although many economists felt that the law, given its broad bipartisan support and sound economic underpinnings, would stand for many years, events soon proved them incorrect. Significant increases in marginal tax rates were passed in 1990 and 1993; subsequent reforms have narrowed the tax base and have increased effective marginal rates in a particularly crazy hodgepodge. The tax system is now probably further from the economic ideal than in 1985, and economists are again calculating and debating the potential gains to the economy from another fundamental tax reform.

Many fundamental reform proposals, such as Robert Hall and Alvin Rabushka’s flat tax or other forms of a consumption tax, promise economic benefits by lowering marginal tax rates and by changing the tax base to bypass those areas of the economy that are particularly costly if taxation distorts them. The key sector is capital formation, which has long and widely been acknowledged as especially impaired by taxation. Most economists concur on the potential magnitude of economic benefits from excluding capital from taxation.

But economists do not agree that a sudden switch to a consumption tax would be an obvious improvement. Many have argued that the severity of the problems of managing a smooth transition would preclude even contemplating such a change. In particular, although the current tax system distorts behavior in many ways, the removal of those distortions would hurt those who played by the old rules. Building in transition relief to help those hurt most by the reform would diffuse the benefits of the reform. Henry Aaron and William G. Gale, a contributor to this volume, conclude in their 1996 work Economic Effects of Fundamental Tax Reform that "the gains from realistic reforms may not be as large as advocates have hoped, and . . . the process of adjustment to a new system will not be easy." By realistic reforms, they mean those that would provide relief to the short-term losers. In many of the simulations by Aaron and Gale, apparently reasonable transition relief almost completely exhausts the potential benefits of tax reform.

Each of the three main chapters in this volume begins by relaxing a simplifying assumption employed by the previous literature and proceeds to explore how the relaxation of that assumption affects the calculus of tax reform. In two ways the authors challenge the perception that we cannot get there from here. They suggest that the benefits of fundamental tax reform are likely to be significantly greater than previously believed and that the transition costs would be significantly less.

In his chapter, Kenneth L. Judd argues that tax-reform analysis by and large has ignored issues of imperfect competition, risk, and human capital and has significantly understated the benefits from fundamental tax reform. Judd lays out the basic economics underlying the claims that the current tax system is particularly pernicious to the national economy. Most important, he points out that a tax system that distorts the savings and investment decision causes a deflection that grows over time. Because even a small distortion becomes enormous over time, only a zero tax on savings and investment is optimal.

Our current system of taxation is clearly not optimal. But what would happen if we switched to a tax system that did not tax savings? To answer this question, Judd incorporates several important real-world features into existing models used to study tax reforms. The first is imperfect competition. Most models used for studies of tax policy assume that firms have no market power. In such a world, the market’s competitive equilibrium in the absence of taxation would be highly efficient. If firms have market power, which seems likely, then the equilibrium in the absence of taxes is inefficient. Firms with market power increase profits by cutting back production. Introducing taxes in such a world would exacerbate existing distortions because the economy would already be out of competitive equilibrium. Indeed, an optimal tax would subsidize capital formation to counteract the output reductions caused by the profit-maximizing firms. When Judd calculates the switch to a consumption-based tax in the presence of imperfect competition, he finds that benefits are much greater than previously forecast.

Judd then adds two layers of complexity. First, he incorporates risk. The current tax system discriminates against risk taking: Risky investments that pay off are taxed, but losses do not lead, at least not in all cases, to tax refunds. Second, he introduces the formation of human capital, which is important for growth but is taxed heavily when income taxes are steeply progressive. Each of these steps contributes significantly to Judd’s measure of the gains from switching to a flatter,
consumption-based tax.

In his final section, Judd uses the lessons derived from the more general approaches to investigate the impact on the distribution of tax reform. The wage increases attributable to higher amounts of capital in the postreform economy would have an important impact on the distribution of the benefits of tax reform, but most analyses uniformly ignore this key point.

Critics of tax reform proposals often argue that lower capital taxation would lead to a stock market crash. The mechanism for that event would be quite simple. Because the reform would lower the cost of capital, new investment would create competition that would destroy the profits of existing firms. Compensating existing capital for such damage is a primary demand for transition relief.

In the next chapter, Andrew B. Lyon and Peter R. Merrill argue that a significant portion of the value of existing firms is attributable to goodwill and other intangibles. Value attributable to these assets would actually increase after a tax reform of the type considered here because the taxes on the future economic profits of such firms would be lowered. The authors demonstrate that even if firms did not have intangible assets, the effects on asset prices from fundamental reforms would be less than previously estimated if actual tax depreciation rules were used in the calculations, instead of the simplified patterns employed in previous research. Lyon and Merrill show that the effect on asset prices would be less if firms adjusted their capital slowly in response to the reform. Finally, Lyon and Merrill review empirical evidence from past reforms and conclude that stock prices have generally increased after fundamental tax reforms; that result confirms their analysis and undermines the case for transition relief to existing firms.

Owner-occupied housing is perhaps the most favored asset under the current tax system, with the deduction for mortgage interest the most lucrative tax benefit for most taxpayers. What would happen to housing prices if the mortgage interest deduction were removed? Many have argued that an Armageddon could occur in the housing sector: The demand for housing would plummet, and housing prices would follow suit. Transition relief for homeowners or the continuation of the current system of deductions for mortgage interest would be the other major complications to a transition. But would housing prices really drop after a tax reform?

Donald Bruce and Douglas Holtz-Eakin explore this issue in the final chapter. They develop a rigorous supply-demand model of the housing market and link the transitional and long-term impact of tax reform. Although some analysts have argued that declines in housing prices would be short-lived because housing starts would drop and thus depress the overall stock of housing capital, Bruce and Holtz-Eakin go a step further. In their setup, the elimination of the deduction for mortgage interest need not lead to a sharp decline in housing prices, even in the short run.

They present a simple, intuitive example for such a result. Suppose that the United States switched to a 20 percent national sales tax and--just to keep the example clean--nobody claimed the deduction for mortgage interest under the old system. When the sales tax went into effect, individuals would pay a 20 percent tax when they bought a new house, but no tax if they bought a "used" house. The price of "used" houses must then rise by 20 percent. Whether such an effect would be empirically important would, of course, depend on the magnitude of the effect on mortgage interest and the impact on the existing stock of housing. Bruce and Holtz-Eakin conclude that the two effects approximately cancel each other out and that housing prices would probably not decline significantly after a fundamental tax reform.

Although commentaries on each chapter outline important qualifications, taken together the essays suggest that the argument for transition relief to homeowners and firms may be weaker than expected. In that case, even if the complications explored by Judd were ignored, the gains from fundamental tax reform would be significant. If imperfect competition, risk, and the formation of human capital were also important real-world considerations, then the gains of fundamental reform might be even higher.