The impact of tax cuts on government revenues

An average person, asked to explain the impact of cutting taxes, might well reason:

I have represented this argument in flow chart form to give it a spurious air of logical coherence. Yet any flow chart is only as good as the reasoning that underlies it. In this case, that reasoning is seriously incomplete.

A tax cut has two immediate impacts on government revenue. First, less revenue is raised from the existing tax base, from the firms, consumers and workers who are presently paying taxes. In the diagram below, the loss in revenue is shown in the two pink-ish rectangles labelled "Revenue loss." Second, a tax cut may reduce the gap between before tax and after tax wages. If it does, people may supply more labour, putting downwards pressure on the the before-tax wage rate, encouraging firms to hire more workers. The tax revenue gained from new workers, and from people working longer hours, is shown in the purple rectangle labelled "Revenue gain" below.  

 

Notice that the benefits of the tax cut are shared between employees, who pay lower taxes, and employers, who are now able to offer lower wages. This division of benefits, as well as the relative magnitude of the revenue loss and revenue gain rectangles depends upon how firms and workers respond to the tax cut. 

Most empirical research suggests that people do not usually change their work hours much when their after-tax wage rate changes. There are even studies that have found 'backwards bending' labour supply curves. People sometimes respond to an increase in their after-tax wage rate by reducing their work hours, because they do not have to put in so many hours to pay the mortgage. In sum, based on what economists know about labour supply, one would expect tax revenues to fall when tax rates are reduced.

Recent experience with tax cuts - the reduction in the federal GST in Canada, for example, or the Bush tax cuts or the US, for example - supports that intuition. As GOP policy adviser Bruce Bartlett put it, "Few people remember that a major justification for the 2001 tax cut was to intentionally slash the budget surplus....In this regard, at least, the Bush-era tax cuts were highly successful."

The reason why hours worked are fairly unresponsive to wage rates is that many people do not have much control over their work hours - a nine to five job requires a fixed number of hours per week. It can be argued that the rich are different from you and me - they have more options, are more free to choose when and where they work, and thus their labour supply is more elastic. Perhaps tax cuts for footloose and fancy free jet setters have some revenue raising potential?

High tax rates on the rich can cause an erosion of the tax base and reduce tax revenue - though the size of this effect is debated. The Rolling Stones' Mick Jagger, Keith Richards and Charlie Watts, for example, fled Britain's high tax rates for the Netherland's less onerous tax regime decades ago.

But, as the NY Times reports "over the last 20 years, according to Dutch documents, the three musicians have paid just $7.2 million in taxes on earnings of $450 million that they have channeled through Amsterdam — a tax rate of about 1.5%, well below the British rate of 40%." There is no way that the British could lure the Rolling Stones back without providing even more generous tax treatment. 

So far I have been taking it for granted that cutting taxes will increase incentives to work and to save. Yet even this is not obviously the case. Economic decisions are made at the margin. Unless a tax cut changes incentives on the margin, it will usually create little or no behavioural response. 

Take, for example, a $1000 increase in the basic exemption or personal amount tax credit, the amount of income that a person can earn without paying income tax. For every person who is currently earning more than the basic exemption, an increase in that exemption is just like getting a cheque in the mail. It means the person has more money in her pocket, but her incentive to work longer hours, to put extra effort in at her job, is unchanged. If anything, she might feel as if she can afford to take a day off, and cut back on her work hours.

For students of economics, the impact of an increase in the basic personal amount on work incentives looks something like this:

Except for individuals who are just to the left of the kinked point on the red budget constraint, the increase in the tax exemption will act like an increase in income. It increases the amount of leisure the individual can afford to consume, and thus would be expected to decrease the hours the individual works.

There are many good reasons to increase the basic tax exemption. It is a progressive way of reducing taxes, as the benefits as a percentage of income are greatest for low income people. It can be an important part of a strategy to reduce "welfare walls" and encourage people to enter the labour force. But it is unlikely to produce any kind of behavioural responses that lead to a significant increase in tax revenues. 

The basic lesson of economics is that people - including governments - aren't stupid. If it was possible to generate an immediate increase in tax revenues by reducing tax rates, taxes would be cut instantly. Taxes are what they are in part because reducing taxes creates an immediate revenue short-fall.

The ultimate impact of a tax cut depends upon how that revenue short-fall is met. Are basic government services, such as transportation infrastructure or the legal system, cut? Inadequate infrastructure is an obstacle to doing business, just like high taxes, and can impede economic growth. Does the government borrow to maintain spending levels? High levels of government debt are hardly good for the economy. Is redistributive spending, such as social security and medicare, scaled back? It might promote economic growth, but it would be political suicide. 

[Update] But what about the argument that Ryan makes in the comments below, "You can't create a low-tax regime in the long run without first cutting at least one tax in the short run"? It is true that circumstances change. If other countries cut corporate tax rates, the country that tries to stick with its existing regime may face a loss of revenue. The internet makes it easier to run a business from a Barbados beach house than it was 20 years ago. The first question to ask someone who proposes cutting taxes is: "What has changed? Why is the previous tax rate no longer optimal?" The second question to ask is: "What is a reasonable estimate of the likely behavioural response?" 

Take, for example, the case of Amazon UK as described in a recent article in the Guardian:

The UK operation avoids tax as the ownership of the main Amazon.co.uk business was transferred to a Luxembourg company in 2006. The UK business is now owned by Amazon EU Sarl and the UK operation is classed only as an "order fulfilment" business. All payments for books, DVDs and other goods go directly to Luxembourg. The UK business is simply a delivery organisation.

The latest 2010 accounts for Amazon EU Sarl show the Luxembourg office employed just 134 people, but generated turnover of €7.5bn (£6.5bn). In the same year, the UK operation employed 2,265 people and reported a turnover of just £147m. According to the SEC filings, UK sales that year were between £2.3bn and £3.2bn. Amazon in the US has earned an average 3.5% profit margin over the past three years.

The only way to persuade Amazon to unwind these lucrative arrangements would be to reduce UK corporate income taxes to a level lower than Luxemburg's. Any smaller reduction would be unlikely to produce any behavioural response.

There are no twenty dollar bills lying on the sidewalk. Cutting taxes has consequences, and not all of them are pleasant. 

Update: for an explanation of the Laffer curve, see this interview with Arthur Laffer on Icelandic television.

Update: this backgrounder from the Center on Budget and Policy Priorities makes the point that tax avoidance and evasion strategies, while they impact tax revenues, do not necessarily have significant impacts on the real economy. Also gives references.

Comments

[Jim Sentance]

I did find a five on the sidewalk once.

Great post.

[Scott P Bacon]

I think you made a strong case for the explanatory power of diagrams here (hope your reading Determinant!). I agree with Jim, great post!

[Sandwichman]

I once found a five on the sidewalk and when I picked it up there was a twenty folded inside it.

[Declan]

"Is redistributive spending, such as social security and medicare, scaled back? It might promote economic growth, but it would be political suicide."

True, the political implications are no doubt our biggest concern (after the economic impact of course, that always comes first), but still, some bleeding hearts might suggest that people (i.e. human beings) might also suffer as a result of these policies. Of course, if that suffering motivates greater economic activity, then we might have to put it in the plus category.

I criticize, but you" rel="nofollow">

[Declan]

Hmm, not sure what mangled the last line of my comment, but what I was saying was, I criticize, but you are still well ahead of 99% of the discourse out there, of course.

[WJ Downie]

My God another Republican a_hole with BS graphs and one who has been born with a silver spoon in his mouth and up his ass. I,m sure your fingernails never ever experience dirt unless you had them up your ass. Republican Bs theories of trickle down economics just does not work. High unemployment due to bad trade deals equals lost tax revenue and a country that will wind up in the toilet like America. But dont worry the rich will get richer and thats what its all about in your world feed the rich Fuck everyone else.

[Thomas Lumley]

"High tax rates on the rich can cause an erosion of the tax rates" Do you mean erosion of the tax base, here>

[Stephen Gordon]

I think we have established a new record of something or other: Someone has inferred from this post that Frances is a Republican man.

[Ryan]

Pretty much comes down to short run versus long run. "Trickle down economics" might be an economic punchline these days, but I don't think the average person thinks any more highly of the phrase "In the long run, we'll all be dead," either.

You can't create a low-tax regime in the long run without first cutting at least one tax in the short run. Obviously, the implication here is low government spending. People who look at that idea and immediately proclaim that we all benefit from roads, plumbing, and social services are missing the point. Would they say the same about government ad campaigns and $200 hammers? Have any of these people been to the parties that ambassadors go to and seen where government revenues actually go? We shouldn't pretend that spending cuts are politically impossible. I can think think of dozens of expenditures off the top of my head that could be eliminated before lunch without causing any kind of political backlash or adverse effect on social services.

[J.V. Dubois]

Great post. I would love to see more articles about wealth vs substition effect on the labor supply as I am basically blind here. Not to mention that there may be many more things going on - I once read an article once that attributed higher growth in Sweden to higher labor costs as it provided incentives for investment in physical and human capital to cope with this effect. There are several authors that attribute the same long-term growth impact to shocks such as Black Death in Europe - that it was the price of labor that drove the accumulation of capital (and institutional changes) needed for transformation of the society.

[Frances Woolley]

Declan: "True, the political implications are no doubt our biggest concern"

That's what it looks like to an outside observer! Notice I didn't say TANF, food stamps or medicaid. Just look at US health care spending and health outcomes relative to any other country in the world - there is definitely room to shake up the system and get better value for money. Social security likewise is pretty generous. Thanks for the link.

Ryan: "I can think think of dozens of expenditures off the top of my head that could be eliminated before lunch without causing any kind of political backlash or adverse effect on social services."

Are you prepared to throw into those expenditures the military, health care spending, and transfers to old people? If you are, then I agree with you. If you aren't, then it doesn't matter how *many* stupid expenditures you name, they're unlikely to add up to very much money.

Of course in a system like Canada's, and to a lesser extent the US, it may be possible to get away with spending cuts politically speaking if the entire burden of those cuts is felt by people with little to no probability of voting for you - e.g., in the Canadian context, cutting federal jobs in safe Liberal or NDP ridings. Yet such cuts *by definition* cannot be the kind of broad based cuts that raise dollars.

You do raise a valid point that sometimes things change, and so there are sometimes reasons to respond to changed circumstances and cut taxes.

[Nick Rowe]

I keep hoping that someone will accuse me of being a Republican; so I can reply that no, I'm a Monarchist.

I think there are two "Tax Cuts arrow Economic Growth" arguments out there. The first is the supply-side, which is what Frances is talking about. But I think there's still an earlier Old Keynesian demand-side "tax cuts increase spending which causes growth" meme out there too.

[Frances Woolley]

J.V. Dubois: "There are several authors that attribute the same long-term growth impact to shocks such as Black Death in Europe - that it was the price of labor that drove the accumulation of capital (and institutional changes) needed for transformation of the society."

I know people have looked at this as a possible backwards-sloping labour supply curve - that is, wages rose after the Black Death, and people responded by working less hard. Another piece of trivia - I've heard, though quite likely I'm just making this up, that after the Black Death increased wealth meant that people could afford new clothes, especially new undergarments. This increased the supply of used linen, and thus indirectly increased the supply of/decreased the cost of paper. This, in turn, led to more rapid accumulation of knowledge and the rest is history.

[Frances Woolley]

Nick, good point. Perhaps you can comment on the Old Keynesian version. It all depends on how people view government debt, and you can probably link to about 20 posts where you've said something insightful on this topic!

[Nick Rowe]

Frances: there's not much to say really. The Bank of Canada controls Aggregate Demand to target inflation. If tax cuts increased AD, the Bank of Canada would do offset that to keep AD the same to prevent inflation rising above target.

[Frances Woolley]

I've added an update to respond to Ryan.

[Mandos]

Frances: there's not much to say really. The Bank of Canada controls Aggregate Demand to target inflation. If tax cuts increased AD, the Bank of Canada would do offset that to keep AD the same to prevent inflation rising above target.

...then Parliament restores its sovereignty and legislates whatever it needs to legislate to put the Bank back into line...

[Ryan]

Frances, thank you for the update. I appreciate the response! I think your argument clearly deals a blow to those who believe that cutting taxes will generate massive government revenue by increasing the tax base - and I agree with you.

But you write: The first question to ask someone who proposes cutting taxes is: "What has changed? Why is the previous tax rate no longer optimal?"

I don't understand why we need to start from the presumption that we somehow already have the "optimal" tax rate. To me that seems like an assumption that requires some justification. I also don't understand why it is inherently valuable to maximize government revenue.

If a person's underlying motive or value system corresponds to greater government expenditures, then maximizing public revenue is a tautologically positive thing. On the other hand, if a person's underlying motive or value system corresponds to lower taxes and smaller government, then what difference does it make which tax rate corresponds to "maximum government revenue?" In short, why would anyone who currently thinks the government wastes lots of money be interested in maximizing public revenue?

To me, the relevant issues are:

1) Is there a growing government debt, and if so, what does that suggest about whether tax rates should change?

2) Is there a growing government surplus - same follow-up question, i.e. is there ever a justifiable reason for government profit?

3) Are the normative judgments of citizens relevant, or should the government simply locate the "optimal tax rate" and just give 'er?

4) Are tax rate choices ever presented to citizens in a way they that facilitates rational decision-making? In other words, are the true costs of government ever presented by line-item with the corresponding tax revenues by source, all on one page such that citizens can actually see what their tax money is purchasing?

5) Is there any value in minimizing the tax rate just because taxes are an economic bad for individuals that would best be minimized for normative reasons?

6) Is government benefit ever measured in anything other than warm-fuzzies? Put another way, if Social Service X is supposed to provide temporary aid to Demographic A, why is it considered "success" when the total number of people served by X increases every single year? When does an increasing pool of need imply social service failure, rather than success? Can social services ever be assessed as failures, and if so, what are the data points that correspond to failure?

I guess where I'm going with this is that to me the main problems with maximizing public revenue aren't technical, they're epistemological. How do we know we're getting the benefits we think we're getting from government, and how can we identify government expenditures that are objectively wasteful? Is it even possible?

You also wrote: Are you prepared to throw into those expenditures the military, health care spending, and transfers to old people?

What I'm saying is that the real money-wasters are things like subsidized bus passes for the army of public servants here in Ottawa, the millions spent on parties at embassies world-wide (I've seen a few of the PALACIAL homes the foreign service stays in), any - and I do mean ANY - ad campaign run by the government (why on Earth do any of us condone expensive, glossy ad campaigns that advertise government services???), subsidized foreign trade (EDC and BDC), and so on and so forth. There are so many no-brainer, apolitical expenditures out there that putting them all in a bucket and throwing them out of the budget would be the biggest billion-dollar free lunch Canada (or any other country) could ever get. Everyone in every political party would support those kinds of cuts. Even if we don't agree about what the tax rate should be, I think we can all agree that TV ads for Service Canada kiosks are a multi-million-dollar waste of taxpayer money.

[Frances Woolley]

Ryan - On your broader point. Sure, there are different types of societies, there are ones where social insurance is provided through families and communities and taxes are low, and there are ones where social insurance is provided through government and taxes are higher. There are societies with higher and lower degrees of income equality. "What level of taxation do we want?" is about asking "What kind of society do we want?" It is a deep question that I wouldn't even pretend to start answering here.

My point here is that, for a country the size of Canada, a low-tax economy must inevitably a low-government-expenditure economy. Sorry. Ain't no way around that.

"the largest billion-dollar free lunch..."

A billion dollars is less than one percent of government spending. A 1 percentage point cut in the GST is 5 to 6 billion. Sure I'd like to see less spent on government advertising, but that's not where the big bucks are.

The most insightful analysis of government waste, however, is provided by David Mitchell here (HT Stephen Gordon)

[Nick Rowe]

Mandos: "...then Parliament restores its sovereignty and legislates whatever it needs to legislate to put the Bank back into line..."

Our sovereign Parliaments, for the last 20 years, have already signed off on the Bank of Canada's 2% inflation target. You can, like me, suggest that the 2% inflation target is not the best target. But the "sovereign Parliament" argument gets you nowhere.

[MikeB]

Frances "Social security likewise is pretty generous". I just checked the US Soc Sec site, for the beginning of 2012 the average is $1230/m. I'm not so sure I'd put that in the generous category.

Nick "If tax cuts increased AD, the Bank of Canada would do offset that to keep AD the same to prevent inflation rising above target." I would ask the question as to how much of the price increase today is too much money chasing too few goods and how much is due to energy prices and maybe house prices inflated by low rates. Are we anywhere near full capacity with 8% unemployment.

Frances "Does the government borrow to maintain spending levels? High levels of government debt are hardly good for the economy." I was under the impression that we were a sovereign country who issues our own currency with no peg or link to a precious metal. Why would we need to borrow from anyone.

Frances "Is redistributive spending, such as social security and medicare, scaled back?" I guess technically speaking 'redistributive' might be correct, but it seems to me that it is a politically charged way of expressing a thought.

[Bob Smith]

"The basic lesson of economics is that people - including governments - aren't stupid. If it was possible to generate an immediate increase in tax revenues by reducing tax rates, taxes would be cut instantly."

Well, we know that's not true, at least based on the empirical research on the revenue raising effects of the Kennedy tax cuts in the 1960s and the Reagan tax cuts in the 1980's (there may be other examples - I wouldn't be surprise if, in a decade, someone told me that the corporate tax cuts in Canada over the last decade had revenue raising effects, or at least, didn't reduce corporate tax revenue). Governments can, and will, pursue tax policies beyond the peak of the laffer curve for extended periods of time. That's not neccesarily because they're stupid (although I wouldn't rule that out), it may be driven by other reasonable policy objectives, say reducing income inequality (although frankly, reducing inequality by making everyone poorer is a pretty dubious objective), or reducing consumption of booze/cigarettes (in the case of sin taxes - although, query whether governments actually operate beyond the laffer curve in the case of sin taxes, anyhone believe that Ontario really wants to discourage drinking and smoking?).

I think we also have to be careful in thinking about the particular taxes we're discussing. For example, if you're increasing the minimum exemption or cutting the bottom rate, unless you're a keynesian there's little reason to think it would have much in the way of an impact on growth (since for most/many people it's an infra-marginal tax cut), or that it would increase revenue (since, while it might encourage people at the bottom of the income spectrum to work more, that isn't likely to have a significant impact on tax revenue - they don't pay much tax). Ditto a consumption tax cut (if only because you typically have to spend money to consume your leisure anyhow, so there's no real incentive effect). But in practice, those are the sorts of tax cuts that are politically popular - since they affect everyone.

On the other hand, taxes on capital are very different beasts, if only because capital is so much more mobile than people and much more responsive to small changes in tax rates. The Rolling Stones have to live somewhere, and while the Caymans are nice, they aren't London or New York or Paris. Their assets can "live" anywhere, and don't much mind if you tell them that, tommorow, they're moving somewhere else. Moreover, there are so many (unavoidable) discontinuities in the treatment of different kinds of income both within domestic tax systems and between different tax systems, that even modest changes to the tax rate on capital could have significant revenue impacts. For example, I've seen US corporations willing to go through significant effort to keep income in their Canadian operating companies (and pay Canadian corporate tax on it), in order to avoid realizing US corporate tax (at punitive rates) by repatriating that money to the US. Good for Canada, not so much for our US cousins. A reduction in the US corporate tax rate would probably see a good chunk of that offshore money repatriated. Ditto the tax planning that used to go into avoiding Ontario's capital tax - that was essentially a tax intended to (a) discourage invesment in Ontario and (b) increase corporate tax revenue in Alberta (since reducing Ontario capital tax often entailed the use of an Alberta financing sructure, which probably didn't collect enough revenue to justify enforcing it.

I also suspect that part of the rationale for reducing taxes at the top is not just that the labour supply is more responsive at the top than at the bottom end of the spectrum, but that, for people at the top, labour income can be more readily converted into capital income than for Joe or Jill Q Lunchbox. If you're working at GM or 7-11, you're going to be getting employment income. If you're a hedge fund manager or a lawyer or own a chain of car dealerships, you can pretty much choose whether you want to earn labour income or not. Well, the rich aren't stupid. Why would Mitt Romney ask Bain Capital to pay him a few million a year as an honorarium, taxable as employment income, when he can hold a partnership interest that spits out capital gains and dividends. While the focus on tax rates and their inpact on the labour/leisure trade-off is the natural focus for an economist, for a tax lawyer the focus is the impact of tax rates on the labour/capital boundary.

[Frances Woolley]

Mike B - fair enough. My point here is the much more limited one: tax cuts usually reduce government revenues. There are a number of ways of adjusting to a lower level of government revenues, none of which are particularly appealing. You wouldn't think such a post would even be necessary, but apparently it is.

[Bob Smith]

"Someone has inferred from this post that Frances is a Republican man."

All the more impressive, since Mr. (judging by the language, I'm assuming he's a guy) Downie apparently didn't read much beyond the (seemingly neutral) title.

[Frances Woolley]

Bob: "based on the empirical research on the revenue raising effects of the Kennedy tax cuts in the 1960s and the Reagan tax cuts in the 1980's"

Huh? Huge run-up in US government debt in the 1980s. The 1960s were a special time economically and demographically - we aren't in the summer of love any more, and no number of little blue pills can change that.

I agree with you absolutely on the labour/capital boundary, and that is why I worry a lot about the idea of moving to consumption-based taxation, which would exempt capital income.

What changes do you think Canada would have to make in its tax regime for high income earners to make it worth while for someone like Eugene Melnyck to repatriate his income? What is a realistic estimate of their revenue impact?

A lot of the costs of sheltering income are up-front costs - once the income is sheltered, there's little point in unsheltering it - that's why I'm very skeptical of these cut-taxes-get-more-revenue claims.

[Frances Woolley]

Bob - it was the flow chart. Gets 'em every time.

[MikeB]

Frances; I was remiss in not saying that this was an important point about tax cuts and revenue and one many people don't consider nearly as fairly as you did.

On taxes generally. I'm a bit of a radical I think. We need to get away from taxing income (at least in the lower levels). How about this for out of the box.
* Zero Corp Tax
* VAT on ALL purchases
* No tax first $100K (numbers may vary)
* ALL income is income, no deductions
* Small surtax $100-$500K
* much higher surtax above $500k
* taxes on inheritance. We don't need rich families getting richer and exerting undue political influence.
* if we want to promote something (child tax credit, RSP, home ownership, etc,,,), send cheques in the mail. Don't do it through the tax code.

How's that for the starting point of a conversation ;)

[genauer]

Interesting post !

a few comments and links:

1. linear
I dont think this linear thinking in a few more hours worked or not describes reality.
Well, at least not in Germany. "Poor" or not fully working people, like mothers, do a tradeoff between social minimum payments, "mini-jobs", and marginal effective tax rates at the bottom (starting social insurance payments of 2 x 20 % employer/ employee) and the perceived benefit of this in an otherwise one-payer system.

2. Laffer curves
At the top end, I think you have to look at the marginal impacts of a multitude of taxes, labor, capital, consumption (VAT),
which make a total tax burden, on which people decide, whether they relocate, or find it worth to come up with tax cheating ways.

See e.g. Trabandt / Uhlig 2012 "How Do Laer Curves Dier Across Countries?" at NBER or SSRN

And dont forget Federal, State, local taxes, or "Solidarity contributions", mandatory tithe collected the Feds in DE.

Soo, the impact of tax rate changes depends fundamentally, on which side of the Laffer maximum you are.

Bush 2001 (from 39 %) was already on the left side, rate cuts meant lower integral tax, Reagan 1983 (from 70 %) and Germany 2000 - 2003 (from 60 %) were on the high side, and tax cuts were beneficial.

[Nick Rowe]

Frances: "Bob - it was the flow chart. Gets 'em every time."

Bingo! Picture is worth 1,000 words, etc. People only look at the pictures.

Mike B: "Are we anywhere near full capacity with 8% unemployment."

March unemployment was 7.2%. Monetary and fiscal policy works with a lag. I do not know (nor does anyone) whether the current stance of monetary policy is correct, given current and prospective unemployment rates, and all other information. But the Bank of Canada thinks it is, otherwise the Bank of Canada would be doing something else. Therefore, if fiscal policy loosened, the Bank of Canada would respond by making monetary policy tighter than it otherwise would. If the Bank of Canada wanted higher AD, it would have looser monetary policy than it currently has.

If we thought that AD was too low, and that inflation would come in below the 2% target, we could simply advocate looser monetary policy.

[genauer]

grummel, typos: "How Do Laffer Curves Differ Across Countries?"

3. Economic Benefits of the Black death
See Robert Allen "How prosperous were the Romans" in Bowman & Wilson 2009 "Quantifying the Roman Economy"
Factor 2 higher wages, impressive for that time ! Nice Graphs, and together with the comparison to the Roman Empire, some real long term perspective

Of course Acemoglu "Why Nations fail" The argument that increased economic power (relative scarcity of labor) leads to increased political power, AND (my add-on) that higher productivity leads to more time available for technological progress / stronger incentive to make labor more efficient.

4. Application to the next 40 years
What we saw in the last 40 years was that simple labor (agriculture, "simple" jobs in the "non-tradeable" sector) was under pricing pressure, and that the somewhat increasing inequality in gross income was compensated by progressive taxation.

What I expect for the next 40 years, is a reversal of that. With a fertility of 1.4, meaning a 1%/anno shrinking working population in Europe, the relative demand for the non-tradeable sector increases, whereas the tradeable, "high-value" sectors comes under increased pressure by competition from Korea, China, India, etc.

[Andrew F]

J.V. Dubois:

"I would love to see more articles about wealth vs substition effect on the labor supply as I am basically blind here. Not to mention that there may be many more things going on - I once read an article once that attributed higher growth in Sweden to higher labor costs as it provided incentives for investment in physical and human capital to cope with this effect. "

That works when the best substitute for domestic labour is capital, and not foreign labour. Thankfully, we're in the process of soaking up much of the cheap labour that is readily available in China and India (Africa is still cheap but needs better infrastructure and institutions to be accessible).

[Bob Smith]

Frances,

Sure, there was a huge run-up in US government debt in the 1980's, but it sure wasn't a function of falling tax revenue (http://en.wikipedia.org/wiki/File:U.S.-income-taxes-out-of-total-taxes.JPG). Reagan may have been a tax cutter, but he did not cut spending - a point glossed over in the usual Republican hagiographies (and usually justified on the basis that he spend the commies into the ground, which might be a reasonable point if many of the military defense spending credited to Reagan hadn't actually started in the last years of the Carter administration). My recollection is that there is some reasonably solid empirical research (i.e. from respectible economists - I want to say Martin Feldstein - not the usual collection of think tanks and internet cranks) to the effect that tax revenues from the top income bracket went up (taking into account, as best they can, other factors).

I've not read it, but I wouldn't be surprised if there weren't similar studies on the impact of the Coolidge tax cuts in the 1920s.

[Frances Woolley]

Here's a recent academic reference:"How Far Are We From The Slippery Slope? The Laffer Curve
Revisited"

For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and by 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation. A dynamic scoring analysis shows that 40% of a labor tax cut and 80% of a capital tax cut are self-financing in the EU-14.

For further evidence, go to scholar.google.com, type "Trabandt Laffer curve", pull up this paper and take a look at some of the dozens of articles that cite it.

I don't know to what extent this paper takes into account the dynamic effects of tax competition, i.e. the impact of everyone cutting capital taxes is very different from the impact of one country cutting capital taxes.

[genauer]

@Frances

1. The international tax competition is actually a very good point.
I think this is in fact, what limits basically everything you do, and not really some Laffer maximum, which depends significantly on a number of assumptions, which are hard to quantify, and especially not by the normal people, who make the decisions:
work / not work, emigrate, cheat on the tax, take some non-monetay benefit, etc.

2. The 2012 paper or version improves over the 2010 version at Stanford (your citation) in the following ways:
a) it takes into account the social contributions (retirement, health, unemployment, etc.) which act as marginal taxes,
at least in most european states
b) it treats the EU states individually, and not summarily
c) some other details, relatively minor to the first 2

This is done, with a focus on, who can increase taxes by how much, in order to pay his debt.

And it comes to the conclusion , that with the better assessment the amount of possible tax increases is much smaller than most people and Uhlig 2010 thought.

So if you can NOT get much more taxes, you either cut your benefits or default.

[Bob Smith]

MikeB,

I agree with a number of your changes, but I just wanted to pick on a few nits.

"* ALL income is income, no deductions"

This is a pet peeve of mine, what do you mean by "income"? Unless you think income=revenue (which is clearly nonsense in a business context), rather than income = profits (i.e., revenue minus expenses), you have to have deductions. For us wage slaves, our income is some else's deduction, and for businesses their revenue is someone else's deduction.

Now, I think your point is we should get rid of the assorted "special" deductions. But in fact, at least in Canada (this probably isn't true in the US) there aren't all that many "special" deductions baked into our tax code and most of the ones that are aren't all that offensive (i.e., a deduction for interest, for offering expenses relating to share offerings, for capital cost allowances) and are intended to ensure that "income" for tax purposes actually reflects what reasonable people would characterize as "income" for commercial purposes. For the most part, though, deductions are just based on general accounting principals relating to the computation of the taxpayer's profit (seriously, my Tax Act and assorted regulations are 2000+ pages long, the section that deals with the computation of the income of a business and under which most deductions are claimed is one sentence and it only says that, generally, your income from business or property is your profit).

No doubt people play fast and loose with their deductions("But my home office needs a flat screen TV - for business purposes"), but it's one of those things where trying to legislate away abuse will do more harm than good (and, in any event, the CRA is often pretty sucessful when it catches some of the more spectacular abuse).

"* Small surtax $100-$500K
* much higher surtax above $500k"

Why a "surtax"? While not just levy a tax? Surtaxes made sense a few decades ago when the provinces had no control over their own tax base, at least if they wanted the feds to collect their taxes for them rather than administering their own tax system (in practice, the provinces except Quebec - which administers its own tax system - just imposed a provincial tax based off of the federal tax). But sometime in the late 1990's, the feds allowed the provinces to have a different tax base, so that the provinces can pick and choose their own rate structure. That Ontario keeps its surtaxes is just a function of the preference of politicians for a tax system that is opaque.

"if we want to promote something (child tax credit, RSP, home ownership, etc,,,), send cheques in the mail. Don't do it through the tax code."

I'm not sure what the difference is. The distinction between a cheque in the mail and, say, a refundable tax credit is one of terminology. The reason governments use the tax system to administer these types of policies is to make it easier for all concerned. Does anyone really care whether government money is paid under the "free money for you Act" or the "Income Tax Act"?

In the case of RRSPs (or other savings regimes), I think there's a logical reason for providing a deduction in the tax system, if you think that the tax base should be consumption rather than income.

[genauer]

Just as an example, how this works in Germany.
Take a "poor" electrician, (a proud "Handwerker") with his own business, ZERO profit,
20k Euro per anno "net income" (27k would be "social minimum" with 1 wife and 2 kids)

He works in your place and sents you an invoice about 100 Euro + VAT

Money Tax rate, comment
Total 119 19% VAT
Invoice 100
Gross 83.3 20% employer social contributions
Net 66.7 20% employee social contributions

So basically, even for the poor guy, only 66.7/119 = 56 % of what you paid, ends in his hand.
And he hasn't paid a single cent income or corporate tax yet.

at some 50k the "keep for yourself" fraction goes down to 40 %. This is a very solid incentive to do some of the work "without invoice". Split the difference, and everybody is better off by a factor of about 1.45. But this would be to easy. So, some people can deduct some "Handwerker" Invoices from their taxes. And, divide and conquer, instead of the many people protesting the overall high total tax levy, everybody tries to optimize his special niche and keeps his mouth shut : - )

Hey, how about you encourage Uhlig / Trabandt to incorporate Canada, and maybe Singapore, Korea in their next version, and maybe help them a little bit with Canada ?

Beyond that, I do not want to say that the Laffer curve, or this version of it, is the final gospel, just as the minimum amount of complexity to base real tax decisions on

[Patrick]

I have no memory for this sort of thing, but in Canada a self employed person who was not incorporated (e.g. she had incorporated a company and worked for the company) would obviously pay federal and provincial income tax, put could elect not to pay CPP (the pension) contributions (probably a bad idea), and would not pay EI (employment insurance) because they don't qualify to receive it. If they were incorporated, the scenario is much more complex and depends on what they actually pay themselves and how (e.g. is it a wage? is it dividends?). If you're making only $20K-30K, I think you'd pay very little tax.

Of course, a qualified electrician in Alberta would have to be very lazy or very unlucky to make only $20K. Some make an order of magnitude more.

[Frances Woolley]

Patrick "in Canada a self employed person who was not incorporated...could elect not to pay CPP (the pension) contributions (probably a bad idea), and would not pay EI (employment insurance) because they don't qualify to receive it."

Actually, wrong on all counts on this one! Self-employed people must pay the employer + employee CPP contributions, adding up to 9.9 % of earnings up to the max pensionable amount (though the employer part is deductible, as opposed to a non-refundable tax credit). For a young person, however, it would typically be a good idea to do so, as the implicit returns on the CPP plan aren't great for people under 50 as current contributors are both paying for current retirees and building up the fund to pay for the later boomers - hence the Wild Rose party platform with respect to CPP. A self-employed person can how opt it to EI for mat/pat leave, though very few people have actually done so - the stats are buried somewhere in the report, I am vaguely thinking it would be a good topic for a post some day.

Not that this is really relevant to anything...

[Micah]

I think your article makes a mistake in asserting one of the basic lessons of economics is that people are not stupid (i.e. they are economically rational). This is one of the basic ASSUMPTIONS of economics, and it is only as good as the predictions it makes, which are not always accurate. The fact that supply side economics is so popular right now undermines that assumption. Rationality is ok to assume in limited circumstances, where people have strong salient incentives, and lots of time to think about political and economic decisions, but it kind of falls apart when they don’t have time for a thoughtful assessment of them. This is why they delegate their opinion making to pundits and political strategists. Perhaps this is rational on some level, but not in the sense expressed in this article (that people always make choices that are most in their interest).

[genauer]

@Patrick,
good points.

With reducing this to "self employed" I simplified the numbers setup a little bit, but raised your reality challenges : -)
And I chose the Revenue intentionally very low, to say income tax is negligible, to make clear that the "indirect taxes" a.k.a. social contributions are the first problem here around, even below poverty level. In order to drive home my point, that considerations with a simple tax rate have very little to do with the reality of these people.

On the side, presently 1 Euro = 1.3 USD, purchasing parity more like 1.5, and 1600 hours per year x 15 Euro is not unusual here in Eastern Germany.

[genauer]

One little example, that people have to be a little more careful with interpretations of especially the Reagan tax cuts.

Let us just take a reasonable mid size corporate fat cat at, or close to, the maximum marginal tax rate. He does his annual performance talk, it was on the good side, and he and his boss want to give something to him, lets say for calculation reasons 100 $ (multiply by 1000 to get to the right size).

There are 2 possibilities, either some non-monetary, material goodie, like using a corporate beach house, whatever, or a straight salary increase.

Prior Reagan, with 70 % marginal, they would have decided on the non-monetary, even if the guy values it only at, lets say, 40 % of the real cost. It generates 40 $ worth, at a cost of 60, versus 30 $ worth for the salary increase.

Now they would go for the salary increase, for sure, 65$ worth vs 40, at a cost of 70.

See the numbers:

Prior Post
Mater. Benefit 100$ 100$
Corp Tax Rate 40% 30%
Effective Cost 60$ 70$

cash worth 40% 40%
cash worth 40$ 40$

Corp cost -60$ -70$
Corp.Tax -40$ -30$
Income Tax 0$ 0$

Society benefit -60$ -60$

Alternative:

Salary increase 100$ 100$
Corp Tax Rate 40% 30%
Effective Cost 60$ 70$

Marg. Tax Rate 70% 35%
Cash worth 30$ 65$

Corp. Cost -60$ -70$
Corp.Tax -40$ -30$
Income Tax 70$ 35$

Society Benefit 0 0

Not wasting total benefit about tax avoidance has major benefits for everybody. A net cash out of 65 $ is much better than a perceived 40 $ non-monetary thing. The tax man gains actually 5 $, instead of loosing 40 $.

Question: And how do I neutralize the 10 $ more, the corp pays, without screwing up the simplicity of the other numbers ?
If somebody feels strongly about modifying some of the numbers, please tell me ! I had this discussion now several times, but simply putting the numbers down, like here, took too much time in the heat of discussion.

Bottomline:
the more you distribute the taxes in smaller portions across various turn-pikes (corporate, income, VAT, etc.) the more difficult it becomes to cheat substantial amounts.

[Ryan]

Speaking of Arthur Laffer, he had a good piece in the Wall Street Journal last year or so showing that actual tax collections go down when tax rates go up, meaning that actual income tax collection, in the USA anyway, is always about 19% regardless of what the "income tax rate" is.

So although it is fair to say that the Laffer Curve is false with respect to empirical reality, I think it would be a bit unreasonable to ignore its contents from the standpoint of pure theory. A 100% tax rate would only generate high revenues if enforcement of such a tax rate were possible. Realistically, it is far too costly to enforce, even if the people assented to such a rate.

[Frances Woolley]

Ryan - we can all agree that tax revenues are close to zero at 1% and 100% marginal tax rates, thus there is some kind of a Laffer curve, and the question is whether we are on the right hand side or left hand side of the curve. That's precisely how Arthur Laffer puts it in that Iceland TV interview.

But believing that - except in fairly exceptional circumstances e.g. in response to increased tax competition or capital/labour mobility - we are on the right hand side of the Laffer curve and thus can increase tax revenues by cutting taxes is wishful thinking, pure and simple.

Micah - the assumption that people aren't stupid is quite different from the standard economic rationality assumption. Economic rationality predicts, for example, that framing doesn't affect choices, e.g. I'm no more likely to eat cookies in a clear glass container in the counter than when those same cookies are hidden in a cupboard. Demonstrably false. People aren't stupid says that people on average avoid doing really dumb things, like charging high tax rates when lower tax rates would generate more revenue.

[Bob Smith]

"A lot of the costs of sheltering income are up-front costs - once the income is sheltered, there's little point in unsheltering it - that's why I'm very skeptical of these cut-taxes-get-more-revenue claims"

That's true, to a degree, but there's two caveats to that. First, it ignores the possibility that people might have new income they want to shelter. The rolling stones or U2 may have all their royalty income offshore, but maybe Adele doesn't. Even if tax changes don't cause past structures to be unwound, they may discourage the future use of those structures.

Second, there's a practical cost of most tax mitigation structures, namely you typically can't access your money. Take the Rolling Stones. According to the article, their tax minimization strategy works because they end up dumping the money into some Netherland Antilles holding company. All well and good, but if Mick and the boys (or their kids, ex-wives, whatever, ever want to blow through that money, they probably have to take it into income somehow (presumably a dividend up to the Dutch foundation, then a distribution of some kind). Avoiding taxes is fun and all, but it's the tail to the dog of having lots of money to blow on things. If you're facing a 75% tax hit (a-la-France), hey, either way you're not going to be able to spend most of that money, at least you might as well stash it offshore. At 20%, hey, pay the tax and buy the Eiffel tower.

[MikeB]

Nick. March R8 from statscan was 11.3%, I thought 8% was generous. Still 7% would seem to indicate lots of slack to me. Are you saying that you don't think we are AD deficient or that the BOC doesn't think so? Having said that, I'm not sure how much looser we can go at this point in history. It seems to me that whether we call it fiscal or monetary really depends on if it is rules based. I remember a recent post from you where you almost seemed to agree that maybe fiscal could be used as long it was based on some well developed rules in partnership with monetary.

Bob Smith: Thanks for the note on my wild ideas. I think I just said surtax meaning tax - not sure why I wrote it that way. Regarding the increase in the personal deduction or any other fiscal measure that puts money in the pocket of the lowest wage earners, I think it is pretty fair to say that any money sent that way would get spent rather promptly. Unlike money directed to a high earner which is not as likely to be all spent. It was my understanding that someone's spending is someone else's income. Wouldn't that be growth. And IF (big if), this caused demand pull inflation, it seems to be we know how to deal with that.

Frances: Sorry for meandering off topic here. You made an excellent and balanced point about how deeply we should consider ALL effects of tax cuts and make informed decisions.

Reading Bill Black recently it seems to be that a race to the Tax and Regulatory bottom is not in our interest in the long term. I know I'll be dead, but for whatever reason I still care. Still, others are doing it, so what do we do in the meantime - good, tough questions. Easy to say, hard to do, but maybe we should begin with a debate of what we want as a country at all levels (Fire, Police, Teacher, Healthcare, Military, OAS, CTB, etc...) and then figure how how we structure our polices (taxes incl) to achieve those goals.

[Patrick]

Frances: Ah yes. That sounds familiar. I *did* say I had lousy memory for stuff! At the time I dealt with it, it was the old EI rules. No soup for me. But mostly I wanted to suggest that a low-income self-employed worker in AB is not paying tons and tons of tax (it still may be too much - I don't really know) relative to what they get in services. Well, at least if they live in Edmonton or Calgary - rural areas are probably a different story.

[Bob Smith]

"Unlike money directed to a high earner which is not as likely to be all spent."

Well let's think about the use of the term "spent". You're right, that high income earners are generally more likely to save than the poor (although not always - the sad story of Antoine Walker is a cautionary tale http://sportsillustrated.cnn.com/vault/article/magazine/MAG1195981/index.htm). But for the most part, they aren't like Scrooge McDuck, that money doesn't get stashed in a bill pool of C-notes and gold coins. It get's invested and someone else spends it (since, as Nick and others are frequently reminding us I = S).

"Reading Bill Black recently it seems to be that a race to the Tax and Regulatory bottom is not in our interest in the long term."

I wrote a paper about the "race to the bottom" theory back in law school, and one of my points was that it only makes sense if you assume that either (i) the people who live in a country don't bear the burden of regulations or (ii) they don't see any benefits from those regulations. To the extent workers (the immobile factor of production) bear the cost of regulation through lower wages, there's no race to the bottom - what do companies care about the cost of regulation if they can pass them on to their employees. And if workers won't trade lower wages for cleaner environments, what does that say about the "price" they're putting on the environment? (The paper was more complicatd than that, of course).

There's a similar story for taxes. In the corporate tax world, the race to the bottom thesis only makes sense if workers don't bear the burden of corporate taxes. And to the extent that workers don't want to bear the burden of corporate taxes (i.e., aren;t willing to work for lower wages), what does that say about the price they're putting on the underlying services funded through corporate taxes?

[Frances Woolley]

Patrick: "a low-income self-employed worker in AB is not paying tons and tons of tax (it still may be too much - I don't really know) relative to what they get in services."

A low-income self-employed worker who is paying any taxes at all needs some tax advice.

It always makes me laugh when I see these stats along the lines of "Canada is such a great incubator of innovation and entrepreneurship, look at the growth in self-employment" or "high taxes don't stifle innovation, look at our self-employment numbers."

Self-employment income is much more advantageously taxed than employment income because of the possibility of writing off home office, transportation and other expenses.

[genauer]

LOL,
when I hear Laffer describing how wonderful everything is in Iceland, I really wonder, why those criminals can't pay their debt to NL and UK.

[Frances Woolley]

genauer - have to say, that video got more laughs when I played it in class this year than it ever has before!

[Ryan]

Frances - True enough, but I'm not sure that in itself is enough to dismiss the idea that increasing tax rates presents new costs and challenges associated with collecting that revenue. But, like I say, in terms of pure theory, the concept is hard to ignore.

More realistically, I think certain individuals are more "tax-sensitive" than others. Like you pointed out, tax cuts only matter to people at the margin. But "the margin" isn't actually determined by the economic conditions, it's determined by that person's utility function.

In other words, some people face a $200 tax decrease and think, "Stephen Harper is ruining this country," and then basically put that money in their bank and forget about. Other people face a $200 tax decrease and think, "THE CONSERVATIVES GOT IT RIGHT AGAIN!!!!1" then they go buy a Playstation to celebrate. I don't even think a person's income level is what determines this, I think it's their values, their utility function. It's intangible. Mises would call it "an ultimate unknown."

[Frances Woolley]

Ryan -
"certain individuals are more tax sensitive than others"

I agree, and I suspect that some things economists tend to dismiss as poor tax policy are basically ways of giving highly tax sensitive people opportunities for low cost tax evasion (claiming children's fitness amounts for kids whose involvement in hockey is limited to the videogame NHL 2012).

"that in itself is enough to dismiss the idea that increasing tax rates presents new costs and challenges associated with collecting that revenue."

One of the key arguments I'm making here is that there's likely to be an asymmetry - high tax rates will induce people to leave. Low tax rates will not necessarily make them come back - tax rates have to be lowered quite substantially to make unwinding tax shelters worth while, plus after a while a person gets settled in New Zealand (or wherever) and doesn't necessarily want to come back.

[Robillard]

I have to commend Amazon's international tax and transfer pricing teams, as well as their external advisers for a job well done avoiding UK corporate taxes. They managed to station almost all the high-value-added functions, risks and assets in Luxembourg, while leaving the routine, low-value-added order fulfillment functions to be performed in the UK. This arrangement is entirely acceptable under transfer pricing rules. I would be more concerned if Amazon UK's business was able to avoid VAT than if it were able to avoid UK corporate tax. That being said, Amazon's arrangements likely also make it likely that if losses occur, they will end up trapped in Luxembourg, where they will be hard to utilize. International tax planning can be a double edged sword.

Also, with respect to the comment that it is easier now to run a business from a beachhouse in Barbados now than it used to be, I respectfully disagree. Without some form of economic substance in Barbados, it is difficult to justify attributing most of the corporate profit there through transfer pricing. It is hard to get a lot of good quality technical and operations staff willing to live and work in a tax haven. A lot of these places have poor infrastructure, air links, schools and hospitals. They also tend to have high living costs.

[genauer]

Frances, I should have seen, that the video was made 4 years ago: - )

With a false quote of the Iron Lady: "socialism works until you run out of other people's money"

This seems to hold for that kind of capitalism as well

btw, how unreadable is my Reagan tax cut example ? completely or just nearly ?

On tax rates, I think the German example is, that you cant run more than 60 % for more than 10 years, without people leaving in substantial numbers, but 48 % seems to be tolerable. And my view into the future is, that we will have some 53% in about 10 years.
Most governments need more money, and prosecuting tax cheats becomes more effective, see what the US do to Switzerland, this is getting pretty rough, even without sending in the 7th cavalry, as a former German FM talked about :- )

From my perspective, a left / green government reducing marginal tax rates to 45 % in 2004 worked remarkably fast to right this ship. There is a lot of psychology in such things, and numbers are not the most important influence.
The (christian democratic) right to raise taxes, and the (social democratic) left to cut benefits leads to unity and cohesion of the broad center, but introduces new fringe parties, like the socialists in 2005 and the pirates now.

Mandos,
the German Ordnungspolitk view on the Central bank independence is:
http://www.bloomberg.com/news/2011-12-02/merkel-says-joint-euro-bonds-unthinkable-as-eu-faces-debt-crisis-marathon.html
Merkel said the ECB has to be free to move in any direction and that she won’t comment on what it does or doesn’t do. The ECB’s independence to take decisions “in any direction” must be guarded, Merkel told lawmakers.
The ECB is independent and must choose its own method of ensuring the euro’s stability “without being praised or criticized”

[Frances Woolley]

genauer - I'm trying to pay some attention to my long-neglected economics of taxation students so am not replying to all posts, but for what it's worth, my totally unscientific reading of this is that Laffer curve effects for most forms income start kicking it at around 50%. Which is not dissimilar to what you're saying for Germany.

[Determinant]

@Scott P Bacon

I think you made a strong case for the explanatory power of diagrams here (hope your reading Determinant!). I agree with Jim, great post!

My complaint was not against diagrams, I am very much in favour of diagrams, my complaint was against drawing conclusions based on logical deductions from axioms that are proven false in the real world, that is I object to conclusion without experimentation and verification. As Frances' post goes into such verification and real-world comparisons in depth, I am quite satisfied with this post.

Second, Frances asked how we could increase tax collection on wealthy people. Simple. Pass some better laws and go after tax-havens.

But, as the NY Times reports "over the last 20 years, according to Dutch documents, the three musicians have paid just $7.2 million in taxes on earnings of $450 million that they have channeled through Amsterdam — a tax rate of about 1.5%, well below the British rate of 40%." There is no way that the British could lure the Rolling Stones back without providing even more generous tax treatment.

Do what the US does and tax citizens on worldwide income. The Stones could not get away with stashing income in Amsterdam under that regime. While we're at it we could go after tax havens who charge those high upfront fees in return for bank secrecy and non-domiciled tax rates.

The US has cracked down hard on Switzerland in the past few years; Swiss bank secrecy is over and in the process they obtained insider testimony on how those Swiss banks with fancy offices in Geneva and Zurich whose customers travel in limousines actually operate. It was criminal, actually criminal (Genauer has more cause to be angry at the Swiss than Icelanders). They would solicit clients in the United States at fancy sponsored gatherings (with no license or registration, in flagrant violation of laws to the contrary), advertise their tax-evasion services (again illegal) and go so far as to pay their customers in diamonds (easy to smuggle and easy to avoid reporting).

I support Canada moving to a worldwide income liability for income tax.

[genauer]

@Determinant,

for EU customers, Swiss bankers didn't have to travel, they were coming into Switzerland, and sitting there and putting money into a bank account is not a crime. That people have to report income themselves is nothing unusual, especially from foreign countries, the same holds for me with my US accounts, nothing illegal with that. Switzerland has now agreed to collect summary taxes on German account holders, equivalent to the German procedure, very nice, supportive, and neighbourly behaviour, ZERO complaints from my side. Just the German social party is throwing a little tantrum, the usual. They have a local election (where they govern) to win, and have to drown out, that their promises of new social goodies were repeatedly rejected for unconstitutional budget, too much debt, the usual :- )

[Frances Woolley]

Determinant: "I am quite satisfied with this post." High praise indeed! Thank you.

"I support Canada moving to a worldwide income liability for income tax."
Interesting, I wonder how many people would renounce their citizenship for tax reasons, and what that would do to the amount of "foreign investment" in Canada. The numbers of people would be small, but the assets owned would be non-trivial (are the descendants of KC Irving resident in Bermuda for tax purposes too?).

[Determinant]

If they aren't resident for tax reasons aren't they foreigners in an economic sense already? The US has worldwide tax liability and the number of renunciations each years is tiny. Hardly any are for tax reasons. Most are for political or personal reasons (life is in another country, wants to integrate, wants high or sensitive office).

@Genauer:

There was a documentary on 60 Minutes with insider testimony from Bradley Birkenfeld, a UBS employee. Identical content here: http://www.globalpost.com/dispatch/europe/100724/swiss-banking-secrecy

Switzerland now has to report the income of US citizens to the IRS. Bank Secrecy for Americans is over.

Earning income and not reporting it for tax purposes is a crime in the US. Providing services where the explicit intent is to not report the income earned to the IRS is a crime and it can happen anywhere in the world because US tax liability is worldwide.

It was fraud. Soliciting financial services in the US without complying with business regulations, for the purposes of tax evasion is fraud.

Banking, especially offshore banking, is all about the "veneer of respectability". Few people question your loans, fewer still question your depositors if you appear to be respectable. There are rows of offshore banks in Nassau, Bahamas with tidy, nice-looking office buildings, resplendent with plans and architectural features, but who are their clients? Why are they not going to their local (usually US) bank? Where is the money going to pay for all those high fees (Swiss banking fees are very high)? Those are the questions they don't want you to ask.

It's the same reason that Canadian banks used to build palatial branches that exuded permanence and wealth.

[genauer]

@Frances,
I actually refused a Green Card because of Tax reasons.

@Determinant
I was talking about the Swiss / EU customer relationship, and there was nothing illegal on the Swiss Side, I have to be indignated about.

Both,
I would really like to discuss my Reagan Tax example with you, because the very most people don't get it, that pushing people into tax avoidance causes substantial social loss.
And I would like to have a somewhat polished example handy for future discussions here, and in other places.

[Determinant]

Further to renunciation for tax avoidance, the US levies an expatriation tax in which a citizen's capital property is deemed to be disposed of on the date of renunciation, triggering significant capital gains liabilities.

On further investigation Canada charges a "departure tax" on those who cease to be resident here for tax purposes, so it is a more matter of refining the definition than objecting to the principle.

Canada generates a significant number of renunciations for the US because of cradle Americans who are defacto Canadians and have been since primary school. Or high-fliers like Bob Hommie (the Friendly Giant, who lived near to were I live now and is remembered well by locals) or Ernie Coombes (Mr. Dressup, who only got his Canadian Citizenship in 1994, I was there on Parliament Hill when he was sworn in.

[rabbit]

There is no doubt that at some point tax reductions do increase revenue.

Consider an extreme case: a 100% tax rate on everything. Government revenue would be zero, since there would be no economy outside of the black market. Here reducing tax rates would increase revenue.

Consider another extreme case: a 0% tax rate on everything. Again revenue would be zero, so increasing tax rates must increase revenue.

Somewhere between these two zero-revenue extremes we have a point of maximum government revenue.

So the proper question is not whether decreasing tax rates can increase government revenue, but under what circumstances does it do so.

[Frances Woolley]

rabbit - We can all agree that there is a Laffer curve, and that it is theoretically possible that we are on the right hand side of it.

This is where the idea that there are no twenty dollar bills lying on the sidewalk comes in.

Fifty or thirty years ago, when income taxes were still relatively young, it might be plausible to argue "we got this wrong, we set the tax rates too high, now we see the light."

It's been over 30 years since Laffer drew the most famous curve ever drawn on the back of a napkin. Tax cutting has become political orthodoxy in a number of places. What possible reason is there to think that - if there were revenue gains to be had from cutting taxes - they would not already have been exploited by aggressive anti-tax governments such as Bush and Harper?

You could respond "ah, yes, but tax competition is more intense than it used to be, our major rivals have reduced their taxes, structural change makes tax enforcement more difficult." In which case *show me the evidence!*

[Determinant]

The Laffer Curve, as Rabbit points out, works on the assumption that avoidance or evasion is a viable alternative and will be taken. That's needs to be examined.

As the Laffer Curve came on the scene, another legal doctrine came on the scene too: the doctrine of fiscal nullity. The UK and Australia have fully adopted it and it is the inspiration for the General Anti-Avoidance Rules in Canada. It works like this:

I could complete transaction A in one step and on the face of it owe tax B. But if I take three steps, each of which is legal, which together generate a tax loss to offset tax B. Formerly this was legal in many places and it led to large tax losses. Under the Fiscal Nullity doctrine the three-steps are considered self-cancelling since they produce a tax loss only and not a true economic loss. I'm not actually out the money. The courts consider the intermediate steps to be an illusion and abusive.

So if you can't avoid taxes through a transnational two-step you can either not report income (but your consumption will be traced, its a basic tax enforcement technique) or leave. But don't try to hide your money in Switzerland, the game is up there.

[Will]

Frances is awesome. This post cuts through some serious BS.

It's interesting to look at what David Hume says in On the Balance of Trade, that it is commonplace for people to assert that the imposition of a new tax generates the ability to pay it. So we've come 180 degrees in the art of holding mistaken assumptions about taxation!

[Timothy Watson]

Very timely post, I just went to a seminar by Roger Gordon yesterday where he told us that corporate tax rate cuts would increase tax revenue- So what's the risk in cutting corporate taxes? Although he didn't go into chapter and verse, I guess he is arguing a corporate tax cut should increase growth and investment (and thereby increase tax revenue), and discourage income shifting by mobile international capital. As an aside, I think he may tend to underestimate the degree to which corporate taxes fall on economic rents.

Taking his comments at face value- An interesting academic question to explore would be looking at the payoff period for such reforms. Because in the short term at least governments that reduce corporate taxes are reducing their tax base, and losing revenue. How long do governments have to wait on average to see a payoff for these reforms? An answer to that question would be very valuable to people in engaged in the process of tax reform.

[Bob Smith]

Interesting, I wonder how many people would renounce their citizenship for tax reasons, and what that would do to the amount of "foreign investment" in Canada. The numbers of people would be small, but the assets owned would be non-trivial (are the descendants of KC Irving resident in Bermuda for tax purposes too?)."

Interestingly, Canada was proposing a series of non-resident trust rules which were intended to deem non-resident trusts with Canadian resident beneficiaries/contributors to be residents of Canada (and thereby subject to tax on their worldwide income). Sounds good in theory. Unfortunately for Finance, in practice, the rules were unworkable. Amongst some of the goofier results, foreign trusts with Canadian investors that were non-taxables (pension plans, etc.) would have been caught by the rules. And, of course, the imposition of Canadian tax on foreign resident entities on their worldwide income would seriously piss-off all Canada's tax treaty partners who, but for these rules, would be the only ones entitled to tax those entities (the rules applied regardless of Canada's tax treaties - who says international law binds parliament). As a result, Finance was told out and out by the Senate that the rules wouldn't be enacted in their then current form (who says the Senate doesn't do anything). They've come back with more modest proposals, which I confess I haven't been following closely.

[Bob Smith]

In terms of imposing tax on the basis of citizenship, I'm not sure the US example is inspiring. How many million US citizens living in Canada are, theoretically, risking hefty fines, if not jail time, for non-compliance with their US tax obligations? Sure, in practice you like to think the US would take a practical view of these things, but who risks their financial health or freedom on the reasonableness of the IRS?

That said, I have wondering about the possibility of imposing a citizenship poll tax on Canadian citizens who are not residents of Canada, if only to discourage the "instant" Canadians who miraculously rediscover their attachment to Canada shortly before WWIII breaks out in their homeland, or when the time comes to be extracted from some hellhole of a foreign prison. But, that's a different topic.

[Bob Smith]

Determinant, unfortunately for CRA (but thankfully for tax advisors and their clients) the GAAR has not lived up the expectations of tax authorities (and the fiscal nullity doctrine, while partly reflected in the GAAR, never made it into Canadian law). It's been a while since I checked the statistics, but my recollection is that CRA still has a losing record in GAAR cases, and that's after a lengthy process of screening out all but the most abusive cases.

In any event, most tax avoidance transactions are less artificial than that. For example, a common one a decade ago (which was subject of a recent SCC case) involved Barbados trusts engaging in "freeze" transactions (in simplified terms you trade you common shares in the company for preferred shares having a fixed redemption value equal to the current FMV of the company, then sell common shares to the Barbados trust for peanuts - because all the value is in the preferred shares). Nothing offensive or artificial about it, but all the future growth of the company accrues in the non-resident trust. So far the CRA has been going after the cases with the best facts (for them) and they've had success without having to rely on GAAR (in one case the court found that the trust was never properly formed, in the recent one the SCC concluded that the "Barbados" trust was actually a resident of Canada).

[Frances Woolley]

Timothy: "An interesting academic question to explore would be looking at the payoff period for such reforms. Because in the short term at least governments that reduce corporate taxes are reducing their tax base, and losing revenue. How long do governments have to wait on average to see a payoff for these reforms?"

A question that is much easier to ask than to answer! Over time the economy will (hopefully) grow anyways. How much of that growth can be attributed to tax cuts? Very hard to say, especially since tax cuts are potentially endogenous, i.e. economic growth causes taxes to be cut rather than the other way around.

[Determinant]

Bob:

I for one fully support enacting the Fiscal Nullity doctrine into Canadian law by whatever statutory means will compel the Supreme Court to actually get with the program. Hmm, something for the Mulcair Government :)

In general I have a very low view of most of the advice tax advisors give, Artificial freeze transactions and the like.

"Amongst some of the goofier results, foreign trusts with Canadian investors that were non-taxables (pension plans, etc.) would have been caught by the rules."

What's goofy about it? Tax the income on accrual (as at present) with exceptions for pension plans, a class that already gets exceptions. Life insurance policies are taxed on accrual if they pass a certain threshold and become more investment-like than insurance like. Other than not liking the tax.

In terms of imposing tax on the basis of citizenship, I'm not sure the US example is inspiring. How many million US citizens living in Canada are, theoretically, risking hefty fines, if not jail time, for non-compliance with their US tax obligations? Sure, in practice you like to think the US would take a practical view of these things, but who risks their financial health or freedom on the reasonableness of the IRS?

This subject was brought up in the Globe & Mail and due to the Canada/US Tax Treaty most people in that class would owe very little tax, besides there was an amnesty anyway.

[Timothy Watson]

Frances,

Wouldn't one method be to use a VAR approach, and decompose the tax effect along with various other explanatory variables chosen?

[Frances Woolley]

Tim - think what the data is going to look like - if econ growth picks up five or ten years after taxes are cut, how do you know it's the tax cut as opposed to something else? There is no theory that says *when* tax cuts should increase revenues, and econ growth means revenues will quite likely increase eventually if you just wait long enough.

One way of thinking about this is to try to imagine where the increased corp inc is going to come from. Remember, it has to be a *lot* of corp inc - e.g. if the corp inc tax rate is cut by 10%, the corp inc tax base has to grow by *more* than 10% to have any kind of revenue impact. That's a lot of growth in the base. So where are we going to get that growth from?

- people who are currently employees starting their own business (the Lee Valley Tools effect). Some of that might happen, but the gains on the corp inc tax side are offset by a loss on the personal inc tax side, and I find it hard to believe that there are a whole bunch of Mr Lees out there with the potential to start multi-million dollar businesses who are thinking "I won't bother trying because the corp tax rates are so high."

- people who are currently relaxing at home or working in the underground economy and using resources for personal consumption starting businesses. Again, there may be some people who are induced to move from growing pot to growing organic vegetables by a reduction in corp inc taxes, but I don't see a huge amount of revenue potential there

- corporations who might otherwise have located in Mexico locating in Canada instead. Sure, we can get corp tax revenue that way for a little while - until our competitors cut their corp taxes. Race to the bottom anyone?

[Frances Woolley]

Tim - I'm not saying that we don't have to respond to international tax competition. People want jobs. But at the end of the day it is highly unlikely that we will end up with more revenue than we have right now. Best case scenario is that we end up with more revenue than *we would have done had we not matched other country's tax cuts*.

Before you say Ireland - EU subsidies. Barbados and Luxemberg can pursue the tax haven strategy because they have such a tiny pre-existing tax base.

[Bob Smith]

"In general I have a very low view of most of the advice tax advisors give, Artificial freeze transactions and the like."

Determinant, that's the point, there's nothing artificial about a freeze transaction. It has real legal and economic substance - at the end of the day, somewhat is subscribing for new shares at fair market value. .

"What's goofy about it? Tax the income on accrual (as at present) with exceptions for pension plans, a class that already gets exceptions. Life insurance policies are taxed on accrual if they pass a certain threshold and become more investment-like than insurance like. Other than not liking the tax."

Well, taxing pension plans (RRSPs, etc.) is goofy - and the rules did that. Taxing foreign trusts on their worldwide income when they have very small investments by Canadian investors is pretty goofy. Trying to tax foreign trusts in violation of our treaty obligations, while legal, is pretty bad policy. And of course, I didn't get into the heart of the rules. Amongst the other provisions, Canadian beneficiaries/contributors to those foreign trusts would be jointly liable for the Canadian tax liabilities of the trust. Fair enough if the trust you have in mind is a Barbadian Trust, but query whether that's quite as sensible when you're a small investor in a large foreign commercial trust (say, something akin to our income trusts). All this keeping in mind that the legislation itself was more or less unintelligble to even the most experienced tax professionals, making compliance a nightmare.

It's easy to think up rules that target abusive transactions, the challenge is dreaming up rules that target abusive transactions without catching perfectly innocent ones. That's a lot harder.

"This subject was brought up in the Globe & Mail and due to the Canada/US Tax Treaty most people in that class would owe very little tax, besides there was an amnesty anyway"

I hope that's not what the Globe and Mail said, because it's wrong. First, liability for tax is less of an issue since most people are paying more tax in Canada than they would in the US, even in the absence of the treaty, they likely wouln't have a net tax liability (although that can be tricky, things that aren't taxed in Canada, TFSAs or the sale of your principal residence, are taxed in the US, so you could have a mismatch between your Canadian income and your US income). Rather the concern relates to the various (very punitive) penalties relating to reporting and filing obligations in the US - the treaty doesn't provide any relief on that front.

Secondly, there isn't an amnesty (there was, but it expired), at least not as conventionally understood. The IRS is extending administrative relief. In essense, dual-citizens are relying on the administrative goodwill of the IRS. You'd hope the IRS would be reasonable in applying US law (and will continue to be so reasonable in the future - their compliance obligations aren't going away), but how keen would you be to rely on the goodwill of a foreign tax collector of a country running a trillion dollar deficit?

And it's worth noting, in keeping with the theme, that in order to try to catch all their citizens, the US has proposed very onerous compliance obligations on foreign financial institutions (the so-called FATCA rules). Two points are worth noting about those rules. First, the impose a hefty cost on non-Americans (since, in theory all sorts of financial institutions, from banks to mutual funds, you name it will have to comply with US reporting and withholding obligations). Second, only the US is in a position to do it - since foreign financial institutions are simply not in a position to say "we're not dealing with you, or investing in your country" (if Canada tried to do something like this, we'd be told to F-off and people would invest their money elsewhere). I gather the US has expressed a willingness to negotiate exceptions to these rules with treaty partners, so we may be able to avoid the worst effect of those rules, but it highlights the unworkability of citizenship based taxation in a globalized world.

[rabbit]

Frances:

You assume that the authorities would immediately cut taxes if this would increase revenue. That is a dubious assumption.

First, the economy is an extraordinarily complex beast. No one can ever be certain just what the effects of a change in the tax code will bring about no matter how smart they are. If you asked ten different economists what the effect of a given change in tax rates would produce, you would get eleven different answers, and they would all likely be wrong.

Second, short-term and long-term consequences can be completely different. An increase in capital gains tax might increase tax revenue in the short run but decrease it in the long run. So one must ask "What is the time horizon?"

Third, politicians are not driven solely by economic concerns. A drop in tax rates for the wealthy might make perfect economic sense but be unpopular with the constituency. A left-leaning party, for example, might be bent on "getting the rich" even to the extent of hurting everyone.