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What Makes a Good Tax Structure

What Makes a Good Tax Structure

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Published by Show-Me Institute
Chapter 143 of Title X of the Missouri Revised Statutes applies to individual and corporate income taxes. We collected data on the number of subsections in Chapter 143 from 1973 through 2012. We plotted the number of effective subsections for each year and found that things have changed over time, with the number of subsections increasing from 54 in 1973 to 154 in 2012.
Chapter 143 of Title X of the Missouri Revised Statutes applies to individual and corporate income taxes. We collected data on the number of subsections in Chapter 143 from 1973 through 2012. We plotted the number of effective subsections for each year and found that things have changed over time, with the number of subsections increasing from 54 in 1973 to 154 in 2012.

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Published by: Show-Me Institute on Oct 09, 2013
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ESSAY 
 ADVANCING LIBERT WITH RESPONSIBILITBY PROMOTINGMARKET SOLUTIONSFOR MISSOURIPUBLIC POLICY 
OCTOBER 2013
 What Makes A GoodTax Structure?
 
By Joseph H. Haslag and Haleigh Albers
1. INTRODUCTION
Have you ever looked at Chapter 143o itle X o the Missouri RevisedStatutes? Tis chapter applies toindividual and corporate incometaxes. Rather than go through a listo each subsection, we collecteddata on the number o subsectionsin Chapter 143 rom 1973 through2012. We plotted the number o eective subsections or each yearin Figure 1. Clearly, things havechanged over time, with the numbero subsections increasing rom 54 in1973 to 154 in 2012.
1
Te next question is, why have thenumber o subsections in Chapter143 o itle X increased? Severalpossible answers apply. For onething, no law is ever written perectly the rst time. So, new subsectionsrene things, such as loopholes that were not evident when the law wasinitially written and to redene what income is subject to taxation.
2
 Additionally, the state assembly sees opportunities to use tax lawsthat seek to stimulate economicdevelopment by changing theamount o income subject to thestate income tax. By implementing such changes, the carrot-and-stick approach aims to modiy people’sbehavior so that the Missourieconomy will grow aster.
3
Tird, i we started rom scratch, would we implement the same seto subsections? Te calls or tax reorm are based on the notion thattax code becomes unnecessarily complicated over time. Te view isthat the number o laws that adjusttaxable income changes over timecomplicate things by altering the
FIGURE 1: Effective Subsections per Year
        2        0        1        2
 
ESSAY  
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SHOW-ME INSTITUTE
2
 
SHOW-ME INSTITUTE
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ESSAY 
2
The purposeof this essay is to focus onthe economicsof taxation.
Specically, we
are interested incharacterizing those principlesthat implement taxes that do theleast harm to people.
set o deductions, exclusions, and creditsthat apply to taxpayers.
4
Each ler mustkeep up in order to comply. Each new subsection adds a layer o new questionsthat taxpayers conront when ling theirtaxes. Do I qualiy or the new tax credit?Does the new deduction apply to me? Onthe other hand, the ler risks either notcomplying or paying too much in taxes i he ignores new tax laws. We have moved systematically throughthree questions. At the end, there is a case to be made or tax reorm, i nothing else, to reduce the complexity and savepeople time. ax reorm, however, is notlimited to dealing with the complexity issue. Indeed, it is also a good time to ask, what kind o taxes do the least harm toMissourians?Te purpose o this essay is to ocus onthe economics o taxation. Specically, we are interested in characterizing thoseprinciples that implement taxes thatdo the least harm to people. In orderto accomplish this goal, we study twospecic policy prescriptions. As weexamine each policy, one will see a singledoctrine that accomplishes two goals: ithelps us see how taxes are harmul andthereore, why more desirable tax policiesdo less harm. In each policy prescription, we avoid the problem o deciding how much the government will spend. Weassume that the spending decision isalready made so we only need to examine which set o taxes will provide thenecessary revenue and do the least harm.Te guiding idea is that doing theleast harm means creating the smallestdistortions. Because tax increases aectater-tax prices, the smallest distortionsoccur when the elasticity o eitherdemand or supply is smallest. At the endo the day, the elasticity principle serves asthe overarching guide or choosing the tax policies that are the least harmul.Te policy prescription starts with thepremise that income must be taxed. Wethen ask whether all sources o income arethe same. In this case, we ollow the work that Christophe Chamley (1986) andKen Judd (1985) conducted separately.Independently, both authors derived thesame result. Tey started by dividing income according to its source. Laborincome is paid or the work eort thata person puts orward. Capital incomeis paid to people or the resources they provide so that companies can purchasebuildings and machines used to producegoods and services.
5
Chamley and Juddasked i there should be dierent tax rates to these two dierent sources o income. Each ound that the best policy is to set the tax rate equal to 0 on capitalincome and that the tax rate on laborincome is high enough to generate all thegovernment’s revenue.Recently, we saw a state implementincome tax reorms that are similar to what Chamley and Judd suggested. In2012, Kansas implemented reormsthat eliminated taxes on incomepaid to owners o sole partnerships,limited liability corporations, and Scorporations as long as the income ispass-through and not paid as wages. We will discuss the dierences betweenthe Kansas income tax changes andthe Chamley-Judd prescription. Inaddition, we consider a numericalillustration that supposes the incometaxes in Missouri i it implemented theChamley-Judd prescription.Te key insight rom Chamley and Judd is really an application o a moregeneral principle that Nobel LaureatesPeter Diamond and James Mirrlees put
 
OCTOBER 2013
3
Labor incomeis paid for the
work effort that 
a person puts
forward. Capital 
income is paid to people for the resourcesthey provide sothat companiescan purchasebuildings and machines used to produce goodsand services.
orward. In their amous 1971 paper,the principle o elasticity was developed.Diamond and Mirrlees demonstratedthat the taxes that did the least harm wereones that were applied to the least elasticitems. Here, the term elasticity reers tothe percentage change in the quantity o the good or service or a given percentagechange in the tax rate.
6
Chamley and Judd showed that capital is extremely elastic because it is mobile. In the long run, a higher tax rate on capital will lowerthe return and result in capital feeing to a lower tax jurisdiction.Our second illustration considersextending the principle o elasticity toits logical conclusion. Land is an itemthat is completely inelastic; you cannotremove a parcel o land rom one state toanother. Tereore, land value constitutesa tax base that is inelastic and warrantsconsideration as a taxable item that doesthe least harm to Missourians. We usethe best data available to determine thetax rate that would apply in Missouri i itsought to implement a land-value tax.Te outline o the paper is as ollows: InSection 2, we lay out the economy thatChamley and Judd studied. In doing so, we oer a more precise denition o what we mean by the phrase “least harm.” Weconduct our numerical experiment orthe Missouri economy in Section 3. Werelax the assumption that income mustbe taxed in Section 4, proposing a tax on land value as an alternative. Section 5oers a brie summary o our ndings.
2. The Model Economy
 A model captures the key eatures o the actual economy. Here, three maintradeos are captured: (1) peoplemake decisions within each yearbetween working, which is costly, andconsuming, which requires, in part,the income rom working; (2) peoplemake decisions about consuming thisyear versus consuming in the uture;and (3) rms decide how intensively to use capital and labor. Clearly, this isnot an exhaustive list o decisions, butit embodies key dimensions that matteror economic well-being. In particular,item 2 is a airly straightorward way tocapture the dynamic eects associated with people’s consumption-saving decision. People look into the uture toproperly capture this tradeo. We begin by describing how thiseconomy works. For example, we need todescribe who lives in the economy, how long they live, and what kind o thingsthey want to buy and sell.How long does this economy last? Weonly need two periods in order to getthe consumption-saving decision to beoperational. In order to get a sense o the long run, however, we think o thiseconomy as lasting or a long time. Tislength o time is divided into periods. Forour purposes, each period is a year. When we get to the analysis, the nice thing isthat the decisions are easily characterizedas i it is about consumption this year andconsumption next year. So, any graph hasonly two dimensions. Who lives in the economy? Te number o people is very large so that no one personpossesses any market power. Put another way, each person takes prices as i they aregiven and cannot implement any unilateraldecision that will aect those prices. We donot need to have an exact number, because we will assume that people are identical,at least with respect to their decisionsregarding current consumption (this period)and uture consumption (next period). Inaddition, everyone lives or two periods.

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