Economic Efficiency

Economic efficiency refers to the point on the supply and demand diagram where both the producer surplus and consumer surplus are maximized; it is the market equilibrium, with no deadweight loss. Taxes put the market out of this equilibrium, thereby decreasing efficiency. Responses induced by taxation can be in three forms: lower quantity consumed, lower price received by suppliers, and higher price paid by consumers.

The formula for efficiency loss contains two important terms. One is elasticity (of supply or demand). The higher the elasticity, the larger the efficiency loss. In everyday language, elasticity refers to how much consumers and producers will change their behavior in response to a tax. When consumers (or producers) are more responsive to changes in price, efficiency loss is greater and tax revenue is smaller. The elasticity of demand varies with the availability of good substitutes: the more substitutes available, the greater the efficiency loss from the tax. The second term is tax rate: higher tax rates cause much more efficiency loss than lower rates; in specific terms, when the rate doubles, the efficiency loss will quadruple. A key inference from this criterion is that tax bases are better to be broad and large to the extent that consumers and producers are unable to avoid the tax by changing their behavior. Then the tax rate can fall to raise a fixed amount of revenue to finance government operations.

Equity

The equity criterion assesses the fairness of taxes, with two goals: that government revenue be raised fairly across taxpayers and that taxation serve to redistribute income across different income groups. This goal multiplicity is a major difference between the public sector and the private sector. While businesses are solely concerned about efficiency, governments simultaneously have to serve several equally important objectives, among which equity is an important one. Equity considerations represent serious trade-offs or unintended consequences from taxation.

Equity objectives may be explicitly considered in setting tax rate structures with two principles. The first is the ability-to-pay principle, which means that individuals and businesses pay taxes based on their ability to pay taxes. In practice, the principle has two different meanings. One is that people with the same ability to pay, pay at the same (effective) tax rate (horizontal equity) and people with different abilities to pay, pay at different (effective tax) rates (vertical equity). Following this principle, tax rates can be structured progressively: effective tax rates rise as income increases. The most common practice is to divide a person's income into several brackets, each subsequent higher bracket being subject to a higher marginal rate, with the lowest bracket often exempt from taxation. Thus, progressivity is built into the rate structure to place heavier burdens on the rich and the able.

The second is the benefit principle, by which the cost of public expenditures should be borne by those who benefit from them. People pay in direct proportion to the amount of benefits that they receive from these services. The concept of fairness is thus based on the relationship between use and payment and its proportionality, not the taxpayer's level of income or wealth. Such taxes are regressive: effective tax rates fall as one's income increases. All sales taxes and user fees belong in this category, as do all per person or per unit of product or service taxes. A caveat applies: since it is not feasible to assign benefits from public goods to individuals, few revenue sources satisfy a strict benefit test. Most government revenue sources satisfy a general benefits notion. For example. the motor fuels tax levies a fixed amount per gallon of gasoline, and the tobacco tax levies a fixed amount per cigarette pack, regardless of the price and grade of the product. These two taxes are very regressive.

Adequacy

The criterion of adequacy is about the revenue-raising capacity of taxes—whether the tax can yield a significant amount of revenue at reasonable tax rates. In general, broad-based taxes rank high on this criterion. These include income taxes, consumption taxes (VAT in foreign countries; sales tax in the United States), and property taxes. In contrast, narrow-based taxes score low on adequacy.

Adequacy can be examined on two dimensions. One is tax elasticity:

or how well revenue from a tax keeps up with changes in the tax base. At unit elasticity (E = 1), revenue growth corresponds perfectly with the base increase. For inelastic taxes (E < 1) like the property tax, revenue growth falls behind the increase of the base. For elastic taxes (E > 1) like income and sales taxes, revenue growth from the tax is higher than increases of the base. Apparently elected officials may typically desire elastic taxes as the major revenue sources for their jurisdiction because these taxes easily keep up with inflation and revenue growth will meet budget needs without (or with less) the trouble of adjusting the taxes or their rate structure.

The other dimension of revenue adequacy is its stability—whether the revenue stream and growth from a tax remain relatively stable (not too volatile) across the boom-bust cycles of the economy. Tax bases (income, consumption, even property value) usually expand during the expansion phase and shrink during the contraction phase of the economic cycle, yielding more revenue in boom years and less in bust years at the same tax rate. Thus, governments tend to collect more taxes than budgeted in booms and less than budgeted in busts. Drawing a time trend of the revenue variables, we can build a volatility ratio:

It is positive in boom years and negative in bust years. The more elastic a tax is, the more extreme this ratio will be. The more a government's taxes are elastic, the more volatile its revenue stream will be. Thus arises a trade-off between tax elasticity and revenue stability. Overall, governments desire a relatively elastic tax that grows with the base, but they have learned to diversify their revenue sources so as to have a mixture of elastic and inelastic taxes. The former yields more revenue in booms and the latter yields more in busts.

Feasibility

The criterion of feasibility refers to the ease with which a tax (system) is accepted by taxpayers and collected by governments. It also has two dimensions. Administrative feasibility relates to how easy it is to collect the tax. This dimension looks into the administrative costs—how much effort it takes the government to collect the tax—and the compliance costs—how much effort it takes for taxpayers to comply with the tax. The second dimension is political feasibility—how likely citizens are to tolerate and accept this tax (system). It is reasonable to believe that polarized extreme scenarios are rare: cases where all taxes are blindly accepted or there is no tax (or increase). In most scenarios, a majority of citizens apply a standard of reasonableness in assessing the value they receive for the tax(es) imposed and pending.

In history, the psychological threshold of top tax rates rose with increasing income levels, living standards, and prevailing intellectual belief. In the second half of the nineteenth century, total taxation of 10 to 12 percent of GDP was thought to be excessive; until the 1940s, economists took 25 percent of GDP as the limit on government size (Clark, 1964). These presumed caps were later wiped out without much effort. However, more recently, the European-style welfare state with top marginal rates above or close to 50 percent has caused huge disincentives to economic growth. At the individual level, there is evidence that the visibility of a tax erodes its popularity, whereas tax exportability, the perception that it is paid by those outside the jurisdiction, tends to increase the popularity of a tax.

Transparency

Transparency cultivates the certainty of a tax system that works to maintain and improve efficiency. Uncertainty, it is often said, is the biggest enemy of economic efficiency. Transparency builds citizen trust of government and the system that is the basis of equity: citizens will not perceive equity, however fair the system is, if the system is opaque. Transparency is also the platform for tax feasibility. However, there have been too many ramifications in tax systems that dampen transparency, thereby damaging the whole system, under the camouflage of equity or efficiency in democratic politics. For example, politicians seek the votes of politically active seniors by promising generous benefits (welfare or tax cuts), but the elderly do not necessarily understand the true cost of the program. A political party in power may advocate an economic program that seems beneficial to the whole country for now, but the long-term impact may be damaging. Expert advice may also go muddy or astray when its long-term impact is not clear. The public does not have the capability to understand, let alone assess it. When these types of information asymmetry become rampant, the public loses confidence in the tax system.

Declining Progressivity

There has been a rich and fast-growing literature on efficiency. Piketty and Saez (2007) estimated US federal tax rates by income groups from 1960 to the early 2000s and found a dramatic decline in progressivity of the federal tax system over that period, due more to lower corporate taxes and estate or pngt taxes than cuts in marginal individual income tax rates, reflecting a change of the revenue system rather than the rates of a single tax. They noted a similar pattern of change in the British revenue system. Over the same period, change in the French tax system was toward more progressivity than in the 1970s.

The Tax Reform Act of 1986 was a major cut into top marginal rates. Since the end of the Great Recession, calls for another round of reforms have been building up momentum. One of the advocates, Feldstein (2011, October), calls the 1986 reform “a powerful pro-growth force for the American economy” and argues that two lessons are important from that reform. On the political front, even politicians holding very different ideologies may agree on a reform with tax rate reduction. On the technical front, taxable income is sensitive to marginal tax rates. Feldstein concludes from a review of empirical evidence that marginal rate reductions induced taxpayer responses that offset a large proportion of the revenue loss due to the rate cut. He calculates that broadening the tax base raised an extra 10 percent of revenue from the personal income tax and that combining this increase with a 10 percent across-the-board cut in all marginal rates may raise an extra 4 percent of existing tax revenue.²

Proportional Tax Scheme

To extend the proposition of lowering the rate and broadening the base further would be an extreme case of the proportional tax scheme. Different from the progressive or regressive schemes, the proportional scheme holds the effective tax rate to be constant across all income levels, basically a flat rate. The flat tax, popularized by Robert Hall and Alvin Rabushka (1985), builds on a 19 percent flat rate. Its major features are that (1) individuals pay a flat tax only on labor income, not capital gains; (2) businesses pay a flat-rate VAT on sales (after deducting input on material purchases and worker wages) to replace current corporate income tax; and (3) all popular exemptions and deductions are eliminated, including employer health insurance, charitable contributions, and home mortgage interests. The plan adds that a twenty-five thousand dollar deduction can be made per household to introduce some progressivity as an appeal to public support.

Many scholars and practitioners have commented on this plan since its publication. The core advantage of this flat rate plan lies in its simplicity, which brings extraordinary benefits in the form of efficiency gains from the broadest definition of income and thereby improves taxpayer compliance. The low rate makes it less worthwhile for taxpayers to change their behavior, and the simple scheme makes it harder for taxpayers to evade the tax. The key problem of this plan stems from its lack of progressivity. The household deduction can turn the tax progressive for low- and middle-income families, but that amount is a decreasing ratio for high-income families as their income bracket increases, making this tax flat. In this sense, a flat tax will be huge windfall for the rich. Drastic decline in progressivity (vertical equity) will be a very hard sell to a majority of the voters. Some scholars also raised concerns with difficulties in transitioning into the flat rate scheme with elimination of popular deductions. Property tax scholars worry that abolishing the mortgage interest subsidy to home owners may cause a drastic drop in home values, even home ownership. Health economists fear that eliminating the employer health insurance deduction may disrupt the health insurance market. Gruber (2011) estimated that as many as 20 million people may lose their health insurance as a consequence.

2001 Russian Flat Tax Reform

Russia changed its personal income tax in 2001, switching from its previous progressive tax scheme to a 13 percent flat tax; so far it is the only large economy that has adopted a proportional tax. While the marginal rates for high-income earners were drastically cut from the 30 percent range, government real tax revenue increased after the reform by 25 percent, which confirms the proposition that a simpler, probably “fairer” tax system induces better compliance and more active participation in the labor market, a combination that might spur productivity.

A group of international scholars studied the Russian reform (Gorodnichenko, Martinez-Vazquez, & Peter, 2009) using the 1998 and 2000–2004 rounds of a panel survey of detailed household income sources and consumption to calculate the gap between household expenditures and reported earnings as a proxy for tax evasion and to control for constant unobservable household and local characteristics in estimations to examine the effects before and after the reform. In this manner they were able to identify and estimate the real effects of the flat rate tax on income, tax evasion, and consumptions at the household level. The study found that tax evasion decreased under the flat tax (underreporting of income was previously widespread), especially for households in the highest tax brackets before the reform. The study concludes, however, that the reform did not substantially increase taxpayer real income: the increase of consumption net of the reform windfall was less than 4 percent for taxpayers with tax rate cuts, which suggests that the “efficiency gains from the reform are at least 30 percent smaller” than the gains implied by conventional approaches.

Most recently, Diamond and Saez (2011) made the case against the call for proportional tax schemes and for tax progressivity based on recent results in optimal tax theory. They advocate three policy recommendations from basic research they believe meet the evaluation criteria for revenue systems: the marginal tax rates for top income earners should be “high and rising,” earnings subsidies (e.g., the earned-income tax credit) should be available to encourage low-income earners to join the workforce (the subsidies will phase out at high implicit marginal tax rates), and capital income should be taxed.

2005 Panel on Tax Reform

As part of the ongoing momentum for tax reform, the 2005 President's Advisory Panel on Federal Tax Reform was entrusted with the task of recommending a plan that would make the tax code “simpler, fairer, and more conducive to economic growth.” The panel proposed several fundamental changes to the structure of the tax code, which generally are “to define income broadly, flatten tax rates, simplify the tax code, and reduce capital taxes.” On home mortgage interest payments, the plan is to replace the complete deduction with a flat 15 percent credit for all taxpayers up to the mean home price in the area. As a compromise between extreme versions, it grants some help for low- and medium-income families but eliminates subsidies on rich households. On charitable giving, the plan allows a deduction for those who donate more than 1 percent of their income. It is worth noting that charitable donations are the financial lifeblood for nonprofit organizations to provide services not usually in the range of government; loopholes do exist. Steuerle (2011) provides some specific, readily implementable measures to Congress. On health insurance, the plan proposes to limit tax exclusion of premiums to below the national average level, which avoids subsidizing highly generous plans. The proposal abolishes deduction of state and local tax payments and reduces tax brackets from the current six to three or four. Overall, these recommendations were theoretically correct and won bipartisan support. Still, the plan quickly got criticisms, according to a New York Times report (cited in Gruber, 2011), for “going too far” by those opposed to reducing capital taxation on equity grounds and for “not going far enough” by those in favor of a pure consumption tax.

Tax Collection Technology and Costs

The core issue in the administrative and technical feasibility of taxation is collection cost. Slemrod (1990) points out that the coercive nature of taxation necessarily leads to high costs in operating any tax system, with large variation across countries depending on the technologies in use. Collection technology advances with socioeconomic progress: the expansion of the market sector alongside the relative decline of the rural sector, employment concentration in large establishments, and the growing literacy and numeracy of the population matter a lot. Therefore, collection costs were typically high in early stages of the modern state and declined over time. These costs are now high in developing countries due to low capacity and low technology.

For many years after its adoption, the personal income tax remained an “elite” tax, collectible only from those with high income. The introduction of withholding dramatically reduced the collection cost, by which each employer by law “works for the government” by withholding from each paycheck an amount calculated from the tax schedule.³ Application of this technology turned the personal income tax into a mass tax and the major revenue source of central governments. In a similar fashion, retailer withholding is also the technology that makes possible state and local sales taxes in the United States.

Improving Compliance

Tax evasion, or noncompliance, is widespread because taxpayers, especially those facing steep marginal rates, have an incentive to exploit all means in order to reduce their tax liability. In the United States, the lost revenue (defined as the gap between tax liability and tax collection) rose each year from 1973 until the 1986 reform. The Internal Revenue Service (IRS) estimated the loss was over 20 percent of liability in the worst year. This revenue gap remains high in recent years (around 16 percent). A 2011 IRS estimate placed the tax gap at $280 billion, 16.3 percent of tax revenue. Thus, any revenue system must build its own enforcement mechanisms as support.

The value-added tax was the “most significant development in tax policy and administration in the second half of the 20th century” (Keen & Lockwood, 2010) and the major recent innovation in tax technology. Its design of built-in incentive for taxpayers at each stage to monitor their immediate upstream and downstream stage of production provides self-enforcement of the tax, which is why despite its double-digit rate (average 17 percent), the VAT quickly spread from the 1960s to over 130 countries by 2010. Among the adopters are not only members of the European Union but also transitional and developing countries in the 1990s. Interestingly, many developing countries took the adoption of VAT as the centerpiece of their tax reform, the means to modernize the structure of their national tax administration and develop and improve the methods of self-assessment. Despite high initial costs, these efforts did help ease administration and compliance in those countries. By 2010, VAT raised on average over 20 percent of tax revenue in these countries (Keen & Lockwood, 2010).

A case of Internet technology helping tax administration is the local property tax. The lack of regular reassessment has been the Achilles' heel of this tax. The declining cost of database systems has increased their use, and the Internet has improved the means for information collection, sharing, and transparency, resulting in shorter reassessment cycles and increased accuracy.

The Case of Developing Countries

The case of developing countries, and the transitional countries also to some extent, is worth attention. These countries lag behind advanced economies in the development of economy, society, and democracy. As a consequence, they often face a dire situation where their tax tools are very limited, with restricted coverage. The administrative capacity of their government is low, without enough professional bureaucrats skilled in financial administration; their technology of tax collection is therefore low, incurring high costs. Furthermore, many of these countries are not rich in natural resources that many others can claim and the royalties from which can often provide some buffer (Burgess & Stern, 1993). Therefore, it is not unusual that these countries encounter extreme difficulty with their revenue administration.

Improving Efficiency and Equity

The formula for efficiency sounds simple: lower the rates and broaden the bases to make the tax code simpler. By an IRS estimate, it takes an average American taxpayer thirteen to fourteen hours to complete Form 1040. This is based on the assumption that most of this person's income is from wages, with no complicated investments or itemized deductions.⁴ Lower rates and broader bases also serve to improve tax compliance (reduce tax evasion) among taxpayers of all income levels.⁵ Fundamental tax reforms can achieve the goal of efficiency by increasing simplicity, and thereby compliance. The US 1986 tax reform was a major move toward this goal; however, its achievement has been largely eroded by subsequent accumulation of changes to the tax code. Such improvement-to-erosion cycles of revenue system efficiency are common in all countries. A political economy explanation goes that concentrated, well-organized interest groups always win over the rest of society, who face diffused loss and thereby cannot easily organize, by influencing politicians for policy changes that complicate the tax code. An example is tax shelters that grant favorable tax treatment by various means to certain groups or for certain activities.

Of course, any tax reform may create transitional inequities that arise because the reform changes the treatment of similar taxpayers who, for different decisions they made in the past, are differentially treated by the reform. Thus, any tax reform inevitably creates winners and losers. One measure to mitigate such inequities, suggested by Feldstein (1976), is to introduce reforms only infrequently and slowly phase in the changes. Another measure is to include a grandfathering article in the reform to allow those who made decisions under the old tax rules to continue benefiting from those rules (Gruber, 2011). Though such an article creates new inequity and inefficiency (rich households often benefit from this article), it may help win support in order to implement the tax reform.

Improving equity remains among the propositions for enhancing revenue systems, as it has long been the case in the process of industrialization and in decades of high economic growth, and thereby high revenue growth for government. However, in the past several decades, especially since the Great Recession, the call for efficiency seems to have dominated reform proposals, and considerations of correcting “disincentives” for the workforce have outweighed other aspects. In such scenarios, moves toward lower rates and broader bases look appear to move away from the old definition of the welfare state, where equity is to be understood as equal access to opportunities for social mobility rather than equality.

Globalization adds another dimension to tax design. The mobility of economic activities long ago caught the attention of economists. Diamond and Mirrlees (1971) noted that governments of small, open economies would incur high costs with tax on capital investment. Gordon and Hines (2002) predict that economic activity in the twenty-first century would assume much greater cross-country mobility and tax bases would become much more responsive to rate increases. Hines and Summers (2009) examined the impact of globalization on tax system design and found evidence that each 10 percent smaller population leads to a 1 percent lower ratio of personal and corporate income tax collections in a country's total tax revenues; thus small countries will have to rely on consumption-type taxes much more heavily than large countries do. They predict that accelerating globalization may push all countries toward expenditure taxes, which challenges concerns about progressive distribution of tax burdens.

Improving Adequacy and Stability

All the major central and local taxes (personal income, value added, sales, and property) are adequate revenue sources; improving technology has made them especially so. Revenue gaps remain large, though, and evasion is still prevalent. Thus, efforts should fall squarely on preventing evasion. In terms of improving stability, fluctuations are inherent in the macroeconomy. It is natural that with the expansion and contraction cycles of the economy, tax bases enlarge and shrink in boom and bust years, respectively. Therefore, government revenue faces inevitable cyclical instability that goes against the demand for basic public services, which tends to be higher in bust years when household incomes are lower. Thus, a gap emerges between cyclically low revenue on the government side and high demand for key services. This gap cries for proper handling, and the recent Great Recession sounded a shocking alarm that the problem is not well solved. Of the three measures we discuss next, the first has been studied a lot; the second and third are yet to be more thoroughly investigated.

Improving Transparency

Transparency is inherent in and closely related to the performance of revenue systems. Tax and budget reforms include efforts to improve it. Fiscal institutions also work in this direction. For example, budgetary principles like comprehensiveness, prior authorization, specification, accuracy, and publicity are means for transparency; balanced budget requirements, limits on general obligation debt, and tax and expenditure limitations are in a sense mandates for transparency. But transparency remains an issue demanding attention because any reforms necessarily bring unintended consequences that complicate the system, and fiscal institutions may also add complexity to tax administration, which is part of the reason that public officials devise and employ policy innovations to facilitate operation of revenue systems that often add further opaqueness.

A more profound problem is incomplete and asymmetric information. Complete, real-time information is not always available for policymakers or experts, so decisions are often suboptimal; the general public does not possess the technical knowledge to understand the details of tax administration. Furthermore, politicians often highlight only part of the full story when campaigning for programs without disclosing the full impact or long-term effects. Thus, it may be difficult to interpret the fiscal position of a government even in a normal year. A lot of work remains to be done to improve transparency.