Thursday, November 7, 2013

7/11/2013: Taxation and Human Capital: Blundel's Thoughts


A recent paper from Richard Blundel, titled “Taxation of Earnings: the impact on labor supply and human capital” (Becker Friedman Institute, 27th September 2013 available at: http://bfi.uchicago.edu/sites/default/files/research/Blundell_BFI%20_September_27_2013.pdf) argues that the tax system can be reformed “to generate the levels of revenue required to fund public goods while reducing the overall level of distortions implicit in the system”.

“The discussion in this paper draws on the work in the [Mirrlees Review (2011)] and concerns the taxation of labour earnings as well as relevant aspects of the welfare benefit and tax credit systems.” The core focus here is “on the empirical foundations for tax reform” in favour of “placing the analysis of earnings taxation in a lifetime setting, recognising the importance of human capital investments.”

Summary

Per Blundel, earnings taxation:
1) Raises revenue for public goods
2) Acts as the main source for funding redistribution of “resources from richer to poorer households”
3) “… From a more dynamic perspective, it ‘insures’ individuals and families against adverse events such as job loss and disability.

“Not surprisingly, it occupies a special place in debates about levels and structure of taxation.”

Several other important aspects that Blundel fails to consider are:
- Earnings taxation represents an opportunity cost of public goods provision in terms of reduced availability of funding for investment in enterprise creation and entrepreneurship; and
- Earnings taxation levies a charge on that part of personal income that is linked directly to individual effort and investments in human capital.

“One central question in the policy debate on earnings tax reform is whether, and to what degree, ‘supply side’ reforms can be used to relieve the pressure from ageing populations.” Thus, the question is: “How best to increase employment and earnings over the working life?” Per Blundel, evidence suggests that “the key to using tax policy for improving the trends in employment, hours and earnings in the longer-run will be to focus on”:
1) labor market entry (“Enhancing the flow into work for those leaving education and for returning mothers after childbirth”)
2) retirement (“maintaining work among those in their late 50s and 60s”) and
3) human capital (“Understanding the implicit incentives (or disincentives) created in the tax and welfare system or human capital investments .... Encouraging human capital improves the pay-off to work and ensures earnings grow, and hold up longer, throughout the working life.”)

Tax reforms accounting for human behavior 

Key here is that “Reform of the tax system as it impacts on labor supply and human capital is not simply about increasing life-time earnings”. In addition to levels of earnings consideration, we must also account for “many other aspects of human welfare, including the utility from consuming goods, from home production, from reducing risks, etc.”

Thus, taxes on earnings “should be seen as part of the whole ‘tax system’. In terms of an overall reform package, it is important to view corporate and personal taxation together as there are many aspects where they overlap: not every tax needs to be progressive for the tax system to be progressive; not every tax needs to be ‘green’ for the tax system to provide the right incentives for environmental protection.” In other words, “we still need to be aware of the interactions with capital, savings and environmental taxes.”

All of the above suggests that the Irish Government approach to tax policy, based on the explicitly defined premise that no matter what, the corporate tax system rests outside the scope of any tax reforms consideration, is not and cannot ever be a good practice.

Complexity avoidance is real

Another major point raised by Blundel is that “In most developed economies, the schedule of tax rates on earned income is rather complex. This may not always be apparent from the income tax schedule itself, but note that what really matters is the total amount of earnings taken in tax and withdrawn benefits—the effective tax rate. The schedule of effective tax rates is made complicated by the many interactions between income taxes, earnings-related social security contributions by employers, welfare benefits, and tax credits.” In other words, Blundel clearly states that total burden – whether via direct or indirect taxes – matters. This is something that the Irish Government simply refuses to recognize.

However, in criticism of Blundel, I would also add that it is too simplistic to look at the effective macro-level (economy-wide or average/media) level of taxation. We have to recognize that many benefits paid out in the economy do not apply or are not available to all participants in the economy. Thus, for example, famers transfers are not available to non-farmers, youth support schemes relating to training and education are not available to older adults, unemployment benefits are not accessible to entrepreneurs and so on.

Taxes and labour supply

“At a very high level, some of the main points that emerge from this evidence are that substitution effects are generally larger than income effects: taxes reduce labour supply. Especially for low earners, responses are larger at the extensive margin—employment—than at the intensive margin—hours of work. Responses at both the intensive and extensive margins (and both substitution effects and income effects) are largest for women with school-age children and for those aged over 55.”


There is much, much more to read in Blundel’s insights, so do not even for a second think the above summary is a substitute to reading the whole paper.

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