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ARE TAX CUTS
SELF-FINANCING?
Presentation at the CEPOS conference on
”Tax Cuts, Employment and Growth”
June 12, 2006
by
Professor Peter Birch Sørensen
University of Copenhagen, EPRU and CESifo
Chairman of the Danish Economic Council
THE LAFFER CURVE
Tax
revenue
0%
100%
Tax rate
DID LAFFER INVENT THE LAFFER CURVE?
● Ibn Khaldun, a 14th century Muslim philosopher, wrote
in his work The Muqaddimah: ”It should be known that at
the beginning of the dynasty, taxation yields a large
revenue from small assessments. At the end of the
dynasty, taxation yields a small revenue from large
assessments.”
● John Maynard Keynes, Collected Writings: ”Nor should
the argument seem strange that taxation may be so high
as to defeat its object, and that, given sufficient time to
gather the fruits, a reduction of taxation will run a better
chance than an increase of balancing the budget.”
THE WELFARE GAIN FROM
HIGHER EMPLOYMENT
1. Gain: Increase in output ≈ pre-tax wage rate: W
2. Loss: Welfare cost of additional work ≈ after-tax
wage rate: W(1-t)
3. Net gain to society = 1.– 2.=
marginal tax rate ● pre-tax wage rate = tW
TAX REVENUE AND WELFARE
Suppose that a tax cut increases total labour supply
by the amount ΔL. Then:
Net welfare gain = tW● ΔL = increase in tax revenue
= ”dynamic effect”
Insight: The ”dynamic effect” on tax revenue is an
indicator of the welfare gain from the tax cut. If we
want to maximize the gain in economic welfare, we
should cut taxes where the expected dynamic effect
(the degree of self-financing) is the greatest.
THE DYNAMIC EFFECT
The degree of self-financing (D):
 t 
D   

 1 t 
ε = elasticity of tax base, t = tax rate. Assume ε = 0.2
Example 1: Initial tax rate t = 50% → D = 20%
Example 2: Initial tax rate t = 75% → D = 60%
Insight: D is higher, the higher the initial tax rate
Intuition: In Example 1 a 10 percentage point cut in the tax rate increases
after-tax income by 20%; in Example 2 a similar tax cut increases after-tax
income by 40%
WHO SHOULD GET THE TAX CUTS?
THE CONCLUSION SO FAR
If we care about economic efficiency rather than
equity, it seems that we should start by cutting
the highest tax rates (from the top of the income
distribution)
but
things are not that simple
TWO DIMENSIONS OF LABOUR SUPPLY
Hours worked (”effort”) are influenced by the
marginal tax rate
Labour force participation is influenced by
the (sum of the) average tax rate on labour
income and the replacement rate (net benefits
relative to wages)
Evidence from the US and the UK:
Participation is more sensitive to economic
incentives than hours worked
A TWO-CLASS ECONOMY: AN EXAMPLE
Hypothetical tax schedule: 30% tax rate on the first 100 units of
income, 50% tax rate on all income above 100
High-income earner
1. Pre-tax labour income
2. After-tax labour income
3. Potential transfer income in case of non-employment
4. Incentive to work = 2. – 3.
200
120
40
80
Low-income earner
1. Pre-tax labour income
2. After-tax labour income
3. Potential transfer income in case of non-employment
4. Incentive to work = 2. – 3.
100
70
40
30
THE EFFECTS OF TAX REFORM ON WORK INCENTIVES
Reform 1: Switch to flat 30% tax
Revenue cost = 20% of 100 = 20
No increase in work incentive for low-income earner
Work incentive of high-income earner increases from 80 to 100 = 25%
Reform 2: In-work benefit = 20% of earnings with cap at
20 and gradual phase-out at earnings between 100 and 200
Revenue cost = 20% of 100 = 20 (note: no benefit to high-income earner)
No increase in work incentive for high-income earner
Work incentive of low-income earner increases from 30 to 50 = 67%
Insight: When labour force participation is sensitive to taxation but hours
worked are not, it is more efficient to concentrate tax cuts at the bottom
of the income distribution
TAX CUTS: DEGREES OF SELF-FINANCING
Type of
tax cut
% change in
progressivity
Degree of
self-financing (%)
Increase in Earned
Income Tax Credit
(beskæftigelsesfradrag)
4.6
50.1
Cut in payroll tax
(arbejdsmarkedsbidrag)
-1.1
54.1
Cut in medium tax rate
(mellemskat)
-10.1
46.4
Cut in top tax rate
(topskat)
-10.7
45.3
Note: All tax cuts are designed to have the same effect on long-run fiscal sustainability. The estimates do not include effects on educational effort and migration
Source: Danish Economic Council, The Danish Economy, Fall 2004.
CAVEATS
The degree of self-financing varies across population groups;
Laffer-effects may occur for some groups and some types of
tax cut
So could tax cuts be self-financing after all?
Mind the words of John Maynard Keynes: ”Nor should the
argument seem strange that taxation may be so high as to
defeat its object, and that, given sufficient time to gather the
fruits, a reduction of taxation will run a better chance than an
increase of balancing the budget.”
Morale: Timing is essential. Don’t cut taxes in expectation of
Laffer effects when the economy works at full capacity.
DYNAMIC EFFECTS:
AN ALTERNATIVE PERSPECTIVE
While tax cuts are generally not self-financing, the introduction
of mandatory individual savings accounts to finance a part of
social transfers is likely to be self-financing
Motivation for introducing individual accounts:
● 74% of the taxes levied to finance Danish social transfers are
paid back to the taxpayer himself over the life cycle
● Many social transfers imply little redistribution of lifetime
income from rich to poor
The redistribution index for Danish transfer programs
Annual
Income
Lifetime
Income
Percentage share
of total spending on
social transfers (2004)
Social assistance
0.70
0.47
6.2
Housing benefits
0.35
0.39
4.4
Disability benefits
0.14
0.39
13.8
Supplementary retirement benefits
0.37
0.19
n.a.
Sickness benefits
0.19
0.18
8.3
Unemployment benefits
0.09
0.11
9.7
Child benefits
0.13
0.10
8.0
Education benefits
0.68
0.04
5.3
Early retirement benefits
0.00
0.04
10.8
Parental leave benefits
0.22
0.02
0.1
Basic retirement benefit
0.22
0.00
28.1*
Transfer
program
* Sum of basic and supplementary retirement benefits. Source: Danish Economic Council.
A DESIGN FOR SOCIAL INSURANCE BASED
ON INDIVIDUAL SAVINGS ACCOUNTS
• For each taxpayer an individual account (IA) is
established
• A mandatory social security contribution is
credited to the IA; the contribution replaces part
of the taxpayer’s labour income tax
• Receipts of certain social transfers are debited
to the IA
• Interest is added to or subtracted from the
balance on the IA
• Any surplus on the IA at the date of retirement is
converted into an annuity which is added to the
public pension. Persons with a negative IA
balance receive the public pension
Properties of the IA system
Insurance properties
● Liquidity insurance
● Lifetime income insurance
Incentive properties
● Reduced marginal tax rate
● Reduced replacement rate
(selective tax and benefit cut for those with
positive IA balances at retirement)
An IA system for Denmark (DEC proposal)
Transfer programs included in IA system:
● Short-term unemployment benefits
● Early retirement benefits
● Education benefits in higher education
● Sickness benefits (up to a limited number of
sickness days)
● Child benefits
● Parental leave benefits
The payroll tax is cut by 7.9 percentage points and
replaced by a mandatory contribution to the IA
The DEC proposal: Average payments to and from the individual accounts and account
balances at the time of retirement across lifetime income deciles1
D1 D2
D3
D4
D5
D6
Lifetime income (index)
62
79
86
92
97
102 107 113 121 141
100
Accumulated payment into account in percent
of accumulated withdrawal from account
34
56
72
84
97
109 123 141 161 210
100
After-tax account balance at retirement2 in percent 0.1 0.4
of accumulated lifetime disposable income3
0.7
0.9
1.2
1.4
3.3
1.6
7.2 17.1 27.7 36.3 43.0 51.2 57.2 65.8 71.0 79.7
45.6
Percent of adult population with positive
account balance
D7
1.8
D8
2.2
1. The estimates assume a zero growth-adjusted real interest rate and unchanged behaviour.
2. Average account balance across the entire sample population, where negative account balances have been set to zero.
3. Accumulated income up until the official retirement age of 65; average across the entire sample population
Source: Danish Economic Council, The Danish Economy, Spring 2005.
D9 D10 Average
2.5
Effects of the IA system on income
distribution: Summary statistics
Gini coefficients
● Lifetime factor income: 0.253
● Lifetime disposable income, current system: 0.127
● Lifetime disposable income, DEC proposal: 0.133
Redistribution of lifetime income
Current system: (0.253 – 0.127)/0.253 = 49.8 %
DEC proposal: (0.253 – 0.133)/0.253 = 47.4 %
EFFECT ON THE PUBLIC BUDGET
Even with moderate labour supply elasticities, the DEC
proposal improves the public budget. The reason is that
the proposal involves
● a cut in the marginal labour income tax rate
combined with
● a cut in the replacement rate in the transfer programs
included in the scheme
Note: Effectively the replacement rate is cut by 100 percent,
but the cut is felt at a stage in the life cycle where the
taxpayer can more easily afford it.
CONCLUSIONS
● Mandatory saving accounts for (part of) social
insurance can offer liquidity insurance and
lifetime income insurance in a more efficient
manner than the current tax-transfer system
● An IA system is likely to be self-financing. It
therefore has the potential to generate a welfare
gain for the majority of the population without
making anybody worse off and without
significantly increasing the inequality of lifetime
income distribution