Questions 2-5

Fundamental Trade-Off:

Balancing increasing tax rates with income due to decreasing marginal utility and declining social weights. Considering decreasing tax rates with income due to declining marginal revenue and elasticity of taxable income.

Arguments in Favor of Income Shifting:

Believed to encourage investment without losing overall investment. Allows for differential taxation of immobile domestic firms and highly mobile MNEs.

Consideration for Heads of Households

Bracket Widths: More generous for low-income heads of households. Marriage Tax/Dowry: Presence depends on income and gap.

Definition of MNE

Business entity, often the parent company, with foreign affiliates (subsidiaries) at least 10% owned, typically wholly owned.

Model of Taxes Based on Taxable Income

Focus: Taxable income of taxpayers, considering exemptions, deductions, and standard deductions. Relevant Periods: - 1913-1948: Introduction of income tax with individual filing required. - 2017: TCJA increased standard deduction for joint filers.

Historical Reluctance to Curtail Income Shifting:

Influenced by perceived benefits of attracting and retaining MNE investment. Governments cautious about measures discouraging foreign investment.

Characteristics of MNEs vs. Domestic Firms

Larger size, higher profitability, global footprint, more economic rents, and emphasis on intangible assets.

Digital Services Taxes

Introduced by 20+ countries, indirect taxes targeting advertising or gross sales for large companies.

. Taxation of Leisure:

Leisure cannot be directly taxed. Proposed solution involves taxing complementary goods to leisure at a higher rate.

Main Strategies for Income Shifting:

Loans (earnings stripping) - A firm in a high-tax jurisdiction borrows money from a related firm in a low-tax jurisdiction. Limited by interest deduction limits Transfer pricing - MNEs engage in inter-firm transactions and set prices for assets, inputs, services, or products that cross borders Transfer of intangible assets (intellectual property) to low-tax jurisdictions. - Transfer intangible assets like licenses, patents, and copyrights to subsidiaries in low-tax jurisdictions

Efficiency consideration

Lower tax rates are proposed on goods consumer disproportionately by the poort and those who tend to consume highly taxed goods

Objective of Optimal Taxation Theory:

Maximizing social welfare is the primary goal. Designing a tax structure that achieves efficiency, equity, and meets fixed revenue requirements.

Anti-tax avoidance provisions

Measures preventing MNEs from shifting income to low-tax jurisdictions to reduce tax liability

Efficiency and Behavioral Responses:

Modeling responses to taxation to minimize its burden. Addressing efficiency concerns in designing tax structures.

Advantages of General Equilibrium:

More complex analysis. Models all market interactions explicitly. Key role in tax incidence analysis, uncovering unexpected effects.

MNE Income Characteristics

More economic rents, substantial profits beyond operational costs, and less risk-free returns.

1969 Reform and Outcome

Objective: Address perceived unfairness for single taxpayers. Outcome: More generous treatment for singles, continued joint filing.

. Results and Variables:

One exogenous variable (TK1 - corporate income tax on all-equity financed capital). Sixteen endogenous variables. Fifteen independent equations with no endogenous tax variable due to lump-sum rebates.

Ramsey Rule:

Optimal commodity tax rates should exhibit zero cross-price elasticities. Ramsey Inverse Elasticity Rule suggests that tax rates should be inversely related to compensated demand elasticities.

. Types of Studies - Extent of Market Adjustments:

Partial Equilibrium: Examines effects in one market, assuming effects in others are small. General Equilibrium: Considers effects in all markets, models all interactions explicitly.

Mankiw-Weinzierl-Yagan (2009):

Prefers lognormal distribution and notes higher Elasticity of Taxable Income (ETI) at higher incomes. Argues that the optimal tax structure is still approximately linear

Nature of International Tax Competition:

Primarily observed in statutory rates, creating a race to attract mobile firms. Downward pressure on CIT rates intensifies with concerns about international income shifting.

Distortion of Housing Consumption Decisions

Property tax is a distortionary tax on all capital owners Property Tax Effects: Profits tax effect (progressive) and excise tax effects. Tiebout-Hamilton Features: Model aligns with capital tax view. Long-Run Result: Capital tax view is a long-run impact on capital allocation.

OECD/G20 Reform - Pillar 1

Proposes a 25% tax on residual profit exceeding 10% of revenues, aiming for a coordinated global approach.

Tax Burden vs. Benefits for Firms:

Research (Testa and Matoon, 2007) suggests taxes paid by businesses exceed benefits received. Governments respond with incentives like tax exemptions or lower rates to attract and retain mobile capital.

Optimal Commodity Taxation - Policy Implications:

Results may be unclear due to conflicting efficiency and equity considerations. Efficiency results suggest relatively high taxes on goods and services that are necessities• Equity results suggest relatively high taxes on luxury goods and services Uniform tax system might not be far from optimal.

GILTI Tax Introduction

foreign source income in excess of return of 10% of qualified tangible investment assets held abroad

Optimal Taxation Literature:

Assumes a small economy with no influence on world prices. In this scenario, optimal capital income tax is considered zero, impacting local wages, land rents, or non-tradable goods.

Horizontal Equity with Respect to the Individual

Definition: Similar individuals should pay the same tax, regardless of marital status. Goal: Combined tax burden should be independent of the decision to marry.

Subsequent Reforms (1981 ERTA, 1986 TRA, TCJA 2017)

1981 ERTA: Introduced "secondary earner deduction." 1986 TRA: Comprehensive reform, reduced marriage taxes. TCJA 2017: Doubled standard deduction, widened brackets for couples.

Partial Factor Tax on Perfectly Mobile Factor:

A partial factor tax on a perfectly mobile factor fixed in total supply is largely borne by the taxed factor. Reallocation of capital depresses the return to capital, influencing overall tax incidence.

Model 2 - Application of Atkinson-Stiglitz Result:

AS Model with two commodities (current and future consumption). Proposes that, with an appropriate non-linear income tax, consumption goods should not be taxed. Advocates for no income tax on capital income.

Uniform Tax Structure Not Optimal:

Achieving efficiency requires considering specific demand characteristics of each good. A uniform tax structure may not be optimal for efficiency reasons.

Social Welfare Function (SWF):

Aggregates individual utilities into a comprehensive societal measure. Utilitarian SWF assumes equal weight for all individuals, while more egalitarian and Rawlsian SWFs assign weights based on preferences regarding inequality.

Optimal Labor Income Taxation:

Aims to maximize a social welfare function with fixed revenue. Considers efficiency and equity concerns in setting tax rates The solution involves setting a tax rate schedule to equalize the socially-weighted ratio of marginal utility loss per dollar of marginal revenue across all individuals.

. Two Alternative General Equilibrium Approaches:

Analytical Approach: Limited markets for tractability, strictly accurate for small tax changes. Numerical Approach: Analyzes various effects, may face the "black box problem" in understanding changes.

Optimal Tax Structure in Mirrlees Model:

Approximately linear but exhibits an inverted U-shape. Implies higher tax rates for middle-income individuals with a low-income subsidy

Basic Model - Zodrow and Mieszkowski:

Assumes a small group of open economies. Capital is perfectly mobile, while labor is immobile. Governments seek to maximize resident welfare, leading to tax competition equilibrium with lower-than-optimal tax rates and public services lower than optimal

Optimal Capital Income Taxation - Model 1:

Assumes long-lived, far-sighted households using a life-cycle or infinite-horizon model. Suggests a significant distortion in future consumption choices due to capital income tax. Typically suggested to be zero to mitigate distortions in future consumption. Similar approach is recommended for labor income associated with human capital formation and saving for future consumption.

Production Efficiency Theorem:

Assumes perfect competition, no economic rents, and full sets of commodity taxes. Suggests all production input taxes should be zero for production efficiency. Implications: no corporate income taxes, and no non-residential property taxes

Hamilton-2 Model - Non-Homogeneous Suburbs

Assumptions: Model still has homogeneous demands for local publicservices, but heterogeneous housing Perfect Capitalization: Home values reflect future taxes vs. benefits. Efficiency: Achieves efficient equilibrium, property taxes act as head tax. Expensive homes sell at a discount, reflecting the fiscal differential in present value (PV) of all future taxes higher than the value of benefits received. Low-value homes sell at a premium, reflecting the PV of future fiscal differentials of taxes lower than the value of benefits received. just head tax, only now differences in tax payments, due to non-homogeneous community, capitalized into home prices

Tiebout Mode

Assumptions: Perfect mobility, information, large number of communities, income independence, local government effectiveness. Equal Cost Shares: Local public goods funded through equal cost shares (head taxes). Implications: Consumer mobility leads to communities offering optimal services. People sort into communities according to tastes forlocal public services

Base Erosion and Anti-Abuse Tax (BEAT)

BEAT is a tax provision aimed at preventing multinational companies from reducing their U.S. tax liability by shifting profits to low-tax jurisdictions. BEAT imposes an additional tax on certain deductible payments (like interest and royalties) made by a U.S. company to its foreign affiliates, particularly if these payments erode the U.S. tax base. Applied to larger MNEs, minimum tax rate at 10%, expanding income base, limiting interest deductions to 30% to prevent excessive interest deductions for income shifting.

Capital Ownership Distribution:

Capital ownership highly concentrated. Top 1% owns 54% ($19.2 trillion), while bottom 50% owns 0.6% ($0.021 trillion).

Solution and Interpretation:

Change in corporate income tax leads to changes in the interest rate. Factor substitution effect (FSE) is positive, indicating a decline in the interest rate. Output effect (OE) is ambiguous in sign. Interpretation depends on the direction of change in the interest rate.

CIT Revenues Cost of Income Shifting:

Clausing (2020) Estimated CIT revenue cost pre-TCJA was $89-141 billion. Provides a best estimate that CIT revenues lost represent approximately ⅓ of total CIT revenues Post-TCJA, CIT revenue cost decreased due to rate reduction from 35% to 21%.

International Tax Competition:

Concern for national governments and subnational entities like U.S. states. Fear of taxing capital income too heavily leading to the departure of mobile capital, affecting new investments and resulting in job loss and wage decline.

Potential Reform: Return to Individual Filing

Considerations: Impact on households, divorce rates. Trend: Declining interest, emphasis on reducing marriage taxes.

Imperfectly Competitive Markets:

Corporate tax may be shifted forward to consumers in imperfectly competitive markets. Economic rents tend to shift the burden to corporate shareholders, with different models assuming varying burdens on labor.

Tax Havens:

Countries with low or zero corporate tax, limited transparency, and no substantial activity requirement to be registered as a resident corporation. Approximately 50 tax havens, including "big seven" such as Bermuda, Cayman Islands, Ireland, Luxembourg, Netherlands, Singapore, and Switzerland.

Local Public Goods

Crucial Difference: Mobility of consumers/residents. Revealing Preferences: Residents express preferences by moving to jurisdictions offering preferred services.

GILTI Tax Provisions

Current taxation at 10.5%, 80% allowance for foreign tax credits, increasing to 13.125% by 2026.

Variable Domestic Capital Stock:

Decrease in interest rate leads to a decline in savings, investment, and domestic capital stock. Reduction in capital stock decreases labor productivity and wages, shifting tax burden from corporations to labor.

Concerns about Income Shifting:

Defined as manipulating profits across jurisdictions to minimize tax liability. International income shifting adds to downward pressure on CIT rates.

Fiscal Federalism

Definition: Balancing responsibilities between national and subnational governments. Ideal Goal: "Perfect correspondence" (Oates Decentralization Theorem). Variations in Local Preferences: Allows for local variations, transparency, accountability, and competition for efficient service provision.

Vertical Equity

Definition: Different income levels should have different tax burdens. Assumption: Requires a progressive marginal rate structure. Challenge: A proportional rate structure may reduce issues related to vertical equity, but with a proportional rate structure, remaining issues due to standard deduction- i.e., still have two rates (zero and flat rate).

Allocation of Resources

Definition: Efficiently allocating resources to achieve economic goals. Interjurisdictional Spillovers Correction: Grants, subsidies, matching grants, block grants, and revenue-sharing mechanisms.

Stabilization (Macroeconomic Policy)

Definition: Managing overall economic stability through macroeconomic policies. Challenges at State and Local Levels: Limited effectiveness due to mobility of people and resources across borders.

Income Redistribution (

Definition: Policies aimed at redistributing income in society. Mobility Challenges: High-income individuals may move away, while low-income individuals may move in.

Horizontal Equity with Respect to the Family

Definition: Similar families should pay similar taxes. Example: Couples with the same income should ideally pay the same tax. Marriage Neutrality: Tax burden should not disproportionately affect married couples.

Equilibrium Equations: Factor Markets:

Demand equations reflecting constant K/L ratio. Marginal product pricing equations for factors (K and L) under CRS and perfect competition. Supply equations reflecting fixed supplies of capital (K) and labor (L).

Equilibrium Equations: Product Market:

Demand equations with no income effects. Supply equations with constant returns to scale production function (CES function). Equilibrium equations for each sector (X1 and X2).

. Optimal Tax Rates:

Determined by the Ramsey Inverse Elasticity Rule. Higher taxes on goods with lower elasticities for efficiency.

Varied Opinions on Zero Capital Income Tax:

Diamond and Banks (2010) argue that zero capital income tax results are not a useful policy guide. Advocate for significant taxation despite the zero-tax suggestion in certain models.

Heterogeneity and Optimal Taxation:

Differences among individuals in income, wealth, ability, and preferences. Achieving efficiency and equity considering individual heterogeneity.

Types of Studies - Disposition of Revenues:

Differential incidence: Examines differential tax incidence, often involving tax substitution with fixed government spending. Balanced Budget Incidence: Examines tax increase financing an increase in government services.

AC per Capita for Local Public Services

Economies of Scale: Declining per capita costs at smaller populations. Optimal Community Size: AC may increase at sufficiently large populations, suggesting an optimal community size.

Criteria in Optimal Taxation (OT) Problems:

Efficiency: Minimizing distortions of individual behavior. Vertical Equity: Addressing optimal progressivity of income tax. Revenue Requirement: Meeting fixed revenue needs.

. Other Goals: Efficiency and Simplicity

Efficiency: Taxing secondary earners at a low rate due to their higher labor supply elasticity, especially concerning decisions related to labor force participation Joint Filing: Considerations for simplicity and benefit principle of equity.

TCJA Transition Provision

Encourages repatriation, spread lump sum taxes over 8 years, rates vary based on asset nature (15.5% on cash and liquid assets, 8% on real investments such as buildings, equipment, etc)

Hamilton-1 Model for Residential Property Tax

Follows Tiebout assumptions: Perfect mobility, full information. Utility-Maximizing Households: Seek community with desired services (G, H) and minimum taxes. Efficiency in Taxation: Property taxes with exclusionary zoning achieve Tiebout's vision. Solution to Hamilton-1 problem• Communities are homogeneous with respect to both demands for public services and housing. Property tax with exclusionary zoning becomes head taxfor services Can tHi >Gi ?• Wealthy homeowners (high housing demanders) haveno desire to stay in community where Hi >Havg becausesubsidize lower income homeowners• So move to homogeneous community where tHi =Gi • Can tHi <Gi ?• Lower-income households have obvious incentive tomove in, buy relatively cheap house, since Gi>tHi• Response: Zone out lower-income income housing -minimum lot size, minimum frontage, minimum squarefootage, minimum number of rooms, maximum numberof residents per household (Fischel, 2015)

Regulatory Responses:

GILTI, BEAT, and OECD's base erosion and profit sharing projects. Attempts to regulate transfer pricing and limit income shifting.

Optimal Commodity Taxation:

Government aims to maximize utility function with a fixed revenue constraint. Commodity taxes (sales tax, VAT) are the only available tax instruments. Solution: The optimal commodity tax rates must satisfy equi-proportionate reductions in all compensated demands.

Historical Tax Rates (1913-1948)

Highest Marginal Tax Rate: 7%. Tax Liabilities: Calculated on an individual basis.

Evaluation of Individual Filing (1913-1948)

Horizontal Equity (Individual): Satisfied. Horizontal Equity (Family): Violated. Efficiency: Promoted for secondary earners.

Evaluation of Full Income Splitting

Horizontal Equity (Individual): Violated. Horizontal Equity (Family): Satisfied. Efficiency: Poor due to first-dollar marginal tax rate for secondary earner.

Identification by IRS

IRS classifies MNE as U.S.-based if headquarters are in the United States.

Decentralization to Match Scope

Ideal Goal: Public goods or services should match the jurisdiction's appropriate size. Matching Geographical Extent: The level of government responsible should match the benefits' geographical extent.

Homogeneous Elasticities:

If elasticities of substitution are equal across sectors, capital bears the entire burden of the corporate income tax.

International Capital Flows:

If the capital stock is fixed, all U.S. corporate tax is borne by worldwide capital owners. If the capital stock declines (due to global saving effects), some burden is borne by worldwide labor, especially in the U.S.

Optimal Commodity Taxation Revisited - Atkinson-Stiglitz Result:

If the utility function exhibits weak separability, then all commodity taxes should be set to zero. Non-linear income tax is considered capable of achieving necessary redistribution without distorting consumption choices. Suggests that with a non-linear income tax in place, there's no need to impose commodity taxes. The income tax can effectively achieve desired redistribution without distorting consumption.

Partial Equilibrium: Excise Tax:

In a competitive market, the agent with a more inelastic demand or supply bears the greater burden. A flatter supply and steeper demand shift more burden to consumers.

FDII deduction

Incentive to keep intangible assets in the U.S., potential illegal export subsidy per WTO and OECD.

Incidence Definition:

Incidence refers to who bears the burden of a tax. Statutory incidence is who legally pays the tax, while economic incidence is who effectively bears the tax after market adjustments.

Extension to Different Individuals:

Individual heterogeneity in tastes and factor endowments. Income shifted among individuals influences tax incidence. Example: A corporate tax affecting capital income may influence the wage rate through an output effect.

Critical Issues with Territorial System

Revenue loss from potential income shifting under a territorial system. Under a territorial system, there is a risk that MNEs could successfully shift income to low-tax jurisdictions, leading to a situation where u.S. may not receive any tax revenue from shifted income

Issues of Time Frame:

Short run: Fixed factors. Intermediate run: total capital, labor fixed but mobile across business sectors Long run: Variable capital and labor, subject to changes in saving, international flows, and labor supply.

Diamond-Saez (2011) Results:

Shows an inverted-U shape initially, increasing around $50,000 and leveling off. Recommends high and rising marginal tax rates on very high earners, departing from Mirrlees' inverted U-shape. Very high earners should be subject to highand rising marginal tax rates on earnings

Harberger General Equilibrium Model Assumptions:

Single-period model without saving or investment consideration. Two production sectors (corporate and non-corporate) with fixed total supply of factors (K and L). Perfect factor mobility and no depreciation. Constant returns to scale, perfectly competitive markets, and full employment of all factors.

Taxation Approaches for U.S. MNEs

Source principle (territorial), residence principle (worldwide)

Incidence Components:

Sources: Changes in prices of labor, capital, and land. Uses: Changes in prices of final consumer goods. Model flexibility for allocating tax burden, considering individuals as both laborers and capital owners.

Division of Government Responsibilities

Stabilization (Macroeconomic Policy):Manages overall economic stability. Allocation of Resources:Efficient resource allocation for economic goals. Income Redistribution:Policies redistributing income in society.

Proposals for Reform:

Strengthen GILTI (drop exemption of 10% return on tangible assets and apply GILTI to all foreign-source income), OECD/G20 BEPS project (15% minimum tax), eliminate cross-crediting of FTC. Move to a country-by-country system for FTCs, repeal FDII, and consider formula apportionment (allocate profits among countries based on fractions of world sales, payroll, property).

TCJA Export Subsidy: FDII

Subsidy for exported income, FDII deduction of 37.5%, qualification linked to U.S. capital assets. Deisnged to encourage and support income generated from exploring goods produced in the United States

Efficiency Conditions for Pure Public Goods

Tastes of Residents: Sum of Marginal Rate of Substitution (MRS) equals Marginal Rate of Transformation (MRT). Minimum Average Cost: At minimum Average Cost (AC), where AC equals Marginal Cost (MC).

Countervailing Factor "Leviathan" Governments:

Tax competition constrains governments aiming to provide extensive public services. Statutory CIT rates declined globally, but CIT revenues remained relatively constant.

Community Property States and Supreme Court Ruling

Taxpayers: Ability to split income for federal income tax purposes. Major Reform (1948): Full income splitting introduced. Tax brackets for married couples doubled.

Post-2017 Taxation System

Territorial principle, CFC rules, GILTI introduction, hybrid nature.

Tax Shifting:

The shifting of tax burden from legal taxpayers to economic payers after market adjustment. Forward shifting: Firms pass taxes to consumers through higher prices. Backward shifting: Firms pass taxes to relatively immobile factors like land and labor.

Capital's Share of Tax Burden:

Theoretical scenario where capital's share of the tax burden is larger than its income share. Empirical observations may vary, especially in capital-intensive sectors like non-corporate agriculture.

Taxation of Digital Services

Traditional (imposed taxes based on the "origin" of the product, where it is produced) vs. destination-based taxation, low income and VAT for tech giants.

Incidence Measurement Time Frame:

Typically measured annually. Recent approaches consider lifetime incidence relative to lifetime income.

Basic Issues in Tax Design

U.S. Tax Basis: Family (joint filing) basis compared to individual basis in other countries. Current Law (TCJA): Marriage taxes apply to top two tax brackets with bonuses for lower-income levels. Impact on Low-Income Levels: Challenges for single heads of households marrying.

Pre-2017 Taxation System

Worldwide (residence) income taxed with FTC, deferral of domestic tax on foreign earnings until funds were repatriatedm, cross-crediting of FTC

Global Intangible Low-Taxed Income (GILTI)

a new category of income added by the Tax Cuts and Jobs Act that relates to "high return" income earned by a U.S. corporation's CFC and subject to a low foreign tax rate.

Incidence Results:

ηD1: Elasticity of demand for sector one (corporate) good. σ1: Elasticity of substitution in production of corporate good. fK1: Production cost share of capital in sector one. fL1: Production cost share of labor in sector one.