Alan Auerbach: «Taxes on consumption are more effective and result in less distortion»

EY’s partner Volodymyr Kotenko spoke with a guru of tax policy, american economist Alan Auerbach

американський економіст, директор Центру Податкової політики та Публічних фінансів в університеті Берклі Алан Ауербах

YouTube / UC Berkeley, Roxanne Makasdjian and Phil Ebiner


Alan Auerbach, famous economist, and director of the Robert D. Burch Center for Tax Policy and Public Finance at UC Berkeley, visited the NBU conference in May. VoxUkraine encouraged Volodymyr Kotenko, a partner at EY, to take  an expert interview with Auerbach. And now we have very interesting and professional conversation about approaches to setting and implementing a tax policy, about how to handle fiscal challenges that arise with population aging, how to change the culture of tax evasion, and about the extent to which consumption taxes can be an alternate of other kinds of taxes. An economist supports the idea of levying taxes on cash flow from consumption spending, salaries are not the case. This conception has some common features with that concerning the tax on withdrawn capital that might be introduced in Ukraine.

Vladimir Kotenko: In Ukraine, like probably everywhere in the world, tax policy is a contentious and “fashionable” topic. As it is a highly political one, there are plenty of disputes and argument about how tax policy should be designed. In your view, is it possible at all to reliably forecast the impact of a tax policy on the economy?

Alan Auerbach: Whether one could do that in Ukraine I do not know.  In countries like the US we have a lot of empirical evidence of the effects of particular tax policies on the economy. It would be more difficult [to forecast – VoxU] if you are adopting a very major change in policy.  It also may be difficult in Ukraine – given special institutions, special problems like tax evasion. So I am not saying I can make a prediction for what will happen in Ukraine for tax reform, but I’m giving a principle.

VK: In your view, what role academics should play in defining countries’ tax policies? In Ukraine now, it seems, that the tax practitioners together with the Facebook audience are those who drive the tax policy discussions.

AA: I think doing research into what the effects of different kinds of tax policies are, either by doing research oneself or being aware of the research of others who have done it for other countries, helps assess whether particular policies would bring an improvement or not.  There is one issue that often comes up and this is where the distinction between economists and lawyers and between academics and practitioners comes in. Economists sometimes do not fully appreciate some of the institutional features of, say, tax administration or tax planning on the part of the businesses and, sometimes, academics have an oversimplified view of what the effect of the tax policy might be. At least in the US and particularly for provisions that can be quite complicated (such as ones affecting multinational companies) there is a pretty good dialog between the economists, tax administrators, and tax lawyers about whether particular ideas would be feasible to implement. And the role that the analysis of the academics should play ideally, is that politicians or their staffs would get input and use that input when formulating policy. It doesn’t work perfectly in any country, you know.  Some countries, depending on who is in the government, incorporate the academic information better than others do. Some countries don’t take very much advantage of what academics have to say.

VK: It sounds like the importance of engaging the academics when formulating the tax policy is hard to overestimate. My interpretation of what you have said is that the role of academics is to tell the truth to the politicians, cool their emotions and minds with facts, empirical data and sometimes to kill myths, if necessary.

VK: There is a wide spread view that the percentage of GDP redistribution through taxes is too high in Ukraine. In your view, is there any gold standard of such a percentage or at least is there a reliable algorithm of such redistribution calculations?

AA: There are ways of evaluating the trade off by basically asking how much of a cost in terms of harm to economic activity do additional taxes involve, how much is it worth to the government to raise additional funds (even with this extra cost to make redistribution). That will depend on both how efficient the tax system is (the less efficient it is the less you should try to raise the redistribution), and also how great the need is in terms of redistribution. In the countries with the relatively uniform distribution of income you don’t need to do much but if there’s great poverty and need you may have to do more, so there is not really any simple answer to that question.

VK: That means the larger inequality is, the larger redistribution could (or should) be. Many people will not like it, as this could potentially lead to a heavier taxation.

OS: Besides there’s also a problem of aging population.

AA: Exactly. There would be more pressure on the fiscal system due to these problems. There are not too many solutions to it. One solution is pension reform, to lessen slowly the growth of pension benefits. I did not get into how to do that, but one thing you could do is to have overall benefits growing more slowly. There may be different ways of doing this, but overall you can make the total sum of benefits to grow slowly if population is aging.

OS: Do you mean that the pensioners have to be less rich?

AA: Well, yes. In terms of how to deal with that, you can delay the retirement, this for people who are able to continue working. You can reduce benefits for people who have more of their own private financial resources. That’s pretty much all you can do in terms of pension reform. You would ultimately have to come up with other resources to pay for those needs. Migration/immigration doesn’t really work.

This is a problem that many countries face, and it looks like Ukraine will face it too, because you have a rapidly aging population. It might look like a good idea to have more immigrants to help finance the old aged pensioners. But there are two problems: first, if the immigrants are not particularly educated, their incomes may not be that high to provide additional tax revenue. Besides, they themselves will qualify for pensions when they get old, and in this case you are just delaying the problem.

VK: One would prefer to have a sort of working tourists, rather than the immigrants?

AA: Exactly, but this doesn’t happen in real life.

VK: In Ukraine, we often hear that there is large shadow economy and tax evasion because the tax payers don’t believe that the government would spend tax money wisely. What do you think is the recipe to cure the problem? Do we have to steadily improve the institutions and the taxpaying culture? Or, as some say,  that it would take too long and we have to abruptly squeeze out the government of the economy and drastically reduce public spending? Maybe a combination of these two approaches would work?

AA: I think overcoming culture of distrust and acceptance of tax evasion is difficult. I don’t think there’s any simple or quick solution to that. We have anti-tax sentiment in the United States, but nevertheless we don’t have such a big problem with tax evasion. A  lot of people would like to see the government shrink, but they still pay their taxes. Obviously, it is easy to say, to the extent that there are government activities that aren’t really crucial, they could be reduced – but that’s not really a very helpful statement. I think the way forward is trying to build up expectation that there will be enforcement so that you are not simply relying on individual honesty, because one of the problems is when people are individually honest but perceive that others are not paying taxes, it makes it a lot harder to motivate oneself to comply. So I think spending more resources on tax enforcement and putting an emphasis on it, would probably be helpful.

VK: Is shadow economy always a bad thing?

AA: Well, there had been some economic analyses suggesting that there may be people who might not work if they have to pay taxes. Typically, in the US we might be talking about day laborers and people  hired for the construction projects, for example, and paid in cash. For people like that, if you started having payroll taxes and income taxes and other taxes, maybe they would not work.

If that is the case, then you probably should have a tax reform and try to have lower tax rates on the work activity of people like this. That would be an ideal approach rather that accepting the black economy.

VK: Clear. The employers in Ukraine often complain that a payroll tax burden is too heavy. In your view, how the government should approach this issue? How to evaluate that the complaints are legitimate?

AA: Well, the government has to raise taxes somehow. So if you’ve determined that the government needs a certain amount of revenue, then you look at which taxes to use. Many economists say that payroll taxes are probably too high and that they limit labor force participation, they may be particularly bad for young entrants, keeping them out of labor force. So, you want to do a comprehensive assessment of the taxes to think about what are the alternative taxes to use.  

VK: It means there is no gold standard of taxing the payroll and the government may engage in as many fiscal maneuvers as possible, just making sure that the taxes it charges are  not harmful to the economy and do not contradict to the objectives the government pursues?

AA: Correct. We have for example in the US payroll taxes, but many years ago we introduced something called the earned income tax credit, which was introduced basically to offset payroll taxes for lower income workers as they enter the labor force. It goes away as their income goes up, but the idea was (in particular for workers who are near the margin of working or not working) to make a way of alleviating the cost of payroll taxes, so that the newcomers could get experience, move up to job ladder. This is just an example of how you might modify payroll taxes, if you’re concerned about labor force participation.

VK: If you would have to replace some taxes with some other ones, do you have any favorites to use as replacement?

AA: I think consumption based taxes are more efficient, more enforceable (not perfect, but more enforceable), and probably have fewer distortions and can be made progressive, particularly if you apply the version that I was supporting, the destination-based cash-flow tax (DBCFT) which focuses not on all consumption but on the consumption financed by business income, with a deduction for wages paid by business. Following that approach, I see the advantage that consumption expenditures are relatively easy to observe and consumers are relatively immobile. Your money, your bank account may be somewhere else but your automobile and your house and your household purchases are here and observable.

VK: What would you say about a viewpoint that consumption taxes are not really  just because they hit the poorest the most?

AA: Yes, consumption taxes are generally thought not to be particularly fair because the poor spend everything and they have no saving and higher income people have saving and so consume less of their income. A simple way of making the consumption taxes fairer is to increase consumption taxes while reducing payroll taxes. Or reduce payroll taxes on lower income people; I mentioned earlier the earned income tax credit. Increase a value added tax and use the revenue to have an earned income tax credit.

VK: And what about property taxes?

AA: You could use them. If we are talking about real estate, it might be a solution. General wealth tax might be much harder to enforce, whereas a property tax is easy to enforce, since property is there and it’s hard to move it somewhere.

VK: There is a viewpoint, expressed sometimes here in Ukraine, that the official taxes should not be significantly higher than the cost of maintaining the shadow schemes. What would you say about this viewpoint?

AA: Well if tax avoidance or evasion is less costly than paying taxes, taking into account the probability of detection, that’s a problem. But there are two different ways of dealing with it. One is to lower taxes; the other is to raise the cost of tax evasion.

OS: It just means that the supervisory system should be much tougher?

AA: Well, it is not just about the supervisory system… That’s a part of it, you know, auditing and enforcement. But it is also about having taxes that are relatively easy to collect. For example having consumption taxes instead of trying to tax the worldwide wealth of Ukrainian residents. That tax would be very difficult to enforce. A consumption tax is not so hard to collect and so you don’t have to worry as much about enforcement.

VK: Do you believe that so called cultural differences should be taken into account when designing the tax system and the counter avoidance measures?

AA: I do think cultural differences matter. Some cultures differ for longstanding reasons, you know, there’s a culture of corruption, or acceptance of tax evasion, which makes it much more difficult to change. But I do not think these things are immutable, you can adjust social norms overtime. It may be much more expensive initially to implement a proper system. You may have to spend a lot more on enforcement than other countries would, but I think over time if you do spend the money on enforcement and if penalties are assessed and if people come to accept that if they don’t pay taxes they will go to jail, I think that can change the culture. But that is just not going to happen overnight.

VK: What would you say about the fashionable tax ideas like anti BEPS action plan?

AA: I’m not a particular fan of the BEPS approach, because I think it is (i) very complicated and (ii) doesn’t really have very clear objectives. Because, as an example, if you say what we do not want is profit shifting by multinationals, you may end up simply encouraging multinationals to shift their operations. And that relates to the fact that they didn’t really think about what it was they were trying to accomplish.  So not every scheme like the BEPS project is well motivated. But in terms of whether policies that are used in developed countries would apply in Ukraine, I think it depends on the policy. There is no general rule.

VK: So basically those fashionable ideas should not be regarded as sort of gold standard to copy but rather should be a source of inspiration for the politicians?

AA: Sure, to think about the ways of reform, that’s right.

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