Nova workboard

a blog from young economists at Nova SBE

The end of tax deductions: what about redistribution?

“Is it possible to repeal or substantially trim most special tax deductions, credits, exclusions, and special rates? If so, potential for lower rates or additional revenue would be significant.”

Congressional Research Service

The main problem associated with any tax is the efficiency loss that is verified in the economy – the higher the tax rate, the higher the loss. In the European Union the average personal income tax (PTI) rate rounds 39%, and if we restrict our analysis to the EU-18 countries, it is even higher reaching 44%. However taxes may also be a way to promote redistribution, for instance through progressive taxation or allowing for some deductions or tax credits – ways to reduce indirectly or directly the total tax bill a tax payer has to pay.

The pressing need of controlling public deficits in several developed economies has launched new debates on the roles of deductions in the personal income taxes. In the US a commission was established to study the subject and they have raised one important question: is it possible to reduce the tax rate by eliminating deductions and tax credits? Also in Portugal a commission studied the challenges to the PIT and also proposes significant changes on it.

But after all, if we believe tax deductions promote redistribution, why should we eliminate them? Firstly if we don’t have deductions our taxable income will increase. Thus, the total amount of tax revenue collected will also increase and there will be a margin to reduce the average tax rate or even to increase social transfers to low-income families, promoting redistribution. Studies show that, if used only for rate reduction, eliminating all US tax expenditures would lead to a decrease of 43% on tax rates.  Secondly, extreme progressive taxation on the richest will increase distortions and market failures instead of correcting inequalities. Finally, evidence shows that the richest can deduct proportionally more than poor families, attaining therefore highest reductions on the taxable income. This means redistribution goals are not being fully reached with deductions mainly because there are lots of deductions which go far beyond poverty policies.

So should we eliminate deductions? The answer is not as linear as one would like. There are some important concerns to be taken into consideration. First of all there is lag between the economic theory predictions and the real world which may prevent a large fraction of potential additional revenue to be realized. Secondly, there is huge lobby against eliminating deductions; political limits are no less real than economic restrictions. This proposal also assumes that governments will use other instruments rather than taxes to fight against inequality, which is not necessarily true. Finally the end of tax deductions may lead to an increase in fraud (fewer incentives to comply with the system).

There are no perfect answers to this debate. Economic theory shows that inefficiency may decrease with the end of tax deductions, and even improve redistribution. However it is important to think about other factors which may affect deductions and about the practical implementation of such a measure. It is not an easy task, but reforming the personal income tax is certainly an important and a pressing issue in society.

Eduardo Costa

Master in Economics 689

Advertisements

Author: studentnovasbe

Master student in Nova Sbe

Comments are closed.