Income taxes impose three kinds of losses on taxpayers. First, citizens must pay the income tax required by the tax schedule. Second, they incur time and money costs in calculating their tax liabilities and filing their returns. And finally, when they are knowledgeable about the financial implications of the tax schedule, taxpayers may choose to behave in a way that differs from their behavior if there were no income tax. For example, taxpayers might devote less time to paid employment if their net earnings were reduced by 20% as a result of the income tax. They might save less if their investment income is reduced 20% by the income tax. The economic distortions produced by an income tax can be trimmed if taxpayers face lower tax rates on their marginal income gains. As Del Negro and his coauthors note, both the government and taxpayers can benefit if taxpayers can voluntarily convert part of their current income tax liability into a lump sum tax. On the margin, taxpayers can keep a larger percentage of the income gains produced by extra work or higher savings, and in the aggregate the government can obtain higher tax revenues if the changes in taxpayer behavior result in a larger economy and higher total incomes.
I think there are two important hurdles to the adoption of an alternative, voluntary tax schedule, even one that promises both to improve some taxpayers’ welfare and to increase the size of the economy. The most important obstacle may be the perception of unfairness. Most taxpayers will hesitate to exchange $4,500 today for the promise they will face 5% lower marginal tax rates over the next 12 months. It is, after all, a risky choice. Taxpayers who accept the offer may end up paying high income taxes (including the up-front payment) in years when they unexpectedly suffer a serious reverse, like loss of a job. The people who turn down the government’s offer of lower marginal tax rates in exchange for an up-front payment will be suspicious about the taxpayers who take advantage of the offer. There are likely to be many examples to support the dark suspicions of average taxpayers: A wealthy investor who pays $4,500 to avoid paying $200,000 in capital gains taxes in a year when he plans to sell a large percentage of his appreciated assets; The business owner who arranges to receive an out-size percentage of payments from customers in a year when he has paid for lower marginal tax rates; A well-placed company officer who pays for lower marginal taxes in a year when he intends to receive millions in performance pay bonuses.
Del Negro and his coauthors might recommend fixes for some of these problems. They may even promise that the net gains outweigh the losses from a few bad cases. But many taxpayers will still be a deeply suspicious of a system in which people who exercise control over the timing of their income can offer fixed payments to the government in exchange for lower tax rates. People who exercise little control over the timing of their income certainly have reasonable grounds for suspicion.
A second hurdle to the alternative tax schedule may be government ignorance. The examples mentioned above highlight the differences in knowledge held by taxpayers, on the one hand, and the government, on the other. Some taxpayers exercise control over the timing of their income; others do not. Tax collectors cannot distinguish the two kinds of taxpayers. The government’s objective is to take in at least as much revenue if the voluntary tax schedule is offered to taxpayers as it receives when there is only one tax schedule. It is easy to think of cases where well-informed taxpayers will take up the government’s offer in years when income is expected to be high but to decline it when their income is likely to be low. From these taxpayers the government collects less revenue in good years and the same revenue in bad years. Of course, the government’s problem would be less severe if it could calibrate each offer to fit the circumstances of individual taxpayers. Taxpayers with large amounts of unrealized capital gains could be charged a higher price to obtain the low-tax-rate schedule than taxpayers without any unrealized gains. This would improve the perceived “fairness” of the alternative tax, and it would increase the government’s expected revenues from taxpayers who have control over the timing of their income. But how likely is it that the government could collect the required information or use it to correctly calibrate its offers to individual taxpayers?
Both voters and legislators require a more concrete demonstration of the fairness and feasibility of the proposed tax system than they can find in a theoretical paper. Public finance economists, however, are likely to be intrigued by the proposal.