Chapter 11 - Applying First-Best Principles ofTaxationWhat to Tax and How

Chapter Outline Designing Broad-Based Taxes: The Economic Objectives 171 Ability to Pay: Theoretical Considerations 173 Two Preliminary Considerations 173 Horizontal Equity 174 From Horizontal Equity to the Ideal Tax Base 174 The Three Principles of Tax Design 174 People Bear the Tax Burden 174 Individuals Sacrifice Utility 174 The Ideal Tax Base as the Best Surrogate Measure of Utility 175 HaigeSimons Income 175 The Sources and Uses of Income 175 Sources of Income 175 Uses of Income 176 Real versus Nominal Income 176 Other Tax Bases 176 Criticisms of HaigeSimons Income 176 A Flawed Surrogate Measure of Utility? 176 A Better Alternative to HaigeSimons Income? 177 Consumption or Expenditures as the Preferred Alternative 178 Consumption versus Income Taxes: An Example 179 The Tax Reform Act of 1986: Income Taxation versus Expenditures Taxation 180 HaigeSimons Income versus Expenditures: Musgrave’s Perspective 180 Horizontal Equity and the Interpersonal Equity Conditions 180 Vertical Equity 182 Progressive, Proportional, and Regressive Taxes 182 Vertical Equity and the Interpersonal Equity Conditions 183 Sacrifice Principles of Vertical Equity 183 Minimize Aggregate Sacrifice 183 Equal Sacrifice 184 Young’s Prescription for Vertical Equity 184 Young’s Six Principles of Taxation 184 Proportional Taxation 186 Progressive Taxation 186 Vertical Equity in the United States 186 Reflections on the HaigeSimons Criterion in Practice: The Federal Personal Income Tax 187 Personal Income 187 Capital Gains 188 The Taxation of Personal Income: The Tax Loopholes 188 Tax Loopholes, Tax Capitalization, and Horizontal Equity 189 Tax Loopholes, Vertical Equity, and Inefficiency 190 The Taxation of Capital Gains: Inflation Bias and Realization 191 The Inflationary Bias against Income from Capital 192 Taxing Realized Gains: Auerbach’s Retrospective Taxation Proposal 193 A Two-Period Example 193 Option 1: Sell and Invest Risk-Free Asset 194 Option 2: Hold for Two Periods 194 The Vickrey Proposal 194 The Auerbach Proposal 194 Capital Gains Taxation: A Postscript 195 The Taxation of Human Capital 196 Summary 197 References 198