A HAIG-SIMONS-TIEBOUT COMPREHENSIVE INCOME TAXA HAIG-SIMONS-TIEBOUT COMPREHENSIVE INCOME TAX CHARLES R. HULTEN* AND ROBERT M. SCHWAB** ABSTRACT requires more than simply eliminating

A HAIG-SIMONS-TIEBOUTCOMPREHENSIVE INCOME TAX

CHARLES R. HULTEN* AND ROBERT M. SCHWAB**

ABSTRACT requires more than simply eliminating the

This paper argues that if we wish to haveexisting deduction. We show that there are

a comprehensive income tax, and if theno essential economic differences between

Tiebout model is a reasonable approxi-publicly owned capital (e.g. streets, parks,

mation of the structure of local govern-schools) and privately owned capital (e.g.

ment, then the implicit income from the lo-owner-occupied housing) in such a world,

cal public capital stock must be includedsince both yield a stream of capital ser-

in the tax base. In a pure Tiebout world,vices and consumers are free to choose the

there are no important differences betweenquantity of both and individuals are able

publicly owned capital (eg., 'streetsto recoup their "equity" share of the com-

I Parks, munity's investment in capital when theyschools) and privately owned capital (eg., sell their home. Thus, while it is com-owner-occupied housing). Therefore the munities, and not individuals, that holdimputed income from the street in front of title to public capital, there is no effectivea family's home must be included in the distinction between public and privatebase of a comprehensive income tax, just capital in the Tiebout model. It thereforeas the implicit income from the home itself follows that some portion of the imputedmust be included. income from the street in front of a fam-

ily's home must be included in the base1. Introduction of a comprehensive income tax, just as the

NE of the goals of the Tax Reform Actincome from the home itself must be in-

Oof 1986 was to move the federal in-cluded.

The policy implications of our resultsdividual income tax closer to a tax on must be interpreted with care. If it is po-Haig-Simons comprehensive income [U.S. litically impossible to tax the imputed in-Department of the Treasury (1984)]. As come from owner-occupied housing, itpart of that broad objective, several pro- would be political suicide for Congress toposals were put forward that would have propose taxing imputed income associ-eliminated the deduction for all state ated with public streets, schools, policelocal taxes. The rationale for these pro- cars, etc. Moreover, state and local taxesgrams was based, in part, on the Tiebout are not pure benefit taxes (as even the(1956) argument that consumers can most strident defender of the Tieboutchoose the level of services they desire by model would admit). But, this does notttvoting with their feet," and that local mean that this imputed income can be ig-taxes are thus equivalent to fees for pub- nored in discussions of tax policy. Anylicly provided services such as education discussion of tax neutrality must ac-and police protection. Reformer, there- knowledge this untaxed source of income,fore argued that if we were to move to- just as it must recognize that second-bestward a comprehensive income tax, it would issues are introduced by the nontaxationmake no more sense to allow a deduction of owner-occupied housing. At a morefor state and local taxes than it would to concrete level, the assertion that limitingallow a deduction for expenditures on any the deductibility of state-local taxes andprivately provided good. eliminating the tax exempt status of mu-

In this paper we argue that a compre- mcipal bond interest are sufficient to makehensive income tax in a pure Tiebout world the federal tax system more neutral [e.g.

*University of Maryland, College Park, MD 20742 U.S. Department of the Treasury (1984)]

and National Bureau of Economic Research. must be recognized as problematic. These**University of Maryland, College Park, MD 20742. proposals might move the tax system

67

68 NATIONAL TAX JOURNAL [Vol. XLIII

toward neutrality, but they would not re- Z. Then consumers in this case choosesult in the comprehensive tax treatment quantities of X and Z in order to maxi-of the state-local sector income. mize their utility function subject to the

The remainder of the paper has the fol- budget constraintlowing organization. In Section II wecharacterize the returns on investment in Y + rW = PzZ + P'X + AW, (1)public capital within the Tiebout model.In Section III we look at the implications where P' and P' are the prices of Z and X.of our results for federal tax reform. We Defining comprehensive income in thisthen generalize some of our results to non- case is straightforward. Under the Haig-Tiebout communities in Section IV and Simons definition, comprehensive incomecharacterize Haig-Simons-Tiebout com- equals the money value of the net in-prehensive income under alternative crease to an individual's power to con-models of public choice. Section V in- sume during a period. This is equal to thecludes estimates of capital income origi- amount actually consumed plus net ad-nating in the state and local sector that ditions to wealth. Equation (1) shows thatshow that as much as $85 billion an- in this case Haig-Simons income equalsnually may escape federal income taxa- the sum of labor income Y and the returntion. The final section includes a brief on current wealth rW; from (1), this sumsummary and conclusions. equals the amount actually consumed FZ

+ PX, plus net additions to wealth AW.

11. A Model of the State and Local Now suppose that consumers form com-

Sector munities for the purpose of providing X.Following Tiebout, let us assume that

Our objective in this section is to show consumers are perfectly mobile and thatthat the tax base of a comprehensive in- they are free to form new communities.come tax in a Tiebout world would have Under these assumptions, local taxes mustto include the implicit return on the stock be benefit taxes-that is, they must equalof community capital. To do so, we pres- a citizen's willingness to pay for localent a set of essentially equivalent models. public goods-because local governmentsConsumers in all of these models receive must make decisions that maximize theutility from two goods, X and Z. In all welfare of their constituents, or else facecases, Z is produced by perfectly compet- the loss of these constituents to commu-itive, profit maximizing, private firms; X, nities where governments do maximizeon the other hand, is provided under dif- welfare. Under certain circumstancesferent institutional arrangements in the [Hamilton (1975)], an equilibrium emergesvarious models. The production of X re- in which consumers with the same de-quires capital K and labor L, and we as- mand for local public goods choose to livesume that the production function for X, in the same community and the cost ofF(K, L), exhibits constant returns to scale. providing public outputs is shared equallyWe abstract from issues of optimal com- among its residents.munity size by assuming that X is per- Does the process of forming connnunityfectly congestible, i.e., there are no econ- governments necessarily change the al-omies to be realized from increasing the location of community expenditure be-size of a community. Consumers receive tween X and Z? Not if the local govem-labor income Y, begin the period with ments enter into an agreement with awealth W which earns interest at the rate perfectly competitive firm to produce X.r, and plan to increase their wealth by AW Under these assumptions, local govem-by the end of the period. ments will face a loss of residents unless

To begin, we first suppose that con- they provide exa@tly the same level of Xsumers purchase X directly from per- as individuals chose in the first model wefectly competitive profit maximizing firms, presented. The only difference is that con-i.e., that there are no essential institu- sumers would pay for these goods differ-tional differences in the provision of X and ently: in the first model they would pay

No. 41 COMPREHENSIVE INCOME TAX 69

P'X directly to firms while in the second in equation (3) is exactly equal to thethey would pay PX in local taxes, and the market price of X in equation (1)- therelocal government would pass this amount are zero profits under perfect competition,on to the private producers. And, since and therefore the price of a unit of outputeveryone consumes the same quantities must equal the minimized cost of produc-of all goods and their wealth riser, by the tion.same amount, their Haig-Simons income This analysis leads to the conclusion thatmust clearly be the same in both cases. It the decision to produce the good X in theis equally clear that there is no basis on public sector rather than in the privateefficiency grounds to allow a deduction for sector has no impact on any of the im-the local tax against the federal income portant variables we have considered. Thetax. same combination of inputs and outputs

Let us now consider what happens to the are chosen as in the case where con-definition of comprehensive income when sumers purchased X directly from firms,local governments decide to "deprivatize" and since Haig-Simons income equalledX by producing it themselves rather than Y + rW in the first model, it must equalcontracting with private firms.' Let us Y + rW in this case as well. Here, again,further suppose that communities do not a federal tax on comprehensive incomehave sufficient capital to purchase pri- would not include a deduction for localvate producers' K outright (i.e. the K that taxes.firms had used to produce X), so that they This conclusion is based on a model indecide to rent the capital instead. The lo- which communities rent the capital theycal government thus becomes a pseudo- use to produce the public good X. How-firm that hires capital and labor at prices ever, it turns out that the definition ofPK and PL, and the utility maximizing comprehensive income is the s -ame whetherproblem thus involves finding the opti- a community chooses to rent or to own itsmal levels of K and L subject to the con- capital. In order to show this, we turn tostraints the model in which the local goverrunent

purchases a stock of K units of capital perY + rW = PzZ + T + AW (2a) capita when the community is formed. We

T = FILL + P@KK (2b) will also assume that the local govem-ment finances lOOoLpercent of the cost of

X = F(K, L) (2c) acquiring this capital with local taxes andthe remaining 100(l - (x) percent with

where T represents per capita local taxes. public debt. This requires the local gov-The solution to this maximization prob- ernment to set an initial tax of otP'Klem can be thought of as a two-part pro- initially on each resident and to issuecess. In the first stage, the community is (1 - (X)PIK in municipal bonds, where Vassumed to choose the combination of is the purchase price per unit of capital.capital and labor which minimizes the cost In subsequent years, the local govern-of producing a single unit of X. This yields, ment must set taxes equal to the sum ofunder constant returns to scale, a unit cost three elements: (i) the cost of restoring thefunction 4@(PL,P() which is the economic capital stock to its initial level 6PK, wheredual of the production function in (2c) and 8 is both the (constant) rate of deprecia-which is equivalent to the marginal cost tion and the rate of debt amortization; (ii)of producing X. In the second stage of the the interest on its bonds r(l - a)PK: andoptimization, the community chooses the (iii) the cost of labor PLL. The maximi-utility maximizing combination of X and zation of voters' utili@i thus involves theZ subject to the constraint following constraints:

y + rW = pZZ + +(pL, p@I)X + AW. (3) Y + r(W - otPK) = PzZ + T + AW (4a)

It is not difficult to see that the "shadowT = BP'K + r(l - a)P'K + pLL (4b)

price" (i.e., marginal cost) of X, +(PL, PK), X = F(K, L). (4c)


Combining (4a) and (4b) yields (5)-the wedge raP'K is the implicit re-turn to the equity in the community's

y + rw = PzZ + PLL public capital stock. Under a comprehen-

+ (r + S)PK +,&W. (5)sive definition of the sources of income,this imputed rent would be included in thefederal income tax base. However, if we

The key question for the study of compre- focus on the uses of income, we would lookhensive income is whether the solution to at the right side of equations (4a) and (5).this optimization problem is the same so- Under the Haig-Simons definition of in-lution (X, Z, L, K) that emerged in all of come as consumption plus changes in netthe previous models we have examined. worth, the cost of the public goods con-To answer this question, we borrow a consumed is PxX = PLL + (r + B)PIK, justcept developed by Jorgenson (1963) to as it would be if X were provided by pri-study private sector investment. Jorgen- vate firms. But, actual expenditures onson showed that cost of using a unit of those goods (i.e., local taxes) are only PLLcapital for one time period, I)K, must equal, + [b + r(l - a)]P'K, which is less thanin equilibrium, the sum of opportunity cost the cost of consuming X by the amount ofand depreciation, or (r + 6)pl.3 This user the wedge, raPK dollars. How is this pos-cost must be the same in all uses, public sible? It is possible because the commu-and private, if we abstract from risk dif- nity in effect "prepaid" part of the futureferentials. Moreover, it is equal to the ex- cost of consuming X when it purchasedplicit rental price of capital, since any part of its initial stock of capital with taxesowner who chooses to rent an asset (rather ELP'K when the community was formed.than use it) will be forced, in a competi- This leads to the conclusion that a trulytive equilibrium to set rent equal to comprehensive income tax would need to(r + B)P. Thus Pie can be substituted for impute an additional roLP'K dollars in in-(r + B)PI in (5), and this produces exactly come to each consumer. This is highlythe same constraint that is obtained by counter intuitive, since few people (if any)combining (2a) and (2b)-i.e., exactly the regard the street in front of their dwell-same result as the case in which govern- ing as a source of income. The residentsments rent rather than own their capital. of a Tiebout community would, however,

This leads to the conclusion that the receive a pleasant surprise if their gov-equilibrium solution (X, Z, L, K) is the emment were to privatize the productionsame regardless of the institutional ar- of X (i.e. return to our first case) by sell-rangements. There is, however, one cru- ing off the community's capital stock K.cial difference between this last case Proceeds from this sale would equal VK,(public ownership of capital) and the pre- and the sum (1 - ot)P'K would be paid toceding cases: with public ownership, money the holder of municipal debt, leavng theincome and Ha@g-Simons income are no residents richer by the amount 'PIK.

longer the same. The left side of (4a) im-plies that consumers have money income An Analogy to Owner-Occupied Housingof Y + r(W - (xP'K), since they paid outaP'K in taxes when the community was There is an obvious parallel between theformed. Haig-Simons income, on the other implicit income from owner-occupiedhand, continues to be Y + rW, since this housing and the implicit return on publicis the amount of Haig-Simons income in capital. It is conventional in public fi-the first model we analyzed, and we have nance to regard homeowners as de factoshown the basic equivalence of all models renters who pay an implicit rent to them-with regard to (X, Z, L, K). selves. This implicit rent is generated by

The wedge between Haig-Simons in- the purchase of the house, which can become and money income, raP'K, can be regarded as a prepayment for futuregiven two equivalent interpretations. From housing services, and it is generally agreedthe standpoint of the sources of income- that income should be "grossed up" by thethe left hand side of equations (4a) and amount of the imputed rent for purposes


of taxation. It therefore follows that the revenue, while community B does noth-prepaid rents from public capital should ing. Assuming no depreciation and a 10also be included in the base of a compre- percent interest rate, the residents wouldhensive income tax. The exact mecha- receive $1 million of benefits from thenism is, of course, different, since Tiebout school but would pay nothing in localgovernments effectively transfer income taxes. With a fixed supply of housing into residents by reducing the local taxes each town, prospective entrants should bethey would otherwise have paid. But, as willing to pay an aggregate premium ofwith owner-occupied housing, the conclu- $10 million for housing in community A,sion is the same: income should be grossed since they would have free access to theup so that it reflects all income received, school (except for operating expenses). Theimplicit and eXpliCit.4 $10 million tax cost of the school is thus

capitalized into housing values in A,

Mobility and CapitaIL-ationthereby allowing those people who leavethe community to recoup their invest-

We have thus far assumed implicitly ment and impose the de facto tax burdenthat consumers never move once they have on entrants.chosen a community. If there were a mar-ket where consumers could sell their shareof the public capital stock for otVK dol- IH. Federal Tax Reformlars then we could drop this assumption Our primary purpose, in this paper, iswithout changing our model in any im- to demonstrate the existence of a here-portant ways. For, if such markets ex- tofore unrecognized form of income. How-isted, then the asset "public capital" would ever, this leads naturally to, the questionbe no different than any other asset: it of tax neutrality, since comprehensivewould yield an annual return and couldbe sold at any time for the discounted taxation is often equated with neutral

present value of those returns.taxation in policy discussions. For exam-

The notion of a "second-hand,' market ple:

for public capital may seem far-fetched, Economic neutrality is ftuthered by a few sunple rulessince people cannot sell the street in front of tax design. Perhaps most importantly, income ftomof their house. There is, however, an in- all sources should be taxed equally; otherwise, too

many resources will be devoted to activities subjectdirect second-hand market for public cap- to the lowest taxes. For the same reason, tax liabilityital. When a consumer purchases a home should not depend on how income is spent. Uniformin a Tiebout community, that consumer treatment of all sources and uses of income requiressimultaneously purchases the right to the a comprehensive definition of income for tax purposesservices of the community's capital stock (U.S. Department of the Treasury (1984), Volume 1,

and accepts the obligation to pay taxes inP13).

order to finance those services. The net It is, of course, well known in the litera-value of the services is the difference be- ture that a comprehensive income tax hastween consumption benefits received and a claim to efficiency only in the specialtaxes paid. If the community paid for its case where the supply of factors of pro-capital with taxes collected in the past, duction are exogeneous,' but even in thisthen the cost of a home must equal the case, our results suggest a fundamentalvalue of housing capital and the value of source of non-neutrality, i.e. the failure tothe prepaid taxes, i.e., taxes previously tax the equity income associated withpaid represent equity income which is public sector capital. In this section, wecapitalized into the value of the homes in examine the tax rule that would be neededa community." to establish tax neutrality in a Tiebout

To make these results more concrete, world where the aggregate levels of cap-consider two communities (A and B) with ital and labor are fixed. We show thatidentical housing stocks, and assume that neutrality can be achieved by a policy thatcommunity A builds a school for $10 mil- is equivalent to (i) taxing the imputed in-lion and finances the construction with tax come from local public capital, (ii) di8al-


lowing a deduction for local taxes, and (iii) Equivalent Neutral Tax Policiestaxing the interest earned on local gov-

Under a flat rate income tax, there areemment bonds.at least two alternatives that yield theThe last two of these conditions were

seriously considered during the debate over same outcome as the neutral rule de-

the Tax Reform Act of 1986; in the end, scribed above. Under the first, implicit

the deduction for state and local sales taxes income is taxed, no deduction for interest

was removed but the deduction for other paid on municipal debt is allowed, and the

taxes and the exemption for municipal interest earned on such debt is exemptbond interest were retained. The results from federal taxation (as under current

we present below imply that in a Tiebout tax policy). If investors exploit arbitrage

world, with fixed aggregate inputs, the opportunities, the after-tax return must

proposals that were put forth were nec- be the same on all investments and there-

essary but not sufficient for establishing fore the municipal bond rate would be 7.20

a neutral federal income tax; the implicit percent in our example. The owners ofincome from the local public capital stock public capital financed with public debtmust be taxed as well. would have a tax liability of $2.80 (since

we no longer allow a deduction for inter-est paid), and therefore the cost of capital

Tax Neutrality would remain $10.00.

We use a simple numerical example in The second alternative exploits the cap-

order to make our point clear. Suppose italization of prepaid local taxes in the

public and private capital do not depre- Tiebout model. If a community finances

ciate, all taxpayers itemize deductions, the acquisition of an additional unit of

everyone faces the same federal tax rate capital with equity, following the line of

of 28 percent, the pre-tax interest rate is argument presented above, the value of

10 percent, and the purchase price of cap- the homes in this community will rise by

ital is $100. Then, as shown in the first $100.00. As a consequence, the annual

part of Table 1, the user cost of capital in implicit rent on those homes will rise by

the private sector must be $10.00 under $10.00. If these implicit rents were in-

both debt and equity financing. The after cluded in the tax base of the federal in'

tax return on alternative investments is come tax, we would then subject the im-

7.20 percent,'and firms must therefore pay puted rent on the public capital stock to

$10.00 in interest or dividends per unit of taxation, because the implicit rent on

capital in order to provide investors with ownBr-occuPied housing equals the returnan equivalent return (since, by assump- on privately owned housing capital and

tion, all income originating in this sector the return on publicly owned infrastruc-

is taxable). ture.

What tax policy leads to a $10.00 usercost of capital in the local public sector? Current Tax PolicyOne answer is, clearly, a Haig-Simons-Tiebout comprehensive income tax. If a Current federal tax treatment of thecommunity finances the acquisition of a state and local sector is not consistent withunit of capital with equity, it incurs an a neutral Haig-Simons tax. Under cur-after-tax opportunity cost of $7.20 (since rent policy, imputed income is not in-the return on an alternative investment cluded in the tax base, state and local taxesis taxable) and pays $2.80 in taxes on its are deductible, and interest on publicimputed income. If it instead uses debt, it bonds is tax exempt. h is not hard to showmust pay $10.00 in interest so that bond- that, in the context of the example weholders realize an after-tax return of $7.20. presented above, these provisions imply aThus, including the imputed income from cost of capital in the public sector of $5.18the public capital stock in the tax base and rather than $10.00 as neutrality wouldeliminating the deduction for state and demand. In the case of an investment fi-local taxes and the exemption for munic- nanced entirely with public debt, the ar-ipal bond interest lead to neutrality. bitrage discussed above will drive the in-


TABLE IUSER COST OF CAPITAL UNDER ALTERNATIVE TAX POLICIES

Eciuity Financed Debt Financed

Private Sector 10.00 10.00

Public Sector

Tax Net Imputed Income 10.00 10.00Remove Deduction for Local TaxesRemove Exemption for Municipal Bonds

Exempt Net Imputed Income 5.18 5.18Retain Deduction for Local TaxesRetain Exemption for Municipal Bonds

Exempt Net Imputed Income 5.18 7.20Retain Deduction for Local TaxesRemove Exemption for Municipal Bonds

Exempt Net Imputed Income 7.20 7.20

Remove Deduction for Local TaxesRetain Exemption for Municipal Bonds

Exempt Net Imputed Income 7.20 10.00Remove Deduction for Local TaxesRemove Exemption for Municipal Bonds

terest rate on those bonds to 7.20 percent capital in the tax base and ended the ex-since interest on municipal bonds is exemption for interest on municipal bonds

empt. Interest paid is included in local and the deduction for state and local taxestaxes and is therefore deductible; thus the would be neutral (under our admittedly

after tax price of capital to a community quite stringent assumptions). Various re-

that uses debt is $5.18. form proposals put forward during the de-

On the other hand, in a community that bate over the Tax Reform Act of 1986 ad-

chooses a pay-as-you-go scheme (and dressed the exemption and deduction

therefore sets a local tax of $100.00 in the issues, but none encompassed the im-

year that it purchases a unit of capital), puted income issue. We now show that

citizens claim a deduction for that amount, those proposals would not have led to

and therefore the cost, net of federal tax neutrality.

savings, is $72.00. Since interest earned Consider first the exemption for state

is taxable and interest paid is deductible and local bonds. In our example, this pro-

under current tax policy, the annual cost posal would imply that the rate on mu-

of a one time, one dollar local tax is $.072. nicipal bonds would have to be the pretax

Thus, the cost of equity financed public rate of 10.00 percent rather than the after

capital under current tax policy is again tax rate 7.20 percent. If this proposal were

$5.18. not coupled with the elimination of the

deduction for local taxes, then the cost of

Eliminating the Exemption for Interestpublic capital would be $7.20 for com-

on Municipal Bondsmunities that enter the municipal bond

market. This proposal would have no ef-

We have shown that an income tax that fect on those communities that use pay as

included the imputed income from public you go plans to finance capital expendi-

74 NATIONAL TAX JOURNAL [Vol. XLHI

tures; for those communities, the cost of assumptions. We therefore turn in thiscapital would remain $5.18. Thus equity section to the question of whether a Sim-financed investments would be treated ilar set of results holds for other modelsmore favorably than debt financed in- of public choice.'veitments and, as a consequence, the mu-nicipal bond market would disappear un-

A General Model of Local Governmentder this proposal. The non-neutrality issuewould, however, remain. A more general model of a local gov-

eriliment would, at minimum, allow for

Eliminating the Deduction for State and heterogeneous preferences for local public

Local Taxes goods. We therefore start by consideringa community that consists of N, not nec-

As for the deduction for state and local essarily identical, people. The govern-taxes, a community which uses equity in- ment in this community, through somecurs an after-tax opportunity cost of $7.20 public choice mechanism, purchased a(since the local tax of $100.00 in the year stock of public capital K when the com-the capital is purchased is no longer de- munity was formed and paid for the cap-ductible). If, on the other hand, a com- ital with local taxes. Each year it hires amunity uses debt it pays $7.20 in interest public labor force L that, together with theeach year (since local taxes are not de- community's capital stock, produce someductible but interest is exempt). There- quantity of the local public good X. Thefore, if the deduction for local taxes is local government finances these publiceliminated but the exemption for interest goods by assigning tax shares, Pi, to theis retained and imputed income is not residents of the community. For simplic-taxed, then the cost of public capital be- ity, we assume that capital does not de-comes $7.20 under both debt and equity preciate and therefore person i's annualfinancing. This proposal thus narrows the local taxes are [email protected] between the cost of capital in the Since this community is heterogeneous,public and private sectors (since capital residents will value the local public goodsreceives a single rather than double sub- the community provides differently. Aaronsidy) but does not eliminate it. and McGuire (1970) argue that we should

evaluate public goods in proportion to

IV. Alternative Models of Public consumers' marginal willingness to pay

Choice for those goods. Thus we would assign toperson i a value of Pi'X, where Ili" is per-

The assumptions of our Tiebout model son i's marginal willingness to pay for X,imply that local public goods are provided i.e., P,?/Pz equals i's marginal rate of sub-on virtually the same basis as private stitution between X and Z.goods. Consumers face a price for local Each household's budget constraint re-public goods that equals marginal cost and quires that its money income equal thethey are free to choose any quantity given sum of its local tax bill, expenditures ontheir resources. Local governments act as Z, and increase in net worth,their constituents' perfectly reliableagents, and investments in public capital Yi + r(Wi - PINP'K)are effectively the same as investments inprivate capital. A comprehensive income PINPLL + PzZi + AWi. (6)tax in Tiebout's world would thus requireus to treat the implicit income generated The corresponding Haig-Simons income,by the public capital stock the same way on the other hand, is the sum of the valuewe would treat the imputed rent from it places on the local public goods it re-owner-occupied housing. ceives P@ixX,expenditures on Z, and change

We have derived these results only for in net worth. If PxX is the per capita costthe Tiebout model. This model is, how- of providing X units of the local public goodever, based on a set of extremely strong to each citizen, and therefore equal to iVK


+ P'L, then the difference between Haig- find that his Haig-Simons income differsSimons income and money income (6) is ftom market income for two reasons: the

imputed capital income attributable to thatVi = PiNrPK + (P@ix- PiNPx)X. (7) individual and the demand effect. The

latter is equivalent to an income transferEquation (7) states that the wedge Vi is equal to the difference between the as-equal to the sum of imputed returns on signed cost of public good and the indi-public capital, the "imputation effect," and vidual's valuation of that good. Thesethe difference between the subjective transfers cancel in the aggregate becauseevaluation and cost of providing local winners balance losers, but in assessingpublic goods, which we term the "demand individual income, the value of theseeffect.)78 transfers must be taken into account.

Within this framework, four special Third, suppose heterogeneous commu-cases are of interest. First, consider the nities reached efficient decisions throughTiebout model once again. We have ar- Lindahl taxation. Under Lindahl taxa-gued that in a Tiebout world the costs of tion, each citizen's taxes would equalproviding local public goods would be willingness to pay, since demands wouldshared equally within a community and be revealed. In the context of our model,therefore Pi in (7) would equal 11N. We tax shares would be assigned so thatalso argued that public decisions would (Pix - PiNPx) equals zero for each indi-be made "as if" the objective were to vidual. Thus, under Lindahl taxation wemaximize the utility of one of the com- reach the same conclusion as in the Tie-munity's identical residents subject to a bout model: the demand effect vanishesresource constraint. Therefore, in a Tie- and the Haig-Simonr, gap is.the implicitbout model, there will never be a wedge income from public capital.9between willingness to pay for local pub- Finally, suppose goods produced by lo-lic goods and their cost, and the demand cal governments had no value whatsoevereffect in (7) vanishes for each individual. (at the margin) to consumers; i.e., sup-Thus the gap between Haig-Simons in- pose governments were able to extract re-come and market income would equal the sources from their constituents withoutimputed return on public capital, as we producing anything of value in return. Inshowed above. this case Pix in (7) would equal zero and

Second, suppose communities are com- Haig-Simons income becomes market in-posed of individuals with heterogeneous come less the wage bill for public sectortastes and incomes and that local govem- labor. This is equal to the aggregate taxments provide the quantity of X which is base under current tax policy, since localefficient conditional on the composition of taxes equal the cost of labor when capitalthe community. Given the heterogeneity is financed from equity. Thus, allowing aof preferences and the definition of Pix, the deduction for local taxes and failing to taxSamuelson rule for the efficient provision imputed income from public capital wouldof public goods would require that Y.PixX be correct only if publicly provided goods= NP. Then for the community as a have no value whatsoever.whole, the wedge between cost and mar-ginal willingness to pay for local public V. Estimated Imputed Income fromgoods would vanish; that is, if we were to State and Local Capitalsum equation (7) over the N individualsthe demand effect would equal zero. Our We have shown that comprehesive fed-Tiebout result would then hold in the ag- eral income taxation in a Tiebout worldgregate, and the Haig-Simons gap for a would require taxpayers to include part ofcommunity as a whole would equal the the imputed income generated by the stocktotal imputed income from the commu- of capital in the state and local sector. Innity's capital stock. this section, we develop rough estimates

While this result holds in the aggre- of the income which escaped federal tax-gate, any individual would (in general) ation in selected years in order to suggest


the potential magnitude of the effect. private purpose bonds were negligible. InThere are three steps in the estimation later years, however, they grew rapidly;

of the imputed "equity" income generated U.S. General Accounting Office (1983), forby public sector capital: (i) calculation of example, estimated that these privatethe stocks of each of three types of capital purpose bonds represented nearly one-halfassets, (ii) estimation of the gross income of all of the $87.5 billion of new state andaccruing to these assets, and (iii) netting local bonds sold in 1982. We have there-out interest on the debt associated with fore adjusted the Census debt estimatesthe acquisition of that capital and a de- to exclude private purpose debt usingpreciation allowance. Treasury Department data.

We presented estimates of the capital Our imputation of the per unit cost ofstocks in an earlier paper [Hulten and capital is based on an extension of equa-Schwab (1988)] and a full discussion of our tion (5) which states that the user cost ofdata is available there. The stock of de- capital P' equals (1 - 0)(r + B)PI, wherepreciable assets (structures and equip- 0 is the matching grant rate for capitalment) can be estimated through a per- projects. The estimates of P, and 8 are thepetual inventory method in which the same as those used in the calculation ofstock in each year equals the stock in the our capital stock series. We measure r asprevious year, less depreciation, plus gross the difference between Moody's Aaa cor-investment. The real investment series is porate bond rate and estimated long termbased on data from the National Income expected inflation."and Product Accounts (NIPA) and unpub- The bottom panel of Table 2 presentslished data from the Bureau of Economic our estimates of gross income PK. UnderAnalysis (BEA). Sufficiently long time se- a comprehensive income tax the ownersries are available so that the initial stocks of capital would be allowed to claim ascan be ignored. We assume, based on work costs the expenses incurred to generateby Hulten and Wykoff (1981), that the de- capital income, e.g., interest on debt andpreciation rate 6 is 13.1 percent for equip- economic depreciation. Net income (grossment and 1.9 percent for structures. BEA income less depreciation and interest) isprovides unpublished estimates of cur- shown in the last row of that table. Theserent dollar land purchases. We use a 1958 estimates suggest that the imputation ef-benchmark from Goldsmith (1962) and a fect amounted to $85 billion of income inprice deflator for land based on data from 1985.the Bureau of the Census and the De-partment of Agriculture. VI. Conclusions

Table 2 presents current dollar esti-mates of the stocks of structures, equip- Most people would be astonished to learnment, and land. We note, in passing, that that they receive income from invest-it has sometimes been argued that the ments in streets and schools, and wouldstate and local sector is labor intensive, be much more than astonished if they wereand therefore productivity growth will be asked to pay tax on this income. But, asslow.'o Table 2 suggests that this might we have shown in this paper, a compre-not be an accurate characterization; in hensive income tax in a pure Tiebout world1985, we estimate that the capital stock leads exactly to this result. The collectivein the state and local sector was worth decision to prepay local taxes is equiva-nearly $2.1 trillion. lent to the individual decision to invest in

The debt calculation presents a difficult private assets, and the prepayment of taxesproblem. The Bureau of the Census pub- to finance public capital formation im-lishes annual data on the stock of out- plies that consumption or net worth canstanding long-term state and local debt. be increased by rotPK in each subsequentThe Census numbers, however, include year. A truly comprehensive income taxt,private purpose" debt, such as mortgage would not ignore this income.revenue bonds and industrial develop- We also acknowledged that the issue isment bonds. Before roughly 1970, these far more complicated if, as most people


TABLE 2ESTIMATED STATE AND LOCAL CAPITAL STOCK AND INCOME (BILLIONS OF CURRENT

DOLLARS)

1965 1975 1985

Cat)ital Stock

Structures 251.4 831.6 1756.2

Equipment 12.2 39.5 108.3

Land 36.2 96.3 209.6

Total 299.8 967.4 2074.1

Gross and N t Income

Gross Income 14.0 48.3 140.5

Depreciation 5.1 15.1 32.4

Interest 4.3 10.6 23.1

Net Income 4.6 22.6 85.0

believe, the Tiebout model is not an ac- required to deal with this externalitiescurate description of decentralized gov- problem. Similar issues arise if local gov-ernment. Once we leave the world Tie- ernments engage in redistribution. About described, the wedge between money community may be reluctant to engage inincome and comprehensive income has two redistribution for fear of attracting lowcomponents: an "imputation effect" which income households and driving out highwe discussed above, and the difference be- income households. If all communitiestween the subjective evaluation and cost reason this way then this free rider prob-of providing local public goods, which we lem means that redistribution may betermed the "demand effect." When both suboptimal if local government spendingeffects are present, it is quite difficult to is not subsidized. Whether or not spill-calculate any particular individual's Haig- overs are important depends not only onSimons income. whether they exist, but also on the extent

It should also be acknowledged that our of Coaseian negotiation. In any event, themodel does not deal with some potentially existence of spillovers-whether Coaseianimportant issues. For example, some have or not-does not imply that we can ig-argued that the benefits of local public nore the implicit returns on public capitalgoods produced in one community often when devising an efficient and equitablett spill over" into other communities (as tax policy.when the residents of Community A might

12use a park built in Community B)

.In

such cases the marginal private benefit of ENDNOTESlocal public goods will be less than mar-ginal social benefit and, all else equal, lo- 'As Bradford, Malt and Oates (1969) argue, the

nd to becharacteristics of the eomrnunity enter the production

cal government spending will te function for public goods. Thus holding purchased in-too low. Current tax policy might then be puts such as teachers and textbooks constant, we would

defended on the grounds that a subsidy is expect to find that children in white collar upper in-


come communitites do better in school than children BIBLIOGRAPHYin blue collar low income communities. The impor-tance of community characteristics in the production Aaron, Henry and l@@ McGuire 1970. "Public Goodsftmction and the fact that public goods are produced and Income Distribution," Econometrica, 38, 907-and consumed within the community suggest simi- 920.larities between our model and Becker's (1965) house- Baumol, W. J. 1967. "Macroeconomics of Unbalancedhold production model. See Hulten (1984) and Schwab Growth: The Anatomy of Urban Crisis," Americanand Zampelli (1987) for a further discussion of these Economic Review, 57, 416-426.points. Becker, G. S. 1965. "A Theory of the Allocation of

2We assume for simplicity that prices, income, the Time," Economic Journal, 75, 1063-1094depreciation rate, and the interest rate are all con- Bradford, D., R. Malt, and W. Oates 1969 "The Ris-stant over time. ing Cost of Local Public Services: Some Evidence

31f we relax our zero inflation assumption then the and Reflections," National Tax Journal, XXIII, 185-user cost of capital would include a capital gains term. 202.

41t might be argued that the owner-occupied hous- Goldsmith, R. W. 1962. The National Wealth of theing differs from public capital in that you can easily United States in the Postwar Period, Princeton Uni-imagine converting the implicit rent into an explicit versity Press, Princeton.cash flow by renting the house, whereas no such con- Gordon, R. H. 1983. "An Optimal Taxation Approachversion is possible for public capital (e.g. you cannot to Fiscal Federalism," Quarterly Journal of Eco-charge a rent for the street in front of your house). Ywmics, 98, 567-586.However, one could imagine local governments set- Hamilton, B. W. 1975. "Zoning and Property Taxa-ting a tax on its citizens as consumers equal to the tion in a System of Local Governments," Urbancost of producing public output PLL + I-'KK, using a Studies, 12, 205-211.part of those revenues to offset the wear and tear on Hamilton, B. W. 1976a. "The Effects of Property Taxesthe comxnunity's capital and to pay public sector and Local Public Spending on Property Values: Aworkers, and then paying the rest as a "dividend" to Comment," Journal of Political Economy, 84, 647-its citizens. Instead, they simply net out the dividend 6150.and set a tax equal to the cost of labor and deprecia- Hamilton, B. W. 1976b. "Capitalization of Intra-tion. jurisdictional Differences in Local Tax Prices,"

'The classic reference in the empirical literature on American Economic Review, 66, 743-753.capitalization is Oates (1969). There is also an exten- Hulten, C. P, 1984. "Productivity Change in State andsive theoretical literature on capitalization; in partic- LocalGovernmen "Review ofeconomics and Sta-ular, see Hamilton (1976a) and (1976b). tistics, vol. LXVI, 2, 256-265.

'If labor supply decisions are exogenous, but sav- Hulten, C. R. and R. M. Schwab 1988. "Income Orig-ings decisions respond to changes in tax policy, then inating in the State and Local Sector," in Harveya comprehensive consumption tax will be neutral. If S. Rosen (ed.) Fiscal Federalism, University of Chi-both labor supply and savings decisions are endoge- cago Press, Chicago.nous, then we are faced with the full optimal tax pol- Hulten, C. R. and F. C. Wykoff 1981. "The Measure-icy and no simple rule (such as tax all income at the ment of Economic Depreciation," in Depreciation,same rate) is necessarily correct. Inflation and the Taxation of Income fmm Capital,

'See Inman and Rubinfeld (1988) for a discussion Charles Hulten, ed., The Urban Institute, Wash-of this issue. ington, DC.

8'Ms decomposition of the gap between Haig-Sixnons Inman, Robert P. and Daniel L. Rubinfeld 1988. "Aand money income points to an important distinction Federalist Constitution for an Imperfect World:between the issues surrounding owner-occupied hous- Lessons from the United States," unpublished pa-ing and public capital. Consumers choose their own per.housing stock and thus the demand effect in housing Jorgenson, D. W. 1963. "Capital Theory and Invest-must be zero; only the imputation effect remains. ment Behavior," American Economic Review, 53,

9The 9Nebout model is in many ways a special case 247-259.of the Lindahl model. Since our basic result holds for Schwab, R. M. and E. Zampelli 1987. "DisentanglingLindahl, it must hold for Tiebout as well. the Demand Function from the Production Func-

"See Baumol (1967), for example. tion for Local Public Services: The Case of Public"Our estimates are based on the corporate rate, Safety," Journal of Public Economics, 33, 245-260.

rather than the municipal rate, since the municipal Tiebout, C. M. 1956. "A Pure Theory of LDeal Expen-rate is low given that interest on municipal bonds is ditures,- Journal of Political Economy, 64, 416-424.exempt from federal taxation. We discuss this ex- U.S. General Accounting Office 1983. "Trends andemption in the next section of the paper. Changes in the Municipal Bond Market as They

See Gordon (1983) for an excellent discussion of Relate to Financing State and Local Public Infra-this problem. structure."

Documents

A HAIG-SIMONS-TIEBOUT COMPREHENSIVE INCOME TAXA HAIG-SIMONS-TIEBOUT COMPREHENSIVE INCOME TAX CHARLES R. HULTEN* AND ROBERT M. SCHWAB** ABSTRACT requires more than simply eliminating