Naissance of TRA86
The primary function of the federal income tax is to provide revenue to finance the operations of government. From its inception, however, the federal income tax has been used to implement fiscal, economic and social policies as well. For example, the first income tax in the United States was imposed by the Union government to finance the Civil War. It also included the first tax incentive designed to encourage taxpayers to purchase government bonds. The tax was removed after the resolution of that conflict. When the income tax was reinstated in the late 1800’s, a primary goal of the tax legislation was to address inequities that resulted from reliance on regressive tariffs and excise taxes. This dual role of the income tax — as both generator of revenue and means of implementing government policy — has continued to the present day.
Because tax law is written to achieve objectives other than the generation of revenue, and because the relationship between tax law and taxpayer behavior is imperfectly understood, changes in tax law have the potential to create economic consequences for business enterprises that are not anticipated by Congress. A recent example is the passage of the Tax Reform Act of 1986 (TRA86). TRA86 was designed: (1) to remove distortions and inequities that had developed in the Tax Code over time; (2) to transfer a portion of the tax burden from individuals to corporations; (3) to ensure that taxpayers pay some minimum level of tax; and (4) to simplify the tax system.] Thus, TRA86 was an adjustment of the Tax Code designed to achieve objectives other than financing government operations. However, if the specific provisions of the law resulted in taxpayer actions that were unanticipated when the law was written, the stated goals of TRA86 may not have been achieved, and business enterprises may have faced a set of economic consequences that are very different than those intended when the law was passed.
One area that has been explored extensively in the finance literature is the relationship between tax policy and corporate capital structure. If specific changes in tax law provide incentives for managers to alter the capital structure of corporations, then it is important to document these changes in capital structure so that potential consequences of tax legislation, both intended and unintended, can be identified and if any, firm behavior assessed. The purpose of this study was to extend prior research which empirically tests finance theories of the effects of tax policy changes on the capital structure of corporations. Specifically, the capital structure and other characteristics of corporations were examined both before and after TRA86 to determine if changes in these variables are associated with changes in tax law.
The Federal Income Tax System: Overview and Importance to Farmers
Tax policy has always been an important concern for farmers because it provides important economic incentives to which they respond. The Federal income tax is a progressive tax imposed on net income and has important impacts on investment, management, and on production decisions in the agricultural sector. To understand how taxes affect most farmers, it is necessary to compare the importance of individual income tax to that of the corporate. Farms operating as sole proprietors are taxed at the individual level, and the most common form of farm organization is the sole proprietorship. According to Durst and Monke (2001) this type of business comprises 86% of all farms and 52% of total sales. Table 2.1 summarizes types of business organization, sales, and net income among all the farms.
As a sole proprietor, a farmer is subject to annual Federal income tax on his or her taxable income. Under the Pre-2001 Tax Act, there are five marginal income tax brackets on ordinary income: 15%, 28%, 31 %, 36%, and 39.6%, with higher marginal rates applied to higher amounts of taxable income.
Taxable income is computed by subtracting allowable adjustments, deductions, and personal exemptions from total income. This income is the sum of wages and salaries, taxable interests and dividends, capital gains, net business income, rental income, taxable social security and retirement income, and other miscellaneous incomes. Business income for farmers operating as sole proprietorships is taxed on a net basis after subtracting allowable business expenses from gross business revenue. Important statutory adjustments for farmers include subtractions for half of the self-employment tax, contributions to tax deferred personal retirement plans, and the self employment health insurance deduction. The standard deductions or itemized deductions (such as medical and home mortgage interest expenses, state and local income taxes, property taxes, and charitable contributions) also reduce the amount of income subject to tax. Personal exemptions provide an additional allowance against taxable income for each person in the household. Income tax rates for individuals vary depending on whether the taxpayers are single, married persons filing joint returns, married persons filing separate returns, qualified widows and widowers, or heads of households.
Most farmers, as the majority of taxpayers, are taxed at the 15% marginal tax bracket (Durst and Monke 2001). However, those in higher tax brackets pay most of the tax collected. Table 2.3 illustrates the distribution of marginal tax brackets and income taxes paid by farm sole proprietors and other taxpayers. This table indicates that 53% of farm sole proprietors were in the 15% tax bracket, but they paid only 20% of the Federal income taxes collected from farmers. In contrast, the 5% of farmers in the top three tax brackets paid 54% of taxes paid by farm sole proprietors. The distributions are similar for nonfarm taxpayers as well with the number of both farm and nonfarm business being skewed toward the extreme high-and low-tax brackets and the taxes paid being skewed toward the higher brackets.
According to the FBFM annual report 2002, Illinois farm firms’ income and social security tax paid amounted to an average of$9,941 in 1999, $9,898 in 2000, $10,328 in 2001, and $8,880 in 2002. These figures represent on average 18%, 13%, 18%, and 17% of net income successively for 1999, 2000, 2001, and 2002. Clearly, the level of income and self employment taxes that farmers pay significantly affects the funds available for debt repayment and reinvestment in farm business.
Evaluation of the Pre-2001 Federal Income Tax System
According to Economic Report of the President of the USA (2003), a good fiscal policy includes a tax system that creates tangible incentives to taxpayers for productive economic activities, and reduces the risk of tax evasion and avoidance. However, Feld (1995), Carman and Boehlje (1996), and Entin (2003) note that income tax incentives in general are less visible than subsidies; their impacts often have not received the same scrutiny given to other government programs and they sometimes have unintended impacts. It is commonly asserted that the Federal income tax law is inefficient; it lacks incentives to increase productive behavior and to promote savings. Furthermore, the law is frequently revised, and new IRS regulations, revenue rulings, and court decisions continually update its application.
Doye and Boehjle (1985), Hitt (1993), Hall and Rabushka (1995), Carman and Boehjle (1996), Cassou and Lansing (2000), and Entin (2003) report a widespread dissatisfaction with the Federal income tax system (and the Internal Revenue Service). Similarly, Klein and Bankman (1993) support the above criticism and add that the Federal income tax system does not make adjustments in any systematic way, for the effects of inflation. According to Klein and
Bankman (1993), inflation gives rise to at least three serious problems. The first is bracket creep, or an increase in tax rates that occurs solely as a result of inflation. From time to time, Congress makes substantial efforts to reduce the nominal rates, yet the effect has always been merely to restore to taxpayers some of the losses resulting from bracket creep.
The second problem deals with deductions for the cost of investments in productive property. Allowances or deductions are typically based on original or historical cost rather than on present value, or replacement value, of the asset. As a consequence, the economic cost is understated and the firm loses access to funds for replacement of assets at the end of their useful lives. A solution to the second problem of inflation consists of increasing allowances for depreciation through provisions that concentrate deductions in the early lives of the assets although its accuracy remains questionable.
Gains from the sale of property, especially those held for a long period, constitute the third serious problem. Such sales have no real economic gain or true economic increment that should be taxed because inflation is the main source of the realized gain. Furthermore, various studies in public finance, which evaluate the Federal income tax system, have concluded that there is a need for a new tax system (Belt and Hunt 1996; the American Institute of Certified Public Accounts and Sullivan 1996; the Economic Report of the President of the USA 2003; and Entin 2003). This fact suggests that a major issue for the U.S. Congress is to decide whether or not to revise or replace the Federal income tax system.
Among the arguments for replacing the Federal income tax system are that the Federal tax code is too complex and costly; it is anticompetitive and it distorts economic activity. To date, the evaluation of the Federal income tax system has led to several proposals to replace it. Advocates of tax reforms blame the Federal income tax system for not meeting the tax system requirements of fairness, neutrality and promotion of economic growth, and simplicity of the administration compliance.
2.3 Alternative Tax Proposals
The following description of major proposals is based on the works of Makin (1985), Teplitz and Brook (1986), the Staff of the Joint Committee on Taxation (1995), Hall and Rabushka (1985, 1995), Sullivan (1996), the United State General Accounting Office (1998), Cassou and Lansing (2000), which represent major critical claims against the Federal income tax system. The focus is on the FT on income and the NRST.
2.3.1 The Flat Tax
An FT is one in which the marginal tax rate remains constant as taxable income increases. Marginal tax rates differ from average tax rates in that the former is the portion of an additional dollar of income that is paid in taxes, whereas the latter is total amounts of tax paid divided by individual’s before-tax income. Most FT proposals (Anney, Shelby, Domenici/Nunn, English, Specter, Lugar, Tauzin, Linder, Souder, Gramm, Faircloth, and Largent/Hutchinson, see Bickley 2000) are derivatives of Robert Hall and Alvin Rabushka’s proposal (1985, 1995) and would change the tax base from income to consumption (Bickley 2000).
The FT proposed by the House majority Leader Dick Anney of Texas was first introduced as H.R. 4585 the Freedom and Fairness Restoration Act of 1994 in June 1994. He then reintroduced largely the same legislation in the 104th Congress as H.R. 2060 on July 19, 1995. At the same time, Senator Richardson of Alabama introduced the same bill in the Senate as S.l050. These proposals are similar to value-added tax collected from both individuals and business. Under these laws, the business tax base is business receipt reduced by wages paid and purchases from other businesses. Under this approach, the entire cost of new capital assets may be expensed in the year of purchase. Nevertheless, this provision to businesses is potentially offset by the loss of deductions for interest payments and for fringe benefits.
With the individual FT, a fixed percentage tax rate is imposed on wage and pension income, whereas interest income, dividends received, and unrealized capital gains are exempted. Large personal and dependency exemptions might remove tens of millions of taxpayers from the tax rolls. For instance, a family of four would be subject to tax only for wages in excess of $31,000. As proposed, the FT has no other deductions for mortgage interest, charitable contributions, state income taxes, and property taxes. Rather than to analyze each FT proposal separately, this study uses a generic FT alternative based on different models. The actual tax rate under an FT proposal as would be implemented is unclear, but three levels that are widespread include 18%, 20%, and 23%. A marginal rate of 18% as suggested by Sullivan (1996) would result in large revenue loss to the Federal Government. Thus, some leading economists in public finance suggest 23% to avoid revenue losses. Indeed, it has been estimated that a 17% FT would result in a $138.3 billion loss of Federal government revenue (US Treasury Department, Office of Tax Analysis 2001).
The goal of the paper is not to determine the tax rate needed to generate a certain level of government receipts, even though that question remains central in the political debate. Instead, a farm level analysis such as this one seeks to shed light on the impacts of different FT rates likely to be proposed for the agricultural sector.
Under the generic FT proposal, the personal deduction is $35,000 per year that consists of a personal exemption of$10,000 for two dependents and a standard deduction of$25,000 for a family of four. The Forbes’ proposal includes a $35,000 personal deduction, whilst the Armey- Shelby FT bill contains three major parts, notably, a 17% rate on wage and pension distribution, a flat 17% tax on net taxable income of business, and a standard deduction for all filers ($10,700 for single filers, $21,400 for joint filers, and $14,000 for head-of-household filers) with an additional standard deduction for each dependent ($5,000). Other studies advocate that a family of four be subject to tax only for wages in excess of $31, 000.
Under the FT alternative, the depreciation deduction is replaced with a deduction for capital purchases that permits capital purchases to be fully expensed in the year of purchase, net of trade in value. If the capital purchases exceed taxable income, the balance is carried forward for an unlimited number of years and an interest rate is added to the carryover of capital purchase for each year. If allowable deductions exceed gross revenue, the negative tax is also carried forward as tax benefits in subsequent years. The carry-forward gains are then not adjusted for inflation in subsequent years. As most FT proposals are silent on the transitions from the Pre-2001 Tax Code, it is generally assumed that the farms’ depreciation for existing machinery and building is an expensable deduction in the first year.
Concerning the calculation of the self-employment and Medicare taxes, the study uses the same tax codes under both the Pre-200l Tax Act and the generic FT. There is however, a difference between the two tax laws because the calculation of the income subject to the employment taxes differs depending on provisions on depreciations, new capital purchases, and interest paid. Furthermore, excess deduction carried forward does not apply when computing the income subject to employment taxes for the FT alternative. That is to say that, in the FT model, the Federal taxable income used to calculate self-employment taxes, should not be reduced by excess tax deductions carried forward.
2.3.2 The National Retail Sales Tax
This proposal is associated with senator Lugar and Congressman Archer, Chairman of the House Ways and Means Committee (Bickley 2000). This ongoing study models the NRST based on provisions offered by the above sources. They propose a tax rate of 17% on taxable goods and services, which generally comprise tangible personal property, services, financial services, and real property, but not investment income. Under the NRST, the personal and corporate income tax including income taxes on capital gains and saving are repealed, namely, estate and gift tax, and all non-trust fund dedicated excise taxes. The following are the primary provisions of the NRST.
- A rate of 15 to 17% is required in a NRST, assuming a broad-based tax. The state that utilizes the existing sales tax departments and procedures collects the tax and receives 1% of the tax to offset collection costs. Likewise, businesses receive 0.5% of the tax collected to offset costs.
- The social security administration collects social security payments and the Medicare tax.
- No income is taxed until it is consumed. Capital gains and interest income are not taxed as long as that income is reinvested.
- Deductions do not exist under a sales tax. All money paid for taxes, or given to charities, is tax-free.
- Goods and services sold at retail are taxed. The NRST applies to any and every final good or service that is consumed.
- No business consumption (inputs) is taxed. Inputs used directly or indirectly to produce a good for retail consumption are taxed.
- The NRST adopts the same calculation of the self-employment and Medicare taxes as the Pre-2001 Federal income tax law.
The NRST appears at first a very attractive alternative to the Pre-2001 Federal income tax law for the main reason that an individual has no longer to file tax returns. Nonetheless, a heavy burden is placed on retailers and tax administrators, particularly if legislators provide exemptions for favored businesses and products.
In spite of special exemptions, substantial problems exist. The major problem is the incentive for tax evasion by small retailers who might not report sales and business owners who might buy items for personal use. These problems increase as the tax rate rises. For instance, a rate in excess of20% is likely to be required to replace revenues loss from the repeal of income tax (Sullivan, 1996). There also exists a large political hurdle against the NRST because it is a highly regressive tax and encroaching on the states sales taxes. Most economists argue that while a Federal retail sales tax is administratively feasible as a supplement to the Federal income tax law, it does not seem to be a good replacement for the Pre-2001 Tax Act.
One understands that the above proposals have different provisions, but still have several characteristics in common. They all involve a move from a tax on income to a tax on consumption. These proposals involve dramatic changes in the U.S. tax system, with significant transition problems. The benefits they bring about depend on the nature of the claims that define the tax base (the definition and calculation of the income, sales, or other measure of economic activity to be taxed) as well as on the particular tax rate selected. Table 2.5 summarizes features of alternative tax systems and the Pre-200! Tax Act and Table 2.6 depicts the individual tax base under the Pre-2001 Tax Act, the FT, and the NRST.
Impacts of Tax Reform on Economic Sector
Minarik (1982b) asserts that an FT rate income tax may reduce the marginal and average tax rate at high incomes and increase with certainty, the average tax rate for middle-income individuals even with a substantial low-income exemption. He also calculates that, without base broadening, a rate of 18.5% FT is desirable to yield tax revenues equivalent to those under the 1982 law. Concerning the effects of FT reforms on work, saving, and investment, Minarik argues that incentives for these macro-aggregates due to reduced tax rates at higher incomes could be offset by disincentives for those with middle incomes. Although this study uses a generic FT proposal with three scenarios that include 18%,20%, and 23% flat rates, it investigates the change in average tax rates of farms with different levels of incomes, and serves as a benchmark against the Minarik study.
Blum and Kalvin (1953) and Minarik (1982a, b) point out that an impact of FT is that there may be no incentive for income reallocation among years. Minarik further proposes a way to make the Federal income tax system a viable alternative. He suggests incorporating various base broadners, and three or four brackets to appropriate tax burden on high incomes while simplifying the system. By doing so, he believes that some existing tax problems such as bracket creep, other inflationary side effects, and savings and consumption disincentives might be reduced. This study considers income reallocation among years to be a possible strategy that farmers use in the years of higher income. Such reallocation is made possible through prepaid variable costs under cash accounting.
Friedman (1980), cited by Elffner, Featherson, and Cole (1998), suggests that an FT system is beneficial to taxpayers and the economy. He states that “A low flat rate-less than 20% on all income above personal exemption with no deductions except for strict occupational expenses is likely to yield more revenue than the present unwieldy structure. Taxpayers would be better off because they would be spared the costs of sheltering income from taxes; the economy would be better off because tax considerations would playa smaller role in the allocation of resources.”
Fellows (1995) supports the concept of an FT, but expresses skepticism about whether such a fiscal policy would really spur much greater economic growth. He argues that the work/leisure substitution effect and the income effect of lower taxes may be largely offsetting. Similarly, Golob (1995) estimates that the elimination of taxation of interest would cause interest rates to drop from 25% to 35%; with consideration of secondary factors, the drop would likely be near 25%. Moreover, Farrell (1996) maintains that the transition to an FT would be very disruptive to the economy so much so that there might be no long-term payoff.
Seldon and Boyd (1996) use a computable general equilibrium (CGE) model to evaluate the economic effects of a 17% FT on various sectors of the U.S. economy and on the income of different income groups and on government revenues. They note that (1) every income group would gain, with the greatest gain in percentage terms (7.6%) going from the lowest-income group; they hold that the earned income tax credit would be eliminated even though it benefits many low-income groups; (2) in percentage terms, the gains of the highest income-group would be the third highest among the six income groups, and (3) the increased economic activity resulting from the elimination of tax variations and from changes in incentives would increase the government’s revenues by 1.8 % points.
Kotlikoff (1993) uses a simulation model to evaluate a proposal to raise the U.S. saving by replacing all Federal personal and corporate income taxes with an NRST. The study, examines the crisis in U.S. savings, its implications for the nation’s economic performance, and the contribution the U.S. current tax structure has made to the crisis. According to Kotlikoff, the shift in tax structures would raise U.S. capital level by at least 29 % and potentially by as much as 49% and the U.S. living standard by at least 7% and potentially by as much as 14%, in the long run.
The United States General Accounting Office GAO (1998) reports that an NRST replacing the Federal income tax would reduce the number of entities filing returns. Compliance burdens would depend on the design of the system, particularly the extent of the exemptions provided and the degree of consolidation with the state systems, and might, in some circumstances, fall on individuals as well as on business filers.
Cassou and Lansing (2000) develop a quantitative general equilibrium model to assess the growth effects of adopting an FT plan similar to the one proposed by Hall and Rabushka (1995). Using parameters calibrated to match the progressivity of the U.S. tax schedule and other features of the U.S. economy, they compute the growth and level effects of adopting a revenue-neutral FT for both a human-capital based endogenous growth model and a standard neoclassical growth model. Growth effects are decomposed into the parts attributable to the flattening of the marginal tax schedule, the full expensing of physical-capital investment, and the elimination of double taxation of corporate dividends. They find that the most important element of the reform is the flattening of the marginal tax schedule. Without this element, the combined effects of the other parts of the reform can actually reduce long-run growth
Entin (2003) refers to President Bush’s proposed tax package that intends to stimulate economic recovery and promote growth. The President’s plan includes accelerating scheduled tax rate cuts, ending the double taxation of corporate income, and increasing the amount of capital expenditures that small businesses can deduct from their taxable income. The President’s goal is to simplify and expand tax-favored saving arrangement.
According to Entin, eliminating this double tax burden would reduce from 7.5 to 4.6 % the pretax return on assets that a company would have to earn to provide a 3% after-tax return to shareholders. He concludes that much idle capacity would be put to work, and potential investments in new plant, equipment, and commercial and residential buildings that could earn more than 4.6% but less than 7.5% would go forward. The capital stock would expand. Share values would rise and firms could more easily raise funds to pay for the added capital. Production costs would drop, benefiting consumers. Productivity would rise, employment and wages would increase, and the expanding economy would generate new government revenues.
Impacts of Tax Reform on Agricultural Sector
Sisson (1982) examined farm versus nonfarm tax burdens under tax structures of that period and found that fanners had significant tax advantages over the general population. He concludes that those farmers, particularly larger ones had substantially lower tax burdens than nonfarm taxpayers under progressive rates. Otto (1983) conducted a similar survey on Iowa and Alabama farmers on farmers’ views on income tax issues and problems. His results indicate that the majority of producers believe tax savings as well as Federal farm program payments were crucial to their net earnings.
Doye and Boehlje (1985) studied the impacts on representative hog and grain farms due to an FT rate. They identified shifts in the tax burden within agriculture in evaluating the tax implications of an FT of20% on the Economic Recovery Tax Act income tax base, and an FT of
20% on a broader income tax base on farms with various size, enterprise, and financial characteristics. They then measured the impacts of the elimination of special tax treatments for agriculture by determining variations in effective tax rates for different representative farms. In general, they discovered that an FT imposes higher average tax burdens on small farms and yields a tax cut from Economic Recovery Tax Act laws for large farms even when the tax base is broadened.
Hardesty, Carman, and Moore (1987) analyzed the effects of tax law changes instituted by the Economic Recovery Tax Act of 1981 on farm firm decision-making using a dynamic optimization model. They found that income tax rules might have been partially responsible for the financial crises faced by many farm firms. Also, they argued that deductibility of depreciation and interest payments, combined with investment tax credits and progressive tax rates, promoted land and machinery purchases and encouraged debt financing during the agricultural boom in the mid-1970. Farmers’ expectations of crop prices, land values, and interest rates proved to be overly optimistic such that in the mid-1980’s, yet many farms experienced substantial financial distress.
Tax advantages already obtained by farm firms are important factors that determine the impact of tax reforms. In this respect, Davenport, Boehlje, and Martin (1982, 1991), argue that tax provisions that are particularly to the benefit of agriculture and that might be lost with reform include: (1) a choice of accounting methods between accrual or cash which allows for accounting simplicity and flexibility in adjusting incomes and expenses for the year, (2) options to the method used to write off capital expenditures, and (3) favorable capital gains treatment of raised livestock used in breeding herds.
Adams and Harl (1995) indicate that eliminating the deduction for interest paid under an FT would significantly impact young, highly leveraged fanners. Without this deduction, many indebted fanners could have a negative net farm income, yet still owe income taxes at the end of the year. Seldon and Boyd (1996) found that, under an FT system, every production sector grows faster than otherwise expected for subsidized agricultural crops.
Carman and Boehlje (1998) assessed previous studies of changes in income tax laws from which they suggest various consequences of an FT. The effects of an FT they proposed include increased farmland price, increased non-farm investor interest, and decreased land availability. They argue that these effects could lead to increased financial requirement and larger barriers to entry into fanning. Carman and Boehlje also suggest that the reduced after-tax cost of capital purchases due to full expensing in the purchase year encourages greater capital investment. They conclude that greater capital investment increases the mechanization of agriculture, increases business activity in machinery and equipment industries, and reduces farm employment. They further argue that the increased tax sheltering could enhance production over time.
Ducan, Koo, and Taylor (1997) appraised the impact of the Anney/Shelby FT proposal on representative farms in North Dakota for 1996-2003 using the North Dakota Farm Price Model in conjunction with the Food and Agricultural Policy Research Institute (FAPRI) commodity price forecasts. They conclude that only large-size farms experience a tax savings under the FT system while small-and medium-size farms would pay higher Federal taxes if 17%
FT rate were applied. They reveal that the key factors that account for the differences in tax liability are the differences between depreciation allowed under the Federal income tax code and the expensing of capital purchases. In their model, the farm incomes of different enterprises are forecast using FAPRI forecasts of inflation adjusted expenses and prices. As a result, net farm incomes do not account for price and yield risks.
Ducan, Koo, and Taylor (1997) estimate that revenue neutrality, which is an important consideration when adopting an FT, requires a 20.8% FT rate. Fewer than 20.8% or more, all three sizes of farms will pay higher federal income tax than under the Federal income tax code. The above theoretical studies shed light on economic impacts of FT proposals in general and those for agricultural sector in particular. They serve as elements of comparison to the present study as they explore potential impacts of income in tax reforms on the agricultural sector. However, they fail to analyze the consequences of tax reform outcomes under uncertainty and are limited to the examination of the expected value of taxes.
Richardson et al. (1996) use the Farm Level Income and Policy Simulation Model (FLIPSIM) to analyze the economic impacts of an FT on representative crop, livestock, and dairy farms in major US production regions. Their results indicate that farms with moderate debt level of 56% (39 of 70) of the farms experience higher total taxes (Federal income and employment taxes) under the FT alternative. Results also indicate that farms that have high debt levels experience higher total taxes under the FT alternative. Furthermore, the representative farms with higher total taxes see their taxes increase largely due to increase in employment taxes.
About one third (22 of70) of the moderate debt farms had higher federal income taxes, 56 of the 70 farms have higher self-employment and Medicare taxes. Elffner, Featherstone, and Cole (1998) develop tax models to analyze the effects of a Federal FT on Kansas’s agriculture. The tax models include: the Current Tax Model (CTM) and the FT Model (FTM). They also evaluate the fairness and progressivity of the current and FT systems to determine the winners and losers resulting from a change in tax systems. Their study also assesses the impact of the FT on interest rates and capital investment.
Their results show that the FT is progressive because it increases the Federal tax liability at an increasing rate as farm profitability and farm size increase. Results also indicate that the average Federal tax that farm family’s pay would drop by 21 %, under the FT proposal and that
3% of the producers would benefit from a movement to the FT system. Under the FT, larger and profitable farms would be better off, while farms with higher leverage ratios would be relatively worse off.
Concerning the effects of an FT on interest rates and capital investment, three scenarios were modeled, including, (1) no change, (2) a 12.5% decline, and (3) a 25% decline in pre-tax interest rates. Elffner et al. notice that land values decline by 12.9% if pre-tax interest rates are unchanged, whereas, they increase by 4.4% on average under a 12.5% decline in pre-tax interest rates, and increase by 30.4% in response to a 25% decline in pre-tax interest rates. In response to the three interest rate scenarios, producers in the 28% tax bracket reduce their after-tax investment in equipment. Those in a 15% bracket would increase investment if pre-tax interest rates decline by 12.5% or more.
Carman and Boehlje (1996) analyzed the impacts on farm due to income tax reforms and found the following: (1) Farmers, particularly large ones, have substantially lower tax burdens than nonfarm taxpayers under progressive rates; (2) majority of producers believe tax savings as well as Federal farm program payments are crucial to them; (3) an FT imposes higher average tax burdens on small farms and yields a tax cut for large farms even when the tax base is broadened; (4) income tax rules may have been partially responsible for the financial crises faced by many farm firms; (5) deductibility of depreciation and interest payments, combined with investment tax credits and progressive tax rates, promoted land and machinery purchases and encouraged debt financing during the agricultural boom in the mid-1970; (6) farm firms’ expectations of crop prices, land values, and interest rates proved overly optimistic in the mid-1980, and as a result, many farms experienced substantial financial distress; (7) tax provisions to the benefit of agriculture that might be lost with reform comprise (a) a choice of accounting methods between accrual or cash which allows for accounting simplicity and flexibility in adjusting incomes and expenses for the year, (b) options to the method used to write off capital expenditures, and (c) favorable capital gains treatment of raised livestock used in breeding herds. (8) eliminating the deduction for interest paid under an FT would significantly impact young, highly leveraged farmers; (9) under an FT system, every production sector would grow faster than otherwise expected for subsidized agricultural crops; and etc.
The paper overviews the research related to impacts of Federal income tax reform on both the economic and the agricultural sectors. Three tax systems are considered namely, the Pre-200l Federal Income Tax Code, the FT, and the NRST. It has been observed that, past models fail to appropriately account for price and yield variability, as well as the variability in tax payment. A feature of this study is its modeling yields at the farm level. No stochastic simulation model has been adequately developed to tackle tax issues at the farm level.
In addition, this study addresses the tax issues by the integration of accounting identities and behavioral relationship due to alternative proposals in describing the amount of taxes paid, net income, and the growth or decay in terminal value of the farm business. It also considers recommendations of recent research (Elffner et al. 1998) to allow investment to vary under the FT system and to examine the amount of revenue that farm firms raise under the alternative tax systems. Finally, this dissertation develops an appropriate simulation model that takes into account interactions of stochastic components and the tax provisions. Such an approach is useful to assess the implications of tax proposals for farms with different sizes and financial positions. As a result, this study contributes to the understanding of how alternative tax proposals affect farm firms.
(Bickley, 2000; Carman & Boehlje, 1996; Davenport, Boehlje, & Martin, 1991; Ducan, Koo, & Taylor, 1997; Elffner, Featherstone, & Cole, 1998; Klein & Bankman, 1993)
Bickley, J. M. (2000). Flat Tax Proposals and Fundamental Tax Reforms: An Overview. National Council for Science and the Environment. Congressional Service Research Reports. http://ncseonline.org.NLE/CRSreports/Economics/CNTS (accessed July 31, 2007).
Carman, H. J., & Boehlje, M. (1996). Agricultural’s Stake in the Federal Tax Income Reform. Choices(Third Quarter), 4-7.
Davenport, C., Boehlje, M. D., & Martin, D. B. (1991). The Effects of Tax Policy on the Structure of American Agriculture. Washington D.C. US: Department of Agriculture.
Ducan, M., Koo, W. W., & Taylor, R. D. (1997). Overhauling the Federal Tax. Do Farmers Gain? Choices(Second Quarter), 28-31.
Elffner, D. D., Featherstone, A. M., & Cole, C. (1998). The Effects of Federal Flat Tax on Kansas’ Agriculture. Paper presented at the NC-221, Annual Meeting. Louisville: Kentucky.
Klein, W. A., & Bankman, J. (1993). Federal Income Taxation: New York: Little, Brown and Company.