Monday, July 29, 2002
Okay, I promised I'd give my thoughts on our tax system and how to reform it, and I've got a few spare moments now, so I'll give it a go.
Let's start with the basics. If you want to have government, you need to have taxes. You could probably run a very low-service frontier town on the basis of user fees alone, but even there you'd have all kinds of implicit taxes in the form of "volunteered" labor to handle things like forming posses to catch bandits, moving the community when there's a flash flood, etc. Anything bigger than that, and you need taxes.
All taxes distort economic decisionmaking to some extent, precisely because they are not user fees or voluntary contributions. So the key questions about tax policy are:
* How can we raise the required revenue most efficiently (i.e. least waste in the collection process)?
* How can we do so with the least economic cost (i.e. creation of the smallest incentive for mal-investment)?
* How can we do so with the least likelihood of political mischief?
* How can we do so with the least social cost or greatest social benefit?
The first question we have to answer is: what do we want to tax? We have, broadly speaking, three choices:
* We can tax income
* We can tax wealth
* We can tax economic transactions
That's really about it. Some folks make a big deal about philosophical differences between these choices - Nozick, for example, argued that income taxation is equivalent to slavery because you are, effectively, being coerced into working for the government - but I don't see it. Everyone wants - nay, needs - to earn income, accumulate wealth, and conduct economic transactions. Government is a communal good (or necessary evil) and so the cost should be born by the whole community, and should not be comprehensively avoidable. So I can't get too excited about the argument that income taxes are absolutely evil while transaction taxes are absolutely fine (philosophically, at least).
In any event, within each category, we can tax at various rates and with varied degrees of discrimination. We have three main taxes on income in the United States, one regressive (the Social Security tax), one relatively flat (the Medicare tax) and one progressive (the Income Tax), all of them highly discriminatory based on the source of income (SSI and Medicare are taxes on wage income only, and the income tax is levied at different rates for wages and capital gains, and has an astonishing maze of exemptions, credits and deductions). Two major wealth taxes we have in the United States are the tax on real property (levied at the state and/or local level), which discriminates based on the kind of property owned (buildings are taxed, gold ingots aren't) and the estate tax, which is levied only once (upon inheritance). There are too many transaction taxes to count, from sales taxes to tariffs to gasoline and cigarette taxes; what is notable is that the United States does not have the most common kind of transaction tax, the value-added tax, which is a major revenue-raiser across Europe.
What's the most efficient way to raise revenue? In general, the more complex the tax system, the greater the transaction costs in terms of accountants, lawyers and lobbyists whose sole function is to game the system to minimize taxes or to distort the system by winning new loopholes. Some degree of complexity is inevitable in a modern economy, but our current system is truly byzantine, and one of the strongest arguments for the flat income tax is that it would realize huge efficiencies by eliminating much of this complexity. Certain taxes stand out for their inefficiency, however, and the estate tax is high on the list. As an economy, we probably spend as much money trying to avoid the estate tax as we pay in estate taxes. That's pretty inefficient. The corporate income tax is similarly a waste; not only is it expensive to collect but it results in double-taxation of income, as corporate income is taxed first by at the corporate level and second at the level of the investor who collects dividends.
What's the tax with the least economic cost? Supply-siders have argued that high marginal rates on income are the biggest disincentive to wealth creation; they therefore argue for low and flat rates of tax on income, if income is to be taxed at all. There's some question whether these disincentives are particularly powerful once you get below truly punitive rates. However, there's not much disagreement that a value-added tax is particularly efficient, both in terms of transaction costs and economic cost. Why? Because it falls equally on all transactions, the VAT causes little in the way of economic distortion. Because it is collected by business, it creates little in the way of new bureaucracy. And because it is passed on to consumers, it creates little incentive for business to invest money or energy in trying to avoid the tax, as they do with the corporate income tax.
The downside of the VAT is political: it is very easy to raise without immediate political impact, and it does impose a drag on the economy by discouraging economic transactions of all kinds. Because it is relatively "cheap" to raise, the VAT imposes less fiscal discipline than the income tax, and this makes it a dangerous tax from a "political mischief" perspective. In addition, the VAT is very regressive; the poor spend a greater percentage of their income, and thus, as a percentage of income, pay a greater amount of VAT than the wealthy. This is undesireable from a social-policy perspective. In addition, at very high VAT levels (as with high sales-taxes), you encourage smuggling.
Wealth taxes are also theoretically "cheap" to impose. They create incentives to put capital to work, since "dead" money is still taxed even if it has no return. A modest wealth tax should therefore be a spur to productive investment. However, wealth taxes have two significant political downsides. First, there's the privacy issue of letting the government know your net worth. Lots of people object to that on principle, and with good reason. Second, there's the consequence of such concerns: people will hide wealth, both legally and illegally. Finally, there is the problem of defining wealth. Real property is relatively easy to tax, as are securities. What about a private business? What about art? What about intangibles like intellectual property? These things all can be valued - they are, when an estate is inherited or in a divorce proceeding. But the burden of making these valuations on an annual basis is significant. In the end, the cheapest wealth tax is a mildly inflationary monetary policy, as inflation is effectively a tax on wealth. This is what we've had in much of the Western world since the 1980s, and what we had in the 1950s as well: a policy of low, stable inflation that correlates better with steady economic growth and rising overall incomes than either the very inflationary policies of the 1970s or the sharp booms and busts of the 19th century gold standard.
Ignoring our entitlement programs that dominate both taxes and spending in absolute dollar terms (but are not part of general revenues), our Federal tax system is dominated by income taxes as our state and local systems are dominated by real property and sales taxes. I believe that the cheapest, most efficient transition we could make from our current Federal tax system would be from a tax on income to a tax on consumed income. We should eliminate the corporate income tax entirely and treat capital gains as regular income, and we should also eliminate the estate tax. (I would eliminate the estate tax and corporate income tax because these are extraordinarily inefficient taxes. I would tax capital gains as ordinary income because the lower rate for capital gains creates economic distortions and one main justification for the lower rate is that capital is already taxed at the corporate level; if we get rid of the corporate income tax, that's no longer a rationale.)
Why do I argue for a consumed-income tax? I believe that it would be superior to our current income tax system in several ways and would be politically and socially more palatable than eliminating the income tax and moving to a VAT. Moreover, it would best leverage the existing infrastructure for tax collection, reducing transition costs.
A consumed-income tax would be a tax on income with an unlimited deduction for investment or charitable giving. Our current income tax, with deductions for various kinds of debt and with rising marginal rates with income, distorts economic decisionmaking to favor consumption and debt over investment and savings. A consumed-income tax would remove these distortions; income would be taxed when it was spent, not when it was earned and reinvested. One reason some people tout a VAT over the income tax is that under a VAT a taxpayer can give herself a tax break simply by cutting back on spending; this would also be true under a consumed-income tax regime.
So why not simply move to a VAT? Four reasons. First, we already have an infrastructure for collecting income taxes, and we don't have one for VAT. The transition costs for moving to a consumed-income tax system would therefore be less than for moving to a VAT. Second, a VAT is a pretty regressive tax, as people with lower incomes tend to spend more of their income, and thus pay a greater percentage burden of tax. Under a consumed-income system of tax, the wealthy could still be taxed at higher rates than the poor, but without the usual negative supply-side consequences because a wealthy person would not pay high taxes simply for earning income, only for earning income and then spending it. Third, as long as we remain within an income-tax framework, we can make charitable giving deductible, which is good social policy. We can't do that under a VAT system. Finally, an income tax would be far more transparent to the citizenry than a VAT, because it would come out of people's paychecks. Therefore, it would be politically more difficult to hike the basic rate to very high levels, unlike the VAT which can be raised stealthily to quite high levels before it encourages either political resistance or smuggling.
I would add a fifth, most tentative reason: a consumed-income tax will promote greater social solidarity. This will happen in three ways. First, because consumed income would be heavily taxed (I would expect a fairly steep rate structure, and higher nominal rates than currently) there will be a strong economic disincentive to conspicuous consumption, and conspicuous consumption by the wealthy is a major cause of social inequality. Second, our current income tax system is rigged to overwhelmingly tax the wealthy, and to exempt an ever-greater percentage of the citizenry from income taxes. Since those who pay the bills make the rules, this has effectively given the wealthy ever greater influence over our government. A consumed-income tax would have a broader base even while it penalized the wealthy with higher nominal rates, and would thus make the government less dependent on the wealthy for its revenue. Third, a consumed-income tax would provide a very strong economic incentive to the lower-middle class to save their excess income, and consistent savings is very highly correlated with migration up the socio-economic scale. Our current system is tilted to make debt-financing as cheap as possible for this group of people. A consumed-income tax would make savings as cheap as possible, and the shift from debt to equity will ultimately be very good for social mobility.
The main risk with a consumed-income tax would be the definition of an investment. Real property and securities would clearly qualify, but what about art? What about perks received from an employer or from one's own business - would these be consumed income, and therefore taxed? They should be, or else these perks will multiply enormously as an untaxed form of consumption. In the end, we'll probably still have a lot of work for tax lawyers and accountants under a consumed-income system. But I still think it would be preferable to the current system for all the reasons outlined above.
Next stop: Social Security reform.