The Case for Fundamental Tax Reform

It’s April 15, and like many Americans I just finished spending much too long trying to figure out what I owe in federal and state income taxes. What better day could there be to consider the need for fundamental tax reform?

The usual complaint about taxes is that they are too high, but that could be fixed without fundamental tax reform. The tax burden could be lowered (or raised) simply by altering the current rate structure, or fiddling with the exemptions, deductions, and credits. This would just be business as usual. The impetus for what I call “fundamental” tax reform comes instead from concerns about both the complexity and the fairness of our current system.

Complexity is the easiest point to make on April 15. Once again this year, I encountered questions I just couldn’t answer. The source of the trouble was a cash-value life insurance policy we redeemed last year. Was that a qualified or non-qualified distribution? I didn’t know, so I answered the question first one way, then the other. Here’s what I learned: It doesn’t matter. My tax bill was exactly the same either way. Apparently, the IRS is just curious. Maybe it’s just a tax accountant’s idea of making conversation.

How can such a complex system survive? Why hasn’t it long since been repealed in favor of the three-line return advertised by Citizens for a Sound Economy? One possibility is that despite the massive inefficiencies that our tax system imposes on taxpayers (CSE estimates that Americans spent 6.4 billion hours filling out tax forms in 2001), it is extremely efficient at producing campaign checks. The size and complexity of the tax code (5.5 million words) make it the ideal place to stash thinly disguised gifts to political supporters, and both parties benefit from the practice. There are other possible explanations — for example, that government can’t resist the temptation to reward us for spending or earning our money in certain ways and punish us for spending or earning our money in other ways — but it seems unlikely that legislators inflict this maltreatment on their constituents purely out of a public-spirited belief that the incentives in the tax code improve economic performance enough to offset those 6.4 billion hours per year.

Fairness concerns come from two directions. High-income Americans sometimes argue that they are paying more than their fair share. For example, the Census Bureau reports that in 2000 the richest 20% of households earned 49.65% of the income but paid 76.6% of the taxes. Is that fair? The middle fifth earned 14.85% of the income but paid only 6.9% of the taxes. Is that fair? Meanwhile, lower- and middle-income taxpayers complain that the rich have too many ways to shield their income from taxation. Wages for a hard day’s labor are subject not only to income tax but to the regressive payroll (social security) tax, while dividends and capital gains enjoy preferential income tax treatment are not subject to the payroll tax at all. Is that fair? And if the rich really think the poor have it too soft, why don’t they just quit their desk jobs and earn less? The subjectivity inherent in the fairness question makes it a perennial occasion for class warfare.

By junking our loophole-ridden income tax with its myriad exemptions, deductions, and credits, CSE’s 17% flat tax would solve the complexity problem. But would it be fair? Most people seem not to think so. Nearly everyone agrees that the rich should pay more than the poor, but there seems to be no durable consensus on how much more. Indeed, we seem to think about progressivity differently depending on the sort of tax we’re dealing with. With a sales tax, there seems to be a permanent consensus that the same amount of tax should come out of every dollar spent, regardless of how many dollars one spends. With a property tax, there seems to be a permanent consensus that the owners of more expensive houses should pay the same rate as the owners of less expensive houses, even though they will obviously pay more dollars. Yet when it comes to the income tax, the idea that the rich should pay not just more dollars but a higher rate seems deeply ingrained in our national consciousness.

But how much higher? A few years ago, I asked about 100 of my high school classmates, from all walks of life, how much of the tax burden should be borne by the top 20% of U.S. households, given that they earn (or earned in 2000) 49.65% of all income. Not one person suggested that the number should be as high as the 76.6% actually reported by the Census Bureau for that year. On the other hand, whenever taxes are cut, and money is being returned rather than collected, there is without exception great public resentment about the disproportionate slice of the pie that goes to the richest households.

Other proposals for tax reform reduce complexity as effectively as the “flat tax” without raising the same fairness objections. For example, a multi-tier “flat tax” – e.g, 10% for some taxpayers, 15% for others, and 20% for others – would be extremely simple as long as there were no deductions, exemptions, credits, or other games. We started to move in that direction in the mid-80s, but it did not go far enough to stick.

Alternatively, we could move to a national retail sales tax or a value-added tax, which would have the added benefit of generating income from the underground economy. Drug dealers, prostitutes, illegal immigrants, and trust-fund millionaires with offshore tax shelters all share at least one common attribute: they buy stuff. Some worry that sales taxes fall hardest upon the poor, but most states have sales taxes and they commonly correct for this regressivity by excluding necessities such as food, medicine, housing, and articles of clothing costing less than a certain amount; since the poor spend much more of their income on such necessities than the rich do, this has the effect of taxing a greater percentage of consumption by the rich.

Estimates vary widely as to how high a national sales tax would have to be in order to be “revenue-neutral.” Some say the tax would be as high as 50%, and conclude that this would be intolerable, but I think this misses the point, or rather misses two points. First, a 50% sales tax is basically the same as a 33% income tax. For example, it makes no difference whether a person earns $150, pays $50 in income taxes, and then buys a $100 tennis racket; or whether he instead earns $150, pays no income taxes, and then buys a $150 tennis racket. Second, we don’t actually make our tax burden any lower by hiding it. In other words, if it really would take a 50% sales tax to make up all the revenue we’re currently collecting, then whether that strikes us as high or low it is nonetheless what we’re currently collecting. It may be high, low, or about right, but it is what it is quite apart from whether we collect it based on income or consumption.

One of the more interesting recent proposals for reform is the “Automated Payment Transaction Tax,” which is to sales taxes what EZ-Pass is to toll booths. The APT Tax would scrap all existing federal taxes in favor of a tax on each voluntary electronic transaction – each direct deposit of a paycheck, each check to the mortgage company, each swipe of the credit card. How much tax? Well, in 2005, a witness to the President’s Tax Reform Panel calculated the revenue-neutral tax rate to be 0.27% — not 27%, but 27/100 of one percent. The two parties to each transaction would split the cost, barely noticing the tax on each transaction. Even if one assumes that people move half of all electronic transactions to cash, the rate would only have to go up to 0.54% — half a percent — to be revenue-neutral. A family making $80,000 and spending it all would have (in the simplest case) $160,000 in transactions for the year (each dollar in once and out once), and those transactions would generate $864 in tax revenue — $432 paid by the family and $432 paid by the people on the other side of the transactions.

There’s no such thing as a free lunch, so what makes up the difference between this $864 and the $20k or so that the family would pay under current law? Well, there are certain large and infrequent transactions, like refinancing a mortgage, that would generate tax even though they have no effect on income, but these would be highly unusual events for most people. That family making $80,000 would have to buy a lot of houses before their total tax burden approached $20,000. People who engage in short-term trading of stocks, bonds, and currency would also generate a disproportionately large number of transactions. Since these are the kinds of transactions that skew overwhelmingly toward the very wealthy, the tax would in fact be relatively progressive. This all seems too good to be true, and I’m sure there must be problems that are not obvious at first blush. But proponents of the APT Tax say it would save a whopping $865 billion per year in compliance and administration costs, which certainly seems to be worth further consideration.

Tax policy is usually considered primarily as a matter of economic regulation, but I think we should also consider it as a matter of political philosophy. The current tax code makes everything depend on an incomprehensible welter of individual factual variations — not just how much you earn, but how you earn it, how many kids you have, what you buy, how much you save, and how you invest. By making our contribution to the common enterprise of self-government depend on so many different considerations, the current system seems to me to atomize us — and also, of course, to invite gaming or outright dishonesty. By contrast, at least some kinds of tax reform tend to put us all in the same boat. In particular, a flat tax, sales tax, or APT tax would emphasize our common membership in one community and our common responsibility to ensure that public needs are paid for. For example, if we are already paying a retail sales tax of 25% and we decide to spend $550 billion for a prescription drug benefit, we can either raise the sales tax, cut spending elsewhere, or borrow the money. The one thing we would not be able to do would be to start a big fight about whether the cost of the benefit should somehow be borne by some of our citizens and not others. Even though the rich would pay more tax than the poor, every citizen would be subject to that same 25% rate, and would have a clear stake in the spending decisions we face as a nation. That’s a lot of citizenship and a lot of community at a very reasonable price, and we save 6.4 billion hours in the bargain.

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8 Responses to “The Case for Fundamental Tax Reform”

  1. Timothy Peach Says:

    Great post. I didn’t know you knew anything about this stuff.

    One constraint has to be that the system implemented doesn’t encourage perverse behaviors or rampant cheating. The transaction tax, which has a lot of conceptual appeal, would be subject to all kinds of evasion, and how could you possibly monitor every system that creates a transaction?

    Here’s an idea for you — to hell with actual tax collection. The US government justs prints itself the money it needs each year. Then you wouldn’t have to directly tax *anything*. The tax would actually be imposed in terms of inflation.

    But then why wouldn’t everyone just dump dollars to avoid the annual currency deflation? Well, for one thing, the US would be a great place to work because you pay no direct tax, and a great place to invest because you pay no direct taxes on gains.

    Furthermore, the annual inflation impact should be manageable because (1) the dilution of the currency is a year’s worth of budget needs vs. the entire outstanding balance of US dollars, and (2) the Fed and Treasury could keep money supply tighter because the economy would be humming along on this no-tax basis and the US government would be creating a healthy level of inflation on the margin.

    This would also eliminate the concept of a deficit, and would make explicit and measurable something they’re doing already anyhow — printing money. Fiscal discipline would be a real issue, but excessive spending would result in excess inflation which should create enough pressure on Congress to keep the purse strings fairly tight.

  2. David Fitzgerald Says:

    Just a few quick thoughts from my experience here across the pond. More questions than answers really because Mark makes some excellent arguments.

    1. Europe has had VAT now for 35 years. It is currently 18%. This tax largely funds the EU bureacracy and regulatory regime. Throughout the 70s and 80s the VAT had the effect of significantly dampening consumer spending which artificially damped EEC economic growth. With the advent of personal credit throughout Europe (especially in the UK) in the 90s and post-millenium, Europeans have started to plug the gap between income and the high cost of goods and services with consumer credit. Those chickens are starting to come home to roost (The Financial Times should be required reading). Of course, one could argue that it is the income tax in most European jurisdictions layered on to the VAT which keeps the cost of living so phenomenally high in Europe and that Europe could do with some tax rationalization itself. That is no doubt true, but do you trust Congress and state legislatures to not layer on additional taxes to the ones we will pay at the cash register?

    2. I think the “flat tax”/VAT tax crowd overstates the economic benefits to be derived from a simpler code and underestimates the creativity of special interest lobbies to bribe politicians to mess with the tax code. There are a number of VAT loopholes and tax avoidance mechanisms built into EU and national law throughout Europe and a TREMENDOUS amount of legal and accounting costs are spent on every transaction trying to find ways around VAT. A 20-50 page tax memorandum is generated on every significant corporate transaction in Europe (not necessary generally in the US) and bank satisfaction with it is a condition precedent to all borrowing. This document is largely a tax avoidance analysis and much of that avoidance involves avoiding the ubiquitous VAT.

    Admit that the perfect should never be the enemy of the good and Mark makes excellent points. This however is an area where the law of unitended consequences is particularly nettlesome.

  3. Ardie Says:

    For over 100 years, from the early 1800s to just after 1913, Americans didn’t pay an income tax! So, from what source did the government get its revenues? It was from tariffs.

    In today’s money tariff revenues might amount to somewhere between 300 and 800 billion dollars a year! That’s right. Great America, at one time, ran her mighty engines on tariff derived revenues. Only with the implementation of “free trade” and “free market” ideas came the dark day when the American taxpayer had to shoulder the cost of the Federal government (the infamous 16th Amendment of 1913).

    When 19th century Great Britian bought the scatology of “free trade” and “free markets” it lost the economic race to the United States and Prince Bismarck’s Germany who were mercantilists. Now we have bought the scatology. We are going the way of Great Britian, while the Asian countries are the new America.

    But we can change–in a heart beat. Just demand tariffs and remember the words of this Representative from the great state of Pennsylvina: “Repeal the tariffs [and] adopt. . . ‘free trade,’ and you will bring down labor here, in every department of industry, to the level of the labor of the serfs and paupers of Europe.” — Andrew Stewart [1836-1903]), Representative from Pennsylvania.

  4. Steve Mohyla Says:

    As long as Congress uses the tax code to initiate social change and not as a revenue generator, there will be no reform.

  5. Mark Grannis Says:

    Steve, you obviously don’t charge by the hour. I think I know what you mean, but can you elaborate?

  6. Steve Mohyla Says:

    For the sake of clarity, I should have written “solely as a revenue generator.”

    For instance, the Estate Tax has come and gone several times in US history. Not until the trust-busting days of Pres. Teddy Roosevelt did its purpose stray from solely revenue generation to wealth redistribution. Agree or disagree with whether there should be an Estate Tax but once it had its purpose changed adding social engineering the tax has proven stickier than it ever was. Its additional purpose? The political agenda of giving back to the have-nots from the haves at death.

    Mortgage interest is deductible to foster the social good of home ownership.

    Proceeds from a life insurance policy are income tax free to promote taking care of one’s family in the event of death to prevent the survivors from having to go on public assistance.

    In regards to capital gains taxes and taxes on dividends, don’t forget that the corporation paying dividends cannot deduct the dividends from its income in the calculation of corporate income tax. Fair? No, but easy. “Tax those mean corporations!” Except that many of the people echoing this sentiment are shareholders in these corporations and their investments suffer from the double taxation. But politicians can say they’ve increased taxes on the corporations and not on the little guy. In this case, I believe the fair thing to do is tax the corporations but not the dividends or tax the dividends and not the corporations.

    A recent study published in the Wall Street Journal showed that due to inflation affecting gains, the effective capital gains tax rate has exceeded 100% at times. One would think that investors would have to take this into account before deciding in what to invest. I think it sad that tax-effect has to be taken into account in the deployment of capital. If the capital gains tax is not eliminated, at least index the gain for inflation before applying the tax.

    Hopefully an answer to your question and as a bonus, a ramble.

  7. Mark Grannis Says:

    Steve, you’re dead right. But why don’t we see through this?

    Fitz, I found your comment informative. It had not occurred to me that a VAT could lend itself to the same sort of monkey business that is at the root of the trouble with the current code.

    Ardie, I have quite a bit of sympathy for the view that free trade is bad for our manufacturing base and may therefore be bad for our society for cultural rather than strictly economic reasons. But you seem to me to be saying we’re economically better off with high tariffs. I’m a little rusty on international economics, but I think it can be mathematically demonstrated that total economic well-being improves under free trade, but I honestly don’t remember whether that mathematical proof includes any offsetting benefits to be had from reducing other forms of taxation.

    Tim, I can’t decide whether you’re serious about the “inflation tax,” but I’m intrigued either way. I remember an economics professor who once spent a whole class arguing that high inflation was preferable to high unemployment. His argument was that once people adapted by putting COLA clauses in everything, the pain of inflation was slight and evenly spread, while the pain of unemployment fell heavily on relatively few people. I suppose the two keys to your system would be (1) limiting spending to some more-or-less rigid mathematical proportion of GDP; and (2) making sure no other taxes survive. Or were you just pulling our legs?

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