Tax Reform Again

A Wall Street Journal oped on tax reform. This complements an earlier oped and see the tax link at right for many others.

The bottom line: I argue for a national VAT instead of (and that is crucial) individual and corporate income taxes, estate taxes, and anything else.

Why? I want to break out of our stale argument. "Lower taxes to boost the economy"  vs. "you just want tax cuts for the rich." It's not going to go anywhere.

I also want to break out of the process. Proposing cuts within the current structure of the tax code, even if proposing them with offsetting cuts in deductions, leads naturally right back to the mess we're in.

Once you tax income much of the rest of the mess follows inexorably.  If we go back to the beginning, and tax spending not income, so much mess vanishes.

Once the government taxes income, it must tax corporate income or people would incorporate to avoid paying taxes. Yet the right corporate tax rate is zero. Every cent of corporate tax comes from people via higher prices, lower wages, or lower payments to shareholders. And a corporate tax produces an army of lawyers and lobbyists demanding exemptions. 
An income tax also leads to taxes on capital income. Capital income taxes discourage saving and investment. But the government is forced to tax capital income because otherwise people can hide wages by getting paid in stock options or “carried interest.”
The estate tax can take close to half a marginal dollar of wealth. This creates a strong incentive to blow the family money on a round-the-world cruise, to spend lavishly on lawyers, or to invest inefficiently to avoid the tax. 
Today’s tax code tries to limit this damage with a welter of complex shelters: 401(k), 526(b), IRA, HSA, deductions for corporate investment, and complex real-estate and estate-tax shelters. Taxing something and then offering complex shelters is a sure sign of pathology. But by taxing cars, houses and boats when people or companies buy them, all this complexity can be thrown out. With a VAT, money coming from every source—wages, dividends, capital gains, inheritances, stock options and carried interest—is taxed when it’s spent. [I left out the whole mess of corporate investment deductions and credits, plus foreign income. All vanishes with a VAT.]
A reformed tax code should involve no deductions—including the holy trinity of mortgage interest, employer-provided health insurance, and charitable deductions. The interest groups for each of these deductions are strong. But if the government doesn’t tax income in the first place, these deductions vanish without a fight.
Zero is important. Eliminating the personal income, corporate income and estate taxes is important. Taxes are like zombies. If you just reduce the rates but leave the taxes in the code, they come back.  And all the deductions, exclusions, credits and the rest come back too. If we just compromise for a VAT in exchange for lower individual and corporate rates, we really will end up at European levels of taxes -- 20%+ VAT, 50% income tax, 20-40% payroll tax, 40%+ estate taxes.

BTW, I should be clear what a VAT is. You pay the VAT, say 20%, on everything you buy. It's collected by the seller. You collect the same VAT on everything you sell, but you may deduct the VAT you have paid on your purchases. If I am in charge, period. Notice this gives people an incentive to collect the VAT.

In this way, a VAT is, in fact, something of a corporate tax, and is largely "paid by" corporations. But it does not distort rates of return as much. More importantly, it is clearer, more transparent, and allows us to throw out the mess of the corporate tax code. The border-adjusted corporate tax reform was sold as a step towards a VAT, and it was -- if you have a PhD in economics to figure that out -- though it retains all the special deductions and carve outs of the corporate tax code. We need a tax that the average voter can understand, and a clean slate.

A second theme of this oped, though for lack of space less visible: Tax reform is stalled because we try to do too much. We try simultaneously to

1) Raise revenue for the government
2) Redistribute income to people with lower incomes
3) Redistribute income to homeowners, electric car drivers, farmers, etc. etc. etc. (Despite the hullabaloo about income redistribution, there is a lot more of this)
4) Redistribute income away from "the rich"
5) Subsidize various activities and industries. Practically all of them. (We simultaneously tax, subsidize, regulate and promote most industries.)
6) Arguments about the structure of the tax code are mixed up with arguments about tax rates, the overall level of taxes, the overall level of spending.

Really, the current discussion is disheartening to an economist, who sees taxes as a necessary evil to raise revenue for the government, to be done with the lowest marginal rates and lowest distortions possible.  The current discussion, entirely on the left and mostly on the right, sees taxes pretty much only as an instrument of redistribution to one or another class.

Eliminating the income tax in favor of a uniform VAT, leaving the rate blank, lets us fix the structure of the tax code without getting sidetracked with all these other issues.

What about progressivity and redistribution? The oped explains briefly how to make a VAT progressive, if that's what you want. The idea is explained more at length in an earlier post. Briefly, you get a rebate for VAT on your first $10,000 of expenditures, half on the next $10,000 and so on. The rebate can happen instantly, like a giant rewards program for debit cards.

But it is becoming clearer to me that our redistribution system is just as chaotic as our tax system. A major observation: Why should every measure be assessed for its redistribution in isolation? For example, a major complaint on the left on the corporate income tax is the idea that corporate taxes end up being paid by shareholders, which are rich people, so it's redistributive. I don't think the fact is right -- corporate taxes are paid more by higher prices and lower wages, and we're all shareholders through our pension funds. But even if we admit the fact, that's a bloody inefficient way to achieve redistribution. The entire corporate tax, with all its shenanigans, exists to try to get more money out of shareholders? Just tax them directly! Get your redistribution elsewhere, and not this way.

So, the thought touched on in the oped: We need at least a comprehensive measure of redistribution, and much more fine-grained than just across income categories. We could have a much flatter tax code if we had a more aggressive social welfare state, no? We should be able to trade these things off, getting better taxes and more effective redistribution, to people who really need the money.

Both points are part of a more general point. We have become obsessed with income, both in taxation and in redistribution. America is becoming a class society with class defined by income. So many social programs treat income the way India used to treat caste. But income is a terrible measure, with little economic meaning. My mid 20's children are "low income." Consumption is a far better measure. And in terms of who deserves taxpayer funded help, we can think of a hundred characteristics that matter -- disability status, say -- much more than income. The income tax and vast amount of redistribution that happens on income alone is reinforcing this. Tax people by what they spend.

Related, a standard objection to the VAT is that it is "regressive." Poor people spend a larger fraction of their incomes, so in a flat VAT they will pay more of their income in tax. First, I answer that with the progressive VAT. But more deeply, why should progressivity be measured as a fraction of income which has little economic meaning, rather than as a fraction of consumption  in the first place? If I leave my income invested for others to use it to build factories, why tax that? Yes, I will be richer in the future, and we will tax that when and if I spend it. If I never spend it... well, good for me. Annual income is just not a particularly useful economic concept.

There are lots of other almost as good ways to implement a consumption tax. The Hall-Rabushka Flat Tax is one, various proposals to implement a progressive consumption tax via the current income tax mechanism is another. My VAT shares a lot with the Fair Tax proposal to replace the income tax with a national sales tax. But reflecting on it, I like the finality of not even measuring income any more. Remember the zombies. And a VAT works better than a sales tax.

However, the VAT is not a pure consumption tax, and I'm not persuaded it needs to be. (The title is a bit misleading, but I don't get to pick oped titles.) I would tax investment goods at the same rate as consumption goods. If not, then a lot of shenanigans will erupt trying to define what's an investment good and what is a consumption good. Is the corporate Ferrari a "investment?" A real corporate investment, like real corporate purchases of VAT taxed inputs, will yield profitable goods, and the VAT paid on investment can be deducted on the sale of those goods. Yes, it will be a few years later, but if the investment is worthwhile the profits should be larger if they come later. Yes, it's not as pure, but it's close -- we avoid the chaotic capital taxation of today, and we avoid trying to make a distinction between investment goods and consumption goods. Everyone pays the VAT. Everyone.

Please don't bother to comment that we can't have a VAT because the politicians will just add back the income tax.  I know the argument. If our country cannot legislate "we put in a VAT, we eliminate the income tax, and that's it," then democracy is doomed already.

As usual, full text in 30 days, or get creative with your Googling.

Update:  I learned of a precedent for the progressive VAT idea, Yaacobi Nir, "Progressive V.A.T. as a Substitute for Income Tax" December 2008

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