Five Principles for Fixing America’s Tax System

The International Economy recently invited me to contribute to a forum on how best to fix America’s tax system. Here’s my piece; for eleven other views, check out the complete forum.

America’s tax system is a mess. It’s needlessly complicated, economically harmful, and often unfair. And it doesn’t raise enough money to pay our bills. That’s why almost everyone agrees that tax reform should be a top priority. Democrats, Republicans, and independents. Accountants, lawyers, and economists. Elected officials and ordinary citizens. All know our tax system is deeply flawed.

Unfortunately, they don’t agree on how to fix it. Some want revenue-neutral tax reform, while others want higher revenues to cut deficits and pay for rising entitlement spending. Some want to fix the income tax, while others want to tax consumption. Some want to cut tax rates across the board, while others would lift rates for high earners.

Public discourse, meanwhile, is hung up on the idea of attacking “loopholes” when the real action is in tax breaks that benefit millions of taxpayers. Tax reform isn’t just about corporate jets or carried interest. It’s about the mortgage interest deduction, the tax exemption for employer provided health insurance, and generous tax incentives for debt-financed corporate investment. Those policies have major flaws, but they are not loopholes. They reflect fundamental economic and social choices, and they benefit well-defined constituencies.

Tax reform will thus involve a prolonged political struggle, as reformers seek some compromise that can attract enough support to overcome the inevitable inertia against change. That won’t be easy, but given our sky-rocketing debt, weak recovery, and flawed tax system, it’s clearly worth the effort.

Even as they seek a reasonable compromise, reformers should continue to articulate their visions of an ideal tax system. Mine would reflect five principles. First, the government should raise enough money to pay its bills. That likely means higher revenues, relative to GDP, than we’ve had historically. Second, it’s better to tax bads rather than goods. That means greater reliance on energy and environmental taxes. Third, it’s better to tax consumption than income; policymakers should thus limit how much they tax saving and investment. Fourth, the tax burden should be shared equitably both across income levels and among people of similar means who make different choices (for example, renting versus owning a home).

Finally, the best tax systems have a broad base and low rates. Policymakers should thus emphasize cutting tax breaks rather than raising tax rates. Indeed, some rates, like the 35 percent rate on corporate profits, should come down.

To afford such cuts, policymakers should go after the dozens of deductions, credits, exclusions, and exemptions that complicate the code and narrow the tax base, often with little economic or social gain. Many of these provisions have been sold as tax cuts, but are really spending in disguise. They should get the same scrutiny that policymakers devote to traditional spending programs.

8 thoughts on “Five Principles for Fixing America’s Tax System”

  1. Why is it necessarily better to tax consumption than income? This would seem to violate your other point regarding being fair to people who make different choices (by taxing people who delay consumption less, which is not only a lifestyle choice, but also one that favors those who are more able to do so – the wealthy). You will also needed a higher tax rate to raise the same revenue from a consumption tax (less broad base of the economic activity because of temporal offsets, assuming net accumulation of wealth over time), and an income tax might have some countercyclical benefits during recessions (people earning less pay less tax, but have less control over tax payments for required consumption). Attempts to fix some of these problems by excluding necessities from a consumption tax would decrease the breadth of the base, violating one of your other principals and increasing the required tax rate on the remaining items. Finally, I’m not sure that the historic benefit of encouraging savings to fund future investments for the economy overall is relevant in our current society, where it is plausible to create money out of thin air. In fact, one could argue that the simplest tax system would be a tax on money itself, where the government collects no revenues and prints whatever money it needs, taxing all money in the system through inflation….not a system likely to lead to good spending decisions by the government though.

    1. Why is it better to tax consumption (destruction) than production (income)? Simply put, because consumption is when the individual actually derives the value of the good or service from society as well as the time that that good or service is destroyed. It is completely fair because it allows the individual to participate in the decision of when and how much they are taxed unlike an income tax–unless you think that the individual can simply decide to not work… A consumption tax does not inherently favor the wealthy. That is a strong function of how the tax is constructed. For instance, the prebate from the Fair Tax makes that a progressive consumption tax. Not only do you pay more total tax the more you spend but your rate asymptotes to the full ~23% inclusive rate the more you spend. A consumption tax is broader based than the current income tax (half of the eligible taxpayers pay no net federal income tax) based upon studies conducted by Beacon Hill. Not only is it broader, flatter and hence lower rate, but it maintains stability in government revenues because consumption does not fluctuate nearly as much as income tax revenues do. I don’t even know hoe to respond to your doubts about the benefits of saving and investment. Governments have had the ability to literally print money for centuries. The devastating inflation is an obvious outcome. I encourage you to go look at the Fair Tax. It addresses all of your points:

      1) Breadth
      2) Progressivity to help lower income groups
      3) Stability of government revenues
      4) Severe handicapping of lobbying efforts to bury subsidies in the tax code, a.k.a. tax expenditures
      5) Everyone spending above the poverty level has some skin in the game. A republic dies when its citizens realize they can vote themselves money.

      I’ll add that I’m not naive enough to think that the Fair Tax solves every problem and introduces none. It does tax new housing providing a disincentive to buy a brand new home. It does penalize existing Roth or other after-tax savers but it helps everyone become a future saver. It will make life even harder on illegal day laborers.

    2. Income is a fiction. Cash (or consumption) is a fact.

      Hot dog vendor spends $50K for a fancy truck. Big success, he earns $75K the first year. Pays himself $25K, uses $50K to buy a second truck. What’s his income, $75K? $75K less some depreciation on the truck? $25K salary? Or is that a dividend? Or return of capital?

      If you say it’s $75K and tax him on that, maybe he can’t afford to buy the second truck. If you say it’s $25K, maybe he buys a Ferrari as a company car,

      Once you get beyond cash salaries, income is a highly subjective concept and fair game for shenanigans, See the current carried interest debate.

  2. (1) Abuses of the current tax system are a reason to fix the tax code, not a reason why an alternative approach is better.

    (2) The appeal to consumption as the step where the individual realizes value as the “natural” point to tax is overly simplistic to me. We buy many things long before we consume them, and few people earn income with no intent to consume (immediately, delayed, as a contingent safety factor, for children, etc.). The point of the full cycle (earn/spend) where taxation is least harmful depends on desired impacts on incentives, fairness, etc. One could argue that individuals with intent to earn but not consume are good people to tax because they may be the least sensitive to factors that reduce their earnings, minimizing negative impacts of taxes.

    (3) I looked at the Fair Tax (Wikipedia). To maintain revenue, it takes money from the middle class and gives it to the rich and poor. Could you structure it differently? Absolutely, but it’s a hard system to use to create a customized model, and doing so would destroy its advantage of simplicity. Can you imagine the political battles as groups fight to have their classes of products exempted from the tax (milk, bread, college tuition, house purchases)? The cheating that will occur when every dependent gets you additional payments from the government? The incentives for people who think that an increase in the tax rate means that they get a bigger check from the government each month?

    (4) While there is an element of choice, I see a difference between a wealthy person choosing to buy a boat and a poor person choosing to eat as far as when they pay taxes. Assuming that income eventually flows to consumption, tax will eventually be paid. The difference is that the individual with more resources can choose to defer taxes, similar to a 401K. The government is transferring wealth to savers as an incentive. If we believe that this is a critical value (i.e. more important than incenting home ownership, green technology, employer provision of health benefits, etc.), then it can be maintained or increased in the current system. It isn’t really an argument for consumption tax per se, although it might be an easier vehicle if you want to allow people to defer taxes in a more unlimited fashion (which I am not convinced of).

    (5) Most people I have talked to feel more comfortable with Roth IRAs than standard ones, because it takes away a level of uncertainty regarding whether tax rates will change in the future and prevent them from having as much money to spend as they expect. Consumption tax creates a similar issue.

    (6) Stability of government revenues is not necessarily a good thing. I would prefer to see a long term balance with more revenue collected in good years and less in bad.

  3. So, in a country plagued with the most acute inequality since the late 1920s the solution is to enact a tax system that exacerbates this inequality? Mexico has a 0% rate on capital gains and dividends. Mexico has a 16% VAT. Mexico has no inheritance tax. Mexico has grown an annual 0.5% GDP/Capita, over the last 30 years.

    Do we want to become Mexico?

  4. re: wallyfurthermore, how is owning a billion dollars not hoarding and a ms-allocation of resources?

Comments are closed.