“We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win.”
JFK
“The purpose of taxes is to fund government. It should do so with the least harm possible to the economy.”
OP
As an undergraduate student in finance, I was taught that the financing decision is separate from the purchase decision. That is, we choose what to buy and then we determine how to pay for it.
Later as a graduate student in economics I learned that the most efficient tax is the one that causes the least distortion to how people make choices. Distortion creates a “dead weight loss” – a loss of satisfaction as taxeschange people’s decisions in response to the change in relative cost.
The only tax that causes no distortion, the best tax, is a head tax – a tax that falls equally on every person so it cannot be avoided by changing behavior. This is considered politically unfeasible so a theory of the ‘second best’ tax was created. A second-best tax has a low rate over a broad base. Keeping the rate low decreases the incentive to change behavior. Keeping the base broad reduces the opportunity to avoid the tax.
Our tax code has many provisions written to advance public interest goals. High marginal rates on some incomes, exemptions and credits to encourage certain behaviors and excise taxes to discourage others distorts choices in conflicting and counterproductive ways. Once added, exemptions and credits are all but impossible to remove. Millions are spent lobbying to add more exemptions, increase some taxes or to reduce other. Compliance is its own industry. The dead weight loss is crushing.
The only way to fix the tax code is to replace the current tax base and lower the rates.
Our tax code primarily taxes income. The income tax coupled with the FICA or payroll tax is about 85% of total federal tax receipts. Capital gains, the profit made on assets held for over a year and then sold, are included in income taxes and represent about 3% of federal tax revenue. Corporate profits are the only other significant source of federal revenue and contribute 7% of federal tax income. I propose replacing the taxes on income and earnings with a new three-part tax base – capital, carbon and consumption.
Replace the payroll tax with a tax on capital. Currently the payroll or FICA tax generates about $1.4 trillion in annual revenue. Total household net worth is estimated to $140 trillion. An annual 1% levy on wealth is enough to fund Social Security and Medicare. No sale or transfer is needed to incur the tax. It is a tax based on the ‘stock’ of wealth – not its transfer. No capital gain need be computed. Most of this wealth is financial assets, about $110 trillion, with the remainder in real estate.
The collection mechanism would be through firms that manage investments and insure property. Financial firms would pay 1% on assets managed. Property insurers would pay 1% on tangible assets insured. Taxing these two bases would broaden the tax base to include both privately and corporately held assets. Also, debt does not offset the computation as it does in net worth calculations. A rate lower than 1% is possible. Financial firms readily know the values of these assets. They generate enough cash flow to easily cover the tax and can pass the cost through to their customers.
I add carbon to the tax base for purely pragmatic reasons and acknowledge it violates the principle of not using the tax code to accomplish policy goals. However, some concession to competing political demands must be made to pass bold tax reform. Climate concerns are widespread, and a carbon tax is considered the most efficient way to reduce greenhouse gasses.
A tax on carbon indirectly taxes consumption but shifts the cost to carbon producers. The negative externality created by carbon is estimated to be $40 a ton. Recent US carbon production is about 5 billion tons annually. A carbon tax would raise $200 billion a year in revenue (5 billion times $40) to offset income taxes.
A consumption tax needs to raise $1.8 trillion under my proposal; $2 trillion currently raised by income taxes less $200 billion in carbon taxes. Recent annual US consumption was about $13 trillion. Dividing this by $1.8 trillion yields a consumption tax rate of 7.25%. Retailers would be responsible for collecting and remitting the federal sales tax just as they currently do with state and local sales taxes.
A criticism of a consumption tax is low-income earners spend a higher percentage of their incomes than higher income earners and thus pay a higher percentage of their income in taxes. One of the most widely promoted consumption taxes, the Fair Tax, addressed this problem with a ‘prebate’, a payment to all households calculated by household size to offset the tax on necessities. A prebate is identical to a Universal Basic Income in practice. Optimally this should replace other Federal income redistribution programs.
The proposal above is a simple application of basic economic principles and even simpler math. If implemented there would be a re-optimization of economic choices based on new relative prices. The overriding goal is to reduce dead weight loss and to increase overall well-being. By the standard of economic efficiency adopting this tax code is easy. The legislative gauntlet is the hard part.
As explained initially, the many rates, deductions and exemptions in our current tax code have powerful defenders who use their political power to create and preserve them. Special interests obtain narrowly focused benefits. The economic costs are diffuse. Politicians rely on the financial contributions of a powerful Washington lobbying cartel. Highly educated and compensated professionals’ livelihoods depend on a complex tax code.
These are the Bold Tax Reform losers. To succeed Bold Tax Reform’s many winners must be clearly identified and highly motivated to fight for real but not readily understood benefits.
Wage earners get an immediate increase in income from the removal of the payroll and income tax.
April 15th is no longer a time of dread.
Businesses immediately have lower labor costs. Workers at every level are more profitable increasing business activity, labor demand and ultimately wages.
All businesses have lower tax code compliance costs. Small businesses benefit relative to big businesses as tax compliance costs are a bigger challenge for small companies without access to expensive tax code experts.
Domestic production costs less relative to foreign production. Imports are taxed upon sale just like domestic goods. US companies are more competitive here and abroad.
The value of financial assets increases as incentives shift to growth to cover the 1% annual tax and away from tax avoidance. Financial assets are allocated more efficiently.
Labor and capital are taxed more equitably. Households and corporations are taxed more fairly.
All households receive a Universal Basic Income.
Everyone benefits from reduced greenhouse gasses.
Reform this bold requires a sustained effort and multiple steps to pass Congress. I propose a three-step process beginning with replacing the payroll tax with a capital tax and ending with the tax on consumption.
Moving the Social Security/ Medicare tax base to capital immediately addresses regressivity in the tax code. It also increases incentives to work at a time worker participation is low. There is a political precedent of eliminating the payroll tax for short periods in response to economic conditions. Politicians have acknowledged benefits to its removal.
A carbon tax is recognized as the most economically efficient way to reduce greenhouse gasses. The political opposition centers on how to implement it and a resistance to adding more taxes. A condition of taxing carbon within the Bold Tax Reform framework is that there must be a dollar for dollar decrease in the income tax. This opens the door to political wrangling over how to cut income taxes. That wrangling should be reduced knowing the last step of tax reform soon follows.
A consumption tax is the final step. Consensus must exist on the rate and the level of Universal Basic Income to offset taxes on essential consumption. It may take a few years to get to this stage of reform. During this time workers will have responded to higher incomes. Businesses will have adapted to lower labor costs. Reallocation of resources will have begun. Economic growth has ensued.
The key to Bold Tax Reform is REPLACE. Any attempt to keep even a small part of the existing tax base must be squashed. But the legislative hurdles must be kept within the possible.
A condition of The Fair Tax was the repeal of the Income Tax Amendment. While desirable this is politically not feasible as a condition for adoption.
A criticism of the Fair Tax was that special interests would reimpose exemptions and credits for their benefit. The authors’ response was that voters must be vigilant to prevent their return. This comes across as contradictory to the proposed repeal of the 16th Amendment. If voter vigilance is sufficient to prevent tax code exemption creep why not a resurgent income tax.
“…it is the people who control the Government, not the Government the people.”
WC
So, I close with an appeal to support Bold Tax Reform. Not because it is easy but because it is hard to do what is best for the people. Because it will organize and measure our best energies and skills. And because the challenge, once accepted, we will win.