Ev Ehrlich's Everyday Economics

One For You, Nineteen For Me (II)

Don’t you just hate it when you’ve invested an hour in a television program that you know is waste of time in the first place, only to find out at the end of the hour that the program is TO BE CONTINUED?  I pulled this stunt last week, setting up some ideas about reforming the tax system, only to stop at the apogee of my orbit.

This week, I outline a proposal – using a broad brush to be sure, but it’s a beginning. 

Let’s start with this question; what is the right basis for the tax system?  There are any number of possibilities.  Income is a good one, as it represents material well-being.  But it poses two problems.  One is that when you tax it, you reduce the incentive to earn it, even if that idea has been carried to extremes in some corners.  Second, we have a system based on income, and it’s failed, due to the holes we’ve poked in, and the contorted definitions we’ve attached to it. 

Which takes us to consumption.  For one, consumption’s like income in that it’s a good measure of well-being.  Moreover, there are times when our incomes are lower than our consumption –as a student or in retirement – or vice versa – like when we’re saving in the peak earning years before retirement – which means that what we choose to spend might be a better measure of our long-term well-being than our actual income.

These aren’t the only two options.  Property is another.  But real estate is too volatile and limited a basis to run a tax system, and a broader tax on “wealth” may be attractive as a measure of who’s really got what, but we’re not there politically by a long shot.  And, to be technical, income and consumption are flows, while wealth is a stock – it requires us to tax someone’s wealth and then tax essentially the same wealth all over again next year?

There is also the idea that we should tax things that are “bad” -- carbon taxes, or taxes on cigarettes or transfats, for example?  We’d be better off if we had a tax on pernicious greenhouse gasses and used the proceeds to fund Social Security instead of the asinine, regressive, anti-employment payroll taxes we now deploy.  But, the problem is that these taxes are designed, if successful, to do away with themselves, which makes them a poor choice as a basis for financing the country. 

So, with all that said, there’s a strong argument for shifting the foundation of the system away from income towards consumption.  Of course, consumption taxes, such as the Value Added Tax used in many industrialized nations, are often criticized as being regressive, for the obvious reason that people with low incomes consume a higher share of their income than people with higher ones.  But this is not a reason not to consider them; it is a reason to implement them as part of a larger program.

That’s because of the advantages a consumption tax offers.  Taxing consumption reduces the incentive to spend and conversely induces saving.  And the broad incentives to save provided by a consumption-type (VAT) tax are far fairer and probably more effective than the archipelago of IRAs, special accounts, and other pinball gimmicks and features that give folks who generally already save a break for doing what they would have done anyway.  While the roots of saving are cultural as well as economic, these broad-based incentives stand a good chance of moving the needle on our saving rate.

Taxing consumption rather than income has other advantages.  Since consumption is usually more steady from year-to-year than is income, government receipts are steadier as well, and less prone to the stage of the business cycle we’re in.  And while fraud and circumvention are always going to be a part of the mix, they’re harder to carry out in the world of buying things than in the world of getting paid –  you can avoid income taxes by working for cash, but sooner or later, that cash must be spent.  No less an economic seer than Frank Zappa embraced them for that reason. 

But a consumption tax alone cannot be the entirety of the system, in large part due to fairness considerations.  For one, as stated, consumption is a declining share of income as one’s income rises – that much is inescapable.  A massive switch to a consumption tax would also be unfair to today’s retirees, who saved income when it was taxed, only to consume it when that became the tax basis. 

Moreover, it’s one thing to save, but it’s another to save without effort – some people may never consume all the income their assets generate.  There is a meaningful difference between someone who defers consumption through savings to finance their children’s education and their own health and retirement, and the well-to-do whose clipped coupons exceed their needs, or even desires.  A consumption tax, for such an individual, is a social license to steal.   

Given these realities, a consumption-based tax must be accompanied by two other components.  The first must be a relatively flat and very broad income tax with a very high personal exemption, which offsets some of the consumption tax burden.  Moreover, preserving the income tax in this fashion would provide a vehicle for maintaining some important and readily-justified features for the working poor.  For example, the Earned Income Tax Credit, child care credits, and other tax-based income support features for this group should be joined into a single, rebatable treatment and administered through the tax system.

And this system should be completed by maintaining an anti-dynastic inheritance tax.  Much has been made of the inequities of the “death tax,” but the inheritance tax has already been loosened aggressively in response to these concerns.  Moreover, the sorrowful stories of, for example, families forced to give up their farms in the face of an inheritance tax bill stemming from the passing of a parent turn out to be just that – stories.  It is very possible to imagine such a situation, but it is nigh on to impossible to find one. 

Adopting this three-legged stool of the income tax, a consumption tax, and an inheritance tax means abandoning many of the special and popular tax provisions referred to above.  The home mortgage interest deduction would be capped and phased out – simply going to the new system would reduce its importance.  (But the phase out must be long enough to allow the already weak housing market to stabilize.)  Special savings accounts would be unnecessary since all savings would go untaxed.  Employer health-care contributions would presumably be part of taxable income.  Income and all forms would be treated equally (partly because the rationale for their different treatments would be eliminated). 

And this system would also allow us to abandon the corporate income tax.  There is, however, a genuine double taxation problem in the code – the taxation of corporate income.  Think of it this way.  The newly-activated Supreme Court recently decided that corporations’ status as legal “people” entitled them to freedom of speech.  The counter-argument is that corporations are distinct entities only insofar as the corporate form defines the limited liability of shareholders, and that granting them “freedom of speech” extends their status as distinct entities beyond reasonableness.  But if progressives believe that argument, then they should question whether corporations should be taxed separately as well. 

Some (again, usually my fellow travelers) see the taxes paid by corporations as the price of the privilege of limited liability.  But there are ample opportunities, through a variety of judicial and regulatory means, to balance that privilege.  In fact, the corporate income tax simply taxes revenue as it makes a pit stop on its way to its ultimate destination, the stockholder.  There are any number of way abolish the double taxation of corporate income – the one favored here (for administrative simplicity) would tax corporate income before dividends were paid and then exempt those dividends from personal income.

Good ideas – such as these purport to be – are the bottom of the policy food chain.  Before the tax debate – or at least this round of it -- is over, people with far greater probity and credential than I have will issue important and well-reasoned reports in the hope that their ideas provide a benchmark in the policy process.  But those people know, as does everyone else, that calling on the system to enact good ideas because they are good is both naïve and futile. 

The question, then, is who will, should, or even could be the champion of such a newly designed system?  An informed and involved citizenry is always best, but let’s get serious.  The best answer may well be – the forward looking elements of the business community.  That’s because they are in a unique position to appreciate and understand how a better tax system leads to a better business environment.

Policies such as these determine to a great extent our nation’s competitiveness.  Our lattice-worked world economy has eliminated virtually every traditional source of “national” economic advantage – capital, technology, education, skill, and everything else can be accessed anywhere in the world if they are unavailable at home.  If any resource can travel anywhere, what makes a nation’s economic environment unique?

What remains “national” in this context is the environment in which these factors are integrated, and that environment includes among other factors, our system of corporate governance and finance, the culture of our business enterprises, the rationality of our regulatory system (including the questions of whether to regulate and how), and the economic policies we pursue.  Taxing and spending decisions are obviously a part of that: encouraging residential construction means discouraging other investments; requiring businesses to be responsible for providing health care will burden them when competing with those freed of that burden; and, most relevant to this case, if we run endless fiscal deficits and ask the people of the world to lend us their dollars, they will have fewer left over to buy our goods.

The business community is in a unique position to fathom this reality and the failings of the current tax system.  Moreover, a balanced approach to taxes can bring their interests and those of the “average American” far closer than before.  And business is in a similarly unique position to demand that the two political parties abandon their scorched earth tactics and come to Jesus on this issue.  One such group has already done so. 

There is a “center” in the tax debate.  The question is whether anyone will occupy that center when the debate takes place.