August 29, 2011
Buffett and a Better Tax System
Buffett and a Better Tax System-Becker
In my blog post last week on inequality I expressed sympathy with Warren Buffett's concern that the share of the income paid in taxes by the very wealthy is considerably smaller than the shares paid by many middle class Americans. But I am troubled by what he proposes to do about it.
He suggests that the 12 member congressional panel set up to cut current and future federal deficits leave tax rates unchanged for 99.7 percent of taxpayers, and only raise rates on the approximately 250,000 households who make more than $1 million. Simple calculations show that a tax increase on such a small number of households, even a very large tax increase, would have a negligible effect on total tax revenue, and hence on closing the budget deficit. As we will see, there are more sensible ways to improve tax revenue.
Warren Buffett has persuaded 68 other billionaires to follow his example and promise to give at least half their wealth to charities. But why hasn't Buffett proposed also that the very rich make large gifts to the federal government to offset what he considers ridiculously low taxes on their incomes and wealth? My guess is that he and the others who pledged to give away their wealth to charity would have little confidence in how the government would spend such gifts. Buffett, for example, is giving most of his wealth to the Gates Foundation, not to the federal government, and is relying on how this foundation will spend his vast gift. Given this reluctance to make large gifts to the federal government, why should anyone have confidence that the federal government will spend additional tax revenue in a sensible way?
Still, I agree with Buffett that the American income tax system makes no sense from an equity viewpoint, nor does it make sense from its effects on the efficiency of the American economy. Of course, it makes great sense from a political economy perspective since special treatments of all sources of income- whether it be capital gains, gifts to charities, or deductibility of interest on home mortgages- are in the tax code not by accident, but are there due to the political power of builders and home owners,ethanol producers, universities and other non-profit organizations, and other special interest groups. However, perhaps with the present concern by voters over present and future deficits, it may be possible to get serious tax reform by overcoming the political power of important interest groups.
From a efficiency perspective, the ideal tax system would replace all income taxes with a flat percentage tax on total consumption of each household, as in a flat inclusive value added tax (VAT). A tax on consumption instead of income has the advantage that it would avoid the double taxation of saving. The present income tax structure first taxes incomes, and then another tax is imposed on the income earned from any of the original income that is saved (although some savings, like in IRAs, may avoid any taxation until they are spent after retirement). A tax on consumption also avoids the double taxation of corporate income. Under the present system corporate income is taxed, and then taxed again when dividends are paid or capital gains realized. A consumption tax also eliminates the complicated calculations about depreciation on capital that are necessary to arrive at the taxable net incomes of businesses.
Of course, the consumption tax rate would have to be pretty high if it were to replace all income taxes. I would guess that a VAT on all consumption of no more than 25% would be adequate to raise the revenue needed to balance the budget, even without the desirable reductions in federal spending. Since the economy would become more efficient with such a tax, real income would expand, perhaps by a lot, which would lower the burden of a consumption tax.
Two objections are commonly raised to replacing all income taxes with a flat consumption tax. One is that it is unfair for the poor to pay the same tax percent on their small amounts consumed as the rich pay on their greater consumption. One way to introduce progressivity into a consumption tax is to impose a lower tax rate on goods more heavily consumed by low-income households, such as bread, cheap apartments, over the counter drugs, and the like. A less arbitrary way is for the government to give monetary transfers to poor households. Households that qualify for such transfers would report their incomes and savings, with consumption measured by the difference between incomes and savings. It is easier for most families to know what their income and savings are than to keep track of their consumption.
Many small government advocates agree that a flat VAT type tax is efficient, and that is what bothers them. For they are concerned that opposition to raising the tax rate of a flat VAT tax would be weak precisely because the tax is efficient. The more efficient a tax, the smaller the cost to taxpayers from higher rates, and so the more willing they are to accept higher taxes. Casey Mulligan and I develop the theory behind these concerns, and also provide evidence that efficient taxes, such as the VAT, may start low but rise over time (see our paper, "Deadweight Costs and the Size of Government" in the Journal of Law & Economics, 2003). Although some other studies have not found such strong empirical effects of efficient taxes, the argument about the greater incentive to raise tax rates from efficient taxes makes a great deal of common sense as well.
Still, no tax system is ever going to be perfect. Taking everything into account, reliance on a flat tax on aggregate consumption rather than income taxes with different tax rates and various exemptions seems to be a worthy goal to strive for. I say "strive for" since the interest groups that have favorable treatment from the tax code will not meekly go away, but will have to be fought constantly to have real hope of meaningful tax reform.
Warren Buffett on Taxing the Wealthy More Heavily—Posner
Two weeks ago Warren Buffett made waves with a brief op-ed piece in the New York Times of August 15 entitled "Stop Coddling the Super-Rich." In it he says that very rich people are undertaxed, but he would leave the federal income tax rates of 99.7 percent of taxpayers unchanged and only raise the tax rates of taxpayers who report more than $1 million of taxable income a year; if they report at least $10 million a year they would pay an additional surcharge. But he doesn't say what the increased tax rates on either group should be. He also wants dividends and capital gains taxed at the same rate as ordinary income but does not say whether he thinks the uniform tax rate should be the present income tax rate (except for those earning over $1 million a year and therefore liable for the lesser or greater surcharge) or perhaps a lower rate because it have a bigger base.
Buffett's piece is short, and really the only thing of interest, besides the celebrity of its author, is his claim, based on his extensive personal knowledge of wealthy investors, that increasing the taxes on the wealthy would not cause them to invest less. He may be right but he does not discuss the distinct issue of whether they would invest differently.
The growth of the federal deficit, which is growing from a very high level at a rate of well over $1 trillion a year, cannot be arrested without more tax revenues. The alternatives are spending cuts and rapid economic growth. They are attractive to many conservatives but will not cut the mustard. The needs of government preclude the kind of drastic spending cuts that would curb the growth of the federal deficit without any need for additional federal revenues. Diehard opponents of increasing tax revenues even by closing loopholes without raising tax rates argue that the federal government is too large and can only be made smaller by reducing its income. But this argument contains two mistakes. One is to think that the federal government can finance its activities only by taxation. Not true; it can finance them with borrowed money, as proved by the Bush tax cuts, which did not lead to a reduction in the scale or spending of the federal government, but merely to an increase in borrowing. Of course, as the federal government approaches bankruptcy, the pressure to curtail federal spending is great and an increase in tax revenues would alleviate the pressure, but probably only slightly because the feasible scope for such an increase is very limited.
Second is a confusion between size of government and amount of government spending. The federal government is not too large in the sense of having too many employees or even too many functions. We need a large military, and we need regulatory agencies that are well staffed—regulatory laxity was a major contributing factor to the financial crisis of 2008 and the broader economic crisis that it triggered. What we can't afford is not federal employees (including soldiers) but careening entitlements. But the administration of vast entitlement programs is not particularly costly. A small government can transfer immense amounts of wealth among its citizens. The problem is the entitlements themselves, not wasteful expenditures on administering them—indeed the Medicare program would probably be more efficient, and, specifically, less susceptible to fraudulent and other overbilling and approval of unnecessary or marginal medical treatments, if the Medicare administration had more staff.
Military spending cannot be cut significantly without endangering national security. Of course there is "waste" in military spending as there is in most activities, but bureaucratic and political imperatives, as well as the inherent uncertainty of threats to national security, place limits on economizing on military spending. Most of the other discretionary spending of the federal government (that is, spending that Congress must approve every year) is likewise justifiable, including spending on domestic security, infrastructure, the environment, basic research, and disaster relief, as well as regulation. Discretionary federal spending can and will be cut if the deficit cannot be reduced by other means, but it probably cannot be cut a great deal without inflicting costs greater than the benefits.
Anyway the real threat to the solvency of the federal government doesn't come from military expenditures, which would be leveling off even if there were no budget crisis, or other discretionary spending, which if it cannot be greatly cut can nevertheless be kept in bounds without great hardship. The real threat to federal solvency comes from the entitlement programs—Medicare, Social Security, Medicaid, and many others—not because they are huge, though they are, and certainly not because they are costly to administer, but because their outlays are growing rapidly, especially Medicare and Social Security outlays because of the aging of the population and the rising costs of medical technology as a byproduct of technological advance. Political resistance to cutting these programs, or at least to cutting Medicare and Social Security, is fierce. The programs may be cut some despite their sacred-cow status, but not enough to reduce the rate of increase of the deficit to the rate of economic growth.
So can economic growth be increased, then? In the near term, the combination of poor economic leadership and management by the Administration with the economic radicalism of congressional Republicans makes it unlikely that the government will do anything to stimulate growth before the 2012 Presidential election and the seating of a new Congress in January 2013. Eventually the economy may rejoin its long-term trend of an annual growth rate of GDP of a little under 3 percent; whether there is a set of economically and politically feasible policies that would increase that rate seems doubtful.
Which leaves increased tax revenues as a seeemingly indispensable weapon against the soaring deficit. Indispensable—but not ideal. Any increase in tax revenues would be counterproductive in the present depressed state of the economy, because it would take money out of the private economy at a time when the government can finance its debt cheaply by borrowing at very low interest rates. The increase in tax revenues would have to be phased in gradually and meanwhile the deficit will be growing.
Merely increasing marginal income tax rates, even on the millionaires and multimillionaires and billionaires, is likely to be counterproductive. Unless the percentage increase is substantial, it will not generate much revenue. And if the increase is substantial, it will induce a flight to loopholes. (Buffett would close only two of them—dividends and capital gains—and there are many more.) Only if increased rates were joined with a thoroughgoing reform of the tax system that would eliminate virtually all deductions and exemptions would the increased rates generate substantially increased revenues by preventing a flight to loopholes. The reform would have to be precise, leaving very little for regulatory adjustments by the Treasury, and represent an unshakeable congressional commitment, eliminating all uncertainty so that taxpayers would know exactly where they stood. Meaningful tax reform along these lines, though falling far short of what was, and today is much more urgently, needed, was achieved during the Reagan Administration; there is no reason, other than interest group pressures and other political forces, why it can't be achieved today. But those pressures and forces are great.