June 16, 2013
Tax Reform
Tax Reform—Posner
There is a good deal of dissatisfaction with the federal tax system (the state and local systems as well, but I'll confine my attention to the federal). Most proposals for reform, however good in theory, are totally impractical from a political standpoint. But since politics is volatile, there is value to evaluating such proposals in order to lay a foundation for future reform.
A tax can be evaluated along four dimensions: cost of collection, allocative effect, revenue effect, and distributive effect. Let me by way of illustration evaluate the Obama Administration's proposal to raise the marginal income tax on couples with taxable income of at least $250,000 a year from 35 to almost 40 percent and to increase the tax on capital gains and dividends from 15 to 23 percent (the 23 percent including a new tax imposed by the Affordable Health Care Act). But I will confine my consideration to the increase in non-capital-gains and non-dividend income.
The cost of collection is likely to increase slightly because a tax increase increases the return to tax avoidance. The increase could also cause a substitution of leisure (which is not taxed) for work; that would be the allocative effect. I am skeptical that an increase even of 14 percent (5/35) would have a significant such effect, given a possible offsetting income effect (taxpayers working harder to maintain their standard of living). Income tax rates have varied greatly over the history of the United States without seeming to affect economic growth, though so much else is happening at the same time that isolating the effect of a tax increase or reduction is very difficult, maybe impossible, to do. The higher tax would increase federal tax revenues and reduce after-tax income inequality (the distributive effect). Given growing income inequality, which seems to be having bad effects particularly on children, and the large federal deficit, the proposed increase in income tax may be a good idea, especially given the political infeasibility of the alternatives.
One of those alternatives would be a federal value-added tax, which is essentially a sales tax but a sales tax imposed at every level of distribution rather than just at the retail level. Such a tax generates large revenues at a low cost of collection, and operates as a tax on consumption and therefore encourages investment. It also increases income inequality, but its revenue potential is such that federal expenditures on wealth redistribution and social welfare benefits could be significantly increased. However, such a tax is politically infeasible, in part because of conservative concern that it would enable a significant increase in the size of the federal government.
The corporate income tax is criticized as penalizing investment, because it taxes the income generated by corporate investment twice—first at the corporate level and second when corporate earnings are distributed to the corporation's shareholders in the form of capital gains or dividends. And penalizing investment reduces economic growth, which depends on investment. But the corporate income tax is so riddled with exceptions and opportunities for avoidance that it accounts for only 8 percent of total federal tax revenues. If the tax were abolished, some other federal tax would have to be increased.
Or would it—the alternative would be to broaden the tax base, so that the same or even a lower tax rate generates the same or even greater tax revenues. Broadening the tax base mainly means eliminating or reducing deductions. The most popular target is the home-mortgage interest deduction. It is an absurd deduction, based on the silly premise that owning a home generates positive externalities: improved maintenance of residential property and enhanced sense of commitment to the community. All residential ownership does is reduce job mobility by increasing relocation costs and delay. But it's a sacred cow.
The charitable deduction is questionable as well; charitable deductions reduce the demand for certain government services, but involve a great deal of duplication and administrative expense, and would probably decline only modestly if the deduction were removed. But again it's a sacred cow, though in the case of both the morrgage-interest and charitable deductions a reduction in the size of the deduction permitted may be feasible.
Regulatory ("Pigouvian") taxes should not be ignored. They are intended to alter behavior rather than to generate revenue, but invariably they generate some, and often a great deal, of revenue. We desperately need a heavy tax on carbon emissions, which pose a great long-term threat to the economy; and undoubtedly such a tax would generate substantial revenues. As would an increase in federal gasoline tax, which would reduce both carbon emissions and traffic congestion.
Given political resistance, the practical feasibility of substantial tax reform is very limited. But at least a modest increase in federal income tax rates seems a politically feasible as well as economically defensible response to the need to increase federal revenue to cope with the fiscal deficit.
Reform of the Tax Code-Becker
The federal tax code is a mess from any economic perspective. It is not efficient, fair, or clear. A complete set of suggestions to improve the tax system would take hundreds of pages, as did the excellent 2005 Report of the President's Advisory Panel on Federal Tax Reform. My discussion will concentrate on a few of the needed changes that would help stimulate a more efficient and faster growing American economy.
A major priority is to eliminate taxes on savings and investments. One reason is that they involve double taxation since personal and corporate incomes are first taxed, and then the returns on the savings and investment out of these incomes are taxed again later on. A second even more important problem with taxes on savings and investments is that in the long run they are shifted to labor because these taxes lower after-tax returns, and thereby discourage investments. A lower rate of investment slows down capital accumulation, which leads to a lower ratio of capital to labor. Wages are lower and pretax returns to capital are higher when the capital/labor ratio is lower.
Moreover, the present system taxes different forms of saving and different types of investment goods at different rates. This distorts the allocation of investments among investment categories. For example, depreciation tax rules allow durable capital to be depreciated more slowly than less durable capital, which lowers the relative tax rate on more durable capital. Similarly, savings that enter tax-free IRA or Roth accounts are taxed less heavily than other forms of savings.
One way completely to eliminate taxation of investments is to allow all investments to be written off immediately as expenses instead of being depreciated over time. Taxing only earnings would eliminate double taxation of savings.
Expensing investments and taxing earnings moves the income tax code a long way in the direction of a tax on consumption rather than on incomes. The basic efficiency advantage of consumption taxes is that they do not distort the decision to consume now rather than consume later since the returns on savings and investments are not taxed. By contrast, income taxes do distort this decision since they tax the incomes earned on savings as well as the incomes that led to the savings.
Whether ones moves to a consumption tax or not, taxes should be simpler and flatter because that would reduce the large cost of tax compliance, and encourage greater investment and work effort. A reasonable proposal that would maintain progressivity yet have a much flatter tax structure would be to have only two or three tax rates, such as 20%, 25%, and 30%. The 20% rate would apply to incomes below a certain threshold, 25% would be the rate on incomes above this lower threshold until an upper income threshold, and 30% would be the tax rate on all incomes above the higher threshold. The tax rate on low labor market earnings would be even less than 20% if the earned income tax credit on low earnings were retained. This credit encourages poorer individuals to enter the labor force rather than staying out to become eligible for various welfare benefits, such as food stamps, unemployment compensation, and housing subsidies.
The income tax base should be widened both because that would be more efficient, and because a wider base would also help maintain tax revenue as rates are flattened, and taxes on savings and investments are removed. For starters, the deductibility of mortgage interest should be eliminated because that artificially encourages investments in home ownership relative to investments in other forms of capital. This deduction also favors higher income families since they are more likely to itemize deductions, and they have higher marginal tax rates. If it were too difficult politically to eliminate this deduction, a big improvement would be to allow a tax credit to all homeowners equal to a fraction of their mortgage interest payments. There would be an upper bound to the amount of interest payments that could qualify for the tax credit.
The exclusion of interest on state and local bonds from income taxes should be abolished because that artificially encourages spending by these governments relative to spending by households and businesses. Since higher income individuals hold the vast majority of state and local bonds, this tax exemption also favors higher income persons in an undesirable way.
The tax on business cash flow (net of investment outlays) should be aligned with the proposed flatter personal income tax structure by lowering corporate and partnership tax rates to the proposed maximum tax rate on personal income, say 30%. Doing this, and taxing business cash flow net of investment deductions, would integrate the business tax into an overall consumption tax.
I discussed the most needed reforms, although other reforms are also desirable-many are considered in the report mentioned above on federal tax reform. Unfortunately, major reforms do not have much chance of enactment in the present political climate, but they are longer run goals that should appeal to both Democrats and Republicans.