Flat-tax Simplicity with a Progressive Twist
My latest column for the Christian Science Monitor:
Tax reform has emerged as a key issue for GOP presidential hopefuls. Texas Gov. Rick Perry wants to scrap our current system and replace it with a 20 percent flat tax on individual and corporate incomes. Former Speaker of the House Newt Gingrich wants to do the same, but with even lower rates.
Then there’s pizza magnate Herman Cain. His “9-9-9″ plan would replace today’s income and payroll taxes with a trio of levies: a 9 percent flat tax on individuals, another on businesses, and a 9 percent retail sales tax. But Mr. Cain’s ultimate vision is to eliminate anything remotely resembling today’s tax system in favor of a national retail sales tax, which proponents call the FairTax.
These three plans have much in common. Catchy names, for one. More important, they all focus on taxing consumption – what people spend – rather than income.
Equally important, however, is the way the flat tax handles investment income. Individuals would pay taxes on their labor income but not on capital gains, dividends, or interest.
That doesn’t mean capital income would escape taxation. Instead, the taxes would be collected at the business level. Businesses would pay taxes on all their income, regardless of whether it’s paid out as dividends or interest. They would also be allowed to write off the entire cost of new investments when they are made.
The net result of these rules is that people would be taxed only to the extent that they consume. In the words of Robert Hall and Alvin Rabushka, the economists who invented the flat tax 30 years ago, “people are taxed on what they take out of the economy, not on what they put in.”
The flat tax is thus a very close cousin to the FairTax and other retail sales taxes (which many Republicans like) and to value-added taxes (which they don’t). The logistics differ: A sales tax is collected on retail purchases, a VAT from businesses at each stage of the supply chain, and a flat tax from individuals and businesses. But the underlying economics work out the same: People get taxed only on their consumption.
There are good reasons to favor a simpler tax system that emphasizes taxes on consumption over income. Some policy experts across the political spectrum embrace exactly that approach to tax reform. But all these plans would be much less progressive than our current income tax, and that’s neither appropriate nor politically viable.
What we need are tax-reform proposals that would maintain progressivity while harvesting many of the benefits of simplicity and consumption taxation. The late Princeton economist David Bradford offered one simple approach: Add progressive rates to a flat tax. Columbia Law School Prof. Michael Graetz offered another: Pair a broad-based VAT with an income tax for folks with high incomes. These ideas might not have much traction among GOP primary voters. But they offer a much better starting point for reform than the plans on the table today.
Two points need to be added:
1. One of the primary motivations for a consumption tax is to impose a one-time haircut on all existing after-tax wealth. Currently $1 of after-tax wealth can but $1 of goods. Imposing a 9% consumption tax confiscates 9% of that value.
2. Countries whose governments spend a higher percentage of GDP than the USA inevitably have more regressive taxation. That’s because when you extract a high percentage of the GDP, you have to reach deeply into the middle class. Those countries also spend more money on the middle class, primarily in health care. The net transfers (taxes minus benefits) are not necessarily more regressive than in the USA. But the tax system viewed alone is more regressive, and there is no way to avoid that.
I would frame the distinction differently than merely whether the systems are more or less progressive or regressive. Fundamentally, the distinction, which is consistent with European tax systems being more “regressive”, is the higher degree of paternalism there. A paternalistic system is inherently regressive and elitist. I think it goes back to feudalism. The basic idea is that we will take your money and spend it for you rather than entrusting that to the individual citizens. Father, after all, does know best.
Yes, but their health delivery system really is better and cheaper.
Whether that health care delivery system is “better” is very highly debatable. I’m not sure on what basis of research or experience you are basing this, but Gary Becker has a good discussion of that issue here: http://www.becker-posner-blog.com/2009/07/index.html
In any event, whether the generic European system would be better, or even cheaper, is pretty much irrelevant to the issue as to whether our tax system should be “progressive”, “regressive” or just plan neutral.
Len Burman has a similar approach to Graetz, which made it into the original Bipartisan Policy Center reforms. Lawrence B. Lindsey would use a VAT-like Net Business Receipts Tax to both distribute credits to lower income families and pay a higher rate for higher income investors and employees, although he has not developed it fully and his approach has the problem of either too much reporting by individuals to employers and brokers or of people either paying too much or not enough. The Graetz approach is, therefore, superior. I also am rumored to have a tax reform proposal along these lines, which includes a VAT, a Net Business Receipts Tax, Payroll taxes (which Graetz and Burman also maintain but Lindsey does not) and a high income surtax. Len, as you know, keeps a low income income tax, but makes filing automatic at the lower rate.
The Tax Policy Center (again) seems to think that a more regressive tax structure is a non-starter. But a Luxembourg Income Study report (look for “Taxation and the Worlds of Welfare” by Monica Prasad and Yingying Deng, April 2009) finds that “For the 13 countries for which it was possible to calculate income, payroll, and property tax progressivity, the U.S. has the most progressive tax structure; Sweden and Denmark are the most regressive.”
I don’t find it especially surprising that the Scandinavians have more regressive structures. After all, for all the complaints about how regressive the max 15% tax rate on dividends introduced by Bush is, according to the Norwegian Ministry of Finance “dividends from Norwegian companies were in practice tax free on the hands of the shareholder…” ie ZERO. The corporate tax rate in Denmark is 25% versus 35% in the US. This lighter taxation of investment could not be combined with the huge VATs in these countries and not end up more regressive than the US overall. The numbers wouldn’t add up.
All this to say that I don’t buy Donald Marron’s starting point, which is that “maintain[ing] progressivity” is critical. I dare say the Scandinavians would even tell you that maintaining the steep progressivity you find in a place like California is IMPOSSIBLE if you are going to shift the tax burden on to consumption to anything like the degree they have.
If Norway were a fiscal basketcase with a depressed standard of living I’d say, sure, let’s not go down that road, but last time I was there the Norwegians seemed to be doing fine!
What about making the current system fairer by eliminating credits and deductions that favor one taxpayer over another and flatter by lowering rates and broadening the base?
If Congress were to implement this type of reform in a revenue neutral manner how much would it be able to lower tax rates?
Some people argue that you can’t eliminate the Mortgage Interest Deduction because so many people depend on it, but wouldn’t lowering rates in exchange for the deduction pay for itself?