Recent Thoughts on Taxes #2: Is the Payroll Tax the Best Income Tax?

Today, we have two main “tax reform” proposals: the Flat Tax, as suggested by Steve Forbes and others, and the “Fair Tax,” suggested by Neal Boortz and others. Over time, I’ve come to appreciate the Fair Tax more than I did before. One of the main criticisms against it is that it would introduce a new Federal sales tax. We could end up with both a sales tax and an income tax. That is why Boortz and others suggest that the Fair Tax would probably have to be paired with a repeal or modification of the Sixteenth Amendment. Obviously, this is a hurdle. I’m not sure I like the “prebate” idea very much either.

Fair Tax fans are against the introduction of a Value Added Tax, although they don’t have many good reasons why. One thing people have found is that there are only two examples worldwide of governments with a sales tax over 10%, and over a hundred examples of VAT. One reason for this is that, as the sales tax gets higher, the incentive for evasion also grows. Even if the VAT rate is 20%, this is charged only on “value added,” which is basically sales minus payments to other corporations (non-employee expenses). Thus, the effective rate, as a percentage of sales, would be below 10% most of the time. You are effectively spreading the “sales tax” among all corporations, at a lower effective rate, rather than applying it only to final sales at a higher rate. Improved tax administration was the goal of this scheme when it was invented in the 1950s, and by all appearances, the principle seems to work. This is actually why many conservatives don’t like it — it has become a cash cow for big government socialism. The revenue/GDP ratio in Europe is ten percentage points higher today than it was in 1965. If the retail sales tax is inherently limited to about 10%, maybe that is a good thing. (In today’s environment, I would say that it definitely is.) But, the combination of a VAT with a repeal of the Sixteenth Amendment eliminating all income taxes might be something conservatives could be happy about.

Flat Tax proposals obviously fit more closely with existing structures in the U.S., where the Federal government is funded mainly with income and payroll taxes, and State governments rely mostly on sales and excise taxes. Typically, Flat Tax proposals do not attempt to make any modifications to existing payroll taxes. One problem with the Flat Tax is that there is a “tax return.” It is structured as a direct tax, rather than an indirect tax. The payroll tax, although it resembles an income tax in many ways, is structured as an indirect tax. There is no “tax return.” In effect, it is a sales tax on employment labor. Although the Flat Taxers’ tax returns are very, very simple, nevertheless it allows an avenue by which further complications can be added later. The tax reform of 1986 simplified the tax code dramatically. To the dismay of tax reformers everywhere, it became complicated again very quickly. Congress has been trading tax favors pretty much since the introduction of the income tax in 1913. Thus, I think that Flat Taxes are at substantial risk of quick overcomplication. It would be interesting to find out what the experience of governments that have adopted Flat Taxes has been on this issue.

The result of having both the existing payroll tax and a Flat Tax is that there is overlap between the two. For middle incomes, above the Flat Tax’s basic deduction, but below the income cap for the payroll tax, people would have to pay both taxes. This is not necessarily a bad thing. Since the payroll tax supposedly directly finances Social Security, perhaps we can just consider that a fee for services rendered — the idea that I talked about earlier.

August 12, 2018: Recent Thoughts on Taxes: In Praise of “Regressive” Taxes

But, it might be nice if we could just get rid of the direct income tax altogether (including a Flat Tax), and keep the payroll tax. It would be a “VAT base,” which means a tax on all employee compensation, including pensions, healthcare and other assorted benefits. (This is the same as the Rabushka/Hall Flat Tax proposal.) The base would be broader, which would allow the rate to be lower. Since most people at the lowest pay grades don’t really have any benefits, this is not much different for them than the situation today.

January 13, 2018: Toward Fundamental Tax Reform (2005), edited by Alan Auerbach and Kevin Hassett

The advantage of this is that the tax thus becomes an indirect tax, paid by the employer. There is no “tax return,” and thus, there is nothing that can become overcomplicated in the future. The payroll tax has been around since 1936, and has proven itself marvelously impervious to Congress’s tax-favor peddling. There is also no upper limit on income, since we don’t have any other income tax. This tax is on employment income only. Self-employed, partnerships, LLCs etc. file a “business tax” return along with corporations, with the same rate as the payroll tax. All investment income — capital gains, interest income, dividends, real estate — is tax free at the individual level. (Interest is taxed at the corporate level.)

This is basically the format of Britain’s first peacetime income tax, introduced in 1843. It was structured as an indirect tax, like today’s payroll tax. There was only one rate (3%), and it applied to the first and last dollar earned. During the nineteenth century, great importance was placed on the idea of “uniformity” in taxes. Once you allowed some people to pay a lower rate, or be exempt from a tax, there would immediately ensue a great struggle to get someone else to pay the taxes, while you enjoyed the services paid for by the taxes. The British system as described made it all the way to 1910 without ever going above 6%. You couldn’t “tax the rich” without taxing everyone else as well, and nobody wanted to be taxed. Once “graduated rates” (higher tax rates on higher incomes) were introduced in 1910, a whole new dynamic appeared. First, you needed a “tax return” which showed which rates were to apply to you. The indirect tax became a direct tax. This tax return could then be stuffed full of every sort of exemption and exclusion, leading to the complication we are familiar with today. And, in a democracy, the majority could overtax the minority. Thus, we immediately get high rates on high incomes, which began with the outbreak of World War I in 1914 and has never gone away in the following century.

In other words, we had 67 years of 6%-or-less rates, via an “indirect” system that was marvelously simple, in Britain when the principle of “uniformity” was applied, and over a hundred years of 40%+ top rates, with a “direct” system with immediate overcomplication, also in Britain, when the principle of “progressivity” was applied. Perhaps we can see why a “progressive” tax system was part of Karl Marx’s Communist Manifesto of 1848.

I haven’t worked out the numbers exactly, but I think that using a single payroll-type tax in this way would require a rate of about 20%. Obviously, this is higher than either the existing payroll tax (15.6%), or most Flat Tax proposals. It is uncomfortably high. This is a good thing, because it puts pressure to bring the rates down, and also, bring down Federal spending as well. (Fair Tax fans seem to feel the same way about the one-rate Fair Tax — that it would be uncomfortably high, and create pressure to reduce the size of government.) But, obviously it creates complications, since the idea of taxing the lowest incomes at a rate higher than today’s is a little distasteful to everyone.

But, who said that Federal spending has to remain unchanged? A plan like this might be implemented at a time when all of the Federal government is undergoing a restructuring. I would like to see the Federal government reorganized on two basic principles: 1) all social/welfare-type programs, including healthcare, are devolved to the State level, to do as they see fit, and to tax as necessary to fund it. 2) Social Security is reorganized as a “provident fund”-type system, possibly with backup provisions (needs-based welfare) should this prove insufficient. With these two changes, the Federal government would shrink to about a third its present size, and could shrink to about a fifth with a little care and attention to the matter. Thus, we would be funding a much smaller government, which could be done with much lower rates, probably around 8% in this model. I have the sense that big changes in taxes will accompany big changes in spending this time around, which was not really on the table in the past.

In practice, it would be much like a VAT. The tax would be “indirect” because corporations would be paying it, just as they pay the payroll tax today. (Even the employee portion is paid by the employer, and there are no “refunds.”) If you use a “VAT base” for the “business tax,” and also a “VAT base” (all employee compensation) for the payroll/”income” tax, the result is very similar. The Rabushka/Hall Flat Tax is structured on this principle.  So, I am basically proposing to use the Rabushka/Hall method, and also integrate the payroll tax, while also eliminating the basic deduction, which allows us also to eliminate the corruptible direct “tax return” in favor of a payroll-tax-like “indirect” administration, and thus apply the principle of “uniformity” to the first and last dollar earned, which is important in a democracy with majoritarian rule. And so, we come to a solution where the Flat Tax and Fair Tax have become almost indistinguishable, themselves little different than the VAT. This is not a bad thing. But, I think there is something to be gained by organizing it as a form of income tax, instead of calling it a VAT.