Toward Fundamental Tax Reform (2005), edited by Alan Auerbach and Kevin Hassett

On the recommendation of a friend, I decided to read Toward Fundamental Tax Reform (2005), a book of papers edited by Alan Auerbach and Kevin Hassett. It was related to an American Enterprise Institute conference, and published by AEI. There were a lot of interesting ideas in the book, worthy of further discussion.

Overall, I was struck by the level of sophistication and mastery here. I have been focused on monetary topics for quite a while now, and the norm there is endless confusion and nonsense — to the point that it seems like whole generations of economists are unable to make sense of a simple and sensible fixed-value system like a gold standard system. I can quibble with some of the authors of this book about their conclusions, but the basic framework that they are working from seems pretty sound. Of course, the fact that it is from an AEI conference means that the authors are more-or-less on the same page — it would be different if you put in something from Thomas Piketty or James Galbraith.

One of the interesting ideas, that I have run into elsewhere too, is that a “flat” income tax, and a VAT, are quite similar. Huh? They seem rather different at first glance. I will admit that I don’t understand all the details of this notion, but the logic goes something like this:

In a VAT, a corporation’s tax base is (gross revenue) – (payments to other companies), aka “value added.” For example, a widget is sold for $100. Other suppliers are paid $40. That leaves $60. A VAT of (for example) 15% is paid on the remainder, $60. $60*15% = $9. The supplier itself pays the VAT on its revenue of $40, minus its own suppliers, and so forth.

This “value added” can be deconstructed as: personnel costs (including all nonwage benefits), and corporate profits. So, if instead of a VAT, you instead pay a 15% income tax on corporate profits and personnel costs, the effective tax is the same. Plus, the payer is the same, namely the corporation, especially if there is withholding, as would normally be the case. So, if the payer is the same, and the amount paid is the same, the rate is the same, and the tax base is the same, then what’s the difference?

In this case, the VAT-like “income tax” does not tax non-employment income, such as dividends, interest income and capital gains. These are taxed at the corporate level (interest is not expensed), and not taxed at the individual level. Also, interestingly, capital expenditures are “expensed,” as all payments to other corporations reduce the corporate tax base on a cashflow basis. Most “flat tax” proposals today include these details, which is why Alvin Rabushka and Robert Hall, the progenitors of the “flat” income tax, apparently sometimes call their flat tax proposal the “progressive consumption tax.” It’s the same proposal, just funny terminology. Unlike a VAT, it allows some “progressivity” by including a large basic deduction.

This deconstruction is insightful, although I sense that it is a little too clever. There would seem to be some substantial differences between a VAT and a “flat” income tax, particularly regarding savings and investment. If there was only a VAT and no income tax, it would seem that an individual could avoid the VAT by saving their income, rather than spending it on consumption; while, if there were only an income tax and no VAT, this would not be possible. With an income tax, wealthy people who do not have employment income would pay taxes on the corporate level on their investments. With a VAT, they would pay taxes only on their consumption, which might be a small fraction of the former amount.

There seemed to be consensus that a “broad base and low rate” was desirable, which implies as few deductions and exemptions as possible — whether in the form of a VAT, or a “flat” income tax. (You could also have an income tax with multiple rates, but the same broad base without exemptions.) One of the main concerns was whether it was politically feasible. The process of handing out tax favors for cash is so deeply ingrained in Congress, and the lobbyists that orbit Congress, that it would seem that even if we could agree on such a “perfect” tax system, and actually legislate it, it wouldn’t remain “perfect” for long. That is exactly what happened after the 1986 tax reform, to the dismay of tax specialists everywhere.

There seemed to be consensus also that a simple retail sales tax, as is common among State governments everywhere, is not a workable model with higher rates. An oft-cited statistic was that only six governments in the world have attempted a national retail sales tax with a rate over 10%; five of them abandoned it. Since State sales tax rates are already approaching 10%, this system seems like it has already been pushed about as far as it can go. Over a hundred governments, however, have VATs, often with rates above 15%. It is, technically speaking, a far better system for a consumption-type tax.

The political problem is that the introduction of a VAT in the U.S. might easily lead to both high VAT rates above 10% and high income tax rates above 25% — basically, a European model. Ironically, a very “efficient” system, which raises a large amount of revenue while minimizing the negative growth effects on the economy, can lead to a greater and greater tax burden. Proposals run in a range between VAT-only “fair tax”, with no income tax, to an income tax only “flat tax,” and also VAT/income tax combos like Herman Cain’s “9-9-9” plan. While these proposals might have merit from a technical standpoint, they might not be politically stable. If we leave consumption-type taxes only to the States, with a retail sales tax naturally limited to about 10%, and limit Federal taxation only to income, we might be able to avoid a European-like outcome with both a high VAT and high income taxes.

The Alternative Minimum Tax was generally reviled, but some people tossed out the idea of keeping the AMT, and doing away with the regular income tax code. The AMT, after all, has a much broader tax base with fewer exemptions and deductions — that is its purpose. Probably it would be best to eliminate both, and rewrite the whole thing from scratch.

But, this inspired me to offer another proposal, which is not mentioned in this book. There is another “alternative income tax” besides the AMT. It’s the regular payroll tax. This has a lot of similarities to the “flat tax.” It doesn’t have any exemptions and deductions at all. You pay on every dollar of employment income — but, you don’t pay on dividends, interest, gifts, inheritance or capital gains. In eighty years, there has never been one new deduction or exemption added. Politically, it seems bulletproof. Nobody has to file a return. This is a big deal, not only because it saves people a lot of hassle, but if there is no return, then there is no opportunity to complicate the return by adding exemptions and deductions — that’s why the payroll tax has remained pristine for decades, while the regular income tax is an orgy of influence-peddling. Self-employed, passthroughs etc. would basically file under the corporate (“business”) income tax system, which would have basically the same rates. “Payroll” should be expanded to include all employment benefits, including healthcare, pensions, etc. Since it’s the higher income people who are enjoying these benefits anyway, making them taxable in effect increases the taxed paid by these upper incomes, introducing an element of “progressivity” compared to the norm today, although the tax rate would be the same.

So, I propose that we get rid of the personal income tax altogether, and just use the payroll tax, which is now 15.3%. This is very close to the 17% rates proposed by some “Flat Tax” advocates. There would be no upper limit on payroll tax income, but also, of course, no other income tax. There would be no issues regarding the integration of payroll and regular income taxes, regarding combined marginal rates. There would be some issues with “progressivity,” for which the earned-income tax credit was created to reduce effective payroll tax rates on the lowest incomes. Ideally, we would like to get rid of the EITC too, simply because it would be a tragedy to have to file a return just for that one purpose.

Perhaps some other mechanism could take its place, possibly similar to the “prebate” element in some “fair tax” proposals, which could also go by the name of a “universal basic income.” Or, maybe we don’t need it. Some have made the argument that payroll taxes on lower incomes are canceled out somewhat because people receive money back in the form of Social Security payments later in life. Also, these Social Security payments have a natural element of “redistribution” — the payouts are similar for all recipients, if not quite the same, so that lower-income people get more than they put in, and higher-income people get less. One fix would be to make Social Security a one-size-fits-all payout. This would mean a bigger payout than is the case today, for people whose earnings (and thus payroll tax contributions) were low, and a smaller payout for people whose earnings were higher.

Another possibility would be to add a Flat income tax on top of this payroll tax system, but at a very high level of income, for example $200,000. If you add a 10% Flat tax rate to the no-limit payroll tax, the effective combined rate would be around 25%. One advantage is that only a relatively small number of people would have to file returns. Politically, it would be hard to “buy off” large portions of the voting population, because they wouldn’t be filing returns at all. Perhaps it would also be easier to “soak the rich,” but that’s the case today anyway. I would prefer something simpler and harder to mess up — a simple flat-rate payroll tax — but others might prefer to have more progressivity in the system.

Over time, I’ve come to see the progressivity coming in terms of services not taxes. The Eastern European flat-taxers often combine a flat income tax, let’s say 15%, with a high payroll tax, let’s say of 20%, with an upper income limit. Often, there is a VAT of around 20% also, which has a “regressive” character. It would seem that the lower incomes are paying 20%, plus the VAT, and the upper incomes are paying 15%. But, actually the upper incomes are paying the 20% payroll tax too. The reason that the taxes are so high is because there are a lot of government services, such as state healthcare and dental, subsidized education, perhaps subsidized daycare or what have you, plus the usual parks, libraries, police service, fire service, and of course a state pension (Social Security). People are getting something for their money, and what they are getting is pretty much the same for everyone. However, they are paying different amounts for it: lower incomes pay less, and higher incomes pay more, in the form of the one-rate payroll tax. Unusually high incomes keep on paying, in the form of the flat income tax, although they get no further benefits beyond the maintenance of the state itself. Upper incomes are also paying more in the form of the VAT. If you think of it this way, there is a kind of fairness and progressivity to it.