We Need Flatter Taxes, Cleaner Rules

 

The Trump administration released a thumbnail sketch last week of its much anticipated tax plan, which has generated opposition and support from all the usual suspects. The critics of the plan take the view that the program will generate windfall subsidies for the rich and increase deficits while doing nothing for growth. Its defenders, including Treasury Secretary Steven Mnuchin, claim that the anticipated growth from lower tax rates will override any objections about increasing income inequality.

It is, of course, difficult to make predictions on matters such as economic growth. The overall effect of any tax plan depends not only on the plan itself, but on other government actions, such as spending rates, which have risen inexorably since the end of World War II, and interest rate increases by the Federal Reserve. It puts the cart before the horse to think about growth and deficits before getting the right tax structure into place. Once that is done, the needed response to changes in economic and financial conditions can be handled solely by changes in tax rates. The enhanced stability of the tax structure itself should be positive for growth. And on tax design, the Trump plan offers a mixed bag.

Politics aside, the best tax plan is also the simplest: I have long advocated that the sole source of general revenues should come from a flat tax, preferably on consumption and not income. A consumption tax eliminates the enormous difficulties of separating out capital gains, which are typically taxed at a lower rate, from ordinary income, taxed at a higher rate. If a consumption tax is unattainable politically, a relatively close substitute would be to defer capital gains taxes on any profits that are reinvested in other capital assets. No other forms of ad hoc taxation, such as the notorious medical device tax, should be used to raise general revenues.

Low flat taxes are intended to stimulate economic activity. They would also work to eliminate the strategic advantage for taxpayers to divide their income among various entities, such as trusts, foundations, and family partnerships. Flatter taxes would also reduce administrative and compliance costs dramatically. Finally, they would make it more difficult for large political majorities to target wealthier individuals for large transfer payments, a feature of the current tax plan that creates an unstable political dynamic. It is just this approach that explains why Estonia, which adopted this system in 1994, has the “the most competitive tax system in the developed world.”

Unfortunately, Trump’s proposal deviates from this simple plan. For one thing, it advocates expanding the child tax credit, which introduces needless complexity into the system. For another, it didn’t eliminate the interest deduction on home mortgages, which distorts the choice between owning and renting a home. That was a missed opportunity to simplify the tax code.

On the positive side, Trump proposes to end the deduction for state and local taxes, which has predictably generated a firestorm of opposition from Republicans and Democrats alike in high-tax states like New York, New Jersey, California, Connecticut, and Maryland—all of which, not coincidentally, have major fiscal problems. We can improve national productivity by eliminating the major cross-subsidy that high-growth states like Texas and the Dakotas have to pay to allow high-tax states to cling to their profligate ways. This move won’t remove the large disparities in the level of aid received from the federal government to help low-income citizens, but it should put pressure on high-tax states to improve their local systems of taxation and regulation.

Trump is also right to keep the charitable deduction in place, even as its value would, and should, go down as tax rates are flattened. Charitable deductions encourage transfers that promote access to critical public goods, like healthcare and education. In effect, the deduction means that government offers matching grants to decentralized programs that can attract private support, which are more efficient alternatives than direct public assistance.

On the matter of tax rates, the Trump program treats tax simplification as a major goal, which results in a reduction in the number of tax brackets, from seven to three (10 percent, 25 percent, and 35 percent). This is an important step towards a flat tax. But as Trump moves the nation toward flatter tax rates, critics are objecting that his tax plan creates a massive “windfall” that would go to the wealthiest citizens, Trump included.

This frequent but misguided objection relies on the assumption that the current rate structure has some conceptual and moral legitimacy. Indeed, that faulty assumption is explicitly accepted by Trump, whose plan keeps open the possibility of raising the rates “to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the tax burden from high-income to lower- and middle-income taxpayers.” Unfortunately, this position introduces a deadly one-way ratchet into tax policy. Even though the Trump administration may not fancy major tax hikes at the top end of the distribution, the next Democratic administration surely will. That new skew will then become the new normal, even if the rates in question make the overall tax system less efficient than it previously was. Any effort to get back to the previous state of affairs will then be announced as yet another sop to the rich, paving the way for additional rounds of selective tax increases.

Within the classical liberal tradition, the primary function of taxation is to fund public goods and essential government functions, not to engage in redistribution, which dulls incentives for production for both those who pay and receive the transfer payments. To be sure, economic changes have led to an increase in income for the wealthiest. And oddly enough, the entitlement state depends on keeping the rich rich, given that 40 percent of all tax revenues are paid by the top one percent of earners, who garner about 20 percent of the nation’s income.

The country runs a major risk of fiscal and social instability when so much is demanded from so few. Rather than engage in over-taxation, a far better approach is to attack the expenditure side by eliminating the built-in subsidies from which some rich people gain a real advantage. Agricultural subsidies, including ethanol subsidies, are a good place to start, followed by subsidies for wind and solar energy. The revenue side can be made more rational if the expenditure side is purged of undeserved goodies.

The Trump administration should also be praised for its effort to rationalize the taxation of corporate income, by seeking to bring the United States in line with international norms. Right now, our system of punitive double taxation—on profits earned both at home and abroad—encourages American firms to park literally trillions of dollars in profits overseas, revenue that could stimulate domestic investment if brought home. And while the current corporate tax rate of 35 percent may have been competitive in the 1980s, it is far too high in the current global market where the worldwide average is now 22 percent. At this point, of course, the question arises of how to make up the shortfall from cutting the corporate tax rate. In the end, we are driven back to the most difficult problem of tax reform: how to set the rates in a consistent matter.

On this issue, Trump is guilty of his usual excessive optimism when he predicts that jobs will come “pouring in” to the United States under his plan. But by the same token, it is easy to underestimate the importance of durable tax cuts to economic growth. The five states that receive the largest subsidy for deducting local and state taxes are in the worst fiscal shape. States like Michigan and North Carolina show how cutting state personal income tax rates by a couple of points can substantially improve a state’s overall economic position. Forget Trump’s unfortunate “America First” rhetoric: globally, the huge attraction of tax simplification and low rates in one jurisdiction spur similar reforms elsewhere. Let’s hope that sensible tax reform can be contagious.

© 2017 by the Board of Trustees of Leland Stanford Junior University

Published in Domestic Policy
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  1. I Walton Member
    I Walton
    @IWalton

     

    Right on everything as usual.  But we should not assume that anything  is politically infeasible until our leaders have failed over many years to sell it.  Whether something is doable depends on who is selling it over what period of time.  Few things worth doing can be done within a political period and probably none can be done by Congress.  Still the new stars on the hill can contribute to a multi year sales job but the white house ultimately must sell it.  It must be simple enough to understand and must have broad multi class appeal.  An across the board VAT that replaced the payroll tax and generated enough revenue to privatize it would appeal broadly and is simple enough to be sold.  The elimination of the corporate profits tax  replaced by treating profits as income of the holder of record would have appeal and would get the super rich the rich but need not be high as the combination of such a tax with a vat would be cash cows and rates could  be lowered.

    • #1
  2. Nick H Coolidge
    Nick H
    @NickH

    I Walton (View Comment):
    An across the board VAT that replaced the payroll tax and generated enough revenue to privatize it would appeal broadly and is simple enough to be sold.

    What do you mean by “privatize it” with reference to a VAT? Privatize the collection of it somehow? While I’m all in favor of having the free market handle more and the government less, this doesn’t strike me as something that could be privatized well. So I’m probably missing something.

    My big concern about a VAT is the risk that the government wouldn’t use it to replace the payroll tax, but just reduce the payroll tax and the income tax in exchange for a VAT. That would give them lots of opportunities to raise rates later (which they certainly would).

    As far as the current Republican tax plan goes, the child tax credit doesn’t add “needless complexity”. The need is there to reduce the penalty to parents that currently exists. https://www.finance.senate.gov/imo/media/doc/Ponnuru%20Testimony%20FINAL.PDF If anything the numbers for the credit that are being floated around are too low.

    • #2
  3. ModEcon Inactive
    ModEcon
    @ModEcon

    Nick H (View Comment):
    What do you mean by “privatize it” with reference to a VAT?

    Perhaps he means privatizing the payroll taxes which are primarily things like social security, unemployment, and medicare. All of which could be privatized.

    • #3
  4. I Walton Member
    I Walton
    @IWalton

    Nick H (View Comment):

    I Walton (View Comment):
    An across the board VAT that replaced the payroll tax and generated enough revenue to privatize it would appeal broadly and is simple enough to be sold.

    What do you mean by “privatize it” with reference to a VAT? Privatize the collection of it somehow? While I’m all in favor of having the free market handle more and the government less, this doesn’t strike me as something that could be privatized well. So I’m probably missing something.

    My big concern about a VAT is the risk that the government wouldn’t use it to replace the payroll tax, but just reduce the payroll tax and the income tax in exchange for a VAT. That would give them lots of opportunities to raise rates later (which they certainly would).

    As far as the current Republican tax plan goes, the child tax credit doesn’t add “needless complexity”. The need is there to reduce the penalty to parents that currently exists. https://www.finance.senate.gov/imo/media/doc/Ponnuru%20Testimony%20FINAL.PDF If anything the numbers for the credit that are being floated around are too low.

    Sorry I wasn’t clear,  privatize Social Security accounts.  To do so with all young people saving their payments rather than paying for ongoing retirements, we must have significant additional revenue.  A VAT allows this.  I want it tied to the Payroll to make it feasible and attractive to workers because the left will stress that it’s regressive, which it is but not as regressive as the payroll tax which can’t be escaped.   If it’s uniform and across the board, rather than variable as in Europe, and even better if its tied to a flat income tax or the equivalent it’s very hard to raise because there is no escape and people won’t want it raised.   I want it because it falls on consumption and should enhance savings adding to the strong saving growth that would occur if we privatized Social Security accounts for everyone under some age, say 40 which is what the Federal Retirement did when it privatized Federal retirement.   We must increase savings because it is the current account deficit that makes our domestic overspending so dangerous.

    • #4
  5. Don Tillman Member
    Don Tillman
    @DonTillman

    I’m not super-knowledgable on this topic, but…

    My understanding is that the complexities in the business tax code are there because those entries are the primary way to bribe congressmen.

    I also understand that the progressive income tax was first seriously proposed by Karl Marx, in The Communist Manifesto, where he called for “a heavy progressive or graduated income tax”.  It’s the second of the Ten Planks of Communism.

    • #5
  6. CliffTOP Inactive
    CliffTOP
    @CliffTOP

    Tax rules represent control.  Call me cynical, but even within the Republican caucus, I struggle to imagine a groundswell of support for giving up control, for the promise of economic growth.  We’ll see…

    • #6
  7. Ralphie Inactive
    Ralphie
    @Ralphie

    Speaking of Michigan, not only did we reduce the income tax slightly, but we also reformed public pensions.  It can be done. The teachers unions are squawking, but it can be done. As mentioned by by @IWalton, it takes more than one political cycle for the effects of policy changes.

    I also think if the income tax is not eliminated when a VAT is put in place, it just gives more opportunity for future political mischief.

    Like other states, Michigan enacted a driver responsiblity fee, actually a tax, as all fees paid to government should be called. Anyway, the congressman that introduced it decided it wasn’t working as planned, and wanted it repealed. Jennifer Granholm was governor then, and said she would agree if a replacement for the money could be found.  So, it wasn’t really about driving safety.  It has currently been introduced again to be repealed, and I notice by both a Democrat and Republican.

    Tax policies make people behave sometimes how they don’t want to.  Those advocating for a cashless society don’t seem to understand that under the table work  is important for a lot of people, especially the poor who want to work.  The tax on services went down in flames under Granholm.  She was worried as we went more toward a service economy and away from products that revenue would shrink.  The government as competitor in the economy is what liberals seem to embrace.

    • #7
  8. I Walton Member
    I Walton
    @IWalton

    Ralphie (View Comment):
    Speaking of Michigan, not only did we reduce the income tax slightly, but we also reformed public pensions. It can be done. The teachers unions are squawking, but it can be done. As mentioned by by @IWalton, it takes more than one political cycle for the effects of policy changes.

    I also think if the income tax is not eliminated when a VAT is put in place, it just gives more opportunity for future political mischief.

    Like other states, Michigan enacted a driver responsiblity fee, actually a tax, as all fees paid to government should be called. Anyway, the congressman that introduced it decided it wasn’t working as planned, and wanted it repealed. Jennifer Granholm was governor then, and said she would agree if a replacement for the money could be found. So, it wasn’t really about driving safety. It has currently been introduced again to be repealed, and I notice by both a Democrat and Republican.

    Tax policies make people behave sometimes how they don’t want to. Those advocating for a cashless society don’t seem to understand that under the table work is important for a lot of people, especially the poor who want to work. The tax on services went down in flames under Granholm. She was worried as we went more toward a service economy and away from products that revenue would shrink. The government as competitor in the economy is what liberals seem to embrace.

    Clearly it must be a single piece of legislation.  New Zealand cut income taxes by half at the same time they imposed the VAT.  They eliminated what appeared an insurmountable debt the first year.  The VAT is a cash cow when uniform and no good is excluded.  Revenues from income taxes increased the first year and it was not a supply side effect since such effects take at least one full tax period.  We could cut to a flat tax of 10% and link it to a VAT of 10% this combined with privatized SS accounts would eliminate the external deficit which is the deficit that matters.   New Zealand was able to do this and other free market reform because  minister of finance was a Chicago school economist, but the government was socialist and gave their left New Zealand’s security arrangement with the US.  Their left was an old Soviet Supporting bunch of fools.  Replacing the payroll tax is what we give our left to justify the VAT.  The difficulty is avoiding having variable rates, i.e. higher taxes on luxury goods which the political class will like as it offers opportunities for corruption, but it would destroy the magic of a uniform across the board vat.  For this reason we must keep a low but broadly applied income tax so we can buy off the left with tax credits through the income tax.

    • #8
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