Principles of Taxation I
It is not yet possible to critique President Trump’s tax reform package that he is expected to announce in the next 2-3 weeks. Analysis of this reform package (which President Trump has said will be phenomenal) will be an interesting exercise. President Trump’s Office of Management and Budget (OMB) says that the 2017 deficit will be $443 billion, a reduction of around 20% compared to the 2016 deficit of $552 billion. This will be accomplished by a 7.3% increase in tax revenues while expenditures increase only 3.1%. Of course, the 2017 budget is pretty much already cooked as we are already in the fifth month of the fiscal year. Looking forward to 2018 is inherently more speculative but OMB projects a further deficit reduction on a 5% increase in revenue against only a 3% increase in expenditures. But this is all before President Trump’s phenomenal tax cut. It is also before promised increases in military spending, infrastructure projects and the continuation untouched of the major transfer programs such as Social Security and Medicare.
During the campaign, Mr. Trump stated that he was going to bring down the deficit “big league and quickly”. When queried on how he stated that he would cut the budgets of the Department of Education and EPA. But as these agencies only represent 2% of the total budget so it is hard to imagine how he would be able to bring down the deficit big league and quickly. The only people to play more fast and loose with financial projections than real estate developers are politicians so we are delving into some real big league hogwash here.
But in anticipation of some real gravity defying leaps of logic in the upcoming phenomenal tax reform proposal, let’s think a bit about what we really want in a tax package.
First of all, let me state unequivocally my opposition of much of the received wisdom regarding taxes. To Republicans, the best way to spur economic growth is to cut taxes and then blindly trust that the Laffer curve will take care of resulting deficits. To Democrats, taxes are best utilized, not to fund government operations, but to extract undeserved wealth from the rich to give to deserving Democratic-leaning voting blocs. They are both wrong. The key principles to ethically utilize the government’s ability to tax its citizens are:
Taxes should be used to pay for the operations of government.
Incomprehensible tax rules undermine the people’s trust in government so tax policy should be made understandable to citizens
It is not possible to create a tax system that will deemed to be “fair”.
Payment of taxes is an obligation of citizenship so all citizens should pay some tax.
Tax policy should not be used to manipulate people or organizations.
Cutting taxes is not an effective means of generating long-term economic growth.
Corporate taxes should be competitive with the tax systems of our major trade partners.
Economic growth is stunted by uncertainty so tax policy should not change every year.
Adequate analysis of these principles will far exceed the optimum length for a blog post of this type. And discussion of these principles also leads to many additional important issues that need to be discussed as well. So we will attack this subject in a piecemeal, but orderly and logical, fashion. For a more in-depth discussion of this topic, I suggest you pick up a copy of my book, Principled Policy, which is available on Amazon and other outlets.
The Purpose of Taxation
So let us take up first, the purpose of taxation. The Founders of our country, after existing a few years under the Articles of Confederation, soon learned that a government that lacks the ability to tax will quickly perish. According to the theory of the social contract as developed by Enlightenment philosophers, citizens cede a portion of their natural rights to government so that the government has the ability maintain the functionality of the social contract. Government needs coercive power to force the payment of taxes in order to guarantee its continued existence and, thereby, the continuation of the social contract that citizens have agreed to.
The cession of certain natural rights by citizens empowers the federal government to enforce laws and collect taxes. In the preamble to the Constitution, the government is also obligated to provide services to the citizens in exchange for this cession of natural rights. In summation, the entirety of all these obligations of the government is to maintain the functionality of the social contract according to its founding principles (unless those principles are changed by the will of the people). The purpose of the taxes citizens pay is to provide the government the ability to fulfill these obligations.
The current lack of trust in government is prima facie evidence that the government has not lived up to its obligations to properly maintain the functionality of the social contract. Trust is the most essential element of the social contract. It is the lack of trust in our interactions with other human beings that motivates us to form social organizations bound by a social contract. Lacking trust, the whole fabric of society begins to unravel.
Toward a Comprehensible Tax System
The current tax code is so complex that there are very few people who understand it in its entirety. This fact alone is a breach of the obligations imposed on the government by the social contract. Much of this complexity arises from sections of the tax code that benefit private interests. Other complexities arise from special benefits or subsidies intended to promote certain government-approved activities such as a tax credit to purchase a plug-in electric car or install solar panels.
But all these benefits, subsidies and deductions clutter up the tax code. In addition to making the tax code complex, using the tax code to provide such benefits muddies up government accounting. Do we actually know how much the plug-in electric car benefit for Tesla cars costs the American public? A hard-working investigator with knowledge of the tax code and oodles of time could probably figure this out (or at least give a good estimate). But for most of us, we haven’t a clue.
The thing is, all of these tax benefits could be done in a different way. Instead of giving a tax credit just give purchasers of plug-in electric vehicles the cash instead. Of course this would require Congress to approve an appropriation for this expenditure and the expense would go directly to expenditures report when calculating the annual deficit instead of lurking safely behind the fog of taxes not collected (the Congressional Budget Office estimates these so-called tax expenditures cost the federal government $1.5 trillion in 2015). But such a simple solution would result in greater accounting transparency of the government, which our public servants try to avoid. Using the tax code also allows the benefit to keep on giving without annual appropriations which might prompt somebody to say, why the hell are we still wasting money on that?”
There is another thing that confuses me and maybe you as well. The Constitution obligates the government to do certain things to maintain the functionality of the social contract. These functions are essential as it builds the trust of citizens in their economic transactions with other citizens and promotes economic growth. Fulfilling these functions costs money and that is why government is empowered to collect taxes.
But in governmentese these constitutionally mandated functions are described as “discretionary expenditures” while transfers of wealth between citizens that are not contemplated in the Constitution are deemed “mandatory expenditures”. In fact, such mandatory expenditures have grown to be more than half of the federal budget and are crowding out discretionary expenditures that are constitutionally mandated.
The government does have an obligation to payout much of these “mandatory expenditures” because people have been paying into these programs all their lives. I have been paying into Social Security for over 50 years and into Medicare since its inception. I had no choice in the matter; the government forced me to make those payments (except for when I worked for the C&O/B&O when I paid into the Railroad Retirement Fund). It would be an injustice to deny benefits to retirees who have been paying into Social Security and Medicare for decades.
So our problem is not that these social welfare payments exist (that discussion would be lengthy and not directly relevant to our discussion of taxes) but how to develop a tax system to address these enormous and mounting obligations. Because money is fungible, government has been using the money paid into these programs for other government expenditures instead of setting them aside in order to fund their ability to provide future benefits. This worked well for the government for many years as payments received exceeded disbursements for benefits. This fortuitous relationship has changed and the government is now depleting the accumulated notional trust funds and will soon be forced to use general tax revenue to fund these benefits. This mixing of operating expenditures and social welfare transfers is confusing (I think purposefully so). I think that dedicating our social welfare contribution to those functions and not mixing them with operating expenses would greatly clarify the tax system. Of course, not allowing government to easily move money around the system would have an impact on how to fund these programs on a sustainable basis.
Trust in government is near all time lows. There are many reasons for this lack of trust and tax reform will not solve this problem. But taxation is one of the raw nerve endings that really gets people worked up. Trust in government is an essential element of the social contract without which the social contract begins to break down. Increasing the public’s trust in the tax system would be a positive first step in restoring the American Social Contract.
In the next essay on taxation we will start by addressing the issue of “fairness.” What fun!