A Summation of the Principles of Taxation
The Trump administration in alliance with the Republican controlled House and Senate has a unique opportunity to reform the arcane and incomprehensible tax code of the United States. Most of what is discussed on TV and on the editorial pages is about tax cuts. But tax cuts and tax reform are two different things and one is possible without the other. Tax cuts are popular because nobody likes to pay taxes. But the justification for tax cuts touted by the political class is that tax cuts generate economic growth and employment. The expected increase in corporate profits and employment for such economic growth is believed to generate additional tax revenue even with lower rates to offset the cost of the tax cuts. Ahhhhh, if only life were so simple we could be living in a Garden of Eden. Let us take a closer look at tax cuts and tax reform to see what makes sense for America.
Before we go running off to cut taxes let’s see where we currently are fiscally. 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. New issues of public debt, which already stands at about $20 trillion, must fund these deficits.
But this is all before President Trump’s phenomenal tax cuts. 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”. But when President Trump presented his fist $3.9 trillion budget it was in effect revenue neutral. Of the 23% of the budget that is “discretionary” his increases to Defense and Homeland Security were offset by reduction to just about everything else. The 73% of the budget that is mandatory (Medicare, Social Security and interest on the debt) was untouched.
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, you will soon notice that my thoughts on taxation differ from both Republicans and Democrats. 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.
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.
Obviously, our legislators in Washington have a different concept of the purpose of taxation. Taxation isn't covering government operations because we are $20 trillion in debt from deficit spending by the government (we don't need to get into the unfunded liabilities of government programs such as Social Security and Medicare at this point of the discussion although those obligations far exceed the current debt).
I would contend that there are four purposes to the current tax regime; 1) micro-managing the private sector through various tax incentive programs, 2) income redistribution through highly progressive and punitive taxes, 3) providing tax benefits to specific industries, companies and other organizations in order to generate donations to political campaigns, and 4) reelecting Congressmen and Senators. I would further contend that points 3 and 4 are foremost in the minds of our legislators and that actually funding government operations is not a major consideration of our legislators.
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. We need a system of taxation that supports the requirements of the nation and not one designed for the shortsighted requirements of elected officials.
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 (just try to find out how much revenue the government has forgone due to these programs). 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 they build 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. (to see a more detailed discussion of how to solve the social welfare conundrum, please refer to Principled Policy (2016) by yours truly, available on Amazon and other outlets).
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 choke points that really get people angry. 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.
Before we talk about tax fairness or developing a “fair” tax system, I would like to explain a bit about my take on the concept of fairness.
Dr. Daniel Kahneman in his book Thinking Fast and Slow (based on his research along with his long time partner Amos Tversky) asserts that the human brain consists of two systems but I could never keep them straight. I call System One (which is quick thinking and intuitive) our instinctual brain while I call System Two our rational and scientific brain that is controlled by reason (and justifies our species being called homo sapiens or wise man). The instinctual brain is more related to our hominid and great ape ancestors. Kahneman further asserts that while the rational brain is what makes us human it is also lazy and is only called to action when necessary. The rest of time the instinctual brain is in charge.
The instinctual brain is the fast part of thinking fast and slow. For primitive man, hesitation on the savannah or the tundra could be the difference between life and death. If it were not for our instinctual brain we would not have survived as a species long enough to become rational. But many of our biases and prejudices lie in the instinctual brain because they were necessary for survival in the primitive world but are an impediment in our current more civilized world.
I believe that the concept of fairness lies deep within the instinctual brain. An animal in the hunting pack that does not get its fair share of the kill does not survive. This relation to survival also explains the visceral reaction to perceived unfairness. We have all seen the pack or pride consuming the fresh meat from the hunt, snarling and snapping at others in the pack to make sure they get their “fair’ share.
Humans do not learn about fairness in the pew or classroom. We learn it on the playground long before we become self-aware. Not a lot of snarling or snapping but a lot of crying and running to mommy to complain about perceived unfairness.
I have been told that the sense of fairness is part of our innate goodness as human beings and that it underlies many of our religious principles and perceptions of civilized behavior. That may be, but that does not alter its savage origins.
Whether it is innate or instinctual, fairness is subjective. There is no such thing as universal fairness. Fairness is personal. A sense of fairness can be shared by many people if it matches their specific circumstances or shared belief systems. But when their circumstances change or when there is a different belief system this shared sense of fairness can evaporate. A ref’s call can be fair or unfair depending on if you are a Packers’ or a Cowboys’ fan no matter if you share the same religious or educational background.
Drs. Kahneman and Tversky had many insightful revelations about how humans react to various situations that they elaborated into the Prospect Theory for which Kahneman won the Nobel Prize in Economics (having passed away Tversky did not receive a prize because these prizes are not awarded posthumously – hey! That’s not fair!). A critical aspect of Prospect Theory is the concept of loss aversion. Kahneman and Tversky asserted that people feel losses more than gains. Gains are pleasing but losses hurt – a lot.
Taxation is a taking of one’s personal property through the use of coercive force by the government. It is inherently unfair from the perspective of the taxpayer. It takes a force of will to summon the rational brain to realize that this payment is for the greater good of society and that, as an individual, you benefit from a smooth running society. It is even a benefit in a not so smoothly running society because it is still better than the Hobbesian chaos of being outside of society.
But even if you realize that taxes are a necessary evil that you willingly (if sullenly) submit to in order to be a part of a greater society, your subjective sense of fairness antennas are up to make sure that others in the society are paying their taxes fairly. But how you define fair depends on your specific circumstances. If you are a rich person you might think a highly progressive income tax is very unfair but a poor person would have the opposite view. Likewise the rich person might think a flat tax would be fair but the poor person would be very upset with such a tax.
Because of the subjective nature of fairness, fairness is not a good standard to use in establishing tax policy. The standard I prefer is the “not too unfair” standard. We might not be able to agree on what’s fair but we should be able to come up with a tax policy that everyone can say (somewhat grudgingly) is not too unfair (although different people might have different perspective of the unfair aspects of unfairness depending on a person’s specific circumstances). The process of judging if a policy is not too unfair engages the rational brain and let’s us control the instinctual brain that is screaming, “not fair, not fair!”
When President Trump announces his new tax proposal he will, no doubt, assert that it is very fair. Whole bunches of people across the country will wail that it is not fair. Of course it will be unfair. But will it be too unfair? In other words, will the majority of the population concede that despite its demerits, the tax policy’s unfairness is outweighed by its benefits to society? That is the essence of the “not too unfair” standard.
But we must take care. The “not too unfair” standard requires a concession from all sectors of society. Keeping in mind that most of our recent national elections have only been won by a few percentage points, a policy that is supported by a narrow majority but violently opposed by a large minority does not meet the “not too unfair” standard. This is why it is important that we agree of the purpose of taxation. If we cannot agree on the purposes to which our taxes will be applied, it will be impossible to reach any sort of consensus on what the actual policy should accomplish.
The Obligation of Citizenship
As noted above, it is difficult to reach a consensus on fairness if the specific circumstances of citizens are very different. If large numbers of citizens pay no tax, their specific circumstances will not only be different than those that pay taxes, their interests will be in opposition to those citizens. Under such circumstances it will be very difficult to reach a “not too unfair” consensus.
In 2013, the bottom 50% of all income earners n the US only paid only 2.78% of income taxes. Of course they also paid Social Security and Medicare taxes (laughingly called contributions) that are not progressive and so paid a higher proportion of those taxes. However, many received welfare benefits in excess of their taxes paid and so had, in effect, a negative tax rate. It is in the interest of these citizens that the rich pay ever more taxes because they receive the benefit of those taxes. It is difficult to build cohesion of the social contract when citizens are in direct conflict with one another because of the tax system.
This rich, of course, use their wealth and power to influence the government to work in their favor (why else would they pay all that money to lobbyists). The rich skew the playing field to their advantage so that they can continue to reap millions. This makes it difficult for the poor to overcome their circumstances and move up the ladder.
The tax system cannot solve all the problems that affect the American Social Contract. But at least it should not exacerbate the situation. All citizens need to pay some tax even if the other benefits received from government by the lower income sectors of society outweigh the taxes they pay. All citizens need to share the pain of loss to the takings of the government by the use of coercive power. In this way the common citizenship of all participants in society is reinforced.
Taxes are powerful incentives that can be used to manipulate human behavior. Harken back to Prospect Theory. Psychologically, taxes are losses and losses hurt much more than gains. Humans, under the marching orders of their instinctual brains, are greatly motivated to avoid taxes even if the tax savings are minimal or not in their best interests.
The mortgage interest deduction has been pushed by realtors (most of these tax incentives are supported by one special interest group or another) as a way to increase the number of people owning homes, because it is considered a good way for most people to build wealth. But home ownership in Canada, which does not have the mortgage interest deduction, is 67.6% while in the United States it is only 64.5%. On the other hand, the average home size in the US is about 11% more than Canada (2164 sq. ft. to 1948 sq. ft.). So it would appear that the mortgage interest deduction does not improve the percentage of home ownership but does increase the average size of homes purchased (this may be an example of another problem with using tax incentives to manipulate people’s behavior – unintended consequences).
In order to promote plug-in electric vehicles, the government offers up to $7500 in tax credits for purchasing such vehicles. This credit only partially offsets the high cost of such vehicles. The New York Times in 2012 estimated that the cost break-even between plug-in electric vehicles and standard vehicles is between 8.6 and 26.6 years, depending on the model. And, although the plug-in cars may not produce CO2, the power plants that supply the electricity do, so it may also take years before the carbon emissions of the production processes for electric vehicles is offset. So the societal gains are marginal at best but the government has determined that it wants to promote these vehicles and that a tax incentive was the best way to do it.
But I don’t mind if government wants to promote plug-in electric vehicles. Governments promote many technologies and industries and some of these promotions have been very successful. Lucrative mail carrying contracts help support the early development of airplanes. The government’s DARPA program spawned the development of the Internet.
But I do object to the government using taxes as the primary incentive for all these promotions. The government is trying to manipulate the behavior of citizens by using Prospect Theory to influence our instinctual brains. Richard Thaler and Cass Sunstein wrote a book, Nudge, about all the wonderful ways the government can manipulate our behavior for our own good. But it is not the government’s job to manipulate our behavior, but rather it is government’s obligation to follow the will of the people. This subtle manipulation has the relationship between the government and its citizens backwards.
By eliminating all these tax incentives we will not only stop all this manipulation of the people, but we will clean up the tax code so that people can actually understand what the government is doing. If the government wants to promote plug-in electric vehicles then write a check. Give it to the purchaser. Oh, and by the way, get the authorization of Congress for the appropriation and make sure the cost is included in the budget report.
Tax Cuts and Economic Growth
Economic growth is the Holy Grail of tax policy. However the relationship of tax policy and economic growth is complex and simplistic solutions like merely cutting taxes are unlikely to generate the long-term economic growth this country needs. I am not talking about economic growth in the second or third quarter of 2017. My son just got promoted to management at his company. I want economic growth that will support his career for the next thirty years. My grandkids are in elementary school. They won’t even be joining the workforce for twenty years. We need the kind of economic growth that America experienced in the nineteenth century that propelled our country from an agricultural backwater to an industrial powerhouse.
But what worked back then won’t work now. Alexander Hamilton espoused high tariffs (our principal source of tax revenue at the time) and protectionism of embryonic domestic industries at the dawn of the Industrial Revolution (mixed in with a little industrial espionage). We need new solutions for the 21st century.
The mantra from Washington is tax cuts. Tax cuts will power economic growth. Economic growth will generate more tax revenues. More tax revenues will change the deficit to a surplus that will pay down the national debt of $20 trillion. The tax cuts will be phenomenal. The deficit reduction will be big league. Isn’t life wonderful?
Let’s put a little reality into the tax cut equation. Tax cuts are the flip side of the Keynesian coin’s increased government spending. The idea is that cutting taxes (or increasing government spending) will put more money in the hands of people who will go out and spend it thereby generate economic growth. In the wake of the Great Recession, our government tried both tax cuts and increased spending. Just about all we got was a doubling of the national debt (it is impossible to prove that things would have been worse if they had not taken these steps). We do know that the tax rebates went into savings accounts and the excess cash in banks sat in reserves - unlent and unproductive.
Keynes theorized that if a government cut spending during a recession because of reduced tax revenue, the reduced spending would exacerbate the recession. He therefore recommended deficit spending during a recession but he also recommended surpluses after the recession was over in order avoid increases in the national debt which otherwise would ratchet up on every downturn. Politicians did not pay attention to the second half of Keynes’ recommendation so we have had surpluses in only 5 of the last 50 years (although we have only had about 7 years of recession in the last 50 years according to Wikipedia).
Milton Friedman hypothesized that tax cuts or deficit spending that increased the national debt would not generate much economic growth because people would realize that the debt would have to be repaid at some time in the future and that would require more taxes or reduced spending motivating people to save for the future rather than spend now (the Paradox of Thrift).
Keynes theory seems to work when government accounts are more or less in balance. And since the US economy is generally growing most of the time, the money required to reduce the debt accumulated during downturns would not be that much of a burden. But our politicians in Washington are loath to be seen restraining the economy in any way so long as even one person is unemployed, even if the purpose of this restraint is to reduce the national debt.
And so our national debt has continued to grow inexorably until it has now become a huge threat to our economy. As the national debt grows, Keynes’ theory becomes less relevant and Friedman’s becomes more relevant. As a result tax cuts and deficit spending do not work well when there is a large amount of national debt.
As fiscal policy has less impact when there is a large overhang of debt, so the effectiveness of monetary policy is also reduced. Like government spending and tax cuts, zero interest rates and quantitative easing are designed to put money in people’s hands in order to induce them to spend more and generate economic growth. But all of the money pushed out into the economy has sat idle while the economy bumps along with sub-two percent growth.
The conundrum we face is not a contest between the theories of Keynes and Friedman. It is a contest between the theories of Keynes and Kahneman. As the national debt grows the likelihood of a major financial crisis also grows. This was clearly demonstrated by Carmen M. Reinhart and Kenneth S. Rogoff in their book, This Time Is Different: Eight Centuries of Financial Folly. The chance of financial crisis increases as debt increases, especially after the national debt exceeds about 70% of GDP. The impacts of such financial crises are much greater than what we experienced during the Great Recession (I know. I lived in Mexico during the Lost Decade after a financial crisis in 1981.). According to Kahneman’s Prospect Theory loss aversion means that the fear of loss can overwhelm the hope of gain and as the national debt increasingly looms over the economy the fear of loss grows exponentially.
Obviously, not all citizens are familiar with these economic and psychological theories but there has been a pervasive feeling of unease in our country. A recent Rasmussen Report stated that 64% of the people in the country believed we are headed in the wrong direction. It is not our rational brain that understands economic theory behind this unease; it is our instinctual brain that raises the hair on the back of our collective necks.
And we must keep in mind the fact that the size of our national debt is dwarfed by the unfunded future obligations of Social Security and Medicare. The net present value of those future obligations has been estimated to be as much as $40-60 trillion. Many of our children and grandchildren don’t believe they will ever see a benefit from these programs. That’s some legacy we are leaving to our offspring.
Many proponents of tax reform believe that the US corporate tax is too high and that this makes US businesses less competitive than their international competitors. The US corporate tax is near the top of those of developed countries. Further, the US is practically the only country to tax global income rather than only the income earned domestically. This uncompetitive corporate tax and its global scope have distorted how US companies do international business.
As a business grows it begins to export its products to other countries. As these markets grow, it may make good business sense to begin to have some operations located in the overseas markets. There are many reasons why a business may want to have some of its operations overseas. Some businesses have taken advantage of lower wages overseas to relocate their manufacturing plants to other countries and importing their products back into the United States (offshoring).
The profits from these operations are taxed at the rate in the foreign country, which is usually less than that of the US. The US does not levy the global tax on these earnings until the profits are repatriated back to the US. This has caused many companies to keep their foreign profits offshore. The amount of unrepatriated profits is estimated to be around $2 trillion. So instead of this money being reinvested in the United States is sits idle overseas or (even worse) it is reinvested overseas generating even more foreign profits (and more foreign jobs).
Some companies have even gone so far as to change their domicile from the US to a low-tax foreign country through a reverse merger (these transactions are called inversions) because it is so much more profitable to be a foreign company. The Obama administration concocted a huge penalty to thwart the proposed inversion of US pharmaceutical giant Pfizer but did not address the poorly conceived tax policy that prompted Pfizer to attempt the inversion in the first place.
Because US companies compete internationally they need a tax policy that does not impair their ability to compete. Some progressives may baulk at lowering corporate tax rates but lower rates that help to improve the ability of American companies to compete would help generate more jobs in America and eliminating the global taxation would bring new investment funds back on shore. Corporate taxes only represent about 11% of federal government revenues so the cost of competitive corporate tax rates would not have a large impact (besides, a good case can be made that the cost of taxes is pushed onto us consumers anyway in higher priced products).
Not only is the US tax regimen horribly complex, even worse, it changes every year. These changes can be minor or major but compliance costs are exorbitant because not reflecting even a minor change in a tax filing can have major penalties and even jail time. These changes can arise from special deductions or subsidies (those K Street lobbyists have to justify the enormous fees they charge) or they may be ideologically oriented (as are some of the taxes and penalties in the Affordable Care Act).
Businesses facing an uncertain tax (or regulatory) environment will be hesitant to invest in new plant and equipment or to hire new employees. A simplified and stable tax regime would permit US businesses to grow and promote economic growth and jobs (although accountants and lawyers might be negatively affected).
With this investigation into how our Founding Principles can be applied to taxation, I think we now have a tool that can be used to propose a broad outline of a tax policy that will be in the interest of our citizens and supportive of business activity.
A Social Contract on Taxation – A Proposal
Given all the complexities above, how do we arrive at a tax regimen that is not only deemed fair, but will be supported by the large majority of citizens? Not only must the majority of the people support it, it must be a plan that promotes growth within a sustainable framework.
Our tax contract depends on five elements: 1) a national consensus of perceived fairness (using the “not too unfair” standard), 2) the belief that the money will be well used, 3) the tax regimen will be competitive with our major trading partners, 4) a more or less balanced budget (financing deficits with debt just transfers the tax burden to future generations) and 5) tax stability (incorporating the previous four requirements). A tax regimen that incorporates these elements will promote growth.
Of course, a new, simplified and functional tax system will only work if the government addresses other structural problems facing our country such as the current cost and future obligations of the social welfare system, an enormous national debt and balancing the budget. But at least a simplified and functional tax system would be a good first step.
A Progressive Tax that Works
There is a lot of controversy about the progressive tax system, that richer folk pay a higher percentage of tax than poorer folk. Progressives will state that the rich can afford to pay more (for some, much more) and that is true. But it is not true that the rich can pay all the taxes. All citizens have a duty to pay taxes. The question is; how do we develop a progressive tax system that is perceived by all parties as "fair" (or rather "not too unfair"). The key word here is perception. The current tax system is already progressive; yet Republicans rail that it is too progressive and Democrats rail that it is not progressive enough.
The numbers don't matter. Both sides can quote numbers until they are blue in the face. Each side of the argument can quote numbers to prove their points. In fact you can get numbers to prove almost anything. What we need is two things: 1) a consensus that the tax system is not too unfair, and 2) that the taxes raised are sufficient to cover the cost of government.
Building a consensus
It is currently impossible to build a consensus about the perceived fairness of the tax system. Its complexity defies analysis and comprehension. It is not sufficient that a few (highly paid) tax experts and policy wonks understand the tax code. It is vital that the people understand how the tax system functions. The opaqueness of the current system caused by its complexity breeds distrust and consensus is impossible under these conditions. So it is essential that the tax code be completely overhauled and simplified. All deductions (including the cherished mortgage interest deduction as well as the double tax exemption of healthcare expenses) need to be eliminated. Further, all subsidies and benefits (sometimes called tax expenditures) must be eliminated. If the government wants to provide these benefits, it should do so directly. It can do this by funding these expenses from the budget. Tax “expenditures” provide enduring benefits without the approval of a budget and an authorization of Congress. We will see how popular these benefits to particular interests are once they see the light of day.
Covering the Cost of Government
Government expenses broadly fall into two categories; 1) constitutionally mandated duties and 2) social welfare payments. The two largest social welfare systems (Social Security and Medicare) have their own proprietary funding system through the FICA contributions people pay. These social welfare systems need to be made self-sustaining and their funds segregated from the general operating funds of the government. This will improve transparency in general and will help to build consensus. With these changes, the operating budget (plus a capital budget for infrastructure) along with the elimination of tax “expenditures” should be more easily understood by the citizenry. This will make it easier to balance the budget and to eventually begin to reduce the public debt to a more manageable size.
Businesses pay taxes on a net basis rather than a gross basis. This means that they deduct the expenses of operating the business, such as purchases of inventory or equipment, payment of salaries, etc. from the gross revenue received by the business. But businesses are often complex and a lot of the lobbying in Washington comes from businesses trying to get special treatment for their deductions. Add in the fact that many people are self-employed, personal services contractors or partners in a limited partnership and our goal of simplifying the tax code seems in danger of spinning horribly out of control. But we must try and stick to this goal. The goal of tax simplification is not to reduce the 77,000-page tax code down to one page. Our society is too complex for that. Further, such over simplification would actually result in unfairness rather than fairness. But business deductions can be reduced to a few principles that apply to most businesses and abuses (such as carried interest) can be eliminated.
Border Adjustment Tax
One of the tax reform proposals being discussed is a border adjustment tax that would levy a tax on imports but not on exports. The goal of this proposed tax is to level the playing field between the US and our international trading partners (and raise a trillion dollars over the next 10 years). But as Veronique de Rugy and Daniel J. Mitchell noted in a recent op-ed piece in the Wall Street Journal ( The Border-Adjustment Sleight of Hand) the playing field is already level. The border adjustment tax is a tariff and will be perceived as such by our trading partners and the WTO as such. To risk a trade war in a transparent attempt to jigger the tax code and justify a tax cut (perceived by many for the wealthy) is no way to build the necessary consensus.
There was a lot of controversy about the inclusion of a deal on estate taxes in the deal to extend the Bush tax cuts to all taxpayers even the wealthy. The deal set the estate tax rate at 35% with an exclusion of $5,000,000 (the rate had been set to go up to 55% with an exclusion of only $1 million). This caused outrage among the liberal wing of Congress bemoaning the burden to future generations caused by letting the wealthy keep their own money.
Truth be told, the estate tax violates the principal foundation on which we are trying to build a national consensus on taxation: that the principal purpose of taxation is to fund the government. The estate tax provides an insignificant portion of federal government revenue (less than 1%). Rather, the purpose of the estate tax is confiscatory. It is designed to take money from the wealthy and give it to someone else: to punish the wealthy for being wealthy. The tax is especially punishing to the wealthy because often their wealth is concentrated in assets that are not easily turned in to cash, such as ownership of a family company or large land holdings. To obtain the necessary cash to fork over to the government, the bereaved family may have to sell the family company, carve up their lands, and hawk family heirlooms (I can see all your crocodile tears). I have no qualm at taxing the wealthy but the estate tax is just mean. If we want to raise money there is a better way.
We need to eliminate the double taxation of dividends. Just as the double tax exemption on medical benefits has caused havoc in the healthcare segment of the economy, the double taxation of dividends has messed up the productive sector of the economy. Again, I believe that the motivation for this policy is envy or meanness. What is the logical rationale for taxing profits at the corporate level and then again at the individual level except that they are profits? Profit, which is the energy driving our free market economy, is a code word for evil among some sectors of the polity.
We have seen in the healthcare industry that a double exemption drives revenue toward the exemption that causes a breakdown in the pricing mechanism by separating the consumer from the price paid for a service. In the case of double taxation, revenues are driven away from the double tax situation. This means that corporations retain earnings rather than pay out dividends. This is not a problem in fast growing industries that need additional capital. They would invest in new plant and equipment (and hire more workers) with or without the double tax on dividends because the returns on the investment are higher for shareholders than other alternatives (companies in tech industries rarely pay dividends). But in other industries, where the returns from new investment are not as high, the double taxation on dividends motivates companies to retain earnings when it would be more productive to distribute them to shareholders. The retained earnings are misallocated by these corporations to either investments in lower returning assets in their current industry, or to higher earning investments in other industries where management may have less experience and expertise.
It is impossible to calculate the cost of this misallocation of capital but it is certain that the result has been lower growth, less employment and a lower return to investors. Dividends should only be taxed at the individual level and at the same rate as ordinary income (which would eliminate the problem of the alternative minimum tax which castigates "passive" income such as dividends and interest).
Charge for Service
There is one more element to the revenue that government extracts from its citizens in charges for services rendered, but here we must tread carefully because of the potential of moral hazard. Corporations or individuals receive benefits from specific government services that they receive. In municipalities this could be for garbage pickup, sewerage, building permits, etc. In seems very clear that these services, which are in the public interest, often have specific benefits. In the national context, these services could be meat or agricultural inspections, customs inspections for imports, drilling permits for offshore oil exploration, etc. These services are necessary but are often the first ones to feel the budget cutter's ax, often to the detriment of the public. Departments such as the FDA and USDA should be able to recoup the cost of the services they provide. True, these costs will be passed on to the public, but principally to the public that benefits from these services (as opposed to the public in general: i.e.; vegetarians wouldn't have to pay for meat inspections because the cost of these services would be reflected in the price of the meat, and not vegetables).
Nevertheless, we must always be aware that bureaucracies tend to grow and never diminish (although most farms in the US had access to electricity by 1952 consumers continued to pay for rural electrification for many more years). Right now, the public is underserved in the areas of meat and agricultural inspections and many other services of government due to underfunding. We do not want to get into a situation where government bureaucrats charge industries more and more for services extraneous to those required for the public good.
How does a government agency determine the appropriate level of service? How many meat inspectors do we need? How often should meat packers be inspected? Too few inspections endangers public health but at some point the addition of more meat inspectors is of declining utility (the law of diminishing returns). The point where the public good is best served is difficult to determine. More inspections may reduce the chance of someone getting sick but will increase the cost. Reduction of risk to zero is impossible and even approaching that level of certainty would make meat (or any other service) outrageously expensive and unaffordable.
Why a Flat Tax won't Work
Although a flat tax (a single tax rate that is paid by all taxpayers) might seem imminently fair, it would be very difficult to implement and be ineffective in achieving the type of consensus we are talking about. Even though a flat tax would appear to be the same to everyone, it wouldn't be perceived to be fair by many, especially to low income earners. Giving up a yacht in order to pay taxes is very different from giving up food or clothing for your children to pay taxes. If the goal of a tax regime is to build a national consensus of perceived fairness, a flat tax must be left at the starting gate. Although there are mechanisms that could be put in place, to ease the inequities of a flat tax, the end result would be a (somewhat) progressive tax – so what's the point? I personally like the concept of a flat tax, but the bitter struggle to impose such a tax regime would preclude the ability to achieve a national consensus. Without a consensus, the tax regime would be changed by the next shift in power from one party to another. Thus it is clear, a flat tax cannot achieve the two principal goals we are seeking; 1) a national consensus, and 2) a stable tax regime.
A Value Added Tax won't Work Either
A value added (or sales) tax suffers from the same problems as a flat tax: it is regressive and would be perceived as unfair. A VAT also suffers from the problem that, in addition to already being charged by the states and municipalities, it could, as in the case of Europe, be added on to existing income tax, thus greatly increasing the overall level of taxation.
Taxation is a complex issue involving not only the differing situations related to tax affecting all citizens but, more importantly, it also underlies the ability of the nation to function and the sense of cohesion amongst citizens. People that try to twist the tax code to their benefit undermine the social contract that forms our nation. While this is a very natural and human response it must be resisted. Private action is always more focused than public action, which has resulted in the hyper-complex and inherently unfair tax code that currently exists. I must admit the current tax policy has achieved a form of national consensus. The consensus is that it sucks! Maybe everyone won't support the ideas listed above, but some type of major tax reform is essential for the revitalization of America.