Set aside the relative performance of the current US economic recovery versus, say, past US recoveries or what’s happening presently in Europe. Instead, let’s focus on absolute performance. Right now the US economy is growing too slowly to generate many jobs or sharply raise incomes. And it may stay in a muddle for some time. Federal Reserve Chairman Ben Bernanke said as much recently. Bond fund manager Bill Gross is predicting 2% GDP growth and 7%-plus unemployment for a decade.
Maybe Bernanke and Gross are right. Maybe not. But why take the risk? Let’s assume the worst and figure out a way to boost growth by at least one percentage point and get back to the post-WWII average of 3.4%.
One bold way to help do that would be to replace the current progressive income tax with a progressive consumption tax. Individuals would pay tax on their wages only, not on any income from saving. And companies could immediately write off their investments, rather than depreciating them over a period of years. A progressive consumption tax could boost GDP by around 6% in the long run. As AEI’s Alan Vaird explains, consumption taxes promote economic growth because they avoid a central flaw of income taxes: Their penalty on saving and investment. An example:
Consider two individuals, Patient and Impatient, each of whom earns $100 in wages today. Impatient wishes to consume only today and Patient wishes to consume only “tomorrow,” which is many years in the future. Saving yields a 100 percent rate of return between today and tomorrow. With no taxes, Impatient consumes $100 today. Patient saves the $100, earns $100 interest, and consumes $200 in the future.
What happens with a 20 percent income tax? Impatient pays $20 tax on his wages today and consumes the remaining $80, which is 20 percent less than in the no-tax world.
Patient also pays $20 tax and saves the remaining $80, earning $80 interest. However, $16 tax is also imposed on the $80 interest. That leaves Patient with $144, which is 28 percent less than in the no-tax world, compared to a mere 20 percent reduction for Impatient.
The income tax imposes a higher percentage tax burden on Patient solely because she consumes later. The income tax’s penalty on saving causes an inefficient distortion of consumer choice and lowers the accumulation of national wealth and the long-run rise of living standards. The current income tax system includes certain provisions that mitigate the saving penalty.
One way we deal with the anti-savings bias of the income tax is by the reduced tax rate on dividends and capital gains. It’s not as efficient as with a consumption tax, but better than nothing. Since switching to a progressive consumption tax is not on the near horizon, we should avoid raising the tax rates on dividends and capital gains as President Obama wishes to do.
Also consider that investment income is already double taxed, first at the corporate level and then at the household level. The combined US rates on capital income are already among the highest in the world, and that’s before increasing the tax rate on capital gains by 60% and tripling the dividend rate, as Obama desires. That is just bad policy. As liberal economics blogger Matthew Yglesias explains, “This is an issue where the conservative position is in line with what most experts think is the right course, and Democrats are outside the mainstream.”
At the very least, we should leave investment tax rates where they are. Even better, we should take a small step toward a consumption tax by reducing these rates the longer an investment is held. Clayton Christensen, a business professor at Harvard University, recommends a zero rate after five years.
Growth, growth, growth!