It’s pretty simple: Income taxes penalize saving. That’s bad. Savings and investment are critical to long-run economic growth.
Consumption taxes do not penalize savings. See, under an income tax, workers who save to consume in the future are taxed more heavily than a worker who consumes today. Replacing the current income tax system with a consumption tax would boost saving, which would increase the capital stock and promote long-run growth.
Yup, pretty simple. So, of course, that is not how the United States does it — as these charts from Michael Graetz of Columbia’s law school show:
The difference here is that US is the only advanced economy without a value-added tax. So not only is the US tax code more progressive as a result of relying on the income tax, it is also less efficient. (Thank heavens for the US entrepreneurial spirit.) In The Wall Street Journal today, David Wessel outlines Graetz’s tax reform plan:
He would impose a new national value-added tax and use the money, in part, to eliminate the income tax – and the filing of income tax returns – for families with incomes under $100,000. For others, there would be three marginal tax brackets (14%, 27% and, for income above $600,000, 31%.) He’d also lower the corporate tax rate to 15%, cut the payroll tax and give cash to low-income families with children.
While the Graetz Plan may not be my first choice for tax reform – it does, after all, keep the income tax rather than converting it into a consumption tax – it is way better than the status quo and unfortunately better than what Washington is likely to cook up.