Disagreement over tax reform is at the heart of the Washington budget stalemate. In a recent Q&A, AEI tax expert Alan Viard lays out some realities — for the left and the right — that should inform the debate:
1.) Over the past 40 years, tax revenue has been about 17% of GDP. That is unlikely to be true in the future. Taxes look they are going up.
I think we will go up to the 20 to 21% of GDP level in the next several decades. Further on, we may have to go higher than that, but it will depend on what we can do on the entitlements side. … But if you have a better tax system, you could raise 20 or 21% of GDP and have less economic damage than you had raising 17 or 18% with a really bad tax system, so I think that also needs to be put into the mix.
2.) Raising the tax rate on investment income to the same level as labor income is a really bad idea.
When you look at either the capital gains tax or the dividend tax, that’s income that’s already been taxed at the corporate level. So to say that there should be the same individual tax on that income as there is on other income, it really doesn’t hold up because that other income has not been taxed at the corporate level, while the dividends and capital gains have been.
You know that we can split the taxation of this income into two pieces and do it at different levels in the economy, once at the firm level and once at the stockholder level. That’s fine. But those aren’t separate taxes. Those are actually part of the same tax burden, even if they’re being collected in two different places.
And so if we let ourselves get tricked, just by the administrative fact that we’ve collected it in two different places, failing to add these up and look at the total burden, that just doesn’t make any sense.
3.) Many tea party Republicans see the FairTax is a viable route to tax reform. It really isn’t.
I think the supporters of the fair tax have their heart in the right place because they’re trying to find a consumption based tax system that avoids the penalty on saving and in investment that’s built into the income tax. The specific proposal they’ve put forward, though, really does have a number of problems. And many, many economists have pointed them out.
First of all, a retail sales tax at that high of a rate is really likely to have a lot of enforcement and compliance problems. And countries that impose consumption taxes at that high of a rate, they tend to use a value added tax structure, which is really economically the same as a sales tax, but administratively is different because you collect it at multiple stages. And that just helps with the enforcement and the compliance.
So it would be a pretty modest change, actually, to say let’s do it in a value added tax administrative mode instead of a sales tax mode. But that’s I think the first change you need to make to their plan.
The rate is also not revenue neutral. They’re proposing a 30% sales tax rate and that’s not enough to replace revenue. And I think, given our deficit environment, obviously a tax reform is not going to be viable if it lowers revenue. So – and of course, there you could just raise the rate.
A bigger problem is that, there’s no progressivity in this and they – well, they have pre-bate that introduces some progressivity, but compared to the taxes they’re replacing, this would be a big shift in the tax burden, away from high-income groups towards middle-income and lower middle-income groups. And whatever you think about that politically, I think that’s just not viable.
4.) A low-rate flat tax, another favorite on the right, is a better idea but still problematic.
I think the flat tax does deserve some consideration. Contrary to what a lot of people understand, it’s actually a consumption tax. It’s more progressive than the fair tax is because it builds in a relatively large exemption amount for workers.
It would be easier to enforce and comply with than the fair tax would. A lot of the proposals for a flat tax also have a rate that’s too low to match current revenue. Of course, you could just adjust the rate to take care of that.
So I think it deserves some consideration. Nonetheless, it does still shift the tax burden away from the top and towards middle and lower middle-income groups, although not as much as the fair tax plan would. I think from a political standpoint, that’s still going to make it tough sledding for it to be adopted.
5.) The future of the US tax code probably going to look kind of European.
I would like to see the progressive consumption tax option adopted. I think, though, that the X tax is hard to explain to people and it doesn’t really have a footing in our political debate right now. And so the odds are probably against that, sad to say.
I think that what we are more likely to end up doing is to have a value added tax alongside an income tax. It’s definitely not an ideal outcome. It means that we are keeping an income tax system that has a penalty on saving and investment. It means we have two tax systems available to the government, which would make it easier for it to raise revenue. But it is a better outcome, of course, than just jacking up income tax rates to stratospheric levels. So it leaves me with a mixed feeling, but that is where most other countries have ended up and I think that’s the single most likely outcome for us as well.
But I’m still going to hold out a glimmer of hope that instead of doing that, maybe we will go with the progressive consumption tax after all, which would certainly be a better way to go.
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