In my blog post last week on inequality I expressed sympathy with Warren Buffett’s concern that the share of the income paid in taxes by the very wealthy is considerably smaller than the shares paid by many middle class Americans. But I am troubled by what he proposes to do about it.
He suggests that the 12 member congressional panel set up to cut current and future federal deficits leave tax rates unchanged for 99.7 percent of taxpayers, and only raise rates on the approximately 250,000 households who make more than $1 million. Simple calculations show that a tax increase on such a small number of households, even a very large tax increase, would have a negligible effect on total tax revenue, and hence on closing the budget deficit. As we will see, there are more sensible ways to improve tax revenue.
Warren Buffett has persuaded 68 other billionaires to follow his example and promise to give at least half their wealth to charities. But why hasn’t Buffett proposed also that the very rich make large gifts to the federal government to offset what he considers ridiculously low taxes on their incomes and wealth? My guess is that he and the others who pledged to give away their wealth to charity would have little confidence in how the government would spend such gifts. Buffett, for example, is giving most of his wealth to the Gates Foundation, not to the federal government, and is relying on how this foundation will spend his vast gift. Given this reluctance to make large gifts to the federal government, why should anyone have confidence that the federal government will spend additional tax revenue in a sensible way?
Still, I agree with Buffett that the American income tax system makes no sense from an equity viewpoint, nor does it make sense from its effects on the efficiency of the American economy. Of course, it makes great sense from a political economy perspective since special treatments of all sources of income- whether it be capital gains, gifts to charities, or deductibility of interest on home mortgages- are in the tax code not by accident, but are there due to the political power of builders and home owners,ethanol producers, universities and other non-profit organizations, and other special interest groups. However, perhaps with the present concern by voters over present and future deficits, it may be possible to get serious tax reform by overcoming the political power of important interest groups.
From a efficiency perspective, the ideal tax system would replace all income taxes with a flat percentage tax on total consumption of each household, as in a flat inclusive value added tax (VAT). A tax on consumption instead of income has the advantage that it would avoid the double taxation of saving. The present income tax structure first taxes incomes, and then another tax is imposed on the income earned from any of the original income that is saved (although some savings, like in IRAs, may avoid any taxation until they are spent after retirement). A tax on consumption also avoids the double taxation of corporate income. Under the present system corporate income is taxed, and then taxed again when dividends are paid or capital gains realized. A consumption tax also eliminates the complicated calculations about depreciation on capital that are necessary to arrive at the taxable net incomes of businesses.
Of course, the consumption tax rate would have to be pretty high if it were to replace all income taxes. I would guess that a VAT on all consumption of no more than 25% would be adequate to raise the revenue needed to balance the budget, even without the desirable reductions in federal spending. Since the economy would become more efficient with such a tax, real income would expand, perhaps by a lot, which would lower the burden of a consumption tax.
Two objections are commonly raised to replacing all income taxes with a flat consumption tax. One is that it is unfair for the poor to pay the same tax percent on their small amounts consumed as the rich pay on their greater consumption. One way to introduce progressivity into a consumption tax is to impose a lower tax rate on goods more heavily consumed by low-income households, such as bread, cheap apartments, over the counter drugs, and the like. A less arbitrary way is for the government to give monetary transfers to poor households. Households that qualify for such transfers would report their incomes and savings, with consumption measured by the difference between incomes and savings. It is easier for most families to know what their income and savings are than to keep track of their consumption.
Many small government advocates agree that a flat VAT type tax is efficient, and that is what bothers them. For they are concerned that opposition to raising the tax rate of a flat VAT tax would be weak precisely because the tax is efficient. The more efficient a tax, the smaller the cost to taxpayers from higher rates, and so the more willing they are to accept higher taxes. Casey Mulligan and I develop the theory behind these concerns, and also provide evidence that efficient taxes, such as the VAT, may start low but rise over time (see our paper, “Deadweight Costs and the Size of Government” in the Journal of Law & Economics, 2003). Although some other studies have not found such strong empirical effects of efficient taxes, the argument about the greater incentive to raise tax rates from efficient taxes makes a great deal of common sense as well.
Still, no tax system is ever going to be perfect. Taking everything into account, reliance on a flat tax on aggregate consumption rather than income taxes with different tax rates and various exemptions seems to be a worthy goal to strive for. I say “strive for” since the interest groups that have favorable treatment from the tax code will not meekly go away, but will have to be fought constantly to have real hope of meaningful tax reform.