There is a good deal of dissatisfaction with the federal tax system (the state and local systems as well, but I’ll confine my attention to the federal). Most proposals for reform, however good in theory, are totally impractical from a political standpoint. But since politics is volatile, there is value to evaluating such proposals in order to lay a foundation for future reform.
A tax can be evaluated along four dimensions: cost of collection, allocative effect, revenue effect, and distributive effect. Let me by way of illustration evaluate the Obama Administration’s proposal to raise the marginal income tax on couples with taxable income of at least $250,000 a year from 35 to almost 40 percent and to increase the tax on capital gains and dividends from 15 to 23 percent (the 23 percent including a new tax imposed by the Affordable Health Care Act). But I will confine my consideration to the increase in non-capital-gains and non-dividend income.
The cost of collection is likely to increase slightly because a tax increase increases the return to tax avoidance. The increase could also cause a substitution of leisure (which is not taxed) for work; that would be the allocative effect. I am skeptical that an increase even of 14 percent (5/35) would have a significant such effect, given a possible offsetting income effect (taxpayers working harder to maintain their standard of living). Income tax rates have varied greatly over the history of the United States without seeming to affect economic growth, though so much else is happening at the same time that isolating the effect of a tax increase or reduction is very difficult, maybe impossible, to do. The higher tax would increase federal tax revenues and reduce after-tax income inequality (the distributive effect). Given growing income inequality, which seems to be having bad effects particularly on children, and the large federal deficit, the proposed increase in income tax may be a good idea, especially given the political infeasibility of the alternatives.
One of those alternatives would be a federal value-added tax, which is essentially a sales tax but a sales tax imposed at every level of distribution rather than just at the retail level. Such a tax generates large revenues at a low cost of collection, and operates as a tax on consumption and therefore encourages investment. It also increases income inequality, but its revenue potential is such that federal expenditures on wealth redistribution and social welfare benefits could be significantly increased. However, such a tax is politically infeasible, in part because of conservative concern that it would enable a significant increase in the size of the federal government.
The corporate income tax is criticized as penalizing investment, because it taxes the income generated by corporate investment twice—first at the corporate level and second when corporate earnings are distributed to the corporation’s shareholders in the form of capital gains or dividends. And penalizing investment reduces economic growth, which depends on investment. But the corporate income tax is so riddled with exceptions and opportunities for avoidance that it accounts for only 8 percent of total federal tax revenues. If the tax were abolished, some other federal tax would have to be increased.
Or would it—the alternative would be to broaden the tax base, so that the same or even a lower tax rate generates the same or even greater tax revenues. Broadening the tax base mainly means eliminating or reducing deductions. The most popular target is the home-mortgage interest deduction. It is an absurd deduction, based on the silly premise that owning a home generates positive externalities: improved maintenance of residential property and enhanced sense of commitment to the community. All residential ownership does is reduce job mobility by increasing relocation costs and delay. But it’s a sacred cow.
The charitable deduction is questionable as well; charitable deductions reduce the demand for certain government services, but involve a great deal of duplication and administrative expense, and would probably decline only modestly if the deduction were removed. But again it’s a sacred cow, though in the case of both the morrgage-interest and charitable deductions a reduction in the size of the deduction permitted may be feasible.
Regulatory (“Pigouvian”) taxes should not be ignored. They are intended to alter behavior rather than to generate revenue, but invariably they generate some, and often a great deal, of revenue. We desperately need a heavy tax on carbon emissions, which pose a great long-term threat to the economy; and undoubtedly such a tax would generate substantial revenues. As would an increase in federal gasoline tax, which would reduce both carbon emissions and traffic congestion.
Given political resistance, the practical feasibility of substantial tax reform is very limited. But at least a modest increase in federal income tax rates seems a politically feasible as well as economically defensible response to the need to increase federal revenue to cope with the fiscal deficit.