Buffett and a Better Tax System-Becker

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.

 

Comments

[Paul Weiser]

A consumption tax is (IMHO) fairer than anything but a poll (head) tax (which implicitely assumes government services have the same value to everyone). Even a pure VAT has only the problem with ease of increasing it, mentioned in the essay.

But once you begin trying to compensate for the "regressive" nature of a pure VAT/consumption tax, as one of the negotiators said during the runup to 2009's massive stimulus and medical enactments, "The store is open." Political decisions will be made and lobbied for what is considered food, drink, shelter, and... what else? Cars? Cable TV? Poor people's liquor vs. rich people's? Surely the VAT could be reduced for plug-in hybrid cars with at least 70% domestic content, defined as...

You see the problem. The other issue is that exemptions based on income immediately become subject to (1) lying about income (see the "earned income" scandal), and (2) information overreach. If income is a factor, the IRS will need to have just as much information as it does now, nullifying major advantages of the VAT in ease of collection. Beyond that, a major advantage of *only* a pure VAT/consumption tax is that the government would have no legitimate need to know anyone's income or its source; this any sort of exemption would destroy.

Bottom line: pure VAT, not bad; impure VAT, worse than we have now because too easily increased.

[alSeen]

Buffett is on record saying that private charities would do better than the government.

‎"I think that on balance the Gates Foundation, my daughter’s foundation, my two sons’ foundations will do a better job with lower administrative costs and better selection of beneficiaries than the government."

http://www.cnbc.com/id/22199472/Warren_Buffett_to_CNBC_Giving_Money_to_Charity_Isn_t_a_Tax_Dodge

[Jimbino]

Becker fails to consider the situation of the poor soul who has worked hard, paying a marginal 60% under current fed & state income tax & FICA on income of some $2M to put $1M in the bank.

Now when he withdraws that money to buy a house or a Ferrari, he is supposed to pay a VAT of $250,000? Serious double taxation!

Anyone who sees a VAT coming needs to spend every cent ASAP.

[Thomas Rekdal]

Jimbino lodges the essential objection for me. A consumption tax does not look very attractive to those of us who have spent a lifetime paying substantial income taxes to fund an after-tax retirement account, and would now face a 25% consumption tax on everything spent out of it. No thanks.

[SID]

Agree with the consumption tax comments. I for one do not want to be doubly taxed after saving my hard earned money. We nee a flat tax without all the special deductions for everyone. No breaks for dividends and capital gains.....plain flat tax and no deductions for kids, houses, etc.

[Cash for Cars Florida]

Thanks for posting! I really enjoyed the report. I’ve already bookmark this article.

[an observer]

Becker is so incredibly dishonest

he writes, "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."

Why does he omit: (1) the richest 1%; (2) CEO's and hedge fund managers; and (3) the Fortune 500, etc.

Never bite the hand that feeds you!!!!!!!

Our tax laws are bad, not because of inefficiency (we are brutally efficient at collecting our most regressive taxes which are employee FICA taxes) but because they are so regressive.

Give me a VAT on all goods, real property, services, insurance, and intangibles

[Jack]

This was great -- the only thing missing was a reference to the FairTax, which is essentially similar and we proposed over 5 years ago by John Linder and Neal Boortz. http://www.fairtax.org

[Laura C]

A VAT invariably punishes the low wage worker. No one can realistically live on minimum wage and not be a burden on society through the need of TANF, Medicaid, and other social services. Deductions and exemptions would have to be necessary in these cases.

[Joseph H. Born]

Those who had saved after-income-tax income could place such savings in special after-tax accounts at the switchover from income tax to VAT. Purchases made (by, say debit card) from such accounts would be exempt from VAT. Although I suppose the exemption could be implemented at the point of sale, it would probably prove most efficient for the government to give a refund based on the account records.

[an observer]

Becker, Posner, and all the other Conservatives have to be happy now, as they have broken the American Spirt

Latest Michigan Survey

More ominously, the once sturdy optimism of Americans appears to have crumbled, according to one key measure. Breaking from precedent, Americans no longer believe they will make more money next year than this year, according to the University of Michigan’s Surveys of Consumers. These expectations used to rebound after recessions; this time they didn’t.

[legalelliot]

A discussion of a VAT only system without the discussing the economic implications of black market transactions or government spending as a share of GDP is dishonest. There is a reason that no industrialized economy uses a VAT only system. Posner was honest enough to state the reality that tax revenues need to be increased. Every argument for the VAT/Fair tax is usually premised on the notion of fairness/simplicity, but it is always a ruse when proponents really mean reduced taxes. Why is it the same the same group of people complaining about paying too much in taxes are the ones behind these alternative tax schemes? Are they really suggesting that they are in favor of paying more taxes, so long as it is more simple to do so?

"Every tax, however, is to the person who pays it a badge, not of slavery but of liberty. It denotes that he is a subject to government, indeed, but that, as he has some property, he cannot himself be the property of a master." - Adam Smith

[Jack]

Observer VAT? Please! Did deeper! And a VAT on R/E? Think a bit! We have to raise something on the order of 20 - 25% of GDP so the VAT would have to total at least that amount (to offset what is not VATTED) sooooooo you buy what's now a $250,000 house for $300,000 paying now NON-deductible interest on the thing. Then? a year later the Boss tell you to go out and head up the Denver office and you pay again.

But surely $50k is something worthy of avoidance efforts.......... sooo, "we" lease? rent? rent to own IF we stay for ten years?

And WHY would WE want to go to such a regressive system when THE problem of our time is that of FAR too much wealth and income being constipated at the topmost tiers? "Flat-tax Forbes" pals and heirs would be laughing their way all around the finest watering holes Europe and Asia have to offer with their now -- untaxed INCOME.

[Jack]

Jack -- I'll mention the "Fair Tax" only to point out that in this era of Brave New World "newspeak" that when some twit comes up spouting something like "The Clean Skies Initiative" or the "Fair Tax" DO look under the hood. If you don't find the screwing of the average working guy there, get a mechanic's creeper and look all around under the chassis; you can count on the screwing being there somewhere, as it is in the "Fair tax".

These days........ you could save on getting your clothes dirty looking around by just rejecting any tax scheme put forth by today's brand of ALL FOR THE RICH "conservatives" whose tasks are apparently that of protecting their sponsors from even the moderate tax rates of the Clinton era boom that paid all the bills and began to generate a surplus.

[frauen]

I agree 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. There are more reasonable ways of tax revenues.

[Thomas Rekdal]

Mr. Born: Your idea of a special after-tax savings account that could be exempt from the VAT is appealing (to me at least), but the need to keep meticulous records of expenditures from it might prove more complicated than the current income tax requirements. Also, it would seem likely to create more opportunities for fraud. But if some arrangement of this sort could be made workable, it would eliminate my objection to a consumption-based tax system. Becker makes many good arguments in its favor.

[Jack]

Recovery only for those too big to fail
ELISE PATKOTAK

From our Anchorage Daily News today:

COMMENT
Published: August 30th, 2011 09:01 PM

Mitt Romney heard we were having a jobless economic recovery and decided to help by tearing down his old beach house in San Diego and putting up a new one to the tune of about $12 million. Thank goodness we didn't let his Bush tax break lapse or some of that money might have gone to feed some hungry school kid whose parents were probably wasting their money on heat or rent or some such silliness. Then where would poor Mitt have been? He'd probably only be able to build an $11,995,000 second home and all his friends would have laughed at his pathetic little beach house. So Mitt did the right thing and put Americans back to work -- at least, we hope they're Americans.

Meanwhile, for those of you flummoxed by the economy's jobless recovery, I think I have finally figured it out. Let me see if I can give you a simple explanation of why we are in this national economic fiasco.

Let's start with those taxes you pay. Some go toward programs like Social Security with a promise from the government that they'll save your money for you and it will be there when you retire. Good luck with that. Some of your tax dollars go to fund critical functions of government such as unfunded wars of choice in countries that posed no threat to us. And some goes toward bailing out financial institutions that created toxic assets that were destroying them. So as we teetered on the brink of national financial ruin, the government squeezed the last drops it could from your taxes and gave it to the financial institutions that created the depr ... oops, I mean recession.

Yes, Virginia, the government took the money you so willingly gave for what you thought was the maintenance and repair of roads and the continued fiscal viability of your retirement program and gave it to those financial institutions that were deemed too big to fail. The result of that transfer of wealth was that those financial institutions did not fail. Most have paid the government back and are now sitting on great piles of money that they are loath to invest in the toxic economy they created. You can understand their hesitation. After all, you fell for their line in the first place. Why should they trust you with money again?

Because they are sitting on so much cash, we are being told over and over again that the economy is in recovery. Except this recovery is being called a jobless recovery because the only groups that seem to have recovered are those financial institutions the feds bailed out and their major shareholders don't really need jobs. Since they were too big to fail and you aren't, the feds will not be knocking on your door in the near or distant future to offer to bail you out of the financial disaster you are experiencing -- a disaster created when those bailed- out companies decided to let you borrow way more than you could pay back for a house not worth what you were paying for it.

Are you still with me or do you need a moment to sit and put your head between your legs until the dizziness stops? Take a deep breath because we haven't finished the journey yet.

So what we have in America today is a recovery of the richest at the expense of the poorest, while what's left of the once-great American middle class is rapidly shrinking. Because the vast majority of Americans who still have jobs have some understandable qualms about going into debt not knowing if those jobs will be there next week, they aren't spending or borrowing a lot. Meanwhile those businesses that were too big to fail have figured out that if they just make their remaining employees multitask and do three or four jobs at once, they can keep their payroll low and not risk expanding in a bad economy. If that keeps this recovery a jobless one, oh well, at least their assets are safe and we won't have to bail them out again in the near future.

The good news is that if you move to San Diego, I think there might be some job openings in construction there in the very near future.

........... does she have it about right?

[NEH]

Just one observation. When taxes are viewed from the individual perspective, no tax is good. This applies too not only, personal income taxes, value added taxes, sales taxes, special taxes and fees, tariffs, customs, duties, etc.. Yet, the benefits of Civilization and Society must still be payed for which require taxes of one sort or another. Perhaps, these benefits are those things which taxes purchase. All to our benefit.

As Ben Franklin quipped many years ago, "There are only two sure things in life - Death and Taxes". To think we can do without is utter nonsense. And as we are all aware, things cost, more so every decade and century...

[David Welker]

I like the idea of replacing the income tax with a VAT. I would simply point out one thing. I think keeping track of everyone's income, as we do now, is possibly too expensive. We would have to keep much of the infrastructure we have now for keeping track of income, which is certainly an expense.

If we are going to do transfers, why not provide them to everyone? This is the minimum income approach advocated by Milton Friedman, and it strikes me as more sensible. Under Becker's system, there is a disincentive to earn more income to the extent that transfers are phased out with increases in income. Perhaps just as significantly, Becker's system is likely to increase the size of the prison population, as some people are tempted to misreport their income in order to receive such subsidies. Why not help limit such opportunities and temptations to engage in fraud in the first place?

It should be pointed out that to the extent that you think that the VAT is more susceptible to being increased, this probably mostly reflects the rational actions of sophisticated private economic actors. If taxes impose less cost on such private actors, they will rationally decide to not devote as much energy to keeping them lower. On what basis do Mulligan or Becker second-guess such decisions by private actors to allocate their energies? Is it actually BETTER if private actors allocate more energy to lobbying for lower taxes instead of innovating? If GE hires more engineers and fewer tax lawyers and tax lobbyists, is this really a bad thing??? I find the idea that we should especially want private actors to allocate their energies to fighting inefficient taxes to be puzzling at best. Then we have to suffer from both the inefficiency of the tax and the inefficiency of the lobbying and search for loopholes. Sounds like a complete deadweight loss to society, if you ask me.

[Guy]

You mentioned that small government advocates are "concerned that opposition to raising the tax rate of a flat VAT tax would be weak precisely because the tax is efficient".

I assume this argument that a VAT rise would have less opposition is relative to raising other taxes, rather than absolutely? Because raising any tax, especially in America, doesn't appear to be the easiest thing to do, ever!

Additionally, given that in America the tax tends to be added at the register, rather than included in the price like most other countries in the West, you are reminded of the tax increase every time you shop, rather than once a month in your pay cheque in the case of an income tax rise.

Finally, it's worth noting that in Australia, there appears to be more opposition to increasing the VAT (GST) than income tax. It has remained at it's original rate of 10% for more than 10 years.

[Rusztowania]

I think this article is very interesting, America tax is normall in Polish tax is very big

[Economic Freedom]

The Value-Added Tax, or VAT, is a horrible idea. I'm surprised Becker favors it. Here's an interesting article on the VAT by Murray Rothbard, which originally appeared in The Freeman during the Nixon administration (1972), which was considering a limited form of the VAT:

http://mises.org/daily/4 2 9 6

"The VAT is essentially a national sales tax, levied in proportion to the goods and services produced and sold. But its delightful concealment comes from the fact that the VAT is levied at each step of the way in the production process: on farmer, manufacturer, jobber and wholesaler, and only slightly on the retailer.

The difference is that when a consumer pays a 7 percent sales tax on every purchase, his indignation rises and he points the finger of resentment at the politicians in charge of government; but if the 7 percent tax is hidden and paid by every firm rather than just at retail, the inevitably higher prices will be charged, not to the government where it belongs, but to grasping businessmen and avaricious trade unions.

While consumers, businessmen, and unions all blame each other for inflation like Kilkenny cats, Papa government is able to preserve its lofty moral purity, and to join in denouncing all of these groups for "causing inflation."

It is now easy to see the enthusiasm of the federal government and its economic advisers for the new scheme for a VAT. It allows the government to extract many more funds from the public — to bring about higher prices, lower production, and lower incomes — and yet totally escape the blame, which can easily be loaded on business, unions, or the consumer as the particular administration sees fit."

Some points made by Rothbard in this article:

1. Like the sales tax, the VAT is regressive, falling mainly on the poor and the middle-class. To alleviate this burden, no doubt some form of "rebate" -- to the poor, to be paid mainly by the middle-class -- would be instituted. Thus, the VAT would probably require (i.e., politically) yet more income redistribution, and possibly be one step closer to a policy of guaranteed minimum income.

2. Proponents of the VAT argue that it taxes producers in proportion to the value they add to the product at each step along the production process. In theory, if Corporation A adds $1,000 value to a widget, and Corporation B adds $1,000 to that widget in a subsequent step in producing it, and if the VAT, for example, were 10%, Corporation A would pay $100 to Uncle Sam and Corporation B would also pay $100 to Uncle Sam. But this ignores the fact that each has to absorb administration costs for tracking and collection involved in the VAT, leading to incentives for vertical mergers. The effect of a VAT would be to disincentivize small businesses and startups, and to incentivize vertical mergers into large conglomerates --- all of which would become yet more fodder for antitrust suits.

3. At the time of writing (1972) Rothboard points out a problem with the VAT in Europe: "In the VAT, every firm sends its invoices to the federal government, and gets credit for the VAT embodied in its invoices for the goods bought from other firms. The result is an irresistible opening for cheating, and in Western Europe there are special firms whose business is to write out fake invoices which can reduce the tax liabilities of their "customer." Those businesses more willing to cheat will then be favored in the competitive struggle of the market."

4. While higher costs of production will undoubtedly be passed on to consumers who will then pay higher prices, there are 2 additional effects of a VAT mentioned in the article: (i) a large, short-run reduction in business profits; (ii) a long-run fall in wage incomes. Re profits: The reduction in business profits will take place during a time of recession when profits are already reduced, or when many businesses actually incur losses; these businesses will be severely affected by a VAT. Also, innovative startups, which usually have low profits, will be severely affected, too. Re wages: unemployment is already high during a recession. Firms can deduct the VAT from their own tax liability, but they cannot do so if they hire more workers; thus, there will be an incentive for "over-mechanization" and a firing of workers. The long-run effect of this will be to lower the demand for wage-incomes, and since union practices and minimum-wage laws would no doubt still apply, there would be higher unemployment.

In sum, with a VAT we could probably expect to see: (i) higher consumer prices, (ii) lower demand for wage-incomes therefore a lower wage rate in general, (iii) short-run reduction in business profits, (iv) tendency for more firms to vertically integrate therefore less competition especially from small, innovative firms (that might be one reason big firms are often in favor of a VAT), (v) the move to vertical integration would spur yet more pointless antitrust suits, (vi) incentives to over-mechanize and fire more workers hence higher unemployment.

Rothbard quotes one of Parkson's Laws of bureaucracy: "for government, expenditure rises to meet income." If classical liberals, libertarians, and fiscal conservatives wish to shrink the size and scope of government, implementing a VAT is the exact opposite of what they should do.

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