Tax Reform—Posner

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.

Comments

[Thomas Rekdal]

In the fantasy spirit of nominating federal tax deductions that ought to go, I suggest we get rid of any deductions for state and local taxes. Why should the taxpayers of one state subsidize the profligate governments of any others?

[Gordon Longhouse]

I have long been a fan of Becner but this post is pretty lame.

To begin with Becker's notion of expensing capital. Most capital expenditure has been financed which makes sense: match the benefits to the cost. Becker suggests allowing as an expense now an expenditure that will produce income for a period of years and was probably acquired in part with borrowed money over a period of years. Why? Surely it would be enough to get rid of accelerated depreciation. Even Italians in the renaissance saw the need to depreciate long life assets over time.

They both wistfully suggest a VAT might be worthwhile while ignoring the history of the VAT everywhere else. Lots of poor countries have brought in VAT as a price of joining the European Union but that hardly seems likely to happen to the US.
Canada brought in a VAT but got rid of a stupid tax: the Manufacturer's Sales Tax instead. Likewise Australia which used its VAT to get rid of a raft of stupid state transaction based taxes. What do Becner propose?
Use VAT to lower taxes on capital. That is to say that the poor who have no savings to speak of will pay the taxes of the rich who do.
When a poor person borrows to buy something, a car or house, the purchase will be subject to VAT.
The interest the poor pay to the well to do will not be subject to tax as this is distortionary to capital expenditure and some how makes the poor poorer.
Then there is the cascading effect of a VAT in a federal system that features sales taxes. Canada after more than 10 years is only just getting to grips with this. Becner don't discuss it at all.
All in all a disappointing post.

[Neilehat]

"Death and Taxes", both undesirable, but a fact of Life none the less. No matter how we slice and dice the Debits and Credits the fundamental fact still remains - the Government must still meet it's financial obligations. Along with every one else. Change and simplification? Hopefully, but I have my doubts.

[Terry Bennett]

At the risk of spontaneous combustion, may I raise the idea in this lair of the consequentialist that perhaps tax policy should be constrained not only by outcome but also by morality? (They are not the same thing, really.) I believe all men are created equal, and progressive and targeted tax schemes are an affront to that principle.

The manifest purpose of tax is to fund the government. If we did not need to fund the government, we would not need tax, and there would still be some extremely rich people and some extremely poor people and a multitude in between, but we would all be free people - free to carry on our affairs and apply our productivity as we saw fit, without having to surrender a share of, or even account for, our individual output. The equalizing effect of tax is a false ideal.

We all need government, and we should all pay for it. Furthermore, if everybody paid for it, everybody would be a budget hawk, and the government would be a lot smaller. Therefore, I am a serious fan of a consumption tax such as the Fair Tax, because it falls on all alike - even tourists.

Going even further, perhaps the most egalitarian tax is a per capita tax, because it does not depend on behavior. It is a tax on membership in society. You want the government to spend $3 billion this year? Divide it by 300 million, and let's each pay $10k, and then it's nobody's business what anybody else does for a living or how much they make. (Obamacare is actually the first such "tax", per the SCOTUS, because it is assessed on people who simply exist, not because of any conduct they have undertaken.) The bonus will be that lots of people will protest if they have to pay $10k, and they will demand that the government spend less.

Here's another approach. Let's exempt the lowest 20% of earners from tax, but put the onus on them to justify their exemption. The other 80% will pay 1.25 shares each, and anyone who pays will not be subject to any kind of audit or review. Maybe the 20% who don't pay shouldn't get to vote on how the money is spent. It should then become a point of personal honor to become sufficiently productive to be a paying member of society.

[RossAnderson]

I posted a very slightly critical comment on Becker's post yesterday. Now it's gone. Maybe Judge Posner should tell him to put it back, as a matter of credibility.

[starsky]

Terry, while I appreciate the sentiment regarding equality, I disagree with your conclusions. Men may be created equal in the eyes of God, but certainly not in terms of wealth or opportunity. Only those with excess wealth can take advantage of investment opportunities. Look at evidence from the Great Depression or the Great Recession -- those with limited means were forced to sell their assets at discounted prices, while those with excess wealth were able to acquire those assets at discounted prices. Furthermore, those with greater wealth have better access to education and contacts, giving them an even greater advantage. The rich get richer and the poor get poorer until, like every game of Monopoly, all the money becomes concentrated among fewer and fewer people until there is one winner and many losers. In short, any completely free, capitalist economy provides those with existing wealth an inherent advantage, which is precisely why taxation must be progressive.