A new understanding of tax.

• Author: McCaffery, Edward J.

TABLE OF CONTENTS I. INTRODUCTION A. Loomings B. The Road Ahead II. IN THEORY: THREE FORMS OF TAX A. An Example B. The Income Tax C. Two Forms of Consumption Tax D. Two Conditions of Equivalence 1. Constant Tax Rates 2. Constant Rates of Return E. The Treatment of Debt III. A PROBLEM OF UNDERSTANDING A. Means and Ends B. The Traditional Logic of Tax C. The Modern Income-Versus-Consumption Debate 1. The Case for Consumption 2. The Income Empire Strikes Back 3. Why It Matters D. Two Political Takes E. Three Neutralities 1. Why Even Care About Neutrality? 2. Three Taxes, Three Neutralities IV. A NEW UNDERSTANDING OF TAX A. Two Norms 1. A Note on Reflective Equilibrium 2. The Norms of Capital B. Two Uses of Capital 1. An Untypical Picture of a Typical Life 2. Smoothing Transactions 3. Shifting or Enhancing (Diminishing) Transactions C. Progressivity D. Debt, Again E. Vickrey's Cumulative Lifetime Averaging, Compared V. IN PRACTICE: THE MESS WE'VE MADE, PART ONE--THE INCOME TAX A. Structural Gaps 1. Tax Planning 101 2. An Example 3. The Practical Facts of the Matter B. Ad Hoc Deviations 1. Retirement Savings 2. More and More C. Tax Shelters and the Noble Failure of TRA 86 1. Some Quick and Dirty Examples 2. What TRA 1986 Did, and Did Not, Do VI. THE MESS WE'VE MADE, PART TWO: BEYOND THE INCOME TAX A. Payroll Taxes B. Death--to the Rescue? C. Corporate Taxes Too D. State and Local Taxes E. Summing Up: A Voluntary Tax VII. THE FAIR TIMING OF TAX A. A Better, If Less Sophisticated, Argument B. Transitions, Implementation, and Objections 1. Implementation 2. The Role of Other Taxes 3. The New Achilles Heel 4. Capital as Power 5. Transitions C. Common Errors About Income and Consumption Taxes 1. We Have an Income Tax 2. The Principal Choice in Comprehensive Tax Policy Is Between an Income and a Consumption Tax 3. Consumption Taxes Are Flat Taxes 4. All Consumption Taxes Are Created Equal 5. Consumption Taxes Do Not Reach the Yield to Capital 6. The Best Argument for a Consumption Tax Is One of Horizontal Equity 7. The Case for Consumption Taxation Is One About the Importance of Capital, on the Individual or Aggregate Level 8. Rates Would Have to Increase Under a Transition to a Consumption Tax 9. The Gift and Estate and Corporate Income Taxes Are Important Backstops to the Individual Income Tax 10. Adopting a Consumption Tax Would Be a Radical Change D. Tax Matters To tax the sum invested, and afterwards to tax also the proceeds of the investment, is to tax the same portion of the contributor's means twice over. The principal and the interest cannot both together form part of his resources; they are the same portion twice counted; if he has the interest, it is because he abstains from using the principal; if he spends the principal, he does not receive the interest. Yet, because he can do either of the two, he is taxed as if he could do both, and could have the benefit of the saving and that of the spending, concurrently with one another. (1)

1. INTRODUCTION

   1. Loomings

      Perhaps we should blame it all on Mill. A great deal and possibly all of the mind-numbing complexity of America's largest and least popular tax follows from the decision to have a progressive personal income tax. (2) Proponents wanted an individual income tax notwithstanding--indeed, in large part because of--such a tax's "double taxation" of savings. This double-tax argument is an analytic point generally attributed to Mill's classic 1848 treatise, Principles of Political Economy. (3) Historically, much of the support for the Sixteenth Amendment, ratified in 1913, came from Southern and Midwestern, progressive, agricultural interests, who wanted, in general, to implement a redistributive tax and, in particular, to collect some tax from East Coast financiers. (4) After all, the Supreme Court had ruled that the income tax of the late nineteenth century was unconstitutional only insofar as it fell on the fruits of capital; no constitutional amendment would have been necessary to retain or implement a national wage or sales tax. (5) The legal raison d'etre of the income tax was to get at such returns to savings as dividends and interest.

      To this day, liberals and moderates insist on retaining the structure of an income tax precisely because it gets at the returns to saving in addition to labor earnings. (6) Consumption taxes of all sorts are set in contrast to the income tax, on another side of a great divide, as taxes that fail to get at the yield to capital--that deliberately avoid Mill's "second" tax. (7) Prominent commentators on the case for consumption taxation--both those in favor and those opposed--continue to cite, as the "best" or "most sophisticated" argument for adopting a consumption-based tax, the analytic facts that consumption taxes do not overly burden capital or its yield, and as such do not distort the savings-consumption decision, or, equivalently, do not favor present over deferred consumption. (8) The literature for and against consumption taxation is strewn with stock "horizontal equity" models, comparing savers and spenders, Ants and Grasshoppers: the idea is that income taxes punish savers, like the mythical Ant, vis-a-vis spenders like her friend Grasshopper. (9) On the other side of the great divide, supporters of redistributive taxation argue that retaining an income tax base is a central task of maintaining or obtaining fairness in tax in large part because it, alone, gets at the return to capital, the nearly exclusive province of the economically fortunate. (10)

      The idea that income taxes and only income taxes effectively get at the yield to capital, and, as explained further below, that consumption taxes of either of two broad types, prepaid and postpaid, do not, constitutes the traditional view of tax. (11) The traditional view has extended well beyond the academy to influence the popular understanding of tax and its possibilities, as well as practical political decisionmaking. This traditional view has generated an impoverished choice set for tax, consisting of a badly flawed status quo on the one hand and a flat consumption tax of some sort on the other. Under the guiding light of the traditional view, we are heading ever closer towards a flat wage tax.

      The traditional view is wrong.

      This Article sets out a new understanding of tax. The key insight is that the canonical understanding of consumption taxes changes under consistently progressive tax rates. (12) No longer are prepaid and postpaid consumption taxes--taxes on wages and spending, respectively--equivalent. Postpaid consumption taxes can and do burden the yield to capital, and not in an arbitrary, random way. Far from it: A progressive postpaid consumption tax emerges as the fairest and least arbitrary of all comprehensive tax systems, precisely because it chooses to make its decisions about the appropriate level of progressivity at the right time. In doing so, it burdens some but not all uses of capital and its yield, and for normatively attractive reasons. These points follow from a simple statement of the analytics of tax.

      This then raises an obvious question from the start: Why has the traditional view persisted for so long, virtually unchallenged? It is true enough that an ideal income tax including all sources of income--both labor earnings, or the yield to human capital, and savings, or the yield to financial capital--is a "double tax" on savings that burdens savers relative to spenders. This is accurate both within the income tax's own framework, in which savers are treated more harshly than spenders, and also compared to a hypothetical no-tax world, with the income tax destroying the pretax financial equivalence between present and deferred consumption. (13) It is also analytically correct that a prepaid, yield-exempt, or (all equivalently) wage tax categorically exempts the yield to savings, preserving the relation whereby savers and spenders under normal circumstances have equal material resources in present value terms. But under progressive tax rates, a postpaid, cash-flow, or (all equivalently) spending tax is not equivalent to a yield-exempt or wage tax; that is, it is not equivalent to an "income" tax with a zero rate of taxation on savings, which is itself a semantic paradox. (14) This is a point that the traditional tax-policy literature has sometimes stated, but only in a passing manner. (15)

      On the occasions when scholars have paused to reflect over the idea that varying progressive rates destroy the equivalence of prepaid and postpaid consumption taxes, they have taken one of two subsequent turns.

      Some scholars simply note that the interaction of progressive rates and a postpaid consumption tax is more or less random. They state that taxes will go up, and hence there will be a "penalty" for savers if consumption occurs in a higher rate bracket than initial earnings; taxes will go down, and hence there will be a "subsidy" for savers if consumption occurs at a lower level than initial earnings. (16) This language of subsidy and penalty is not helpful: It tends to confuse matters, perhaps because of an innate or intuitive aversion to nonneutral sounding rules, a belief that neutrality per se is an end. (17) More deeply, this first move does not take the analytical understanding of tax far enough. When savings or the yield to capital will decrease or increase a taxpayer's burden of taxation under a consistent, progressive postpaid consumption tax is not random. The burden of taxation will decrease when a taxpayer uses capital transactions (borrowing, saving, investing) to smooth out the pattern of her lifetime labor earnings, and thereby to consume, in any given year, at the level of her average annual lifetime labor earnings in constant dollar terms. The burden will also decrease when capital transactions result in diminished consumption, again measured against the average annual labor earnings as the baseline. The burden of taxation...