A user's guide to proposals to replace the U.S. tax system and strangle fiscal policy.

Author:Buchanan, Neil H.

Taxes evoke strong and contradictory emotions. The desire to keep as much money as possible conflicts with the sense that we should contribute to the good of society. Respect for privacy collides with the need to ensure that others are paying their fair share. Dislike of complexity clashes with the desire to be responsive to unique situations. Given this fundamental ambivalence, it is not surprising that the tax system is a constant target of revision.

As the 1998 midterm elections fade into memory and the presidential election looms in 2000, tax "reform" will again be the order of the day. Anti-tax rhetoric such as "confiscatory tax rates," "punishing success," and "a penalty on the creation of wealth," as well as the all-purpose reactionary insult "social engineering," will fill the airwaves.

While many tax proposals are offered piecemeal, such as reducing or eliminating specific types of levies, the recent trend in the United States (at least among presidential aspirants) has been to think big and to propose The Perfect Tax System. There are no new proposals, of course. Instead, rewrapped packages arrive containing the same old proposals to shift taxation away from corporations and wealthy individuals and toward everyone else.(1) As an expression of the belief that these new systems really are perfect, many proposals are also spiked with constitutional provisions to make future changes in the tax system more difficult.

As a matter of political marketing, promoters stress each proposal's greater simplicity relative to the current system.(2) Most are also claimed to increase the rate of national saving. Both of these effects (simplicity and saving-friendliness) will supposedly lead to greater investment, higher levels of long-term economic growth, higher standards of living, and greater international competitiveness. These claims are, of course, specious. On this, readers of this journal might refer to Buchanan [1999].

This paper provides descriptions of the four prototypes for extreme tax restructuring that have become popular in U.S. policy circles: direct consumption taxes, saving-exempt taxes, labor-income taxes, and simplified income taxes.(3) While some reference to specific proposals offered in Congress over the last several years will be useful, the analysis will generally emphasize concepts over administrative details.

In addition to rebuilding the federal tax system, many proposals would cement the new arrangements with special constitutional and legislative provisions. These proposals - and their interactions with other aspects of the tax code - are the focus of the second section of the paper.

Moving from description to critique, the third section dissects three familiar arguments that underlie all but one of the four proposals. We are told that we are over-taxing capital, that we should eliminate "double-taxation," and that the tax system should be designed so that it does not "distort" the economy. These arguments are, at best, half-truths; and they are more likely dishonest rationalizations for a massive upward redistribution of income. They certainly do not add up even to a minimal case for fundamental tax restructuring.

Outlines of the Major Approaches to Tax Restructuring

As noted above, current discussions of sweeping tax restructuring in the United States generally revolve around four prototypes: direct consumption taxes, saving-exempt taxes, labor-income taxes, and simplified income taxes. The differences among the first three are largely cosmetic but are politically important. Each of the three is designed to encourage saving by taxing consumption exclusively. All four systems will be described in turn below.

Taxes on Consumption

Value-Added Taxes (VATs), common in Europe and elsewhere, are business taxes that are levied at each stage of the production process. Each participant in every production process pays a certain percentage of the difference between the cost of their inputs and the revenue from their outputs.

In a pure VAT, the tax would be levied on all products, including investment goods. In that sense, the VAT is not inherently a tax on consumption. Therefore, since most proponents of the VAT intend it to work as a tax on consumption, they must make sure that the tax is not levied on the items that they wish to favor. The only way to make the VAT "investment friendly" is to create an exemptions list, which itemizes those goods not subject to tax or that will be subject to preferential tax rates. In practice in Europe, this has resulted in a bewilderingly complex system. Unlike sales taxes, VATs are not added to the sales price at the cash register, but are already included in the price, so a consumer does not know whether an item is tax-preferred or not. The VAT hides these political choices from the voters.

A practical problem with the concept of the value-added tax is that the term is too broad to be useful. Virtually any tax system can be called a "modified" VAT. For example, the flat tax (discussed below) has been described as "precisely a value-added tax, plus a rebate of taxes to families based on their labor income and family size" [Slemrod 1995]. Most people think of a VAT as being equivalent to a national sales tax, when in fact a national sales tax is merely one type of VAT.

Other than the income tax, perhaps the most familiar tax to most Americans is the sales tax. Repealing the entire tax code and replacing it with a national sales tax has become a potential goal of several prominent politicians, the most politically powerful of whom is House Ways and Means Committee Chairman Bill Archer (R-Texas).

Of course, the basic issue in tax policy does not disappear with a national sales tax. The difficult political decisions (and the complexity) will come when the tax base is defined. Should educational expenses be taxed as consumption or exempted as investment in human capital? What about preventive personal health care? These decisions would be the grist of tax debates for future elections, just as discussions of personal exemptions and exclusions dominate policy debates today.

Saving-Exempt Taxes

VATs and sales taxes are designed to tax consumption, specifically so that they will encourage saving - which is wrongly assumed to be the same as encouraging investment. It is also possible to promote saving much more explicitly by simply telling people that they will pay no taxes on income that they put into savings vehicles. In this category, it is useful to discuss the details of a specific proposal, the "USA Tax," because it is one of the only proposals that has been offered as a complete piece of legislation. While it certainly will never be adopted in its original form, it provides many useful concepts and details that can frame the discussion.

Originally proposed by former Senator Sam Nunn (D-Ga.) and Senator Pete Domenici (R-N.M.), the USA Tax (Universal Saving Allowance Tax) is essentially a "universal IRA" plan. It allows people to put as much money as they want into a saving vehicle and not pay taxes on that money until they withdraw the money at a later date. If a person earns $20,000 and saves none of it, therefore, they would pay the same in current taxes as a person who earns $50,000 and saves $30,000 of it. The rate structure can be as progressive or regressive as one wants it to be. For the USA Tax, there are three rates: 15, 20, and 40 percent. On the business tax side, the USA Tax would levy a single tax rate of 11 percent on net cash flow.

The rate structure for personal taxes is actually less graduated than it appears, since the USA Tax would allow deductions for payroll taxes (Social Security and Medicare). With these credits included, the three rates are reduced to 11 percent (for taxable income up to $5,400 for married filers), 19 percent ($5,400-$24,000), and 32 percent ($24,000 and over). With the cutoff points as low as they are, moreover, the progressivity of the system would be much less than even the top rate of 32 percent would imply, since larger and larger portions of income would be saved (and thus untaxed) as personal income rises.

Take, for example, a person with $50,000 in gross income and $25,000 in taxable income (after subtracting family exemptions, savings, college tuition, mortgage interest, and charitable contributions). If that person earned and consumed another $1,000, their tax bill would rise by $320 because their marginal tax rate is 32 percent. On the other hand, if a higher-income person earned an extra $1,000, it is much more likely that they would save much or all of it, meaning that they will pay lower taxes on their marginal income. The difference in tax treatment implies that the middle-income person would face a higher tax rate merely because he or she has not reached the point where consumption spending has leveled off. By supply-side logic, then, that implies a relative work disincentive for the person whose consumption needs are the most immediate, since his or her effective tax rate is higher.

The USA Tax retains the deductions for mortgage interest and charitable contributions while it eliminates the deductions for state and local taxes. Significantly, however, it introduces a "higher education" deduction, treating expenditures for tuition at colleges and universities, junior colleges, and various technical training schools as an expensable investment, rather than consumption.

If for no other reason, therefore, the USA Tax is significant in including such a straightforward incentive to invest in human capital, a feature that is sadly lacking from the current tax code and in all of the other proposals. Of course, this need not be part of a saving-exempt tax at all. However, it nicely illustrates just how easy it is to load both good and bad details onto a supposedly simple approach.

The Flat Tax

Taxes on labor income provide a different angle on taxing people, rather than machines. The most famous of...

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