TCS Daily

The Fairer Tax

By Pejman Yousefzadeh - October 31, 2003 12:00 AM

We have some good news on the economic front from the Department of Commerce, which states that the economy grew 7.2% in the past quarter, far exceeding the expected 6% growth. If this degree of economic growth continues, the U.S. will be able to fully recover from the recession of 2001, and the somewhat stunted economic growth since. The key is ensuring that the growth continues, and making certain that this past quarter's economic performance isn't a fluke. One of the best ways we can encourage continued strong economic growth is to reform a tax structure that hinders that growth. The so-called "progressive income tax" has been in effect since the adoption of the 16th Amendment in 1913, but as is increasingly clear, it has outlived its usefulness.


For starters consider its immense complexity. The myriad loopholes, exemptions, and the generally abstruse language of the tax code mean that many people are befuddled as to what the tax code requires of them. To figure out their tax obligations, they are often forced to pay hundreds of dollars to tax consultants and accountants. Should they get anything wrong, they are subjected to time-consuming audits, which cost money to defend against and deal with. The transaction costs of processing income tax returns, with the commensurate complications of audits, tax liens, and advising citizens of their tax responsibilities under a very difficult system, only serve to increase the cost of maintaining the current tax structure.


Tax withholding means that you have less take-home pay. This only serves to weigh down economic growth by discouraging spending. An economy that expands less will only serve to bring in less revenue into government coffers.


While proponents of the current tax structure will likely counter with the argument that the government can spend tax revenue, and thus prime the economic pump, this overlooks the fact that much of government spending is wasteful and designed more to preserve the political standing of those who craft and endorse a given economic stimulus package. Additionally, it neglects the fundamentally condescending nature of a policy that trusts government to spend the people's money more than it trusts the people themselves.


Finally, the current tax code imposes a cost on citizens because of its complexity, and because of the commensurate difficulty of citizens to make financial planning choices while at the same time seeking to comply with the tax laws.


These and other concerns have prompted Congress to consider H.R. 25 and S. 1493 -- bills that seek to replace the current income tax system with a consumption tax. The consumption tax has a whole host of advantages over the current income tax structure.


For one thing, the consumption tax is simple to understand -- far simpler than the current income tax structure. The bills would repeal the income tax -- along with payroll, estate and gift taxes. In their place, it would enact a sales tax that would cover all consumption of goods and services in the U.S. without exception, but without double taxation.


The need to reduce costs to the economy that are brought about by the current income tax structure is urgent. This report out of the Cato Institute indicates that in 2001 alone, costs for time lost in seeking to comply with federal income tax laws was $183 billion, as calculated by the Office of Management and Budget -- a consequence of a tax code which requires 6.1 million man hours to comply with it. And this estimate does not even include the cost to citizens to contend with IRS levies, fines, notices, audits and seizures -- many of which are erroneous.


A consumption tax such as the one contemplated by H.R. 25 and S. 1493 will reduce transaction costs to a minimum, eliminate the need for concerns about loopholes and exemptions, and save people the time and expense of having to consult tax experts for the payment of taxes -- or lawyers for advice on how to defend against audits. This, in turn, will dramatically reduce the need for an expanding bureaucracy in the IRS, thus allowing for a dramatic reduction in the size of government through the elimination of unnecessary government personnel positions, along with substantial savings to the economy. The report linked to in the previous paragraph indicates that compliance costs could be reduced by as much as 95% via the implementation of a consumption tax. These savings will be found through simplification, through a reduction in bureaucracy, and by harmonizing the federal tax structure with the structure of the states, as both H.R. 25 and S. 1493 call for -- a move that is particularly important given that states have the most experience with administering and collecting sales taxes.


Any attempt to change the current tax structure will likely provoke protests from those enamored with the current structure's "progressivity." One such common protest against the consumption tax is that it will allow the wealthy to avoid paying their fair share by deferring their consumption. But as New York University Law Professor Daniel N. Shaviro -- an authority on tax law and tax policy -- points out, concerns that wealthy people will avoid the consumption tax by deferring consumption are ill founded, given that wealth is valuable because of the real purchasing power that it commands. Shaviro demonstrates a consumption tax has an effect on unspent wealth, which means that any burden imposed by such a tax is not escaped by the deferment of consumption. Additionally, Shaviro shows the falsity of claims that the consumption tax exempts capital income, thus allowing the implementation of the consumption tax to bring about true progressivity -- the kind that the income tax has failed to realize.


The current withholding scheme serves to allocate money to programs like Social Security, Medicare, and state employment taxes. Concerns that Social Security and Medicare will be underfunded through the implementation of a consumption tax can be met through legislative language that will set a statutory allocation amount of federal revenue to both programs. Both H.R. 25 and S. 1493 ensure that a consumption tax is inclusive of Social Security benefits indexation. (Of course, many want to see the implementation of legislation that would allow people to opt out of Social Security altogether, as private rates of return for pension investments are significantly higher than the government's rate of return, but that's another argument for another day.) Similarly, Medicare can have a statutory allocation that will remove concerns about underfunding the program.


Allowing people to take home the full value of their paychecks will bring about another benefit -- increased worker productivity. This study, done jointly by Professor Edward C. Prescott of the University of Minnesota, and the Federal Reserve Bank of Minneapolis, demonstrates a powerful correlation between low marginal tax rates and high worker productivity. Additionally, the study finds that high marginal rates -- such as those found in European countries, don't even help fund the welfare states of those countries, because they end up reducing labor market participation, thus resulting in a less wealthy citizenry.


Assuming that the study is correct in its correlation between high worker productivity and low marginal rates, imagine the increase in worker productivity that would be brought about by the implementation of a consumption tax -- which effectively eliminates withholding. Productivity gains are important because they allow the economy to grow without increasing the risk of inflation, and because worker salaries can be increased without an increase in the price of the goods the worker produces -- a price increase that would serve to offset the wage gain. The only concern with this increase in worker productivity would be that productivity might outdistance GDP growth in certain situations, thus leading to job losses. However, this would be an extreme case scenario, and ultimately, the economy benefits more from an increase in productivity, and a commensurate increase in the standard of living.


The tax system is one presidential candidate Jimmy Carter described in 1976 as "a disgrace to the human race." He was right then, and yet, the income tax code's disgraceful and deleterious effect on America's economic performance has continued unabated. It's long past time to reform the tax code, and for the sake of continuing and encouraging what might finally be the economic growth we have been waiting for since 2001, we ought to start that reform process immediately.


TCS Daily Archives