TCS Daily

Toward a Single-Digit Tax Rate

By Arnold Kling - November 16, 2004 12:00 AM

"I haven't given the idea of combining tax reform with a rate hike much thought, largely because I'm so wary of reform in the first place. Two thoughts come to mind: All the distortions and breaks in the tax code become less important the lower the rates are. And if you're doing a comprehensive reform, you're probably better off politically reducing tax rates -- you don't want opponents of the reform to be able to say the whole thing is a tax-raising scheme."
-- Ramesh Ponnuru

When I learned economics, the idea of public finance was to design a tax system for wise, public-spirited legislators to enact. We were supposed to worry about economic incentives, implicitly assuming that political incentives were always pure.

Today, economists no longer assume away problems with political incentives. In fact, many of us have come to believe that when it comes to fiscal policy, it is as foolish to ignore political incentives as it is to ignore economic incentives.

In this essay, I will propose a tax system that from an economic perspective will seem flawed and peculiar. However, the intent is to accomplish two political objectives:

1. Reduce the incentive of interest groups to lobby for special exemptions

2. Reduce the incentive of Congress to spend money

Four Single-Digit Taxes

Today, we have a payroll tax that is roughly 15 percent (combining employer and employee contributions), a personal income tax that has maximum marginal rates over 35 percent, and a corporate income tax with maximum marginal rates over 35 percent. However, because of various exemptions, the average tax rates are much lower: less than 12 percent for payroll taxes, less than 15 percent for personal income, and less than 25 percent for corporate income.

What I propose is that we adopt a value-added tax (VAT), also known as a consumption tax, in addition to the other taxes, while adopting a rule that says no single tax may have a double-digit marginal rate. My thinking is that with this reform, we would have all four taxes -- personal income, corporate income, payroll, and VAT, each at a rate of, say, 8 percent.

Reducing the personal income tax, payroll tax, and corporate income tax rates to 8 percent each would curtail government revenue. However, I would propose abolishing all tax credits that go with these taxes, along with most exemptions.

The most important exemption to abolish is the exemption of incomes over $87,900 from payroll taxes. I would subject all salaries to payroll taxes, but not increase Social Security benefits for people with higher incomes. That is, the $87,900 ceiling would still apply for calculating the benefits to which you are entitled. In fact, as discussed below, the relationship between today's wages and tomorrow's benefits could be severed altogether.

Phase Out Social Security

I like Laurence Kotlikoff's proposal to phase out Social Security and replace it with private accounts. The first step is to stop accruing new Social Security benefits, so that current workers would receive only the benefits which have accrued to them by this point. Someone aged 50, for example, would receive benefits when they retire based on what they have paid in up to now.

Kotlikoff's idea is to substitute forced saving for Social Security. He would force workers to contribute to accounts, which, unlike Social Security, would be personal accounts.

"All account balances are invested in a single, global, market-weighted index fund, providing all workers the same fully diversified portfolio and rate of return. The government fully guarantees the downside; workers can only gain from investing in the market. At retirement, balances in this Personal Security System are gradually sold off and converted to inflation-indexed pensions. The Social Security Administration handles all paperwork, investing and pension conversions. Wall Street plays no role and collects no fees."

The forced saving accounts would be in addition to taxes. Like taxes, they would reduce disposable income today. However, unlike taxes, they would go into accounts that belong to individuals, not to the government.

In Kotlikoff's proposal, a VAT would be introduced in order to help fund the transition to private accounts, but the payroll tax would be abolished altogether. My modification is to keep the payroll tax but have single-digit rates for all taxes.

Shut Down K Street

From an economic perspective, having four broad-based taxes seems silly. Pure economic theory would say that you should have only one broad-based tax in the economy. With the four-tax approach, we would be double-taxing (or triple-taxing) labor income and capital income. For example, your salary would be taxed as a payroll tax, as part of the income tax, and then when you buy goods and services you would be taxed again through the VAT.

From a political perspective, however, having four broad-based taxes with low rates would help to discourage lobbying. The incentive to lobby for an exemption is much higher when marginal rates are 35 percent than when rates are 8 percent.

For example, consider the corporate income tax. As it stands now, the social cost of the corporate income tax (including compliance costs, the costs of rent-seeking as K Street lawyers lobby for exemptions, and the costs of economic distortions) exceed the revenue that it brings in, which is why it is reasonable for economists to support abolishing the corporate income tax altogether. My hypothesis is that with a tax rate of 8 percent, the K street rent-seeking would diminish sharply, compliance costs would decline because of reduced complexity as well as reduced incentives to dodge the tax, and the economic distortions would be reduced as well.

Reducing the marginal tax rates on personal and corporate income from 35 percent to 8 percent would reduce the value of tax exemptions by 80 percent. I think that this would shut down the K Street tax lobbying industry, or at least curtail it sharply. Even the real estate lobby might decide that the mortgage interest deduction is not worth fighting for when the marginal personal income tax rate is only 8 percent to begin with.

Raise Spending, Screw the Poor

An even more vexing political incentive problem is the incentive for legislators to spend money. As it stands now, the Democratic Party says that spending can be funded by raising taxes on "the top 2 percent" and the Republican Party says that spending does not have to be funded at all. Thus, neither party sees any restraint on spending.

What I propose is two rules that would limit spending.

1. All spending must be funded by taxes. Deficits would be allowed in recessions, but the cyclically-adjusted deficit would have to be balanced.

2. Tax rates may not be changed. Taxes can only be increased by reducing the Low-Income Threshold (defined below).

I would have the payroll tax and the income tax be negative for people with low incomes. That is, the tax rate would be 8 percent only for people with incomes above a Low-Income Threshold, say, $25,000. For people with incomes below $25,000 the tax rate would be negative 8 percent. That is, they would receive 8 percent of the difference between their income and $25,000. If you get $10,000 in labor income and no other income, then you would receive $1200 (8 percent of $15,000) each from both the income tax and the payroll tax.

Milton Friedman proposed a negative income tax years ago. I am proposing both a negative income tax and a negative payroll tax, while abolishing other provisions in the tax code, such as the Earned Income Tax Credit, which are similar in spirit.

My main suggestion is that with tax rates fixed, the only way for legislators to adjust revenue would be by changing the Low-Income Threshold. The higher the threshold, the lower would be everyone's taxes. The lower the threshold, the higher would be everyone's taxes.

What that would mean in political terms is that to pay for new spending, you would have to reduce the Low-Income Threshold, from, say $25,000 to $22,000. That means that new spending has an adverse impact on the poor (as well as non-poor taxpayers). Do you want to spend more money on highways? You have to screw the poor. Do you want to fund research into space travel or alternative fuels? Screw the poor. Do you want to fund the arts? Screw the poor.

In fact, these spending programs screw the poor and middle-class today, but legislators can hide from this fact. The goal of this fiscal reform would be to have legislators recognize what economists call opportunity cost. That is, when you get one thing, you have to give up something else. As things stand now, spending decisions are made without regard to opportunity cost.

Wishful Thinking?

In order for these proposed fiscal reforms to have their desired effect, at least two things would have to happen. One is that Congress would have to adopt a (cyclically-adjusted) balanced-budget mechanism, so that spending cannot be raised without identifying the revenue to pay for it. The second is that Congress would have to commit itself to single-digit tax rates, so that taxes can only be raised by adjusting the Low-Income Threshold. If it were easy for Congress to break either one of these rules, then the reforms would not work.

In that sense, any reform represents wishful thinking. In the end, if the incentive to spend is more powerful than the incentive to stick to a reform, there is no reform that will work.

To have any lasting impact, tax reform has to do more than just temporarily simplify and rationalize the tax code. The real objective of fiscal reform should be to reduce the incentives for Congress to spend and to use the tax code as a vehicle for granting favors. That is the yardstick that should be used for comparing alternative proposals for tax reform.


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