How would you rewrite the US tax code? What would the new tax brackets be? Would you keep the Earned Income Tax Credit or the Alternative Minimum Tax? Would you repeal the mortgage interest deduction or enact the Buffet rule?
I’ve been thinking about this one for a long time.I don’t think the income tax can be redeemed. It is impossible to make it work.Here are three absolutes for a tax:Revenue raisingFairnessAdministrabilityThe problem with the income tax is that you can any two elements, but you cannot have the third. Income tax is just too complex.I’m not talking about the personal income tax on employment income. That’s pretty easy to measure most of the time. But as soon as you tax business or property income (things like interest, dividends, rents, royalties and capital gains), it gets complicated.Why? Because you’re not just measuring the inflow, you’re measuring net income. That’s after deductions. Not just arbitrary deductions, like mortgage interest, but a general class of expenses incurred to earn that income.Now layer on top of that complexity the fact that people can (and often must, for non-tax reasons) incorporate their businesses, or run them through other forms of organization (in the United States, partnerships and LLCs, among others).That’s not enough? Now you have to do it in an international environment. What do you do about domestic companies earning foreign income? What about foreign companies earning domestic income? Ever hear of a Double Irish? Sounds like a good drink, or a sex position. It’s not. But if you’re particularly hungry, it comes with a Dutch Sandwich.Oh, the income tax can raise money, and it does. At least for a while. And it can be made mostly fair. But this is what the US regulations look like:And of course in an international world, there is something like this in the other countries as well. So every company has to pay expensive people (lawyers and accountants like me) to figure this stuff out forwards and backwards.And the governments have to do the same.Of course, governments don’t pay their civil servants very well, so they (mostly) don’t have the same expertise as the opposite side. They simply don’t have the skilled manpower to audit enough to find the errors and omissions (whether intentional or not).And that doesn’t even take into account the fact that Congress is slowly defunding the IRSBut I digress.Of course, you could simplify things. Tax only domestic income, not foreign income. That would stop things like Tax inversions. But would it be fair? There’s a long list of simplifications that could be made, but most of them would open up loopholes. A huge part of tax legislation is nothing but loophole-closing.Or you could dramatically lower tax rates. It doesn’t pay to use me, if you’re only going to save $12 in tax. Lower tax rates make tax strategies inefficient.But that would lower the amount of revenue raised.Are you ready to halve Social Security? Bye-bye Obamacare (Trumpcare, whatever).The solutionDo what the Europeans do (and Canada, and New Zealand, and lots of other places) - institute a Value-added tax (“VAT”).But do it with an American twist - kill the income tax.A VAT is a sales tax, but it’s levied on just about everything (properly done, even food). It’s a sales tax, not an income tax. That means your costs are irrelevant. That makes it much simpler (a business just has to measure your input tax credits, but that’s just the amount it paid in VAT on its purchases - that’s easy).Because the base is so broad, the rate can be much lower than the income tax rate, to generate the same revenue.It is far simpler to run than an income tax. There are scores of examples that prove this.ObjectionsMoving tax from corporations to individualsA major objection is that it removes tax from corporations, and lays it all onto individuals. This appears at first blush to be a reasonable objection. But there is a great deal of evidence, accepted by economists across the spectrum, that corporate taxes don’t really fall on shareholders - they fall primarily on employees of the corporation (and some on customers). Just because corporations write the check to the government doesn’t mean they actually bear the cost.Tax incidence - WikipediaProgressivityThe biggest objection is that a VAT is regressive. That’s easy to overcome - pay out a subsidy to low-income people. This is how every VAT is instituted.In a country with no income tax (as I suggest), the solution is to pay the subsidy to everyone. Yes, this appears expensive, but for most people, it’s just money running around in a circle. You can set the rate appropriately to do this. And you can combine it with a Guaranteed Annual Income - a darling concept of both the left and right.Is it as progressive as income tax? No. There’s no tax that can replicate the income tax’s progressivity, because progressivity is specifically defined (now) as causing a higher-income person pay tax at a higher rate.The problem with this definition is the definition of “high income”. As noted above, “income” is a very difficult concept to measure consistently, especially at the highest levels. So we come up with some proxies for it. They’re still not very good.And when you apply very high tax rates (hello France, Canada, California and New York City), you get economically inefficient behavior. People spend a lot of time trying to minimize their taxes instead of earning more income. Instead of employing more factory workers they employ more accountants. Good for me, but not so good for the economy.Or they cheat. Or they leave the jurisdiction altogether. Do you think it’s a coincidence that so many American professional athletes live in Florida rather than New York? Oh yeah‣ it’s just for the weather‣ yeah.Millionaire athletes flee states with high income taxesDoes anybody remember The Goose That Laid the Golden Eggs?Tax on foreignersAnother objection is that a VAT imposes no tax on foreigners. Right now, if a foreigner earns US investment income, s/he/it has to pay US income tax. That revenue would be lost.Actually, no. Again, for the same reason that corporations effectively bear no tax, neither do foreigners. Their after-tax rate of return (for a given risk level) is fixed. The net effect here would be to increase foreign investment in the United States, creating jobs.How about a different definition of progressivity?In real life, rich is what you spend, not what you earn. Rich people spend a lower proportion of what they earn. They give away the difference. Some goes to charities, and some goes to family. But in either case, when it gets spent, it would generate VAT revenue.ConsistencyOne factor that people often miss in tax policy design is consistency. A good tax will generate roughly the same governmental revenue in good years and bad. The reason this kind of a tax is beneficial is that it allows for future planning. Governments spend on short-term stuff, but they also make long-term commitments. Predictable revenues make the political choices more transparent.Income taxes - especially business taxes, and tax from rich people - bounce up and down quite a lot. When the economy’s good, they gush. When the economy is bad, those entrepreneurs generate losses.VAT revenues are much less affected by these fluctuations.If you’re a Keynsian, and you want to use government to “prime the pump”, you can still do this - but with spending (again, politically transparent), rather than the tax system.TransparencyThe best thing, for people, about a VAT is that if governments want more money, they have to raise the rate - on everybody. Right now, there’s a lot of “don’t tax me, don’t tax thee, tax that guy behind the tree”. Politically easy targets get tax hikes, even if it makes little economic sense.A VAT is good for democracy. There’s no free money. Politicians can’t fool you by taxing one person, but having another bear the cost.ConclusionA VAT beats an income tax hands down. Except for politicians who use income tax to fool people.