Many Happy (Tax) Returns

by Reihan Salam

The expiration of the payroll tax cut has reduced the disposable income of a large majority of wage-earning U.S. households, yet it does not appear to have had a significant impact on consumption. Brad Plumer cites a survey which finds that while 30 percent of Americans have reduced their spending in response to the expiration of the payroll tax cut, 48 percent have yet to register its expiration.

This came to mind as I read Liz Day’s new story on how Intuit, the company that makes TurboTax and a wide array of other consumer financial software products, has lobbied against “return-free filing,” in which the government draws on data from employers and banks to determine tax liability. The idea is that taxpayers will then be issued completed tax returns, which can be corrected as necessary. This voluntary default option would greatly reduce the compliance burden associated with income taxes. 

Another way of looking at return-free filing is that it exploits the passivity of taxpayers to achieve a political objective, namely to reduce the intensity of anti-tax sentiment. Day observes that Intuit has been joined in its opposition to return-free filing by anti-tax activists like Grover Norquist of Americans for Tax Reform, among others. That Intuit has a self-interested objection to return-free filing makes intuitive sense, as does the opposition from Norquist and his allies. One of Day’s sources, James Maule of the Villanova University School of Law, observes that the typical taxpayer wouldn’t take the time to scrutinize her return, thus potentially leaving money on the table. This suggests that return-free filing could yield increased revenues. 

The debate over return-free filing brings to mind the origins of income tax withholding, which was first introduced during the Second World War. In an interview with Brian Doherty of Reason, the libertarian economist Milton Friedman recounted his contribution to the effort. Before income tax withholding, the relatively small number of individuals who owed income tax in one year paid it the following year in quarterly installments. The income tax burden was very modest and it fell exclusively on high-earners, who as a general rule had enough financial sophistication to retain enough money to pay their bills with (relative) ease. Withholding allowed what had been a “class tax” to become a “mass tax.” Return-free filing can be understood as yet another step in this direction.

To the extent anti-tax activists fear that return-free filing will prove harmful because it will shield taxpayers from fully experiencing the burden of taxes, I would recommend a different approach, namely exempting most households from the income tax and replacing the lost revenue with a highly visible consumption tax, as Michael Graetz has proposed. Specifically, Graetz’s Competitive Tax Plan (CTP) envisions an income tax exemption of $50,000 for single filers, $75,000 for head of household filers, and $100,000 for married couples, above which income would be subject to a basic rate of 16 percent and a surtax rate of 25.5 percent on income above $200,000. A consumption tax of 12.3 percent would be levied on virtually all goods and services. To shield low-income households, rebates would be provided to offset payroll tax liability. 

The most palpable political benefit of CTP is that it would surface the cost of financing the federal government in virtually every daily economic transaction, as the cost of the consumption tax would be highlighted by law in every receipt.

Conservatives tend to oppose consumption taxes like the value-added tax (VAT) that are in use in virtually all other market democracies, as they’re concerned about the compliance burden for business enterprises (which Graetz addresses by exempting small firms) and because they fear that VATs are stealthy money machines, as tax is embedded in the cost of goods and services. It is worth noting, however, that the Australian VAT rate has never increased since it was first established in the early 2000s, and the Canadian VAT has been cut twice since it was first established in the 1990s. The experience of both countries is arguably more relevant to the U.S. that European VATs, which reflect a very different institutional context. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.