Designing a Better Tax System
Our present tax system punishes investment and distorts incentives. A VAT has dangers, but it also holds great promise.


Tax hikes, in one form or another, are simply unavoidable. That’s the blunt message conveyed by Erskine Bowles and Alan Simpson, chairmen of the Obama deficit commission, in their much-ballyhooed portfolio of budget recommendations. Their smartest tax proposals include lowering and simplifying individual-income-tax rates, widening the base by abolishing or capping tax “expenditures” (such as the mortgage-interest deduction) that disproportionately benefit the wealthy, ditching the Alternative Minimum Tax, and trimming the corporate rate while closing loopholes. They also suggest lifting the payroll-tax threshold for Social Security, raising the federal gasoline tax, and dramatically boosting tax rates on capital gains and dividends by treating them as regular income.

Bowles and Simpson deserve lavish praise for their contribution to solving America’s fiscal problems. Yet their tax plan is insufficiently focused on the growth imperative, which reflects a failure of imagination. In the aftermath of a calamitous financial meltdown triggered by a debt-fueled housing binge, tax reform cannot be divorced from the broader structural adjustments necessary to build a more sustainable, investment-oriented economic model. “If the economy must pivot toward investment and exports,” writes Glenn Hubbard, who was chief White House economist under George W. Bush, “tax policies must be changed to encourage productive investment over consumption.”

In other words, American lawmakers need to craft a revenue structure that relies more on consumption taxes and less on income taxes. Jacking up tax rates on capital gains and dividends would move us in the opposite direction. It would also be a terribly inefficient way to plug the deficit. Economists Mathias Trabandt of the European Central Bank and Harald Uhlig of the University of Chicago have estimated that raising U.S. capital-income taxes could yield a maximum revenue increase of only 6 percent. For that matter, Trabandt and Uhlig calculate that 51 percent of a capital-income-tax cut would actually be “self-financing,” i.e., a cut would effectively pay for half of itself.

“Taxing capital distorts economic incentives enormously,” says UCLA economist Lee Ohanian, who favors transferring a hefty portion of the tax burden from income to consumption. The Economist has rightly argued that “America’s tax system stands out as one of the least efficient” in the OECD because of its excessive dependence on taxing a relatively narrow base of income. While Democrats often kvetch that America’s income-tax structure is slanted in favor of the rich and has fostered yawning economic disparities, a 2008 OECD study controlled for income inequality and found that household taxes are more progressive in the United States than they are in Australia, Canada, Japan, New Zealand, South Korea, or any major Western European country save Ireland.

Household taxes, mind you, do not include regressive consumption taxes such as the notorious value-added tax (VAT), which provides a significant chunk of government revenue in those countries. America is the only OECD member that still lacks a national VAT, and the Bowles-Simpson blueprint does not advocate one. By contrast, the fiscal strategy mapped out by the Domenici-Rivlin panel (a task force organized by the nonprofit Bipartisan Policy Center) would introduce a “debt-reduction sales tax” of 6.5 percent.

Despite the mind-boggling severity of America’s fiscal mess, the VAT remains radioactive on Capitol Hill. Earlier this year, 85 senators — including most Senate Democrats and every single Senate Republican serving at the time — endorsed a nonbinding resolution expressing their opposition to the tax. But if the federal government needs more revenue, it should seek to collect that revenue in the least damaging way possible. A 2008 OECD paper concluded that corporate taxes are “most harmful for growth, followed by personal income taxes, and then consumption taxes.” Indeed, there is a strong case for replacing a large portion of federal income taxes (both corporate and personal) with a VAT.