Politics & Policy

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.

Just ask Columbia law professor Michael Graetz, who served as a senior Treasury Department official under George H. W. Bush. He proposes slashing the federal corporate-tax rate from 35 percent to 15 percent and removing all Americans earning less than $100,000 a year from the federal income-tax rolls. Those making more than $100,000 would be subject to a simplified tax code with lower marginal rates. To recoup lost revenue, Graetz would establish a national VAT starting at 10 to 14 percent. He stresses that the regressivity of the new tax could be offset through VAT debit cards for the poor. America’s overall tax code would remain highly progressive, he argues, while becoming much more hospitable to investment and much less injurious to economic growth.

The present U.S. revenue structure depends inordinately on income taxes. “Although we’re a low-tax country, we’re not a low-income-tax country,” says Graetz. Tax Foundation economist Robert Carroll reckons that the “deadweight loss” associated with the federal tax on individual income is somewhere between 11 and 15 percent — which means that “in the course of raising roughly $1 trillion in revenue through the individual income tax, an additional burden of $110 to $150 billion is imposed on taxpayers and the economy.”

Of course, devising the “optimal” tax structure is an inherently subjective process: It involves weighing myriad economic and social aims that often conflict. The need to promote GDP growth must be balanced with the need to gather sufficient revenue. The desire to slash marginal rates and eliminate harmful distortions must be balanced with the desire to maintain a certain level of progressivity. The goal of simplifying the tax code by scrapping tax preferences must be balanced with goals such as curbing poverty (via the Earned Income Tax Credit), rewarding investment in children (via the Child Tax Credit), and promoting philanthropy (via the tax deduction for charitable giving).

Just as there is no optimal tax structure, there is no optimal level of revenue or government spending. Bowles and Simpson identify 21 percent of GDP as a long-term target for federal receipts and outlays. Critics have dismissed that figure as hopelessly arbitrary and/or too low. By way of perspective, prior to fiscal year 2009, the last time federal spending had reached 21 percent of GDP was 1994, according to the Congressional Budget Office. In 2000, at the height of the Clinton-era tech boom, it totaled only 18.2 percent. That same year, federal tax revenue hit 20.6 percent of GDP, its highest level in modern U.S. history.

The public sector consumes a much bigger share of GDP in Scandinavia than it does in America, yet each of the Nordic countries has a lower average statutory corporate-tax rate than the United States, which has the second-highest combined federal-state rate (over 39 percent) in the OECD. Yes, American corporate taxes are partially offset by a slew of deductions and credits. But as University of Calgary economists Duanjie Chen and Jack Mintz have shown, the effective U.S. corporate-tax rate on new capital investments is still way too high.

“We have to have a tax system that is conducive to investment in the United States,” says Graetz. “And we do not now have such a tax system.” Indeed, America’s present tax framework has stifled capital formation, contributed to excessive leveraging on Wall Street (because debt capital is treated far more favorably than equity capital), and suppressed wages. Harvard economist Greg Mankiw has argued that reducing the corporate-tax rate “is perhaps the best simple recipe for promoting long-run growth in American living standards.”

Over the past two decades, corporate-tax rates have been dropping all across Europe — in Ireland, Sweden, Germany, the Netherlands, and elsewhere — thanks in part to the revenue stream provided by the VAT. The relative efficiency of the tax explains why many American conservatives fear that it would greatly inflate public spending. But if the VAT were substituted for a huge chunk of U.S. income taxes, rather than added to the existing tax system, the net revenue increase would probably be minimal.

Moreover, while the VAT can lead to higher spending, it does not inevitably have that effect. Consider what happened in Canada, where the Progressive Conservative government of Brian Mulroney implemented a federal VAT in 1991. Since then, as economists William Gale and Benjamin Harris of the Urban-Brookings Tax Policy Center point out, “the size of the Canadian federal government has shrunk significantly.” The VAT rate started at 7 percent, but it has fallen to 5 percent under the Conservative government of Prime Minister Stephen Harper, which has also slashed corporate taxes.

In New Zealand, it was a neoliberal Labour government that embraced the controversial consumption tax. During the mid-1980s, Prime Minister David Lange and his finance chief, Roger Douglas, spearheaded a radical program of fiscal consolidation that included massive income-tax reductions, deep spending cuts, ambitious deregulation, and a 10 percent VAT. (The rate ticked up to 12.5 percent in 1989.) As economist Thomas Dalsgaard later wrote, these reforms made New Zealand’s tax system “one of the most broadly based, neutral and efficient in the OECD.” There was some backsliding during the 1990s and 2000s, but the current Kiwi government (led by Prime Minister John Key of the conservative National Party) has used a VAT hike to help fund substantial income-tax cuts. “These changes shift the burden of taxes to sources less harmful for growth,” says the New Zealand Treasury.

New Zealand and Canada rank ahead of America in the 2010 Index of Economic Freedom (compiled by the Wall Street Journal and the Heritage Foundation). So does Australia, which rolled out a VAT in 2000, and so do Singapore and Switzerland, two famously low-tax countries that each instituted a VAT in the mid-1990s. According to a World Bank analysis, it is easier to do business in Singapore and New Zealand than in the United States. As for global competitiveness, the World Economic Forum now considers the Swiss economy to be the most competitive on earth.

The second-most competitive, it reckons, is the Swedish economy. Between 2000 and 2008 — a period when Sweden enjoyed robust economic growth — the country’s tax revenue declined by 9.1 percent as a share of GDP, according to Eurostat. This suggests that policymakers reduced the overall tax burden, which they did. But while Sweden’s implicit tax rate (ITR) on labor — that is, the ratio between total labor taxes paid and the total labor-tax base — fell by 8.5 percent, the ITR on consumption actually increased by 8 percent. Meanwhile, the ITR on capital plunged by a whopping 35.4 percent.

At 25 percent, Sweden’s standard VAT rate on most goods and services is tied for the highest in the European Union. (Denmark and Hungary also impose a 25 percent standard VAT.) Those who warn that an American VAT would gradually climb toward Swedish levels raise a legitimate concern. The tax could indeed become a “money machine” (in the famous words of Larry Summers) that would exacerbate fiscal profligacy. Therefore, write Gale and Harris, the ideal American VAT would be fully transparent (like the Canadian VAT) and explicitly tied to spending restraint. Its regressivity would be counterbalanced, not with complicated product exemptions, but with rebates or tax credits. As for the states, they would have strong incentives to “harmonize” their sales taxes with the federal VAT.

Despite being more efficient than an ordinary sales tax, a VAT carries significant administrative costs, and piling it on top of the present U.S. tax structure would be a mistake. But using the VAT to eliminate a sizable amount of distortionary U.S. income taxes would yield a far more growth-friendly system than the one we have today. Over the long run, America must reorient its economy away from consumption and toward investment while boosting its dangerously low savings rate. A VAT is certainly not the only way to promote those objectives, but it should at least be part of the conversation.

— Duncan Currie is deputy managing editor of National Review Online.

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