The Corner

Let’s Move to a Consumption Tax

The debate over Mitt Romney’s tax burden makes me think it is time to revive the idea that the income tax should go and a consumption tax should replace it.

Just as Warren Buffett claimed that he pays a smaller share of his income in taxes than his secretary, Romney has announced that he pays around 15 percent in taxes. That’s because, like Mr. Buffett and other very high-income earners, a large share of his income comes from investments, not wages or salary. According to Shaila Dewan and Robert Gebeloff:

The percentages fluctuate from year to year, but in 2007, the top 1 percent of earners received 20 percent of their income from capital gains, while everyone else received, on average, 2 percent of their income from capital gains. In 2011, according to estimates by the nonpartisan Tax Policy Center, the top 1 percent paid 70 percent of the total federal tax on capital gains.

Consider this chart:

Here is where most people see the system as being unfair: The blue part of this chart is taxed at a lower rate (usually 15 percent) than the red part of the chart (top marginal income tax is 35 percent for income above $380,000).

Strangely ignored by Romney — like Buffet before him — is that the reason for the current preferential treatment of capital and dividends is to offset the “double taxation” of corporate profits. Leaving aside the fact that this probably means that the rate should be zero rather than 15 percent, this means that Romney’s income is really taxed twice: once at the corporate tax rate of 35 percent, then again at a 15 percent rate when it is passed on to him as dividends or via capital gains from the sale of stock. The Wall Street Journal explains:

 All income from businesses is eventually passed through to the owners, so to ignore business taxes creates a statistical illusion that makes it appear that the rich pay less than they really do. By this logic, if the corporate tax rate were raised to, say, 60% from today’s 35% and the dividend and capital gains tax were cut to zero, it would appear that business owners were getting away with paying no federal tax at all.

According to CBO data, the top 1 percent of earners pay about 10 percent of their income in corporate taxes. And the WSJ shares this table:

This constant confusion about who pays what should serve as evidence that the income-tax system, as it is designed today, is extremely complex. People should understand how much money they are actually paying to the government, but these recurring stories about millionaires and their taxes makes it evident that even wealthy business people are having trouble understanding the whole thing.

But there are more reasons to move away from an income tax. #more#As economist Scott Sumner has explained over and over again, “income is a nearly meaningless concept in economics.” For instance, there is usually a huge discrepancy between who is targeted by a given tax and who actually pays that tax — in other words, the statutory incidence of a tax is very different from its economic incidence. Take the corporate income tax: As I have mentioned in the past, several much-discussed studies have found that it is likely that most of the burden of the tax is borne, not by capital, not by shareholders, but by domestic labor, in the form of lower wages. Here is CBO’s William Randolph (2006):

Burdens are measured in a numerical example by substituting factor shares and output shares that are reasonable for the U.S. economy. Given those values, domestic labor bears slightly more than 70 percent of the burden of the corporate income tax. The domestic owners of capital bear slightly more than 30 percent of the burden. Domestic landowners receive a small benefit. At the same time, the foreign owners of capital bear slightly more than 70 percent of the burden, but their burden is exactly offset by the benefits received by foreign workers and landowners.

I assume the same thing can probably be said about capital gains taxes. More importantly, this discussion underlines how meaningless and artificial the distinctions are between capital income, corporate income, and personal income. Instead of debating whether rich people should pay more capital gains tax or more income tax, we should call for the end of this fake classification of income. Sumner adds:

I hope I showed that “income” is meaningless if it includes capital income. It is misleading because it leads people to talk about the share of “income” earned by the top 1% as if it is all actual labor income, whereas it is often mostly capital income, aka deferred consumption and not income at all.  And it’s harmful because it leads to the establishment of an extremely annoying, inefficient, and sometimes even repressive system called the income tax.  And it punishes thrift and rewards spendthrifts.

One option people sometime talk about would be to eliminate the corporate income tax, the capital-gains and dividend taxes, and other wealth taxes and simply roll all income into one category taxed at a low rate (the idea being that if there is going to be double taxation of income, it should be done at a lower rate).

But this system still penalizes savings and over consumption. A much better alternatively is to eliminate the corporate income tax, the capital-gains and dividend taxes, and other wealth taxes and replace the whole thing with consumption-based tax system. Economically, taxing consumption makes more sense. I would prefer a flat rate; Sumner argues for a progressive consumption tax.

A criticism of the flat-rate consumption tax is that it is regressive. I have a limited problem with that. As I explained yesterday, much of the government spending goes to the middle class and I think they should pay for most of it. That’s how the Europeans do it; they use regressive taxes to pay for their government spending. (Their government spending is more progressive than our middle-class-centric system, I should add.) Besides, no matter how we look at it, raising taxes only on the rich won’t pay for all our spending on Medicare, Social Security, and Medicaid. And if it is true that many voters are only in favor of symbolic cuts (to foreign aid, government waste, etc.) and opposed to reforming Medicare, then they should have to pay for it.

Obviously, I find it weird that people would rather get the government to provide most of these services than the private sector or that people would want to be taxed to get their money back in the form of relatively crappy government services. Yet if that’s what voters want, those who consume the services should pay for it (not counting the genuinely poor), not push the bill onto future generations.

For all these reasons, we should move to a consumption tax and get rid of the income tax.


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