Reposted from The New York Times
A Tax Code of Politics, Not Reason
Eduardo Porter | April 10, 2012 | NY Times
The deadline for filing tax returns is almost upon us. If you are like me, you must be pondering how such a rich, high-technology democracy as the United States could endure what must be the most inefficient, mind-bogglingly complex tax system known to man.
Either you’ve hired an accountant to prepare your tax returns or you’ve spent countless hours plowing through schedule after schedule, noting deductions, exemptions and limitations and hoping the software you are using will get it right. Exhausted and anxious, you’re thinking surely there must be a better way.
There are, in fact, more efficient ways for government to collect money. They are much less complicated. And they can raise a lot of revenue to solve our long-run budget deficit and pay for the increased benefits demanded by our aging society. What’s more, they can do so without raising income tax rates. Unfortunately, history suggests we won’t really consider these alternatives.
Our byzantine tax code is built upon a longstanding political deal: Democrats wanted a tax scale with higher rates for richer Americans to finance social programs aimed at the poor and the middle class. Republicans countered by pushing for tax exceptions, exclusions and deductions that shielded the incomes of the rich from the taxman and reduced government revenue.
This compromise has left us with a loophole-riddled code that isn’t very good at raising money. The richest 1 percent of Americans, who make $1.5 million on average, pay 28 percent of their income in federal taxes, according to the nonpartisan Tax Policy Center. That’s way below the top rate of 35 percent. The rest of us also pay little. The bottom 85 percent of taxpayers have an average federal tax rate of 12 percent. The poorest 25 percent pay less than 1 percent of their income — $77 a family, on average.
Compared to other developed countries, the United States doesn’t collect much tax at all. Tax revenue at all levels of government adds up to less than 25 percent of the nation’s gross domestic product, putting us behind every other rich country and even some poor ones. Among the 34 nations in the Organization for Economic Cooperation and Development, only Mexico and Chile collect less in taxes. The average across the O.E.C.D. is 9 percentage points higher.
In my column two weeks ago, I argued that given the giant budget deficits on the horizon, the government might consider raising the top tax rate on the rich to 50 percent or more. Recent economic research suggests that top rates could go pretty high without slowing growth. And they could bring in a lot of money.
Yet, as a few readers pointed out, increasing revenue from income taxes might be harder than it looks: bigger loopholes could easily wipe out any gains from higher rates. Since the end of World War II, top federal income tax rates have topped out at more than 90 percent. Yet federal tax revenue has not surpassed 21 percent of the nation’s output. Last year it was under 15 percent.
Not only is our tax code bad at raising money, it is also plagued with perverse incentives that, added up across the population, can push us to distort the economy and slow it down. When I came to New York eight years ago, I bought a bigger house, got a bigger mortgage and plowed more of my savings into the place than I would have otherwise because the Internal Revenue Service let me deduct the interest from my taxes. Today, that doesn’t look quite as wise as it did then.
Allowing businesses to give health insurance to their workers tax-free does promote insurance, but it also encourages overspending on health care. Letting companies deduct interest on their debt encourages them to borrow. Placing high taxes on income and capital can reduce the incentives for people to work and invest.
The only reason our stilted code doesn’t do more harm is that it generates so little in revenue that the perverse incentives aren’t that significant. If more money was involved, the economic damage would be greater. And our representatives in Congress would have more of an incentive to ditch the tax code and come up with a better, more effective and efficient alternative.
What would a better tax system look like? Most other rich countries have one. While each country has a different version, they share a core feature: they raise a lot of money taxing people’s consumption, at the point of sale.
Consumption taxes create fewer perverse incentives because taxing what people buy doesn’t affect their choices about work and investment. If anything, such a system might promote savings, generally good for growth. These taxes are also easy to collect and hard to evade. They don’t add complexity to your tax return. Because they produce few perverse incentives, they can be used to raise a lot of money.
Consumption taxes are supported by a vast majority of economists. They underpin Western Europe’s welfare systems, which are based on the proposition that all citizens are entitled to similar income support and services to guarantee a minimum standard of living, and that everybody should pay proportionately for them. Denmark and Sweden collect about 10 percent of their gross domestic product with a value-added tax, a modern tax on consumption.
In the United States, by contrast, states raise only 2.2 percent of G.D.P. through various sales taxes. There is no federal consumption tax at all. And that’s probably not going to change any time soon.
A federal consumption tax has been proposed more than once. A report last year by the Congressional Research Service found that for every 1 percent levied in a value-added tax, the federal government would raise up to $55 billion a year. This new source of money could help change the political deal underpinning our tax system and pave the way to cull loopholes and reduce our top tax rates.
In 2010, the Bipartisan Policy Center’s Debt Reduction Task Force — headed by Pete Domenici, a former Republican senator from New Mexico, and Alice Rivlin, former vice chairwoman of the Federal Reserve — proposed a 6.5 percent sales tax to raise more than $3 trillion from 2012 to 2020.
But a consumption tax suffers from two political weaknesses. As Lawrence Summers put it in 1988, before he became Treasury secretary in the Clinton administration or worked as an adviser for President Obama, “Liberals think it’s regressive, and conservatives think it’s a money machine.”
Consumption taxes are regressive because the poor spend a bigger share of their income than the rich. But the charge misses a couple of points: our current tax schedule isn’t very progressive, either, pockmarked as it is by exclusions and exceptions. European welfare systems that rely heavily on consumption taxes to provide generous benefits do a better job at reducing income inequality than the government does here. The poor pay more into the system, but they also get more from it.
Mr. Summers suggested that politics might turn in favor of a value-added tax if only the politicians were to focus on the opposite end of the argument. If conservatives realized that the expansion of government would be financed in part by the poor and the middle class rather than the rich, they might be less adamant in their opposition. If Democrats focused on the amount of money they could raise, they, too, might come around.
But the precedent is not heartening. Al Ullman, the Oregon Democrat who was chairman of the House Ways and Means Committee, proposed a 10 percent value-added tax coupled to a reduction in income and payroll taxes in 1979. The idea died. In 1980, Mr. Ullman was defeated by a Republican who accused him of having lost touch.