Simplifying the Tax Code by Fixing the Base

The Sunlight Foundation blogs today about the 6,503 registered tax lobbyists in Washington, and they provide 11 examples of the changes that these folks are pushing for.

I share Sunlight’s concern about special-interest lobbying, but their list actually drives home the more important point that tax simplification should begin by getting the tax base right first.

In this Cato study, I described why consumption-based taxation would be far superior to the current income tax for both growth and simplification reasons. A consumption-based tax—such as the Hall-Rabushka flat tax—would get rid of two of the most complex parts of the current code—capital gains and the capitalization of investment (which involves depreciation and amortization).

Let’s look at Sunlight’s list of 11 proposed tax changes:

  • Five of them (#1, #3, #7, #10, #11) have to do with capitalization. Number 7, for example, regards allowing fire equipment to be expensed rather than depreciated. But under a consumption tax, all investments would be expensed (that is, written off in the first year), which is both simpler and more efficient.
  • Two of them (#6, #8) have to do capital gains. Capital gains taxes would abolished under a consumption tax.
  • Two of them (#4, #9) are tax credits. Almost all tax credits are bad tax policy, including these two. Number 9 is a proposal for a $500 tax credit for hearing aids. Good grief.
  • Two of them (#2, #5) are over my head.

Here’s what I concluded in my study:

The key factor that causes rising income tax complexity is that the tax base is inherently difficult to measure. The Haig-Simons measure of income favored by many academic theorists is economically damaging and too impractical to use in the real world. As a result, policymakers have fallen back on ad hoc and inconsistent rules to define the income tax base. That intensifies complexity and creates instability as policymakers gyrate between different definitions of the tax base. In addition, the lack of a consistently defined tax base increases the use of the tax code for special-interest tax breaks, thus further adding to the system’s complexity.

The complexity and inefficiency of the individual and corporate income taxes have led to great interest in replacing them with a consumption-based tax. The leading consumption-based tax proposals, including the national retail sales tax and the Hall-Rabushka flat tax, could dramatically simplify federal taxation. Those tax systems would eliminate many of the most complex aspects of federal taxation, including depreciation accounting and capital gains taxation.

Imposing the largest federal tax on income was a historic mistake: no simple, efficient, and stable measure of income has been found in nine decades of the income tax. It is time to recognize this mistake and replace the income tax with a consumption-based alternative.