Tag: Tax Reform

Tax Loopholes Are Corrupt and Inefficient, but They Should only Be Eliminated if Every Penny of New Revenue Is Used to Lower Tax Rates

There’s been a lot of heated discussion about various preferences, deductions, credits, shelters, and other loopholes in the tax code. Some of this debate has revolved around whether it is legitimate to refer to these provisions as “tax expenditures” or “subsidies.”

Michael Cannon vociferously argues that subsidies and expenditures only occur when the government takes money from person A and gives it to person B. On the other side of the debate are people like Josh Barro of the Manhattan Institute, who argues that tax preferences are akin to subsidies or expenditures since they can be just as damaging as government spending programs when looking at whether resources are efficiently allocated.

Since I’m a can’t-we-all-get-along, uniter-not-divider kind of person, allow me to suggest that this debate should be set aside. After all, we all agree that tax preferences can lead to inefficient outcomes. So let’s call them “tax distortions” and focus on the real issue, which is how best to eliminate them.

This is an important issue because both the Domenici-Rivlin Task Force and the Chairmen of the Simpson-Bowles Commission have unveiled plans that would reduce or eliminate many of these tax distortions and also lower marginal tax rates. That’s the good news.

The bad news is that their plans result in more revenue going to Washington. In other words, the tax increase resulting from fewer tax distortions is larger than the tax decrease resulting from lower tax rates. To put it bluntly, the plans would increase the overall tax burden.

Some argue that this is an acceptable price to pay. They point out, quite correctly, that lower tax rates will help the economy by improving incentives for productive behavior. And they also are right in arguing that fewer tax distortions will help the economy by improving efficiency. Seems like a win-win situation. What’s not to like?

The problem is on the spending side of the fiscal ledger. The Simpson-Bowles Commission and the Domenici-Rivlin Task Force were charged with figuring out how to reduce red ink. We already know from Congressional Budget Office data, however, that we can balance the budget fairly quickly by limiting the growth of government spending. As the chart illustrates, the deficit disappears by 2016-2017 with a hard freeze and goes away by 2019-2020 if spending increases by two percent each year (and this assumes all the 2001 and 2003 tax cuts are made permanent).

If tax revenue is increased, that simply means that the budget gets balanced at a higher level of spending. And since government spending, at current levels and composition, hinders economic growth by diverting labor and capital to less productive (or unproductive) uses, any proposal that enables higher levels of government spending will further undermine economic performance.

It goes without saying (but I’ll say it anyhow) that this analysis is overly optimistic since it assumes that politicians actually will balance the budget. In all likelihood, as explained in today’s Wall Street Journal, any tax increase would probably be followed by even more spending. So if politicians raise the tax burden, we might still have a deficit of $685 billion in 2020 (CBO’s most-recent estimate assuming  all programs are left on auto-pilot), but the overall levels of both spending and taxes would be higher. This modified cartoon captures this real-world effect.

This is why revenue-neutral tax reform, like the flat tax, is the only pro-growth way of eliminating tax distortions.

There Ain’t No Such Thing as a Tax Subsidy, Either

I hit a nerve with my post, “There Ain’t No Such Thing as a Tax Expenditure.”  To recap: The federal tax code has credits, deductions, exemptions, and exclusions that reduce tax revenue.  By convention, budget experts call that forgone revenue a “tax expenditure,” a “tax subsidy,” or even “backdoor spending in the tax code.”  This is incorrect.  To claim that forgone tax revenue is a government expenditure implies that the money at stake actually belongs to the government, which is graciously letting taxpayers keep it, rather than to the people who earned it.  Government is not spending that money; it is merely not extracting that money from the private sector.  Statists deliberately use terms like “tax expenditure” precisely because that erroneous impression obscures their efforts to raise your taxes.

Less than an hour after posting, Matthew Yglesias of the Center for American Progress Action Fund called me “daringly inaccurate.”  (Why be timid?)  The Manhattan Institute’s Josh Barro devoted a very thoughtful 1,155 words to the topic at NRO.

Yglesias explains in an email:

I understand why you might want to object to the “tax expenditure” phrasing, but surely we can agree that there’s such a thing as a “tax subsidy,” right? If the government declares that fuel-efficient hybrid cars are now tax-deductible, that’s a subsidy to the makers and purchasers of Priuses.

I’m afraid I cannot agree to that.

  • The term “tax expenditure” is nonsense because not taking Peter’s money, conditional on Peter buying a Prius, is not the same as spending the same amount of money on a Prius.  The outcome may be exactly the same.  But no one can spend money that he doesn’t possess.
  • The term “tax subsidy” is likewise nonsense because a subsidy involves giving something to someone else.  Not taking Peter’s money, conditional on Peter buying a Prius, is not a subsidy to Peter.  The government is not giving Peter anything.  Nor is it a subsidy to Paul, even though he profits from Prius sales: the government is not giving anything to Paul, either.  Again, the outcome may be exactly the same as a government subsidy.  Notably, Paul’s income rises.   Yet it does not rise because Paul received a subsidy.  Paul’s income rises because the state used coercion in a different way: to alter, for Peter, the cost of a Prius relative to other uses of Peter’s income.
  • To see the absurdity, consider what it would mean to eliminate a “tax subsidy.”  All else equal, eliminating an actual government subsidy reduces the tax burden.  Eliminating a “tax subsidy” increases someone’s tax burden.  Which is the whole point, isn’t it?

Barro makes more of our disagreement than actually exists.

  • We agree targeted tax preferences are harmful.  (I argue, for example, that the tax exclusion for employer-sponsored health insurance operates more like a tax hike than a tax break because, among other atrocities, it denies the typical parent control over $10,000 of her earnings.)
  • We agree they expand government power.
  • We agree government should account for them.  (Along those lines, the Congressional Budget Office has developed a concept it calls the “federal budgetary commitment to health care,” which is the sum of all federal health spending and all tax revenue forgone due to health-related tax loopholes.  The CBO calls them “tax expenditures” –  grrrr.  I dislike “budgetary commitment” for the same reason: the government can’t commit resources it doesn’t possess. But the CBO is on to something. We need an aggregate measure of “federal budgetary interference in the economy.”)
  • Finally, Barro and I probably agree that Congress should simultaneously eliminate all such loopholes and reduce marginal payroll- and income-tax rates – perhaps to zero.

I reject the term “tax expenditure” – as distinct from the concept – because it is nonsensical and biases the debate toward more government control of the economy and our lives.   Barro asks what term I’d prefer. Until someone comes up with something pithier than “tax revenue forgone due to targeted tax preferences,” I’ll stick with that.

Is the FAIR Tax a Political Liability?

In the past 15 years, I’ve debated in favor of a national sales tax, testified before Congress on the merits of a national sales tax, gone on TV to advocate for a national sales tax, and spoken with dozens of reporters to explain why a national sales tax is a good idea. Even though I prefer a flat tax, I’ve been an ardent defender of sales tax proposals such as the FAIR tax because it would be a great idea to replace the current system with any low-rate system that gets rid of the tax bias against saving and investment. I even narrated this video explaining that a national sales tax and flat tax are different sides of the same coin — and therefore either tax reform proposal would significantly improve prosperity and competitiveness.

I will continue to defend the FAIR tax and other national sales tax proposals that replace the income tax, but I wonder whether this is a losing battle. Every election cycle, candidates that endorse (or even say nice things about) the FAIR tax wind up getting attacked and put on the defensive. Their opponents are being dishonest, and their TV ads are grossly misleading, but they are using this approach because the anti-FAIR tax message is politically effective. Many pro-tax-reform candidates have lost elections in favorable states and districts, largely because their opponents were able to successfully demagogue against a national sales tax.

The Wall Street Journal reaches the same conclusion, opining this morning about the false — but effective — campaign against candidates who support a national sales tax.

In 16 House and three Senate races so far, Democrats have blasted GOP candidates for at one point or another voicing an interest in the FAIR tax. …FAIR tax proponents are right to say these Democratic attacks are unfair and don’t mention the tax-cutting side of the proposal, but the attacks do seem to work. Mr. Paul’s lead in Kentucky fell after the assault, and the issue has hurt GOP candidate Ken Buck in a close Colorado Senate race. In a special House election earlier this year in Pennsylvania, Democrat Mark Critz used the FAIR tax cudgel on Republican opponent Tim Burns. In a district that John McCain carried in 2008, Mr. Critz beat the Republican by eight points and is using the issue again in their rematch. This is a political reality that FAIR taxers need to face. …[I]n theory a consumption tax like the FAIR tax is preferable to an income tax because it doesn’t punish the savings and investment that drive economic growth. If we were designing a tax code from scratch, the FAIR tax would be one consumption tax option worth debating. But … voters rightly suspect that any new sales tax scheme will merely be piled on the current code.

We won’t know until next Tuesday what is going to happen in Kentucky and Colorado, and we won’t know until then what will happen in the other campaigns where the FAIR tax is an issue. But if there are two tax reform plans that achieve the same objective, why pick the approach that faces greater political obstacles?

FAIR tax proponents presumably could defuse some of the attacks by refocusing their efforts so that repealing the income tax is the top priority. This would not require any heavy lifting since all honest proponents of a national sales tax want to get rid of the 16th Amendment and replace it with something that unambiguously prohibits any direct tax on income. So why not lead with that initiative, and have the national sales tax as a secondary proposal? This is what I propose in the video, and I think it would be much harder for demagogues to imply that a FAIR tax would mean a new tax on top of the corrupt system that already exists.

The IRS’s Tax Rate on Google’s Foreign-Source Income Is 2.4 Percentage Points Too High

There’s been considerable attention to the news that the IRS only managed to grab 2.4 percent of Google’s overseas income. As this Bloomberg article indicates, many statists act as if this is a scandal (including a morally bankrupt quote from a Baruch College professor who thinks a company’s lawful efforts to lower its tax liability is “evil” and akin to robbing citizens).

Google Inc. cut its taxes by $3.1 billion in the last three years using a technique that moves most of its foreign profits through Ireland and the Netherlands to Bermuda. Google’s income shifting – involving strategies known to lawyers as the “Double Irish” and the “Dutch Sandwich” – helped reduce its overseas tax rate to 2.4 percent, the lowest of the top five U.S. technology companies by market capitalization, according to regulatory filings in six countries. …Google, the owner of the world’s most popular search engine, uses a strategy that…takes advantage of Irish tax law to legally shuttle profits into and out of subsidiaries there, largely escaping the country’s 12.5 percent income tax. The earnings wind up in island havens that levy no corporate income taxes at all. Companies that use the Double Irish arrangement avoid taxes at home and abroad as the U.S. government struggles to close a projected $1.4 trillion budget gap and European Union countries face a collective projected deficit of 868 billion euros. …U.S. Representative Dave Camp of Michigan, the ranking Republican on the House Ways and Means Committee, and other politicians say the 35 percent U.S. statutory rate is too high relative to foreign countries. …Google is “flying a banner of doing no evil, and then they’re perpetrating evil under our noses,” said Abraham J. Briloff, a professor emeritus of accounting at Baruch College in New York who has examined Google’s tax disclosures. “Who is it that paid for the underlying concept on which they built these billions of dollars of revenues?” Briloff said. “It was paid for by the United States citizenry.”

Congressman Dave Camp, the ranking Republican (and presumably soon-to-be Chairman) of the House tax-writing committee sort of understands the problem. The article mentions that he wants to investigate whether America’s corportate tax rate is too high. The answer is yes, of course, as explained in this video, but the bigger issue is that the IRS should not be taxing economic activity that occurs outside U.S. borders. This is a matter of sovereignty and good tax policy. From a sovereignty persepective, if income is earned in Ireland, the Irish government should decide how and when that income is taxed. The same is true for income in Bermuda and the Netherlands.

From a tax policy perspective, the right approach is “territorial” taxation, which is the common-sense notion of only taxing activity inside national borders. It’s no coincidence that all pro-growth tax reform plans, such as the flat tax and national sales tax, use this approach. Unfortunately, America is one of the world’s few nations to utilize the opposite approach of “worldwide” taxation, which means that U.S. companies face the competitive disadvantage of having two nations tax the same income. Fortunately, the damaging impact of worldwide taxation is mitigated by a policy known as deferral, which allows multinationals to postpone the second layer of tax.

Perversely, the Obama Administration wants to undermine deferral, thus putting American multinationals at an even greater disadvantage when competing in global markets. As this video explains, that would be a major step in the wrong direction. Instead, policy makers should junk America’s misguided worldwide system and replace it with territorial taxation.

An Australian Lesson about Capital Gains Tax Rates and Revenues

A decade ago, amid much controversy, I persuaded the Australian government to cut the capital gains tax rate in half.

Stephen Kirchner, an economist from Australia’s leading think tank, the Center for Independent Studies, reviewed the results last November.

This a brief summary:

The introduction of capital gains tax discounts for individuals and funds as part of the 1999 Ralph business tax reforms has received a lot of bad press, but much of this commentary is ill-informed… .

Those who called for reform of Australia’s capital gains tax regime 10 years ago argued that the Ralph reforms would likely raise more revenue because of the increased incentive they provided for taxpayers to realise capital gains that would otherwise go untaxed. Supply-side economist Alan Reynolds predicted that the reforms would raise twice as much revenue in the long run. He was right. The capital gains tax share of Commonwealth tax revenue nearly doubled between the introduction of the Ralph reforms and 2006–07. In absolute terms, CGT revenue rose from $4.6 billion in 1998–99 to $17.3 billion in 2006–07. CGT revenue growth has been strongest among individuals, who received the larger discount of 50%, followed by funds, which received a 33% discount. The slowest CGT revenue growth has been from companies, which received no discount.

The data suggest that the Ralph CGT reforms have resulted in more tax revenue through increased realisations of capital gains. They have thus strengthened rather than weakened the ability of the tax system to serve equity objectives. The Ralph reforms demonstrate the basic supply-side insight that lower effective tax rates lead to faster growth in the tax base and tax revenue.

Russia Scraps Capital Gains Tax

The former communists running Russia apparently understand tax policy better than the crowd in charge of U.S. tax policy. Not only does Russia have a 13 percent flat tax, but the government has just announced it will eliminate the capital gains tax (which shouldn’t exist in a pure flat tax anyhow).

Here’s a passage from the BBC report:

Russia will scrap capital gains tax on long-term direct investment from 2011, President Dmitry Medvedev has said. …Mr Medvedev told the St Petersburg International Economic Forum that long-term direct investment was “necessary for modernisation”. …Its oil revenues fund, which has been financing the deficit, is expected to end next year, and the government wants to attract more foreign investment to boost the economy.

Sounds like President Medvedev has watched my video explaining why there should be no capital gains tax. Now we just need to get American politicians to pay attention.

Dan Mitchell Gets Results

I gave a speech in Hungary about two weeks ago and now the government has announced a big step in the direction of better fiscal policy. My role was about as meaningful as the rooster crowing, followed by the sunrise, but this is still good news. According to Reuters, “Hungary’s new government plans to introduce a flat personal income tax of 16 percent from 2011, as well as a 15 percent cut in public sector wages.” Those are the headline initiatives, but the fiscal reform package includes other good policies. Here’s a blurb from The Economist.

After a three-day emergency cabinet meeting over the weekend, Viktor Orban, the prime minister, announced the government’s new economic programme this afternoon. The battered forint quickly jumped almost 2% in response. …The introduction of a 16% flat personal income tax is a daring move, and could have important repercussions beyond balancing the state’s books. Unemployment, or at least that element of it which is declared, is nudging 12%, and one reason is Hungary’s cumbersome bureacracy and heavy tax burden. Now Mr Orban has announced that corporation tax for companies with annual profits of less than 500m forints will be reduced from 19% to 10%. Ten more small and bothersome taxes are set to be abolished altogether.

A few years ago, when several nations each year were adopting the flat tax, I arbitrarily decided that this rock classic would be the theme song of the tax reform movement. Sadly, it doesn’t look like we’ll get to play it in America anytime soon.