Commentary

Taxing Income Once

This article was published in the Washington Times, Feb. 9, 2003.

A recent political cartoon depicted President Bush juggling many balls, from dividend tax relief to allowing more personal choices in education, Medicare and Social Security. But artful juggling is not just clowning around — it can be an act of admirable skill.

Proposing to completely eliminate the second layer of taxes on dividends was a hard act to follow. Yet two almost equally amazing new balls were tossed in the air with the release of the new budget. The administration proposes bold new tax-deferred savings plans that could begin to bring coherence to the confusing hodge-podge of savings plans: IRA, Roth IRA, SEP-IRA, Keogh, 401(k), 403(b), 457, Archer Medical Savings Accounts, Coverdell Educational Savings Accounts, etc.

Any money saved outside of one of these hyper-regulated accounts is taxed in unfair and discouraging ways. Outside the numerous IRA clones, taxes are much higher on income saved than on income spent. Before you can save, you have to earn. And those earnings are subject to income and payroll taxes. If you don’t work too hard, you might be lucky enough to keep 60 cents out of each dollar. If you then rush out and spend it all on fast cars and slow gin, you may have to pay a few cents more on sales tax but that’s the end of it. For each 60 cents you save, on the other hand, you are going to face numerous other taxes, including the infamous double tax on dividends and (unless you can spend it fast enough to make Medicaid pay your nursing home bills) the despicable death tax.

Ending the double tax on dividends is one partial solution. The newly proposed savings accounts are another. The administration offers two plans — one for retirement (Employer Retirement Savings Accounts, ERSA) and the other for anything your heart desires, including security (Lifetime Savings Accounts, LSA). Consolidation is one obvious benefit. Other retirement plans can be converted into ERSAs, and contributions to IRAs would stop. Medical and educational plans can be converted into LSAs.

Both plans are similar to a Roth IRA in the sense there is no deduction for after-tax income that you plunk into savings, but also no second tax whenever you want or need to dip into those savings (except penalties for tapping retirement accounts before age 58).

There are two ways a tax system can be neutral between savings and consumption — neither favoring frugality nor subsidizing profligacy. One is to allow a deduction for the amount saved, like the $3,000 annual deduction for a traditional IRA, and then to levy income tax when the money is later taken out to cover the costs of retirement, housing, college, etc. The other is to collect income tax upfront, but then let after-tax dollars accumulate interest, dividends and capital gains without any further taxation. In both cases, income is taxed only once. Income is either taxed before you save it, as with a Roth IRA, or it is taxed after you take it out, as with a traditional IRA.

Economists often call this a “consumption tax,” but that is misleading. All taxes are paid by people, as suppliers of labor or savings, and nearly all income is eventually used to pay for consumption. A tax system that treats saved income the same as spent income is still an income tax; it just defines income in a sensible way.

As a matter of fairness and economic efficiency, every dollar of everyone’s savings should be treated either the way we treat traditional or Roth IRAs. But politics has until now kept contributions tiny and sometimes limited the plans to those too poor to make use of them. The president’s plan limits the amount you can save in tax-deferred fashion to $7,500 a year for retirement and another $7,500 for pre-retirement savings. Those are generous amounts for young couples, but not later in life.

What is marvelously unique is that this plan does not say that if you earn “too much” you cannot participate. Since the nation would clearly benefit from extra savings being available to finance extra investment, it never made sense to exclude those with enough money to save.

Although there is no tax deduction for contributions to these plans, critics nonetheless claim the budget would suffer because people would otherwise save just as much and therefore pay punitive double taxes on that savings. On the contrary, because these plans would surely leave the economy with much more capital, financing more and better plants and equipment, the future economy and therefore the tax base would end up much larger.

According to Rep. Charles Rangel of New York, “The best way to improve national savings is to lower the deficit.” That is a statement of faith [in government], not fact. From 1984 to 2000, as the U.S. budget moved from a huge deficit to an equally huge surplus, private savings fell from 21 percent of gross domestic product to 13.5 percent, leaving the overall national savings rate smaller rather than larger.

Fixing the government’s budget at the expense of the budgets of private households and firms is never the way to fix the economy. No economy ever taxed itself into prosperity. And despite all the myopic fascination with trying to “stimulate consumer demand” — i.e., putting more on the credit card — more fairness to frugality could do a lot more good.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.