Cato Online Forum

Growth and Taxes

By Peter Howitt
December 2014

For generations, economists have tried in vain to find the magic bullet that enables economic growth. Perhaps someone will find it someday. Personally I doubt that it exists. In my reading of the evidence, growth results from a complex combination of factors, some of which can be identified by cross-country studies and by careful use of rich micro-data,1 but none of which can be said to hold the secret to economic growth.

One important factor is taxation.2 A low tax rate, applied uniformly across all sectors and all participants, promotes high rates of capital accumulation and efficient resource allocation, both of which are important background conditions for innovation and technological progress. In the particular case of the U.S. economy in 2014, one of the main impediments to economic growth is our complex and illogical income tax code. Both personal and corporate taxation currently work to distort capital allocation decisions and waste creative talent on compliance and avoidance.

Growth would be strengthened if we were to scrap all income taxes and replace them with a wealth tax and a consumption tax. For example, a 1 percent annual tax on net worth combined with a 10 percent tax on all consumption expenditures would have raised $1.47 trillion in tax revenues in 2011, which is $200 billion more than the combined revenue of the corporate and personal income taxes that year, and would have created far less distortion and wasted far less talent.

Consider first the personal income tax. Housing income in the U.S. represents about one quarter of total national income. Yet little of it is taxed, because most of it is the implicit income that people receive on owner occupied housing. Removing the deductibility of mortgage income would reduce but not remove the distortion created by the non-taxation of implicit housing income. It would eliminate the subsidy of those who debt-finance their housing ownership by those who pay cash. But it would not alter the fact that the non-taxation of housing income distorts the allocation of national investment, away from the physical capital and innovation that generate taxable returns and towards residential construction that generates a tax-free return.

If a wealth tax were in place, then a person considering whether to invest in housing or the stock market would pay the same taxes in either event, and the decision would be made on the basis of anticipated benefits, not tax considerations. Likewise, we would no longer be encouraging leverage on the part of homeowners; the homeowner who borrowed instead of selling stocks to acquire a house of a given price would end up with the same wealth. Of course this would require us to define wealth in terms of net worth — assets minus liabilities.

Another distortion in the personal income tax code arises from the favorable treatment given to capital gains and qualified dividends. Personal investment decisions are distorted by this treatment because it is not accorded to interest income. As a result, personal portfolios are tilted towards the acquisition of risky equity and against bonds, again for no good economic reason. Moreover, there is an incentive for people to avoid taxation by declaring that their income takes the form of capital gains, as in the case of private equity and hedge fund managers.

Under a wealth tax there would be no advantage to investing in assets whose yield took one form or another, or to having one’s income declared to be of one form or another. Taxes would depend on accumulated wealth, no matter how the accumulation took place.

On the corporate side, the tax code is riddled with special provisions that reflect special interest lobbying, with the result that corporate capital gets allocated at least to some extent on the basis of private loopholes rather than social economic benefits. The extent of loopholes is evident in the fact that the US has one of the highest nominal corporate tax rates in the developed world, and yet the actual ex post rate of taxation is near the average across countries. Some corporations avoid taxes entirely.

Companies that can’t take advantage of loopholes can engage in strategic transfer pricing, or in tax inversion. Strategic transfer pricing is an accounting practice that arranges for profits to accrue in a company’s subsidiaries located in low-tax countries. Tax inversion takes place when the company is bought out by another company in a low-tax country, thereby escaping the higher US corporate taxes.

To the extent that these international maneuvers are merely accounting practices that do not affect the fundamental production, employment and investment behavior of the company, they may appear to be relatively benign. But they are not. The taxes that the company avoids must be paid by some other entity, whose effective tax rates are therefore higher than they would otherwise be. And any increase in effective tax rates has some distortionary effect.

Under a wealth tax, the fundamental economic behavior of businesses would not be affected by loopholes or international maneuvers. Investments would be made in such a way as to maximize the investors’ wealth, in whatever form. Capital in favored industries would be taxed at the same rate as capital in any other industry. Likewise, the US owners of a corporation that located its profit in some other jurisdiction would still pay the same taxes unless the location decision affected the value of their holdings.

Shifting to a wealth tax would not only end these distortions in the tax code; it would also greatly reduce the tax compliance cost paid by U.S. companies and individuals. Some have estimated these costs to be as large as 400 billion dollars per year,3 and as the tax code gets more complicated the burden increases. With a wealth tax, individuals would no longer need to hire clever accountants and financial advisors to minimize the tax consequences of their portfolio allocation decisions, because there would be no such consequences except for those that flow from the effects on the individual’s net worth. Meanwhile those clever people would be induced to redirect their talents towards innovations that benefit society instead of innovations that shift the tax burden to someone else.

Of course it would still take some accounting expertise to calculate an individual’s net worth, but that can be done without specialized knowledge of a tax code too complicated for non-accountants to master. Assessment of capital assets without a liquid market and an observable market price might be difficult but in the case of real estate investments this is already what property tax assessors do. And consumption taxes could be collected the same way that state sales taxes are already collected, at the point of sale.

Likewise, with no tax considerations to worry about, U.S. corporations could forget about paying experts to arrange complicated deals that exist simply to exploit the tax code, or even to tailor deals in such a way as to minimize the resulting tax burden. For the only way to reduce one’s tax burden under a wealth tax would be to reduce one’s net worth, which few would opt to do.

One possible objection to a wealth tax is that it would discourage saving. But it would not necessarily discourage saving any more than would a uniform income tax applied to all kinds of income, including the income to capital. What matters to an saver is the after-tax rate of return. If the before tax rate of return is, for example, 5 percent per annum, then the after-tax rate under a 1 percnet wealth tax would be the same as under a uniform 20 percent income tax. If the before-tax rate were 10 percent per annum then the after-tax rate would be the same as under a uniform 10 percenti income tax. In any event, there is considerable debate within the economics profession over the question of whether saving is even responsive at all to after-tax rates of return.

Another common objection to a wealth tax is the claim that it would be time-inconsistent — i.e., that the government would promise a low tax rate so as to encourage people to accumulate wealth but then impose a high rate once people had made irreversible accumulation decisions. To this objection I say that time-inconsistency in fiscal policy is an overrated issue. Fiscal changes are too slow moving and the political process too uncoordinated for anything resembling a coherent strategic entrapment effort by the U.S. government to be a serious threat.

Another possible objection is that of liquidity. What if wealth were in the form of the family farm that would have to be liquidated in order for the owner to pay the 1 percent tax? I would give taxpayers the option of declaring the asset to be illiquid and allowing the government to accept either a 1 percent equity claim on any future disposition of the asset or a collateralized debt, at some fair interest rate, with face value equal to 1 percent of the value of the asset, in lieu of current tax payment on the asset.

Finally, the combination of wealth and consumption tax would provide a fair degree of progressivity to the tax scheme. Given that the median US household in 2011 had net wealth of less than $70,000, most of the burden of the wealth tax would be paid by the top 50 percent of wealth owners. And given that wealth is more unevenly distributed than income, taxes as a percentage of income would end to rise as income rose above the median. For those far below the median, it might seem unfair to impose a 10 percent consumption tax, but in that case I would advocate a negative tax for those with little or no income, provided they also have little or no wealth. The burden would be on the household to demonstrate absence of income and wealth.

Lobbying by special interests is the ultimate source of our dysfunctional income tax system. Perhaps lobbyists would eventually find a way to distort the simple wealth/consumption tax alternative that I am proposing. But it would take time. Meanwhile the alternative would go as far as any other single measure I can think of to revive economic growth in the United States.

1 For more details, see Philippe Aghion and Peter Howitt, The Economics of Growth, MIT Press, 2009.
2 Narayana Kocherlakota and Kei-Mu Yi, “Is there Endogenous Long-Run Growth? Evidence from the United States and the United KingdomJournal of Money, Credit, and Banking 29 (May, 1997): 235-62.
3 Jason Fichtner and Jacob Feldman, “The Hidden Costs of Tax Compliance,” Mercatus Center, George Mason University, 2013.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

Peter Howitt is the Professor of Economics Emeritus and Lyn Crost Professor of Social Sciences Emeritus at Brown University.