In recent months a political consensus has begun to emerge that the current income tax system is in need of radical surgery. There are two points of general bipartisan agreement on the defects of the U.S. tax code. First, the U.S. tax system reduces economic growth through punitive tax rates on savings and investment. Second, the needless complexity of the tax code imposes large costs on American businesses and workers.
But there is also a third source of large-scale public dissatisfaction with the income tax that has so far escaped much of the policy debate over tax reform in Washington. That defect is the tremendous and growing intrusiveness of the income tax system. Increasing numbers of Americans object not just to the level of taxation, but the invasive and intimidating manner in which taxes are collected today.
Several tax reform proposals have been introduced in Congress to repair the income tax. These include most prominently the Dick Armey flat tax plan and the Domenici-Nunn consumed income tax. A third proposal that is gaining political momentum is the national sales tax as a complete replacement of the income tax. House Ways and Means Committee chairman Bill Archer will soon introduce a national sales tax bill, as will Reps. Dan Schaefer and Billy Tauzin. Mr. Archer says that he wants to "pull up the income tax system by its very roots."
This paper examines these three leading proposals in the context of the three defects of the income tax: 1) reduces economic growth; 2) complexity; and 3) intrusiveness. The paper also adds a fourth important criterion for assessing these tax plans: tax visibility. In the context of these four criteria, the Domenici-Nunn proposal is good; the Armey flat tax is better; the Archer plan is best. This paper will first enumerate the major defects of the current tax system; second, explain why the Archer plan is superior; and finally outline the features of a well-constructed national sales tax.
The Economic Deficiencies of the Income Tax
Today the typical American household pays more than $16,000 in federal taxes.(1) This constitutes roughly 40 percent of family household income and is roughly twice in inflation adjusted dollars the level of taxes imposed in the 1960s.(2) Taxes clearly impose a heavy burden on American workers and businesses.
Although most attention seems focused on the issue of the burden of taxes, American workers and businesses are increasingly disadvantaged by the economically destructive way that the federal government imposes taxes. One problem with the current tax code is the disincentive effects of high marginal tax rates.
The highest marginal income tax rate at the federal level today is 42 percent. When state taxes are included in the calculation, many individuals face a more than 50 percent marginal tax rate. Studies show that these lofty income tax rates apply in large part to small business owners.(3) Paradoxically, punitive tax rates are designed to soak the rich, but lower tax rates generally lead to higher tax contributions by the wealthy. For example, after the Kennedy tax cuts in 1963 which lowered the top income tax rate from 90 to 70 percent, reported taxable income by the richest Americans rose by 40 percent.(4) Similarly, in the 1980s, after Reagan cut income tax rates, the share of income taxes paid by the wealthiest 1 percent of Americans rose from 18 percent in 1981 to 25 percent by 1990.(5) But since the 1990 tax rate increases, the share of taxes paid by the rich has fallen slightly. The federal government is estimated by the Joint Economic Committee of Congress to have lost about $50 billion in tax revenues from 1987 through 1991 because of the raising of the capital gains tax rate from 20 to 28 percent.(6)
The working elderly are particularly victimized by our punitive income tax rate structure. Senior citizens in the work force face high marginal income tax rates, special earnings penalties, and just-enacted higher taxes on Social Security benefits. The National Center for Policy Analysis calculates that some working elderly face marginal tax rates of up to 80 percent.(7)
Even middle-income workers face high marginal tax rates today. Most middle-income earners are in a 28 percent federal tax bracket, a 15 percent payroll tax bracket, and a 5 percent state/local income tax bracket. This means that the tax collector snatches 48 cents of every additional dollar a middle- income worker earns today.
These high marginal tax rates reduce economic output and national savings? A study by economist Robert Genetski shows that high marginal tax rates are inversely related to productivity growth.(8) Productivity and thus wages tend to rise when marginal income tax rates are low, but productivity falls or grows more slowly when marginal income tax rates are high--as they are today.
High tax rates discourage capital formation. The United States imposes some of the highest tax rates on capital of any developed nation. For example, the federal government's 28 percent long term capital gains tax rate is unindexed for inflation. This is among the highest in the world; it compares with a 20 percent rate in Germany; a 16 percent rate in France; and a 0 percent rate in Japan.(9)
The 1993 tax increase was especially inimical to capital investment in the U.S. The National Center for Policy Analysis concludes that because of the new Clinton income taxes, the new marginal tax rate on capital in the U.S. will be 58.5 percent. Investment is expected to decline by a staggering $1.8 trillion below what it would otherwise be between 1994 and 1998.
The income tax system also retards long term economic growth by double taxing savings and investment, via capital gains, corporate income, and other such taxes on capital formation. The result has been an alarming reduction in the American savings rate. The U.S. savings rate is now about one-third what it was in the 1950s. Today the savings rate in the United States is one half that of Europe and one-third that of Japan. A survey of twelve developed countries recently placed the U.S. last in savings.(10) This is a prescription for very slow long run economic growth.
Economists have attempted to estimate the lost output that results from the growth disincentives in our current tax code. Harvard economist Dale Jorgenson suggests the efficiency loss could be more than $200 billion per year.(11) In other words, Dr. Jorgenson finds that with a more economically efficient tax system, the federal government could collect roughly the same amount of tax revenues, and raise economic output by about $2,000 per household. Complexity of the Tax Code
The income tax also imposes costs on the economy through its unnecessary complexity. It is worth noting that the original 1913 income tax was a two-page form, with a two page instruction sheet and included just 15 pages of tax law. The top tax rate was 6 percent (with some legislators complaining that it would soon reach the unthinkable level of 10 percent.) Less than one percent of Americans even needed to fill out an income tax return.(12)
Today, virtually all workers must file a tax return. There are now over 9,000 pages of tax law. Despite past efforts at tax "simplification," most Americans do not view the tax code as simple or easy. About two-thirds of the tax returns using professional tax preparers in 1992 were filed by Americans with incomes below $50,000. Money magazine discovered in 1991 that 70 percent of the members of Congress on the two major tax writing committees--House Ways and Means and Senate Finance--used professional tax preparers to figure out their taxes.(13) All told, Americans spend about $30 billion a year for the services of tax accountants and lawyers.(14)
A 1992 study by political scientist James L. Payne estimated that Americans spend roughly 5.4 billion man-hours computing their taxes.(15) This is more man-hours than used to build every car, van, truck, and airplane manufactured in the United States. It is more than the total number of hours worked in a year by every resident of the state of Indiana. The deadweight economic loss is estimated by Dr. Payne at well over $200 billion.
These figures do not consider the complications added to the tax code by the Clinton tax bill enacted into law in 1993. The Clinton tax hike not only raised marginal tax rates, it has set in motion an unraveling of the Tax Reform Act of 1986, which had been a small step in making taxes simpler.
Clearly, the well-intended 1986 TRA to simplify the code has failed. Judged on simplicity grounds, the U.S. tax system receives failing grades.
The intrusiveness of the income tax is not a subject widely studied by economists. The reason is clear: intrusiveness is more of an issue of civil liberties rather than economics. But for economists to reject the significance of the growing civil liberties complaints about the Internal Revenue Service, is to ignore perhaps the major issue that is driving the populist clamor for tax reform.(16) It is quite possible that any plan that fails to address the issue of the overly-intrusive nature of the income tax will fail politically.
The Internal Revenue Service now has 115,000 auditors and agents. To put the size of this police force in perspective, the IRS has roughly the same number of employees as all other federal regulatory agencies. That is, the IRS has more enforcement personnel than the EPA, BATF, OSHA, FDA, and DEA combined. Today, without a search warrant, the IRS has the right to search the property and financial documents of American citizens. Without a trial, the IRS has the right to seize property from Americans--and it does so routinely. Last year, Congress added 5,000 IRS agents even as it was forced to acknowledge that hundreds of auditors were illegally scouring through the returns of American citizens.
With the IRS, privacy rights are relegated to secondary status behind compliance enforcement. Fred Goldberg, former commissioner of the IRS during the Bush administration, recently wrote that "the IRS has become a symbol of the most intrusive, oppressive, and nondemocratic institution in our democratic society."
This paper is not meant to prove the case that the IRS is overly intrusive. That case has been made in several exhaustive studies and books in recent years.(17) The Cato Institute just recently published a study entitled "Why You Can't Trust the IRS," which lays out the civil liberties case against the IRS in a concise fashion. Assessing the Leading Reform Proposals
To these three defects of the current income tax system, a fourth must be added: visibility. A sound tax system is one that is highly visible to the taxpaying public. Hidden taxes are undesirable, because they disguise the true cost of government to the voters.
There are now three major tax overhaul bills before Congress. The first is the Nunn-Domenici plan. Simply stated, the Nunn-Domenici proposal would transform the income tax code into a "consumed income tax." The consumed income tax works very much like the current progressive income tax system, but it allows the tax filer to deduct all savings from taxes. On the business side, the Nunn-Domenici plan would replace the corporate income tax with a value added tax, or VAT. This would allow businesses to deduct all capital investment from taxation.
How does Nunn-Domenici fare on our four criteria for judging tax proposals? By ending double taxation of savings by individuals and investment by businesses, Domenici-Nunn is a substantial improvement on economic efficiency grounds over the current tax system. However, because Domenici-Nunn retains the progressive rate structure of the current code, it leaves unsolved the problem of high marginal tax rates on consumption. Since the purpose of earning income is to eventually consume it, high tax rates on consumption will discourage work and investment.
On each of the last three reform criteria Domenici-Nunn rates poorly. It does not simplify the tax code. It does not make it less intrusive. Finally, Domenici-Nunn may actually make taxes less visible to the voter. The value added tax is an invisible tax. In Europe the evidence is very persuasive that the VAT has been an engine of government growth.(18) Although the switch to a consumed income tax on the personal income tax side, would be an improvement, on the business side a VAT is no improvement over the current corporate income tax.
The Dick Armey flat tax proposal is modeled after the Hall- Rabushka plan first developed more than ten years ago.(19) It would eliminate all deductions, credits, and loopholes; end the withholding tax; end the double taxation of savings; and institute a 20 percent flat rate tax. All income would be taxed once and only once at the 20 percent rate. The real selling point of the Armey plan is the postcard return. Americans currently spend about 20 hours figuring out their taxes each year. Under the Armey plan this would be reduced to 20 minutes. How does the Armey plan fare on our four criteria? Like Domenici-Nunn, it ends the double taxation of savings and investment. It scores better than Domenici-Nunn on this measure because the low marginal tax rates in the Armey plan also promote work.
The post-card feature of the Armey plan makes it much simpler than the current system. It passes the simplicity test with flying colors.
Because the flat tax is still an income tax, however, it does not make our tax system less intrusive. The IRS would still need to investigate the private pecuniary financial transactions of all Americans. Indeed, if withholding taxes were abolished (an idea I support), the IRS's enforcement budget and staff would probably have to be increased substantially to ensure compliance.
The Armey tax would make taxes more visible than the current system--especially because it would end withholding. The Armey plan would require the taxpayer to write a check each month to the IRS. On the other hand, the Armey plan retains the corporate income tax, which is one of the more invisible taxes.
The final plan to examine is the national sales tax proposal. This is the only plan that fixes every one of the defects of the current income tax system. Here is how:
1) Because the sales tax exempts all savings and investment, the double taxation problem would be eliminated. Because the sales tax is a single flat rate, the disincentive effects from high marginal rates would be eliminated. 2) The sales tax eliminates the income tax entirely. Compliance costs would be substantially reduced.
3) The sales tax would virtually eliminate the Internal Revenue Service. The sales tax is the only plan that solves the invasive nature of the current system.
4) A sales tax would be paid by consumers every time they purchased a good or service at the cash register. The tax would appear on the receipt. Hence, the sales tax is one of the most visible taxes.
The grid below summarizes how each of the three major tax reform proposals fares on each of the four criteria discussed above. The current system fails on each of the criteria; the sales tax is the only plan that succeeds on each criteria.
|RATING THE LEADING TAX REFORM PROPOSALS|
Economic Impact of a National Sales Tax
In 1993 the Cato Institute commissioned a study by economist Lawrence Kotlikoff of Boston University to examine the economic impact of replacing federal income taxes with a national sales tax.(20) The sales would apply to all consumption purchases-- including services. Only real estate and securities would be exempted. The purpose of the Kotlikoff study was to determine a) What would be the impact of the sales tax on economic variables such as savings, wages, and output? and b) What is the necessary sales tax rate to completely replace on a revenue neutral basis the federal personal income, corporate income, and estate tax?
Kotlikoff discovered that to completely replace federal income taxes would require an initial sales tax rate of 17.4 percent. After five years the rate could be reduced to 15.4 percent, and after ten years the rate could be lowered to 13.9 percent. The reason the rate can be lowered is that the study finds a very positive economic feedback from the tax change. Specifically, the Kotlikoff study finds that after ten years, a national sales tax would:
1) More than double the national savings rate.
2) Increase the capital stock by 8 percent above the level attained under the current tax system.
3) Raise income and output by 6 percent more than would be achieved under the current tax system. That would increase national output by almost $400 billion per year.
4) Lift the real wage rate by 3 percent.
5) Reduce interest rates by 8 percent.
Kotlikoff concludes the study by issuing the following endorsement for a sales tax: "A shift to a national sales tax has the potential for dramatically improving incentives to save. The distortion to save is so great under our current system of income taxation, that it appears we could switch to consumption taxation...and end up with much higher rates of saving and capital accumulation and a higher level of per capita income."
The Features of a National Sales Tax
A national sales tax has the virtue of being simple, non- intrusive, visible, flat and economically efficient. But there are potential political problems with a national sales tax as well. One of these is that a sales tax is said to be regressive. Another is that a sales tax of more than 15 percent is said to encourage large scale evasion. And a third potential problem is that the sales tax may not be a replacement, but rather an add-on to the current income tax.
First, the regressivity issue can be overcome easily. If we were to provide a rebate on a generous portion of the tax that every American pays, then the regressivity disappears. I advocate that every individual receive a rebate on the tax paid on the first $5,000 of purchases he makes during the year. This would mean that a family of four would pay no tax on its first $20,000 of purchases each year. There are various ways of providing this rebate. Assuming that the sales tax were set at 18 percent, a family of four would be entitled to a rebate of $3,600 ($20,000 x 18 percent) for the year. The government could send a quarterly rebate check of $900 to every family of four; a $450 check to every family of two; and so on.
Another possibility would be to provide every family with an annual "smart card" that would have a sales tax credit based on family size. A married couple with no kids would receive a $10,000 credit on its card. Each time the couple made a purchase, the smart card would deduct that amount until the card's $10,000 credit was used up. After the first $10,000 of purchases, the family would begin to pay the sales tax.
Regardless of how the rebate is offered, the main point is that a sales tax need not be regressive.
What about the problem of evasion without a massive federal revenue collection police force? First, one virtue of the national sales tax is that 45 states already have a sales tax. Hence, states could be made responsible for collecting the tax and most of the IRS could be dismantled. A small IRS enforcement force Could be retained for the purpose of ensuring that states were collecting the tax. A national sales tax of 18 percent, when added to the existing states sales taxes, would bring the total sales tax to between 20 and 25 percent.
Critics are right when they argue that a sales tax this high would encourage evasion. But evasion is already a large-scale problem with the income tax. An estimated $150 billion of income tax goes uncollected each year--according to the IRS's own
calculations. Moreover, states report that the their sales taxes are generally easier to collect than their income taxes.
Moreover, the sales tax may not stay at 18 percent for long. According to the Kotlikoff study, when accounting for the dynamic economic feedback effects of the sales tax, after about ten years of the switch to a consumption tax, the sales tax rate could be lowered by 2 to 3 percentage points because of higher wages and output. Hence, the rate would then be closer to 15 percent. More importantly, because of the high visibility of the sales tax, I believe there would be a very positive public choice dynamic to this tax system. Americans would begin to demand less government, because taxpayers could receive an immediate dividend from reductions in spending--via a reduction in the sales tax rate. Politicians could ask the voters: which would you rather have, a Department of Energy or a one percentage point reduction in the national sales tax?
Finally, there is the very real concern voiced by many conservatives that a danger of the sales tax idea is that America will end up with both a sales tax and an income tax. This has been the experience with the consumption tax VATs in Europe. For this reason, some critics argue that the sales tax is only acceptable if the 16th Amendment to the Constitution authorizing a federal income tax were repealed. That would certainly be desirable, but is not necessary. First, a condition of approval for the sales tax would be outright repeal of all federal income taxes. To prevent the income tax from returning, a supermajority requirement to raise taxes would seem to be ample protection against efforts to reintroduce the income tax.
Broad-based tax reform seems almost a political certainty over the next two years. The debate is being driven by concerns about the failure of the current tax system with respect to economic growth, simplicity, and intrusiveness. This paper argues that only the national sales tax redresses each of these problems.
For tax reform to succeed, the reform proposal needs to be economically sensible and politically salable to the public. Economists and business lobbyists must recognize that tax reform will be driven not so much by the tax code's economic failings, as much as its civil liberties failings. The political appeal to the Armey flat tax is the post card. The political appeal to the national sales tax is that it would no longer be the government's business how much money a person makes.
The populist appeal of the flat tax or the sales tax is clearly what is energizing the politics of the tax reform debate. The fix on the capital formation side is likely to occur only in the context of a plan that the public views as simpler and fairer.(21) For this reason, I believe that many of the reform ideas now in the mix will soon fall out of the picture and the national debate will begin to revolve around just two proposals: the flat tax and the national sales tax. My preference is the sales tax, but either of these would be vast improvements over the current system.
(1) "Government: America's Number 1 Growth Industry," Institute for Policy Innovation, Lewisville, TX, 1995.
(2) Data from Tax Foundation, Washington, D.C., 1995.
(3) Gary Robbins and Aldona Robbins, "Tax Fairness: Myth and
Reality," National Center for Policy Analysis, Dallas, Texas, 1991; and Gary Robbins and Aldona Robbins, "Capital, Taxes, and Growth," National Center for Policy Analysis, Dallas, Texas, 1992.
(4) Lawrence Lindsey, The Growth Experiment, (New York: Basic Books, 1990), pp. 15-27.
(5) Stephen Moore, "Weighing Reaganomics," San Diego Union, Nov. 10, 1991, p. C-1, C-4; and Lawrence Lindsey, The Growth Experiment, pp. 82-104.
(6) "Capital Punishment: How High Capital Gains Tax Rates Are Harming the Economy," Joint Economic Committee, 1993.
(7) Robbins and Robbins, 1992.
(8) Robert Genetski, Taking the Voo Doo Out of Economics, Chicago, Regnery, 1986).
(9) American Council for Capital Formation, 1991.
(10) Data compiled by Merrill Lynch, 1995.
(11) Dale Jorgenson, "Constructing an Agenda for U.S. Tax Reform," Testimony before the Ways and Means Committee, U.S. House of Representatives, December 18, 1991.
(12) Peter Meyer, "A Short History of Form 1040," Harpers, April, 1977, p. 22.
(13) Cited in: Dan Pilla, How to Fire the IRS, 1994.
(15) James L. Payne, Costly Returns: The Burden of the U.S. Tax System, (Institute for Contemporary Studies, 1991), p. 21.
(16) Stephen Moore, Ax the Tax," National Review, April 17, 1995, pp. 38-43.
(17) David Burnham, A Law Unto Itself: Power, Politics and the IRS, 1990; and Charles Adams, For Good and Evil, (University of America Press, 1992).
(18) Grover Norquist, "Why the VAT is Bad," Americans for Tax Reform, 1994.
(19) For a summary of the Armey plan, see: Dick Armey, "The Freedom and Fairness Restoration Act," 1994.
(20) Laurence J. Kotlikoff, "The Economic Impact of Replacing the Federal Income Tax with a National Sales Tax," Cato Institute Policy Analysis, April 15, 1993.
(21) Wall Street Journal, "Take Fairness Head-On," April 14, 1995, editorial page.