ur nation’s tax system is badly broken. No one quarrels with that. The income tax law inflicts numerous substantial distortions on our economy. The only area of the economy where the tax system creates jobs is in tax return preparation and software, tax planning, tax controversies and tax compliance. Astounding income tax complexities confront taxpayers at every income level. They sow confusion and create the perception that those who can afford advisers escape paying their fair share of taxes. All of this, in turn, erodes the goodwill and honesty crucial to the system’s functioning, making it ever more vulnerable to deliberate noncompliance.
In a recent report, National Taxpayer Advocate Nina Olson estimated that individuals and businesses spend 6.1 billion hours per year on tax compliance—the equivalent of full-time work for more than three million people. I am surprised the number is that small. The Form 1040 instruction booklet spans more than a hundred pages, and the form itself has more than ten schedules and twenty worksheets. No wonder more than 60 percent of income-tax filers hire tax preparers and so many of the rest rely on computer programs for instruction. The tax profession is not inventing new drugs or medical devices, streamlining manufacturing or creating useful new products. It is, strictly speaking, a transactional cost that, along with externalities such as pollution, should be subtracted from productive activity to arrive at a net national product. These enormous transactional costs are not, to borrow President Obama’s phrase, helping this nation to “win the future.” Even low- and moderate-income Americans waste enormous amounts of time and dollars complying with the income tax—time that could be much better spent with one’s family, dollars that might pay for rent, utilities, gasoline or groceries.
Few Americans today realize it, but it wasn’t until World War II that the Federal government expanded the income tax beyond wealthy individuals to tax nearly all Americans with average income. Seventy years later, this system is unable to secure adequate revenues for the future without threatening economic growth. Moreover, relying as heavily as we do on income-tax revenues to fund government has become a particularly acute liability in the current international marketplace. In a world now immeasurably more interdependent than the mid-20th century, when our current system of taxation took shape, any reform proposal must answer a vital question: Will it make American workers and businesses more competitive in the global economy while maintaining the progressive structure that fits with our nation’s historical insistence on fairness?
To meet its funding requirements, a government has four basic choices as to what it can tax: income, wages, wealth or consumption. From these four basic categories, the United States since World War II has chosen two—income and wages—as its primary forms of government funding. While it is true that the Federal government has at one time or another imposed more than fifty kinds of taxes on everything from filled cheese to cotton futures, telegraph messages and the manufacture of tires, none of these revenue streams would ever be able to fund today’s government budget. Our individual and corporate income taxes, along with our payroll tax on wages, together account for more than 90 percent of Federal revenues annually. State and local governments rely on their own versions of these taxes in addition to taxes on sales and property. And while the Federal government imposes a handful of excise taxes (on alcohol, tobacco and gasoline, for example) and imposes an estate, or wealth, tax on inheritances from the very affluent, it does not, unlike most of the world, have a national tax on the fourth category, consumption.
verall, the United States is a relatively low-tax country, but not with respect to income taxes. Looking at total Federal, state and local taxes as a percentage of total economic output, the United States, at about 25 percent, has considerably lower taxes than the European Union, which averaged about 40 percent before the recent addition of ten new members with lower taxes, mostly from Eastern Europe. Our taxes are also lower than the approximate average (36 percent of GDP) of the thirty countries of the Organization for Economic Cooperation and Development (OECD). Our income-tax level is comparable, however. We typically collect about 12 percent of GDP in corporate and individual income taxes, while the OECD nations average about 13 percent. The biggest difference is that most other nations rely much more heavily on consumption taxes than we do: 11 percent of GDP in the OECD compared to about 5 percent in the United States. Indeed, we are the only OECD nation that does not impose a national level tax on sales of goods and services.
Although an income tax helped finance the Civil War, it did not become a permanent fixture until World War I. The corporate income tax dates back to 1909, but not until the 16th Amendment was ratified in 1913 did Congress successfully enact a tax on individual incomes. From the end of the Civil War until 1913, the Federal government raised its revenue almost exclusively from tariffs on imported goods and assorted excise taxes. By the beginning of the 20th century, however, there was great dissatisfaction with this system. Tariffs and excise taxes raised the costs of goods for everyone, while large fortunes accumulating in real estate, corporate stock and other investments were left untaxed. The extraordinary public support necessary to amend the Constitution and impose an income tax arose to fund a reduction in tariffs and to balance the effect of taxes on consumption with a tax more closely linked to people’s ability to pay.
At first, the income tax was expected to contribute only a small portion of ordinary government revenues and to supplement other revenue sources in times of emergency. It was not originally supposed to play the central role in financing the Federal government that it does today. Until World War II the tax code had exemptions that shielded most Americans from having to pay. The income tax played a crucial role in financing World War I, but at war’s end the tax was rolled back to its original limited scope. From 1918–32, only 5.6 percent of the population filed taxable income returns, and from 1933–39, that number dropped to an average of 3.7 percent. Public opinion polls in 1938–39 showed large majorities of Americans favored an exemption level that would exclude at least 75 percent of the population from income taxes. Thus even after the economic shocks of the Great Depression and the creation and expansion of the New Deal the reach of the income tax remained very limited. True to its original conception, it was a low-rate tax on a relatively small group of higher-income Americans—until World War II.
Legislation in 1940–41 increased the number of Americans subject to the income tax by 400 percent, from 7.4 million to 27.6 million. After the United States entered the war, the number of income tax payers expanded dramatically. By 1943, taking into account both the regular income tax and a so-called “Victory Tax” (a 5 percent tax on incomes over $624) fifty million Americans, or nearly 70 percent of the population, were required to file tax returns. Our nation’s basic tax structure came into place, then, in the World War II era, when the United States essentially had all the money there was and even a horrid tax system with income tax rates up to 91 percent could not stall economic progress. From 1946–73, when OPEC quadrupled the price of oil, the economy grew by an average of 3.8 percent per year, and unemployment averaged 4.5 percent. Since 1973, the economy has grown more slowly, and middle-class wages have stagnated. The U.S. economy must now compete with other countries for the investment capital essential for economic growth and a rising standard of living: not only Europe and Japan, but also Brazil, Russia, China and India.
Domestically, the imposition of the income tax on nearly the entire population has been problematic in its complexity and has also badly distorted presidential and congressional policymaking. One reason the current individual income tax is such a mess is that our elected officials ask it to do too much. Presidents and members of Congress from both political parties have come to believe that an income tax credit or deduction is the best prescription for virtually every economic and social problem. In effect we have made the Internal Revenue Service the administrator of many of the nation’s most important spending programs.
To keep track of all these tax benefits, the Federal budget each year is required to enumerate tax “expenditures”, defined as all tax credits, deductions or exclusions that deviate from a normal income tax. Many tax benefits are equivalent substitutes for government spending. According to a February 2011 report of the Staff of the Joint Committee on Taxation, these tax expenditures have grown enormously since 1986, from 128 to 202. The staff also points out the ratchet effect that generally accompanies these tax benefit expenditures: No matter how ineffective or damaging, once enacted, tax expenditures “tend to stay in place.” Their total cost in lost revenues is estimated to exceed $1 trillion per year.1
Tax expenditures extend beyond narrow special-interest tax loopholes, encompassing tax breaks widely available to broad segments of the general public. This explains the popularity of the largest tax expenditures, such as tax advantages for employees’ health insurance payments and retirement savings; deductions for home mortgage interest; state and local taxes and charitable contributions; and low or zero rates for taxes on capital gains.
The folly of trying to solve the nation’s problems through targeted tax breaks is plain to see. Take health insurance, for example. Our nation, unlike most, has long relied on a tax benefit for employers and employees as its main mechanism for covering Americans who are neither poor, disabled nor elderly. This helps explain why health-care costs in the United States are the highest in the world, and about fifty million Americans are uninsured. These costs also make American businesses and products less competitive in the world economy and erode wage increases for American workers. Likewise, tax breaks for oil and gas companies haven’t produced better results, tax credits for working parents don’t produce affordable childcare, and so on.
Historically, when competing policy ideas aimed at a common goal emerged in Congress, the leaders of the tax-writing committees fashioned a compromise provision. Congress often “compromises” now by enacting all of the ideas, leaving unsophisticated taxpayers bewildered about how to respond. Consider, for instance, the income-tax incentives for paying for higher education. There are eight tax breaks for current-year education expenses: two tax credits, three deductions and three exclusions from income. Five other provisions promote savings for college expenses. In 1987, there were only three provisions encouraging college expenditures or savings. The 1997 Act added another five provisions that were estimated to cost $41 billion over five years. Together they represented the largest increase in Federal funding for higher education since the GI Bill.
It’s a daunting task for any mere mortal to understand how the tax savings provided by these provisions, their various eligibility requirements and their recordkeeping and reporting requirements all interact. Each of the provisions has its own eligibility criteria and definition of qualified expenses. For example, they do not provide consistent treatment of room and board, books and supplies, sports equipment and related expenses, other non-academic fees, or the class of relatives whose expenses may be taken into account. A student convicted of a felony for possession or distribution of a controlled substance is ineligible for one of the education credits, but such a conviction is no bar to another one. And this is just the tip of the iceberg.
aken together, most prominent tax reform proposals now being discussed would reprise the 1986 Tax Reform Act. To be sure, the 1986 Act was a major improvement, but it was based on retaining and strengthening the income tax itself rather than heeding the calls of many economists and politicians to replace all or part of it with some form of consumption tax on purchases of goods and services. Given the internationalization of economic activity during the past 25 years and the increased competition from abroad, the 1986 Act’s reliance on increased capital gains and corporate income taxation now seems inapt. We need to attract capital to create better conditions for American workers and businesses, goals that the current tax system stifles. In order to do that, the United States must become a more attractive place for both foreign and domestic investment, and American companies need to be positioned to take full advantage of the global market for goods and services, labor and capital.
Thus, while many current income tax reform proposals might improve the law, they don’t go far enough. As we know, it doesn’t take very long after a good cleansing of the income tax for things to get very dirty again. Even those who applauded the 1986 Act as a wildly successful tax reform must concede now that this legislation was not a stable solution. Over time, many of its reforms have been reversed: Its broad base and low rates have been transformed into a narrower base with higher rates. It is clear that radical surgery is the only viable option for fixing this nation’s tax woes for the long term.
Continuing to rely on income tax deductions and credits will be about as successful a solution to our national problems as handing out more gunpowder at the Alamo. Unfortunately, the largest of these deductions and credits are very popular with the public. The public may accept some trimming of them—a floor on deductions here, a ceiling or haircut there—but the only path to real tax reform success is to remove most Americans from the income tax altogether. To create an internationally competitive, administratively efficient and viable long-term solution to our funding requirements, we should return the income tax to its original, manageable purpose: the collection of a simpler tax on high-income earners who tend to have multiple income sources. We should dramatically lower our corporate income tax rate. In order to do that, we need to tax consumption—that is, sales of goods and services.
y plan, as described in 100 Million Unnecessary Returns: A Simple, Fair and Competitive Tax System for the United States, has four key elements.
First, enact a value-added tax (VAT), a broad-based tax on sales of goods and services now used by more than 150 countries worldwide. We are the only OECD country that does not have such a tax. Second, use the revenues produced by that consumption tax to finance an income-tax exemption of $100,000 of family income and to lower substantially the individual income-tax rate on income above that amount. Third, lower the corporate income tax rate to 15 percent. Fourth, replace the earned income tax credit and provide low- and middle-income families with tax relief from the VAT burden through payroll-tax offsets and debit cards.
This plan has seven significant advantages over current law and other tax reform alternatives.
First, this competitive tax system would encourage saving and investment in the United States, stimulating economic growth and creating additional opportunities for American workers. It would take advantage of our status as a low-tax country by making us a low income tax country as well.
Second, a 15 percent corporate income-tax rate would be among the lowest in the world and would solve the most vexing issues of international tax policy.
Third, the plan would eliminate more than 100 million of the 140 million income tax returns filed annually and would free more than 150 million Americans from ever having to deal with the IRS.
Fourth, with only a relatively few high-income Americans filing tax returns, Congress could not plausibly present income-tax exclusions, deductions and credits as adequate or appropriate solutions to the nation’s most pressing social and economic problems.
Fifth, a VAT would be border adjustable under WTO international trade rules, which means that we could tax imports and exempt exports. VATs can be imposed on such a “destination-basis”; business income taxes cannot.2
Sixth, this plan would avoid most of the difficult transition issues that have haunted other proposals to replace the income tax with consumption taxation.
Seventh and finally, by combining taxes already commonly in use throughout the world, this system would facilitate international coordination and fit well with existing tax and trade agreements—something that most other consumption tax proposals fail to do. (The Tax Policy Center, pursuant to a contract with Pew Charitable Trusts, is currently in the process of estimating the revenue and distributional consequences of my plan and has given me permission to describe their preliminary results. Estimates for 2015 suggest that my proposal is essentially revenue and distributionally neutral with a VAT rate under 12.5 percent, a 15 percent corporate income-tax rate, and tax rates for married couples of 16 percent on income between the $100,000 family allowance and $200,000 and 25 or 26 percent for income above $200,000. Offsets are provided for low- and moderate-income families.)
Opponents of value-added taxes often complain that they are regressive. If such a sales tax were to fully replace our income tax, as proponents of the “fair tax” urge, this complaint would be valid. Therefore, I designed my Competitive Tax Plan so as to change neither the progressiveness of the tax system nor the amount of revenue produced under current law. This allows my proposal to be evaluated in direct comparison to the current system. It also follows the important precedent of neutrality, which facilitated enactment of the 1986 Tax Reform Act.
he simplification advantages of a consumption tax depend on how it is implemented. Retail sales taxes and VATs are collected from businesses rather than families, who no longer have to deal with the tax collector. Other forms of consumption taxes, such as the so-called flat tax (which the public often mistakenly believes is an income tax), tax the wage element of value added to individuals and thus require households to file tax returns. Since under the “flat tax” only wages would be taxed to individuals and all deductions, exclusions and credits would be eliminated, its proponents claim that the annual tax return would shrink to the size of a postcard that everyone would be able to fill out quickly and easily. Adding more than one tax rate, as President Bush’s tax reform panel recommended, does not substantially complicate matters.
The flat tax (and its cousin, the “Growth and Investment Tax” proposed by President Bush’s tax reform panel in 2005), economist Alan Auerbach’s “Modern Corporate Tax” and Congressman Paul Ryan’s Business Consumption Tax are all variations on a form of VAT that resembles an income tax. This kind of VAT taxes the difference between the total receipts from a business’s sales of goods or services and the total amount of the business’s purchases of goods or services from other businesses. Variations on this subtraction-method VAT enjoy great favor among some consumption tax advocates. At the same tax rate and with no exceptions, a retail sales tax, a subtraction-method VAT and the much more common credit-method VAT should produce similar results. But exemptions for particular goods or services or for small businesses, for example, are far more troublesome under a subtraction-method VAT than in the more common credit-invoice method.
The flat tax proposals essentially split the collection of a single rate subtraction-method VAT between businesses and individuals. Rather than denying businesses any deduction for wages, as usually occurs under a subtraction-method VAT, the flat tax allows businesses to deduct wages in addition to purchases from other businesses. This type of consumption tax is collected at each stage of production, as under a typical VAT, except that the tax on wages is directly remitted by individual wage-earners. In combination, the total of the business and individual tax bases should equal total sales, putting aside any exemptions. The principal advantage of dividing a VAT between businesses and individuals is that it enables the exemption of a certain amount of wages and may thereby alleviate the burden for wage-earners at the bottom of the income scale. It also allows for progressive rates on wages, although it is a mystery to me why only wages and not investment income should be subjected to progressive tax rates.
Three problems remain, however. First, the flat tax and its variations are consumption taxes invented by academics that have not yet been tested in the real world. Second, all experience warns us that, even in the unlikely event that such a tax could be enacted without deductions, exclusions and credits, the tax would not stay flat for very long. Tax breaks for homeownership, charitable gifts and education expenses, to name only a few, would soon make their way back into the tax code. Third, as President Bush’s panel discovered, taxing only individuals’ wages and not their income from investments offends the public’s notions of tax justice. This is why the panel—hardly a bunch of liberals and none of whom was up for re-election—coupled their consumption tax proposal with a tax on interest, dividends and capital gains (albeit at a lower 15 percent rate).
Many of these consumption tax alternatives also seem problematic in the context of international tax and trade treaties. My proposal, by contrast, would harmonize our tax system with international standards and thus open up the possibility of real cost savings for companies doing business outside the country. Value-added taxes of the standard credit-invoice sort fit well with international agreements. They are imposed only by the country where the consumption takes place. Thus they tax imports and exempt exports, so that the location where a good is produced is irrelevant. In contrast, income taxes are typically imposed on all domestic production, and the tax on production abroad is generally ceded to the country where the production occurs.
It is puzzling, then, that U.S. economists and policymakers have struggled to fashion novel consumption tax alternatives when the VAT, a well-functioning consumption tax, is used throughout the OECD and in more than 150 countries worldwide. Given the interconnectedness of the world economy, consumption-tax design does not seem the right place to insist on American exceptionalism.
he so-called “FairTax”, first introduced in Congress in 1999, proposes a single national sales tax to replace all individual and corporate income taxes. FairTax advocates are correct that a retail sales tax might be simpler than a VAT, but it is telling that no country has a retail sales tax at a rate above 10 percent. At the proposed 30 percent rate, the tax would be difficult to collect and would bring substantially greater compliance risks. (Some call this a 23 percent rate, which is calculated on a tax-inclusive basis, thus disguising how high it actually is.) In addition, unlike VATs around the world, retail sales taxes often do not apply to services, so they are imposed on a much smaller base.
Moreover, retail sales taxes in the United States do apply to many purchases by businesses (which they should not), causing double or multiple taxation (known as “tax cascading”). While there are no reliable estimates of how much of this occurs, the only two extant estimates suggest that as much as 40 percent of U.S. retail sales tax revenues are from sales to businesses rather than to final consumers. This levies significant economic costs and distortions; a credit-method VAT avoids such cascading.
Finally, because consumption accounts for a lower percentage of income among wealthier individuals, the FairTax proposal would in effect reduce taxes on those at the top and make up the lost taxes from people with less income or wealth. This seems particularly inappropriate when gains in income and wealth are already so skewed toward the top.
Stranger still, FairTax advocates claim their reform can eliminate the IRS and turn the assessment and collection of virtually all Federal revenues over to the states. This is just a political ploy, a fanciful illusion. How are we to believe that the Federal government can collect trillions of dollars of taxes annually without a tax collection agency? They have further claimed that under their plan workers would receive 100 percent of their paychecks with no taxes withheld and that the sales tax would not increase prices. Thus they claim wages will not fall nor will prices go up. Either of these claims might be true, but they cannot both be true simultaneously. A sales tax either must be paid out of people’s wages, like the income tax, or when people buy goods and services. You can find economists who believe one or the other would happen, but no respectable economist believes that neither would occur.
Moreover, no independent analysis has confirmed that a 30 percent retail sales tax (or a VAT at that rate) would generate revenues adequate to fund the repeal of all of the taxes that FairTax advocates claim they would eliminate. Given their wildly unrealistic claims, it is hardly surprising that they have generated considerable enthusiasm for their plan especially among higher-income folks, who would enjoy a huge tax cut from its enaction.
his history of failed attempts to enact a consumption tax teaches us that any politically viable alternative must have a practical outcome that is better for businesses, better for savings and investment, feasible, and fair to moderate-income Americans. While previous plans have not succeeded, consumption taxes clearly have a role to play in a modern tax system. They are used in the states and throughout the industrial world as a part of tax systems that typically also contain progressive income taxes. Enacting a VAT—a national sales tax with withholding by businesses other than retailers—would permit a major restructuring of our tax system into one that is vastly simpler and far more conducive to savings, investment and economic growth. As my Competitive Tax Plan demonstrates, this can be accomplished in a way that is fair, and that neither increases the tax burden of low and moderate-income taxpayers nor shifts taxes away from those at the top of the income scale.
Given its widespread application around the world, it is clear that the United States can readily administer a VAT. The best VAT practices are not to be found in Europe but in the more modern VATs enacted in Singapore, New Zealand, Canada, Australia and South Africa. These taxes are imposed on broad consumption tax bases at a single rate to minimize distortions. As in my proposal, the tax is made less regressive with measures directed at low- and moderate-income households, rather than with exemptions for items such as food and clothing, which would also apply to purchases by high-income households. The Canadian experience, in particular, demonstrates that a national VAT and state retail sales taxes can live side by side, as well as the fact that it is more efficient for states to replace their retail sales taxes with a harmonized VAT that minimizes compliance and administrative costs. Finally, while many countries do not publicize their VAT rates to consumers, Canada requires its VAT to be separately stated on sales receipts, creating resistance to rate increases. In Canada, federal revenues and spending have fallen relative to GDP since introducing a VAT in 1991.
This last point is particularly important in light of the perilous fiscal situation we currently face. As a result of the recent financial crisis and a vast amount of government spending aimed at combating the recession and high unemployment, our nation’s short and long-term fiscal condition has deteriorated dramatically since I first advanced my Competitive Tax proposal. We have never in modern times faced such a dangerous ongoing imbalance between the levels of Federal spending and revenues. Our Federal debt as a percentage of our economic output is greater than it has been at any time since the end of World War II, a time when our economy was poised to grow for decades at an unprecedented pace and the government owed 98 percent of the money it had borrowed to finance the war to its own citizens. The Congressional Budget Office now projects that in a decade our national debt will exceed $20 trillion, roughly equal to our annual economic output, with more than half owed to foreigners, many of whom we cannot call friends.
These fiscal facts highlight a great advantage of my Competitive Tax Plan: A border-adjustable value-added tax on sales of goods and services that decreases dependence on the income tax to finance our government’s spending will give us a tax system that is fair and yet substantially more favorable to economic growth than our current system.
Former Treasury Secretary Larry Summers once remarked that Republicans don’t like value-added taxes because they are a revenue machine and Democrats don’t like them because they are regressive. “We will get a VAT”, he said, “when Democrats realize that they are a revenue machine and Republicans realize that they are regressive.” To the contrary, I believe that we will only get a VAT when it is included as part of a tax reform designed to ensure that it is neither regressive nor a money machine. That is what my Competitive Tax Plan does.
Despite the daunting challenges of our fiscal situation, I believe that it would be a mistake to enact a VAT without using a substantial portion of its revenues to help finance major reform and simplification of income taxes. That would indeed be an opportunity wasted. If we don’t solve the problems of our grossly inefficient system of raising revenues, all the other challenges our government faces will eventually be overwhelmed by one overarching reality: We will have too little money, and we will lack the means to raise more without damaging our economy. Quite literally, we can’t afford not to act.
1Staff of the Joint Committee on Taxation, “Background Information on Tax Expenditure Analysis and Historical Survey of Tax Expenditure Estimates”, February 28, 2011.
2Most economists insist that border adjustments make no difference in international trade due to offsetting changes in exchange rates, but business owners do not accept that exchange-rate adjustments happen as readily in practice as theory suggests. China certainly seems to confirm the business view. In any event, destination-based consumption taxes do not depend on either the headquarters of multinational corporations or the source of income but rather on where consumption takes place. As a result, they have major advantages for tax compliance (for example, with regard to transfer pricing). Moreover, given the size of our nation’s trade imbalances, border adjustments would likely result in hundreds of billions of dollars of additional revenues to the U.S. Treasury over the 10-year budget period and beyond.