Tax Reform: What are the Options?

While Washington DC may be currently preoccupied with Russia investigations, the GOP appears determined to try its hand at tax reform at some point this year. The broad outlines of GOP tax plans have been discussed here and elsewhere, but rather than focus on just one approach, what are the real options for tax reform today?

Government Funding:
65% Labor Taxes, 15% Borrowing, 12% Capital Taxes, 8% Other

While most breakdowns of government funding look at taxes paid by income group, we can look more broadly at revenue from labor, borrowing, business, and other:

  • $2.51 Trillion: Labor (2016 personal income + all payroll taxes, less capital gains)
  • $0.59 Trillion: Government Borrowing
  • $0.45 Trillion: Capital (corporate income taxes + capital gains taxes)
  • $0.31 Trillion: Federal Reserve income + excise tax + customs + estate + other

It’s clear from the above that working men and women (and not business) carry the weight of the government on their back. With all the concerns around automation taking jobs, it’s surprising that few analysts note how biased the tax code is against good old-fashioned labor! If we want workers to have a shot against software and robots, perhaps step one is to take the anvil off their backs.

Balancing the Tax Code: Tax Reform Options

There are many goals in tax reform, with simplification and decreasing distortions in the economy (thereby encouraging growth) usually cited as key goals. Let’s add balancing the tax code between labor, capital, consumption, and other activities to this list – in an ideal system no one participant in the economy should shoulder the whole burden. The typical ideas like eliminating deductions and lowering rates have been proposed and covered many times. Here instead is a short list of some of the more novel tax reform ideas we might entertain, along with the revenue that each might generate:

National Sales Tax:
Potential Revenue: $600 Billion at a 5% tax rate

Proponents of a national sales tax, like the organization FairTax, point to the idea of using a 25% sales tax to eliminate all other federal taxation. But most states also levy sales taxes, bringing the total sales tax burden above 33% in many locales under this plan. In order to reach these lofty levels, the sales tax would have to apply to all services (e.g. doctor’s appointments, salon visits, etc) in addition to traditional retail sales.

Value-Added Tax: A direct tax on economic activity
Potential Revenue: $900 Billion at a 5% tax rate

According to KPMG Research, over 140 countries use a VAT in some form today, and the United States is among the only developed nations without a VAT.

The VAT has built-in defenses against tax evasion relative to similar sales taxes, leading to greater potential revenue at a given rate. Critics grouse that the VAT is “too efficient” and leads to growth in the size of government as taxation becomes more efficient.

Wealth Tax: Property taxes on all assets
Potential Revenue: $500 Billion at a 0.5% rate

A broad wealth tax is similar to a property tax, but is levied across all assets instead of just real estate. The total net worth of individuals and corporations in the US is nearly $100 trillion, so that even very low rates could generate substantial revenue. Capital is mobile, however, so a successful approach would likely involve lowering or eliminating capital gains taxes to prevent capital flight.

Transaction Taxes: Wall Street Financial Transaction Tax
Potential Revenue: $100B per year at 0.1%

As income inequality has soared in the United States, the idea of taxing financial transactions has garnered attention. Care must be taken as even very small transaction taxes might result in capital flight to other markets. As with a wealth tax, a transaction tax might be possible if capital gains taxation was lowered to incentivize capital to stay in US markets. A 10 basis point transaction tax might raise close to $200B per year, but would likely have to be offset with a capital gains reduction, so that the tax might only net half that amount.

The gross receipts tax is another form of transaction tax, levied on all revenue generated by all businesses. Since total business revenue in the US is likely in the $40 Trillion range, a 0.25% transaction tax might lead to roughly $100 Billion in annual revenue. Texas, Washington, and Ohio all levy this form of tax.

Pollution Taxes: Carbon Tax, other emissions taxes

Potential Revenue: $120B per year

Pigovian taxes, which seek to tax activities that cause economic externalities, are theoretically quite attractive as they both raise revenue and decrease externalities like pollution. A tax on carbon could help achieve this – a carbon tax of $20/ton might raise  $120B billion in revenue while lowering long term emissions trends.

 

With so many options, which to choose?

Reviewing the options above, it’s clear that only a handful (the VAT, national sales tax, and wealth tax) generate enough revenue to help rebalance the tax code away from its current Labor tax orientation. Of these, the VAT and national sales tax are both forms of consumption tax – and the VAT provides superior audit trails while also being easy to implement.

Combining a 5% VAT with a 0.5% wealth tax would produce around $1.4 Trillion in revenue, enabling a halving of both taxes on labor and traditional taxes on capital. The new balance of revenue might look like this:

  • $1.31 Trillion: Labor (~50% reduction in income and payroll taxes)
  • $0.90 Trillion: Consumption Tax (new 5% Value-Added Tax)
  • $0.75 Trillion: Capital (new wealth tax,  ~50% reduction in corporate income taxes + ~50% reduction in capital gains taxes)
  • $0.59 Trillion: Government Borrowing
  • $0.31 Trillion: Federal Reserve income + excise tax + customs + estate + other

There you have it – the tax code rebalanced to encourage and reward work, while spreading the burden across consumption and capital. It’s important to note that a small wealth tax combined with a capital gains cut rewards risk and productive deployment of capital. Holding a savings account at 1% interest becomes much less appealing, while deploying capital in the form of equity becomes more appealing with capital gains taxation at 10%.

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