Congress is talking about tax reform. Hopefully something will get done. The US tax code is overly complicated and discourages growth.
This post will lay out some rough goals for tax reform, with a few details on how to achieve the goals. It’s aimed at the US tax code, but some principles apply anywhere.
The problems and potential solutions are complex, but broad goals are easily stated. The tax code should (a) promote broad prosperity, (b) collect enough money to fund government, and (c) be simple.
WHAT: To improve prosperity, we need to encourage economic growth. This is the most important goal for tax reform, just as it is the most important goal for our economic lives more generally. See this post for more on why growth is valuable.
In the current situation, corporate tax reform probably offers better prospects for growth because US corporate taxes are so uncompetitive compared to other countries. See this post for more on why cutting corporate taxes makes sense.
HOW: How can the tax code encourage growth? By lowering tax rates and eliminating tax preferences (loopholes, deductions, and credits for chosen industries or activities).
Low rates encourage working, producing, and investing because they increase the “take-home” financial reward for productive activity. Low tax rates and fewer tax preferences allow people to make decisions based on what makes economic sense rather than which artificial rules are inserted into the tax code.
A tax code with low tax rates and few preferences does the most to encourage growth because it does the least to discourage or distort productive economic activity.
Collect enough money
WHAT: Society needs to collect enough taxes to fund the necessary government.
HOW: A tax code with low tax rates and few tax preferences is good for raising tax revenue because it increases the size of the economy and discourages tax avoidance.
It increases the size of the economy for the reasons mentioned above. Then the larger economy will yield higher tax revenues.
It discourages tax avoidance because few people bother to avoid low tax rates. People won’t do much to avoid a 1% tax, but they will move heaven and earth to avoid a 99% tax. Fewer tax preferences also means fewer opportunities for tax avoidance.
Make it simple
WHAT: The individual tax code is bewilderingly complex with many confusing incentives, penalties, exemptions, deductions, and credits that phase in and out at different income levels. This complexity makes it difficult for many people to truly understand their own taxes. Compliance ties up extra resources that could otherwise be applied toward something more value-adding.
The tax code should be simple enough that most taxpayers can understand and complete their own tax return. It should be simple enough that unintentional mistakes are rare.
HOW: Minimize or eliminate the numerous incentives, penalties, exemptions, deductions, and credits. Consolidate or eliminate duplicative items. Eliminate the Alternative Minimum Tax.
Simplicity is more achievable if we view taxation as merely a way to fund government, rather than a tool to mold and shape society, or an avenue for seeking political power.
Minimize lobbying and corruption
WHAT: A complex tax code with high tax rates is like waving a red flag in front of a bull. It encourages lobbying and political corruption. The complexity makes it easier for special interests and politicians to ‘hide’ tax preferences into the tax code. A high tax rate makes it more lucrative for special interests to seek loopholes, and therefore more likely they will do so.
HOW: Low tax rates and simple tax codes reduce lobbying and corruption.
WHAT: In some cases, the same income is taxed twice. For example, businesses pay dividends with after-tax profits, then individuals also pay taxes on the same money when they receive dividends. When the individual dies, if those dividends are part of a taxable estate, the same money will be taxed a third time! It’s more efficient, fair, and transparent to tax income only once.
HOW: Eliminate taxes on capital gains and dividends. Eliminate estate taxes. At a minimum, make the rates low.
Make it permanent
WHAT: Due to Congressional rules, tax reform can either be ‘permanent’ or expire after ten years. Permanent is better.
Why? Leaving more money in the pockets of consumers and businesses is good, but not the primary benefit. More significant is the behavioral incentive of lower marginal tax rates to encourage productive activity and investment. The incentives matter more, and temporariness dilutes incentive.
HOW: Permanency is a worthwhile goal. I’m not sure of the best way to accomplish this given the esoteric nature of Congressional budget rules.
Make it revenue-neutral?
WHAT: Should tax reform be revenue-neutral? That is, should the reformed tax system collect the same amount of tax revenue as before, or a smaller amount?
I can accept either. Both are better than status quo. A reduction in overall tax collections would likely involve meaningfully lowered tax rates, which is better for long-term growth and prosperity. However, even revenue-neutral reform will improve growth if it lowers tax rates, eliminates uneconomic distortions, and simplifies the tax code.
HOW: Revenue-neutral reform involves lowering tax rates and then ‘paying’ for it by reducing or eliminating deductions and tax preferences. Stronger growth also helps pay for lower rates.
What should tax rates be?
WHAT: My preference would be to drop the rates as much as the political process allows. I think the corporate tax rate can drop to 20%. That would make the US competitive with most countries. If possible, I’d like to see the top individual tax rate drop to 25%.
Because investment is imperative for growth and prosperity, I would prefer eliminating taxes on investment income (capital gains, dividends). This is not likely, so I’ll settle for a top rate of 15%.
HOW: Dropping rates this low would likely require significant reduction of deductions and tax preferences.
If you worry about tax RATE cuts reducing tax REVENUE, please understand the Laffer Curve. It basically says that a lower tax rate might collect the same tax revenue as a higher tax rate because marginal tax rates influence people’s behavior. A lower tax RATE collects more tax REVENUE than commonly expected because it (a) encourages taxable economic activity and (b) discourages tax avoidance.
To illustrate, a tax rate of zero and a tax rate of 100% will both collect the same tax revenue: zero.
Comments on 9/27 proposal
Republicans announced a tax reform proposal yesterday. It’s preliminary with some details not yet known and changes likely to come, but here are a few comments.
The corporate tax side seems quite good. The 20% corporate tax rate, 25% ‘pass-through’ tax rate, immediate deductions for investments, and switching to a territorial system would make the US economy and US companies much more competitive on the global stage. This would in turn benefit individual workers and investors.
The individual tax side seems less good. My main complaint is that the proposal does not lower the top tax rate of 39.6% enough (or may not lower it at all). I assume this springs from political fear of claims that the proposal is “tax cuts for the rich.”
But let’s be honest. People will claim “tax cuts for the rich” about any conceivable tax reform. Why not propose what best accomplishes broad growth and prosperity and justify it accordingly? Maybe that’s why I’m not a politician…
Still, the overall proposal seems very much worth doing.
If any tax preferences are threatened, you can count on special interest groups of various types lobbying to prevent the loss of their particular advantage. They will lobby, and produce ads that tug at our heart strings. People rarely want to lose whatever they are getting for ‘free.’
I doubt Congress will do as much reform as I want, especially the removal of distorting preferences, but hopefully they will persevere and do as much good as possible: comprehensive tax reform that lowers rates, removes economic distortions, and simplifies.
I encourage you to enter comments or questions below. Two rules: 1) be reasonably polite, 2) address the issue and avoid personal attacks.