Real Tax Reform
Edward J. McCaffery
Imagine you are Bill Gates, or some other ludicrously wealthy American. It turns out that you never have to pay any major tax for the rest of your life, and it is quite possibly malpractice if your tax advisor doesnt point this out to you. Now imagine (as is more likely) that you are a wage earner in the middle or upper middle class, with limited assets outside of perhaps a pension plan and some home equity. You could easily be paying 40 percent or so of your gross income in taxes, and you might even find yourself in a 50 percent marginal tax rate bracket, all taxes considered. And theres not all that much you can do about it.
Here we have one of the great disgraces of our tax system: wage-earners are highly taxed while property-owners are barely taxed at all. If we had a more responsive political system, we would be witnessing a bipartisan, civic-minded attempt to rid the tax laws of such inequities. No such luck. Instead, tax reform is snared in partisan politics, entangled in greed on the right and defensive dogma and inertia on the left and center. It need not be this way: its possible to make the tax system simpler and more just, if were willing to rethink first principles. Ill return to that theme shortly, but first lets take a closer look at current tax politics.
Republicans, for their part, have been attacking the American tax system for some time now, at least since Ronald Reagan taught them just how successful this strategy can be. But conservatives have their own agendas, and tax reform has been little more than a means for them to pursue other, more greatly desired, ends.
The conservative strategy, perhaps best illustrated in the 1994 Contract with America, ingeniously blends three distinct goals:
1. Improve the form of taxation, by making it simpler, fairer, and more
Public outrage over tax is linked principally to the first goal. Almost everybody hates our tax system, with its confusing forms, intimidating audits, and disturbing sense that more is going on than one can possibly understand. Republicans long ago figured out that you could go pretty far in American politics simply by attacking the IRS, the Internal Revenue Code, tax forms, and any other paraphernalia or indicia of tax.
But there is no reason sounding in logic, experience, economics, or political morality to hook up the first goal with the next two. Times are relatively good right now, and polls and practices consistently reveal that Americans are reasonably happy witheven complacent aboutthe overall size of the government and its provisions of services. There is thus not a huge clamor for tax reduction (goal two), at least outside of a surplus politics that tends not to be about the size of government per se, as much as about what we are doing with its "extra" funds. Even with regard to the surplus, the Clinton administration and congressional Democrats have been willing to stand fast against major tax reduction, preferring to shore up the social security system and pay down the national debt. The political success of this strategy to date confirms that no public groundswell supports major tax or government reduction.
There is long-standing support in America for at least moderately progressive tax rates, though there is considerable question as to whether we in fact have any real progressivity today. The intellectual, economic, moral, and philosophical case in favor of flat taxes (goal three) is weak.1 Even if taxes should be flat in the aggregate, a good case can be made that some progressivity in income taxes is needed to make up for regressivity in other taxes, such as federal payroll and state and local sales taxes, which account for an increasingly large share of total tax revenue. It is also the case that the wealthiest Americans are far and away the big "winners" in any move towards flat taxes, which would mean an increase in taxes on the middle to pay for tax reduction for the rich. Whats fair about that? Why should the middle classes, who almost certainly suffer the most under the current mess, pay a dollar price for its improvement? Politicians like Steve Forbes and Jack Kemp have discovered, typically too late for their own good, that flat-tax fever subsides as soon as middle-class Americans see a distributive chart on the front page of the newspaper labeling them as "losers" in any move to a flat tax.
But logic and tax have rarely been bedfellows in politics. Republicans happily blur the issues about the form, size, and distribution of the burden. The standard tune in many Republican ralliessuch as the one found in the 1997-98 Scrap the Tax Code tour led by Reps. Billy Tauzin and Dick Armeyis remarkably simple. "Raise your hand if you hate taxes.... Good, now keep them up while I tell you what a great plan I have for you."
The elision of the three agendassimplify/cut/flattenis nicely illustrated in Amity Shlaes recent commercial success, The Greedy Hand: How Taxes Drive Americans Crazy and What To Do About It. Shlaes, an editorial writer for the Wall Street Journal, does a commendable job of setting out the vast and annoying panoply of taxes that haunts ordinary citizens from cradle to grave. The table of contents of the book says most of what there is to say. After the introduction, the chapter headings read: "Your Clothes," "Your Work," "Your Marriage," "Your House," "Your Baby," "Your School," "Your Accountant," "Your Success," "Your Retirement," "Your Death." The point is plain: we are taxed everywhere, as we work, play, marry, retire, even die. Shlaes has done her homework; she is learned, and she writes well. Liberals and Democratsthe people least likely to endorse any of Shlaes solutionsare well advised to read her descriptions. The system she describes leaves Americans mad as hell, and something has to give.
The simple fact is that whoever first and best states a case customarily gets the first stab at posing solutions. After over two hundred pages of polemic and anecdote carefully mustered against the status quo, The Greedy Hands final chapter, "Conclusion: Your Choice," is a scant nine pages. What are Shlaes solutions? No surprises here: taxes have to be not only simpler, but also lower, flatter, and more local (and while we are at it, we ought to privatize social security). None of these solutions are defended at any great length, nor are they very good ones. Smaller and less redistributive taxestwo changes that would help the richwould do nothing at all for the rest of us, and are certainly not needed to reduce the maddeningly intrusive complexity of the current system. The cases for downsizing government and flattening tax burdens are highly debatable in precisely a way that the senselessness of the basic tax system is not. Yet by that point in the book or out on the campaign trail, who cares? Conservatives score well on the empathy test; by kvetching about the tax system, they show they feel our pain. Liberals should pay heed.
Sophistry and disingenuity on the rightcombined with the fact that "flat" taxes are a political loserwould create a tremendous opportunity for the left or center, were they not also ensnared in dogma and inertia. If the right seeks to marry popular demands for simplification with its own agendas of reduction and flattening, the left and center typically defend the status quowith its absurd and intrusive complexitiesas a way to fight off conservative efforts to downsize government or redistribute its burdens away from the rich. This has put liberals and Democrats in the intellectually untenable position of supporting a tax system that features an income-plus-estate tax combined with an almost equally largeand regressivepayroll tax. Factoring in the numerous opportunities for tax-favored savings, this system falls heavily on work while leaving the property-owning class alone. Worse, by failing to get a seat on the anti-tax bandwagon, Democrats have left themselves vulnerable to extremely conservative politicians. Whenever tax looms large, you can count on Republican electoral victories. By getting tax wrong, the left and center have ceded a major issue to the right, which has been using it to seize offices and shape social policy at least since the late 1970s.
On closer inspection, Democratic and liberal tax policy takes one of two forms, each dogmatic and doctrinaire in its own way. The mainstream political response, best epitomized by the Clinton administration, is a policy of piling on "targeted" provisions to a highly flawed status quo. A typical Clinton-era provisionsay the "Hope Learning Credit" or a credit for families with adoptive childrendoes little except add to the bulk of the tax codes complexity. Such credits are non-refundable, meaning that they do nothing for the roughly 40 percent of Americans who do not pay positive income taxes but are still burdened by payroll taxes and often by the loss of welfare or workfare benefits. On the other end of the spectrum, these credits are "phased out" at upper income levels, the parties most sensitive to tax-induced behavioral change. In the end, President Clinton makes deal after deal with the devil, trading complexity for a good press conference sound byte. The Clinton administration will go down as the greatest complexifier in the history of taxa remarkable achievement indeed.
A second avenue of responsemore characteristic of the intellectual leftis to call for a de novo reform along utopian lines. Bruce Ackerman and Anne Alstott of Yale Law School perfectly well illustrate this approach in their recent book, The Stakeholder Society. Ackerman and Alstott call for granting to each citizen a "stake" of $80,000 as she turns 21. To finance this scheme, they would set up a new tax system, featuring an annual wealth tax of 2 percent (which would mean that Bill Gates would write a check for $2 billion or so every year, probably forever); a "progressive privilege" tax, which is an annual surcharge based on the relative fortune of ones upbringing; and a nearly confiscatory gift and estate tax (parents would be allowed to make gifts of up to $1,000 per year per child, and to give away $50,000, on life or death, within the family; above that, they would have to pay the government or qualified charities).
This might all be useful enough as an intellectual exercise. But Ackerman and Alstott seem strangely serious about their idea as a practical proposal: they argue details of practical implementation on nearly every page. To cite just one example, Ackerman and Alstott devote pages to the possibility that immigrants would flock to America just before they turn 21 in order to claim their stake. The fact that immigrants in my state, California, had to fight in the courts simply to receive such essential public services as education and emergency medical treatment shows just how far Ackerman and Alstott are removed from contemporary reality. To be sure, their book is important and valuablemuch as Shlaes book is, though for different reasons. But their program isnt going to happen any time soon. Discussion of real tax reform will need to look very different.
To begin a discussion of practical ways to improve the tax system and make it more fair, we need to think a little more clearly about what we are and are not trying to do. In that spirit, I propose that we make it our goal to fix the tax system without downsizing government or shifting the general distribution of taxes. Lets pursue, that is, the first of the three goals set out above: improve the form of taxation, by making it simpler, fairer, and more efficient. And let us combine a good, solid analytical understanding of tax, on the one hand, and a close observation of characteristic American valuesespecially the values of the middle class, the most important taxpayerson the other. So doing, it isnt hard to reach a compromiseto see that the best tax would be a consumption tax with progressive rates.
The case for such a progressive consumption tax begins with the observation that a tax is composed of two major parts: a base, or the "what" of taxation, and a rate structure, or the "how much." Lets look first at the base side. Consider what happens when you get your hands on some money: you either spend it or you dont. (Income, in other words, equals consumption plus savings.) An "income" tax taxes all "income," whether it is used for consumption or for savings.
One could just as easily choose a different base. If we did not tax savings, we would be left, by definition, with consumption as the tax base. It turns out that there are compelling reasons to do just that. For one thing, savers are arguably double-taxed under an income tax: first on their receipt of wealth, second on the yield to savings. (People sometimes dispute this claim about "double taxation," and argue that the yield to savings is an additional source of income and therefore ought to be taxed. But we dont tax the additional psychological yield to consumption, and we do tax the yield to savings even to the extent that it simply compensates for inflation.) Estate or inheritance taxes hit savings yet again, this time with surcharges on money saved until death. It is fairer (as well as less complicated and costly) to savers to tax that wealth just once.
Somehow, Americans seem to have figured this out in practice. Although we nominally have an income tax, in reality we have a hybrid system with powerful strands of the consumption tax model. We already exempt various kinds of savings from taxation: contributions to retirement accounts, "unrealized" appreciation, the rise in value of home equity, the cash build-up inside life insurance policies, and so on. A consistent consumption tax would simply extend that exemption to all other forms of saving. Indeed, all major proposals for tax reformfrom the conservative calls for a national sales tax or a flat tax with an exemption for capital gains to Clintons calls for unlimited savings accountslower or eliminate the tax on savings, and so, by definition, move us toward a consumption tax. So, too, with the calls to repeal the gift and estate, or "death," tax; such taxes only fall on saved wealth, thus encouraging consumption by the elderly rich while discouraging long-term savings.
The development of this hybrid system has permitted the rich, clever, and well-advised property holders to perform a simple arbitrage operation that allows them to pay little, or no, federal tax. This is the key to the Bill Gates puzzle. On the one hand, where the law follows a consumption tax modelinside pension plans, for example, or by buying and holding growth stocksproperty owners can save or invest in ways that do not produce taxable income. When Microsoft stock goes up, Gates pays no tax on this "mere" rise in value. On the other hand, where the law follows the income tax modelit doesnt tax spending financed by debt, for a large examplea property owner like Gates can borrow cash and then spend away. If the game goes on until deathif one dies with both large stores of appreciated assets and debt, as most of the very rich dothen the assets can at last be sold, tax-free, to pay off the debts. The net result? Lots of consumption and no tax revenueno income tax, no social security or other payroll tax, no national consumption tax. With nearly $100 billion of wealth, Gates has no problem finding ready and willing lenders. So he gets richer, lives richer, and pays no tax.
Meanwhile, given the hybrid income/consumption structure, other puzzles abound. It is no surprise, for example, that all the additional "targeted" savings provisions enacted during the Clinton presidency arent generating a net increase in private savings. Anyone can put $2,000 in an IRA with one hand and run up $2,000 worth of credit card debts with the other. This action is more profitable for Bill Gates than for the rest of usthanks to his immense wealth he gets a much better interest rate from his creditors. But the point still holds. Adding on targeted savings incentives while doing nothing to tax borrowing is like pouring more water into a leaky bucket.
How do we get out of this dilemma? We could, perhaps, close the Gates loophole by taxing all forms of savings. But that would mean going after retirement savings, the appreciation in home equity, the realization requirement, preferential capital gains rates, possibly even the rise in "human capital"steps that would be practical, not to mention political, nightmares. A better answer? Lets tax consumption. A national consumption tax, one that fell on spending, not work or savings, would alleviate the fundamental inequities of US tax policy, whereby wage earners like you and me are highly taxed and property owners like Gates are not. It would also genuinely help prudent savers, and eliminate death taxes.
So much for the tax base. Now for the other part of the picturethe rate structure. And it turns out, there is no reason whatsoever for a consumption tax to be "flat." Consumption is about the "what" of taxes, rates are about "how much." We can easily have a progressive consumption tax. In fact, one was actually proposed, by then Senators Sam Nunn and Pete Domenici, back in 1995.
This is the compromise:we concede the tax base issue to the right, by consistently taxing consumption, not work or savings. But we insist on a progressive spending tax. This is tax reform without downsizing government or shifting burdens away from the rich. Far from itit makes rich spenders, at last, pay something for their good fortune.
Its also fairly easy to do. Suppose we adopt a national sales tax or a value-added tax of 15 percent. There are complexities in such a tax, of course, but these are no greater than those under an income tax, which is also theoretically committed to taxing all consumption. We add on a rebate, either through payroll taxes, or by mailing a check to taxpayers. This takes care of the current zero and 15 percent brackets, or some 90 percent of American taxpayers. (Approximately 100 million taxpayers wont have to fill out any more tax forms.) Next, to ensure progressivity at higher income levels, we add on a "supplemental consumption tax," with an exemption level for a family of four of perhaps $75,000 to $100,000. This tax consistently subtracts savingsthat is, it has unlimited savings accountsbut includes debt. It has moderate rates, starting at 15 percent, as shown in Figure 1.
People with incomes near or above the exemption level on the supplemental tax still have to fill out tax forms, much like 1040 forms used today. But they will consistently subtract deposits made into their unlimited savings accounts. Taxpayers can also ignore, for tax purposes, what they do inside the accountif they sell stocks to buy bonds, or vice versa, and so forth. This is just like what happens inside an IRA or pension plan today. The system still has some complexities, to be sure, but nothing like the current systemthere is no need for the tax concepts of "basis," "depreciation," "capital gains," and so on. This supplemental consumption tax, when combined with the broader sales-type tax, yields a consistent progressive consumption tax, with the consolidated rate structure shown in Figure 2.
Thats it. We tax debt, exempt savings, raise rates a bit at the high end, and we have a progressive national consumption tax. Under the current system, Bill Gates could consume five billion dollars a year without any federal tax. In contrast, under a consumption tax, Gates would see his spending taxed at a 50 percent marginal rate, and he would therefore have to cut a large check to the governmentone nearly equal to what he spends on himself.
I have not charted out the numbers for this tax plan in any great detail, but the rates are roughly the same as those under current law. The elimination of all taxes on savings, including the estate tax, should be more than matched by the inclusion of debt and the abolition of any special lower rates for spending out of capital. After all, there is something like 15 trillion dollars in appreciation in the economy today, and little reason to think that we can ever tax much of it under the current structure. Things can be fine-tuned, of course: a higher bracket can be added, exemption rates adjusted, and so forth. But the plan is roughly revenue-neutral. Meanwhile, the supplemental tax can also preserve all of the most popular exclusionshome mortgage, medical and charitable deductions, and so forth. There is nothing conceptually different in allowing these provisions under a consistent consumption tax than under an inconsistent "income" tax.
This plan may look radical, but there is nothing crazy about it. Representative Sam Gibbons, a Democrat from Florida, put a comparable two-part proposal on the House floor in 1996, and Michael Graetz (a Yale Law Professor and former Bush Administration Treasury Official) followed suit in his 1997 book, The Decline (and Fall?) of the Income Tax, although both Gibbons and Graetz would combine a supplemental income tax with a national sales or value-added tax.The unlimited savings accounts under the progressive consumption tax continue the grand compromise. They allow property to be privateto be held, managed and invested by its nominal owner, all subject to certain general rules designed to prevent the political abuse of the tax-favored accounts, following existing practice for pension plans and against the lobbying expenditures of tax-favored charities. But in an important sense, the plan insures that the use of large fortunes will be communal. The wealthy are given a choice of how to help. They can either continue to save, helping all through their contributions to the common capital stock, or they can spend their money on themselves but pay a toll for their pleasures.
And although the plan rests on the idea that it is improper to tax savings, it need not be any more anti-consumption than current fiscal policy. Just because we call something a "progressive consumption tax" doesnt mean it has to lead to less consumption. And if the result under the progressive consumption tax was indeed "too much" savings, we could simply lower rates until the macro-economy is balanced. The main idea of the plan is to put the tax system on a more consistent, principled, basiswithout cutting government or raising taxes on the middle to pay for tax reduction for the rich.
This is where tax could be headed if we put aside the crudest forms of partisan politics and used some basic common sense. Lets just not count on it, thoughtheres an election, of sorts, coming up.
1 Joseph Bankman and Barbara Fried did a wonderful job of debunking the arguments for flat taxes in Boston Reviews Summer 1996 issue. The article is available on the Web at http://bostonreview.net/BR21.3/bankman.html.