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Archive for the ‘Income tax’ Category

Last week, I shared very grim data, going all the way back to 1880, on the growth of the welfare state.

I even claimed that the accompanying graph was the “western world’s most depressing chart” because it showed the dramatic increase in the burden of government spending for redistribution programs.

And I didn’t even mention that the numbers likely will get even worse because of changing demographics.

Now it’s time for the western world’s second-most depressing chart. Like the first chart, the data for this second chart comes from “Our world in data,” only this time it shows the relentless and astounding (in a depressing way) expansion in tax burdens starting in 1868. It only shows four countries, but other western nations would show the same pattern.

What isn’t shown in this chart is that the tax burden used to be reasonable because governments generally did not have income taxes.

The United Kingdom was an early adopter, but France, Sweden, and the United States didn’t impose that onerous levy until the 1900s. And it’s no coincidence that the tax burden exploded once politicians learned to exploit that source of revenue.

An obvious lesson is that it is never a good idea to give politicians a new source of revenue. We see in the above chart what happened once nations imposed income taxes. We’ve also seen increases in fiscal burdens in nations that imposed value-added taxes (which is why Americans should fight to their dying breaths before allowing that levy in the United States).

From the perspective of politicians, they like new sources of revenue because that increases “tax capacity,” which is an Orwellian term that describes their ability to grab more money from the economy’s productive sector.

And here’s another chart from “Our world in data” showing how income taxes and VATs (along with income-tax withholding) have become ubiquitous.

Very depressing trends. Reminds me of the biased grading of tax regimes from the World Bank.

Let’s close with the tiny bit of good news from the website. Here’s a chart showing how top rates for the personal income tax dropped substantially between 1979 and 2002.

This happened, needless to say, because of tax competition. As globalization expanded, it became easier and easier for taxpayers to move themselves and/or their money from high-tax nations to low-tax jurisdictions.

Politicians thus were forced to lower tax rates so the geese with the golden eggs didn’t fly away.

Sadly, updated versions of this chart now show top tax rates heading in the wrong direction, in large part because tax havens have been weakened and politicians no longer feel as much competitive pressure.

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The best policy for a state (assuming it wants growth and competitiveness) is to have no income tax. Along with a modest burden of government spending, of course.

The next-best approach is for a state to have a flat tax. If nothing else, a flat tax inevitably will have a reasonable rate since it’s politically difficult to pillage everyone (though Illinois is trying very hard to be an exception to that rule).

Moreover, a flat tax also sends a signal that politicians in the state don’t (or can’t) play the divide-and-conquer game of periodically raising taxes on different income groups.

Today, we have some good news. Kentucky has ditched its so-called progressive income tax and joined the flat tax club. The Tax Foundation has the details (including the changes in the state’s ranking).

…legislators in Kentucky overrode Governor Matt Bevin’s veto to pass HB 366, a tax reform package, in the last few days of the session. Ultimately, HB 366…increases Kentucky’s ranking on the State Business Tax Climate Index from 33rd to 18th. …Here’s how HB 366 changes Kentucky’s tax code: Replacing the current six-bracket individual income tax, which has a top rate of 6.0 percent, with a 5 percent single rate individual income tax; …Replacing the current three-bracket corporate income tax, with its top rate of 6.0 percent, with a 5 percent flat rate; …Expanding the sales tax base to include select services…; and Raising the cigarette tax from 60 cents to $1.10 per pack. …the changes in this tax reform package dramatically improve the state’s tax climate. By broadening bases while lowering rates, starting to correct the inequities in the sales tax base, and taking steps to make the state more friendly to investment, policymakers in the state took a responsible approach to comprehensive tax reform.

Kentucky will have a better tax system, but there is a dark lining to the silver cloud of reform.

The legislation is a net tax increase, meaning state politicians will have more money to spend (which is a variable that is not included in the Tax Foundation’s Business Tax Climate Index).

As a big fan of the no-tax-hike pledge, that makes me sympathetic to some of those who opposed the legislation.

But I confess that I’m nonetheless happy that there’s now another state with a flat tax.

Which motivated me to create a five-column ranking for states with regards to the issue of personal income tax.

The best states are in the first column, since they don’t impose any income tax. The second-best option is a flat tax, and then I have three options for so-called progressive tax regimes. A “low-rate” state means the top bracket is less than 5 percent and a “class-warfare” state means the top bracket is higher than 8 percent (with other states in a middle group).

Kentucky has moved from the fourth column to the second column, which is a nice step. Very similar to what North Carolina did a few years ago.

Kansas, by contrast, recently went from the fourth column to the third column and then back to the fourth column.

And I may have to create a special sixth column for states such as California.

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Every time I write a column criticizing Trump’s protectionism, I get pushback. Some of the resistance is from people who genuinely think trade barriers are a good thing, and I routinely respond by asking them to ponder these eight questions or these five charts.

But I also get negative feedback from people who point out that the United States imposed significant import taxes in the 1800s, a period when the United States transitioned from agricultural poverty to middle-class prosperity.

Doesn’t this prove tariffs are pro-growth?

That’s sort of what Brian Domitrovic asserts in a recent column for Forbes.

There is an indisputable chronological correlation between the tariff and phenomenal economic growth. From the late 18th to the early 20th twentieth centuries, the United States steadily developed into the most successful economy in the world.

Brian’s column explores how trade taxes worked in the early history of the United States, but let’s skip to the part that is relevant to today’s discussion.

From 1789 to 1913, the size of the federal government in the economy as a whole averaged about 3%, with variation in time of war. Today, that number is over 20%—a 7-fold increase. State and local government was another 3% back then, and is another 12% today. Where total government was 6% of economic output in the era of the tariff, it is five times larger at over 30% today.

In other words, the real lesson to be learned is not that trade taxes are good for growth, but rather that an economy can prosper if the public sector is very small. And Brian is right that the federal government used to be only a tiny burden in the United States.

Brian even makes the case that government may have stayed small during the 1800s precisely because import taxes were seen as naked cronyism.

The quid pro quo the populace made with the tariff is that Congress and its conspirators in business got their favors, but in turn Congress’s realm, the government, had to stay small. Therefore, the private economy was free… Boundless growth at the hands of entrepreneurs and a talented and ambitious workforce built up year after year as Congress got to curry its petty favors on the condition that government stayed limited in size.

He also explains that politicians back then were very cognizant of the Laffer Curve.

A tariff “for revenue” was one where a rate was set low enough for the good in question to flow into the country in sufficient quantity to bring in increasing receipts to the government. A “prohibitive” tariff was one that was so high, receipts would go up if a rate were lowered. The “Laffer curve” concept was the most discussed theorem in political-economic debates in the United States in the 19th century.

The same principle applies to the income tax today. A modest rate generates lots of revenue, whereas a punitive rate can actually cause a drop in tax receipts.

And, speaking of the income tax, the introduction of that awful levy actually gave Hoover and other politicians the fiscal leeway to impose “prohibitive” tariffs…with very bad results.

After the income tax was put in place in 1913, the tariff shed its revenue purpose and became exclusively a vehicle for cronyism. Therefore it got very high—so high, in 1930, that…the…system was ruined and the result was the Great Depression.

For what it’s worth, I think there were lots of other bad policies from Hoover and Roosevelt that caused – and then exacerbated – the economic damage of the 1930s, so high tariffs don’t deserve all the blame.

But let’s not digress from our main topic of whether trade taxes can be justified.

Brian’s column doesn’t say that tariffs are good, but he does point out that such a system was only capable of financing a very small government. And that meant the private sector had lots of breathing room to operate.

But a “sin of omission” is that he also could have elaborated on the economic benefits of having no income tax. During the 1800s (with the exception of Lincoln’s income tax during the Civil War and an income tax in 1894 that was declared unconstitutional in 1895), there was no personal income tax. And no corporate income tax. And no payroll taxes. Or death tax. Or capital gains tax.

Dean Clancy highlighted these benefits when considering the conditions that would be necessary for him to support trade taxes.

I sort of agree. But I hope Dean would agree to a friendly tweak to his tweet, so that it read “McKinley-size tariffs were a less-worse option because of…”, and then list the polices that actually were good, such as no taxes on income and very small government.

Sadly, I don’t see any practical way of unwinding all the bad policy of the past 100 years.

So the case for trade taxes is very similar to the market-friendly case for a value-added tax. Yes, there is a theoretical argument to replace all income taxes with a VAT, but it’s not realistic.

Likewise, I’m open to the argument that higher tariffs might be acceptable, but only if someone first shows me a practical plan to 1) shrink the federal government back down to what the Founding Fathers envisioned, and 2) get rid of the IRS and all taxes on income.

P.S. Alexander Hamilton, writing about tariffs and excises in Federalist 21, clearly appreciated the insights of the Laffer Curve: “It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue.”

P.P.S. The Cayman Islands is the closest example of a successful modern economy that finances a big chunk of government with import taxes. But that example is somewhat limited since almost all goods are imported. For such an economy, tariffs are basically the same as a sales tax. For what it’s worth, I would argue Cayman’s fiscal system has more in common with Monaco today than with the United States in the 1800s.

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Whenever I see an otherwise sensible person express support for a value-added tax, it triggers a Pavlovian response. And it’s not a favorable reaction.

But I just read a pro-VAT column and I liked it.

So what happened? Have I surrendered to big government? Did I ingest some magic mushrooms?

Actually, I think you’ll agree that I’m still the same lovable guy. Yes, Professor John Cochrane of the University of Chicago (also a Cato adjunct scholar) has a column in the Wall Street Journal that embraces a VAT. But unlike all of the others I just cited, he includes a condition that is mandatory, necessary, vital, and non-negotiable. It’s so important that it deserves the opposite of fine-print treatment.

…eliminate entirely the personal and corporate income tax, estate tax and all other federal taxes. …it is essential that the VAT replace rather than add to the current tax system, as it does in Europe.

Amen. John hits the nail on the head.

The VAT isn’t theoretically bad. Like the flat tax, it would have one rate. There also would be no double taxation of saving and investment. And it also can be designed to have no loopholes.

In other words, the good news is that the VAT – when compared to the internal revenue code – is a less-destructive way of generating revenue.

The bad news, though, is that the VAT is capable of generating a lot of revenue. And as we’ve seen in Europe, that’s a recipe for enabling a larger burden of government spending.

Which is why the idea of a VAT should only be on the table if the plan would first abolish all other federal taxes. Which is what John is proposing.

Except I’d take it one step farther. Just like I’ve argued when contemplating a national sales tax, I’d only allow the VAT if we first repeal the 16th Amendment and replace it with something so ironclad that even John Roberts and Ruth Bader Ginsberg couldn’t rule in favor of an income tax at some point in the future.

By the way, John is right that the economy would grow faster if the income tax was totally abolished. The current system is filled with warts.

Much of the current tax mess results from taxing income. Once the government taxes income, it must tax corporate income or people would incorporate to avoid paying taxes. Yet the right corporate tax rate is zero. Every cent of corporate tax comes from people via higher prices, lower wages, or lower payments to shareholders. And a corporate tax produces an army of lawyers and lobbyists demanding exemptions. An income tax also leads to taxes on capital income. Capital income taxes discourage saving and investment. But the government is forced to tax capital income because otherwise people can hide wages… The estate tax can take close to half a marginal dollar of wealth. This creates a strong incentive to blow the family money on a round-the-world cruise, to spend lavishly on lawyers, or to invest inefficiently to avoid the tax. …A reformed tax code should involve no deductions—including the holy trinity of mortgage interest, employer-provided health insurance, and charitable deductions. The interest groups for each of these deductions are strong. But if the government doesn’t tax income in the first place, these deductions vanish without a fight.

By the way, I will quibble with a couple of things he wrote.

First, I don’t necessarily think the correct corporate tax rate is zero. What’s important is eliminating either the corporate tax or the tax on dividends. That way the income is only taxed once. And since it’s probably administratively easier to tax the income once at the business level rather than once at the shareholder level, I’m not fixated on abolishing the corporate tax.

Second, it’s very important to get rid of double taxation (what he calls “capital income”), but you don’t need a VAT to make that happen. There’s no double taxation with a flat tax.

Third, he should have explicitly included the state and local tax deduction in his list of loopholes to abolish (I’m guessing he assumed it would be the first deduction on the chopping block and therefore didn’t need to be mentioned).

There’s another part of John’s column that deserves attention. He points out that you need to have small government if you want a low tax burden.

…if the federal government is going to spend 20% of gross domestic product, the VAT will sooner or later have to be about 20%. Tax reform is stymied because politicians mix arguments over the rates with arguments over the structure of taxes. This is a mistake. They should first agree to fix the structure of the tax code, and later argue about rates—and the spending those rates must support.

At the risk of being pedantic, I think the VAT rate would have to be significantly above 20 percent, both because the tax base will be smaller than GDP and also because there will be loopholes or rebates. But the point he’s making is spot on. You can’t have a low tax rate and a big government. I’ve made the same point when writing about Belgium and Germany, nations where middle-class taxpayers are pillaged because the welfare state is too big.

My bottom line on this issue is that Professor Cochrane has produced a column showing that a VAT is theoretically worth considering, but only if all other federal taxes are permanently abolished.

But since that’s not going to happen any time soon, I don’t think there’s any reason to ease up on my dogmatic (and pragmatic) opposition to that levy.

P.S. My clinching argument is that Reagan opposed a VAT and Nixon supported a VAT. That tells you everything you need to know.

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The internal revenue code is a reprehensible mess that torments taxpayers and undermines American competitiveness.

The good news is that Americans don’t like the tax system.

The bad news is that they don’t dislike it nearly as much as they should. At least in my humble opinion.

There are two reasons for the inadequate level of disdain.

  • First, nearly half of all households are no longer are subject to the income tax. Indeed, the system is actually a revenue generator for some households since the EITC wage subsidy is a redistribution program laundered through the tax code.
  • Second, many people get a warm and fuzzy feeling when they file their taxes because of the expectation that they will get a sizable refund, even though that payment from the IRS is simply a reflection of having paid too much tax during the prior year.

For those of us who want to scrap the tax system, this is a challenge.

And I’m not shy about admitting the problem.

About three-quarters typically get money back, with refunds so far this year averaging almost $3,000. For many, it will be the single biggest payment they receive all year. …the fact that so many people are getting paid by the IRS, and not the other way around, takes some of the edge off a day when they’re trying to stoke public anger at the tax system. “The fact that people are looking forward to tax time rubs me the wrong way,” said Dan Mitchell, a tax expert at the libertarian Cato Institute. “I would like them to be upset.”

I also have a good idea of why the problem exists.

It’s withholding. And it started back during World War II. Here’s some background.

During the war, tax rates went up, and a broader number of people were expected to pay them. Professor Anuj Desai from the University of Wisconsin Law School said there was a saying that income tax went from “a class tax to a mass tax.” …“The thought was that if we withhold a little bit every bit every paycheck, people won’t have to worry about the problem of coming up with a huge chunk of money,” Desai said. But withholding is also a remarkably efficient way for the government to raise money, and policymakers knew that. …“You could never have the taxes that were levied during World War II without withholding. It was absolutely essential for that purpose,” economist Milton Friedman said in an interview… Friedman worked with the Treasury Department at the time withholding was introduced. Withholding stuck around after the war, much to Friedman’s chagrin. “Unfortunately, once you got it installed, it’s almost impossible to get rid of it,”  Friedman said. “It’s too useful to the people in power.”

Jeffrey Tucker of the Foundation for Economic Education elaborates.

The problem is…the withholding tax. Instead of being collected directly from the payer, the government  collects them “at the source,” which is to say that they are collected from the institution that pays wages and salaries — on behalf of the taxpayer. …one of the most amazingly brilliant innovations of the modern state. This tinkering with the system — the creation of the institution called withholding — has created an illusion that paying taxes is really about getting free money! When the check arrives from the government a month or so later, the taxpayer is actually tempted to think: wow, this is really great! A pillaging has been spun to look like a gift. …Withholding dramatically changed the psychology of paying taxes. It almost feels like you aren’t paying any at all. The worker gets used to how much after-tax income she makes and adapts to it quickly. Then when tax time arrives, there is no more to pay. Instead you file and find yourself on the receiving end of what seems like an unexpected gift of a check from government. Yet in reality your refund is nothing more than the belated return of a zero-interest loan you were forced to provide the government.

Exactly.

Every time I talk to somehow who is happy about a refund, I ask them whether they will give me an interest free loan instead. After all, I’d be happy to collect money from them all year long and then return it the following April.

But I’m digressing.

Jeffrey points out how the political dynamics of tax day would change in the absence of withholding.

If we really wanted to make a wonderful change in favor of transparency and decency, one that would mark a shift in people’s perceptions of the costs of government, the withholding tax could just be repealed completely. …every taxpayer would pay the full amount owed to the government every April 15 and otherwise receive full compensation the rest of the year. Such a seemingly small change would have a dramatic effect on public perceptions of taxation and government. Even from the age of 16, every citizen would have a more pungent reminder of the costs of government. We would no longer live the illusion that we can all get something for nothing and that government isn’t really expensive after all.

Ben Domenech of the Federalist agrees.

The overwhelming majority of Americans pay their taxes by having them extracted from their paychecks before they ever see the money. Operating under the fiction that the government is giving you money as opposed to returning what it has already taken is damaging to the psyche of the nation’s taxpayers. …Withholding was originally mandated as a wartime step, but its continuation since then disguises the property rights involved, essentially offers the government an interest free loan, and shields taxpayers from the ramifications of federal spending. The country would be better off if everyone experienced what entrepreneurs and business owners do: writing the most sizable checks every year to the government, and watching that hard-earned money walk out the door.

By the way, this isn’t merely impractical libertarian fantasy.

There’s a real-world example of a tax system where people actually write checks to the government and are much more aware of the cost of the public sector. It’s called Hong Kong, which is – not coincidentally – an economic success story in large part because of a good fiscal system.

And I would argue that good fiscal system exists because taxpayers are directly sensitive to the cost of government (it also helps that there’s a spending cap in Hong Kong).

Let’s close with some government propaganda. This Disney cartoon was produced before withholding. As you can see the government basically had to make the case that people should set aside money out of their paychecks so they would have enough money to make periodic tax payments.

This was a plausible case when seeking to finance a war against National Socialism and Japanese imperialism. It wouldn’t be nearly as persuasive today when the government seems to specialize in financing waste, fraud, and abuse.

P.S. At the bottom of this column, you can watch a much better cartoon from the 1940s.

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I don’t like the income tax that’s been imposed by our overlords in Washington. Indeed, I’ve speculated whether October 3 is the worst day of the year because that’s the date when the Revenue Act of 1913 was signed into law.

I don’t like state income taxes, either.

And, as discussed in this interview about Seattle from last week, I’m also not a fan of local income taxes.

From an economic perspective, I think a local income tax would be suicidally foolish for Seattle. Simply stated, this levy will drive some well-heeled people to live and work outside the city’s borders. And when revenues fall short of projections, Seattle politicians likely will compensate by increasing the tax rate and also extending the tax so it is imposed on those with more modest incomes. And that will drive more people out of the city, which will lead to an even higher rate that hits even more people.

Lather, rinse, repeat.

Though I pointed out that this grim outcome may be averted if the courts rule that Seattle doesn’t have the legal authority to impose an income tax.

But I also explained in the discussion that a genuine belief in federalism means that you should support the right of state and local governments to impose bad policy. I criticize states such as California and Illinois when they expand the burden of government. And I criticize local entities such as Hartford, Connecticut, and Fairfax County, Virginia, when they expand the burden of government.

But I don’t think that Washington should seek to prohibit bad policy. If some sub-national governments want to torment their citizens with excessive government, so be it.

There are limits, however, to this bad version of federalism. State and local governments should not be allowed to impose laws outside their borders. That’s why I’m opposed to the so-called Marketplace Fairness Act. And they shouldn’t seek federal handouts to subsidize bad policy, such as John Kasich’s whining for more Medicaid funding.

Moreover, a state or local government can’t trample basic constitutional freedoms, for instance. If Seattle goes overboard with its anti-gun policies, federal courts presumably (hopefully!) would strike down those infringements against the 2nd Amendment. Likewise, the same thing also would (should) happen if the local government tried to hinder free speech. Or discriminate on the basis on race.

By the way, it’s worth pointing out that these are all examples of the Constitution’s anti-majoritarianism (which helps to explain why the attempted smear of James Buchanan was so misguided).

The bottom line is that I generally support the rights of state and local governments to impose bad policy, so long as they respect constitutional freedoms, don’t impose extra-territorial laws, and don’t ask for handouts.

And I closed the above interview by saying it sometimes helps to have bad examples so the rest of the nation knows what to avoid. Greece and France play that role for the industrialized world. Venezuela stands alone as a symbol of failed statism in developing world. Places like Connecticut and New Jersey are poster children for failed state policy. And now Seattle can join Detroit as a case study of what not to do at the local level.

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There was some genuinely good news in 2016, which is more than I can say for 2015 (my “best” development for that year was some polling data, followed by some small-ball tinkering).

Though the good news for 2016 was mostly overseas. Here are the four things from around the world that made me happy this year.

And while we didn’t have any major positive developments in the United States, there was a bit of good news. Yes, it’s “small-ball tinkering,” but I’m always glad for any progress.

So those are the noteworthy good things that happened this year. Now let’s look at the other side of the ledger. What was the bad news of 2016?

Well, the good news (so to speak) is that there was not a lot of bad news. At least if we’re focusing on actual policy changes.

But there are three developments that cause me to worry about the future.

Tomorrow I will write about my hopes and fears for 2017.

Let’s close today’s column with a few special categories.

If there was an award for the most disgusting news of 2016, the NAACP would be the clear winner for their decision to sacrifice black children in order to collect blood money from teacher unions.

And if we also had a prize for most moronic leftist in 2016, there would be another easy winner. Trevor Noah inadvertently showed why gun control doesn’t work even though he wanted to make the opposite point.

Last but not least, if there was a category for surprising news in 2016, there’s no question that Paul Krugman would win that prize for writing something sensible about tax policy.

P.S. My most popular post in 2016 (which also set the all-time record) was the very clever image showing that the enemies of liberty are looters, regardless of their economic status.

P.P.S. My most surreal moment in 2016 was getting attacked on the front page of the Washington Post. I must be doing something right.

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