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Posts Tagged ‘Double Taxation’

My buddy from grad school, Steve Horwitz, has a column for CapX that looks at the argument over “trickle-down economics.” As he points out (and as captured by the semi-clever nearby image), this is mostly a term used by leftists to imply that supporters of economic liberty want tax cuts for the “rich” based on a theory that some of those tax cuts eventually will trickle down to the less fortunate.

People who argue for tax cuts, less government spending, and more freedom for people to produce and trade what they think is valuable are often accused of supporting something called “trickle-down economics.” It’s hard to pin down exactly what that term means, but it seems to be something like the following: “those free market folks believe that if you give tax cuts or subsidies to rich people, the wealth they acquire will (somehow) ‘trickle down’ to the poor.”

But Steve points out that no economist actually uses this argument.

The problem with this term is that, as far as I know, no economist has ever used that term to describe their own views. …There’s no economic argument that claims that policies that themselves only benefit the wealthy directly will somehow “trickle down” to the poor.

So why, then, do leftists characterize tax cuts as “trickle-down economics” when no actual advocate uses that term or that argument?

There are a couple of possible answers, one of which is malicious and one of which is mistaken.

  • First, they’ve latched on to a politically effective way of characterizing tax cuts, so it’s understandable that they want to continue with that approach.
  • Second, their argument for Keynesian economics actually is a version of trickle-down economics since the people who get money from so-called stimulus programs spend the money, which means it gradually trickles to other people (that part is true, but Keynesians fail to understand that government can’t inject money into the economy in this fashion without first taking money out of the economy by borrowing from private capital markets). And since they believe the economy is driven by people spending money (rather than people earning money) and having it trickle to other people, maybe they assume that advocates of tax cuts believe the same thing.

In reality, of course, proponents of lower tax rates are motivated by a desire to improve incentives for people to earn additional income with more work, more saving, and more investment. That’s the basic insight of supply-side economics. It has nothing to do with how they spend (or don’t spend) their income.

With that out of the way, I want to address the part of Steve’s column where he suggested that policies which benefit one group are never helpful to other groups.

I don’t think that’s worded very well. If we lower the capital gains tax on people making more than $10 million annually, that is a policy that obviously benefits only the rich, at least when looking at direct or first-order effects.

But the impact of less double taxation should boost economic performance, even if only by a modest amount, and that will benefit everyone in society.

By the way, this works both ways. If we do something that is particularly beneficial for the poor, such as cutting back on occupational licensing requirements, that presumably doesn’t generate any direct benefit for rich people. But they will gain (as will middle-class people) as the economy becomes more productive and efficient.

Steve understands this. He closes his column by making a very similar argument about the economy-wide benefits of more economic liberty.

…allowing everyone to pursue all the opportunities they can in the marketplace, with the minimal level of taxation and regulation, will create generalized prosperity. The value of cutting taxes is not just cutting them for higher income groups, but for everyone. Letting everyone keep more of the value they create through exchange means that everyone has more incentive to create such value in the first place, whether it’s through the ownership of capital or finding new uses for one’s labor.

Now that we’ve dispensed with the silly left-wing caricature of trickle-down economics, let’s discuss how there actually is a sensible way to think about the issue.

Way back in 1996, I gave a speech in Sweden about the impact of fiscal policy on economic growth (later reprinted as a Heritage Foundation publication).

As part of my comments, I spoke about the damaging impact of the tax code’s bias against saving and investment and explained that this lowered wages because of the link between the capital stock (machinery, technology, etc) and employee compensation.

I also quoted John Shoven, a professor at Stanford University who wrote a paper back in 1990 about this topic for the American Council for Capital Formation. And here we actually have an example of an economist using “trickle-down economics” in the proper sense.

The mechanism of raising real wages by stimulating investment is sometimes derisively referred to as “trickle-down” economics. But regardless of the label used, no one doubts that the primary mechanism for raising the return to work is providing each worker with better and more numerous tools. One can wonder about the length of time it takes for such a policy of increasing saving and investments to have a pronounced effect on wages, but I know of no one who doubts the correctness of the underlying mechanism. In fact, most economists would state the only way to increase real wages in the long run is through extra investments per worker.

Amen. Capital and labor are complementary goods, which means that more of one helps make the other more valuable.

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What’s the worst possible tax hike, the one that would do the most economic damage?

Raising income tax rates is never a good idea, and there’s powerful evidence from the 1980s about how upper-income taxpayers have considerable ability to change their behavior in response to changes in incentives.

But if you want to know the tax hikes that do the most damage, on a per-dollar raised basis, it’s probably best to focus on levies that boost double taxation of saving and investment.

The Tax Foundation ran some estimates on five different tax increases, for instance, and found that worsening depreciation rules (an arcane part of the tax code dealing with the degree to which new investment is taxed) would do the most damage, followed by a higher corporate tax rate, and then higher individual income tax rates.

But I wonder what they would have found if they also modeled the impact of a higher death tax. That levy is particularly destructive because it directly requires the liquidation of capital. The assets of investors, entrepreneurs, farmers, small business owners, and other victims take a big hit as politicians grab as much as 40 percent of what they’ve worked for during their lives.

This is bad for the economy because it directly reduces the capital stock. Sort of like harvesting apples by cutting down 40 percent of the trees in an orchard. The net result is that the economy’s ability to generate future income is undermined.

But it’s also bad for the economy because it reduces incentives for successful taxpayers to both earn and invest while they’re alive. Why bust your rear end when the government immediately will take at least 39.6 percent (actually more when you consider Medicare taxes, state taxes, and double taxation of interest, dividends, and capital gains) of your income, and then another 40 percent of what you’ve saved and invested when you kick the bucket?

Unfortunately, Hillary Clinton doesn’t seem to care about such matters. She actually just decided to double down on her destructive tax agenda by endorsing an even bigger increase in the death tax.

I’m not joking.

The editorial page of the Wall Street Journal is not exactly impressed by Hillary’s class-warfare poison.

On Thursday she decided that her proposal to raise the death tax to 45% from 40% isn’t enough and endorsed even higher levies that would apply to thousands of estates. Though she defeated Bernie Sanders in the primary, she is adopting the socialist’s death-tax rate structure. She’d tax all estates over $10 million at 50%, apply a 55% rate on estates over $50 million, and go to 65% on assets above $500 million. The 65% rate would be the highest since 1981 and is another example of how she is repudiating the more moderate policies of her husband and the Democrats of the 1990s. …the Sanders plan that Mrs. Clinton is copying did not index exemption levels for inflation. …Mrs. Clinton would also end the “step-up in basis” on stock valuations for many filers, triggering big capital gains taxes for a much broader population.

Wow, this is class warfare on steroids. And the part about this being more like Bernie Sanders than Bill Clinton hits the mark. Economic freedom actually increased in America between 1992 and 2000.

Hillary, by contrast, is a doctrinaire and reflexive statist. I’m not aware of a single position she’s taken that would reduce the burden of government.

By the way, here’s a bit of information that won’t shock anyone familiar with the greed and hypocrisy of the political class.

Hillary and her friends will largely dodge the tax, which mostly will fall on small business owners who lack the ability to create clever structures.

…most of her rich friends will set up foundations, as she and Bill Clinton have, to shelter most of their riches from the estate tax. …In any case, Mrs. Clinton is now promising total tax hikes of $1.5 trillion over a decade if elected President.

Gee, knock me over with a feather.

The Tax Foundation may not have included the death tax when it compared the harm of different tax hikes, but it has looked at how the death tax hurts the economy by discouraging capital formation and capital accumulation.

…an estate tax increase would cause economic production to be allocated away from business equipment, reducing the quantity of business equipment in the economy. …Many of the assets that fall under the estate tax, such as residential structures, commercial structures, and business equipment, enhance productivity, or gross domestic product (GDP) per hour worked. …The relationship between these assets and productivity is the focus of one of the most common models in economics, an equation called the Cobb-Douglas production function, which describes how workers and capital goods together produce economic output. Under this model, more capital increases output or income, even as the number of workers is held constant. It therefore increases GDP per hour worked, making people richer. Under such a model, reallocating economic production away from the capital goods that enhance output would reduce GDP in the long run. This is an effect that one might expect to see in a macroeconomic analysis of the estate tax.

Amen. If you want more output and higher living standards, you need to boost worker pay by increasing the quality and quantity of capital in the economy.

But politicians like Hillary

Here are the estimates of what happens to the economy with a 65 percent death tax.

So what would happen if lawmakers instead did the right thing and abolished this wretched example of double taxation?

The Tax Foundation has crunched the numbers. Here’s the impact on the overall economy.

And here’s what happens to federal revenue over the same period.

By the way, the Wall Street Journal editorial cited above did contain a bit of good news.

Congress is starting to push back against President Obama’s stealth death tax increase. Rep. Warren Davidson (R., Ohio) read our recent editorial about Treasury plans to raise taxes on minority stakes in family businesses by artificially inflating their value, and he’s drafted a bill to stop Treasury’s tax grab as a violation of the separation of powers. …A former owner of several businesses, Mr. Davidson says the U.S. economy needs owners focused on “growing assets, not structuring them for life events.” He explains that many farms in particular may carry high values but hold little cash, and so the death tax triggers land sales to pay the IRS. “The whole concept of a death tax is immoral,” Mr. Davidson says, and he’s right. The tax confiscates assets that have already been taxed once or more when first earned, and it punishes a lifetime of investment and thrift.

I wrote about this issue the other day, so I’m glad to see that there’s pushback against this Obama Administration scheme to unilaterally boost the burden of the death tax.

P.S. Politicians are not the only beneficiaries of the death tax.

 

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While Switzerland is one of the world’s most market-oriented nations, ranked #4 by Economic Freedom of the World, it’s not libertarian Nirvana.

Government spending, for instance, consumes about one-third of economic output. That may be the second-lowest level among all OECD nations (fast-growing South Korea wins the prize for the smallest public sector relative to GDP), but it’s still far too high when compared to Hong Kong and Singapore.*

Moreover, while the Swiss tax code is benign compared to what exists in other European nations, it also is not perfect. One of the warts is a wealth tax, which is a very pernicious levy that drains capital from the private sector.

Let’s look at some excerpts from a report in the Wall Street Journal, starting with a description of the Swiss system.

Switzerland has taxed wealth since the late 18th century. Its 26 cantons in 2014 levied taxes on net wealth with rates varying from 0.13% in the lighter taxing German-speaking parts to 1% in French-speaking Geneva. Swiss wealth taxes are also special because they apply from wealth as low as 25,000 Swiss francs, ensuring large swaths of the middle class incur them. Typical taxpayers pay a rate of just over 0.5%.

Here are the wealth tax rates in the various cantons, based on a recent study of the system.

As noted in the WSJ story, that study contains strong evidence that the tax is hurting Switzerland.

…according to a new paper, …taxing wealth leads declared wealth to disappear. Based on experience in Switzerland, which uses wealth taxes the most, reported wealth falls around 20 times as much in response to an increase in a wealth tax as it does to an equivalent increase in a tax on capital income, such as dividends or capital gains. …Economists at the University of Lausanne and Massachusetts Institute of Technology found that a 0.1 percentage point increase in Swiss wealth taxes caused a 3.5% reduction in reported wealth. That’s equivalent to 100,000 Swiss francs going missing for a person worth 3 million francs. …they conclude in a study investigating changes in wealth tax rates on Swiss taxpayers’ reported wealth from 2001 to 2012.

Why is there such a big response?

For the same reason that class-warfare taxes don’t work very well in the United States. Simply stated, taxpayers have considerable ability to rearrange their financial affairs when governments try to tax capital (or capital income). And that ability is especially pronounced for those with higher levels of income and wealth.

Individuals have greater control over their reported wealth–especially financial wealth such as bank deposits, stock and bonds–than their reported income.

By the way, the story also included this nugget of good news.

Thanks primarily to tax competition, many nations have eliminated wealth taxes over the past 20 years.

…only five members of the Organization for Economic Cooperation and Development still levy annual taxes on individuals’ total financial and non-financial wealth… That is down from 14 nations two decades ago.

And if you want more good news, the Swiss cantons also are lowering their tax rates on wealth.

Here’s another map from the study. It shows that a couple of French-speaking cantons have imposed very small increases in the tax since 2003, while the vast majority of cantons have moved in the other direction, in some cases slashing their wealth tax rates by substantial amounts.

Since I’m a big fan of Switzerland, let’s close with some more good news about the Swiss tax system. Not only are tax rates on wealth dropping, but there’s no capital gains tax. And there are no taxes on interest.

So while there is a wealth tax, which is a very unfortunate and destructive imposition, the Swiss avoid many other forms of double taxation on income that is saved and invested.

*The burden of government spending also is excessive in Hong Kong and Singapore. Based on historical data, economic performance will be maximized if total government spending is less than 10 percent of GDP.

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I’ve been advocating for good tax reform for more than two decades, specifically agitating for a simple and fair flat tax.

I get excited when politicians make bold proposals, such as many of the plans GOP presidential candidates proposed over the past year or so.

But sometimes I wind up feeling deflated when there’s a lot of discussion about tax reform and the final result is a milquetoast plan that simply rearranges the deck chairs on the Titanic. For instance, back in 2014, the then-Chairman of the House Ways and Means Committee unveiled a proposal that – at best – was underwhelming. Shifts in the right direction in some parts of the plan were largely offset by shifts in the wrong direction in other parts of the plan. What really doomed the plan was a political decision that the tax code had to raise just as much money (on a static basis) as the current system and that there couldn’t be any reduction in the amount of class warfare embedded in the current system (i.e., the “distribution” of the tax burden couldn’t change).

Well, we have some good news. Led by the new Chairman of the Ways and Means Committee, Kevin Brady, House Republicans have unveiled a new plan that it far, far better. Instead of being hemmed in by self-imposed constraints of static revenue and distributional neutrality, their two guidelines were dynamic revenue neutrality and no tax increase for any income group.

With those far more sensible constraints, they were able to put together a plan that was almost entirely positive. Let’s look at the key features, keeping in mind these theoretical principles that should guide tax reform.

  1. The lowest possible tax rate – High tax rates on work and entrepreneurship make no sense if the goal is faster growth and more competitiveness.
  2. No double taxation – It is foolish to penalize capital formation (and thereby wages) by imposing extra layers of tax on income that is saved and invested.
  3. No loopholes or special preferences – The tax code shouldn’t be riddled with corrupt deductions, exemptions, exclusions, credits, and other goodies.

What’s Great

Here are the features that send a tingle up my leg (apologies to Chris Matthews).

No value-added tax – One worrisome development is that Senators Rand Paul and Ted Cruz included value-added taxes in their otherwise good tax plans. This was a horrible mistake. A value-added tax may be fine in theory, but giving politicians another source of revenue without permanently abolishing the income tax would be a tragic mistake. So when I heard that House Republicans were putting together a tax plan, I understandably was worried about the possibility of a similar mistake. I can now put my mind at rest. There’s no VAT in the plan.

Death tax repeal – Perhaps the most pure (and therefore destructive) form of double taxation is the death tax, which also is immoral since it imposes another layer of tax simply because someone dies. This egregious tax is fully repealed.

No state and local tax deduction – If it’s wrong to subsidize particular activities with special tax breaks, it’s criminally insane to use the tax code to encourage higher tax rates in states such as New York and California. So it’s excellent news that House GOPers are getting rid of the deduction for state and local taxes.

No tax bias against new investment – Another very foolish provision of the tax code is depreciation, which forces companies to pretend some of their current investment costs take place in the future. This misguided approach is replaced with expensing, which allows companies to deduct investments when they occur.

What’s Really Good

Here are the features that give me a warm and fuzzy feeling.

A 20 percent corporate tax rate – America’s corporate tax system arguably is the worst in the developed world, with a very high rate and onerous rules that make it difficult to compete in world markets. A 20 percent rate is a significant step in the right direction.

A 25 percent small business tax rate – Most businesses are not traditional corporations. Instead, they file using the individual portion of the tax code (using forms such as “Schedule C”). Lowering the tax rate on business income to 25 percent will help these Subchapter-S corporations, partnerships, and sole proprietorships.

Territorial taxation – For a wide range of reasons, including sovereignty, simplicity, and competitiveness, nations should only tax economic activity within their borders. The House GOP plan does that for business income, but apparently does not extend that proper treatment to individual capital income or individual labor income.

By shifting to this more sensibly designed system of business taxation, the Republican plan will eliminate any incentive for corporate inversions and make America a much more attractive place for multinational firms.

What’s Decent but Uninspiring

Here are the features that I like but don’t go far enough.

Slight reduction in top tax rate on work and entrepreneurship – The top tax rate is reduced to 33 percent. That’s better than the current top rate of 39.6 percent, but still significantly higher than the 28 percent top rate when Reagan left office.

Less double taxation of savings – The plan provides a 50-percent exclusion for individual capital income, which basically means that there’s double taxation of interest, dividends, and capital gains, but at only half the normal rate of tax. There’s also some expansion of tax-neutral savings accounts, which would allow some saving and investment fully protected from double taxation.

Simplification – House GOPers assert that all their proposed reforms, if enacted, would create a much simpler tax system. It wouldn’t result in a pure Hall-Rabushka-style flat tax, with a 10-line postcard for a tax return, but it would be very close. Here’s their tax return with 14 lines.

In an ideal world, there should be no double taxation of income that is saved and invested, so line 2 could disappear (in Hall-Rabushka flat tax, investment income/capital income is taxed once and only once at the business level). All savings receives back-ended IRA (Roth IRA) treatment in a pure flat tax, so there’s no need for line 3. There is a family-based allowance in a flat tax, which is akin to lines 4 and 9, but there are no deductions, so line 5 and line 6 could disappear. Likewise, there would be no redistribution laundered through the tax code, so line 10 would vanish. As would line 11 since there are no special preferences for higher education.

But I don’t want to make the perfect the enemy of the good. The postcard shown above may have four more lines than I would like, but it’s obviously far better than the current system.

What’s Bad but acceptable

Increase in the double taxation of interest – Under current law, companies can deduct the interest they pay and recipients of interest income must pay tax on those funds. This actually is correct treatment, particularly when compared to dividends, which are not deductible to companies (meaning they pay tax on those funds) while also being taxable for recipients. The House GOP plan gets rid of the deduction for interest paid. Combined with the 50 percent exclusion for individual capital income, that basically means the income is getting taxed 1-1/2 times. But that rule would apply equally for shareholders and bondholders, so that pro-debt bias in the tax code would be eliminated. And the revenue generated by disallowing any deduction for interest would be used for pro-growth reforms such as a lower corporate tax rate.

What’s Troublesome

No tax on income generated by exports and no deduction for cost of imported inputs for companies – The House GOP proposal is designed to be “border adjustable,” which basically means the goal is to have no tax on exports while levying taxes on imports. I’ve never understood why politicians think it’s a good idea to have higher taxes on what Americans consume and lower taxes on what foreigners consume. Moreover, border adjustability normally is a feature of a “destination-based” value-added tax (which, thankfully, is not part of the GOP plan), so it’s not completely clear how the tax-on-imports  portion would be achieved. If I understand correctly, there would be no deduction for the cost of foreign purchases by American firms. That’s borderline protectionist, if not over-the-line protectionist. And it’s unclear whether this approach would pass muster with the World Trade Organization.

To conclude, the GOP plan isn’t perfect, but it’s very good considering the self-imposed boundaries of dynamic revenue neutrality and favorable outcomes for all income groups.

And since those self-imposed constraints make the plan politically viable (unlike, say, the Trump plan, which is a huge tax cut but unrealistic in the absence of concomitant savings from the spending side of the budget), it’s actually possible to envision it becoming law.

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The value-added tax is a very dangerous levy for the simple reason that giving a big new source of revenue to Washington almost certainly would result in a larger burden of government spending.

That’s certainly what happened in Europe, and there’s even more reason to think it would happen in America because we have a looming, baked-in-the-cake entitlement crisis and many politicians don’t want to reform programs such as Medicare, Medicaid, and Obamacare. They would much rather find additional tax revenues to enable this expansion of the welfare state. And their target is the middle class, which is why they very much want a VAT.

The most frustrating part of this debate is that there are some normally rational people who are sympathetic to the VAT because they focus on theoretical issues and somehow convince themselves that this new levy would be good for the private sector.

Here are the four most common economic myths about the value-added tax.

Myth 1: The VAT is pro-growth

Reihan Salam implies in the Wall Street Journal that taxing consumption is good for growth.

Mr. Cruz has roughly the right idea. He has come out in favor of a growth-friendly tax on consumption… Rather sneakily, he’s calling his consumption tax a “business flat tax,” but everyone knows that it’s a VAT.

And a different Wall Street Journal report asserts there’s a difference between taxing income and taxing consumption.

…a VAT taxes what people consume rather than how much they earn.

Reality: The VAT penalizes all productive economic activity

I don’t care whether proponents change the name of the VAT, but they are wrong when they say that taxes on consumption are somehow better for growth than taxes on income. Consider two simple scenarios. In the first example, a taxpayer earns $100 but loses $20 to the income tax. In the second example, a taxpayers earns $100, but loses $20 to the VAT. In one case, the taxpayer’s income is taxed when it is earned and in the other case it is taxed when it is spent. But in both cases, there is an identical gap between pre-tax income and post-tax consumption. The economic damage is identical, with the harm rising as the marginal tax rate (either income tax rate or VAT rate) increases.

Advocates for the VAT generally will admit that this is true, but then switch the argument and say that there’s pervasive double taxation in the internal revenue code and that this tax bias against saving and investment does far more damage, per dollar collected, than either income taxes imposed on wages or VATs imposed on consumption.

They’re right, but that’s an argument against double taxation, not an argument for taxing consumption instead of taxing income. They then sometimes assert that a VAT is needed to make the numbers add up if double taxation is to be eliminated. But a flat tax does the same thing, and without the risk of giving politicians a new source of revenue.

Myth 2: The VAT is pro-savings and pro-investment

As noted in a recent Wall Street Journal story, advocates claim this tax is an economic elixir.

Supporters of a VAT…say it is better for economic growth than an income tax because it doesn’t tax savings or investment.

Reality: The VAT discourages saving and investment

The superficially compelling argument for this assertion is that the VAT is a tax on consumption, so the imposition of such a tax will make saving relatively more attractive. But this simple analysis overlooks the fact that another term for saving is deferred consumption. It is true, of course, that people who save usually earn some sort of return (such as interest, dividends, or capital gains). This means they will be able to enjoy more consumption in the future. But that does not change the calculation. Instead, it simply means there will be more consumption to tax. In other words, the imposition of a VAT does not alter incentives to consume today or consume in the future (i.e., save and invest).

But this is not the end of the story. A VAT, like an income tax or payroll tax, drives a wedge between pre-tax income and post-tax income. This means, as already noted above, that a VAT also drives a wedge between pre-tax income and post-tax consumption – and this is true for current consumption and future consumption. This tax wedge means less incentive to earn income, and if there is less total income, this reduces both total saving and total consumption.

Again, advocates of a VAT generally will admit this is correct, but then resort to making a (correct) argument against double taxation. But why take the risk of a VAT when there are very simple and safe ways to eliminate the tax bias against saving and investment.

Myth 3: The VAT is pro-trade.

My normally sensible friend Steve Moore recently put forth this argument in the American Spectator.

…a better way to do this…is through a “border adjustable”…tax, meaning that it taxes imports and relieves all taxes on exports. …The guy who gets this is Ted Cruz. His tax plan…would not tax our exports. Cruz is right when he says this automatically gives us a 16% advantage.

Reality: The protectionist border-adjustability argument for a VAT is bad in theory and bad in reality.

For mercantilists worried about trade deficits, “border adjustability” is seen as a positive feature. But not only are they wrong on trade, they do not understand how a VAT works. Protectionists seem to think a VAT is akin to a tariff. It is true that the VAT is imposed on imports, but this does not discriminate against foreign-produced goods because the VAT also is imposed on domestic-produced goods.

Under current law, American goods sold in America do not pay a VAT, but neither do German-produced goods that are sold in America. Likewise, any American-produced goods sold in Germany are hit be a VAT, but so are German-produced goods. In other words, there is a level playing field. The only difference is that German politicians seize a greater share of people’s income.

So what happens if America adopts a VAT? The German government continues to tax American-produced goods in Germany, just as it taxes German-produced goods sold in Germany. There is no reason to expect a VAT to cause any change in the level of imports or exports from a German perspective. In the United States, there is a similar story. There is now a tax on imports, including imports from Germany. But there is an identical tax on domestically-produced goods. And since the playing field remains level, protectionists will be disappointed. The only winners will be politicians since they have more money to spend.

I explain this issue in greater detail in this video, beginning about 5:15, though I hope the entire thing is worth watching.

Myth 4: the VAT is pro-compliance

There’s a common belief, reflected in this blurb from a Wall Street Journal report, that a VAT has very little evasion or avoidance because it is self enforcing.

…governments like it because it tends to bring in more revenue, thanks in part to the role that businesses play in its collection. Incentivizing their efforts, businesses receive credits for the VAT they pay.

Reality: Any burdensome tax will lead to avoidance and evasion and that applies to the VAT.

I’m always amused at the large number of merchants in Europe who ask for cash payments for the deliberate purpose of escaping onerous VAT impositions. But my personal anecdotes probably are not as compelling as data from the European Commission.

To give an idea of the magnitude, here are some excerpts from a recent Bloomberg report.

Over the next two years, the Brussels-based commission will seek to streamline cross-border transactions, improve tax collection on Internet sales… In 2017, the EU plans to propose a single European VAT area, a reform of rates and add specifics to its anti-fraud strategy. …“We face a staggering fiscal gap: the VAT revenues are 170 billion euros short of what they could be,” EU Economic Affairs and Tax Commissioner Pierre Moscovici said. “It’s time to have this money back.”

For what it’s worth, the Europeans need to learn that burdensome levels of taxation will always encourage noncompliance.

Though, to be fair, much of the “tax gap” for the VAT in Europe exists because governments have chosen to adopt “destination-based” VATs rather than “origin-based” VATs, largely for the (ineffective) protectionist reasons outlined in Myth 3. And this creates a big opportunity to escape the VAT by classifying sales as exports, even if the goods and services ultimately are consumed in the home market.

P.S. At the risk of being wonky, it should be noted that there are actually two main types of value-added tax. In both cases, businesses collect the tax, and the tax incidence is similar (households actually bear the cost), but there are different collection methods. The credit-invoice VAT is the most common version (ubiquitous in Europe, for instance), and it somewhat resembles a sales tax in its implementation, albeit with the tax imposed at each stage of the production process. The subtraction-method VAT, by contrast, relies on a tax return sort of like the corporate income tax. The Joint Committee on Taxation has a good description of these two systems.

Under the subtraction method, value added is measured as the difference between an enterprise’s taxable sales and its purchases of taxable goods and services from other enterprises. At the end of the reporting period, a rate of tax is applied to this difference in order to determine the tax liability. The subtraction method is similar to the credit-invoice method in that both methods measure value added by comparing outputs (sales) to inputs (purchases) that have borne the tax. The subtraction method differs from the credit-invoice method principally in that the tax rate is applied to a net amount of value added (sales less purchases) rather than to gross sales with credits for tax on gross purchases (as under the credit-invoice method). The determination of the tax liability of an enterprise under the credit-invoice method relies upon the enterprise’s sales records and purchase invoices, while the subtraction method may rely upon records that the taxpayer maintains for income tax or financial accounting purposes.

P.P.S. Another wonky point is that the effort by states to tax Internet sales is actually an attempt to implement and enforce the kind of “destination-based” tax regime mentioned above. I explain that issue in this presentation on Capitol Hill.

P.P.P.S. You can enjoy some amusing – but also painfully accurate – cartoons about the VAT by clicking here, here, and here.

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When I compared the tax reform proposals of various 2016 presidential candidates last month, Ben Carson got the best grade by a slight margin.

But I’ve now decided to boost his overall grade from a B+ to A-, or perhaps even A, because he’s finally released details and that means his grade for “specificity” jumps from a C to A-.

Here’s some of what’s been reported in the Wall Street Journal.

Republican presidential candidate Ben Carson on Monday called for imposing a 14.9% flat tax rate on income, ending taxes on capital gains and dividends and abolishing the charitable deduction and all tax credits.

By the way, the reporter goofed. Carson is proposing to end double taxation of dividends and capital gains, but all income would be taxed. What the reporter should have explained is that capital and business income would be taxed only one time.

But I’m digressing. Let’s review some additional details.

Mr. Carson’s flat tax would apply only to income above 150% of the poverty level… In some respects, Mr. Carson’s plan is similar to those of the other candidates, all of whom want to lower tax rates… But he goes farther, particularly with his willingness to rip up parts of the tax system that have been in place for a century. …In addition to eliminating the charitable deduction and investment taxation, Mr. Carson would also repeal the estate tax, the mortgage-interest deduction, the state and local tax deduction,  depreciation rules and the alternative minimum tax.

Wow, no distorting preferences for charity or housing. And no double taxation of any form, along with expensing instead of depreciation. Very impressive.

Carson has basically put forth a pure version of the plan first proposed by economists at Stanford University’s Hoover Institution.

Perhaps most important of all, Carson’s plan is a flat tax and just a flat tax. He doesn’t create any new taxes that could backfire in the future.

Here’s what the Carson campaign wrote about his flat tax compared to the plans put forth by Rand Paul and Ted Cruz.

Unlike proposals advanced by other candidates, my tax plan does not compromise with special interests on deductions or waffle on tax shelters and loopholes. Nor does it falsely claim to be a flat tax while still deriving the bulk of its revenues through higher business flat taxes that amount to a European-style value-added tax (VAT). Adding a VAT on top of the income tax would not only impose an immense tax increase on the American people, but also become a burdensome drag on the U.S. economy.

I would have used different language, warning about the danger of a much-higher future fiscal burden because Washington would have both an income tax and a VAT, but the bottom line is that I like Carson’s plan because the worst outcome is that future politicians might eventually recreate the current income tax.

What I don’t like about the Paul and Cruz plans, by contrast, is that future politicians could much more easily turn America into France or Greece.

Here’s my video that explains why the flat tax is the best system (at least until we shrink the federal government to such a degree that we no longer need any form of broad-based taxation).

P.S. If you want to get hyper-technical, Carson’s plan may not be a pure flat tax because he would require a very small payment from everybody (akin to what Governor Bobby Jindal proposed). Though if the “de minimis” payment is a fixed amount (say $50 per adult) rather than a second rate (say 1% on the poor), then I certainly would argue it qualifies as being pure.

P.P.S. Carson still has a chance to move his overall grade to A or A+ if he makes the plan viable by proposing an equally detailed plan (presumably consisting of genuine entitlement reform and meaningful spending caps) to deal with the problem of excessive government spending.

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With all of the GOP presidential candidates proposing varying plans to reduce the tax burden and reform the tax system, I’m constantly asked which one is best.

But that’s hard to answer because all of the proposals have features I like…as well as some features that leave me underwhelmed, or perhaps even worried.

My fantasy proposal is to have no income tax, or any broad-based tax, because we shrink the federal government to less than 5 percent of economic output (which is what existed for much of our nation’s history).

But since most of my fantasies won’t happen (at least in the near future), my intermediate goal is to junk the current tax system and replace it with a simple and fair flat tax, which would mean a low tax rate, no double taxation, and no corrupt and distorting tax preferences.

The bad news is that there hasn’t been a stampede by candidates to embrace this type of fundamental tax reform. But the good news is that they all want to move in that direction.

The best site for seeing what the various candidates are proposing is the Tax Foundation, and you can click here to learn everything that you need to know about their plans. There’s less detail, but the Committee for a Responsible Federal Budget also has a helpful summary that can be perused here.

Conservative Review put together some useful graphs to compare the major plans. Here’s the tax rate structure for households.

Though this is not very accurate since the value-added taxes in the plans put forth by Rand Paul and Ted Cruz mean the real tax rates on labor income would actually be 29 percent and 26 percent, respectively.

And here’s the degree of double taxation in the major plans.

What stands out in this chart is the fact all the candidates want to reduce double taxation, but Marco Rubio’s plan gets rid of that pernicious practice completely.

There are lots of additional metrics. Most of the candidates abolish the death tax, which is a very damaging form of double taxation.

They all lower or eliminate the corporate income tax.

Most of the candidates also replace depreciation with expensing, thus ensuring the proper treatment of business investment.

And the candidates generally scale back on favoritism in the tax code, particularly the deduction for state and local taxes.

To summarize, the plans have lots of good features, but none of them are perfect. Which is why they all get similar grades. Here’s my back-of-the-envelope assessment (with apologies to John Kasich, Rick Santorum, Mike Huckabee, Carly Fiorina, etc, since I imposed my own arbitrary cutoff on which candidates merited close consideration).

Ben Carson gets the best grade because he says he wants a pure flat tax. But he doesn’t get an A because there are no details. In theory, you don’t need a lot of details because the plan is so simple, but the fact that he hasn’t even pinned down the rate (it was 10 percent, but is now 15 percent) leaves me uncertain. Moreover, he hasn’t put forth many details on how to reduce the burden of government spending, which would be necessary to make a low-rate flat tax viable.

By the way, Carly Fiorina would probably get a grade similar to Carson since she’s talked generically about a pure flat tax, and Rick Santorum’s more detailed support for a not-quite-pure flat tax also merits applause.

Jeb Bush and Chris Christie are almost identical (and John Kasich probably would be in the same category) because they make good progress (but not great progress) in almost all areas of the tax code.

Rand Paul and Ted Cruz are more aggressive taking big steps in the right direction, but the value-added tax is a very worrisome feature of their plans.

Donald Trump has the biggest net tax cut, but seems to have no interest in controlling the burden of government spending. He also is the only candidate (to my knowledge) who doesn’t want to replace America’s anti-competitive worldwide tax system with a territorial tax regime.

And Marco Rubio is unique in that his plan is great on double taxation, but is a bit of a dud with regards to tax rates.

Last but not least, Mike Huckabee’s support for replacing the income tax with a national sales tax is theoretically appealing, but it’s either impractical (because there aren’t enough votes to repeal the 16th Amendment) or too risky (because the crowd in Washington would adopt a sales tax without completely repealing the income tax).

P.S. For those who really care about these issues, there’s a debate tomorrow morning (December 8th) between representatives of the Cruz, Paul, Bush, Rubio, and Kasich campaigns.

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I’m a big fan of the flat tax because a low tax rate and no double taxation will result in faster growth and more upward mobility.

I also like the flat tax because it gets rid of all deductions, credits, exemptions, preferences, exclusions, and other distortions. And a loophole-free tax code would be a great way of reducing Washington corruption and promoting simplicity.

Moreover, keep in mind that eliminating all favors from the internal revenue code also would be good for growth because people then will make decisions on the basis of what makes economic sense rather than because of peculiar quirks of the tax system.

Sounds great, right?

Well, it’s not quite as simple as it sounds because there’s a debate about how to measure loopholes. Sensible people want a tax code that’s neutral, which means the government doesn’t tilt the playing field. And one of the main implications of this benchmark is that the tax code shouldn’t create a bias against income that is saved and invested. In the world of public finance, this means they favor a neutral “consumption-base” tax system, but that’s simply another way of saying they want income taxed only one time.

Folks on the left, however, are advocates of a “Haig-Simons” tax system, which means they believe that there should be double taxation of all income that is saved and invested. You see this approach from the Joint Committee on Taxation. You see it from the Government Accountability Office. You see it from the Congressional Budget Office. Heck, you even sometimes see Republicans mistakenly use this benchmark.

Let’s look at three examples to see what this means in practice.

Example #1: Because they don’t want a bias that encourages people to spend their income today rather than in the future, advocates of a neutral tax code want to get rid of all double taxation of savings (Canada is moving in that direction). So that means they like IRAs and 401(k)s since those vehicles at least allow some savings to be protected from double taxation.

Proponents of Haig-Simons taxation, by contrast, think that IRAs and 401(k)s are loopholes.

Example #2: Another controversy revolves around the tax treatment of business investment. Advocates of neutral taxation believe in expensing, which is simply the common-sense view that investment expenditures should be recognized when they actually occur.

Proponents of Haig-Simons, however, think that investment expenditures should be “depreciated,” which means companies are forced to pretend that most of their investment costs which are incurred today actually take place in future years.

Example #3: Supporters of neutral taxation think capital gains taxes should be abolished because there already is tax on the income generated by assets such as stocks and bonds. So the “preferential rates” in the current system aren’t a loophole, but instead should be viewed as the partial mitigation of a penalty.

Proponents of Haig-Simons, not surprisingly, have the opposite view. Not only do they want to double tax capital gains, they also want them fully taxed, which would mean an economically jarring jump in the tax rate of more than 15 percentage points.

Now, having provided all this background information, let’s finally get to today’s topic.

If you’ve been following the presidential campaign, you’ll be aware that there’s a controversy over something called “carried interest.” It’s a wonky tax issue that seems very complicated, so I’m very happy that the Center for Freedom and Prosperity has produced a video that cuts through all the jargon and explains in a very clear and concise fashion that it’s really just an effort by some people to increase the capital gains tax.

There are four points from the video that deserve special emphasis.

  1. Partnerships are voluntary agreements between consenting adults, and both parties concur that carried interest helps create a good incentive structure for productive investment.
  2. Capital formation is very important for growth, which is one of the reasons why there shouldn’t be any capital gains tax.
  3. A capital gain doesn’t magically become labor income just because an investor decides to share a portion of the gain with a fund manager.
  4. An increase in the tax on carried interest would be the camel’s nose under the tent for more broad-based increases in the tax burden on capital gains.

By the way, I liked that the video also took a gentle swipe at some of the ignorant politicians who want to boost the tax burden on carried interest. They claim they’re going after hedge funds, when the tax actually is much more targeted at private equity partnerships.

But what really matters is not the ignorance of politicians. Instead, we should be focused on whether tax policy is being needlessly destructive because of high – and duplicative – taxes on saving and investment.

Such levies would reduce investment. And that means lower levels of productivity and concomitantly lower wages.

In other words, ordinary people will suffer a lot of collateral damage if this tax-the-rich scheme for carried interest is implemented.

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I’m pleasantly surprised by the tax plans proposed by Marco Rubio, Rand Paul, Jeb Bush, and Donald Trump.

In varying ways, all these candidate have put forth relatively detailed proposals that address high tax rates, punitive double taxation, and distorting tax preferences.

But saying the right thing and doing the right thing are not the same. I just did an interview focused on Donald Trump’s tax proposal, and one of my first points was that candidates may come up with good plans, but those proposals are only worthwhile if the candidates are sincere and if they intend to do the heavy lifting necessary to push reform through Congress.

Today, though, I want to focus on another point, which I raised starting about the 0:55 mark of the interview.

For the plans to be credible, candidates also need to have concomitant proposals to restrain the growth of federal spending.

I don’t necessarily care whether they balance the budget, but I do think proposals to reform and lower taxes won’t have any chance of success unless there are also reasonable plans to gradually shrink government spending as a share of economic output.

As part of recent speeches in New Hampshire and Nevada, I shared my simple plan to impose enough spending restraint to balance the budget in less than 10 years.

But those speeches were based on politicians collecting all the revenue projected under current law.

By contrast, the GOP candidates are proposing to reduce tax burdens. On a static basis, the cuts are significant. According to the Tax Foundation, the 10-year savings for taxpayers would be $2.97 trillion with Rand Paul’s plan, $3.67 trillion under Jeb Bush’s plan, $4.14 trillion with Marco Rubio’s plan, all the way up to $11.98 trillion for Donald Trump’s plan.

Those sound like very large tax cuts (and Trump’s plan actually is a very large tax cut), but keep in mind that those are 10-year savings. And since the Congressional Budget Office is projecting that the federal government will collect $41.58 trillion over the next decade, the bottom line, as seen in this chart, is that all of the plans (other than Trump’s) would still allow the IRS to collect more than 90 percent of projected revenues.

Now let’s make the analysis more realistic by considering that tax cuts and tax reforms will generate faster growth, which will lead to more taxable income.

And the experts at the Tax Foundation made precisely those calculations based on their sophisticated model.

Here’s an updated chart showing 10-year revenue estimates based on “dynamic scoring.”

The Trump plan is an obvious outlier, but the proposals from Jeb Bush, Rand Paul, and Marco Rubio all would generate at least 96 percent of the revenues that are projected under current law.

Returning to the original point of this exercise, all we have to do is figure out what level of spending restraint is necessary to put the budget on a glide path to balance (remembering, of course, that the real goal should be to shrink the burden of spending relative to GDP).

But before answering this question, it’s important to understand that the aforementioned 10-year numbers are a bit misleading since we can’t see yearly changes. In the real world, pro-growth tax cuts presumably lose a lot of revenue when first enacted. But as the economy begins to respond (because of improved incentives for work, saving, investment, and entrepreneurship), taxable income starts climbing.

Here’s an example from the Tax Foundation’s analysis of the Rubio plan. As you can see, the proposal leads to a lot more red ink when it’s first implemented. But as the economy starts growing faster and generating more income, there’s a growing amount of “revenue feedback.” And by the end of the 10-year period, the plan is actually projected to increase revenue compared to current law.

So does this mean some tax cuts are a “free lunch” and pay for themselves? Sound like a controversial proposition, but that’s exactly what happened with some of the tax rate reductions of the Reagan years.

To be sure, that doesn’t guarantee what will happen if any of the aforementioned tax plans are enacted. Moreover, one can quibble with the structure and specifications of the Tax Foundation’s model. Economists, after all, aren’t exactly famous for their forecasting prowess.

But none of this matters because the Tax Foundation isn’t in charge of making official revenue estimates. That’s the job of the Joint Committee on Taxation, and that bureaucracy largely relies on static scoring.

Which brings me back to today’s topic. The good tax reform plans of certain candidates need to be matched by credible plans to restrain the growth of federal spending.

Fortunately, that shouldn’t be that difficult. I explained last month that big tax cuts were possible with modest spending restraint. If spending grows by 2 percent instead of 3 percent, for instance, the 10-year savings would be about $1.4 trillion.

And since it’s good to reduce tax burdens and also good to restrain spending, it’s a win-win situation to combine those two policies. Sort of the fiscal equivalent of mixing peanut butter and chocolate in the famous commercial for Reese’s Peanut Butter Cups.

P.S. Returning to my interview embedded above, I suppose it’s worthwhile to emphasize a couple of other points.

P.P.S. Writing about the prospect of tax reform back in April, I warned that “…regardless of what happens with elections, I’m not overly optimistic about making progress.”

Today, I still think it’s an uphill battle. But if candidates begin to put forth good plans to restrain spending, the odds will improve.

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The American Enterprise Institute has published a comprehensive budgetary plan entitled, “Tax and spending reform for fiscal stability and economic growth.”

Authored by Joseph Antos, Andrew G. Biggs, Alex Brill, and Alan D. Viard, all of whom I know and admire, this new document outlines a series of reforms designed to restrain the growth of government and mitigate many of the tax code’s more punitive features.

Compared to current law, the plan is a huge improvement.

But huge improvement isn’t the same as perfect, so here’s my two cents on what’s really good, what’s partially good, and what has me worried.

I’ll start with something that’s both good and bad.

According to the latest CBO estimates, federal tax revenues for 2015 will absorb 17.7 percent of GDP and spending will consume 20.4 percent of economic output. Now look at this table showing the impact of the AEI proposal. As you can see, the burden of taxes and spending will both be higher in the future than today.

That’s obviously bad. One would think a conservative organization would present a plan that shrinks the size of government!

But here’s the catch. Under current law, the burden of government is projected to climb far more rapidly, largely because of demographic changes and poorly designed entitlement programs. So if we do nothing and leave government on auto-pilot, America will be saddled with a European-sized welfare state.

From that perspective, the AEI plan actually is good since it is based on reforms that stop most – but not all – of the already-legislated expansions in the size of the public sector.

So here’s the bottom line. Compared to what I would like to see, the AEI plan is too timid. But compared to what I fear will happen, the AEI plan is reasonably bold.

Now let’s look at the specific reforms, staring with tax policy. Here’s some of what’s in the report.

The goal of our tax reform is to eliminate the income tax’s inherent bias against saving and investment and to reduce other tax distortions. To achieve this goal, the income tax system and the estate and gift taxes would be replaced by a progressive consumption tax, in the form of a Bradford X tax consisting of a…37 percent flat-rate firm-level tax on business cash flow and a graduated-rate household-level tax, with a top rate of 35 percent, on wages and fringe benefits.

At the risk of oversimplifying, the AEI folks decided that it was very important to solve the problem of double taxation and not so important to deal with the problem of a discriminatory and punitive rate structure. Which is sort of like embracing one big part of the flat tax while ignoring the other big part.

We’d have a less destructive tax code than we have now, but it wouldn’t be as good as it could be. Indeed, the plan is conceptually similar to the Rubio-Lee proposal, but with a lot more details.

Not that I’m happy with all those additional details.

To address environmental externalities in a more cost-effective and market-based manner, energy subsidies, tax credits, and regulations would be replaced by a modest carbon tax. The gasoline tax would be increased to cover highway-related costs.

I’m very nervous about giving Washington a new source of revenue. And while I’m open (in theory) to the argument that a carbon tax would be a better (less worse) approach than what we have now, I’m not sure it’s wise to trust that politicians won’t pull a bait and switch and burden us with both a costly energy tax and new forms of regulatory intervention.

And I definitely don’t like the idea of a higher gas tax. The federal government should be out of the transportation business.

There are also other features that irk me, including the continuation of some loopholes and the expansion of redistribution through the tax code.

Child and dependent care expenses could be deducted… A 15 percent refundable credit for charitable contributions… A 15 percent refundable credit for mortgage interest… A refundable credit for health insurance…the EITC for childless workers would be doubled relative to current law.

Though I should also point out that the new tax system proposed by AEI would be territorial, which would be a big step in the right direction. And it’s also important to note that the X tax has full expensing, which solves the bias against investment in a depreciation-based system.

But now let’s look at the most worrisome feature of the plan. It explicitly says that Washington should get more money.

… we also cannot address the imbalance simply by cutting spending… The tax proposals presented in this plan raise necessary revenues… Over time, tax revenue would gradually rise as a share of GDP… The upward path of tax revenue is necessary to finance the upward path of federal spending.

This is very counterproductive. But I don’t want to regurgitate my ideological anti-tax arguments (click here if that’s what you want). Let’s look at this issue from a strictly practical perspective.

I’ve reluctantly admitted that there are potential tax-hike deals that I would accept, at least in theory.

But those deals will never happen. In the real world, once the potential for additional revenue exists, the appetite for genuine spending restraint quickly evaporates. Just look at the evidence from Europe about the long-run relationship between taxes and debt and you’ll see that more revenue simply enables more spending.

Speaking of which, now let’s shift to the outlay side of the fiscal ledger.

We’ll start with Social Security, where the AEI folks are proposing to turn Social Security from a substandard social insurance program, which is bad, to a flat benefit, which might even be worse since it involves a shift to a system that is even more focused on redistribution.

The minimum benefit would be implemented immediately, increasing benefits for about one third of retirees, while benefits for middle- and high-earning individuals would be scaled down to the wage-indexed poverty level between now and 2050.

Yes, the system they propose is more fiscally sustainable for government, but what about the fact that most workers are paying record amounts of payroll tax in exchange for a miserly monthly payment?

This is why the right answer is personal retirement accounts.

The failure to embrace personal accounts may be the most disappointing feature of the AEI plan. And I wouldn’t be surprised if the authors veered in this unfortunate direction because they put the cart of debt reduction ahead of the horse of good policy.

To elaborate, a big challenge for real Social Security reform is the “transition cost” of financing promised benefits to current retirees and older workers when younger workers are allowed to shift their payroll taxes to personal accounts. Dealing with this challenge presumably means more borrowing over the next few decades, but it would give us a much better system in the long run. But this approach generally isn’t an attractive option for folks who fixate on near-term government debt.

That being said, there are spending reforms in the proposal that are very appealing.

The AEI plan basically endorses the good Medicare and Medicaid reforms that have been part of recent GOP budgets. And since those two programs are the biggest drivers of our long-run spending crisis, this is very important.

With regards to discretionary spending, the program maintains sequester/Budget Control Act spending levels for domestic programs, which is far too much since we should be abolishing departments such as HUD, Agriculture, Transportation, Education, etc.

But since Congress presumably would spend even more, the AEI plan could be considered a step in the right direction.

Finally, the AEI plan calls for military spending to consume 3.8 percent of economic output in perpetuity. National defense is one of the few legitimate functions of the federal government, but that doesn’t mean the Pentagon should get a blank check, particularly since big chunks of that check get used for dubious purposes. But I’ll let the foreign policy and defense crowd fight that issue since it’s not my area of expertise.

P.S. The Heritage Foundation also has thrown in the towel on personal retirement accounts and embraced a basic universal flat benefit.

P.P.S. On a completely different topic, here’s a fascinating chart that’s being shared on Twitter.

As you can see, the United States is an exception that proves the rule. I don’t know that there are any policy implications, but I can’t help but wonder whether America’s greater belief in self-reliance is linked to the tendency of religious people to believe in individual ethics and moral behavior.

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In my ultimate fantasy world, Washington wouldn’t need any sort of broad-based tax because we succeeded in shrinking the federal government back to the very limited size and scope envisioned by our Founding Fathers.

In my more realistic fantasy world, we might not be able to restore constitutional limits on Washington, but at least we could reform the tax code so that revenues were generated in a less destructive fashion.

That’s why I’m a big advocate of a simple and fair flat tax, which has several desirable features.

The rate is as low as possible, to minimize penalties on productive behavior.

There’s no double taxation, so no more bias against saving and investment.

And there are no distorting loopholes that bribe people into inefficient choices.

But not everyone is on board, The class-warfare crowd will never like a flat tax. And Washington insiders hate tax reform because it undermines their power.

But there are also sensible people who are hesitant to back fundamental reform.

Consider what Reihan Salam just wrote for National Review. He starts with a reasonably fair description of the proposal.

The original flat tax, championed by the economists Robert Hall and Alvin Rabushka, which formed the basis of Steve Forbes’s flat-tax proposal in 1996, is a single-rate tax on consumption, with a substantial exemption to make the tax progressive at the low end of the household-income distribution.

Though if I want to nit-pick, I could point out that the flat tax has effective progressivity across all incomes because the family-based exemption is available to everyone. As such, a poor household pays nothing. A middle-income household might have an effective tax rate of 12 percent. And the tax rate for Bill Gates would be asymptotically approaching 17 percent (or whatever the statutory rate is).

My far greater concerns arise when Reihan delves into economic analysis.

…the Hall-Rabushka tax would be highly regressive, in part because high-income households tend to consume less of their income than lower-income households and because investment income would not be taxed (or rather double-taxed).

This is a very schizophrenic passage since he makes a claim of regressivity even though he acknowledged that the flat tax has effective progressivity just a few sentences earlier.

And since he admits that the flat tax actually does tax income that is saved and invested (but only one time rather than over and over again, as can happen in the current system), it’s puzzling why he says the system is “highly regressive.”

If he simply said the flat tax was far less progressive (i.e., less discriminatory) than the current system, that would have been fine.

Here’s the next passage that rubbed me the wrong way.

…there is some dispute over whether ending the double taxation of savings would yield significant growth dividends. Chris William Sanchirico of Penn Law School takes a skeptical view in a review of the academic research on the subject, in part because cutting capital-income taxation as part of a revenue-neutral reform would require offsetting increases in labor-income taxation, which would dampen long-term economic growth in their own right.

I’m not even sure where to start. First, Reihan seems to dismiss the role of dynamic scoring in enabling low tax rates on labor. Second, he cites just one professor about growth effects and overlooks the overwhelming evidence from other perspectives. And third, he says the flat tax would be revenue neutral, when virtually every plan that’s been proposed combines tax reform with a tax cut.

On a somewhat more positive note, Reihan then suggests that lawmakers instead embrace “universal savings accounts” as an alternative to sweeping tax reform.

Instead of campaigning for a flat tax, GOP candidates ought to consider backing Universal Savings Accounts (USAs)… The main difference between USAs and Roth IRAs is that “withdrawals could be made at any time for any reason,” a change that would make the accounts far more attractive to far more people. …Unlike a wholesale shift to consumption taxation, USAs with a contribution limit are a modest step in the same general direction, which future reformers can build on.

I have no objection to incremental reform to reduce double taxation, and I’ve previously written about the attractiveness of USAs, so it sounds like we’re on the same page. And if you get rid of all double taxation and keep rates about where they are now, you get the Rubio-Lee tax plan, which I’ve also argued is a positive reform.

But then he closes with an endorsement of more redistribution through the tax code.

Republicans should put Earned Income Tax Credit expansion and other measures to improve work incentives for low-income households at the heart of their tax-reform agenda.

I want to improve work incentives, but it’s important to realize that the EIC is “refundable,” which is simply an inside-the-beltway term for spending that is laundered through the tax code. In other words, the government isn’t refunding taxes to people. It’s giving money to people who don’t owe taxes.

As an economist, I definitely think it’s better to pay people to work instead of subsidizing them for not working. But we also need to understand that this additional spending has two negative tax implications.

  1. When politicians spend more money, that either increases pressure for tax increases or it makes tax cuts more difficult to achieve.
  2. The EIC is supposed to boost labor force participation, but the evidence is mixed on this point, and any possible benefit with regards to the number of people working may be offset by reductions in actual hours worked because the phase out of the EIC’s wage subsidy is akin to a steep increase in marginal tax rates on additional labor supply.

In any event, I don’t want the federal government in the business of redistributing income. We’ll get much better results, both for poor people and taxpayers, if state and local government compete and innovate to figure out the best ways of ending dependency.

The rest of Reihan’s column is more focused on political obstacles to the flat tax. Since I’ve expressed pessimism on getting a flat tax in my lifetime, I can’t really argue too strenuously with those points.

In closing, I used “friendly fight” in the title of this post for a reason. I don’t get the sense that Mr. Salam is opposed to good policy. Indeed, I would be very surprised if he preferred the current convoluted system over the flat tax.

But if there was a spectrum with “prudence” and “caution” on one side and “bold” and “aggressive” on the other side, I suspect we wouldn’t be on the same side. And since it’s good for there to be both types of people in any movement, that’s a good thing.

P.S. I got a special treat this morning. I was at Reagan Airport for a flight to Detroit at the same time as a bunch of America’s World War II vets arrived on an Honor Flight to visit the WWII Memorial.

Here’s my rather pathetic attempt to get a photo of one of the vets being greeted.

Since I’ll never be in demand as a photographer, you should watch this video to learn more about this great private initiative to honor World War II veterans.

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With so many Americans currently filled with anxiety about their annual tax forms, this is the time of year that many people wistfully dream about how nice it would be to have a simple and fair flat tax.

Unfortunately, there are many obstacles to better tax policy. I’ve previously addressed some of these obstacles.

1. Politicians who prefer the status quo make appeals to envy by making class-warfare arguments about imposing higher tax rates on those who contribute more to economic output.

2. Politicians have created a revenue-estimating system based on the preposterous notion that even big changes in tax policy have no impact on economic performance, thus creating a procedural barrier to reform.

3. Politicians enormously benefit from the current corrupt and complex system since they can auction off tax loopholes for campaign cash and use the tax code to reward friends and punish enemies.

Today, we’re going to look at another obstacle to pro-growth reform.

One of the main goals of tax reform is to get a low flat rate. This is important because marginal tax rates affect people’s incentives to engage in additional productive behavior.

But it’s equally important to have a system that taxes economic activity only one time. This is a big issue because the current internal revenue code imposes a heavy bias against income that is saved and invested. It’s possible, when you consider the impact of the capital gains tax, corporate income tax, double tax on dividends, and the death tax, for a single dollar of income to be taxed as many as four times.

And what makes this system so crazy is that all economic theories – even Marxism and socialism – agree that capital formation is critical for long-run growth and rising living standards.

Yet here’s the problem. The crowd in Washington has set up a system for determining tax loopholes and that system assumes that there should be this kind of double taxation!

I’m not joking. You see this approach from the Joint Committee on Taxation. You see it from the Government Accountability Office. You see it from the Congressional Budget Office. Heck, you even see Republicans mistakenly use this benchmark.

This is why I organized a briefing for Capitol Hill staffers last week. You can watch the entire hour by clicking here, but if you don’t have a lot of time, here’s my 10-minute speech on the importance of choosing the right tax base (i.e., taxing income only one time).

Since I’m an economist, I want to highlight one particular aspect on my presentation. You’ll notice near the end that I tried to explain the destructive economic impact of double taxation with an analogy.

I shared a Powerpoint slide that compared the tax system to an apple tree. If you want to tax income, the sensible approach is to pick the apples off the tree.

But if you want to mimic the current tax system, with the pervasive double taxation and bias against capital, you harvest the apples by chopping down the tree.

Needless to say (but I’ll say it anyway), it’s utterly foolish to harvest apples by chopping down the tree since it means fewer apples in following years.

In this analogy, the apples are the income and the tree is the capital.

But as I thought about the issue further, I realized my analogy was imperfect because our current system doesn’t confiscate all existing capital.

Which is why it is very fortunate that one of the interns at Cato, Jonathan Babington-Heina, is a very good artist. And he was able to take my idea and come up with a set of cartoons that accurately – and effectively – show why discriminatory taxation of capital is so misguided.

By the way, this isn’t the first time that an intern has come to my rescue with artistic skill.

My highest-viewed post of all time is this famous set of cartoons that shows the dangerous evolution of the welfare state.

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In my 2012 primer on fundamental tax reform, I explained that the three biggest warts in the current system.

1. High tax rates that penalize productive behavior.

2. Pervasive double taxation that discourages saving and investment.

3. Corrupt loopholes and cronyism that bribe people to make less productive choices.

These problems all need to be addressed, but I also acknowledged additional concerns with the internal revenue code, such as worldwide taxation and erosion of constitutional freedoms an civil liberties.

In a perfect world, we would shrink government to such a small size that there was no need for any sort of broad-based tax (remember, the United States prospered greatly for most of our history when there was no income tax).

In a good world, we could at least replace the corrupt internal revenue code with a simple and fair flat tax.

In today’s Washington, the best we can hope for is incremental reform.

But some incremental reforms can be very positive, and that’s the best way of describing the “Economic Growth and Family Fairness Tax Reform Plan” unveiled today by Senator Marco Rubio of Florida and Senator Mike Lee of Utah.

The two GOP senators have a column in today’s Wall Street Journal, and you can read a more detailed description of their plan by clicking here.

But here are the relevant details.

What’s wrong with Rubio-Lee

In the interest of fairness, I’ll start with the most disappointing feature of the plan. The top tax rate will be 35 percent, only a few percentage points lower than the 39.6 percent top rate that Obama imposed as a result of the fiscal cliff.

Even more troubling, that 35 percent top tax rate will be imposed on any taxable income above $75,000 for single taxpayers and $150,000 for married taxpayers.

Since the 35 percent and 39.6 percent tax rates currently apply only when income climbs above $400,000, that means a significant number of taxpayers will face higher marginal tax rates.

That’s a very disappointing feature in any tax plan, but it’s especially unfortunate in a proposal put forth my lawmakers who wrote in their WSJ column that they want to “lower rates for families and individuals.”

What’s right with Rubio-Lee

This will be a much longer section because there are several very attractive features of the Rubio-Lee plan.

Some households, for instance, will enjoy lower marginal tax rates under the new bracket structure, particularly if those households have lots of children (there’s a very big child tax credit).

But the really attractive features of the Rubio-Lee plan are those that deal with business taxation, double taxation, and international competitiveness.

Here’s a list of the most pro-growth elements of the plan.

A 25 percent tax rate on all business income – This means that the corporate tax rate is being reduced from 35 percent (the highest in the world), but also that there will be a 25 percent maximum rate on all small businesses that file using Schedule C as part of a 1040 tax return.

Sweeping reductions in double taxation – The Rubio-Lee plans eliminates the capital gains tax, the double tax on dividends, and the second layer of tax on interest.

Full expensing of business investment – The proposal gets rid of punitive “depreciation” rules that force businesses to overstate their income in ways that discourage new business investment.

Territorial taxation – Businesses no longer will have to pay a second layer of tax on income that is earned – and already subject to tax – in other nations.

No death tax – Income should not be subject to yet another layer of tax simply because someone dies. The Rubio-Lee plan eliminates this morally offensive form of double taxation.

In addition, it’s worth noting that the Rubio-Lee plan eliminate the state and local tax deduction, which is a perverse part of the tax code that enables higher taxes in states like New York and California.

Many years ago, while working at the Heritage Foundation, I created a matrix to grade competing tax reform plans. I updated that matrix last year to assess the proposal put forth by Congressman Dave Camp, the former Chairman of the House Ways & Means Committee.

Here’s another version of that matrix, this time including the Rubio-Lee plan.

As you can see, the Rubio-Lee plan gets top scores for “saving and investment” and “international competitiveness.”

And since these components have big implications for growth, the proposal would – if enacted – generate big benefits. The economy would grow faster, more jobs would be created, workers would enjoy higher wages, and American companies would be far more competitive.

By the way, if there was (and there probably should be) a “tax burden” grade in my matrix, the Rubio-Lee plan almost surely would get an “A+” score because the overall proposal is a substantial tax cut based on static scoring.

And even with dynamic scoring, this plan will reduce the amount of money going to Washington in the near future.

Of course, faster future growth will lead to more taxable income, so there will be revenue feedback. So the size of the tax cut will shrink over time, but even a curmudgeon like me doesn’t get that upset if politicians get more revenue because more Americans are working and earning higher wages.

That simply means another opportunity to push for more tax relief!

What’s missing in Rubio-Lee

There are a few features of the tax code that aren’t addressed in the plan.

The health care exclusion is left untouched, largely because the two lawmakers understand that phasing out that preference is best handled as part of a combined tax reform/health reform proposal.

Some itemized deductions are left untouched, or simply tweaked.

And I’m not aware of any changes that would strengthen the legal rights of taxpayers when dealing with the IRS.

Let’s close with a reminder of what very good tax policy looks like.

To their credit, Rubio and Lee would move the tax code in the direction of a flat tax, though sometimes in a haphazard fashion.

P.S. There is a big debate on the degree to which the tax code should provide large child credits. As I wrote in the Wall Street Journal last year, I much prefer lower tax rates since faster growth is the most effective long-run way to bolster the economic status of families.

But even the flat tax has a generous family-based allowance, so it’s largely a political judgement on how much tax relief should be dedicated to kids and how much should be used to lower tax rates.

That being said, I think the so-called reform conservatives undermine their case when they argue child-oriented tax relief is good because it might subsidize the creation of future taxpayers to prop up entitlement programs. We need to reform those programs, not give them more money.

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Last week, I shared a TV interview about Obama’s budget, but much of the discussion was routine and didn’t warrant special attention.

But there was one small part of the interview, dealing with the silly claim that America became a rich nation because of socialism, that got me all agitated.

Well, to quote the great Yogi Berra, it’s deja vu all over again. Here’s an interview I did with CNBC about labor unrest. As you might expect, I made the standard libertarian argument that it’s not the job of government to pick sides when labor and management have squabbles.

That’s a point I’ve made before (here, here, here, here, here, and here), so there’s no need to elaborate on that issue.

But if you pay attention at the 3:00 mark of the video, you’ll notice that the discussion shifts to income inequality. And this is what got me agitated. I’m completely baffled that some people think that redistribution is more important than growth.

As I point out in the interview, nobody wins in the long run if you have a stagnant economy and politicians are fixated on re-slicing a shrinking pie.

The goal of everyone – including unions and leftist politicians – should be growth. If we get robust growth, that will mean tight labor markets, and that’s a big cause of rising wages.

But here’s my hypothesis to explain why statists don’t support good policies. Simply stated, I think they hate the rich more than they like the poor.

That sounds like a rather bold claim, but is there any other explanation for why they reject the types of tax policies (such as lower corporate rates, reduced double taxation, and expensing) that will increase investment, thus boosting productivity and wages?

Heck, look at this chart showing the relationship between capital formation and labor compensation.

Any decent person, after looking at the link between capital and wages, should be clamoring for the flat tax.

Yet Obama wants to move the tax code in the opposite direction!

I confess that I have no idea if this is because of malice or ignorance, but I do know that no nation has ever generated faster growth with class warfare.

I realize I’m ranting, but the more I think about this topic, the more upset I get. Politicians and their allies are making life harder for workers, and I hope I never stop being outraged when that happens.

P.S. On a totally separate subject, here’s a good joke forwarded to me by a friend this morning. It definitely belongs in my collection of gun control humor.

A state trooper in Kansas made a traffic stop of an elderly lady for speeding on U.S. 166 just East of Sedan, KS. He asked for her driver’s license, registration, and proof of insurance. The lady took out the required information and handed it to him.

In with the cards, he was somewhat surprised (due to her advanced age) to see she had a concealed carry permit. He looked at her and asked if she had a weapon in her possession at this time. She responded that she indeed had a .45 automatic in her glove box.

Something, body language, or the way she said it, made him want to ask if she had any other firearms. She did admit to also having a 9mm Glock in her center console. Now he had to ask one more time if that was all. She responded once again that she did have just one more, a .38 special in her purse.

He then asked her “Ma’am, you sure carry a lot of guns. What are you so afraid of?”

She looked him right in the eye and said, “Not a damn thing!”

You can enjoy other examples of gun control humor by clicking here, here, here, here, here, and here.

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The most compelling graph I’ve ever seen was put together by Andrew Coulson, one of my colleagues at the Cato Institute. It shows that there’s been a huge increase in the size and cost of the government education bureaucracy in recent decades, but that student performance has been stagnant.

But if I had to pick a graph that belongs in second place, it would be this relationship between investment and labor compensation.

The clear message is that workers earn more when there is more capital, which should be a common-sense observation. After all, workers with lots of machines, technology, and equipment obviously will be more productive (i.e., produce more per hour worked) than workers who don’t have access to capital.

And in the long run, worker compensation is tied to productivity.

This is why the President’s class-warfare proposals to increase capital gains tax rates, along with other proposals to increase the tax burden on saving and investment, are so pernicious.

The White House claims that the “rich” will bear the burden of the new taxes on capital, but the net effect will be to discourage capital investment, which means workers will be less productive and earn less income.

Diana Furchtgott-Roth of Economics 21 has some very compelling analysis on the issue.

President Obama will propose raising top tax rates on capital gains and dividends to 28 percent, up from the current rate of 24 percent. Prior to 2013, the rate was 15 percent. Mr. Obama seeks to practically double capital gains and dividend taxes during the course of his presidency, a step that would have negative effects on investment and economic growth. …the middle class would be harmed by higher capital gains tax rates, because capital would be more likely to go offshore. …[a] higher rate would have negative effects on the economy by reducing U.S. investment or driving it overseas. If firms pay more in capital gains taxes in America, they would make fewer investments — especially in the businesses or projects that most need capital — and they would hire fewer workers, many of them middle-class. Higher capital gains taxes would reduce economic activity, especially financing for private companies, innovators, and small firms getting off the ground. Taxes on U.S. investment would be higher compared with taxes abroad, so some investment capital is likely to move offshore.

At this point, I want to emphasize that the point about higher taxes in America and foregone competitiveness isn’t just boilerplate.

According to Ernst and Young, as well as the Organization for Economic Cooperation and Development, the United States has one of the highest tax rates on capital gains in the entire developed world.

The only compensating factor is that at least these destructive tax rates aren’t imposed on foreign investors. Yes, it’s irritating that our tax code treats U.S. citizens far worse than foreigners, but at least we benefit from all the overseas capital being invested in the American economy.

By the way, Diana also points out that higher capital gains tax rates may actually lose revenue for the simple reason that investors can decide to hold assets rather than sell them.

Here’s some of what she wrote, accompanied by a chart from the Tax Foundation.

…higher capital gains tax rates rarely result in more revenue, because capital gains realizations can be timed.  When rates go up, people hold on to their assets rather than selling them, expecting that rates will go down at some point. …Capital gains tax revenues rose after 1997, when the rate was reduced from 28 percent to 20 percent, and again after 2003, when rates were reduced further to 15 percent… The decline in rates resulted in higher tax receipts from owners of capitals, as they sold assets, giving funds to Uncle Sam.

Yes, the Laffer Curve is alive and well.

Not that Obama cares. If you pay close attention at the 4:20 mark of this video, you’ll see that he wants higher capital gains tax rates for reasons of spite.

But I don’t care about the revenue implications. I care about good tax policy. And in an ideal tax system, there wouldn’t be any tax on capital gains.

It’s a form of double taxation with pernicious effects, as the Wall Street Journal explained back in 2012.

…the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings. …If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax. Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.” …keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.

John Goodman also has a very cogent explanation of the issue.

…why tax capital gains at all? …The companies will realize their actual income and they will pay taxes on it. If the firms return some of this income to investors (stockholders), the investors will pay a tax on their dividend income. If the firms pay interest to bondholders, they will be able to deduct the interest payments from their corporate taxable income, but the bondholders will pay taxes on their interest income. …Eventually all the income that is actually earned will be taxed when it is realized and those taxes will be paid by the people who actually earned the income. ……why not avoid all these problems by reforming the entire tax system along the lines of a flat tax? The idea behind a flat tax can be summarized in one sentence: In an ideal system, (a) all income is taxed, (b) only once, (c) when (and only when) it is realized, (d) at one low rate.

And if you want to augment all this theory with some evidence, check out the details of this comprehensive study published by Canada’s Fraser Institute.

For more information, here’s the video I narrated for the Center for Freedom and Prosperity, which explains why the capital gains tax should be abolished.

P.S. These posters were designed by folks fighting higher capital gains taxes in the United Kingdom, but they apply equally well in the United States. And since we’re referencing our cousins on the other side of the Atlantic, you’ll be interested to know that Labor Party voters share Obama’s belief in jacking up tax rates even if the economic damage is so severe that the government doesn’t collect any revenue.

P.P.S. Don’t forget that the capital gains tax isn’t indexed for inflation, so the actual tax rate almost always is higher than the statutory rate. Indeed, for folks that have held assets for a long time, the effective tax rate can be more than 100 percent. Mon Dieu!

P.P.P.S. In the past 20-plus years, I’ve seen all sorts of arguments for class-warfare taxation. These include:

I suppose leftists deserve credit for being adaptable. Just about anything is an excuse for soak-the-rich tax hikes. The sun is shining, raise taxes! The sky is cloudy, increase tax rates!

Or, in this case, Obama is giving a speech, so we know higher tax rates are on the agenda.

P.P.P.P.S. You deserve a reward if you read this far. You can enjoy some amusing cartoons on class-warfare tax policy by clicking here, here,here, here, here, here, and here.

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According to the bean counters at Ernst and Young, the United States has one of the highest capital gains tax rates in the world.

But if you don’t trust the numbers from a big accounting firm, then you can peruse a study from the pro-tax Organization for Economic Cooperation and Development that reaches the same conclusion.

But does this really matter? Is the United States harmed by having a high tax rate?

The Wall Street Journal certainly makes a compelling case that high tax rates on capital gains are self-destructive.

And this remarkable chart shows that workers are victimized when there is less investment.

Let’s add to all this evidence.

Jason Clemens, Charles Lammam, and Matthew Lo have produced a thorough study for the Fraser Institute about the economic impact of capital gains taxation.

A capital gain (or loss) generally refers to the price of an asset when it is sold compared to its original purchase price. A capital gain occurs if the value of the asset at the time of sale is greater than the initial purchase price. …Capital gains taxes, of course, raise revenues for government but they do so with considerable economic costs. Capital gains taxes impose costs on the economy because they reduce returns on investment and thereby distort decision making by individuals and businesses. This can have a substantial impact on the reallocation of capital, the available stock of capital, and the level of entrepreneurship.

It turns out that there are many reasons why the capital gains tax harms economic performance. Clemens, Lammam, and Lo explain the “lock-in effect.”

Capital gains are taxed on a realization basis. This means that the tax is only imposed when an investor opts to withdraw his or her investment from the market and realize the capital gain. One of the most significant economic effects is the incentive this creates for owners of capital to retain their current investments even if more profitable and productive opportunities are available. Economists refer to this result as the “lock-in” effect. Capital that is locked into suboptimal investments and not reallocated to more profitable opportunities hinders economic output. …Peter Kugler and Carlos Lenz (2001)…examined the experience of regional governments (“cantons”) in Switzerland that eliminated their capital gains taxes. The authors’ statistical analysis showed that the elimination of capital gains taxes had a positive and economically significant effect on the long-term level of real income in seven of the eight cantons studied. Specifically, the increase in the long-term level of real income ranged between 1.1 percent and 3.0 percent, meaning that the size of the economy was 1 percent to 3 percent larger due to the elimination of capital gains taxes.

Then the authors analyze the impact of capital gains taxes on the “user cost” of capital investment.

Capital gains taxes make capital investments more expensive and therefore less investment occurs. …Several studies have investigated the link between the supply and cost of venture capital financing and capital gains taxation, and found theoretical and empirical evidence suggesting a direct causality between a lower tax rate and a greater supply of venture capital. …Kevin Milligan, Jack Mintz, and Thomas Wilson (1999) sought to estimate the sensitivity of investment to changes in the user cost of capital…and found that decreasing capital gains taxes by 4.0 percentage points leads to a 1.0 to 2.0 percent increase in investment.

Next, they investigate the impact on entrepreneurship.

Capital gains taxes reduce the return that entrepreneurs and investors receive from the sale of a business. This diminishes the reward for entrepreneurial risk-taking and reduces the number of entrepreneurs and the investors that support them. The result is lower levels of economic growth and job creation. …Analysing the stock of venture capital and tax rates on capital gains from 1972 to 1994, Gompers and Lerner found that a one percentage point increase in the rate of the capital gains tax was associated with a 3.8 percent reduction in venture capital funding.

Last but not least, the authors also discuss the impact of capital gains taxation on compliance costs, administrative costs, and tax avoidance. They also look at the marginal efficiency cost of capital gains taxation and report on some of the research in that area.

Dale Jorgensen and Kun-Young Yun (1991)…estimate the marginal efficiency costs of select US taxes and find that capital-based taxes (such as capital gains taxes) impose a marginal cost of $0.92 for one additional dollar of revenue compared to $0.26 for consumption taxes. …Baylor and Beausejour find that a $1 decrease in personal income taxes on capital (such as capital gains, dividends, and interest income) increases society’s well-being by $1.30; by comparison, a similar decrease in consumption taxes only produces a $0.10 benefit. …the Quebec government’s Ministry of Finance…found that a reduction in capital gains taxes yields more economic benefits than a reduction in other types of taxes such as sales taxes. Reducing the capital gains tax by $1 would yield a $1.21 increase in the GDP.

Here’s my video on the topic, which explains that the right capital gains tax rate is zero.

The bottom line is that the United States is shooting itself in the foot.

Or, to be more accurate, politicians are hobbling America’s productive sector  and undermining U.S. competitiveness with senseless class-warfare taxation.

And don’t forget that the United States compounds the damage with the world’s highest corporate tax rate, pervasive double taxation of dividends, and a punitive death tax.

So while some countries are doing the right thing and abolishing their capital gains taxes, the United States is languishing in the international contest for more investment.

The only “good news” is that a few other nations also impose foolish policies as well.

P.S. It’s worth noting that all good tax reforms, such as the flat tax, completely abolish the capital gains tax.

P.P.S. This is yet another example of first-rate research from the Fraser Institute. They’re the publishers of Economic Freedom of the World, as well as some excellent research on the harmful impact of excessive government spending.

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Since all economic theories – even Marxism and socialism – recognize that capital formation is a key to long-run growth, higher wages, and improved living standards, it obviously doesn’t make sense to penalize saving and investment.

Yet that’s exactly what happens because of double taxation in the United States, as can be seen by this rather sobering flowchart.

So how can we fix the problem? The best answer, particularly in the long run, is to shrink the burden of government spending so that there’s no pressure for punitive tax policies.

Good reform is also possible in the medium run. Policy makers could implement a big bang version of tax reform, replacing the corrupt internal revenue code with a simple and fair flat tax. That automatically would eliminate the tax bias against saving and investment since one of the key principles of the flat tax is that income gets taxed only one time.

That being said, there’s no chance of sweeping tax reform for the next few years (and maybe ever), so let’s look at some pro-growth incremental reforms that would reduce or eliminate the extra tax penalties on income that is saved and invested.

On the investment side of the ledger, any policies that lower or end the capital gains tax and the double tax on dividends would be desirable.

But let’s focus today on the saving side. And let’s start by explaining how a fair and neutral system would operate. Here’s what I wrote back in 2012 and I think it’s reasonably succinct and accurate.

…all saving and investment should be treated the way we currently treat individual retirement accounts. If you have a traditional IRA (or “front-ended” IRA), you get a deduction for any money you put in a retirement account, but then you pay tax on the money – including any earnings – when the money is withdrawn. If you have a Roth IRA (or “back-ended” IRA), you pay tax on your income in the year that it is earned, but if you put the money in a retirement account, there is no additional tax on withdrawals or the subsequent earnings. From an economic perspective, front-ended IRAs and back-ended IRAs generate the same result. Income that is saved and invested is treated the same as income that is immediately consumed. From a present-value perspective, front-ended IRAs and back-ended IRAs produce the same outcome. All that changes is the point at which the government imposes the single layer of tax.

The key takeaways are in the first and last sentences. All savings should be protected from double taxation, not just what you set aside for retirement. And that means government can tax you one time, either when you first earn the income or when you consume the income.

Our friends to the north can teach us some lessons on this issue.

Here are some excerpts from a column in the Wall Street Journal, authored by my colleague Chris Edwards and Amity Shlaes of the Calvin Coolidge Foundation.

Some Republicans are advocating a giant child tax credit, but there are more effective means for helping the middle class. One is a tax program already road-tested in the country whose populace most resembles our own, Canada. It’s called the Tax-Free Savings Account and TFSA, as most Canadians refer to it, is a roaring success. …what is this Canadian savings account? The nearest U.S. equivalent would be Roth Individual Retirement Accounts. With a Roth, workers pay taxes on earnings before they put their cash into the account. The money then grows tax-protected, and people pay no tax when they withdraw it.

But these accounts are much better than Roth IRAs.

Though these savings accounts were introduced only five years ago, 48% of Canadians have already signed up. That compares with only 38% of U.S. households owning any type of IRA—though IRAs have been around for decades….Roth accounts have numerous restrictions. You can’t open a Roth easily if your earnings are above certain limits: $191,000, for example, for a married couple filing jointly. You can’t withdraw cash whenever you feel like it, at least not without daunting penalties. …Canada’s TFSAs are like Roth IRAs—but supercharged. Citizens may deposit up to $5,500 after-tax each year, and all account earnings and withdrawals are tax-free. However, unlike Roth IRAs, funds can be withdrawn at any time for any reason with no penalties or taxes. Another feature: The annual limit on a contribution carries over from year to year if a citizen doesn’t reach it. So if a Canadian contributes $2,000 this year, he can put away up to $9,000 next year ($3,500 plus $5,500). There are other attractive features: Unlike in a Roth, there are no income limits for individuals contributing to a TFSA, and there are no withdrawal requirements at retirement.

In other words, the Canadian accounts are like unlimited or unrestricted Roth IRAs.

And because the government isn’t trying to micro-manage how people save, Canadians are very receptive. Chris adds some additional information in a post for Cato at Liberty.

…released new data confirming the popularity of TFSAs. In just the past year, TFSA account assets increased 34 percent, and the number of accounts increased 16 percent. In June 2014, 13 million Canadians held $132 billion in TFSA assets. Given that the U.S. population is about 10 times that of Canada, it would be like 130 million Americans pouring $1.3 trillion into a new personal savings vehicle. …In just five years, TFSAs have become the most popular savings vehicle in Canada, outstripping the Canadian version of 401(k)s.

Here’s a chart Chris included in his blog post.

And he adds some more analysis on the importance of simple vehicles to protect against double taxation.

Everyone agrees that Americans don’t save enough, so why don’t we kick-start a home-grown savings revolution with a U.S. version of TFSAs? …Canada has now run the real-world experiment on such accounts, and it has succeeded brilliantly. TFSAs, or USAs, are a better way to handle savings in the tax code. Currently, many people are scared off by the complexity of U.S. savings vehicles and by the lack of liquidity in retirement accounts. TFSAs solve these problems.

I guess we’ll have to wait and see whether American policy makers pay attention and follow Chris’ sage advice.

P.S. I realize I’m being picky, but I wish the Canadians didn’t use the term “tax-free savings accounts.” After the all, the income is taxed before it gets put into the accounts. Though even a nit-picker like me realizes that it might be a bit awkward to call them “no-double-taxation savings accounts.”

P.P.S. I do like that Chris and Amity argued that the accounts would be better than big child tax credits, particularly since I also argued in the Wall Street Journal that there were better ways to help the middle class.

P.P.P.S. Canada also can teach us important lessons on other issues, such as spending restraint, corporate tax reform, bank bailouts, and privatization of air traffic control. Heck, Canada even has one of the lowest levels of welfare spending among developed nations.

P.P.P.P.S. No wonder the two most capitalistic places in North America are in Canada. And Canada ranks above the United States in the Economic Freedom of the World Index.

P.P.P.P.P.S. Though there are still plenty of statists north of the border, so I’m not sure it’s the best escape option for advocates of small government. Though I doubt leftists no longer see it as an escape option, which was the premise of this joke that circulated after the 2010 election.

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I’ve already shared a bunch of data and evidence on the importance of low tax rates.

A review of the academic evidence by the Tax Foundation found overwhelming support for the notion that lower tax rates are good for growth.

An economist from Cornell found lower tax rates boost GDP.

Other economists found lower tax rates boost job creation, savings, and output.

Even economists at the Paris-based OECD have determined that high tax rates undermine economic performance.

And it’s become apparent, with even the New York Times taking notice, that high tax rates drive away high-achieving people.

We’re going to augment this list with some additional evidence.

In a study published by a German think tank, three economists from the University of Copenhagen in Denmark look at the impact of high marginal tax rates on Danish economic performance.

Here’s what they set out to measure.

…taxation distorts the functioning of the market economy by creating a wedge between the private return and the social return to a reallocation of resources, leaving socially desirable opportunities unexploited as a result. …This paper studies the impact of taxation on the mobility and allocation of labor, and quantifies the efficiency loss from misallocation of labor caused by taxation. …labor mobility responses are fundamentally different from the hours-of-work responses of the basic labor supply model… Our analysis builds on a standard search theoretic framework… We incorporate non-linear taxation into this setting and estimate the structural parameters of the model using employer-employee register based data for the full Danish population of workers and workplaces for the years 2004-2006. The estimated model is then used to examine the impact of different changes in the tax system, thereby characterizing the distortionary effects of taxation on the allocation of labor.

They produced several sets of results, including a look at the additional growth and output generated by moving to a system of lump-sum taxation (which presumably eliminates all disincentive effects).

But even when they looked at more modest reforms, such as a flat tax with a relatively high rate, they found the Danish economy would reap significant benefits.

…it is possible to reap a very large part of the potential efficiency gain by going “half the way”and replace the current taxation with a ‡at tax rate of 30 percent on all income. This shift from a Scandinavian tax system with high marginal tax rates to a level of taxation in line with low-tax OECD countries such as the United States increases total income by 20 percent and yields an efficiency gain measured in proportion to initial income of 10 percent. …a transition from a Scandinavian system with high marginal taxes to a system along the lines of low-tax OECD countries such as the United States. This reduces the rate of non-employment by around 10 percentage points, increases aggregate income by almost 20 percent (relative to the Scandinavian income level), and gives an efficiency gain measured in proportion to income of 9.9 percent. Thus, almost 80 percent of the efficiency loss from marginal taxation (9.7% divided by 12.4%) would be eliminated by shifting from a Scandinavian tax system to the system of a low-tax OECD country according to these estimates.

The authors also confirmed that lower tax rates would generate revenue feedback. In other words, the Laffer Curve exists.

We may also use the reform experiment to compute the marginal excess burden of taxation as described above. When measured in proportion to the mechanical loss of tax revenue, we obtain an estimate of 87 percent. …this estimate also corresponds to the degree of self-financing of the tax cut. Thus, the increase in tax revenue from the behavioral response is 87 percent of the mechanical loss in tax revenue.

Too bad we can’t get the Joint Committee on Taxation in Washington to join the 21st Century. Those bureaucrats still base their work on the preposterous assumption that taxes have no impact on overall economic performance.

Since we just looked at a study of the growth generated by reducing very high tax rates, let’s now consider the opposite scenario. What happens if you take medium-level tax rates and raise them dramatically?

The Tax Foundation looks at precisely this issue. The group estimated the likely results if lawmakers adopted the class-warfare policies proposed by Thomas Piketty.

Piketty suggests higher taxes on the wealthiest among us. He calls for a global wealth tax, and he recommends establishing a top income tax rate of 80 percent, with a next-to-top income tax rate of 50 or 60 percent for the upper-middle class. …This study…provides quantitative estimates of what his proposed tax rates would mean for capital formation, jobs, the level of income, and government revenue. This study also estimates how Piketty’s proposed income tax rates would affect the distribution of income in the United States.

Piketty, of course, thinks that even confiscatory levels of taxation have no negative impact on economic performance.

Piketty claims people (or at least the upper-income people he would tax so heavily) are totally insensitive to marginal tax rates. In his world view, upper-income taxpayers will work and invest just as much as before even if dramatically higher taxes reduce their after-tax rewards to a fraction of what they were previously. …Piketty’s vision of the world strains credulity.

When the Tax Foundation crunched the numbers, though, its experts found that Piketty’s proposal would be devastating.

Under Piketty’s 55 and 80 percent tax brackets, people in the new, ultra-high tax brackets will work and invest less because they will be able to keep so little of the reward from the last hour of work and the last dollar of investment. …As the supplies of labor and capital in the production process decline, the economy’s output will also contract. Although it is only people with upper incomes who will directly pay the 55 and 80 percent tax rates, people throughout the economy will indirectly bear some of the tax burden. For example, the average person’s wages will be lower than otherwise because middle-income workers will have less equipment and software to enhance their productivity, and wages depend on productivity. Similarly, people throughout the economy will have fewer employment opportunities and will lose desirable goods and services, because businesses will grow more slowly and be less innovative.

The magnitude of the damage would depend on whether the higher tax rates also applied to dividends and capital gains. Here’s what the Tax Foundation estimated would happen to the economy if dividends and capital gains were not hit with Piketty-style tax rates.

These are some very dismal numbers.

But now look at the results if tax rates also are increased on dividends and capital gains. The dramatic increase in double taxation (dwarfing what Obama wanted) would have catastrophic consequences for overall investment (the “capital stock”). This would lead to a big loss in jobs and a dramatic reduction in overall economic output.

The Tax Foundation then measures the impact of these policies on the well-being of people in various income classes.

Needless to say, upper-income taxpayers suffer substantial losses. But the rest of us also suffer as well.

…the poor and middle class would also lose. They would suffer a large, but indirect, tax burden as a result of the smaller economy. Their after-tax incomes would fall over 3 percent if capital gains and dividends retain their current-law tax treatment and almost 17 percent if capital gains and dividends are taxed like ordinary income.

And since I’m sure Piketty and his crowd would want to subject capital gains and dividends to confiscatory tax rates, the 17 percent drop is a more realistic assessment of their economic agenda.

Though, to be fair, Piketty-style policies would make society more “equal.” But, as the Tax Foundation notes, some methods of achieving equality are very bad for lower-income people.

…a reasonable question to ask is whether a middle-income family is made better off if their income drops 3.2 percent while the income of a family in the top 1 percent drops 21.0 percent, or their income plummets 16.8 percent while the income of a family in the top 1 percent plummets 43.3 percent.

Of course, if Margaret Thatcher is correct, the left has no problem with this outcome.

But for those of us who care about better lives for ordinary people, this is confirmation that envy isn’t – or at least shouldn’t be – a basis for tax policy.

Sadly, that’s not the case. We’ve already seen the horrible impact of Hollande’s Piketty-style policies in France. And Obama said he would be perfectly content to impose higher tax rates even if the resulting economic damage is so severe that no additional revenue is collected.

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I’m a long-time proponent of the flat tax for three simple reasons.

1. It replaces the discriminatory “progressive” tax with a single tax rate at the lowest possible level, thus reducing the tax penalty on productive behavior.

2. It gets rid of all forms of double taxation, such as the death tax and capital gains tax, meaning economic activity is never taxed more than one time.

3. Other than a family-based allowance, it gets rid of all loopholes, deductions, credits, exemptions, exclusions, and preferences, meaning economic activity is taxed equally.

Some people say that these are also three reasons to favor a national sales tax.

My response is that they’re correct. In simple terms, a national sales tax (such as the Fair Tax) is like a flat tax but with a different collection point.

If you want more details, I often explain the two plans are different sides of the same coin. The only difference is that the flat tax takes of slice of your income as you earn it and the sales tax takes a slice of your income as you spend it. But neither plan has any double taxation of income that is saved and invested. And neither plan has loopholes to lure people into making economically irrational decisions.

Instead of class warfare and/or social engineering, both plans are designed to raise money is the least-damaging fashion possible.

So even though I’m mostly known for being an advocate of the flat tax, I have no objection to speaking in favor of a national sales tax, testifying in favor of a national sales tax, or debating in favor of a national sales tax.

With this bit of background, you can understand why it caught my attention that an economics professor at the University of Georgia (Go Dawgs!) wrote a column for Forbes with the provocative title of “I Will Support The Fair Tax When Its Backers Tell The Truth”.

Professor Dorfman writes that “such a consumption tax has much to recommend it from an economic point of view” but then warns that he “cannot support the Fair Tax as long as its backers continue to make implausible claims for their proposed reform.”

So what are the implausible claims? Let’s check them out and see if his friendly criticism is warranted.

He first expresses skepticism about the claim that take-home pay will rise to the level of gross pay under a Fair Tax, particularly given the assertion that prices won’t rise.

…the odds are that your gross pay will shrink over time under the Fair Tax. …employers can offer workers lower pay because of the lower cost of living (same prices, but higher take home pay). Because workers evaluate pay offers based on the purchasing power of that pay, the same competitive forces that will lower prices after the removal of business taxes, will lead to lower pay for employees in the long run as the labor market adjusts.

I suspect Professor Dorfman’s critique is correct, but I don’t think it matters. Workers understandably care first and foremost about the purchasing power of their paycheck, and that won’t be negatively impacted.

The Professor than looks at whether the Fair Tax gets taxes the underground economy.

…let’s tackle the claim that the Fair tax will do a better job of collecting taxes on criminals, the underground economy, and those who underreport their income. The idea is that people may hide some of their income or that drug dealers and others in the underground economy do not report their income, but that everyone spends money so the Fair Tax will tax everyone. Unfortunately, this claim is not true… Retailers are just as capable of underreporting revenue and not sending in the corresponding Fair Tax as people are of underreporting their income. …The incentive to avoid such consumption taxes will only increase when the rate is four or five times what it is now. If you don’t believe consumption taxes suffer from collection problems, go ask Greece.

And he looks specifically at taxing criminal activity.

Another reason that the Fair Tax will not capture extra revenue from illegal activities is that it only switches which side of the transaction is missed by the tax system. Currently, while drug dealers may not report their income, the people who buy drugs are paying with after-tax income. Under the Fair Tax, the drug dealers will pay tax when they spend their drug profits. However, unless the drug dealer sends in the Fair Tax on their sales, the drug buyers will now avoid tax on their purchases. Under either tax system, one side of the underground transactions will be paying taxes and one will not.

I think Professor Dorfman is correct, particularly in his explanation that drug dealers and other criminals will not collect sales tax when they peddle their illicit goods.

And he’s also correct when he says that the Fair Tax won’t collect all taxes on legal products.

But that doesn’t mean the Fair Tax is somehow flawed. Indeed, it’s quite likely that the underground economy will shrink under a national sales tax since the incentive to evade tax (on legal products) is a function of the tax rate. So if we replace the punitive high-rate internal revenue code with a low-rate Fair Tax, there will be a higher level of compliance.

But not zero evasion, so Fair Tax supporters exaggerate if they make that claim.

The next point of contention is whether the IRS can be repealed under a Fair Tax.

…some agency needs to collect all the sales taxes, ensure retailers are sending in the full amount, and handle all the mechanics of the prebate. The prebate requires this federal agency to know everyone’s family size and have a bank account or other method of sending out the prebate each month. So while individuals will have less interaction with the federal tax agency, there will still be some. For retail businesses, their interactions with federal tax officials will be at least as much as now, if not more.

The Professor is right, though this may be a matter of semantics. Fair Tax people acknowledge there will be a tax collector (the legislation creates an incentive for states to be in charge of collecting the tax), but they say that the tax authority under their system will be completely different than the abusive IRS we have today.

Last but not least is the controversy over whether everyone benefits under a Fair Tax.

…while Fair Tax proponents often act like nobody loses under the Fair Tax that is simply not possible. If the Fair Tax is implemented in a revenue neutral manner (collecting the same amount of total revenue as all the taxes it replaces), and some people win then other people must lose. Poor people pay roughly no tax either way, so the Fair tax would be neutral for them. The very rich will assumedly pay less since they spend a lower percentage of their income and spend more overseas. Thus, the suspicion is that the middle class will be paying more. One other group pretty sure to pay more is the elderly. The elderly have paid income tax while earning income, and under the Fair Tax would suddenly pay high consumption taxes right when their income drops and their spending increases. In the long run, this is not a problem, but early in a Fair Tax regime, the elderly definitely are losers.

Once again, Professor Dorfman is making a good point (and others have made the same point about the flat tax).

My response, for what it’s worth, is that supporters of both the flat tax and national sales tax should not be bound by revenue neutrality. Especially if the revenue-estimating system is rigged to produce bad numbers. Instead, they should set the rate sufficiently low that the overwhelming majority of taxpayers are net winners.

And in the long run, everyone can be a net winner if the economy grows faster.

And that, as Professor Dorfman agrees, is the main reason for tax reform.

The Fair Tax really has much to recommend it. It is simpler than the current system. It causes fewer distortions in the daily economic decisions that people make. The main distortion it does introduce is positive: to encourage saving and discourage consumption which would make the country wealthier in the long run.

Though I would quibble with the wording of this last excerpt. I don’t think the Fair Tax creates a pro-savings distortion. Instead, it removes an anti-savings bias. Just like the flat tax.

Now let me add a friendly criticism that Professor Dorfman didn’t address.

Advocates of the Fair Tax correctly say that their proposal shouldn’t be implemented until and unless the income tax is fully repealed. But as I explain in this video, that may be an impossible undertaking.

To be blunt, I don’t trust politicians. I fear that they would gladly adopt some form of consumption tax while secretly scheming to keep the income tax.

P.S. Actually, what I really want is a very small federal government, which presumably could be financed without any broad-based tax. Our nation enjoyed strong growth before that dark day in 1913 when the income tax was imposed, so why concede that politicians today should have either a flat tax or Fair Tax? But that’s an issue for another day.

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Allister Heath, the superb economic writer from London, recently warned that governments are undermining incentives to save.

And not just because of high tax rates and double taxation of savings. Allister says people are worried about outright confiscation resulting from possible wealth taxation.

It is clear that individuals, when at all possible, need to accumulate more financial assets. …Tragically, it won’t happen. A lack of trust in the system is one important explanation. People simply don’t believe the government – and politicians of all parties – when it comes to long-terms savings and pensions. They worry, with good reason, that the rules will keep changing; they are afraid that savers are an easy target and that they will eventually be hit by a wealth tax.

Are savers being paranoid? Is Allister being paranoid?

Well, even paranoid people have enemies, and this already has happened in countries such as Poland and Argentina. Moreover, it appears that plenty of politicians and bureaucrats elsewhere want this type of punitive levy.

Here are some passages from a Reuters report.

Germany’s Bundesbank said on Monday that countries about to go bankrupt should draw on the private wealth of their citizens through a one-off capital levy before asking other states for help.

Since data from the IMF, OECD, and BIS show that almost every industrialized nation will face a fiscal crisis in the next decade or two, people with assets understandably are concerned that their necks will be on the chopping block when politicians are scavenging for more cash to prop up failed welfare states.

Though to be fair, the Bundesbank may simply be sending a signal that German taxpayers don’t want to pick up the tab for fiscal excess in nations such as France and Greece. And it also acknowledged such a tax would harm growth.

“(A capital levy) corresponds to the principle of national responsibility, according to which tax payers are responsible for their government’s obligations before solidarity of other states is required,” the Bundesbank said in its monthly report. …the Bundesbank said it would not support an implementation of a recurrent wealth tax, saying it would harm growth.

Other German economists, however, openly advocate for wealth taxes on German taxpayers.

…governments should consider imposing one-off capital levies on the rich… In Germany, for example, two thirds of the national wealth belongs to the richest 10% of the adult population. …a one-time capital levy of 10% on personal net wealth exceeding 250,000 euros per taxpayer (€500,000 for couples) could raise revenue of just over 9% of GDP. …In the other Eurozone crisis countries, it would presumably be possible to generate considerable amounts of money in the same way.

The pro-tax crowd at the International Monetary Fund has a similarly favorable perspective, relying on absurdly unrealistic conditions to argue that a wealth tax wouldn’t hurt growth. Here’s some of what the IMF asserted in its Fiscal Monitor last October.

The sharp deterioration of the public finances in many countries has revived interest in a “capital levy”— a one-off tax on private wealth—as an exceptional measure to restore debt sustainability. The appeal is that such a tax, if it is implemented before avoidance is possible and there is a belief that it will never be repeated, does not distort behavior (and may be seen by some as fair).

The IMF even floats a trial balloon that governments could confiscate 10 percent of household assets.

The tax rates needed to bring down public debt to precrisis levels…are sizable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) a tax rate of about 10 percent on households with positive net wealth.

Many people condemned the IMF for seeming to endorse theft by government.

The IMF’s Deputy Director of Fiscal Affairs then backpedaled a bit the following month. He did regurgitate the implausible notion that a wealth tax won’t hurt the economy so long as it only happens once and it is a surprise.

To an economist, …it’s close to an ideal form of taxation, since there is nothing you can now do to reduce, avoid, or evade it—the holy grail of what economists call a non-distorting tax. …Such a levy would entail a one-off charge on capital assets, the precise base being a matter for choice, but generally larger than cash left on kitchen tables. Added to the efficiency advantage of such a tax, many see an equity appeal in that such a charge would naturally fall most heavily on those with the most assets.

But he then felt obliged to point out some real-world concerns.

…governments have rarely implemented capital levies, and they have almost never succeeded. And there are very good reasons for that. …to be non-distorting the tax must be both unanticipated and believed certain not to be repeated. These are both very hard things to achieve. Introducing and implementing any new tax takes time, and governments can rarely do it in entire secrecy (even leaving aside transparency issues). And that gives time for assets to be moved abroad, run down, or concealed. The risk of future levies can be even more damaging; they discourage the saving and investment that generate future capital assets.

Though these practical flaws and problems don’t cause much hesitation on the left.

Here’s what Joann Weiner recently wrote in the Washington Post about the work of Thomas Piketty, a French economist who apparently believes society will be better if higher taxes result in everyone being equally poor.

A much higher tax on upper income — say 80 percent — coupled with a significant tax on wealth — say 10 percent — would go a long way toward making America’s income distribution more equitable than it is now. …capital is the chief culprit… Piketty has another pretty radical, at least for the United States, way to shrink the share of wealth at the top — introduce a global tax on all capital. This means taxes on not just stocks and bonds, but also land, homes, machines, patents — you name it; if it’s wealth or if it generates what tax authorities call “unearned income,” then it should be taxed. One other thing. All countries have to adopt the tax to keep capital from fleeing to tax havens.

Writing in the New York Times back in January, Thomas Edsall also applauds proposals for a new wealth tax.

…worsening inequality is an inevitable outcome of free market capitalism. …The only way to halt this process…is to impose a global progressive tax on wealth – global in order to prevent (among other things) the transfer of assets to countries without such levies. A global tax, in this scheme, would restrict the concentration of wealth and limit the income flowing to capital.

Not surprisingly, there’s support in academia for confiscating other people’s money. One professors thinks the “impossible dream” of theft by government could become reality.

…this article proposes a yearly graduated tax on the net wealth of all individuals in excess of $100 million. The rate would be 5% on the excess up to $500 million and then 10% thereafter. …Such taxes are attacked as “class warfare” that runs counter to America’s libertarian and capitalist traditions. However…the time may once again be ripe for adopting a new tax to combat the growing wealth inequality in the nation. …wealth inequality harms the very social fabric of society. …The purpose of the proposed Equality Tax would not be to raise general revenue, although revenue would be raised. Instead it would be focused on establishing a societal value that for the health of society, no individual should accrue wealth beyond a certain point. Essentially, once an individual has $100 million of assets, …further wealth accumulation harms society while providing little economic benefit or incentive to the individual. …At a minimum such a tax would raise
at least $140 billion a year.

Let’s close by looking at the real economic consequences of wealth taxation. Jan Schnellenbach of the Walter Eucken Intitut in Germany analyzed this question.

Are there sound economic reasons for the net wealth tax, as an instrument to tax stocks of physical and financial capital, to be levied in addition to taxes on capital incomes?

Before even addressing that issue, the author points out that policy actually has been moving in the right direction, presumably because of tax competition.

There has been a wave of OECD countries abolishing their personal net wealth taxes recently. Examples are Spain (abolished in 2008), Sweden (2007) as well as Finland, Iceland and Luxembourg (all 2006). Nevertheless, the net wealth tax repeatedly surfaces again in the public debate.

So what about the economics of a wealth tax? Schnellenbach makes the critical point that even a small levy on assets translates into a very punitive rate on actual returns.

…every tax on domestic wealth needs to be paid out of the returns on wealth, every net wealth tax with a given rate is trivially equivalent to a capital income tax with a substantially higher rate. …even an – on aggregate – non-confi scatory wealth tax may at least temporarily actually have confi scatory eff ects on individuals in periods where they realize sufficiently low returns on their capital stock.

He then looks at the impact on incentives.

…a net wealth tax will have similar distortionary e ffects as a capital income tax. …Introducing a comprehensive net wealth tax would then, through the creation of new incentives for tax avoidance and evasion, also diminish the base of the income tax. Scenarios with even a negative overall revenue eff ect would be conceivable. There is thus good reason to cast doubt on the popular belief that a net wealth tax combines little distortions and large amounts of revenue. …A wealth tax aggravates the distortions and the incentives to evade that already exist due to a pre-existing capital income tax.

And he closes by emphasizing that this form of double taxation undermines property rights.

The intrusion into private property rights may be far more severe for a wealth tax compared to an income tax. …It takes hold of a stock of wealth that consists of saved incomes which have already been subject to an income tax in the past… Our discussion has shown that economically, the wealth tax walks on thin ice.

In other words, a wealth tax is a very bad idea. And that’s true whether it’s a permanent levy or a one-time cash grab by politicians.

Some may wonder whether a wealth tax is a real threat. The answer depends on the time frame. Could such a levy happen in the next year or two in the United States?

The answer is no.

But the wealth tax will probably be a real threat in the not-too-distant future. America’s long-run fiscal outlook is very grim because of a rising burden of government spending.

This necessarily means there will be a big fiscal policy battle. On one side, libertarians and small-government advocates will push for genuine entitlement reform. Advocates of big government, by contrast, will want new revenues to enable and facilitate the expansion of the public sector.

The statists will urge higher income tax rates, but sober-minded folks on the left privately admit that the Laffer Curve is real and that they can’t collect much more money with class-warfare tax policy.

That’s why there is considerable interest in new revenue sources, such as energy taxes, financial transaction taxes, and the value-added tax.

And, of course, a wealth tax.

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I generally get very suspicious when rich people start pontificating on tax policy.

People like Warren Buffett, for instance, sometimes advocate higher taxes because they’re trying to curry favor with the political elite. Or maybe they feel compelled to say silly things to demonstrate that they feel guilty about their wealth.

Tax SystemRegardless, I don’t like their policy proposal (as you can see from TV debates here and here).

That being said, I also realize that stereotypes can be very unfair, so it’s important to judge each argument on the merits and not to reject an idea simply because it comes from a rich guy.

That’s why I was very interested to see that Bill Gates, the multi-billionaire software maker, decided to add his two cents to the discussion of tax reform.

Here’s what Gates said at an American Enterprise Institute forum (transcript here and video here).

…economists would have said that a progressive consumption tax is a better construct, you know, at any point in history. What I’m saying is that it’s even more important as we go forward.

He doesn’t really expand on those remarks other than to say that it’s important to reduce the tax on labor.

That part of Gates’ remarks doesn’t make much sense for the simple reason that workers are equally harmed whether the government takes 20 percent of their income when it’s earned or 20 percent of their income when it’s spent.

But his embrace of a “progressive consumption tax” is very intriguing.

I don’t like the “progressive” part because that’s shorthand for high marginal tax rates, and that type of class-warfare policy is a gateway to corruption and is also damaging to growth (see here, here, here, here, and here).

But the “consumption” part is one of the key features of all good tax reform plans.

For all intents and purposes, a “consumption tax” is any system that avoids the mistake of double-taxing income that is saved and invested.

Both the national sales tax and the value-added tax, for instance, are examples of consumption-based tax systems.

But the flat tax also is a consumption tax. It isn’t collected at the cash register like a sales tax, but it has the same “tax base.”

Under a flat tax, income is taxed – but only one time – when it is earned. Under a sales tax, income is taxed – but only one time – when it is spent. They’re different sides of the same coin.

Most important, neither the flat tax nor the sales tax has extra layers of tax on saving and investment. And that’s what makes them “consumption” taxes in the wonky world of public finance economists.

This means no death tax, no capital gains tax, no double taxation of interest or dividends. And businesses get a common-sense cash-flow system of taxation, which means punitive depreciation rules are replaced by “expensing.”

So Bill Gates is halfway on the path to tax policy salvation. His endorsement of so-called progressivity is wrong, but his support for getting rid of double taxation is right.

If you like getting into the weeds of tax policy, it’s interesting to note that Gates is advocating the opposite of the plan that was proposed by Congressman Dave Camp.

Camp wants to go in the right direction regarding rates, but he wants to exacerbate the tax code’s bias against capital. Here’s what I said to Politico.

Dan Mitchell, an economist at the libertarian Cato Institute, said he didn’t see it as an individual versus business issue, but rather took issue with Camp’s punitive treatment of savings and investment. “The way Camp is extracting more money from businesses — more punitive depreciation and the like — is he is making the tax system more biased against savings and investment,” said Mitchell, who worked for Republican Sen. Bob Packwood after the historic 1986 tax act that Packwood helped negotiate as chair of the Finance Committee.

By the way, this doesn’t mean Camp’s plan is bad. You have to do a cost-benefit analysis of the good and bad features.

Just like that type of analysis was appropriate in 1986, when the bad provisions that increased taxes on saving and investment were offset by a big reduction in marginal tax rates.

The 1986 law did take aim at some popular business benefits, including a lucrative investment tax credit. But the reward was a lot sweeter. “At least then, we got a big, big reduction in tax rates in exchange,” Mitchell said.

Here’s an interview I did with Blaze TV on Congressman Camp’s plan. If you pay attention near the beginning (at about the 2:00 mark), you’ll see my matrix on how to grade tax reform plans.

Now let’s circle back to the type of tax system endorsed by Bill Gates.

We obviously don’t know what he favors beyond a “progressive consumption tax,” but that bit of information allows us to say that he wants something at least somewhat similar to the old “USA Tax” that was supported by folks such as former Senators Sam Nunn and Pete Domenici.

Is that better than the current tax system?

Probably yes, though we can’t say for sure because it’s possible they may want to increase tax rates by such a significant amount that the plan becomes a net minus for the economy.

Not that any of this matters since I doubt we’ll get tax reform in my lifetime.

P.S. Speaking of taxes and the rich, you’ll enjoy this very clever interview exposing the hypocrisy of wealthy leftists.

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To make fun of big efforts that produce small results, the famous Roman poet, Horace, wrote “The mountains will be in labor, and a ridiculous mouse will be brought forth.”

That line sums up my view of the new tax reform plan introduced by Congressman Dave Camp, Chairman of the House Ways & Means Committee.

To his credit, Congressman Camp put in a lot of work. But I can’t help but wonder why he went through the time and trouble. To understand why I’m so underwhelmed, let’s first go back in time.

Back in 1995, tax reform was a hot issue. The House Majority Leader, Dick Armey, had proposed a flat tax. Congressman Billy Tauzin was pushing a version of a national sales tax. And there were several additional proposals jockeying for attention.

To make sense of this clutter, I wrote a paper for the Heritage Foundation that demonstrated how to grade the various proposals that had been proposed.

As you can see, I included obvious features such as low tax rates, simplicity, double taxation, and social engineering, but I also graded plans based on other features such as civil liberties, fairness, and downside risk.

Tax Reform Grading Matrix

There obviously have been many new plans since I wrote this paper, most notably the Fair Tax (a different version of a national sales tax than the Tauzin plan), Simpson-Bowles, the Ryan Roadmap, Domenici-Rivlin, the Heritage Foundation’s American Dream proposal, the Baucus-Hatch blank slate, and – as noted above – the new tax reform plan by Congressman Dave Camp.

Given his powerful position as head of the tax-writing committee, let’s use the 1995 guide to assess the pros and cons of Congressman Camp’s plan.

Rates: The Top tax rate for individual taxpayers is reduced from 39.6 percent to 35 percent, which is a disappointingly modest step in the right direction. The corporate tax rate falls from 35 percent to 25 percent, which is more praiseworthy, though Camp doesn’t explain why small businesses (who file using the individual income tax) should pay higher rates than large companies.

Simplicity: Camp claims that he will eliminate 25 percent of the tax code, which certainly is welcome news since the internal revenue code has swelled to 70,000-plus pages of loopholes, exemptions, deductions, credits, penalties, exclusions, preferences, and other distortions. And his proposal does eliminate some deductions, including the state and local tax deduction (which perversely rewards states with higher fiscal burdens).

Saving and Investment: Ever since Reagan slashed tax rates in the 1980s, the most anti-growth feature of the tax code is probably the pervasive double taxation of income that is saved and invested. Shockingly, the Camp plan worsens the tax treatment of capital, with higher taxation of dividends and capital gains and depreciation rules that are even more onerous than current law.

Social Engineering: Some of the worst distortions in the tax code are left in place, including the healthcare exclusion for almost all taxpayers. This means that people will continue to make economically irrational decisions solely to benefit from certain tax provisions.

Civil Liberties: The Camp plan does nothing to change the fact that the IRS has both the need and the power to collect massive amounts of private financial data from taxpayers. Nor does the proposal end the upside-down practice of making taxpayers prove their innocence in any dispute with the tax authorities.

Fairness: In a non-corrupt tax system, all income is taxed, but only one time. On this basis, the plan from the Ways & Means Chairman is difficult to assess. Loopholes are slightly reduced, but double taxation is worse, so it’s hard to say whether the system is more fair or less fair.

Risk: There is no value-added tax, which is a critically important feature of any tax reform plan. As such, there is no risk the Camp plan will become a Trojan Horse for a massive expansion in the fiscal burden.

Evasion: People are reluctant to comply with the tax system when rates are punitive and/or there’s a perception of rampant unfairness. It’s possible that the slightly lower statutory rates may improve incentives to obey the law, but that will be offset by the higher tax burden on saving and investment.

International Competitiveness: Reducing the corporate tax rate will help attract jobs and investment, and the plan also mitigates some of worst features of America’s “worldwide” tax regime.

Now that we’ve taken a broad look at the components of Congressman Camp’s plan, let’s look at a modified version of my 1995 grades.

Camp Tax Matrix

You can see why I’m underwhelmed by his proposal.

Congressman Camp’s proposal may be an improvement over the status quo, but my main reaction is “what’s the point?”

In other words, why go through months of hearings and set up all sorts of working groups, only to propose a timid plan?

Now, perhaps, readers will understand why I’m rather pessimistic about achieving real tax reform.

We know the right policies to fix the tax code.

And we have ready-made plans – such as the flat tax and national sales tax – that would achieve the goals of tax reform.

Camp’s plan, by contrast, simply rearranges the deck chairs on the Titanic.

P.S. If you need to be cheered up after reading all this, here’s some more IRS humor to brighten your day, including the IRS version of the quadratic formula, a new Obama 1040 form, a list of tax day tips from David Letterman, a cartoon ofhow GPS would work if operated by the IRS, an IRS-designed pencil sharpener, a sale on 1040-form toilet paper (a real product), and two songs about the tax agency (hereand here),  and a PG-13 joke about a Rabbi and an IRS agent.

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Back in the 1960s, Clint Eastwood starred in a movie entitled The Good, the Bad and the Ugly.

I was thinking that might be a good title for today’s post about some new research by Michelle Harding, a tax economist for the OECD. But then I realized that her study on “Taxation of Dividend, Interest, and Capital Gain Income” doesn’t contain any “good” news.

At least not if you want the United States to be more competitive and create more jobs. This is because the numbers show that the internal revenue code results in punitive double taxation of income that is saved and invested.

But it’s not newsworthy that there’s a lot of double taxation in America. What is shocking and discouraging, however, is finding out that our tax code is more punitive than just about every European welfare state.

This is the “bad” part of today’s discussion. Indeed, the tax burden on dividends, interest, and capital gains in America is far above the average for other industrialized nations.

Let’s look at some charts from the study, starting with the one comparing the tax burden on dividends.

OECD Study Dividend Tax Rates

As you can see, the United States has the dubious honor of having the sixth-highest overall tax rate (combined burden of corporate and personal taxes) among developed nations.

Though maybe we should feel lucky we’re not in France or Denmark.

The next chart looks at the tax burden on capital gains.

OECD Study Cap Gains Tax Rates

Once again, the United States has one of the most onerous tax systems among OECD countries, with only four other nations imposing a higher combined tax rate on capital gains.

By the way, if you want to know why this is a very bad idea, click here.

Last but not least, let’s look at the tax burden on interest.

OECD Study Interest Tax Rates

I’m sure you’ve already detected the pattern, but I’ll state the obvious that this is another example of the United States being on the wrong side of the graph.

So the next time you hear somebody bloviating about Americans being too short-sighted and not saving enough, you may want to inform them that there’s not much incentive to save when the IRS gets a big share of any interest we earn.

Not that any of us are getting much interest since the Fed’s easy-money policy has created an atmosphere of artificially low interest rates, but that’s a topic for another day.

Let’s now move to the “ugly” part of the analysis.

Some of you may have noticed that the charts replicated above are based on tax laws on July 1, 2012.

Well, thanks to Obamacare and the fiscal cliff deal, the IRS began imposing higher tax rates on dividends, capital gains, and interest on January 1, 2013.

And because of the new surtax on investments and the higher tax rates on dividends and capital gains, the United States will move even further in the wrong direction on the three charts.

I don’t know if that means we’ll overtake France in the contest to have the most anti-competitive tax treatment of dividends and capital gains, but it’s definitely bad news.

Oh, and let’s add another bit of “ugly” news to the discussion.

The OECD study didn’t look at death tax rates, but a study by the American Council for Capital Formation shows that the United States also has one of the world’s most punitive death taxes.

Even worse than France, Greece, and Venezuela, which is nothing to brag about.

I don’t want to be the bearer of nothing but bad news, so let’s close with some “good” news. At least relatively speaking.

It’s not part of the study, but it’s worth pointing out that the overall burden of taxation – measured as a share of GDP – is higher in most other nations. The absence of a value-added tax is probably the most important reason why the United States retains an advantage in this category.

Needless to say, this is why we should fight to our last breath to make sure this European version of a national sales tax is never imposed in America.

P.S. One of the big accounting firms, Ernst and Young, published some research last year that is very similar to the OECD’s data.

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I’m a big proponent of tax reform, so at first I was very excited to learn that Senators Max Baucus (D-MT) and Orrin Hatch (R-UT) were launching an effort to clean up the tax code.

But on closer inspection, I don’t think this will lead to a simple and fair system like the flat tax. Or even a national sales tax (assuming we could trust politicians not to pull a bait-and-switch, adding a new tax and never getting rid of the income tax).

But judge for yourself. Here’s some of what’s contained in a letter they sent to their colleagues, starting with some language about the growing complexity of the tax code and the compliance cost for taxpayers.

…since then, the economy has changed dramatically and Congress has made more than 15,000 changes to the tax code. The result is a tax base riddled with exclusions, deductions and credits. In addition, each year, it costs individuals and businesses more than $160 billion to comply with the tax code. The complexity, inefficiency and unfairness of the tax code are acting as a brake on our economy. We cannot afford to be complacent.

Sounds good, though they also could have mentioned other indicators of nightmarish complexity, such as the number of pages in the tax code, the number of special tax provisions, or the number of pages in the 1040 instruction manual.

I’m a bit mystified, however, at the low-ball estimate of $160 billion of compliance costs. As explained in this video, there are far higher estimates that are based on very sound methodology.

But perhaps I’m nit-picking. Let’s see with Senators Baucus and Hatch want to do.

In order to make sure that we end up with a simpler, more efficient and fairer tax code, we believe it is important to start with a “blank slate”—that is, a tax code without all of the special provisions in the form of exclusions, deductions and credits and other preferences that some refer to as “tax expenditures.”

I don’t like the term “tax expenditure” since it implies that the government taking money from person A and giving it to person B is equivalent to the government simply letting person B keep their own money. These two approaches may be economically equivalent in certain cases, but they’re not morally equivalent.

Once again, however, I may be guilty of nit-picking.

That being said, there is a feature of the “blank slate” approach which does generate legitimate angst. There’s a footnote in the letter that states that the Joint Committee on Taxation is in charge of determining so-called tax expenditures.

A complete list of these special tax provisions as defined by the non-partisan Joint Committee on Taxation.

This is very troubling. The JCT may be non-partisan, but it’s definitely not non-ideological. These are the bureaucrats, for instance, who assume that the revenue-maximizing tax rate is 100 percent! Moreover, the JCT uses the “Haig-Simons” tax system as a benchmark, which means they start with the assumption that there should be pervasive double taxation of income that is saved and invested.

This is not nit-picking. The definition of “tax expenditure” is a critical policy decision, not something to be ceded to the other side before the debate even begins.

As illustrated by this chart, the tax code is very biased against saving and investment.

Between the capital gains tax, the corporate income tax, the double tax on dividends, and the death tax, it’s possible for a single dollar of income to be taxed as many as four different times.

This is a very foolish policy, particularly since every school of thought in the economics profession agrees that capital formation is a key to long-run growth. Even the Marxists and socialists!

To make matters worse, double taxation puts America at competitive disadvantage. To get a sense of how the U.S. tax system is a self-inflicted wound, check out these sobering international comparisons of death tax burdens and the degree of double taxation of dividends and capital gains.

Here’s what the Haig-Simons tax base means.

1. An assumption that new business investment should be penalized with depreciation instead of being treated neutrally with expensing.

2. An assumption that IRAs and 401(k)s are loopholes to be eliminated, when they’re actually ways to protect against double taxation.

3. An assumption that various other forms of double taxation – such as the capital gains tax – should be retained.

But that’s not the only preemptive capitulation to bad policy.

The “blank slate” assumes that the class-warfare bias in the tax code also should be part of the benchmark against which possible reforms will be judged.

…we asked the nonpartisan Joint Committee on Taxation and Finance Committee tax staff to estimate the relationship between tax expenditures and the current tax rates if the current level of progressivity is maintained. …The blank slate approach would allow significant deficit reduction or rate reduction, while maintaining the current level of progressivity.

Since the internal revenue code already imposes a disproportionate burden on upper-income taxpayers – even when compared to European welfare states, it doesn’t make sense to automatically assume an ideological agenda such as progressivity.

This has been a very long answer to a simple question, but it’s very important to realize that tax reform is a three-legged stool. If we want to minimize the economic damage of generating revenue for government, we should have 1) a low tax rate, 2) no distorting tax preferences, and 3) no distorting tax penalties such as double taxation.

Unfortunately, too many people focus only on the first and second legs of the stool. And while tax rates and deductions are important, so is double taxation.

I’m not asserting that the “blank slate” should have assumed no double taxation (sometimes referred to as the “Fisher-Ture” tax base or “consumption” tax base).

But I don’t think it would have been unreasonable for Senators Baucus and Hatch to have told other Senators that one of their choices would be to pick either the Haig-Simons approach or the Fisher-Ture approach.

Heck, even the Congressional Budget Office acknowledged that there are two ways of measuring tax expenditures. To reiterate, the choice of tax base should be a policy decision, not a built-in assumption.

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As a long-time advocate of tax reform, I’m not a fan of distortionary loopholes in the tax code. Ideally, we would junk the 74,000-page internal revenue code and replace it with a simple and fair flat tax – meaning one low rate, no double taxation, and no favoritism.*

The right kind of tax reform would generate more growth and also reduce corruption in Washington. Politicians no longer would have the ability to create special tax breaks for well-connected contributors.

But we won’t get to the right destination if we have the wrong map, and this is why a new report about “tax expenditures” from the Congressional Budget Office is so disappointing.

As you can see from this excerpted table, CBO makes the same mistake as the Tax Policy Center and assumes that there should be double taxation of income that is saved and invested. As such, they list IRAs and 401(k)s as tax expenditures, even though those provisions merely enable people to avoid being double-taxed.

Likewise, the CBO report assumes that there should be double taxation of dividends and capital gains, so provisions to guard against such destructive policies also are listed as tax expenditures.

CBO Tax Expenditure List

The CBO report says that tax expenditures will total about $12 trillion over the next 10 years, but about one-third of that amount (which I’ve marked with a red X) don’t belong on the list.

By the way, at least the Tax Policy Center has an excuse for putting its thumb on the scale and issuing a flawed estimate of tax expenditures. It’s a project of the Brookings Institution and Urban Institute, both of which are on the left side of the political spectrum. So it’s hardly a surprise that they use a benchmark designed to promote punitive tax policy.

But what’s CBO’s excuse?

To be fair, at least CBO admitted in the report that there’s a different way of seeing the world.

…tax expenditures are measured relative to a comprehensive income tax system. If tax expenditures were evaluated relative to an alternative tax system—for instance, a comprehensive consumption tax, such as a national retail sales tax or a value-added tax—some of the 10 major tax expenditures analyzed here would not be considered tax expenditures. For example, because a consumption tax would exclude all savings and investment income from taxation, the exclusion of net pension contributions and earnings would be considered part of the normal tax system and not a tax expenditure.

But admitting the existence of another approach doesn’t let CBO off the hook. At the very least, the bureaucracy should have produced a a parallel set of estimates for tax expenditures assuming no double taxation. That basic competence and fairness.

By the way, the Government Accountability Office is worse than CBO. When GAO did a report on corporate tax expenditures, that bureaucracy didn’t even acknowledge that there was an alternate way of looking at the data.

*Actually, the ideal approach would be to dramatically reduce the burden of government spending, shrinking the size and scope of the federal government back to what the Founding Fathers had in mind. Under that system, there presumably wouldn’t be a need for any broad-based tax.

P.S. This new report is not even close to being the worst thing produced by CBO. The bureaucrats on several occasions have asserted that higher taxes are good for growth, even to the point of implying that the growth-maximizing tax rate is 100 percent! And CBO is slavishly devoted to Keynesian economics, notwithstanding several decades of evidence that you can’t make an economy richer by taking money out of one pocket and putting it in another pocket.

Yet for inexplicable reasons, Republicans failed to deal with CBO bias back when they were in charge.

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The folks at the Center for Freedom and Prosperity have been on a roll in the past few months, putting out an excellent series of videos on Obama’s economic policies.

Now we have a new addition to the list. Here’s Mattie Duppler of Americans for Tax Reform, narrating a video that eviscerates the President’s tax agenda.

I like the entire video, as you can imagine, but certain insights and observations are particularly appealing.

1. The rich already pay a disproportionate share of the total tax burden – The video explains that the top-20 percent of income earners pay more than 67 percent of all federal taxes even though they earn only about 50 percent of total income. And, as I’ve explained, it would be very difficult to squeeze that much more money from them.

2. There aren’t enough rich people to fund big government – The video explains that stealing every penny from every millionaire would run the federal government for only three months. And it also makes the very wise observation that this would be a one-time bit of pillaging since rich people would quickly learn not to earn and report so much income. We learned in the 1980s that the best way to soak the rich is by putting a stop to confiscatory tax rates.

3. The high cost of the death tax – I don’t like double taxation, but the death tax is usually triple taxation and that makes a bad tax even worse. Especially since the tax causes the liquidation of private capital, thus putting downward pressure on wages. And even though the tax doesn’t collect much revenue, it probably does result in some upward pressure on government spending, thus augmenting the damage.

4. High taxes on the rich are a precursor to higher taxes on everyone else – This is a point I have made on several occasions, including just yesterday. I’m particularly concerned that the politicians in Washington will boost income tax rates for everybody, then decide that even more money is needed and impose a value-added tax.

The video also makes good points about double taxation, class warfare, and the Laffer Curve.

Please share widely.

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In previous posts, I put together tutorials on the Laffer Curve, tax competition, and the economics of government spending.

Today, we’re going to look at the issue of tax reform. The focus will be the flat tax, but this analysis applies equally to national sales tax systems such as the Fair Tax.

There are three equally important features of tax reform.

  1. A low tax rate – This is the best-known feature of tax reform. A low tax rate is designed to minimize the penalty of work, entrepreneurship, and productive behavior.
  2. No double taxation of saving and investment – All major tax reform plans, such as the flat tax and national sales tax, get rid of the tax bias against income that is saved and invested. The capital gains tax, double tax on dividends, and death tax are all abolished. Shifting to a system that taxes economic activity only one time will boost capital formation, thus facilitating an increase in productivity and wages.
  3. No distorting loopholes – With the exception of a family-based allowance designed to protect lower-income people, the main tax reform plans get rid of all deductions, exemptions, shelters, preference, exclusions, and credits. By creating a neutral tax system, this ensures that decisions are made on the basis of economic fundamentals, not tax distortions.

All three features are equally important, sort of akin to the legs of a stool. Using the flat tax as a model, this video provides additional details.

One thing I don’t mention in the video is that a flat tax is “territorial,” meaning that only income earned in the United States is taxed. This common-sense rule is the good-fences-make-good-neighbors approach. If income is earned by an American in, say, Canada, then the Canadian government gets to decide how it’s taxed. And if income is earned by a Canadian in America, then the U.S. government gets a slice.

It’s also worth emphasizing that the flat tax protects low-income Americans from the IRS. All flat tax plans include a fairly generous “zero-bracket amount,” which means that a family of four can earn (depending on the specific proposal) about $25,000-$35,000 before the flat tax takes effect.

Proponents of tax reform explain that there are many reasons to junk the internal revenue code and adopt something like a flat tax.

  • Improve growth – The low marginal tax rate, the absence of double taxation, and the elimination of distortions combine to create a system that minimizes the penalties on productive behavior.
  • Boost competitiveness – In a competitive global economy, it is easy for jobs and investment to cross national borders. The right kind of tax reform can make America a magnet for money from all over the world.
  • Reduce corruption – Tax preferences and penalties are bad for growth, but they are also one of the main sources of political corruption in Washington. Tax reform takes away the dumpster, which means fewer rats and cockroaches.
  • Promote simplicity – Good policy has a very nice side effect in that the tax system becomes incredibly simple. Instead of the hundreds of forms required by the current system, both households and businesses would need only a single postcard-sized form.
  • Increase privacy – By getting rid of double taxation and taxing saving, investment, and profit at the business level, there no longer is any need for people to tell the government what assets they own and how much they’re worth.
  • Protect civil liberties – A simple and fair tax system eliminates almost all sources of conflict between taxpayers and the IRS.

All of these benefits also accrue if the internal revenue code is abolished and replaced with some form of national sales tax. That’s because the flat tax and sales tax are basically different sides of the same coin. Under a flat tax, income is taxed one time at one low rate when it is earned. Under a sales tax, income is taxed one time at one low rate when it is spent.

Neither system has double taxation. Neither system has corrupt loopholes. And neither system requires the nightmarish internal revenue service that exists to enforce the current system.

This video has additional details – including the one caveat that a national sales tax shouldn’t be enacted unless the 16th Amendment is repealed so there’s no threat that politicians could impose both an income tax and sales tax.

Last but not least, let’s deal with the silly accusation that the flat tax is a risky and untested idea. This video is a bit dated (some new nations are in the flat tax club and a few have dropped out), but is shows that there are more than two dozen jurisdictions with this simple and fair tax system.

P.S. Fundamental tax reform is also the best way to improve the healthcare system. Under current law, compensation in the form of fringe benefits such as health insurance is tax free. Not only is it deductible to employers and non-taxable to employees, it also isn’t hit by the payroll tax. This creates a huge incentive for gold-plated health insurance policies that cover routine costs and have very low deductibles. This is a principal cause (along with failed entitlement programs such as Medicare and Medicaid) of the third-party payer crisis. Shifting to a flat tax means that all forms of employee compensation are taxed at the same low rate, a reform that presumably over time will encourage both employers and employees to migrate away from the inefficient over-use of insurance that characterizes the current system. For all intents and purposes, the health insurance market presumably would begin to resemble the vastly more efficient and consumer-friendly auto insurance and homeowner’s insurance markets.

P.P.S. If you want short and sweet descriptions of the major tax reform plans, here are four highly condensed descriptions of the flat tax, national sales tax, value-added tax, and current system.

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My friends at Americans for Tax Reform have received a bunch of attention for a new report entitled “Win Olympic Gold, Pay the IRS.”

In this clever document, they reveal that athletes could face a tax bill – to those wonderful folks at the IRS – of nearly $9,000 thanks to America’s unfriendly worldwide tax system.

The topic is even getting attention overseas. Here’s an excerpt from a BBC report.

US medal-winning athletes at the Olympics have to pay tax on their prize money – something which is proving controversial in the US. But why are athletes from the US taxed when others are not? The US is right up there in the medals table, and has produced some of the finest displays in the Olympics so far. … But not everyone is happy to hear that their Olympic medal-winning athletes are being taxed on their medal prize money. Athletes are effectively being punished for their success, argues Florida Senator Marco Rubio, a Republican, who introduced a bill earlier this week that would eliminate tax on Olympic medals and prize money. …This, he said, is an example of the “madness” of the US tax system, which he called a “complicated and burdensome mess”.

It’s important to understand, though, that this isn’t a feel-good effort to create a special tax break. Instead, Senator Rubio is seeking to take a small step in the direction of better tax policy.

More specifically, he wants to move away from the current system of “worldwide” taxation and instead shift to “territorial” taxation, which is simply the common-sense notion of sovereignty applied to taxation. If income is earned inside a nation’s borders, that nation gets to decided how and when it is taxed.

In other words, if U.S. athletes earn income competing in the United Kingdom, it’s a matter for inland revenue, not the IRS.

Incidentally, both the flat tax and national sales tax are based on territorial taxation, and most other countries actually are ahead of the United States and use this approach. The BBC report has further details.

The Olympic example highlights what they regard as the underlying problem of the US’ so-called “worldwide” tax model. Under this system, earnings made by a US citizen abroad are liable for both local tax and US tax. Most countries in the world have a “territorial” system of tax and apply that tax just once – in the country where it is earned. With the Olympics taking place in London, the UK would, in theory, be entitled to claim tax on prize money paid to visiting athletes. But, as is standard practice for many international sporting events, it put in place a number of tax exemptions for competitors in the Olympics – including on any prize money. That means that only athletes from countries with a worldwide tax system on individual income are liable for tax on their medals. And there are only a handful of them in the world, says Daniel Mitchell, an expert on tax reform at the Cato Institute, a libertarian think tank – citing the Philippines and Eritrea as other examples. But with tax codes so notoriously complicated, unravelling which countries would apply this in the context of Olympic prize money is a tricky task, he says. Mitchell is a critic of the worldwide system, saying it effectively amounts to “double taxation” and leaves the US both at a competitive disadvantage, and as a bullyboy, on the world stage. “We are the 800lb (360kg) gorilla in the world economy, and we can bully other nations into helping enforce our bad tax law.”

To close out this discussion, statists prefer worldwide taxation because it undermines tax competition. This is because, under worldwide taxation, individuals and companies have no ability to escape high taxes by shifting activity to jurisdictions with better tax policy.

Indeed, this is why politicians from high-tax nations are so fixated on trying to shut down so-called tax havens. It’s difficult to enforce bad tax policy, after all, if some nations have strong human rights policies on privacy.

For all intents and purposes, a worldwide tax regime means the government gets a permanent and global claim on your income. And without having to worry about tax competition, that “claim” will get more onerous over time.

P.S. Just because a nation has a right to tax foreigners who earn income inside its borders, that doesn’t mean it’s a good idea to go overboard. The United Kingdom shows what happens if politicians get too greedy and Spain shows what happens if marginal tax rates are reasonable.

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Considering that every economic theory agrees that living standards and worker compensation are closely correlated with the amount of capital in an economy (this picture is a compelling illustration of the relationship), one would think that politicians – particularly those who say they want to improve wages – would be very anxious not to create tax penalties on saving and investment.

Yet the United States imposes very harsh tax burdens on capital formation, largely thanks to multiple layers of tax on income that is saved and invested.

But we compound the damage with very high tax rates, including the highest corporate tax burden in the developed world.

And the double taxation of dividends and capital gains is nearly the worst in the world (and will get even worse if Obama’s class-warfare proposals are approved).

To make matters worse, the United States also has one of the most onerous death taxes in the world. As you can see from this chart prepared by the Joint Economic Committee, it is more punitive than places such as Greece, France, and Venezuela.

Who would have ever thought that Russia would have the correct death tax rate, while the United States would have one of the world’s worst systems?

Fortunately, not all U.S. tax policies are this bad. Our taxation of labor income is generally not as bad as other industrialized nations. And the burden of government spending in the United States tends to be lower than European nations (though both Bush and Obama have undermined that advantage).

And if you look at broad measures of economic freedom, America tends to be in – or near – the top 10 (though that’s more a reflection of how bad other nations are).

But these mitigating factors don’t change the fact that the U.S. needlessly punishes saving and investment, and workers are the biggest victims. So let’s junk the internal revenue code and adopt a simple and fair flat tax.

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Mitt Romney is being criticized for supporting “territorial taxation,” which is the common-sense notion that each nation gets to control the taxation of economic activity inside its borders.

While promoting his own class-warfare agenda, President Obama recently condemned Romney’s approach. His views, unsurprisingly, were echoed in a New York Times editorial.

President Obama raised…his proposals for tax credits for manufacturers in the United States to encourage the creation of new jobs. He said this was greatly preferable to Mitt Romney’s support for a so-called territorial tax system, in which the overseas profits of American corporations would escape United States taxation altogether. It’s not surprising that large multinational corporations strongly support a territorial tax system, which, they say, would make them more competitive with foreign rivals. What they don’t say, and what Mr. Obama stressed, is that eliminating federal taxes on foreign profits would create a powerful incentive for companies to shift even more jobs and investment overseas — the opposite of what the economy needs.

Since even left-leaning economists generally agree that tax credits for manufacturers are ineffective gimmicks proposed for political purposes, let’s set that topic aside and focus on the issue of territorial taxation.

Or, to be more specific, let’s compare the proposed system of territorial taxation to the current system of “worldwide taxation.”

Worldwide taxation means that a company is taxed not only on it’s domestic earnings, but also on its foreign earnings. Yet the “foreign-source income” of U.S. companies is “domestic-source income” in the nations where those earnings are generated, so that income already is subject to tax by those other governments.

In other words, worldwide taxation results in a version of double taxation.

The U.S. system seeks to mitigate this bad effect by allowing American-based companies a “credit” for some of the taxes they pay to foreign governments, but that system is very incomplete.

And even if it worked perfectly, America’s high corporate tax rate still puts U.S. companies in a very disadvantageous position. If an American firm, Dutch firm, and Irish firm are competing for business in Ireland, the latter two only pay the 12.5 percent Irish corporate tax on any profits they earn. The U.S. company also pays that tax, but then also pays an additional 22.5 percent to the IRS (the 35 percent U.S. tax rate minus a credit for the 12.5 percent Irish tax).

In an attempt to deal with this self-imposed disadvantage, the U.S. tax system also has something called “deferral,” which allows American companies to delay the extra tax (though the Obama Administration has proposed to eliminate that provision!).

Romney is proposing to put American companies on a level playing field by going in the other direction. Instead of immediate worldwide taxation, as Obama wants, he wants to implement territorial taxation.

But what about the accusation from the New York Times that territorial taxation “would create a powerful incentive for companies to shift even more jobs and investment overseas”?

Well, they’re somewhat right…and they’re totally wrong. Here’s what I’ve said about that issue.

If a company can save money by building widgets in Ireland and selling them to the US market, then we shouldn’t be surprised that some of them will consider that option.  So does this mean the President’s proposal might save some American jobs? Definitely not. If deferral is curtailed, that may prevent an American company from taking advantage of a profitable opportunity to build a factory in some place like Ireland. But U.S. tax law does not constrain foreign companies operating in foreign countries. So there would be nothing to prevent a Dutch company from taking advantage of that profitable Irish opportunity. And since a foreign-based company can ship goods into the U.S. market under the same rules as a U.S. company’s foreign subsidiary, worldwide taxation does not insulate America from overseas competition. It simply means that foreign companies get the business and earn the profits.

To put it bluntly, America’s tax code is driving jobs and investment to other nations. America’s high corporate tax rate is a huge self-inflected wound for American competitiveness.

Getting rid of deferral doesn’t solve any problems, as I explain in this video. Indeed, Obama’s policy would make a bad system even worse.

But, it’s also important to admit that shifting to territorial taxation isn’t a complete solution. Yes, it will help American-based companies compete for market share abroad by creating a level playing field. But if policy makers want to make the United States a more attractive location for jobs and investment, then a big cut in the corporate tax rate should be the next step.

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