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Posts Tagged ‘Income tax’

There are some fortunate people (in the Cayman Islands, BermudaMonacoVanuatuAntigua and Barbuda, and a few other places) who don’t have to pay income taxes.

The United States used to be in that lucky club. The income tax did not become a permanent blight upon the nation until 1913 (there was a temporary income tax during the Civil War and an attempted income tax in 1894 – ruled unconstitutional in 1895).

Indeed, this odious tax is a relatively new invention for the entire world. If my memory is correct, the first income tax was a temporary measure imposed by the United Kingdom to finance the fight against Napoleon. And the U.K. also was the first country to impose a permanent income tax (ironically, to help offset lower taxes on international trade).

In every case, politicians followed the same script. Income taxes originally were supposed to have low rates and only apply to the rich.

But it was simply a matter of time before small taxes on the wealthy became punitive taxes on everybody.

Since today is tax filing today for Americans, let’s take the opportunity to highlight two specific unfortunate consequences of the income tax.

First, it enabled the modern welfare state. You can see from the chart that the explosion of redistribution spending only occurred after politicians obtained a new source of revenue (a problem that was exacerbated in Europe when politicians adopted value-added taxes and were able to further increase the burden of government spending).

Needless to say, this is a reason to oppose an energy tax, a wealth tax, or a financial transactions tax. Giving politicians a new source of revenue is like giving alcoholics the keys to a liquor store.

Second, the income tax enabled costly economic discrimination. Prior to income taxes, governments largely relied on trade taxes and excise taxes, and those levies did not create many opportunities for mischief.

An income tax, by contrast, allows the government to impose all sorts of special penalties – either with discriminatory tax rates or with extra layers of tax on saving and investment – on people who generate a lot of economic output.

And it’s worth mentioning that the income tax also allows politicians to create all sorts of special credits, exemptions, deduction, exclusion, and other preferences (about 75,000 pages of them) for politically well-connected interest groups.

These penalties and preferences are both morally troubling (rampant cronyism) and economically damaging (back-door methods of central planning).

Let’s wrap up today’s column with this helpful reminder that the income tax is basically a penalty on productive behavior.

P.S. Politicians can play games with other revenue sources (i.e., special VAT rates or differential tariff burdens), but the income tax stands apart because it is capable of generating large amounts of revenue while simultaneously giving politicians considerable ability to pick winners and losers.

P.P.S. If you need some gallows humor to make it through tax day, go to the bottom of this column.

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I’m currently in the Cayman Islands, which is one of my favorite places since – like Bermuda, Monaco, Vanuatu, Antigua and Barbuda, and a few other lucky places in the world – it has no income tax.

At the risk of stating the obvious, the absence of an income tax has helped make the Cayman Islands very prosperous, 14th-richest in the world according to the latest data from the World Bank on per-capita economic output (top 10 in the world if you exclude oil-rich jurisdictions).

This does not mean, incidentally, that economic policy is perfect in the Cayman Islands.

There is a overly large and excessively compensated government bureaucracy. Indeed, financing the civil service is becoming such a burden that the Cayman Islands almost made a suicidal decision to impose an income tax earlier this decade.

And the absence of an income tax doesn’t mean an absence of taxes. Here’s a chart from a 2010 report on the jurisdiction’s fiscal challenges. Yes, the tax burden is low compared to many nations, but the government nonetheless collects plenty of revenue from import duties, fees on financial services, and tourism.

But the key thing to understand is that not all taxes are created equal. Some levies impose much more damage than others.

Richard Rahn, a fellow member of the Cayman Financial Review editorial board, explained this insight a few years ago in a column for the Washington Times.

Cayman is prosperous… Critics of Cayman and other offshore financial centers call them “tax havens,” ignoring the fact that they all have many taxes, particularly on consumption — which is good tax policy — rather than on productive labor and capital — which is bad tax policy. The statist political actors in the high-tax jurisdictions will not admit that people do not work, save and invest if they are going to be overly taxed and otherwise abused by their own governments.

And it’s also worth noting that the Cayman Islands are a role model for racial tranquility.

There are people from 135 nations and “mixed” is the largest racial category.

Here are some excerpts from a column published by Forbes about the progressive social structure of the Cayman Islands.

Somebody recently said to me “The Cayman Islands is just a mailbox.”  I started wondering if that was fair. The Cayman Islands are a real places where people live.  And they are not all attorneys and accountants, although they do have more than their fair share.  …a big upside to the Caymans. …Mr. Leung, who is of Asian descent, noticed a whiff of it in Scotland, but finds the Caymans utterly devoid of racism.  Pirates, refugees, shipwrecked sailors and enslaved people might not seem to be the best material to start a country to some, but clearly there is an upside.

I’ll close by noting that there is some trouble in paradise.

The Cayman Islands faces unrelenting pressure from international bureaucracies and high-tax nations. There is a lot of resentment because the jurisdiction is so successful.

The Cayman Islands will not be bullied by countries that cannot compete with this jurisdiction on a level playing field, Premier Alden McLaughlin told an audience… He said that despite the Cayman government’s cooperation on international standards, the Netherlands and others are more concerned about the zero tax rate here. …“But we will not be bullied by those who are jealous of our success, resentful of our tax policies and unable to compete with us on a level playing field,” McLaughlin said.

What makes these attacks so ironic and unfair is that the Cayman Islands actually has much tougher standards than “onshore” nations such as the United States and United Kingdom.

Since I began this column by looking at World Bank data on the most prosperous, let’s wrap up by perusing the U.N.’s numbers.

Hmmm…, lots of so-called tax havens are on this list. I wonder if we can draw any conclusions?

Folks on the left have accused me of “trading with the enemy” for supporting these jurisdictions, but the real story is that we should emulate rather than prosecute these low-tax jurisdictions.

P.S. My affection for the Cayman Islands is mutual.

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There’s an ongoing debate about Trump’s endgame on trade. Is he simply a crude protectionist, or is he disrupting the status quo in order to force other nations to reduce their protectionist barriers?

I hope it’s the latter, though I fear it’s the former.

But one thing I can state with certainty is that the President misreads early American history. Here’s a tweet that he recently sent about how America became a strong and rich country during an era when the federal government relied on tariffs to generate revenue.

Trump is partially right. The United States became a rich country in the 1800s when tariffs were a primary source of revenue.

But I have argued that America became rich because of other policies.

  • The federal government was very small, with the budget consuming on average less than 3 percent of the economy’s output.
  • Prior to that awful day in 1913, there was no income tax, no payroll tax, no capital gains tax, no death tax, and no corporate tax.
  • There was no sprawling and intrusive administrative state imposing costly regulations that hinder the private sector.

No, the United States was not a laissez-faire paradise in the 1800s. I’m simply making the case that the economy had more than enough “breathing room” to generate ever-higher levels of national prosperity.

Meaning the economy grew, not because of tariffs, but because other bad policies didn’t exist.

And I’m not the only with this perspective. Eric Boehm’s article in Reason concludes with an offer to trade the income tax for a modest tariff.

After the ratification of the Constitution, the very first law passed by the new Congress was the Tariff Act of 1789. It imposed an 8 percent tax on pretty much all imports into the United States, with the revenue from the tariffs used to fund the new national government and to pay down debts accumulated during the Revolutionary War. …those early tariffs did solve a very practical revenue problem for the early United States government. In those days before H&R Block (indeed, before income taxes) collecting taxes was a difficult prospect. It was much easier to post-up customs officials at every port and collect taxes on the physical stuff that came ashore than to send tax collectors to every town and borough across 13 states to collect taxes from the populace—especially since many of those would-be taxpayers weren’t entirely sold on the idea of a powerful central government, and had a recent history of armed rebellion against excessive taxation. …If Trump wants to make the argument that America should use tariffs to raise revenue, like we did in the 1790s, he better have a plan to abolish all federal taxes on income, investments, and labor. If he wants to have that discussion, well, I’ll listen.

Brian Domitrovic, writing for Forbes, hits the nail on the head. He starts by agreeing with Trump’s assertion about strong growth in the era of tariffs.

…there is a general sense, among the American public, that previously in history, when the American economy really grew at great rates in the extensive stretch of time before the era of free-trade ideology after 1945, we had tariffs. Tariffs and American prosperity went together. Why not try to get that mix again? …This country’s economy regularly grew at rates double ours today, when the tariff was in force from 1789 until early in the 20th century.

But he points out that other factors deserve the credit. Especially the absence of any type of taxation on income.

…there was a condition that obtained in these years that is absent today. That condition is that the tariff was in the main the only form of federal taxation. There was no income or profits tax, no wage tax, no tax on investment gains… When the American economy really boomed under the tariff, over the first half of our history, financiers and entrepreneurs plowed money, energy, and ideas into businesses knowing that all receipts were available to recover costs and make a profit. …A company’s pay rates did not have to exceed the wage needs of the employees so as to cover their income and payroll tax obligations, as today. The money left to a company from sales after costs faced no corporate tax. And there was no inheritance tax.

And I’ll add one additional point. One of the good things about tariffs is that they are inherently self-limiting because of the Laffer Curve. As Alexander Hamilton pointed out, the government gets less revenue if trade taxes get too high.

Anyhow, the moral of today’s story is that tariffs are bad, but they are less bad than the modern welfare/administrative state.

But here’s the challenge.

If we want to solve the problems caused by the western world’s second-most-depressing chart, we’ll need to figure out how to reverse all the bad policies that produced the western world’s most-depressing chart.

Unfortunately, Trump has been making government even bigger, so the likelihood of returning to a tariff-only tax system has dropped from 0.00005 percent to 0.00001 percent.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Doesn’t this prove tariffs are pro-growth?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Amen. John hits the nail on the head.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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