Executive Summary: There is an opportunity developing for the two major political parties to address the obvious national need of a broad-based tax reform. Recent reports indicate President Clinton and House Ways & Means Chairman Bill Archer have discussed the potential of a bipartisan effort in the four years remaining to each of them in government. This paper is not intended as a comprehensive discussion of tax policy, but a singular perspective written to assist the leadership of the two political parties. Its aim is to demonstrate there can be a broad area of agreement on basic reforms once a common conceptual framework is understood. Debate is impossible if there is no common understanding of what constitutes income, savings, investment, consumption, production, or wealth. A basic agreement that the stronger should bear greater tax burdens than the weaker is elemental, but does stronger imply "rich" in income or wealth? How does the law of diminishing returns, when broken, cause the burden of taxation to fall on the weak, while the incidence of the tax is still technically borne by the strong? Another central tenet is that basic federal tax reform must engage the needs of state and local government, which may best be accomplished by taxing production at the national level and consumption at the state and local level. The paper is meant to suggest to both parties that an ideal tax system is not necessarily one designed according to the purity of an economic idea, but one that also meets the needs of Democrats and Republicans.
A Bi-Partisan Framework for Tax Reform
Among those of us who for the last 25 years have been thinking about reforming the American system of taxation, there are several distinct issues. Should the ideal aim to maximize production and national wealth? Should it aim to maximize revenues? Simplicity, fairness, social mobility? Entrepreneurial capitalism, international competitiveness? Centralized federalal power, devolution of power to state and local government? Individual opportunity, collective welfare? The tax system we now have has evolved with trade-offs along all these lines since the earliest days of the Republic, especially since 1913 when the Constitution was amended to permit a federal income tax. Thus, there is a certain rough justice in the current system, which leads some to argue that it does not need to be fixed in a major way but can continue to be adjusted incrementally.
Most of the ruling class recognizes there is an obvious need for broad-based fundamental reform, if only because simplicity has been the principal victim of the tax system's incremental evolution of the past century. Complexity alone seriously drains the productive energies of the American people, to the point where it is readily acknowledged on all sides of the issue that the cost of collecting and paying taxes in America today runs to several hundred billion dollars. This consideration alone is an embarrassment to any in our political Establishment, Democrat or Republican, who pretend that nothing need be done. The 7,500,000 words that constitute the federal tax codes and the many more that comprise the tax codes of the 50 states are direct evidence that our present system is far from the ideal in every respect. It optimizes neither national production and wealth, revenues, fairness, social mobility, entrepreneurial capitalism, international competitiveness, individual opportunity nor collective welfare. As long as the established political parties shrink from the task, the kind of third party movements that Ross Perot has mounted will continue to disrupt and divide the traditional two-party political system.
If the United States is to fundamentally reform its system of taxation in preparation for the coming century, it must do so in the context of its own experience of the last two centuries. The experience, first of all, is a federal experience. Almost all of the discussion about tax reform that has taken place in recent years -- including that of the Kemp Tax Commission undertaken at the behest of Bob Dole and Newt Gingrich -- has pondered the federal tax code in isolation. The impression is left that the national government will do what is best for itself and leave state, county and local governments to fend for themselves. It would be far better if our political leaders first thought through a philosophy of taxation appropriate to the warp and woof of our national fabric before lunging in one direction or another. While the thoughts presented here represent the experience of the United States, the philosophy of entrepreneurial capitalism that underpins them easily can be adapted to all other countries or regions.
It is hard to imagine that a brand new system could be enacted without the broad concurrence of both major political parties, which means that even a conceptual framework must take into account the perspectives of both parties. Reports that President Clinton is open to a broad-scale tax reform in the next four years are welcome news, because in some ways it is more likely that such a reform can be enacted in a divided, but harmonious government, than in one dominated by one of the major parties. If President Clinton and Chairman Bill Archer of the House Ways & Means Committee are genuinely prepared to work toward this historic goal, there is no reason why it cannot happen. Misunderstandings that arise out of poor communication will be the primary barriers. It is in this spirit that I undertake this philosophical outline.
At a time when the nation is thinking of replacing its entire federal tax system, it is first useful to review what taxation is all about. Prior to civilization there was no such thing as taxation. Human beings clustered together in families and clans and shared what they had without a formal system of taking from those who had and giving to those who did not. Outside of family and clan, the law of the jungle applied. Might made right and the fittest survived. Civilization meant government and government meant money and taxation and spending and borrowing and markets. All government action constitutes an affirmative action, to explicitly benefit one individual or group or class at the expense of another. The community takes precedence over the individual in the context of civilization, as opposed to Darwinian survival in which the individual takes precedence over the community. As first principles of taxation, the government should tax only as much as it needs, in accordance with the wishes of the community, and it should place the greatest burdens of taxation on those best able to bear them. In the evolution of our current tax system, we have gotten further and further away from that idea. It makes no sense to tax the poor and the lower-income classes in order to finance government programs to assist the poor and the lower-income classes. Another first principle is that in extraordinary times, during wars or depressions or costly transition periods from war to peace, the community may, if it can, borrow more heavily from its citizens than it taxes. This is in order to spread the cost over future as well as current production.1 The goal of a balanced budget is necessary to any civilization that wishes to live absent wars, depressions, or costly transitions from war to peace.
The history of taxation has taught many lessons, one of which has been that small sources of tax revenue can sometimes cause great disruptions of productive activity and political unrest. Large sources of revenue, by the same token, are often preferable to many small sources that are costly to collect, nuisances to pay, and create tensions between the government and the people. At the dawn of the first millennium, Caesar Augustus carried out the tax census that his adoptive father, Julius Caesar, had conceived on these principles. If the Roman state knew of all those who might be eligible for taxation, the tax base could be so widened that a light tax on many could replace a heavy tax on a smaller number. In the centuries since, taxation has gone in many directions, with empires rising and falling on their methods of public finance. In the last century, since the widespread introduction of the income tax, we have had a great many experiments in the laboratories of many nations at peace and at war, during monetary inflations and deflations. At the same time, industrial and technological advance have brought astonishing increases in living standards throughout the world, but with great discrepancies from the richest to the poorest nations, and from the richest to the poorest individuals within those nations. If Caesar Augustus were alive today, to plan a new system, he would have a wealth of experience to draw upon before putting pen to paper. Yet in many ways, he would not have to depart from what was known about political economy and human behavior in his own day. He would find, I think, that a new system could be designed with great simplicity, as long as it followed a few sound principles.
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Definitions: When we read or hear of the need for tax reform, it is often in the context of a need to tax consumption instead of income, or consumption instead of savings. The terms - income, savings and consumption — are most relevant to a demand model of the economy, one in which the consumer is the central actor. In this model, the taxing authority first sees money as income headed into the consumer's pocket or bank account. Before it arrives, it is taxed as income by the authority. The consumer then has the choice of saving what is left or consuming it. He saves it by keeping it as cash in his pocket or checking account, or by putting it in an interest-bearing savings account, or by buying stocks or bonds with it, as claims on future consumption.
Proponents of reform leading to a consumption tax instead of an income tax will often argue that underground income -- either income acquired illegally or income that somehow skirted the income tax -- would have more difficulty escaping taxation at the point of consumption. The weakness of the argument is that it sets as its primary goal the maximization of revenue rather than a healthy, growing economy. The demand model out of which the idea arises is also, unavoidably, static. This is because production is a given, a fixed assumption, as represented by the phrase: Demand creates its own supply. In other words, the money flowing toward the consumer's pocket or bank account is the product of a fixed amount of production, some legal, some illegal. Finding a more efficient way to prevent the illegal source of income from escaping taxation may, though, change the amount of income from legal sources of production. Indeed, there is no analysis on how the consumption tax might have feedback effects that would discourage legal sources of production and income.
A more general weakness of this static, zero-sum nature of the demand model is that it produces a paradox for its adherents: If consumption is to be taxed instead of saving, does this mean we will tax the purchase of a Chevrolet and not tax the purchase of a share of General Motors? The question suggests a reductio ad absurdum, with everyone buying GM stock and nobody buying their cars.
Instead, it makes more sense to concern ourselves with how and in what balance we will tax production and consumption. In a supply model, production is not a given, but it should be a central concern of government because there can be no consumption without production. When we tax production, we are taxing the incomes of those who are making and selling Chevrolets — including the workers, the managers, and the corporate entity known as General Motors. After this ordinary income or wage income or business income relating to production of goods and services is taxed, what remains as disposable income constitutes wealth. When we tax consumption, we tax the disposition of wealth. Confusion frequently arises in political debates on taxation because the concepts of income and wealth are used interchangeably to identify "the rich."2 To keep things clear, we should employ only three conceptual classifications of taxation: 1) A tax on production; 2) a tax on the disposition of wealth; 3) a tax on the increased value of an asset, i.e., a tax on capital gain. These clear definitions enable us to avoid the paradox of how you can increase production while decreasing consumption. If a change in one tax rate can cause production to increase, consumption can increase simultaneously.3 The objective of tax reform should be to increase production and consumption with less effort.
All economists agree there is a difference between the incidence of a tax and the burden of a tax, but frequently avoid discussing these differences when advising partisan policymakers. When the government places a tax on an income class or a form of economic activity, this is called the incidence of the tax. If those who had this tax directed at them avoid the tax, simply by not engaging in the taxed activity, the burden of the tax will fall on those who were formerly employed in that activity. In the 1990 tax act, for example, Congress imposed a luxury tax on the purchase of yachts. Government revenues immediately declined as the purchase and construction of yachts fell off so sharply that the entire industry was wrecked. The incidence of the tax fell on the "rich," but the burden of the tax fell on others who were not rich, as well as the government itself, which lost revenues from a variety of sources.
The Law of Diminishing Returns: No broad-based tax reform can reasonably be designed without a total acceptance of the idea that there is, with each and every tax, a point at which a further increase causes less, not more, revenue to be collected by government. The political arena is the proper forum for deciding when that point of diminishing returns is reached. It is unreasonable to expect serious discussion about broad-based tax reform if one major party or the other insists that higher rates always produce more revenues and lower rates less revenue.4 The history of civilization is testimony to the law of diminishing returns in all human behavior, which includes the reaction to tax policy. It is a primary obligation and responsibility of the political leadership of all political jurisdictions to discuss and debate, fix and alter the various tax rates as circumstances change.
The tax base: The dominant form of taxation at the national level is on income, i.e., production.5 At the individual level, this includes wages, salaries, commissions, tips and bonuses received for the original production of goods and services. We should refer to this as "ordinary income," because it flows from original production, as opposed to "investment income," which flows from the successful investment of after-tax ordinary income or wealth. (In technical tax parlance, the term "ordinary income" applies to all sources of income except certain capital transactions involving capital gains.) The dominant form of taxation at the state and local level is on the consumption or transfer of wealth.6 When we buy something with after-tax income, we pay a sales tax, i.e., a tax on our consumption of wealth. A property tax is a tax on the use of wealth to own and enjoy real property. When we travel on a state or local toll road or bridge, we pay a fee out of our wealth. When we transfer our wealth to our children or to heirs, there may be a gift or estate tax on that transfer of after-tax income or the real or financial assets that the after-tax income has purchased.
Taxing "savings": What we have come to call "investment income" really includes income that flows from both "saving" and "investment," which are separate concepts and should be kept separate. When we simply save, for all practical purposes we really do not put money at risk. This is because saving at the margin is a necessity, not an option for human beings. The risk of not saving in your productive years is greater than the risk of saving, and in that sense saving has negative risk. Your most productive years, by definition, are those in which you are producing more than you are consuming. In most cases, these are a person's middle years, from 35 to 60, when one is paying down debts accumulated in one's early years and saving for retirement. If all production were consumed on the day of its production, society could not survive even a few days of no production. At the first level of saving, individuals or households keep money in its most liquid form, by which we mean its most accessible form — in a cookie jar or under a mattress. When there is sufficient liquidity at this level, individuals will deposit funds in banks, in checking accounts that are most liquid, and passbook savings accounts, which require a trip to the bank to withdraw funds for the purpose of consumption.
It is at this point where the issue of taxing savings first arises. Instead of consuming our wealth or transferring it, we are simply depositing it in an institution, to keep it as secure as possible. The institution — a financial intermediary — has sufficient skill in assessing risks that it can transform saving into a low-risk investment. It gathers resources from depositors and lends those resources to individuals or business entities, taking the promise of collateral in return. If the borrower cannot pay back the principal with interest, the intermediary can take possession of the asset put up as collateral. The lending institution will be subject to tax on the net profit it turns as a financial intermediary, a profit net of the interest it pays to the depositor. The institution does not pay interest on deposits with after-tax profits, but treats the interest paid as a cost of doing business. The depositor, though, is subject to a tax on the interest earned. The question of double-taxing this form of "saving," with money lent, not invested, does not arise. Interest rates will be very low on savings deposits when they reflect only the risks of bank failure and a small reward for traipsing to the bank. If the risks include government devaluation of the currency, interests rates will be higher, or individuals would simply buy gold or silver as saving instruments that will hold their value better than paper. Under monetary regimes anchored by gold, interest rates on passbook savings rarely exceed 2%, just enough to persuade people to deposit funds instead of hoarding them.
Taxing "investment": Savings becomes "investment" when it is put at risk, not merely loaned in a nearly risk-free exchange of goods and services for collateralized bonds.7 Debt is of course a form of capital, the supply of which counts as investment every bit as much as equity, but for tax purposes we should not consider a collateralized bond a capital investment. Smith does not invest in Jones by lending him $1000 to buy a $2000 car, with Jones agreeing to pay back $1000 plus interest, or if he can't, by turning over the car to Smith. We invest when we buy a stake in an enterprise in hopes that it will succeed in making profits, out of which it will pay us a dividend. We are putting our money at risk in a corporate entity or some sort of contractual partnership. The government typically does not tax the transfer of our wealth to a corporate entity at the time of purchase. Instead, it stands aside to see if the investment is successful enough to warrant corporate payments of dividends back to the investor. It takes its tax cut at that point.
There is often a complaint from the business community and from tax reformers that, because the corporate entity has already paid a tax on its income (profit), the tax on the dividend paid to the investor represents double taxation. In our conceptual framework, this is not the case. When John Doe receives income from production, it is taxed. When he transfers what is left to another person, by purchasing or gifting, it is subject to tax again. So too with John Doe Incorporated. The business entity pays tax on its income from production. When it transfers what is left to another person, via a dividend, it is subject to tax again. If John Doe reinvests his aftertax income in himself or his children, for example, in education, there is no tax levied on the purchase. So too with John Doe Inc., if it reinvests its after-tax income in its own potential for earning. The argument against so-called double taxation of dividends becomes louder when there is a high effective tax on capital gains — which is then called the triple tax on business capital. Capital acquired in exchange for equity cannot be treated as a cost of doing business, as is interest on borrowed funds.8 With a zero tax on capital gains, there is no excuse for a business ever paying a dividend that is subject to tax. A business entity has the option of avoiding what it terms double-taxing of dividends by using its after-tax profits to repurchase the shares of itself which it had sold to investors. If the shares are worth more than at the time they were issued, the investor will enjoy a capital gain, which are taxed more lightly, or not at all, because the entity's use of the funds has already produced a revenue stream for the government.
Prior to the monetary inflation of the last 30 years, the complaint of double-taxing of dividends was not an issue. This is because very few individual taxpayers were taxed on their dividend income. Prior to the 1970s, middle-class families received a dividend exclusion that was the equivalent today of $2,000 and paid low marginal rates above that level. Those in higher brackets did not own stocks that paid high dividends, concentrating on tax-free municipal bonds, growth stocks with high capital gain potential and no dividend payout, and the various tax shelters that drew capital into oil and gas exploration, for example. The "subchapter S" corporation today enables most small business to avoid having taxable income pass through two tax gates.
Wealth and capital: Wealth and capital are different concepts. Wealth does not become capital until it is put at risk for the purpose of producing a new stream of production.9 If we simply put our wealth in the form of a piece of land or a bar of gold, it remains wealth. Economists frequently argue all such acquisitions are made in hopes their commercial value will appreciate. Just as frequently, though, they are acquired in hopes their value will at least remain constant in a period of declining values of currencies and financial assets. If owners of such assets collateralize them and buy all or part of an enterprise, they receive in exchange a paper asset that entitles them to dividend income, if the enterprise succeeds in producing a profit. At the point of transfer, that piece of paper has no value over and above the wealth transferred. There is no capital gain at the moment of investment. The value of the piece of paper, like the value of a ticket on a horse at a racetrack, will rise or fall as the market assesses the ability of the corporate entity to produce profit. There should never be a tax on the rise in the value of the paper asset, any more than we would expect a ticket at a race track to be taxed if it changes hands before the end of the race.
Taxing capital: Capital at risk should never be taxed unless the enterprise financed is deemed to be socially undesirable. Revenues that flow from successful risk-taking should instead be subject to tax. There is an important difference. When a government announces that it will tax a capital gain, it is explicitly discouraging risk-taking that may or may not lead to success. We do not tax an individual's purchase of education, which may add value to his human capital. We tax the income that flows from the application of that human capital in the marketplace. The same principle applies to corporate individuals. When ten corporate entities raise capital to search for oil and gas, the risks are so high that only one in ten will succeed in finding it. The personal incomes of all those involved in the search are subject to tax. So is the income from the one enterprise that discovers oil or gas and sells it at a profit. The value of the capital of the one in ten investors who has succeeded will enjoy a commensurate rise. It should be apparent this gain should not be taxed when the paper asset is sold to another. If it is, the reduced after-tax reward for risk-taking will have to be taken into account before the ten explorers are financed. Any tax at all on the reward to risk-taking will reduce the number of explorers financed. The nation not only will lose the real addition to its wealth in the amount of oil and gas discovered. It also will lose the income tax revenues of those who would otherwise have been engaged in exploration, as well as the sales and property taxes levied on the costs of exploration.
Here is another explicit example of a tax whose incidence is on the "rich," but whose burden is on the least "rich," those with no capital. Any tax on capital gains discourages those with capital from putting it at risk, which means the burden of the tax falls on the highest-risk individuals or enterprises. In an economic pyramid, with the poorest on the bottom and the richest at the pinnacle, the higher the capital gains tax, the less capital is available to those at the bottom. Those at the bottom of the pyramid, who feel the burden of the capital gains tax, rarely see the root of their inaccessibility to capital. Instead, they organize themselves politically to force the government to tax even more resources away from the top of the pyramid and make them available through government programs to people at the bottom of the pyramid.
Dividing the tax base: Both production, which is primary, and consumption, which is secondary, can always be taxed. In our federal system, it makes most sense to retain the income tax on personal and corporate production and to reserve for state and local governments the taxation of consumption or wealth. If the federal income tax were to be replaced with a system of consumption taxation, state and local governments would be forced to rely more on primary income taxation. An income-tax system can be designed at the national level to exempt low-income workers, enabling them to get a head start on the accumulation of capital. A consumption-tax system, which taxes wealth, cannot realistically be designed in the current environment to exempt low-income workers.10
Tax 'flatness": Supply-side economics has become identified with a "flat-tax" system as the ideal. In fact, a single tax rate for all income levels would not permit the exemption of low-income workers. In other words, a single threshold at which an income-tax rate is encountered really means there are two rates - a zero rate for the low-income classes that have been exempt from the tax and one that applies to all income above that specified threshold. In fact, there is little violence done to the ideal with two or three different rates in a progression, as long as the top rate does not exceed 25% in peacetime. The law of diminishing returns has indicated to too many people throughout history that a rate above 25% is counter-productive. John Maynard Keynes, the hero of liberal Democrats for the past 60 years, put that number on the ceiling. Even this threshold can be crossed without serious effect on production and revenue if the threshold is placed high enough. A 99% tax rate on income in excess of, say, $100 million a year for individuals would have no effect on production. We could thus imagine an almost ideal supply-side tax system with several rates, with thresholds so high that they produce no ill effects.
Taxing the rich: In the case of the taxpayers with the highest incomes — for example Bill Gates of Microsoft — it should be clear that they would not need to pay themselves incomes at a level that would mean a 99% confiscation, if that were the top rate. They could not consume it fast enough. High rates can only be justified on the political grounds that the accumulation of capital by a single individual has invidious social effects. Among the Founding Fathers, there was concern on this point during the drafting of the Constitution. The concern has proven to be unwarranted, the reason being that even when wealth accumulates with increases in capital gains, it remains at risk, presumably producing goods and services that benefit the community in general. Wealth is only a political concern when it can be used to buy political influence that is used to corrupt the very principle of government — and transfer wealth from the poor to the rich. The current tax system does just that. What does it mean to tax resources away from Bill Gates in order to prevent him from accumulating capital gains at a greater rate? It means the government believes it can invest the resources better than Gates. At some point that may well be the case, but that point is not an obvious one. This is why proportionality in income taxation at some level below 25% seems a reasonable rule of thumb for public tax policy.
Value-added taxation: VAT taxes are generally favored by established corporations because they have special advantages to established corporations, especially those with significant export potential. Exports are typically exempt from all VAT taxation, which reduces the unit costs of exports as compared to normal business taxes. Suppliers that feed the large corporations must pay the VAT even if is ultimately rebated to the exporting company. This is one reason why this tax is inimical to entrepreneurial capitalism. In theory, suppliers eventually will share in the export rebate through competition, but the big corporations always will have an advantage over the small. The more important reason VAT is not compatible with the kind of entrepreneurial capitalism that has characterized the American system is that start-up enterprise normally does not pay business tax, because it is usually years before taxable profits are earned. As long as a new business is growing and adding labor, the costs of which can be deducted from revenues in arriving at taxable profit, it need pay no tax. In any VAT scheme, start-up companies pay VAT from the first day of doing business.
The argument that the VAT is perfectly neutral to the factors of production is correct. Its failing is that the absence of any progressivity puts a relatively greater tax burden on the young and those struggling to remain viable than it does on older and established enterprise. Not surprisingly, the Washington business lobbies that favor VAT are usually supported by corporations that have reached a point of maturity that will cause them to benefit from VAT if it is used to replace corporate taxes that now favor less mature enterprise. The VAT, like a tax on capital gain, has the ancillary effect of discouraging social mobility and fluidity. European and Latin political economies that prefer to maintain social stratification are comfortable with VAT systems.
Tariffs: Tariffs on imported goods are a legitimate source of federal tax revenues and have been since the founding of the Republic. A tax on a trade between an American and a foreigner is as legitimate as a tax on a trade between a New Yorker and a Texan. There is no legitimate reason why tax rates between nationals and foreigners should be eliminated as long as there are taxes on transactions between nationals. To the degree a tariff is high enough to produce revenue, but not high enough to discourage commerce, it should be maintained. Those who argue for zero tariffs on imports are business entities whose marginal production is sold abroad rather than at home. Those citizens who argue for higher tariffs are naturally those whose marginal production is sold at home, and who compete against foreign production. In a nation that is a net creditor to the world, the forces advocating higher tariffs will generally exceed those advocating lower tariffs. This is because the credits can only be paid down by the debtor nation exporting more than it imports. This was the position of the United States in 1929, when the U.S. business Establishment pushed the government into the Smoot-Hawley Tariff Act, at a time the United States was a major creditor nation. The incidence fell on foreign producers. The burden fell dramatically on U.S. creditors, who now could not be paid through a trade surplus run by their foreign debtors. In 1997, the United States is a net-debtor nation, which means the forces advocating lower trade barriers will exceed those advocating higher tariffs. Established enterprise, which sells its marginal production abroad, may see more profit in an external trade where it can import labor-intensive goods. High value-added U.S. producers of goods and services are especially interested in seeing foreign trade barriers lowered, which would produce greater immediate returns than tax policies that tap underutilized domestic labor.
Estate taxes: Eliminating the federal estate tax will provide state government with a tax base that will enable states to dissolve their income tax systems. Estate taxes that presume to be able to tax away more than 50% of an estate above an exempt amount now provide less than 1% of federal tax revenues. This is because lawyers, accountants and lobbyists have written enough loopholes into the law to permit taxpayers to economize on estate taxes at death. Most of the wealth which avoids estate taxation is in the form of unrealized capital gains that, in large part, is purely the result of inflation. With the elimination of the capital gains tax entirely, the need to avoid reasonable estate taxation dissolves as well. Rates at 10% or below would not encourage most people from taking avoidance action, i.e., moving to locales without any estate taxes. In other words, below a 10% rate, the incidence and the burden of the estate tax should be the same.
Tax simplicity: The drafting of a new tax code should have as a primary objective its simplification. The code now requires 7,500,000 words and a minimum of 110,000 tax collectors because every special interest group in the nation has made certain that it gets its fair share of the tax breaks in the code. As a result of everyone having a tax break, the advantage to any one is minuscule at best. The burden to the whole people has become enormous, requiring a significant amount of human capital to be consumed in the processing of tax collection. If all tax breaks were removed simultaneously, those who have minuscule advantages would lose them, but would find the great burden of tax processing lifted from their own household, farm, financial and industrial endeavor. The simplicity of the system also eliminates the principal source of political corruption. The army of lobbyists now occupying Washington, having nothing to do, would quickly be drawn into productive employment by the rapidly expanding economy.
Regressive taxation: The term has a particularly negative connotation as a result of the demand-side analytical model that we have lived with for more than 60 years. "Regressive" is a pejorative term, meaning "backward," because it indicates a tax on those who are less able to afford to pay tax, A sales tax on food or medicine or a poll tax on voting are considered especially regressive, in that the government extracts precisely the same amount from the poorest as from the richest. It actually makes no sense at all for the government to tax income resources away from the lowest income people, only to return it to them in the form of government services. Regressive taxes on income rarely occur, usually as quirks in the tax code, as this necessarily means that the higher your income, the lower the rate you pay at the margin. Regressive income tax rates obviously benefit society when the regression begins at the point of diminishing returns, where taxes would otherwise be avoided or production withheld. Payroll taxes are often incorrectly referred to as being regressive, in that the rates are usually capped at a certain income level. But as with Social Security or Medicare or unemployment benefits, the resources withdrawn from the paycheck are for the most part directly calibrated to the promise of future benefits. There is no regression, any more than the price of a theater ticket is regressive because the rich person gets the same benefit for the price as a poor person at the same price.
Progressive taxation has a positive connotation because it implies that those better able to afford a contribution of resources to the common pool will be taxed more heavily than the poor. Progressive taxation makes sense, at least up to a point, in that government exists partly to transfer resources from the more successful to those who are the least successful (not to the less successful). Progressive taxation makes no sense if the progression passes a supply-side point of diminishing returns. There is nothing inherently wrong with tax progressions on incomes, production or wealth. Progressions are only destructive when the rates reach a point that discourages production, or the accumulation of wealth through production. In the private sector, the market routinely supports price progressions, which charge the rich more than the non-rich for the same product. A family that is willing to clip newspaper coupons for supermarket discounts is essentially paying lower prices for its groceries than the family that has less interest in such savings. Private colleges will negotiate lower tuitions for students in lower income classes and parents in higher income classes will be unconcerned, pleased that they can afford to pay list price. Estate taxes are progressive and productive until they reach a point where society is willing to go to extraordinary lengths to avoid them. Progressive taxation on capital gains is inherently counterproductive in every case, however. This is because any tax on the primary act of risk-taking leading toward capital formation will lower productivity with no offsetting beneficial gain.
The mortgage interest deduction: One of the reasons the mortgage interest deduction is so popular is that it is almost a perfect offset to the inflation of the progressive tax system for everyone in the country, those who own and those who rent. If the United States had gone through an equivalent monetary deflation in the last 30 years, instead of an inflation, the mortgage interest deduction would have no special popularity. That is, if the price of gold had fallen to $3.50 per ounce from $35, taking wages and prices down by a factor of ten, the benefits of mortgage interest deduction would have been minuscule. That is, when a taxpayer pays $2000 a year in interest and has an income of $10,000 a year, the deduction means little because the rate on a $10,000 bracket is so low. As inflation pushes the taxpayer to a higher and higher income bracket, the $2000 deduction becomes more and more valuable. The reverse is also true. In a monetary deflation, taxpayers fall into lower brackets where their fixed-interest charges have less and less value. In a world that continues to tilt toward monetary inflation, the benefits to the whole population of the mortgage interest deduction are probably roughly equal to a cashing out of the deduction in order to lower the effective rate of income tax. This is because the ownership of a home or rental unit intermingles the factors of consumption and investment. A renter benefits from the deduction because he consumes part of the benefit the unit's owner gets as an investment.
Charitable deductions: Charities are twice benefitted by the existing tax system, in that both income and wealth transfers are free of taxation. When I produce, I deduct my charitable giving from gross income. When I transfer wealth to a charity, the charity does not pay tax on the receipt. In a reform of the federal tax system, there is no reasonable justification for this double benefit, one being sufficient to encourage charitable giving.
State and local tax deductions: There would be no justification for permitting a deduction against federal gross income, if the principles stated here are followed. In an ideal tax system, the objective would be to have state and local governments dissolve their own income tax systems over time, relying exclusively on the broad tax base the federal government would leave on wealth taxation — consumption, sales, property, gifts and estates. Citizen pressures to eliminate state and local income taxation would be effective as revenues accumulate in an expanding economy and as spending on social services decline.
Health care deductions: The current tax system exempts the employer from paying tax on insurance premiums for employees. The practice began during World War n and has led to gross distortions in the health-care delivery system. The practice has become very costly to the nation in the amount of manpower required to simply deal with the paperwork and should be ended in a new simplified system.
Personal exemptions: As a rule of thumb, personal income tax should not be levied on workers who are in a start-up phase of their productive lives or at low incomes. Rates on higher incomes can be higher, up to the 25% marginal range, in order to eliminate all income (production) taxation for workers below the level of skilled craftsmen.
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The design of a new tax system for the 21 st century should not have to accommodate any fixed set of spending projections. An ideal tax system for the United States is one that will encourage an optimum society, one that invites maximum fluidity among income classes, at the same time that it encourages maximum production and national wealth with the least amount of physical effort. The nation's requirements of federal resources easily will be accommodated if the resources are optimum. Considering the stunted growth rate and social pathologies of the current economy due to the complexity and inefficiency of the current system, to do otherwise would be the tail wagging the dog. If the ideal can be identified by open bipartisan discussion and debate, there is then no reason to hold it hostage to immediate budgetary needs. As long as the system is designed to produce optimum economic growth without inflation, any temporary shortfall in revenues easily can be bond financed.
These observations of an American philosophy of taxation are not meant to imply they are unsuitable for other nations. Quite the contrary, in a universe dominated by the American experience, the U.S. system of taxation could easily be emulated where it fits another country's culture and stage of development.
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1 In 1862, when the Lincoln administration had difficulty borrowing to cover the mounting costs of the Civil War, it had to resort to direct taxation through the issuance of "greenbacks," fiat money not guaranteed in gold or silver. This is the purest form of taxation, when a government simply prints money for itself and goes into the marketplace to take the goods it wants, leaving the paper in exchange.
2 In England after WWI, when the tax rates on ordinary income were kept high, the idea took hold that Money made by money should be taxed more than money made by people. The concept of "earned income" and "unearned income" came into play. The personal income tax evolved into a dual rate system, with a base rate on wages and other ordinary income, and a higher marginal rate on income from interest and dividends rising as high as 96%. Capital gains were exempted from tax, however. The idea of "earned" and "unearned" income spread to the United States, and while capital gains were never exempted here, they enjoyed preferential treatment until the 1986 tax reform pegged the highest rate on ordinary income and capital gains at 28%. In the United States, interest income on state and municipal bonds has always been exempt from income tax.
3 There is no direct tax on wealth in the United States, except for property taxes, real and personal, which are paid annually ad valorem, on the same asset. A federal devaluation of the currency, the dollar, is the same as a direct tax on wealth. That is, when the government borrows resources from its citizens in exchange for a dollar-denominated bond, and then causes the dollar to lose value in terms of the resources it has borrowed, the citizenry essentially has its wealth reduced by the amount of the devaluation.
4 The graphic description of Law of Diminishing Returns as it applies to tax policy is termed the Laffer Curve, after Arthur B. Laffer, who was chief economist of the Office of Management and Budget in the Nixon Administration and subsequently a professor of economics at the University of Chicago. The graphic curve, which I named for Laffer after I observed him drawing it on a cocktail napkin in December 1974, for Deputy White House chief-of-staff Richard Cheney, simply makes the obvious and axiomatic point that there are always two tax rates that will produce the same revenue, one at a higher level of production, one at a lower level.
5 Prior to enactment of the Sixteenth Amendment in 1913, which made it constitutional to tax income, the primary source of national revenue was through tariffs and excise taxes. The first federal income tax was 1% at the equivalent today, in gold dollars, of $60,000 per year for a single person and $80,000 for a couple. The top rate of 7% was reached at today's equivalent of $ 10 million. The rates shot up during World War I. At the peak, in 1918, the top rate of 77% was reached at today's equivalent of $20 million in annualincome. In the 80 years since, the rates have increased almost entirely because of inflation. The dollar in 1913 was defined in terms of gold, at $20.67 per ounce. Today, the dollar/ gold price is roughly $350. The 1913 rates, originally intended for the extremely well-to-do, have thus come to reach all but the poorest Americans.
6 There were no state income taxes until the late 1940s, while today the state without an income tax is a rare exception. States were forced to enact their own income taxes as a defense against the federal government, which was draining so many resources from the states with its federal income tax. At least, a state income tax could be deducted from taxable income at the federal level. A federal income tax reform that gradually retraced its inflationary steps would encourage states to eliminate their income taxes, especially if they were no longer deductible from taxable income at the federal level.
7 "Junk bonds" are an exception to the rule, but only in the sense that they act more like preferred stock than bonds. Banks cannot lend to new enterprises that cannot collateralize the risk of the venture. Equity markets cannot bring capital to such enterprises because the investment cannot be adequately compensated when dividends are paid out of after-tax profits and capital gains are taxed at high rates and not protected by inflation. By calling a financial asset "equity" that is in almost every way "debt," the creditor can benefit from the fact that interest is paid out of pre-tax profits.
8 A capital gain on equity put at risk should not be taxed. If the value of a debt instrument rises to produce a capital gain, there is no reason to exempt it from taxation because there is always an equal and offsetting capital loss. That is, when creditor and debtor agree on an interest rate, which is the price of credit, the terms are fixed in advance. If the price of the bond rises or falls, it will be because the government has inflated or deflated the value of the unit of account, the dollar. One side of the transaction will gain and one will lose.
9 In the National Income Accounts, to simplify matters, savings = investment, but the economy and taxation of the economy is more complicated. Savings of course equals debt plus equity, but taxing debt presents different problems and yields different results than taxing equity.
10 Prior to the enactment of the income tax in 1913, there essentially were no taxes on production, only taxes on the consumption, exchange or transfer of wealth. For emerging nations that have only a tiny number of individuals who have accumulated wealth, it makes sense to emulate the early United States and the developed nations of Europe and operate without individual or business income taxes. Most of the economic difficulties of African, Asian and Latin countries since the 1950s can be traced to their adoption of income-tax systems that thwart individual initiative and entrepreneurial capitalism.
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