Memo To: SSU Students
From: Jude Wanniski
Re: Dr. Norman Ture essay on taxation
The economic growth criterion calls for reducing tax barriers against those activities, which lead to an expansion of production capacity in the private sector of the economy. If we lived in a perfectly neutral tax environment, defining neutrality as above, the decision to alter the tax structure in the interests of accelerating growth would pose a conflict between these two criteria. In fact, however, the present income tax system appears to be heavily biased against private capital accumulation. Reducing this bias, therefore would serve both the neutrality and growth criteria.
The principal source of this bias is the incremental taxation, under the present system, of the returns to capital. This bias against capital stems primarily from the inclusion of saving in the tax base. It is offset in varying degree by an assortment of provisions in the tax law with respect to capital recovery. At one extreme, the tax law affords virtually no capital recovery in the case of private, human investment; the most egregious cases are to be observed with respect to most professional training, At the other extreme, the income tax law provides for virtual expensing of some types of capital outlays, closely approaching, in such cases, the neutrality conditions. But by and large, the failure to exclude saving from the tax base intrudes a serious bias against private capital accumulation which is only partially offset by capital recovery provisions.
This bias is compounded by the separate taxation of corporate income. The corporation income tax may be fairly characterized as a differential excise imposed on equity capital employed by corporate enterprises. The traditional analysis of the shifting and incidence of any differential excise strongly suggests that the ultimate burden of the tax is borne by <I>all</I> private capital, i.e. the private sector eventually accumulates less capital than would otherwise be the case.
Finally, the anti-capital bias is accentuated by the taxation of capital gains and of other property transfers. A capital gain is the capitalization of the anticipated increase in the future income stream generated by the asset(s) involved. Since that increase in the future income stream will be taxed as it occurs, taxing its capitalized value as well necessarily involves an incremental tax on the returns to this capital. Much the same may be said of other property transfers. Whether transferred property is taxed under an estate or gift tax or under an income tax, the consequence is a higher effective tax rate on the return to such property merely by virtue of its being transferred.
In all such cases, the application of progressively graduated marginal rates of tax must be viewed as enhancing the bias against private capital accumulation. Such graduation progressively increases the cost of any additional accumulation the larger the amount of prior accumulation, i.e., the greater the amount of resources the taxable entity has available for investment.
Moreover, if we assume, as we reasonably may, that in general the return per unit of any factor of production affords a reasonable measure of that factor unit’s productivity, progressive, marginal rate graduation imposes a higher rate of ax the more productive the agency of production. In other words, such graduation imposes a tax bias against productivity-incr1easing activities.
The aggregate impact of these tax biases against growth-generating activity is, of course, extraordinarily difficult to assess. But even were we to find that the rate of expansion of productive capacity is little affected, the direction effect is clearly adverse.
A great deal is made of simplification of the tax laws as an objective of tax reform, but surely no other goal of tax policy is more honored in the breach. We need not look very far for the principal source of the ever-increasing complexity of the income tax. Both experience and analysis urge that it is the progressively graduated marginal rate structure. This rate structure has exerted enormous pressures for changes in the law to afford exceptions from the full application of the high, graduated rates of tax, with respect to particular groups of taxpayers, particular types of income and expense, and particular uses of income. Each such exception introduces additional complexity into the law and provides a powerful impulse for emulation by other taxpayers. To constrain such impulses, additions to the statutes and regulations are required. Each new set of rules imposes additional compliance burdens on taxpayers and costs on administrative and enforcement agencies.
It should be obvious that the search for tax shelters will continue, with the consequences noted above, so long as marginal rate graduation continues to afford such strong incentives for tax shelters. For the same reason, tax reform drives which focus on redefinition or broadening of the tax base are likely to meet with little success in the long run. Indeed, their principal effect is to change somewhat the rules of the game in the hunt for tax shelters.
Recognition of this fact would give the appropriate emphasis to rate reduction and rate structure flattening as the sine qua non for effective tax reform. At the limit, a low, flat rate tax would eliminate virtually all of the present premium for the exotic arrangements which some taxpayers now undertake to avoid the punishing effect of progressive tax rates.
Do we need a progressively graduated rate structure to meet the revenue adequacy criterion of taxation? I define the revenue adequacy criterion of tax policy as calling for equality in the long-term rate of growth of government expenditures and of revenues. Views of this score differ widely, but I know of no concept of this criterion in which progressive graduation of marginal income tax rates plays a significant role.
It has been repeatedly observed that the progressively graduated marginal rate structure in the U.S. individual income tax makes only a very modest contribution to the total revenues from the tax. For the taxable year 1967, for example, a flat rate tax of 20 percent applied to the total taxable income reported on all individual returns would have resulted in the same total tax liability as actually reported in that year. Of the roughly $302 billion of taxable income, other than that subject to income averaging, reported that year, about $232 billion, or 76.6 percent, was taxed at marginal rates not in excess of 20 percent. And of the $62.9 billion of individual income tax liabilities in that year, about $47.9 billion, or 76.2 percent was accounted for my marginal tax rates of 25 percent or less. Tax rates above 50 percent accounted for all of $2.8 billion in liabilities, about 4.4 percent of the total.
In short, progressively graduated marginal tax rates can hardly be justified in terms of their contribution to the total revenues. Considering the price paid for such graduation in terms of the other criteria of taxation, we are hardly getting our money’s worth from it.
An Alternative to Progressive Rates
In the light of the major criteria of tax policy, progression in the rate structure of an individual income tax fares poorly. The application of graduated rates to a tax base which conforms haphazardly at best with the standards for equal tax treatment of equals accentuates the possibilities for violating the horizontal equity criterion. Examination of the vertical equity criterion reveals virtually no solid basis for progressive graduation of marginal rates. Such graduation is completely at odds with the neutrality criterion. It is, moreover, the principal source of the differentials which erode the tax base and make the tax so complex and so costly to comply with and to administer. Finally, its contribution to total revenues is modest, hardly adequate to offset its other disadvantages.
These deficiencies of marginal rate graduation are widely acknowledged and are reflected in a broad spectrum of tax reform proposals. One familiar set of such proposals would substantially flatten the rate structure while greatly expanding the tax base, principally by fully excluded under present law and by disallowing various deductions deemed primarily to benefit the rich. Combined with increases in the personal exemption, these structural changes presumably would at least maintain, if not increase, effective progression, while allegedly minimizing the distortions which result from marginal rate graduation.
Flattening the marginal rate schedule, or itself, would represent a major step in reducing the deficiencies of the income tax with respect to the neutrality, equity, and simplicity criteria. But the price to be paid in the conventional reform proposals would be excessive. For example, full taxation of capital gains, always included in these proposals, would significantly aggravate the present bias against saving, as would many of the standard reform recommendations with respect to capital recovery allowances. Indeed, implementation of the conventional base-broadening, rate-reduction reform package, with no net change in the revenue yield of the income tax, would result in substantially heavier taxation of saving and capital formation than under the present law.
There is, however, a far more desirable alternative which would also broaden the income tax base and reduce or eliminate rate graduation with little, if any, loss in effective progression. In contract to the standard base-broadening reform proposal however, this alternative would largely undo, rather than accentuate, the present tax bias against saving. Under this alternative, all private sector saving, of both households and business, would be deducted from the tax base in the year in which the saving would be fully included in income, without any depreciation or depletion deduction as an offset, as such income materialized. In each year, in effect, all private sector purchases of assets in which savings are invested would be deductible, while the full amount of all returns on such assets and all proceeds from the disposition of such assets would be included in income. To a rough approximation, the base of the tax, before personal exemptions, would be equal to the sum of consumption plus the excess of gross returns to saving over gross private domestic investment.
Implementation of this proposal would greatly reduce the existing income tax bias against saving, without disproportionately burdening consumption. In contract with the present law, saving would not be doubly taxed as compared with consumption; although the amount saved in any year would be deductible, the gross returns on that saving would be fully included in the tax base.
This alternative, moreover, would afford enormous simplification in the most complex areas of the income tax law. Capital gain and loss provisions, often identified as the single most important source of complexity, would entirely disappear, since the full proceeds from the disposition of assets would be included in income as they are realized. Similarly, depreciation and depletion provisions would be entirely eliminated by the full, deductibility of asset purchases in the year of acquisition. Virtually all of the complexity under existing law attributable to timing of income and expense for tax purposes would automatically disappear.
To be sure, some problems in tax accounting for individuals would be aggravated by the new requirements for identification of saving in the taxable year, but these difficulties are probably more substantial in contemplation than they would be in practice. Surely this approach would reduce the incentives for and the resources devoted to finding escape hatches or “tax shelters”.
As to the equity criterion, the implementation of this proposal could facilitate measurement of similarity of relevant circumstances. It could not, however, guarantee against policy decisions to afford exceptions to the application of the basic principles upon which it is based, anymore than effective barriers to such exceptions are to be found in the present tax system.
Can any such compromise of the presumed public preference for progression with the tax purist’s views of a good tax be achieved? Proposals of this sort take cognizance of the fact that the personal exemption, to a far greater extent than graduated tax rates, accounts for the actual progression in effective rates of tax. Adoption of the proposal just outlined would permit a significant increase in the personal exemption from its present level without loss of revenue. Progression in effective rates from this source, therefore, could be enhanced. Moreover, the single statutory rate which would need to be applied to provide the present yield from the tax would be surprisingly low.
For example; for the taxable year 1970, the broadened tax base, before personal exemptions, might have been of the order of magnitude of $750 billion; with the present per capita exemption, a single statutory rate of about 20 percent would have generated the same amount of corporate and individual income tax liabilities as actually were incurred in 1970. A $1,000 personal exemption in lieu of the present figure, combined with a single statutory tax rate of about 23 percent applied to the broad income base, would have yielded the same revenue.
Moreover, effective progression for most of the individual taxpayer population, particularly at the lower and middle-income levels, probably would be substantially greater than at present. At the upper end of the income distribution, effective progression might be somewhat reduced, although the broadened tax base would certainly eliminate many of the gross disparities in effective rates among upper income taxpayers.
The proposed single rate tax would not, of course, eliminate all of the deficiencies so readily apparent in the present income tax. Yet the potential gains from a basic revision of the individual income tax of this sort are so great as to warrant giving it the most serious consideration as the most hopeful route to basic, long-term income tax reform.
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