The Ideal Tax Regime – 1

Taxes are nothing but destructive to all parts of society with the exception of government and its employees. Unless you are obscenely rich or abjectly poor, you probably have your own complaints about how much government rips away from you. When dollars pass from you to government, the loss of assets you could have used for your own purposes reduces your opportunities and personal freedom. Perhaps because of this loss you can no longer take that ocean cruise in the Caribbean you so desired. Perhaps that house you wanted is beyond your reach.

Nevertheless, taxes are a necessary evil, as I am sure you are aware.  No matter what your political persuasion (unless you are an anarchist, of course), there will be some minimal set of functions you want the government to perform. One way or another these government operations must be financed, even if the financing is deficit financing. Enough taxes must be levied so that revenues equal the paid-for fraction of expenditures (with the non-paid-for fraction financed with bonds) plus the interest on the national debt. Once we get to the point in time when the federal government can no longer pay interest on its debt, the government will cease to exist financially. How it can continue to exist in any meaningful sense beyond that point is hard to understand. Unless government expenditures are reduced to a point where they grow no faster than the GDP, we will most certainly reach that ominous point in time.

Therefore any complete discussion of taxes must also include what government expenditures are expected. However, that is a much larger subject than we can cover in a single post, or even in one hundred posts! As a result I propose to do something much more modest, and consider what characteristics a tax regime should have to cause the least distortion and destruction of society. Once we decide on those characteristics, we can possibly set the fraction of total taxes that would be brought in by each individual type of tax, in which case we can scale the fractions to any total government revenue needed. Even this goal might be too ambitious, but I will at least start the task of thinking about it.

We know what we want taxes to do. We want them to finance the government’s expenditures. We should start by thinking about what we do not want them to do. I would propose the following list:

1. Taxes should not favor some economic activities over others. As we have noted before, politicians and bureaucrats are terrible judges of how economic assets should be allocated in producing goods and services. If government gives tax preferences to some industries and not others, they will inevitably introduce imbalances in supply, from both the preferred and unfavored companies, with the demand for their products.
2. Either dividend income or corporate income should not be taxed. If it is, that income has been doubly taxed, first as corporate income and then as it is paid out as dividends.
3. Corporate income earned in another country’s markets and taxed by that country’s government should not be taxed a second time by our government when it is brought to this country.
4. Taxes should not make U.S. goods significantly less competitive in foreign markets than another country’s taxes reduce its own goods’ competitiveness. Stated in a more positive way, U.S. corporate taxes should be internationally competitive. 
5. Taxes should not be complicated.
6. Taxes should not be oppressive on the poor.

The first of these requirements would remove much of the ability of the federal government to damage the economy. If tax preferences can not be given, government must leave the decision of which companies are economically favored to markets. In addition, without tax preferences  a great deal of government corruption through crony capitalism is removed.

Double taxation of corporate income as addressed in the list’s second item distorts markets by discouraging the payment of dividends. If corporate profits are retained by companies to avoid double taxation, stock holders profit by the amount they will not be taxed and is owned by them as increased value of the companies. If the companies have ways to profitably invest in productive capacity what they do not pay as dividends, everything is fine and no harm is done. In fact if companies can make such investments, they probably would not have decided to pay dividends in the first place, even without taxes on dividends. Nevertheless, if a company lacks such profitable opportunities, they might well direct the funds to not-so-profitable investments. If instead the money goes to stock holders as dividends, they have the opportunity to spend that money for purposes of highest utility to them. In this way they act as a part of Adam Smith’s invisible hand directing assets to their highest economic utility.

The third item in the list addresses a very real and present problem. It is estimated that in 2013 American multinational corporations had kept $2.1 trillion in foreign profits overseas to avoid taxation as income in the United States. The United States taxes U.S. corporations on all profits earned anywhere in the world, but deferred until the profits are brought back to the U.S. This worldwide approach to corporate taxation is being  challenged by the more frequently used “territorial approach” of other countries.  This usual international practice is to tax corporate income only in the country where it is earned. The Tax Foundation has posted a chart showing how the use of the worldwide approach has decayed with time in the 34 advanced nations of the Organization for Economic Cooperation and Development (OECD), which is shown below.

The Tax Foundation notes that overwhelmingly economically-developed countries are adopting the territorial approach. As long as we do not, we place our corporations at a competitive disadvantage due to higher taxes with foreign companies taxed with the territorial approach. In addition we lock out that $2.1 trillion of overseas profits, which would be of great benefit if they came back to the United States, either through job-producing investments or as dividend payments to stock holders. For the benefit of everyone we should adopt a territorial system of corporate income taxes.

This seamlessly brings us to the fourth item in our list, because while a worldwide approach to corporate income taxes erodes U.S. companies’ international competitiveness, so does the corporate rates for their operations within the United States. The Tax Foundation again informs us that the “United States has the third highest general top marginal corporate income tax rate in the world at 39.1 percent, exceeded only by Chad and the United Arab Emirates.” While the U.S. has a top marginal rate of 39.1%, the worldwide average top corporate income tax rate is much lower at 22.6%. Europe has the lowest average rate by region at 18.6%. Not only do our tax rates diminish U.S. companies competitiveness, but they also provide U.S. companies a tremendous incentive to leave the United States and relocate in a more capital-friendly country. We noted almost 3 months ago in the post Beware BEPS!, along with the New York Times, that the OECD’s  Base Erosion and Profit Shifting (BEPS) project has caused the G20 countries to adopt policies that would make U.S. corporations even more uncompetitive due to taxes. The New York Times warned as early as the beginning of 2016, we could see a large migration of U.S. companies to Europe, especially England, as a result.

Finally, from the fifth and sixth points on the list, taxes should not be complicated and should not be oppressive to the poor. Taxes complicated by conditional tax credits and deductions create headaches and mistakes, and mistakes cause an inefficient allocation of labor to their correction. Even without mistakes a complicated tax code has given rise to an inefficient allocation of manpower to an income tax preparation industry. In addition a complicated system of tax breaks violates our first principle of not favoring one taxed entity over another.

To satisfy these six principles, two major systems have been suggested: a national sales tax and a flat tax. We will continue this discussion concerning them with our next post about taxes.

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