The Ideal Tax Regime – 2

In the last post on tax policy I suggested six attributes the ideal federal or state income tax regime should have. I reproduce them below.

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.

In this post we shall look at two common suggestions for tax regimes with these properties: a flat tax and a national sales tax.   

A Flat Tax

A flat tax is just an income tax with one tax rate for all income levels and no deductions for anyone. This makes the tax extremely simple, and with no deductions it can not give favors for any particular individuals, companies, or economic activities. Generally, proposals of this kind would exempt some fraction of income from taxation and then apply the flat tax for all income above that support level. This would be done to avoid hurting the poor. For example, the first $36,000 of income might be exempt, and then every dollar of income above that level would be taxed, say at 17%.

This was Steve Forbes’ famous flat tax proposal when he ran for President in 1996. Lately, although he is not running for President, he has been touting a flat tax proposal of 17% with an $9000 exemption for every family member. Then a family of four would not pay income tax until its income was over $36,000. Forbes would also exempt all income that is saved and invested. Since this only leaves income that would be consumed to be taxed, this one part of the plan effectively changes the income tax to a consumption tax, and encourages savings and investment at the same time. Forbes leaves the payroll taxes for social security and medicare alone,

A second, competing proposal by John Goodman and Boston University economist Laurence Kotlikoff in 2005 would eliminate the $9000 exemption for every family member and lower the flat tax rate to 14%. The saved exemption would then be given as rebates to the bottom third of earners who bring home less than $25,000 for a family of four. Another part of this proposal is that all income would be taxed for the payroll taxes for social security, not just the first $90,000 as in present law, at the same rates as the income tax. This creates some income progressivity for the tax that would be attractive for progressives.

Because one of our principles was that the corporate income tax must be internationally competitive, and corporate income earned overseas should not be taxed by the U.S., i.e. the territorial tax model, a flat tax for companies should equal the minimum effective tax rate overseas and should not be applied to overseas income. Since the lowest average top corporate rate is that of Europe at 18.6%, I would propose a corporate flat tax of 19%.

In light of the preceding discussion, my own first modest proposal for a flat tax would be the following.

1. Individuals would have a flat tax of 14% with no deductions of any kind. In order to avoid double taxation of corporate profits, dividend income would not be counted as part of an individual’s income. Individual taxable income would be income minus dividend income minus saved and invested income minus $10,000 for each family member ($5000 if filing jointly with a spouse). If the taxable income is less than $0, it will be rounded up to $0.
2. Payroll taxes for social security and medicare would be calculated at the same rate with no limit on the amount of income taxed.
3. Corporations and other companies would have a flat tax of 19% with no deductions of any kind and with only income produced within the United States taxed.

This particular plan would satisfy all of the six requirements listed above, would actually be a variety of consumption tax for individuals (no taxes for savings and investments). By giving internationally competitive tax rates to companies, it would not encourage companies to relocate overseas through corporate inversions.

A National Sales Tax

The second possible replacement tax is not an income tax at all, but an ordinary sales tax. A sales tax that is identical for everyone would certainly greatly simplify taxes for both individuals and corporations. The tax would be levied on consumers at the point of sale of goods and services, and then the businesses collecting the tax would pay it to a greatly scaled down IRS. There would be no necessity for individuals to fill out or file tax forms, which I am sure many would count as a tremendous advance!  Clearly, a sales tax is a tax on consumption rather than income.  At one time some conservatives favored consumption taxes over income taxes, both because a consumption tax tends not to change people’s behavior as much as an income tax, and also a consumption tax does not discourage investment and production as much.

The regressive effect on the poor can be considerably softened by exempting basic, necessary items, such as food, clothing, medical care, and housing.

Corporations would pay sales taxes for what they buy, conceivably at a different tax rate. To make corporate taxes internationally competitive, the corporate sales tax rate should be 19% or less, and should not be applicable to what the corporations buy overseas.

Much of the perceived advantage of a sales tax over a flat income tax evaporates if the income taxed excludes income saved or invested. If this is done to a flat tax, the difference from a flat national sales tax becomes very small indeed.  There are two considerations that I believe break the equivalence between them. It is somewhat harder to ensure a sales tax does not harm the poor, and that being the case, it would also be hard to sell to progressive politicians. The second reason is if a sales tax is enacted and if the Sixteenth Amendment to the Constitution is not repealed, there is no assurance at all that some future progressive President and Congress might enact both a sales and an income tax at the same time. For these marginal reasons, I would opt for a flat income tax as outlined above.

How do you think the ideal tax regime should be constructed? And why should that tax regime be considered the ideal?

GO TO HOME

Sharing is caring!