Tax Reform 101

While economic policy makers focus their attentions on Social Security, President Bush's Tax Reform Commission is quietly going about its work and receiving almost no notice. But it is only a couple of months until the commissioners are required to reveal the outcome of their work. At that moment, we can expect the debate about tax reform to reignite, which is a good thing, because the possible benefits of tax reform are impressive.

Tax reform is at times complicated business, but it need not be. Indeed, the key logical setup for the tax debate is quite simple, and involves only three key observations.

Here they are:

1) Consumption is a better tax base than income.

Economists have studied the problem of tax design for decades, and have concluded that taxing capital income leads to a reduction in activity that gets worse and worse over time. Thus, systems that tax people based on their current consumption, rather than their current income can lead to more savings, investment, and economic growth. Our current tax code taxes income, rather than consumption. If we had been taxing consumption instead of income for the last decade, the odds are that GDP today would be between 5 and 10 percentage points higher.

2) A Value Added Tax is a consumption tax.

Many of us have paid a Value Added Tax (VAT) while traveling abroad. A VAT is like a sales tax. You pay it when you buy something. Accordingly, a VAT is a consumption tax. If you put money in the bank and buy nothing, you avoid the VAT. So if you agree that you want to have a consumption tax, and want to think about how to enact one in the U.S., then you need to understand the mechanics of the VAT.

Here is how the VAT works. A business pays tax on the difference between its sales and the payments it has made to other businesses. That is it. Notice a business does not subtract wages before it calculates its VAT liability.

3) Consumption tax proposals are just modified VATs.

Robert Hall and Alvin Rabushka noticed many years ago that a wholesale switch to a VAT faced a serious political obstacle. Since a VAT is like a sales tax, and since poor people on average spend almost all of their income, poor people would face a significant tax hike if the U.S. adopted a VAT. They came up with a clever scheme to offset this effect, and make a VAT-like consumption tax more politically viable. If we allow businesses to subtract wages before they calculate their tax liability, and charge individuals a tax on their wages at the same rate the business pays, then we have something that is mathematically identical to a VAT. In a pure VAT, the business pays the wage tax. Under this modification, the same amount of tax could be paid, but at the individual level instead. The two schemes are, on paper at least, identical.

But requiring individuals to pay the wage tax allows tax designers to introduce redistribution into the mix. In a Flat Tax, some of a person's wage (say, the first $20,000) is exempted from tax. Wages higher than that pay the same tax that businesses pay. This exemption is a small modification of the VAT, and simulations have suggested that much of the economic benefit of a consumption tax can be achieved even in this more progressive version. Similarly, plans such as David Bradford's famous "X-tax" that allow wages to be taxed at a number of different rates also can deliver healthy benefits.

Distributive justice is not the only problem that different observers have had with a VAT; indeed, there is a whole grab bag full of additional concerns. There is some evidence, for example, that VATs have tended to grow over time, suggesting that they may be a recipe for big government. Can reform include safeguards to stop a VAT from swallowing up revenue like the blob?

But the conceptual problem is the same, and can be stated generally like this: "We really would like a VAT, but there are a number of concerns--like redistribution--associated with VATs. How can we construct a tax reform that is mathematically as close to the VAT as possible, while addressing those concerns?"

That is what the tax reform panel is grappling with right now.

Kevin A. Hassett is a resident scholar and the director of economic policy studies at AEI.

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