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This article appears in the February 6, 2017 issue of National Review.
Tax reform will be front and center this year. There are enough supply-siders in power that it seems certain that tax rates will go down. But if Republicans want to supercharge the economy, they should look not just at tax rates, but also at the things we choose to tax in the first place and the best practices around the world.
The goal of the best tax policy is to raise enough revenue to pay government’s bills while changing behavior as little as possible. The economy suffers when people make decisions based not on the pure pluses and minuses of their own situations but rather on the incentives provided by government policy. Economists who have run different types of tax policy through their models agree that the most efficient tax is on consumption. If you tax business profits, businesses can move to Ireland. If you tax the consumption of Americans, they can’t move their consumption to Ireland.
The consumption tax also simulates growth through the “tax avoidance” behavior that it does induce. If you don’t like the tax on consumption, then your best avoidance strategy is to save rather than consume. If you pursue this strategy for a few years, you might even become wealthy, and meanwhile, the bank that has your money will lend it to businesses that create jobs. If we want to produce more output in the future, we need to have more inputs in the future. Postponed consumption is future capital and future production.
This simple lesson from optimal-tax theory has been digested by almost every country on earth, except the U.S. Indeed, 34 out of the 35 OECD countries have consumption taxes in the form of a goods-and-services tax (GST) or a value-added tax (VAT). Using data from the OECD Tax Database, the graph below shows the distribution of VAT tax rates. Most OECD countries have a VAT rate around 20 percent, with a few outliers on both sides of the distribution. Other than the U.S., the lowest VAT in the developed world is in Canada, which has a VAT of 5 percent. The next-lowest tax after Canada’s is 8 percent. Indeed, 31 out of 35 developed countries have a rate higher than 10. Twenty-two out of 35 have a rate greater than or equal to 20.
As policymakers consider ways to reform our tax code, it will be natural for them to consider ways to move toward the international norm. One proposal already in the books is the House Blueprint plan, which would impose a “business cash flow” tax that is quite similar to a VAT. Such a tax would, as can be seen in the chart, put us in the middle of the pack in terms of tax rates and move the tax base toward the international norm.
It is too soon to tell whether this plan will survive the legislative process, and there are certainly numerous other ways to accomplish moving our tax system toward a more rational base. Let us hope that the architects of tax reform keep in mind how out of step we are with global best practices.
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