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Both parties are thinking way too small. We don't need higher income taxes, or slightly lower income taxes. We need zero income taxes.
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Although the need for tax reform has never been greater, today’s tax policy debate is trapped in partisan gridlock, as Republicans call for tax cuts to promote economic growth and Democrats counter that the rich must pay their fair share. Many Americans reject the terms of this debate, insisting on a tax system that promotes both growth and fairness. Fortunately, we can achieve this goal by returning to the innovative thinking of the late Princeton economist David Bradford. In 1986, he proposed a progressive consumption tax named the X tax that removes the income tax’s impediment to growth while maintaining progressivity.
Economic growth is impeded by the income tax’s penalty on saving and investment. Under today’s income tax system, people who save to spend later in life may be taxed many times on their saving – first on the income they save and then on the returns to their savings over time. In contrast, those who spend today are taxed only once. The use of consumption taxation would avoid this disparity – everyone would be taxed once, regardless of when they spend. This bias against saving and for current consumption is a fundamental flaw embedded in the income tax.
Taxing saving properly is critical to America’s future. Savings are the life-blood of economic growth because they finance investment in plant, equipment, and technological innovation. Economic research suggests that a switch to consumption taxation is likely to boost the economy’s long-run output by several percent.
When people hear “consumption tax,” they usually think of regressive sales taxes and value added taxes collected at the cash register. In fact, replacing the income tax with those taxes would sacrifice fairness for growth, unacceptably shifting the tax burden to those who are less well off.
The X tax, in contrast, is a progressive consumption tax that would both promote growth and maintain fairness.
The X tax has two components. Individuals file annual tax returns and pay tax on their wages. There are higher tax brackets for workers with higher wages and lower brackets for low-paid workers. Exemptions and credits can be included to add further progressivity or meet other policy objectives. Business firms are taxed on their cash flow at a flat rate equal to the rate on the highest-paid workers.
At first glance, the X tax looks a lot like an income tax. But, two key features make it a consumption tax.
On the individual side, interest, dividends, capital gains, and other income from saving are tax-exempt, eliminating today’s tax penalty on those who save. On the business side, firms immediately write off all of their investment rather than depreciating them over a period of years. This up-front write-off exactly offsets the tax penalty for new investments, although the tax system still pulls in revenue from investments made before the X tax was adopted and those with extra-high returns.
Because the X tax doesn’t penalize saving and investment, it is a consumption tax. But, it’s definitely not a sales tax, because it doesn’t tax all consumers at the same rate. The highest-paid workers pay the top rate. Investors who saved before the X tax was adopted and those who earn extra-high returns are taxed at the same rate through the business tax. Middle-class workers pay lower tax rates and those at the bottom of the economic spectrum pay nothing.
The X tax design also promotes simplicity. Individuals report only the wages listed on their W-2s, not their harder-to-measure income from saving. And, the up-front investment write-off banishes depreciation, inventory accounting, and a host of other complications from business tax returns.
Of course, any tax reform faces some challenges. There are difficult questions about how to transition to the new system and the tax rules that will apply to pensions, housing, international trade, financial institutions, and so on. Reform proposals often gloss over these issues, but no reform will be seriously considered until these concerns are addressed. In our new book about the X tax, we offer concrete answers to these questions, explaining how to make the X tax a reality.
The Bradford X tax is a game-changing idea – an efficient, fair, and simple tax that will help build a prosperous future for the American people.
Alan D. Viard is a resident scholar at the American Enterprise Institute. Robert Carroll is a principal with Ernst &Young LLP’s Quantitative Economics and Statistics group. They are the authors of Progressive Consumption Taxation: The X Tax Revisited, just published by AEI Press.
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