It’s clear from my comment sections that people just don’t understand taxes. In this post I’ll try to explain a few basic concepts, so that we can have an intelligent discussion.
The biggest confusion is that people don’t understand why capital income should not be taxed, and why a wage tax is equivalent to a consumption tax. Consider someone with $100,000 in income, who can choose to consume, or invest in a fund that will double in value over 20 years. Suppose we want to raise revenue with a present value of $20,000, from this person. We could have a wage tax of 20%, and raise $20,000 right now. Let’s also assume that this person decided to spend 1/2 of his after-tax income—leading to $40,000 in consumption today, and save the other $40,000, leading to $80,000 in consumption in 20 years. Note that both current and future consumption are reduced by 20% relative to the no tax case.
Alternatively, we could directly tax consumption at the same rate (say with a VAT). Let’s assume the person saved $50,000 and spent $50,000 on consumer goods. After paying VAT they consume $40,000 today, and the government gets the other $10,000. After 20 years the $50,000 saved turns into $100,000, but you must pay $20,000 in VAT, leaving consumption of $80,000. Exactly the same as with a wage tax. The total revenue to the government looks bigger, but is the same in present value terms.
In contrast, an income tax doubles taxes the money saved, once as wages, and again as capital income. So now it’s $40,000 consumption this year, and only $72,000 in 20 years ($80,000 minus 20% tax on the $40,000 in investment income), an effective tax rate of 28% on future consumption. And of course with inflation the effective real tax rate is still higher. Income taxes make no sense at all; if you want progressivity, tax big consumption more than little consumption.
People also get confused when we try to link these abstract concepts to real world aspects of the tax code, like IRAs and depreciation. Consider the wage tax and the VAT tax discussed above:
1. Wage tax = Roth IRA with no restrictions–pay when you earn
2. VAT = 401K with no restrictions–pay when you spend
An unlimited Roth IRA would allow you to put all of your savings into IRAs, as would an unlimited 401k. And you would not be forced to withdraw at retirement–you could have your heirs spend the money, and pay the tax.
What about depreciation? Why should capital investment be expensed? The IRAs I just discussed are financial investments. But we know that saving equals investment, so there is a corresponding physical activity associated with financial saving. Consider a simple example:
A utility spends $1 billion on a huge solar facility in the desert. For simplicity assume they can sell $100,000,000 in electricity each year, and there are no there costs. If we treated this like the 401k, the utility would deduct the expense of the initial construction from its current taxable income, just as you deduct money you put into a 401k. But then they’d have to pay taxes on the full $100 million in annual revenue (unless reinvested), just as you must pay taxes on the full cash flow of your 401k (unless reinvested). If the utility later sells the solar facility to another company, obviously the full sales price is taxable, just as money you withdraw from a 401k is fully taxable.
Note that even though you pay tax on money you withdraw from a 401k, this is not a tax on capital income; it is a deferred tax on labor income.
In principle, you could tax consumption, or you could tax all of GDP. We’ve adopted a weird intermediate scheme, to tax GDP minus depreciation, sometimes called net income. If there’s a rationale for this I’d love to hear it. Now of course we don’t actually deduct depreciation, as it’s hard to know how fast assets are deteriorating in value, so we simply make up numbers, like a sliding 30-year depreciation schedule. This is lots of busywork for accountants, with no practical value that I’m aware of. I can think of two things that accountants might be interested in:
1. Cash flow
2. Value of a company’s assets
The later might involve “depreciation,” but it might just as well involve “appreciation,” especially in real estate.
If you allow companies to expense all investments, then you have essentially turned an income tax into a consumption tax. (Unless I’m mistaken, that’s what Rubio/Lee is trying to do.) If you allow no write-offs of depreciation at all, then you have a tax on GDP, or gross income.
I get hit from both the left and the right, both sides making errors:
1. The left complains my proposal is too regressive, as it LOOKS LIKE income taxes would hit heavy saving rich guys more than a consumption tax. But people only absorb the burden of a tax to the extent that it reduces their consumption. If Bill Gates pays an extra $10 billion in taxes, and doesn’t reduce his consumption, but instead gives $10 billion less to the poor in Africa, then he hasn’t really absorbed the burden of this tax. Look, a country can’t consume more than it consumes. Does anyone disagree with that? But lots of liberals believe in the following combination of statements, which is logically impossible:
1. Most Americans live right on the edge, consuming all their income.
2. Rich fat cats have lots of extra income they don’t need, which could be given to average Americans.
3. Lots of redistribution would not hurt investment. OK, that means it won’t boost consumption.
4. Even paying lots more taxes, the rich would consume almost as much.
So if the rich consume almost as much, and total consumption doesn’t change, how are the rest of us helped? If all those things are true then it’s logically impossible for the average people to be better off, as we’ve assumed they consume all their income, and you’ve told me that aggregate consumption and investment don’t change. Liberals simply aren’t thinking clearly about the true burden of taxation. Gates and Buffett aren’t bearing the burden of the taxes they do pay, someone else is.
From now on liberal commenters must tell me why so many brilliant liberal economists have favored replacing income taxes with progressive consumption taxes, and what’s wrong with this argument. If that can’t do so, I won’t respond to their complaints.
2. Conservatives complain my proposed tax rates are too high. I agree. Let’s reduce loopholes and lower government spending. But the GOP doesn’t want to do this. And that means we need much higher tax rates than Singapore. All that Medicare spending and military adventurism and no-child-left-behind from the Bush administration must be paid for.
Their second mistake is to confuse consumption tax rates with income tax rates. Yes, a 50% income tax rate for the rich is too high. Hell a 1% income tax rate for the rich is too high. But a 50% marginal consumption tax rate for the rich is not too high, given the amount of revenue we need to collect. Also recall that the rich don’t pay payroll taxes above about $120,000 or so, and they pay relatively little tax on gas, booze, cigarettes, etc. But again, convince the GOP and Dems to reduce the size of government, and I’m all for lower MTRs.
Another mistake is to complain that some plans are hard to enforce, because of tax evasion. Yes, but that’s equally true of YOUR plan.
1. If we go the wage tax route, tax should be paid on all cash and financial assets you receive from the company you work for. Period. If you’ve paid taxes on the fair market value of company stock that you get in year one, then no more tax should be paid if the stock later appreciates. I understand that people will look for loopholes AS THEY ALREADY DO, but the IRS needs to do the best job it can.
2. If we go the VAT route, then you must distinguish between consumption and investment. I propose all business meals be treated as consumption. Ditto for company cars that can be used off hours. For air travel, it should be the difference between actual cost of travel and an economy class ticket. The extra luxury is consumption.
Arguments over “who pays” are usually ill informed. People simple assume that just because big corporations write out checks to the IRS, that corporations must be bearing the burden of the corporate income tax. Well cigarette companies write out big cigarette excise tax checks to the government, does than means smokers don’t pay? The fact is that no one knows who ultimately bears the burden of the corporate (and to a lesser extent personal) income tax.
In a better world both parties would agree on an efficient tax regime, and then fight over progressivity. When the GOP won elections they could cut taxes, and when the Dems won elections they could raise taxes.
In a better world.