November 20, 2012

The Flat Tax Solution

To step back from the fiscal cliff, we need to simplify our tax policy.

This past Friday, I gave the “Presidential Address” at the Southern Economic Association (SEA) in New Orleans, on the topic of what President Obama’s reelection means for the future of liberty in the United States. As a classical liberal, my outlook is best captured in one simple proposition: a system of sound governance needs to promote a mixture of individual liberty and private property in order to allow individuals to maximize the gains from individual effort and social cooperation.

A strong government that can protect these rights must, of course, backstop the market system by collecting tax revenues that are spent on the public goods that markets cannot easily or efficiently supply, such as defense and social infrastructure. The use of state power always opens up the path for general abuse because large doses of government discretion allow all political forces to secure factional gains that result in overall social losses. The central challenge for government is to incur minimum political distortions while allowing taxes to raise the revenues needed to discharge essential government functions.

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  Illustration by Barbara Kelley

Taxation vs. Factions

There are two key methods by which to constrain the political risks of faction. The first is to adopt only a single instrument of taxation—most likely an income or consumption tax—in order to reduce the risk of political intrigue. There is, for example, no place under a sound system of taxation for special excise taxes like the 2.3 percent tax imposed on medical devices to help fund ObamaCare. The second is to make the system of taxes durable over time, so that the form and incidence of the tax is not subject to constant maneuvering. Our fiscal cliff has arisen because tax policy is revised every two years, provoking political crises.

Without question, the form of taxation that best meets these dual requirements is a flat tax on consumption—a position which enjoys virtually no visible political support today. My speech to the SEA was not optimistic in large measure because virtually every key tax policy initiative today lurches in the opposite direction. The constant calls for higher levels of progressivity; the short-shelf life for key tax rates that must be renegotiated every year or two; and the constant playoff between interested parties jockeying to shift wealth among income, death, and excise taxes, which only magnifies the amount of political mischief. Unless something is done to alter the direction of political discourse in the United States, the next four years will be a replay of the last four years. We will witness a slow decline in the standard of living across all groups within the United States. Tax policy is a key piece in that overall mosaic.

The Perils of Static Tax Policy

The President is obsessing about the increases in income inequality, which for him clinches the case for higher tax rates for privileged individuals that earn over $200,000 per year, or privileged couples that earn over $250,000. The President thinks that revenue growth from taxes can be reduced to a simple task of addition and multiplication. Start with the current tax base, and multiply it by the increased tax rates in order to determine the added tax revenues. That static thinking was also embraced in a New York Times editorial:

The special low tax rates for investment income are among the largest tax breaks in the code. They allowed investors to pocket some $100 billion in 2012 alone compared with what those investors would have paid if investment income were taxed the same as regular income.

What this editorial never asks is whether we would have had the same amount of capital gains revenue if capital gains rates were higher. The answer to that question is likely to be no. The lower rate of return will make it more likely that individual investors will hold on to their stocks for longer periods of time, which could reduce the total amount of gains in ways that more than offset the tax increase.

The slow down in the rate of capital turnover spells bad news to the economy because it reduces the efficiency of capital markets by making it more costly for investors to reallocate capital from weaker to stronger ventures. Both the President and the New York Times support a whopping tax increase in dividend income—from the current 15 percent to 39.6 percent—which will surely retard the mobility of capital.

The Virtues of a Flat Consumption Tax

A sound tax system has as few moving parts as possible. We should scrap the current system in favor of a flat tax on consumption.

Radically simplifying the tax system to a flat tax on consumption would facilitate two desirable economic changes. First, it reduces taxes to zero when capital is redeployed from one venture to another, which in turn would induce better investor monitoring of current firms. The ability of investors to sell out without adverse tax consequences thus provides an added incentive for efficient market behavior. Second, it eliminates the need to draw any distinction between ordinary income and capital gains, which is one of the weak points of the current system.

It is, of course, difficult to work an immediate transition from an income tax to a consumption tax. But it is possible to exempt all capital gains from taxation to the extent that it is reinvested in other capital assets. Right now, that approach is in fact tax policy with respect to an exchange of capital assets as part of a business reorganization, such as a recapitalization or merger. It takes little ingenuity to use the same system for any sale and reinvestment. Any short term loss in revenue is likely to be made up by the combination of higher wages, higher dividends (at least if the tax is kept low), and higher capital asset values, which would generate additional revenues when liquidated for other uses.

One advantage of introducing the flat tax on consumption is that its variation leaves the government the only degree of freedom that it needs to make necessary budget adjustments. It is commonly thought that during economic slowdowns, the government should engage in deficit spending, just as ordinary individuals try to even their consumption patterns by borrowing, while making up the gap by saving in good times. Any aggregate target can be achieved by just manipulating a single rate to achieve the desired revenue goals. At this point, the deliberations in question will become simpler, in sharp contrast to today’s bitter, protracted, and expensive negotiations.

Rate stabilization will also lead to more reliable and rational decisions in both capital and labor markets, by removing one gratuitous degree of uncertainty from business risk. These indirect benefits are typically ignored because they are so hard to measure directly. But they are ubiquitous, and should prove substantial because they operate quietly and reliably in both the long and the short run. The stability of social institutions was a great theme of such classical writers as David Hume and Adam Smith. It should not be forgotten today.

Private Responses to Public Mischief

Current tax policy puts items like income and deductions into political play, generating deleterious short-term consequences. Evidence of this can be seen in the rapid response of investors, who are anticipating the future tax hikes and scaling back on their investments. The adverse responses are not confined to large firms but also extend to wealthy individuals who will bear the brunt of any tax increase.

The proposed increase in the estate and gift taxes, targeted exclusively at high-income taxpayers, has set off an immediate flurry of tax planning efforts by well-to-do individuals to minimize the bite of these unknown and unwelcome tax changes. Typical of the common hijinks are the estate planning tactics recently reported in the Wall Street Journal by Annamaria Andriotis, which should belie the naïve belief that high-income taxpayers don’t respond to incentives.

It is not just that people go to extra lengths to alter their patterns of giving in order to take full advantage of the life-time exemption from the gift and estate taxes and annual exclusions (now $13,000 per each donor/donee pair); it is that they engage in the conscious destruction of wealth in order to minimize the impact of taxes. Thus one common scheme involves the transfer of a valuable asset—a family vacation home, for example—to a limited liability company (LLC) where it is then owned by several family members. This decision to complicate the state of the title reduces the marketability of the asset, and thus reduces the amount of tax that it will attract at the death of the senior generation. The cold-blooded calculation is that the tax savings for the family unit more than justifies the losses in market value.

Yet what possible social reason is there to spend tax deductible dollars in order to reduce social wealth? Moving to a system of taxation that looks to consumption only treats the transfer of wealth from one person to another as a non-taxable event. The result is the better mobility of capital, lower tax drag, and fewer wasteful tax planning expenses. It will also generate more income (or consumption) tax from more productive firms.

Choosing the Right Path

This sensible push for tax simplification and tax reduction does not look through the world with rose-colored glasses. Since the advent of the income tax in 1913, tax rates have gyrated from high to low and back again. As Stephen Moore has once again demonstrated in the Wall Street Journal, the typical response to these tax reductions is a spur in economic activity that results in the collection of larger amounts of capital gains taxes from wealthy individuals, who also prosper under the regime by their higher after-tax earnings. As Moore points out, strong revenue surges followed the tax cuts under John F. Kennedy, Ronald Reagan, and George W. Bush, as investors responded with higher levels of economic activities and more rapid turnover of investments.

What makes the situation more impressive is that these overall gains were achieved in a less than ideal tax environment. Tax rates were still progressive; multiple instruments of taxation were still in use; tax horizons were short; and special gimmicks were the order of the day.

There is a desperate need to get this nation’s fiscal house in order. The last way in which to achieve that goal is to double-down on the structural defects of the current tax structure in the hopes that it will generate some much needed relief to the middle class. If we sock it to the rich, we run the risk of impoverishing the nation.

Too many people agree with the implicit supposition of the President that taxation is a zero-sum game, whereby the rest of the population can gain amounts that are taken from the rich through taxation. Not so. The explicit tax increases on the rich will be passed on in a variety of ways to the population as a whole so that everyone is made worse off in the name of income equality. John F. Kennedy famously said that a rising tide raises all ships. A falling tide will leave many of these same ships grounded.


Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).


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