April always brings complaints about the pain of paying taxes—and the complaints are justified. According to the Bureau of Economic Analysis, over 30% of U.S. gross domestic product is taxed away to fund federal, state and local governments. Tax compliance costs are also large, estimated to be around 1% of GDP.
The hidden cost of the tax system is the biggest of all—namely, the slower economic growth that results from taxing investment, which impedes the formation of capital and hinders productivity and wage growth. An easy way to remove the impediment to growth is to move toward a consumption tax by allowing the full and immediate deductibility of capital investment.
The argument rests on two points. First, consumption taxes are better for economic growth than are income taxes. Second, allowing full expensing (immediate deductibility) of investment turns the current tax system into a consumption tax.
Consumption taxes are better for economic growth because they create stronger incentives to save and invest than do income taxes. Under an income tax, a person who consumes what he earns immediately is taxed once, specifically on the earnings that he receives in that year. If instead he invests what he earns, the interest on that investment, which is compensation for deferring consumption, is also taxed. This pushes him toward consuming more now and saving less.
The reduced incentive to save that results from taxing returns drives up interest rates and retards investment. Incentives to invest would be improved if the returns were untaxed. By contrast, a consumption tax does not tax the returns to investment. It taxes only once, at the time that actual consumption occurs. Moving to a consumption tax eliminates the tax on returns to investment and improves investment incentives.
Allowing investment expenses to be fully and immediately deductible turns an income tax into a consumption tax, but the logic is subtle. All of an economy's output is used to produce either current consumption or investment goods. If all income, which must equal output, is taxed, then both consumption and investment are taxed. But if we tax only the part of output that is not investment by allowing investment expenditures to be deductible, all that remains is consumption so only consumption is taxed.
There is no need for any complicated new tax laws or bureaucracies to make this change. Investments in plants, equipment, R&D and even human capital would be deductible from profits when paying taxes, and the deduction could be used now or against future or past tax liabilities.
The potential benefits of moving away from taxing investment to a consumption tax are well documented. A 2005 Tax Advisory Panel appointed by President George W. Bush estimated from Treasury data that moving to a consumption tax by removing taxes on investment would result in a 5%-7% increase in GDP. (Its scoring included lower and flatter individual and corporate rates, though expensing accounted for most of the gain.) A 2001 study in the American Economic Review by David Altig, Alan J. Auerbach and others estimates that GDP would rise more than 9% by moving to full expensing of investment spending (with a flat tax).
Taxing investment reduces after-tax returns to investing. Investors care about after-tax returns and a tax policy that lowers investment returns is especially harmful to long-term economic growth. For example, a 2001 report by the Organization for Economic Cooperation and Development, "Tax Policy Reform and Economic Growth," found that corporate taxes are the most harmful type of tax for economic growth, followed by personal income taxes and then consumption taxes, with recurrent taxes on immovable property being the least harmful tax.
Capital taxation introduces the most distortions because capital can move across international borders easily. If one country overtaxes investment, the marginal investor will move money to a country that treats investment more favorably. It is more difficult for labor to move so taxing labor has fewer adverse incentives. Finally, land is truly locked in and land taxes are the least problematic from an economic efficiency standpoint.
Lower corporate tax rates is a move in the right direction, but it is not as effective in stimulating investment as is full-expensing. The bang-for-the-buck was estimated by Treasury to be about four times as high for full-expensing than for lowering rates. The reason? Lowering corporate rates reduces taxes for all capital, old and new alike. An investment that was made 10 years ago gets the benefit of lower rates as does one that is made tomorrow. But full expensing applies only to new investment because it is only investment going forward that is deductible. As a result, all of the power of reducing taxes works for new investment in the case of full expensing.
Full expensing will likely be labeled a "trickle down" policy that will not help the working American. This is unfortunate because labor would benefit greatly. Investment is crucial for increasing labor productivity and higher productivity is necessary for higher wages. Productivity and wages move together. Without productivity increases wages cannot grow.
There are many changes that would improve the efficiency of the tax code, but cutting the tax on investment heads the list.
Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-09, is a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow.