How to Think about Taxes

Tuesday, January 30, 1996

How We Punish Saving

The U.S. corporate and personal income taxes (and other taxes at both the federal and state level) tax some types of saving once, others twice, some three times, and in some instances even four times. To set concepts, it is generally understood that a pure income tax would tax saving twice: first when it is earned as part of income and again when it earns a return in the form of interest or dividends. An alternative way to think about this is that present consumption is taxed once while future consumption is taxed twice because the bulk of saving is done for the purpose of future consumption, for example, during retirement.

Now consider the separate corporate and personal income tax and a family putting their saving in corporate equities. The family first pays taxes on their own income (perhaps their wages). That is tax one. They save some of that after-tax income in the form of corporate equities. But the corporation pays corporate taxes (on behalf of the family as a shareholder). That is a second tax. Then the family pays taxes again when it receives dividends or capital gains (in this case one has to net out inflation, deferral, the possibly slightly lower tax rate, incomplete loss offset, and so on to determine the true effective tax rate). That is a third tax on the saving. If the family is fortunate enough to accumulate, even at a few thousand dollars a year compounded over a lifetime, enough to leave a taxable estate, the saving is taxed a fourth time.

Of course, there are numerous exceptions to this rule. For example, employer-provided pensions, 401(k) plans, IRAs, and so on are forms of tax deferral (not tax forgiveness) that eliminate one layer of the taxation of saving. But going through the entire complexity of the tax code still produces the overall conclusion that capital formation is taxed especially heavily in the United States relative to other uses of income and relative to our competitors.

How We Can Tax Consumption Instead

There are numerous ways to simplify the tax system and remove the distortion between the present and the future, between consumption and saving of households, and among types of investments. That is, there are numerous ways to tax consumption in the economy. The main features of the principal reform proposals, and of current law, are presented in.

Although these are very different approaches to consumption taxation, with very different attributes, it is important to stress their conceptual equivalence. Consumption equals income minus saving; thus the Nunn-Domenici type tax with an unlimited net saving deduction is a consumed income tax (in the case of Nunn-Domenici levied at progressive rates). Consumption taxes can be levied directly as a retail sales tax on the purchases of goods and services. But consumption is also equal to income less investment and therefore labor income plus capital income less investment. Hence, a tax such as the so-called flat tax of Majority Leader Armey (which owes much to my Hoover colleagues Bob Hall and Alvin Rabushka), which taxes wages at the personal level and capital income less expensed investment at the business level, also winds up with consumption as the tax base.

Table 1. Comparison of Current Law and Major Reform Proposals

Present Law

  • Summary

    Theoretically, a progressive tax on corporate and personal income. Numerous special features (e.g., exemptions and deductions). Some income taxed only when consumed (e.g., pensions). Fringes (e.g., health insurance) and owner-occupied housing favored relative to ordinary income. Complex depreciation, inventory accounting. Inflation still a big problem. Progressive rate structure.

  • Personal Tax

    Numerous special provisions make tax a complex hybrid of income and consumption bases. Biggest items not taxed as income accrues are tax-deferred pensions, mortgage interest deductions, employer-paid heath care, and property tax deductions.

  • Corporate Tax

    Thirty-five percent rate on corporate income (special rates apply to small incomes). Business depreciates capital cost over asset life. Debt favored relative to equity.

  • Most Controversial PointsComplexity; high rates; huge administrative and compliance costs; changed every few years; inflation, depreciation, present immense problems. Considered large drag on economy relative to pure forms of alternatives.

Value-Added Tax
(VAT) and/or National Retail Sales Tax (Proposed by Congressman Bill Archer and others.)

  • Summary

    Separately, or in combination, replaces corporate and personal income tax with broad-based consumption tax. With a VAT, businesses taxed on difference between gross revenue and input costs including purchases of capital goods. With a retail sales tax, a flat percentage added on retail price of goods and services.

  • Personal Tax

    VAT: No direct tax on individuals, but consumers pay through higher prices.
    Retail Sales Tax: Consumers pay tax added to price, as is common with state sales taxes.

  • Corporate Tax

    VAT: Tax on value added or cash flow and wages.
    Retail Sales Tax: Flat rate added to price of final goods and services. Special exemptions or lower rates for "necessities" such as food have been proposed by some. Rates not yet specified, likely in 15-16 percent range unless there is extensive erosion of the base.

  • Most Controversial

    Taxing services; dealing with low-income households; tax on old capital. Worry will be new tax to expand spending rather than replacement for income tax.

Flat Tax
(Proposed by the Hoover Institution's Robert Hall and Alvin Rabushka. Now championed by Congressman Dick Armey.)

  • Summary

    Replaces corporate and personal income taxes with two related taxes: a single (flat) rate on personal labor income (including pension income) only. Businesses pay same rate on gross revenue minus costs of inputs, capital goods, wages, and pension contributions. Large personal exemptions in personal tax.

  • Personal Tax

    Individuals are taxed on all compensation and pension distributions but not other sources of income (e.g., interest and dividends). Large exemption plus per dependent deduction. Family of four would start paying only on compensation above about $36,000 in current plan. Tax rate is subject of controversy. Hall-Rabushka estimate 19 percent. Armey starts at 20 percent, declines to 17 percent as assumes spending cut. Others estimate rate would have to be 22 percent to avoid increase in deficit (using static scoring analysis).

  • Corporate Tax

    Business tax on gross income minus cost of inputs, wages, pension contributions, and corporate capital (e.g., expensed immediately). Other fringes not deductible. Rate 20 percent to start decreases to 17 percent as spending is cut. But some question numbers, claiming may have to be 22 percent to avoid deficit increasing (under static scoring).

  • Most Controversial Points

    Separately taxing labor and capital income may be hard to explain to public used to current system; requires renegotiation of foreign tax treaties; distributional arguments; eliminating charitable deductions and mortgage interest deductions. Some versions abolish withholding.

Nunn-Domenici USA Tax
(Proposed by Senators Sam Nunn and Pete Domenici.)

  • Summary

    Replaces corporate and personal income tax with a personal progressive-rate consumed income tax applied to income minus (net) saving. Single-rate VAT imposed on business income. Both taxes have a credit for payroll taxes.

  • Personal Tax

    Individuals taxed on all income except fringes and tax-exempt interest. Unlimited deductions for net saving, some education costs, mortgage interest, and charitable contributions. Payroll tax credit and exemptions and dependent deduction amounting to about $12,500 for a family of four. Progressive rates rise quickly from 8 percent to 40 percent as (consumed) income increases.

  • Corporate Tax

    Tax, like VAT, on gross revenues minus cost of inputs, capital purchases (i.e., capital is immediately expensed). Compensation not deductible. Rate = 11 percent.

  • Most Controversial Points

    High tax rates; not simple.

Would Tax Reform Be Worth the Trouble?

Each type of tax will require far greater examination from the polity and the public, as they are not yet well understood. Each of these alternatives has its pluses and minuses. If it could completely replace the corporate and personal income tax, a national retail sales tax probably in the end would be the simplest to administer and do the best job at getting at the underground economy. The value-added tax, which, although it has a self-policing feature, is somewhat more complex than the retail sales tax but still relatively simple compared with income taxes. In either case, I personally could support such an approach only if it were used to replace income taxes fully, lest it be used to expand the scope of government.

The flat-rate tax would be a major improvement over the existing income tax system, but again, to the extent that exemptions, deductions, and so on were left in place or crept back in over time, some of its advantages would be eroded. And, as with a broad-based sales tax or VAT, I would be concerned that small increases in the rate would raise lots of revenue and that, over time, we would evolve back toward a higher-rate system unless spending was strictly controlled.

What is likely to be gained by moving to one of these tax systems? Will it be worth the substantial political capital and transition costs to various families, firms, industries, and economic disruption that accompany any major tax change? The answer, in my opinion, is that the gains are potentially quite large. My review of the literature plus my own modeling reveals estimates of long-run gross domestic product up to 10 percent higher per year by replacing the current corporate and personal income taxes with a broad-based, low-rate direct, or indirect tax on consumption or consumed income. Perhaps a conservative estimate would be 5 percent per year, which, however, is gained partly by forgoing some current consumption. This occurs because the increased saving and capital formation increase wages and future income. These are large potential gains, large enough, in my opinion, to begin a serious dialogue and discussion, indeed national debate, on the desirability and feasibility of fundamental tax reform, which in turn might develop the support for legislation in the near future.