Oct
13

Tax Reform Done Right

With elections right around the corner, tax proposals are surfacing like mushrooms after a rainstorm.  While we can all agree that the current tax code is a disaster, the most recent proposals regrettably range from just bad to positively dreadful.  Why?  They are political documents designed to attract voters — not tax policy experts and economists!  With this in mind, I offer several key principles that should be generally followed in any successful tax reform.

The primary goal of taxation is to raise revenue while causing the least economic damage possible.  This means broadening the tax base.  Think about it; if the only thing we taxed was oregano, we would all stop buying oregano.  If however, we taxed all spices equally, there would be no reason to avoid oregano, but there would be a strong incentive to eat bland food and smuggle in spices.  But if we tax everything equally, then you have no incentive to alter your behavior as you cannot reduce your taxes.  Better yet, as you broaden the base, you will be able to lower tax rates and still collect the same amount of revenue.  Of course, this means doing away with most deductions, credits, and exclusions, including tax breaks for charitable donations, employer-provided health insurance and state and local income taxes.

The next step involves simplification.  Most taxpayers resent the fact that the rich hire clever accountants and lawyers, thus reducing their tax payment to nothing or next-to-nothing.  This is corrosive behavior, creating distrust of the entire system across the political spectrum.  Moreover, simplifying our 75,000-page federal tax code would cause entrepreneurs to think harder about how to make more money and grow their businesses, not on which lobbyists and lawyers to hire and how many racehorses to buy, all of which are unproductive activities.  Tax simplification means doing away with the corporate income tax and all the insane rules regarding investment expensing, depreciation schedules, repatriation of profits, tax-deductibility of debt, R&D tax credits and so on.

Third, tax consumption — not savings.  When the government taxes savings, income, interest payments, dividends, capital gains, wealth and even inheritances (but we can argue about that one), it reduces the incentive to save, invest in new plant and equipment, and, most critically, take financial risks.  Recognizing this, the government already allows for health-savings accounts, IRAs, life-insurance exemptions and a multitude of trusts that the rich use to shelter wealth and avoid inheritance taxes.  Why not let everyone do it without having to jump through any hoops?  While consumption taxes such as sales taxes or value added taxes may sound regressive, they need not be.  Consumption by the wealthy can be taxed at a higher rate than consumption by the poor.  In this way, the tax code can remain progressive.  Moreover, as the consumption tax will be based on the difference between what you earn and what you save, this plan will discourage hiding assets offshore, giving our economy yet another boost!

The last time the tax code was reformed was during President Reagan’s second term; roughly 30 years ago!  We are clearly overdue.  While reaching a compromise that both ends of Pennsylvania Avenue will agree to will be tough, if done as outlined above, it will boost GDP growth and improve living standards.  Congress, get going!

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