Here’s How to Replace the Income Tax
Monday, June 18, 2012
Alan Viard discusses the benefits of junking the income tax system in favor of a progressive consumption tax.
Editor’s note: Alan Viard is a resident scholar at the American Enterprise Institute and one of the most respected public finance economists in the nation. He is the co-author of a new book, "Progressive Consumption Taxation." The book explains how the United States can move away from taxing income and toward taxing consumption; and how this new system is both fair and promotes economic growth.
NICK SCHULZ: How would an “X” tax—a progressive consumption tax—work?
ALAN VIARD: Using the fact that national consumption is equal to wages plus business cash flow, the X tax implements consumption taxation in two parts. First, households are taxed on their wages under a progressive rate schedule, with higher tax rates on higher-paid workers and exemptions and tax credits for low-paid workers. Households are not taxed on income from saving. Second, business firms are taxed on their cash flow at a flat rate equal to the rate on the highest-paid workers. Firms are allowed to immediately deduct all of their investment costs rather than depreciating them over a period of years. The X tax design is identical to that of the Hall-Rabushka flat tax, except that the flat tax applies a single tax rate to all wages above an exemption amount, while the X tax features progressive tax rates.
Under an income tax, a worker who saves to consume in the future is taxed more heavily than a worker who consumes today.
Although the X tax may look like an income tax, it functions as a consumption tax because it does not impose a tax penalty on those who save and invest to consume in the future, relative to those who consume today. The household part of the tax clearly does not penalize saving, because tax is imposed only on wages, not on any income from saving. And the business part of the tax imposes no investment penalty on the margin, because the immediate deduction for investment costs fully offsets the expected taxes on the marginal investment’s future payoffs. The business tax does collect revenue, however, from investments made before the reform was adopted and investments that yield extra returns above those earned by the marginal investment.
The X tax is progressive because the top tax rate applies to the highest-paid workers, people who made investments before the reform was adopted, and people who make investments with extra-high returns. Other workers pay lower tax rates and the lowest-paid workers pay nothing.
The X tax design is also simple. Household tax returns are simplified because there is no need to report any income other than wages, and business tax returns are simplified because investment costs are immediately deducted.
NS: Why is consumption taxation better than income taxation?
AV: Income taxation penalizes saving, a major source of long-run economic growth, while consumption taxation does not. Under an income tax, a worker who saves to consume in the future is taxed more heavily than a worker who consumes today. Both workers pay tax on their wages, but the worker who saves also pays tax on the returns to his or her saving. In contrast, under a consumption tax with a constant tax rate, both workers pay the same percentage tax on their spending, so there is no bias against saving.
NS: How would switching to the X tax affect growth?
AV: Replacing the income tax system with an X tax would boost saving, which would increase the capital stock and promote long-run growth. Economic simulations suggest that such a switch would increase output by several percent in the long run, but such estimates are subject to significant uncertainty.
NS: Critics of the value-added tax (VAT) argue that we are likely to end up with both the current tax system and a VAT on top of it, making the tax burden larger than it currently is. Is that argument correct? Does a similar argument apply to the X tax?
Replacing the income tax system with an X tax would boost saving, which would increase the capital stock and promote long-run growth.
AV: A VAT or a retail sales tax would be regressive. As a result, complete replacement of the income tax by a VAT or retail sales tax would significantly shift the tax burden toward those who are less well-off, which makes such a replacement difficult to adopt. Instead, a VAT or sales tax would likely be added on top of the income tax system, although the income tax might be scaled back to some extent when the new tax was introduced. The availability of another revenue source would make it harder to control government spending.
In contrast, the X tax is progressive, so complete replacement of the income tax by the X tax would not shift the tax burden toward those who are less well-off. The X tax can and should be adopted as a complete replacement of the income tax system.
NS: Do you have a view as to the proper level of tax revenue (and by extension, the proper level of federal spending) as a percentage of GDP?
AV: Under current policies, medical cost increases and population aging will trigger a steep increase in federal spending on Medicare, Medicaid, and Social Security. If those policies are not changed, federal tax revenue will ultimately need to soar far above its recent average of 18 to 19 percent of GDP in order to cover these costs. To promote economic growth and limit the size of government, we must make policy changes to significantly restrain those programs’ spending growth. Even with spending restraint, though, I expect that revenue will need to rise over the upcoming decades to 21 percent of GDP or so. Such a revenue increase will be much less harmful if we raise the revenue from the X tax rather than from the inefficient income tax system.
NS: The X tax was originally proposed by David Bradford. Please tell readers who Bradford was.
AV: David Bradford was an eminent public finance economist at Princeton University’s Woodrow Wilson School of Public Policy, who wrote prolifically about consumption taxation and a wide range of other tax policy issues. He received his PhD in economics from Stanford University in 1966. He served in government twice, as deputy assistant secretary for tax policy in the Treasury Department from 1975 to 1976 and as a member of the president’s Council of Economic Advisers from 1991 to 1993. He was also an adjunct scholar at AEI. His books included Untangling the Income Tax, Fundamental Issues in Consumption Taxation, Taxation, Wealth, and Saving, and The X Tax in the World Economy. His tragic death from a fire in his home in 2005 deprived the economics profession of a great thinker. Like many other public finance economists, I have been strongly influenced by Bradford’s tax policy insights.
FURTHER READING: Viard also writes “The Capital Gains Preference: Imperfect, but Useful,” “True Entitlement Reform Will Hit Upper and Middle Classes,” and “Should Groceries Be Exempt from Sales Tax?” Alex Brill contributes “Understanding Tax Fairness (and Why the Buffett Rule Is a Distraction).” Aparna Mathur describes “How Taxing the Rich Harms the Middle Class.”
Image by Darren Wamboldt / Bergman Group