Tax Reform: What It Ought to Look Like
Congress is currently bogged down in discussions over the fate of the twin tax reform bills passed by the House and Senate respectively.
Conservatives complain that the bills as written will substantially increase the federal budget deficit. Liberals complain that the burden of tax cuts for corporations and high-income Americans will fall primarily on the poor.
The debate reminds me of a lecture I attended when I was taking classes at the Vienna University School of Business and Economics for my LL.M. degree in international tax law.
Our professor quoted Jean-Baptiste Colbert, the finance minister for French King Louis XIV. Colbert declared that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”
The professor also observed that an ideal tax system combines relatively low rates with a variety of revenue sources. If revenue from one tax goes down, revenues from other taxes will make up the difference. Relatively stable funding sources also give legislators the ability to set budgets with confidence.
Keeping these ideas in mind, what would the “perfect” tax reform bill look like?
Lower corporate rates. The US imposes the highest taxes on corporations of any country – a top rate of 39%, including federal, state, and local taxes. The tax reform proposal working its way through Congress lowers corporate tax rates to 20%. I think that’s a step in the right direction.
Opponents of the proposal claim that the lower rates will lead to lower tax revenues, but I don’t agree. Lower rates will mean corporations will be less likely to engage in complex planning to reduce taxes. Many companies will simply pay the tax, rather than park their profits in subsidiaries in low-tax jurisdictions.
Another argument against decreasing corporate tax rates is that it’s unfair to the poor. But that claim falls apart when you look at the facts. Of course, corporations pay corporate tax to the federal government. But in reality, shareholders, workers, and consumers bear the costs. Shareholders must accept lower dividends and lower share prices. Workers must accept lower wages, and consumers must accept higher prices. But economic research suggests that workers take a much bigger hit than shareholders and consumers. High corporate tax translates to lower wages. With lower corporate taxes, more money will be available to pay workers.
Territorial tax system. In a territorial tax system, an individual or company pays tax only on domestic income. And income generated outside the country where you live or where your business is incorporated is tax-free.
Currently, the US taxes both US-resident individuals and companies on their worldwide income. In addition, US citizens living in other countries must pay US income tax on their worldwide income as well. This is an almost unique system known as citizenship-based taxation (CBT). Only one other country – the totalitarian dictatorship of Eritrea – shares this tax system.
The tax bills before Congress would move the US corporate tax toward a territorial model. Most profits generated outside the US would be tax-free. A 12.5% tax would apply to profits from intangible assets such as patents and royalties earned by non-US subsidiaries of US companies. US corporations would also pay a 10% tax on money shifted to non-US subsidiaries.
This is a step in the right direction, but it should be combined with an end to CBT. This change would have very little impact on federal revenues, because the vast majority of the 9 million US citizens living overseas already pay tax in the countries they live in. Indeed, the most popular countries for Americans to live in (Canada, Mexico, the UK, and Germany) all have personal income tax rates as high or higher than the US.
Ending CBT will make it far easier for these individuals to fit into their adopted countries. And Americans would no longer need to give up their US citizenship in order to stop Uncle Sam from taxing their non-US income.
Flat personal income tax. More than 40 countries have imposed some variation of a flat tax on personal income. For the most part, these systems have worked well. Hong Kong, which gives individuals the option of paying a flat rate of 15%, is among the world’s most prosperous societies. Even Russia has enacted a 13% flat tax on personal income!
Back in 1995, presidential candidate Steve Forbes proposed a flat tax. When detractors claimed the idea would take away popular tax breaks, Forbes proposed giving taxpayers the choice of paying a 17% flat tax or file under the current Tax Code.
The primary benefit of a flat tax is simplicity. Even the IRS admits that its agents don’t understand the rules. US taxpayers spend 6 billion hours annually completing tax forms and spend more than $200 billion annually to comply with the Tax Code. Meanwhile, the Tax Code and the rules interpreting it grow ever longer and more complex – more than 10 million words in all.
By reducing the number of tax brackets from seven to four, the proposed tax bill is a step toward a flat tax. The House plan would lower the top bracket to 35%. The Senate plan would keep it at 39.6%. A true flat tax would be better.
Value added tax (VAT). Lower corporate taxes, a territorial tax system, and a movement toward a flat tax system would greatly simplify tax compliance. But it wouldn’t solve a fundamental problem that is growing more serious every day: an ever-growing federal deficit, now totaling more than $20 trillion.
Like most libertarians, I’d prefer to deal with the soaring deficit with spending cuts. The bloated military-industrial complex would be my first target, followed by entitlement reforms. But politically, that’s not likely to happen.
For that reason, I’d be willing to consider a VAT. A 10% VAT, for instance, is estimated to raise about 3% of US GDP – about $570 billion annually. The US is the only Organisation for Economic Co-operation and Development (OECD) member that does not collect a VAT.
There’s no mention of a VAT in either the House or Senate plan. That’s unfortunate, because a VAT is the least economically harmful way to raise enormous amounts of revenue. The tax is applied only to consumption; it doesn’t frustrate savings or investment. Thus, it doesn’t hamper economic growth.
Some conservatives hate the idea of a VAT because it is an “automatic” tax that will send hundreds of billions of dollars into the US Treasury, and liberals will spend that money immediately. Liberals hate it because poor people pay the same rate as wealthy people. However, it would be possible to tailor the VAT to exempt groceries, prescription drugs, and other basic necessities. But of course, the more exemptions, the more complex the VAT regime would become, and the less revenue it would raise.
Ultimately, Congress will decide which feathers will be plucked as it debates tax reform. And inevitably, the hissing will continue.
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