Chapter XII: Taxes and Tax Reform

This is the twelfth chapter in Equity and Equilibrium: The Political Economy of Distributism. The draft of each chapter is posted as it is written, in order to get some help form my readers about what works and what doesn't. All comments and critiques are welcome.

The Fourth Factor

Thus far, we have been speaking of economics in terms of three factors of production, land, labor, and capital. This way of speaking has a long tradition in economics, but in fact there is a fourth factor: government. Production takes place within a framework of laws, institutions, and improvements such as roads, schools, airports, coinage, national defense, courts, etc. There are those who claim that these things can be provided apart from government. That may indeed be true, and for some things it must be true. However, since it has never happened, in all of human history, that all of these things were supplied apart from the government, we have no such systems to examine, and hence we can safely leave that argument to the higher realms of economic speculation, and concentrate on what actually occurs in the real world.

Are Taxes Theft?

Unfortunately, all of these things have a cost and need to be paid for. Typically, they are funded through taxation. “All taxes are theft” proclaim certain libertarians. Perhaps. But the claims would have more force if libertarians would refuse to call the police when their homes have been robbed, or the fire department when they are burning. One could say that this holds the libertarian to too high a standard, since we must all live in the world as it is and obey its rules. But since we do live in the world, we must pay for the services we consume; this is not theft, it is simply being an adult.

Nevertheless, even if we cannot agree that all taxes are theft, we might agree that most taxes are, or at least are ill-considered, poorly administered, unfairly allocate the burdens of government, negatively impact production, are expensive to administer, intrusive into the private life of citizens, and a host of other complaints as well, all of which are valid objections. From both the right and the left, we have a near-unanimous consensus that something is wrong. Unfortunately, they cannot agree on just what is wrong. Reform proposals abound, but none have sufficient political support to gain any traction. The major disputes concern two issues: the progressive nature of taxes (whether those who make more should pay a proportionally higher rate) and the whether income from capital ought to be privileged over income from labor, or even whether such income should be taxed at all. On the left, the principles of progressive taxation and the taxing of capital are generally agreed upon, and reform is simply a matter of adjusting the existing code to realize these principles more perfectly. But on the right, there are at least two proposals which eliminate or seriously compromise the progressive nature of income taxes and reduce or eliminate taxes on capital income. These proposals are called the flat tax and the fair tax. Examining these proposals will give us some insight into the nature of income taxes.

The Flat Tax

The flat tax replaces the current graduated tax rates with a single tax rate applied to all incomes. The rate is designed to be “revenue neutral,” that is, to raise the same amount of money for the government that the current income tax does. And if that were all it was, the debate would be confined to the question of whether taxes ought to be “progressive,” that is, whether those with a higher income ought to pay a greater share of that income. However, most flat tax proposals go far beyond this to radically redefine the very notions of income and cost accounting.

The flat tax would have a single rate, usually about 17% in most proposals, and also eliminate all deductions, except a standard deduction, usually about $12,000 for each adult and $6,000 for each child. Proponents of this plan say that all the complex tax forms can be reduced to two postcards, one for individual payers and another for businesses. The individual postcard would simply have a line for “income,” a line for the standard deduction and another for the 17% tax rate. The business postcard would have a line for revenues, another for cost of goods sold, and any positive difference between the two would be taxed at 17%. The business taxes would exclude income from interest, dividends, rents, and capital gains. Proponents believe that they can get the nine-million word tax code down to a few pages. It should be pointed out that the “postcard” form for individuals already exists, the 1040EZ, which although it is not printed on a postcard, could be and still remain legible.

The first problem with the flat tax is that it only replaces current income taxes, not the Social Security and Medicare taxes. These taxes come to 15.3% when the employer's contribution is considered. Therefore, the average worker will have all of his income taxed at 15.3%, and any amount over the standard deduction taxed at a total of 32.3%. This is close to the 35% currently paid by those with the highest incomes on the last portion of their income. Further, since the wealthy earn a higher proportion of their income from interest, dividends, rents, and capital gains, a large portion would not be taxed at all. The result would be a massive shifting of the tax burden from the rich to the middle class; people at the bottom would continue to pay the FICA taxes, as today, the people in the middle would have their total tax increased to 32.3%, and the rich would see their taxes substantially lowered or eliminated entirely. To put it another way, the rich will pay approximately what the middle class now pays, while the “middle class” (defined as anybody making more than the poverty level) will pay a marginal rate equal to what the rich now pay. And those among the rich whose income is completely from capital (dividends and interest) will see their taxes abolished entirely; they will be “taxed” as if they were desperately poor, at a 0% marginal rate.

Indeed, any “revenue neutral” scheme can only shift taxes, not lower them, by definition. If everybody pays the same rate, and if that rate raises the same revenue as the current system, then some must be paying more and other less. Proponents of the flat tax counter that fairness demands equality under the law, while opponents argue that fairness demands a higher rate from greater incomes. But whatever the outcome of the moral argument, the economic argument is dubious. The poor and middle class would lose precisely what the rich will gain. The resulting reduction in the take-home pay of the average worker must have a negative impact on aggregate demand. The rich simply cannot spend or invest their increased incomes fast enough to make up for the losses in wages. This is a phenomenon known as the velocity of money. Money simply moves faster (is more efficient) at the lower end of the income scale. For example, if you give a dollar to a poor man, he immediately takes it to lunch, or spends it to fulfill some other pressing need. But if you give the same dollar to Bill Gates, he doesn't know what to do with it. It fills no immediate need and takes a long vacation before it does any work. During that vacation, it represents purchasing power lost to the economy.

But that is not the only problem with this scheme. The two real problems are, one, the flat tax radically changes our notions of financial accounting, and; two, it conflates “exemptions” with “loopholes.” To take the latter problem first, an “exemption” is some provision in the tax code that allows a person or firm to deduct some specific expense, such as charitable contributions or mortgage interest, from their income. There are thousands of these exemptions in the tax code, most of which benefit some preferred business group. But while an exemption is something specifically addressed in the tax code, a loophole is just the opposite: it deals with situations that are not addressed in the code, but which arise in real business situations and about which the taxpayer is allowed to make his own ruling, a ruling he usually makes in his own favor. There are excellent arguments for eliminating all or most of the exemptions; there are no good arguments for multiplying loopholes. Exemptions are eliminated by repealing portions of the tax code, but loopholes are eliminated by adding to it. The fair tax proponents want to “slim down” the 60,000 page tax code to a few pages. But while this will eliminate all the exemptions, it will multiply the loopholes exponentially.

Why? This brings us to the first issue, the treatment of revenue, expenses, and income as simple and uncomplicated notions. But this is not so. If you ask an accountant how to compute a firm's expenses or income, and they will point you to the Financial Accounting Standards Board's rulings, which run several volumes, and which are always growing as new situations arise. No tax code that deals with income can be any shorter than the Generally Accepted Accounting standards, and in fact must be some multiple of them, since the accounting standards allow wide latitude in the choice of methods, a latitude that would simply allow businesses to choose their reported income, which would, in effect, abolish any tax on business. Income taxes can only work to the extent that they are intrusive and complex, and any attempt to “simplify” them turns the tax code into a series of loopholes that benefit mostly the rich and shift the entire burden of taxation onto labor.

The fair tax plan also makes some other rather odd changes to financial accounting. All capital expenses would be 100% deductible in the year they were made, rather than amortized over the life of the capital goods purchased. This, in effect, converts financial accounting from an accrual basis to a cash basis. In fact, the flat tax as it applies to business is really a cash-flow tax rather than an income tax. A business would pay no taxes on its investment income, but interest expense would not be deductible, which sounds bizarre. Equally bizarre is the provision that payments for “fringe” benefits, including the employer-paid social security tax and health insurance, would not be deductible. This would force these payments to be made as “wages” and therefore taxable to the employee at the 32.3% rate. It is hard to interpret this provision as anything but a direct and gratuitous attack on labor.

The “Fair” Tax

If incomes cannot be taxed without an intrusive and complex code, what about consumption? This is the idea behind the so-called “fair” tax, which is actually a National Sales tax of 30%. Unlike the flat tax, this tax would replace all income, social security, and medicare taxes, and would be levied on purchases of new goods and services by all consumers and governments. Business purchases would be exempt. “All” purchases here means just that: cars, homes, medical services, drugs, food, insurance policies, etc.

Since a 30% tax would cripple the poor, a monthly “prebate” would be given to all citizens, equal to a “consumption allowance” calculated to be near the poverty line. For example, a single person would have a consumption allowance of $10,400/year, and 23% of that amount would be “prebated” to him on a monthly basis at a rate of $199/month. A family of four would get a prebate of $567/month. This amount would go to all citizens, whether they were poor or not; everyone would be on the welfare system.

Fair tax proponents believe that the entire Internal Revenue Service and its army of agents could be eliminated because the current state sales tax agencies would collect the tax. They argue that the accounting expenses of the tax code would be eliminated, prices would go down because there are no tax expenses on production, that there would be no deductions on paychecks so that workers would keep all that the earn. Further, the proponents claim that there would be no room for fraud. All of these claims can be easily shown to be false or even fraudulent.

The first problem is that fraud would be rampant, and the new system creates many opportunities for fraud. The first opportunity is that all business purchases are exempt. But since the elimination of the income tax means that businesses no longer report their incomes to the government, everybody will want to declare themselves a “business” and exempt all of their purchases. Without auditing their books, it will be impossible to know whether or not they really are a business or just a tax dodge. In order to prevent such fraud, you would have to have a reporting system similar to the one that is already in place. The second opportunity for fraud comes from legitimate businesses converting all of the living expenses of their owners or employees into business expenses, thereby making them exempt from the tax. Without auditing their books, it will be impossible to say if the expense actually is a business or a personal expense. The third source of fraud comes in the exemption for “used” goods. The plan does not define a “new” and “used” good, nor the method to distinguish between the two. The simplest way would be to define a “used” good as something upon which the tax had previously been paid. But this would require an enormous record-keeping system, and the system would be easy to avoid. For example, suppose a builder had a new home valued at $300,000, upon which a tax of $90,000 would have to be paid, for a total price of $390,000. Instead, he “sells” it to a confederate for $100,000 plus the tax, now $30,000. Now he has a “used” home, and can sell it for what he likes with no tax He sells it for $360,00, pays his confederate a commission, and undersells his competition by $30,000. But the biggest source of fraud would be in false identification papers. Since every citizen is entitled to a prebate, the traffic in manufactured id's will be tremendous. No self-respecting crook would be without at least ten social security cards, and the prebate that goes with them. Short of the establishment of a police state, it would be impossible to monitor all citizens closely enough to see if they were real persons or imaginary ones.

Nor would this proposal eliminate the IRS. On the contrary, it would vastly expand its powers. It is true that most states have a mechanism for collecting sales taxes, but they all operate under different rules. And no state has a sales tax that intrudes into the doctor's office, home sales, insurance payments, and every other possible purchase. All 50 state departments will have to be put under the direct supervision of the IRS. Further, and a vast welfare apparatus will have to be created to pay the prebate, a welfare department that will cover every citizen, whether real or fraudulent. This would constitute the largest expansion of government intrusion into the life of its citizens since the establishment of the income tax itself.

The proponents of the fair tax claim that pre-tax prices would go down by an amount equal to the tax itself, since businesses would no longer be paying any taxes. But it is not at all clear that this would happen. Certainly, some prices would go down, for items made in this country by firms in highly competitive markets. But this is hardly true of all products, or even most of them. For example, it will have no effect on the price of oil; the Arabs will not give us a break because we have an unreasonable sales tax. Indeed, it will have no effect on imports in general, and they are, alas, a large part of our consumption. In truth, nobody can know what the effects of such a tax would be, because it constitutes the biggest government intervention into free-market pricing ever contemplated since the Russian Revolution; we simply have no experience to guide us in assessing the effects of such a massive intervention.

One cost that would go up under the fair is the cost of state and local government. This is because government purchases are taxed under this plan. And these governments, unlike everybody else, are not likely to engage in tax dodges. Now, at the federal level, this makes little difference; the government both pays and collects the tax; there will merely be some additional bookkeeping costs. But state and local governments will have to raise property and other taxes to pay for the 30% increase in the cost of their purchases.

Finally, for people who must consume all or most of what they make, a sales tax is the equivalent of an income tax; all of their income must be converted to purchases. Every dollar earned beyond the poverty rate will be taxed at 30%, a rate near what the rich pay on their last dollar earned.

Is Reform Possible?

I could offer further critiques of both of these tax plans, but the more interesting question is why two such obviously flawed—indeed, harebrained—tax schemes could generate such support and loyalty. Part of the reason is ideological. People raised on standard economic theory tend to believe that it is wrong to tax capital in any way; they have been taught that capital is the driver of growth, and taxes on capital limit growth more than any other tax. Hence labor, and labor alone, must bear all the burden of taxation. Whatever the differences in these plans, this is the one point upon which they agree. Now, it is certainly true that a tax on anything limits that thing. Hence, a tax on capital limits capital formation (to what degree, however, is debatable). However, a tax on labor limits labor, and labor, not capital, is the true source of all economic values. To limit labor is, therefore, to eventually limit capital formation; the two have the same source.

The second reason is that people are genuinely disgusted with the intrusive nature of the income tax and the government bloat that seems to accompany it. All of our financial dealings must be reported to officers of the state, which is sure to make us all uncomfortable, even when we acknowledge the necessity of paying taxes.

The third reason is that people see the tax code as nothing but a network of loopholes, a veritable tunnel system that allows the rich and well-connected to get around any meaningful taxation, and they believe that these systems will somehow change that. Of course, the “reforms” will just make this worse, but it is the perception rather than the reality that counts in politics.

If the flat and fair taxes are not a practical basis for tax reform, are we limited to fiddling with the various rules and rates that make up the current codes? We have seen this kind of “reform” for the last 30 years and especially in the last eight. The results have not been encouraging. Even in the so-called “recovery,” growth rates were sluggish and seemed to be driven not by any real growth, but by a mere credit bubble in housing, a bubble that is now collapsing with disastrous consequences. Indeed, during this time, the median wage actually fell. And above it all, the debt of the United States is expanding at a dangerous rate, a debt that whose interest now comes to $429 Billion per year and rising.

If the Republican plan has been a disaster, will a “reform” in the other direction work? Obviously, it will work as well (or as poorly) as it worked in the past. These reforms generally have the effect of broadening the tax base to include more capital income, and redistributing that income. This has the effect of giving a slight preference to labor, or would if all the odd exemptions are eliminated.

All of these debates center around the question of whether capital or labor should get preferential treatment. But is this really a rational question? On the one hand, it seems bizarre to tax the labor of a man who digs ditches for a living, while exempting the “labor” of another who only clips coupons. On the other hand, if the bonds that the coupon-clipper clips represent savings from his past labor, his prior-period ditch-digging, why should he be penalized in any way? So the real question is, “Should labor and capital be taxed at all, or, if they are, should the be the primary source of government revenue?”

From our current perspective, this question is astounding. Income taxes are the mainstay of the federal budget, most state budgets, and even many city budgets. Could these taxes be abolished or significantly reduced without wrecking all public finances? What could possibly replace them? However, income taxes are not a constant in human history, nor even in American history. The founders recognized the possibility of an income tax and and prohibited them in the constitution. It was not until the 16^th Amendment was passed in 1913 that the tax had a legal basis. The tax was originally 7% of incomes over $500,000, an enormous sum in those days that would likely have affected a few hundred persons at most. Therefore, the income tax was really on tax on concentrated wealth. But under the pressure of war, debt, and depressions, the rates went up and the minimum income level went down, so that it quickly became a labor tax.

Historically, such taxes have always been regarded as suspicious, or even a sign of oppression. In 1381, for example, when Richard II imposed a poll tax (essentially, a labor tax), the result was Wat Tyler's rebellion, which gathered widespread support across England and quickly captured London and the King. Tyler nearly succeeded in establishing a republican form of government in England centuries before it actually happened, and would have done so, had not Richard reneged on the promises he was forced to sign and had Tyler killed after his army disbanded. Would that we were as conscious of our rights as were the medieval peasants.

But if we exclude or severely limit these taxes, what is left? An age that requires battleships for defense and freeways for transportation might be somewhat more expensive to run than 14^th century England. How will we finance such things? That question can only be answered if we first answer some questions about the scale and scope of government, and the government's role in producing the wealth and prosperity that we all share, or wish to share. These questions are the subject of the next chapter.