Growth versus class warfare in the tax system debate

"Don't tax you, don't tax me.  Tax that guy behind the tree."
—Russell B. Long 

It should be obvious by now that no tax rate increase is necessary to "fix" our current fiscal situation; economic growth is making the deficit disappear.  The economy should soon be growing faster than the debt, which will make the debt clock (at upper right) tick backwards.  The power of economic growth, I hope by now, is unarguable.   

How might our leaders enhance the private sector's ability to grow the economy?  Growth-minded people invariably agree that one of the biggest obstacles to growth is the complexity of our tax system; simplification, one way or another, would be very growth-friendly, for about a million reasons. 

Unfortunately, growth-friendly tax simplification ideas face formidable political opposition, fueled by extremely effective class warfare rhetoric.  Although there are several proposals for simpler tax systems (e.g., single- and dual-rate flat tax, sales tax, and others), the single rate flat tax proposal will serve as a good example of how we might overcome the stalemate and rid ourselves of the status quo tax system we're saddled with.  Here's the single-rate flat tax example...

Proponents of a single-rate flat tax lead with their strength: simplicity. 

It's so simple, all it takes is a postcard-size form to do your taxes each year.  All income over and above an exempted amount is taxed at the same flat rate, no matter how much you make and no matter who you are.  The private sector can stop wasting resources on tax compliance and redirect those resources to innovation, job creation, and growth.  Because every taxpayer pays a single marginal rate, the divide-and-conquer class warfare strategy would no longer be available to tax-hiking lawmakers—because a rate increase would affect every taxpayer, not just a small fraction of them.

Opponents immediately counter with their strength: class warfare. 

Tax system fairness requires progressive tax rates, not a flat rate; the rich can and should pay a higher percentage.  A flat tax would cause a huge shift of the tax burden from the rich to the middle class and poor.  Besides, a flat income tax does nothing about the regressive payroll tax, which is especially unfair to the non-rich.  We will fight the flat taxers with everything we've got, to protect the middle and low income taxpayers, and make sure the rich are shouldering their fair share of the tax burden.

History tells me that this particular duel is a stalemate.  Result: We are still saddled with the status-quo.  But I strongly dislike the status-quo, and prefer a more growth-friendly, special-interest-unfriendly taxation system, so I took some time constructing the beginning of a compromise that would address most of the purported concerns against the idea. 

The basic idea of the compromise is to retain the growth-friendliness of the proponents' ideas while deflating the opponents' purported objections.  For starters, we need to include the payroll tax in the analysis instead of isolating just the income tax.  Here's a chart showing total tax dollars paid by a self-employed individual for various levels of taxable income (note the hypothetical income tax scenario at bottom of chart):

The higher one's income, the more tax one pays.  No surprise there.  But look at the bend in the payroll tax line.  That's where the FICA tax stops, even though the Medicare tax keeps going.

Now the bad news: look at how that translates into effective tax rates.  Although the effective rate on the so-called flat income tax is progressive, due to the exempted amount, the regressive payroll tax drags the total tax into a regressive shape.  As history has demonstrated, that is politically untenable. 

If growth-minded people can't think of a way to fix the total-tax regressivity, we might as well get used to the status quo.  I don't care how good the economic argument might be, because politics trumps economics.

But guess what: I thought of a way to fix it (...and yes, it requires a change of thinking on both sides).  To get the desired flat rate on the income tax side (above the exempted amount), replace the payroll side's regressive rate with a revenue-neutral, reduced flat rate that never runs into a cap.  Here's the result (for the hypothetical scenario):

The entire system is progressive, because the payroll tax is no longer regressive; admittedly, we'd have to reconstruct the explanation of FICA taxes paid in versus SS benefits paid out, but that was coming our way within a decade or two anyway.  Is the system not progressive enough?  Okay, then tweak the exemption amount to adjust that.  Still not progressive enough?  Okay, then think up a rebate scheme on the spending side of the budget.  Just do something, because the additional growth this would foster would pay for any transition headaches many times over.

Last but not least: My fear
The above measures are economic remedies for the purported flaws in the single-rate flat tax system chosen for this illustration.  What I fear is that the true agenda of the opponents of tax simplification is not above-board economic concerns, but hidden political concerns.  A simplified tax system would shift power from favor-dispensing lawmakers to a huge, unified block of private sector taxpayers, all of whom pay a single flat rate (above the exempted amount).  That would be a double-whammy to power-broker politicians experienced in working today's complex system: it would mean (1) more difficulty dispensing tax goodies to special interests; and (2) more resistance to any proposal to increase the single tax rate (i.e., all taxpayers, not just a small group, would protest).  That's a double-whammy that many politicians would find impossible to take.  But at least we'd flush out the true agenda by proposing the compromise, wouldn't we? 

==========
End note:
I've been writing for years about why growing incomes and productivity are so important to our economic future; it's time I started addressing how our government could help the private sector enhance our country's economic growth rate.  This is the first article in a series I've been planning on the subject of taxation systems.

Comments

[Stephen Reed]

The most difficult part of our current tax system is figuring out "taxable income". Once you have that amount, figuring out the tax owed is rather simple.

And let's face it, it will not be politically tenable if people can no longer get their special deduction/credit for their child, for child care, for college expenses, for their mortgage interest, etc. While we would be all better off if these were all eliminated, our special interest society makes it seem unlikely for that to happen as no one will want to give up their favorite deduction. People have a high incentive to advocate for a tax-break that directly favors them and little incentive to actively advocate for deduction that they do not use to be eliminated since the cost of each individual deduction is small for such a person.

Additionally, other complex areas of tax law deal with corporations and partnerships. The way that the basis in assets is determined can be rather complex and detailed. You need to know the basis to determine what the income is once you sell an asset, such as a partnership interest.

For these reasons, I think by far the best tax for the country would be a national sales tax with a flat monthly sales tax rebate. To make it more progressive, you increase the sales tax rate and also increase the flat monthly sales tax rebate.

[TDM]

Just think of how much we could increase growth if we could liberate all that premium human capital to do something productive rather than tax accounting, planning, evasion, and enforcement.

Even more simple than a flat tax is selling bonds. We can collect several percent of GDP with just a computer to run an exchange and calculate interest. All of it collected voluntarily from those who can afford it.

[mark]

Steve,
This is by far the best post I have seen on the subject of the flat tax. Most proponents of the flat tax want to leave SS as a separate issue. The reason is quite obvious in your effective tax rate graph; the middle class would have a higher tax rate (just what Steve Forbes would love).
About a month ago I posted suggesting eliminating all income taxes (including SS and medicare) and going with a flat (or slightly progressive) labor tax on business. Most responses said it was a dumb idea. But I ask the following question. If an employer paid an employee lets say $80 and the government $20, what's the difference if the employer paid the employee $100 and the employee had to give the government $20? Both cases have the same end result (employer pays out $100, employee gets $80 and govt gets $20). In case 1 the employee gets paid a set amount (hopefully market driven) and cannot complain about taxes because they are not paying any (income tax anyway). In my opinion, who pays the tax (employee vs employer) is arbitrary. Making the employer pay the tax makes it simple without the complaining. Do you see any problems with this idea Steve?

[Joe C.]

The problem with any income based tax system is that of free-riders. As it is, the bottom 50% of earners pay next to 0 in taxes, therefore, they are very susceptible to the class-envy arguments and have no incentive to support pro-growth legislation - apart from EITC, they cannot benefit any more. They're incentive is to vote for further redistribution of wealth schemes since they have no other financial stake. The "rising tide" argument is lost on them. The goal should be to re-empower this 50% so that they have an economic stake in their revealed preferences (votes).

In the current system, the AMT should be on the bottom 50% who should be required to pay something, and should not be desensitized to the effects of their choices. This is why the "regressivity" of broad-based taxes like those on gasoline and state and local sales taxes are more politically sensitive and change less frequently and by minimal increments.

A completely consumption-based tax scheme would do this as well as incentivize productivity rather than penalize success, eliminate free-riders (for the most part), and retire the dead-weight losses associated with the current tax code. Until everyone has a stake in pro-growth policies, the political dynamic will not change.

[Bob]

Steve,

Your fear is understandable, indeed grounded in what I consider the problems we are facing to be beyond the capacity of our politicians to solve.

And, I suggest, the citizenry is too pampered and simply does not have the will nor the knowledge to tackle what lies ahead.

My predictions:

Unless a dramatic change occurs between now and the presidential election we will have a Democrat in the White House. I'm not sure about the make-up of Congress.

In three years we will have Universal Health coverage.

Corporate and high earner tax rates will increase after 2010.

There will be no meaningful energy plan in the near term (0-6 years).

We will continue to limp along with 2.5% real GDP growth. Somehow.

It's a rather pessimistic outlook, I concede. My premise is that humans, especially large political bodies, do not accept change until
the pain gets too great. We simply have not suffered enough pain. For proof of this hypothesis look back to when Reagan won in a landslide. Inflation was killing us, unemployment was double what it is now, Iran still had our people as hostages..we were in the tank and in pain.

I wish I were as optimistic as you.

[Jim]

Mark - The issue I'd see with the employer paying the tax is in the political reality that certain businesses will find a way to lobby for a tax cut on their business or industry, while the rest will have to foot the bill. Who could really blame them in looking for a competitive advantage? With the tax paid by individuals, it is harder for one group to lobby for an exemption.

Steve - Interesting plan, and a good analysis of the flat tax schemes. I agree that tax reform could be a great stimulus for growth by freeing up those compliance costs for more innovative purposes. I think you pointed out the big flaw with your plan in this comment: "admittedly, we'd have to reconstruct the explanation of FICA taxes paid in versus SS benefits paid out". FDR himself supposedly said: "I guess you’re right on the economics. They are politics all the way through. We put those pay roll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program. Those taxes aren’t a matter of economics, they’re straight politics.” If you removed the contibution limit, it seems to me that SS would become more of a means of income redistribution, not just a guaranteed retirement income, unless you did as you said and modified the contribution versus benefits. Unfortunately, it doesn't seem likely that we'll see a plan that people will get behind. They'll say, "we're giving all the SS benefits to the rich" and vote it down without mentioning that they intend to take a lot more money from those rich people.

[Mike H]

I'm really looking forward to these future articles Steve. I've been wondering for a while what exactly the government could do to actively spark growth. I knew it must be able to do something, but I was having trouble coming up with it on my own.

Bob- I'm afraid I agree with your prediction. If Universal Health Care is inevitable then I wish we could come up with the most economically viable way of doing it. I really REALLY don't trust our politicians with my health, any of them. But I can't help but believe there would be a good way to do it. I'm open to it, but it's one area where I lack much optimism. Still, to do anything that drastic, they are going to need 60 votes in the Senate, and I'm always thankful for that.

[Bob]

Mike H.

What I have learned is that if something has a high probability of happening, like single payer health insurance, we may want to focus our energies on how to make it as palatable as possible instead of fighting it. I know that may sound defeatist and I am so against it...but we only have so much energy and time. Lord knows I've fought many a wrong battle in my life.

Back to the idea of simplifying the tax code. Simple and government is a classic oxymoron. Steve, had a very strong view on the last immigration bill. However, it was anything but simple. In fact, it was incredibly complex. Why should the tax code be any different? It's brought to you by the same people.

[Steve]

to Jim:

"FDR himself supposedly said: 'I guess you’re right on the economics. They are politics all the way through...'"

That is a terrific quote; I assume it was an indirect recollection by someone. Do you remember where you read it?

Thanks for posting that.

[Jim]

Steve,

It is a recollection recorded in a memo by Luther Gulick of FDR's words.

www.socialsecurity.gov/history/Gulick.html

[Steve]

Thanks a lot, Jim. That just about says it all.