Tax Policy @ OptimalPortfolio.net

Negative Income Tax has been proposed as a solution to the regressive nature of flat taxes (whether on income or consumption). There is a great deal of debate on this topic and I don’t presume to have a definitive answer.

Business may object to a consumption tax because it will increase the apparent cost of products purchased, even though consumers will have more money in their pockets as a result of simultaneously eliminating the withholding tax.

If business doesn’t rail at a consumption tax because of the apparent cost increase, they’ll certainly object to the used goods loophole because it expands the price gap between new and used goods.

Paranoid members of the business community may object to taxpayers having more money in their pockets and an indirect incentive to save because some of those consumers will use accumulated savings to start small businesses which will increase competition for existing businesses. And, they’d be right – one hope of consumption oriented taxation is that the economy will eventually see an increase in capital reserves, hopefully a consequent improvement in robustness (stability), and possibly an increase in new business formation.

The used goods loophole is intended to give low income taxpayers a means of paying less tax. A broader tax base will bring down the average tax rate for the middle class. The elimination of business expense deductions will mean that current pre-tax travel expenses will become taxable in a consumption tax regime. Yet, a flat consumption tax may still be too regressive to be palatable.

At least two solutions are possible: a negative income tax for those who wish to file (it really would be voluntary); and a reduction in government (the less likely alternative). Others?

Government’s usual answer to a shortfall in income tax compliance is to step up enforcement, yet no matter how effective enforcement could ultimately be, it will certainly involve increased cost and can’t ever be perfect. So you end up with ludicrous optimality condition where revenue from improved compliance is finally equaled by the incremental enforcement cost.

Taxes that require disclosure could lead to criminal prosecution for those that earn income from illegal activities, so they won’t file.   Similarly, illegal aliens risk deportation, so they can’t risk filing.  The net effect is therefore that income taxes effectively subsidize illegal activities, and transfer the burden from cash businesses (who can get away with declaring less) to salaried taxpayers (clerks, secretaries, school teachers, pharmacists, steel workers, …).

People that risk incriminating themselves by indicating their source of income generally don’t declare it, i.e. drug dealers (where the respective drugs are illegal), prostitutes (where prostitution is illegal), thieves, burglars, and bookies (where gambling is illegal). Illegal aliens also avoid paying income taxes because they don’t want to risk being deported. People with cash businesses often report less than they are actually taking in because there’s no hard evidence to the contrary.

Here’s a blog entry on How The Rich Avoid Paying Taxes on the Brookings Institution’s TaxVox blog indicating that 7,300 U.S. taxpayers earning $200,000 or more paid no income taxes whatsoever. Another 85,000 paid worldwide taxes amounting to less than 10% of their income. These figures underscore the argument for abandoning income taxes and all of its associated loopholes in favor of a fairer policy.

The TaxVox story is based on this blog entry: 7,389 Returns With Incomes of $200,000 Paid No U.S. Income Tax In 2005 on Stan Collender’s Capital Gains and Games blog.