Tax Policy @ OptimalPortfolio.net

With $150B+ in improved economic efficiency on the table and the potential for improved quality of life and better corporate returns, why haven’t legislators funded a study to replace income/capital taxes with consumption taxes? One justification might be that a $13.8T economy would only see a 1.1% improvement in efficiency by adopting consumption taxes. Legislators may believe that they have bigger fish to fry. On the other hand, giant economic entities, whether government or corporate, rarely get opportunities to improve efficiency by anything like 1% merely at the dash of a pen.

Another justification might be elasticity. If tax revenues were derived from consumer spending, revenues could take a hit if consumers lacked confidence in their future prospects. Governments that aren’t required to balance their budget usually print a bit more money during economic downturns. So how would that be different?

The real explanation is more likely to be soft money. Income tax credits and loopholes allow government to provide a boost to this or that special interest group by diverting revenue away from the treasury before it’s actually captured. The Internal Revenue Service is controlled by the Secretary of the Treasury, who reports directly to the President, which means that the executive branch can in a very real sense ‘fund’ special interests by exempting them from portions of their tax liability.

The point is that the legislative branch does not have a hand on the purse strings of soft money. If the federal government were to abandon income taxes in favor of a consumption tax policy, the executive branch would lose its control over soft money ’spending.’ Article 1, Section 8 of the Constitution grants the power to tax and spend to the legislative branch. We fought a war with King George over taxation without representation.

Tens of thousands of people fought and died to domesticate tax authority, yet soft money ’spending’ does an end-around the legislative branch, effectively crowning a new King, whose vast executive branch has the power to manipulate tax policy and soft money spending without a word or a wink from the legislative branch.

No president who enjoys the trappings of power is going to lobby for an end to soft money spending. Can we conclude that presidents in general are likely to veto a switch to consumption taxes because it would mean the end of their soft money authority?

Soft money is outside the legislative negotiation process, so no representative can be held accountable - blame is clearly within the executive branch. Even better than pointing fingers at the president, some civil servant deep in the bowels of the IRS is the ultimate culpable party for any unpopular ’spending’ program. The legislature gets off Scot-free and the president can rely on plausible deniability.

What were we thinking?

Needed… documentation of the size of each of the loopholes and the soft money ‘budget’.  Following are a couple of significant, yet accessible sources of information on abused income tax loopholes:

America: What Went Wrong? by Donald L. Bartlett and James B. Steele. 1992, Andrews McMeel Publishing. ISBN-10: 0836270010

America: Who Really Pays the Taxes? by Donald L. Bartlett. 1994, Simon & Schuster. ISBN-10: 0671871579

My general objection to tax loopholes is that they have the effect of reducing the tax burden on one class of citizens at the expense of others. Usually this means that the vocal or well organized minority opts out and the silent, poorly organized remainder carries the burden. The situation applies to subsidies as well as deductions and credits.

Naturally, the eventual result is increased complexity in the tax code and therefore increased compliance costs. However, a subtler effect is also at work - the opt out class is now silenced with respect to objections to that particular element of tax policy. By silencing objections from a minority, government is allowed to grow beyond the pain threshold of the population at large.

If one observes the high cost of government contracts relative to commonly available off the shelf prices (e.g. $160 hammers and $600 toilet seats), it should be obvious that government is not a value oriented consumer. Milton Friedman on government spending: “There are four ways in which you can spend money.

• You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money.
• Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost.
• Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch!
• Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.”

Conversion of capital into goods and services is optimized when income earners and consumers are one and the same. If taxpayers are to get the most bang for their aggregate buck, they should spend it themselves - a clear argument for a minimalist government.

Anyone that has an interest in limiting the growth of government might logically object to policies that allow tax rates to grow beyond the painful revolt threshold of taxpayers. Despite the obvious regressive impact, loopholes that effectively exclude classes of citizens from certain aspects of taxation should be limited because their adoption enables larger government and its associated inefficiencies.

If the number of citizens engaged in the tax policy debate is maximized, government will be forced to operate on a budget defined by the threshold of pain dictated by the poorest voters. Admittedly, this must sound absolutely awful from a socioeconomic perspective, but if one considers government as a living organism, striving to grow and dominate the economic landscape, it’s logical to conclude that such a constraint threshold might motivate it to improve the quality of life of the threshold class, thereby enabling its own growth. That should be the desired effect of government.

Further reading:

Seven Principles for Sound Public Policy

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?