Friday, January 22, 2016

Tax Oped -- full version

Source: Wall Street Journal
An Oped at the Wall Street Journal, "Here's what genuine tax reform looks like." I posted the teaser a month ago, now I can post the whole thing.

Left and right agree that the U.S. tax code is a mess. The men and women running for president in 2016 are offering reform plans, and proposals to fix the code regularly surface in Congress. But these plans are, and should be, political documents, designed to attract votes. To prevent today’s ugly bargains from becoming tomorrow’s conventional wisdom, we should more frequently discuss the ideal tax structure.

The first goal of taxation is to raise needed government revenue with minimum economic damage. That means lower marginal rates—the additional tax people pay for each extra dollar earned—and a broader base of income subject to tax. It also means a massively simpler tax code.


In my view, simplification is more important than rates. A simple code would allow people and businesses to spend more time and resources on productive activities and less on attorneys and accountants, or on lobbyists seeking special deals and subsidies. And a simple code is much more clearly fair. Americans now suspect that people with clever lawyers are avoiding much taxation, which is corrosive to compliance and driving populist outrage across the political spectrum.

What would a minimally damaging, simple, fair tax code look like? First, the corporate tax should be eliminated. Every dollar of taxes that a corporation seems to pay comes from higher prices to its customers, lower wages to its workers, or lower dividends to its shareholders. Of these groups, wealthy individual shareholders are the least likely to suffer. If taxes eat into profits, investors pay lower prices for less valuable shares, and so earn the same return as before. To the extent that taxes do reduce returns, they also financially hurt nonprofits and your and my pension funds.

With no corporate tax, arguments disappear over investment expensing versus depreciation, repatriation of profits, too much tax-deductible debt, R&D deductions, and the vast array of energy deductions and credits.

Second, the government should tax consumption, not wages, income or wealth. When the government taxes savings, investment income, wealth or inheritance, it reduces the incentive to save, invest and build companies rather than enjoy consumption immediately. Taxes on capital gains discourage people from moving or reallocating capital toward their most productive uses.

Recognizing the distortion, the federal government provides a complex web of shelters, including IRAs, Roth IRAs, 527(b), 401(k), health-savings accounts, life-insurance exemptions, and the panoply of trusts that wealthy individuals use to shelter their wealth and escape the estate tax. If investment isn’t taxed, these costly complexities can disappear.

All the various deductions, credits and exclusions should be eliminated—even the holy trinity of tax breaks for mortgage interest, charitable donations and employer-provided health insurance. The extra revenue, over a trillion dollars annually, could finance a large reduction in marginal rates. This step would also simplify the code and make it fairer.

Imagine that Congress proposed to send an annual check to each homeowner. People with high incomes, who buy expensive houses, borrow lots of money or refinance often, would get bigger checks than people with low incomes, who buy smaller houses, save up more for down payments or pay down their mortgages. There would be rioting in the streets. Yet that is exactly what the mortgage-interest deduction accomplishes.

Similarly, suppose Congress proposed to match private charitable donations. But rich people would get a 40% match, middle class people only 10%, and poor people nothing. This is exactly what the charitable deduction accomplishes.

Zeroing out deductions, credits, and corporate and investment taxes matters—for permanence, for predictability and for simplicity. If the corporate rate is drastically reduced, or if deductions are capped, it seems that the economic distortions go away. But the thousands of pages of tax code are still in place, the army of lawyers and accountants and lobbyists is still in place, and the next administration will itch to raise the caps, and the rate.

Why is tax reform paralyzed? Because political debate mixes the goal of efficiently raising revenue with so many other objectives. Some want more progressivity or more revenue. Others defend subsidies and transfers for specific activities, groups or businesses. They hold reform hostage.

Wise politicians often bundle dissimilar goals to attract a majority. But when bundling leads to paralysis, progress comes by separating the issues. Thus, we should agree to first reform the structure of the tax code, leaving the rates blank. We will then separately debate rates, and the consequent overall revenue and progressivity.

Consumption-based taxes can be progressive. A simplified income tax, excluding investment income and allowing a full deduction for savings, could tax high-income earners’ consumption at a higher rate. Low-income people can receive transfers and credits. I think smaller government and less progressivity are wiser. But we can agree on an efficient, simple and fair tax, and debate revenues and progressivity separately.

We should also agree to separate the tax code from the subsidy code. We agree to debate subsidies for mortgage-interest payments, electric cars and the like—transparent and on-budget—but separately from tax reform.

Negotiating such an agreement will be hard. But the ability to achieve grand bargains is the most important characteristic of great political leaders.

Mr. Cochrane is a senior fellow at Stanford University’s Hoover Institution.

30 comments:

  1. John,

    "The first goal of taxation is to raise needed government revenue with minimum economic damage."

    No.

    The first goal of tax reform should be to make fiscal policy independent of monetary policy. Meaning the federal government never borrows money under any circumstance.

    The second goal of tax reform should be to make tax policy more responsive to prevailing economic conditions.

    "Taxes on capital gains discourage people from moving or reallocating capital toward their most productive uses."

    I call bull for several reasons.

    1. As a shareholder of a company, you have a voting responsibility to make sure that capital is directed towards a productive use.

    2. In as much as capital gains are taxed, capital losses are tax deductible. And so by taxing capital gains and making capital losses tax deductible, the federal government performs a type of investment smoothing. The intent is to encourage investment in riskier ventures.

    3. You are making the assumption that income obtained from the sale of shares in company A are automatically invested in company B - that income from capital gains is always reinvested. That is not always the case.

    All that being said, there are already methods on the books to do tax free stock swaps with no money (and thus no capital gains) changing hands:

    https://www.macabacus.com/taxes/tax-free-acquisitions

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    1. When you start with a ridiculous statement, no one is going to bother reading the rest.

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    2. The first statement was a quote from above:

      "The first goal of taxation is to raise needed government revenue with minimum economic damage."

      I wouldn't call that statement ridiculous even though I don't agree with it.

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    3. I was referring to your "No."

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    4. Okay,

      You are perfectly within your rights to disagree. But let me show you what ridiculous looks like. From above:

      "That means lower marginal rates—the additional tax people pay for each extra dollar earned—and a broader base of income subject to tax. It also means a massively simpler tax code."

      So John wants a broader base of income subject to tax.

      "Second, the government should tax consumption, not wages, income or wealth"

      So John wants no taxes on income.

      "First, the corporate tax should be eliminated."

      And this broadens the tax base? Sounds to me like a narrowing of the tax base.

      "Taxes on capital gains discourage people from moving or reallocating capital toward their most productive uses."

      Again, eliminating taxes on capital gains broadens the base or narrows it?

      I could go on but there are far too many contradictions to enumerate. And yes, despite the "ridiculousness" of it all, I did manage to read through John's entire Op Ed.

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    5. No question he has contradictions. But I don't take anything I've said back or regard it as untrue. John started with a premise of the need for tax reform and why it has been so hard to achieve. It garnered interest with good thoughts on both matters. Then he listed a lot of ideas, some of which may be contradictory, but his opening was good enough that I read on. Your opening comment, was something along the lines of "the number 1 goal of tax reform should be to make fiscal policy independent of monetary policy." It's a complete nonstarter and silly.

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    6. Donk,

      "It's a complete nonstarter and silly."

      So silly that numerous central bankers including Greenspan here:

      http://www.bloombergview.com/articles/2015-03-18/central-bank-autonomy-is-under-attack

      "Against an ever-shifting political backdrop, monetary policy can provide a bedrock of economic certainty -- but only if central bankers can discharge their duties without fear of government interference."

      Or Bernanke here:

      http://www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm

      "Chief among these aspects has been the ability of central banks to make monetary policy decisions based on what is good for the economy in the longer run, independent of short-term political considerations."

      Or the current Fed Chair Janet Yellen here:

      http://www.bloomberg.com/news/articles/2015-07-23/yellen-fed-s-independence-under-attack-despite-economic-rebound

      "Yellen and her allies in academia argue that obliging the Fed to obey a monetary policy rule—even one it set for itself—would reduce the bank’s flexibility and increase the risk of mistakes."

      Have all come out and said as much - I agree with them despite how "silly" or "ridiculous" it may sound to you.

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    7. Took me a little while to find it but:

      http://johnhcochrane.blogspot.com/2012/02/fed-independence-2025.html

      From the words of John Cochrane:

      "My preferred answer would be to save the independence, competence, and a-political nature of the Federal Reserve."

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    8. Frank,

      Oh my! Where to start?

      Why do you believe and independent monetary policy is the same thing as the government never borrowing money? Do you understand the difference between the Treasury Department and the Federal Reserve? Do you understand the tools available to the Fed to conduct monetary policy and that they involve the buying and selling of Treasuries?

      As an aside to John, thank you for teaching me the basics of monetary policy so many years ago! I miss my days at Chicago where rational, informed discourse was the norm.

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    9. Anonymous,

      "Why do you believe and independent monetary policy is the same thing as the government never borrowing money?"

      Interest rate adjustments made by the federal reserve can negatively impact the fiscal position of an indebted federal government. In the extreme case, the federal government can end up in a position where interest payments on existing debt can exceed available tax revenue.

      "Do you understand the tools available to the Fed to conduct monetary policy and that they involve the buying and selling of Treasuries?"


      Certainly. I also understand that the U. S. central bank (Fed) was created in 1913. The federal open market committee was not created until 1933 (20 years later). And so for a period of about 20 years, the central bank operated without the tool of open market operations.

      And so, by eliminating government debt you avoid the situation where interest rate adjustments made by the central bank negatively affect the government's fiscal position and you return the central bank to it's pre-1933 status.

      "I miss my days at Chicago where rational, informed discourse was the norm..."

      I would think an informed discourse between two people would include knowing each person knowing the other's name - oh my indeed.

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  2. This is really simple when you think about it:

    Question: Why does a government tax?
    Answer: To create a demand for a common currency.

    Question: Who should pay taxes?
    Answer: Anyone that benefits from the use of that common currency.

    And so if shareholders need to be able to move capital from unproductive investments to productive investments and they don't want to pay taxes on capital gains, they can barter their way along. If they want government to provide a common currency, they can pay for the privilege of using it.

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  3. I generally agree with your argument, I'm just concerned that it seems just as easy to game a consumption tax as an income tax, especially if you have a giant incentive to classify things as investment.

    If I buy a yacht for fun I have to pay the consumption tax. If I buy a yacht as a capital expenditure for a yacht charter company I don't pay consumption tax. How do you differentiate between the two? Obviously as I then pay to rent the yacht from my own charter company, I pay the consumption tax on that, but is there going to be a rule mandating that businesses can't lose money? That seems unworkable, and I could imagine someone setting up these sort of shell businesses to hide their fun consumption and then charging themselves below market rate for the use of their own toys. I'm sure that's just the start of the ways to sidestep it.

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  4. Lots to.like here.

    I agree on taxing consumption rather than income of any type, with perhaps an exemption for food and medical expenses.

    I am inclined to think that the $1 trillion in annual "national security" outlays, that is the Department of Defense, the VA, the DHS, the black budget, and prorated debt, should be entirely financed by taxes levied on the top 1%.

    I think only the top 1% has the influence necessary to counterbalance the interest groups aligned with "national security" spending. Going back to a citizen draft, one that takes people from, say the freshman class of the top 100 universities and colleges in the country, would also be an effective tonic to our foreign policy expeditions, and a lot cheaper too.

    BTW, the AEI has commented that eliminating the corporate income tax, while leaving personal income taxes in place, will result in a lot of income being artificially shifted to the corporate side from what had been the personal income side.

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  5. Alan Fortini-CampbellJanuary 23, 2016 at 10:00 PM

    First, I take no issue with the specific recommendations, but wish to consider the premise.

    A prince who had life tenure, barring violent deposition, might well think "[t]he first goal of taxation is to raise needed government revenue with minimum economic damage," or the more pragmatic "getting the most feathers with the least squawking." But the goal of those who actually make our tax laws is different. Members of the Senate Finance and House Ways and Means committees derive power from their perceived influence over tax carrots and sticks. Consequently, whatever degree of simplification might be achieved spasmodically after the election of an enlightened candidate will inevitably be undone by succeeding Congresses.

    In the long term, the quality of the revenue-raising system will matter less if spending is reduced relative to the size of the economy. So, focus on spending rather than taxation. Call this a corollary of Friedman's advice to focus on spending rather than the deficit.

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    1. Alan,

      "In the long term, the quality of the revenue-raising system will matter less if spending is reduced relative to the size of the economy."

      Except that the government is permitted to borrow to make up the difference between taxes received and money spent.

      "But the goal of those who actually make our tax laws is different. Members of the Senate Finance and House Ways and Means committees derive power from their perceived influence over tax carrots and sticks. Consequently, whatever degree of simplification might be achieved spasmodically after the election of an enlightened candidate will inevitably be undone by succeeding Congresses. "

      Bingo, you have hit the nail on the head here. To get tax policy right and keep it from going off course, consider the history of U. S. government sponsored money. From 1862 to 1971, the U. S. Treasury issued legal tender called U. S. notes. From 1913 to 1971 those U. S. notes circulated in parallel with Federal Reserve legal tender notes created by the U. S. Central bank. More information on U. S. notes can be found here:

      https://en.wikipedia.org/wiki/United_States_Note

      The quantity of U. S. Notes in circulation was determined by Congress. By 1971 Congress had ceded the power of money creation to the central bank.

      This ceding of power must also occur with tax policy to have any hope of long term success.

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    2. Each dollar spent must come from taxes now or be borrowed and repaid with taxes raised later. Taxes raised later can be the explicit collection of nominal dollars or the hidden taking of inflation.

      I wonder what the Constitution would have looked like if the Founders had thought more about monetary policy, fractional reserve banking and fiat currency.

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    3. Alan,

      Your statement:

      "But the goal of those who actually make our tax laws is different. Members of the Senate Finance and House Ways and Means committees derive power from their perceived influence over tax carrots and sticks."

      The only point I was making is that there is a prior history of Congress ceding power to an apolitical organization, namely the creation of the Federal Reserve and legal tender. And so it is not totally unreasonable to picture a scenario where power is forfeited by the House Ways and Means and Senate Finance committees.

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    4. Good piece. Tax simplification, as always, a great idea - both personal and corporate. Frustrating since "both sides" can agree on this being obvious. As noted, eliminate corporate tax - eliminates all the distortions, breaks, etc. On a wonky point, it should be noted that lower corporate taxes will increase profits only if they result in a higher deficit - that is, if the lower taxes are not offset by spending cuts. If spending cuts are made such that deficits remain the same, the drop in business revenues will about match the drop in business taxes - leaving profits unchanged. For those unfamiliar with "how profits work" check "Kalecki equation" used by economists (Public sector deficits are one of the four principle contributors to after-tax profits).

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    5. Alan Fortini-CampbellJanuary 26, 2016 at 9:23 PM

      Frank, thanks for explaining and I get it now. I'm entirely ignorant of what powerful Reps and Senators thought when they created the Federal Reserve, but my imagination's not strong enough to picture the Ways & Means or Finance Committee members agreeing to cede power to technocrats. Were there House and Senate "Monetary Committees" when the Fed was birthed?

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    6. Alan,

      As with most "major" changes in government policy, the creation of the Federal Reserve began first with economic upheaval (Panic of 1907) and then political upheaval (Democratic Party sweep in the 1912 elections).

      https://en.wikipedia.org/wiki/Party_divisions_of_United_States_Congresses

      From 1897 to 1911, the Republican party controlled the U. S. Senate, the U. S. House of Representatives, and the Presidency. Then in 1912 the Democrats took over capturing the Senate, the House, and the Presidency.

      The driver of that Democratic takeover was a fracturing of the Republican Party and the creation of the short lived Progressive Party.

      https://en.wikipedia.org/wiki/Progressive_Party_(United_States,_1912)

      The political will behind the creation of the federal reserve began earlier with the Panic of 1907, Senator Nelson W. Aldrich (Republican from Rhode Island), and the National Monetary Commission.

      https://en.wikipedia.org/wiki/Nelson_W._Aldrich
      https://en.wikipedia.org/wiki/National_Monetary_Commission

      There are some good books out there that describe the creation of the central bank from an economic and political perspective.

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  6. Bitcoin is coming soon.., to much waste in current arrangement. atb

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  7. The goal of taxation to raise revenue for the government is important in maintaining our economy. I agree with what was stated in this article. I also agree with taxing consumption rather than other incomes. I believe we should have more of an incentive to save and invest in order to help our money grow, rather than saving and spending it on taxes. Therefore we would be promoting progressive taxation. Changes in the way people are taxed could promote more investments and could help our economy to grow in positive ways.

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  8. I agree with Knut Wicksell's theory of just taxation -- consumers of public goods should be taxed in proportion to the utility they get from government expenditures. Yes, you'd have to make some guesses at marginal utilities to get to even a decent approximation of that, but trying is better than ignoring the basic principle. However, to get anywhere towards a better tax system, we need to take politicians' self interest out of the equation -- in other words, taxes are too important to leave to the pols. And we have a small hurdle in the Constitution to reach that end. Meanwhile, we will be taxed to get the pols reelected. Simple public choice in action, actually. In plain English, it's hopeless already.

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    1. Anonymous,

      The problem with Wicksell's theory is that it is time inconsistent. A lot of public goods are delivered in times of distress (foreign invader, natural disaster, public unrest, etc.) where increased taxation can make a bad situation worse. And so financial markets (debt / equity) exist to smooth over that gap in time between when bad things happen and when tax revenue becomes available to pay for the remedies.

      The question then becomes how should tax revenue be allocated to service a build up of prior government obligations.

      "However, to get anywhere towards a better tax system, we need to take politicians' self interest out of the equation -- in other words, taxes are too important to leave to the pols. And we have a small hurdle in the Constitution to reach that end."

      It is a small hurdle, but it is not insurmountable. I agree with the sentiment though, if taxes are to be a macro oriented policy tool, then Congress and political give and take must be removed from the equation.

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  9. I think your dismissal of property taxes as "bad" (discouraging wealth accumulation) is premature, as "everything" depends on real property. Thus, a property tax would have weak (if any) marginal effects.

    Looking at benefits, you have low transactions costs (land register = tax register), no need to track beneficial ownership, easy valuation (a combo of purchase price plus recent equivalent sales), and stable revenues. What's the downside? Rich people own most property and would lobby FURIOUSLY to keep taxes on income (so they can be dodged).

    Thoughts?

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    1. David,

      "I think your dismissal of property taxes as "bad" (discouraging wealth accumulation) is premature, as "everything" depends on real property. Thus, a property tax would have weak (if any) marginal effects."

      Except the government does not accept real property to settle a tax bill. If I have 100,000 acres of land, the government will not accept 1,000 acres to pay a 1% land tax. The problem is forced liquidation.

      Taxing property may force the owner to sell of some of the land to pay the taxes on it. Add up enough land owners selling land to pay the taxes and suddenly those sales can put downward pressure on land values.

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    2. Frank, that is exactly the point! If you just hold 100,000 acres of land in a way that is so unproductive that you cannot cover the land tax, then it is good that there are incentives that push you to transfer the land to someone who can. And if you want to hold that land simply for your personal enjoyment (consumption), you should pay for that, one way or the other. Surely if the land in question is valuable at all, you can also use it as a collateral to finance that consumption.

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    3. Anonymous,

      "If you just hold 100,000 acres of land in a way that is so unproductive that you cannot cover the land tax..."

      Land can be productive over a significant period of time and yet go through over performing and underperforming periods. This happens all of the time with crop rotation and with seasonal changes.

      The question isn't whether the land is / is not productive, the question is whether government can devise a land tax system that distinguishes between "lack of effort" productivity changes from "natural cause" productivity changes.

      Droughts and other natural phenomenon still happen. Lack of crop rotation will cause land will go fallow. Either (drought or crop rotation) may cause a decline in farmland productivity. Your plan is to tax land as if natural changes in productivity ever happen?

      "Surely if the land in question is valuable at all, you can also use it as a collateral to finance that consumption..."

      Yes I could use the land to finance that consumption (borrow against it), but it is unlikely that I would get a floating interest rate on a loan from a bank to reflect the natural changes in the productivity of the land.

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    4. Anonymous,

      "If you just hold 100,000 acres of land in a way that is so unproductive that you cannot cover the land tax, then it is good that there are incentives that push you to transfer the land to someone who can."

      I understand what you are saying, but a land tax where taxes are settled in nominal monetary terms does not accomplish that.

      Is a field of winter wheat generating $2,000 of income an acre any less productive than a field of summer corn generating $5,000 of income an acre? How do you come up with a singular land tax system where the same plot of land has a variety of uses - each with a different return on investment?

      With an income tax, the seller of goods is only taxed on the income that he receives from the sale of goods. The corn farmer is only taxed on the monetary value of the corn he / she is able to sell. The wheat farmer is likewise only taxed on the wheat he / she is able to sell.

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  10. John:

    I agree that separating the collection process from the "subsidy" process is an excellent idea. However, I would change "subsidy" to standard deduction/progressivity/safety-net.

    The revenue collection process should be as efficient as possible. Because of the legacy problem of taxes embedded in gross salary, a flat tax on income is best. Employers would withhold the correct percentage of salary, and with consumption only taxes, there would be no need for employees to file annual tax returns at all.

    On the corporate end, the tax rate should be the same as that on employees. There should be no double taxation.

    There should be no subsidies, however, with a Unconditional Basic Income set at 100% of the poverty line, we could eliminate federal welfare, and have a highly progressive effective tax rate. For those paying taxes, the UBI would replace deductions for mortgage interest, medical payments, etc.

    The effective tax rate would smoothly go from negative toward the flat rate. Distribution would be monthly and exactly the same for every citizen (adults would receive more than children). It would eliminate citizen poverty and reduce income inequality, while treating everyone equally.

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