Wednesday, October 5, 2016

A first step to progressive consumption taxes

What's an easy way to get going on progressive income taxes? Simply remove all limits on contributions to and withdrawals from IRAs. (I thank my Hoover colleague Michael Bernstam for this clever idea, and the Hoover coffee room for bumping us into each other.)

Background: Once people see that a consumption tax, in place of income tax, corporate tax, estate tax, etc. is much simpler and more economically efficient, the natural question is "what about progressivity?" The answer is that there are lots of ways to make a consumption tax progressive.


My favorite (today) is a flat consumption tax, with the same rate on everything, collected as a VAT.

Then, realize that progressive taxation is the same thing as flat taxation plus redistribution. If I pay 40% tax and you pay 20% tax, that's the same thing as both of us paying 40% tax and you receiving a check from the government. So, I think, separate taxation (raising revenue for the government at minimum cost), subsidy, and redistribution. Make redistribution coherent, integrate it with other programs, and implement it by sending people checks, on budget.

Most countries try to make it progressive by charging different rates for things that rich people buy vs. poor people. But that is a mistake as it distorts the economy. Even rich people can buy more tacos and less yachts, and maybe a poor person wanted to buy a yacht and start a rental business.

An alternative implementation is to turn the current income tax system into a progressive consumption tax. If you can fully deduct savings from income, the "income" tax becomes a consumption tax. Alternatively, pay taxes on all "earned" income, but no tax on  dividends, interest, or capital gains. That works out to the same thing -- no tax distortion on whether you consume the day you get the income, or later after returns compound.

That approach leads to all sorts of definitional problems, which is why I haven't been a huge fan. (Though I'm not strongly opinionated, recognizing that people who advocate it know a lot more about the tax code than I do.)

So, along comes Michael. Why not just remove all limits on IRAs? Contribute as many pre-tax dollars as you want. Interest, dividends, and capital gains accumulate tax free. No minimum distributions, estate taxes, etc. But when you take money out of the IRA, to consume it (otherwise you'd leave it in!) you pay income tax.

Yes, it's imperfect. It doesn't solve the Trump issue that what is "income" is an elastic concept in the hands of lawyers and lobbyists. But it's a quick and easy step that gets us a long way there.

Our tax code sort of recognizes that taxing rates of return is a bad idea. We tax "unearned" income -- but then there is a huge list of complex exemptions. 401(k), 526(b), IRA, Roth IRA, health savings accounts, college savings accounts, step up of capital gains at death, like-kind exchanges, and on and on, each with complex rules to follow. Just removing all limits on IRAs would be a big step towards a consumption tax, and then we wouldn't need all these other ones either.

Objections? I'm not great on tax law, so it will be fun to hear comments.

52 comments:

  1. John,

    "If you can fully deduct savings from income, the income tax becomes a consumption tax. Alternatively, pay taxes on all earned income, but no tax on dividends, interest, or capital gains. That works out to the same thing -- no tax distortion on whether you consume the day you get the income, or later after returns compound."

    How should negative savings be handled? I earn $30,000 in a year (pre-tax), consume $15,000 worth of perishable / semi-perishable goods in the year, and take out an auto loan for $25,000. My annual consumption ($40,000) exceeds my annual income ($30,000).

    And what metric should be used to determine who receives the benefits of progressive consumption taxation:
    1. Lower pretax income generates a lower tax rate
    2. Lower pre-tax income minus consumption generates a lower tax rate
    3. Lower consumption as a percentage of pretax income generates a lower tax rate

    "Alternatively, pay taxes on all earned income, but no tax on dividends, interest, or capital gains."

    Finally, if you believe that holders of financial contracts (bonds, stocks, etc.) should pay no taxes to the government, then I presume that you also believe that owners of financial contracts should receive no legal protections afforded by government either - no Securities and Exchange Commission, no Bankruptcy Law, etc.

    Otherwise, your no different than any other liberal - you want free stuff from government. Yes you want the federal government to provide a legal service to holders of debt obligations in the event that borrowers default on their loans, but you don't want those loan holders to pay any taxes to fund that legal service.

    I realize that you are living under the assumption that those untaxed earnings will eventually be spent on consumption goods (or maybe not), but the world goes round while those earnings accumulate.

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  2. Great idea. Not new, by the way. I recall this being talked about in the 1980s.

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    1. Steve Landsburg has discussed this extensively as well.

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  3. I'm still not 100% sure how I feel about consumption taxes although I strongly agree we should focus less on the progressivity of taxes and more on the progressivity of our overall fiscal system.

    This seems like a poor compromise versus a consumption tax though. One of the main "problems" that prevents us (in my opinion) from taxing capital gains at a much lower rate is the ease in which our system allows people to shift labor income into capital income. I don't see an IRA requirement preventing this from happening.

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  4. The problem is that you pile up huge amounts in IRAs that then create the possibility of huge potential windfall gains or losses in the future with changes in rules and/or taxation on withdrawals. Trust me, I'm from Australia where around 120% of GDP is locked up in tax favoured savings accounts (and rising fast) and it is, as you'd expect, the subject of endless political lobbying.

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    1. This is a very good point. The temptation is ever there for "just this once" capital grabs.

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    2. That is not unique to your proposal. It exists now with respect to all financial accounts.

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    3. No, but messing with money in people's bank accounts is much closer to people's - and judges' - ordinary understanding of theft and disappropriation, than changing the tax rate or some rule about when you can (for instance) draw down your money.

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  5. disclaimer: i'm not an economist so the terms i use might not be 100% correct.

    "Why not just remove all limits on IRAs? Contribute as many pre-tax dollars as you want. Interest, dividends, and capital gains accumulate tax free. No minimum distributions, estate taxes, etc. But when you take money out of the IRA, to consume it (otherwise you'd leave it in!) you pay income tax."

    the proposal has a time-inconsistency that might result in favouring consumption over savings. if my money is taxed only when i buy things and i am worried that the government will increase taxes in the future (people usually are) then i will spend more now.
    i don't think it is a good idea, considering households are already more indebted than they should.

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    1. Unknown,

      "I am worried that the government will increase taxes in the future (people usually are) then i will spend more now. I don't think it is a good idea, considering households are already more indebted than they should."

      If the progressiveness in a consumption tax was tilted such that you pay a higher tax rate in the current year based upon the percentage of your income that you spend in the current year, then you might not elect such a path.

      For instance, imagine a consumption tax something like this:

      20% Tax - When an individual spends less than 20% of his income on consumption goods

      30% Tax - When an individual spends between 20% and 50% of his income on consumption goods

      40% Tax - When an individual spends between 50% and 75% of his income on consumption goods

      50% Tax - When an individual spends over 75% of his income on consumption goods

      In this case, I doubt you would go in serious debt to buy more stuff.

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  6. "Then, realize that progressive taxation is the same thing as flat taxation plus redistribution. If I pay 40% tax and you pay 20% tax, that's the same thing as both of us paying 40% tax and you receiving a check from the government. "

    It is not the same thing - probably in the second version most people will be subjected to an higher marginal rate than in the first version (making it less economically efficient, even if in the end they pay the same amount in taxes)

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    1. Miguel,

      It really depends on how progressive taxation is implemented.

      John has $40,000 of pretax income and spends $20,000 of it on consumption goods.

      Jane has $60,000 of pretax income and spends $15,000 of it during the year.

      Nick has $100,000 of pretax income and spends $25,000 of it on consumption goods.

      Who should get the benefit of a progressive consumption tax?

      1. John because he has the lowest pretax income of the three

      2. Jane because she spent the smallest percentage (20%) of her pre-tax income on consumption goods of the three

      3. Nick because he spent the smallest total $ from his pretax income on consumption goods of the three

      If the whole point of a consumption tax is to encourage saving in lieu of consumption, then it seems reasonable that any progressiveness in a consumption tax code should also favor thriftiness. Meaning that the progressiveness should be tilted towards either Jane or Nick.



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  7. John,

    This approach was actually on the table back in the early 90s. Under the banner of the "USA Tax" (because Patriotism sells), unfortunately it was unsuccessful. It created Unlimited Savings Allowances (USAs) and then replaced all business taxation with a broad based VAT. I'm now convinced that such an approach while simpler and more efficient than what we have today is still to complicated to enforce. (For more info: Laurence Seidman wrote an excellent book on the proposal -https://www.amazon.com/USA-Tax-Progressive-Consumption-Press/dp/0262514532)

    I personally favour the X-Tax (Wage Tax + Business Cashflow Tax) of David Bradford (and later Viard), but I'm pessimistic on the prospects of fundamental tax reform.

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  8. Sounds great. To balance the government budget, a higher (flat) rate of consumption tax will be needed. This might harm domestic production and favor imports. No?

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    1. If anything, I imagine that a sales tax benefit domestic production and harm imports (at least compared with other kinds of taxes), because imports pay the sales taxes and the exported share of domestic production not.

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    2. Bart,

      "To balance the government budget, a higher (flat) rate of consumption tax will be needed."

      Presuming that the federal government doesn't reach the top of the consumption tax Laffer Curve.

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  9. The key to doing this well is to remove limits on Traditional IRAs but to eliminate Roth IRAs entirely. If all returns to capital were normal, then these two tax provisions would work identically. However, because a large share of returns to capital are super-normal, a Roth IRA ends up exempting some consumption from taxation.

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  10. This is William Gale from PBS Newshour interview with Jim Lehrer back in 2005...

    William Gale: What does it tax? A consumption tax essentially taxes people when they spend money. And the income tax you’re fundamentally taxed when you earn money or when you get interest, dividends, capital gains, and so on. And a consumption tax that wouldn’t happen, you would be taxed essentially when you actually spent the money at the store.

    Now one way to think about a consumption tax relative to the existing income tax is suppose we had our current system, but we made IRA contribution limits infinity, so you could put as much as us wanted into an IRA and you could take it out for any reason, all right. That to the first order of approximation would be a consumption tax.


    Brian

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    1. William Gale is wrong simply because consumption can be financed rather than paid for out of current income.

      "Now one way to think about a consumption tax relative to the existing income tax is suppose we had our current system, but we made IRA contribution limits infinity, so you could put as much as us wanted into an IRA and you could take it out for any reason, all right. That to the first order of approximation would be a consumption tax."

      Okay so I put all of my current $30,000 income in a tax sheltered IRA and then run up $30,000 on my credit card to pay for my consumption. How has my consumption been taxed?

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    2. Wouldn't your credit card be charges for $30,000 plus tax?

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    3. Alan,

      Read the statement by William Gale. He states that a consumption tax is equivalent to an income tax where IRA contributions are unlimited and untaxed at any point (if I understand him correctly).

      A true consumption tax would assess taxes on consumption goods no matter the means by which the money is obtained to buy the goods.

      An income tax with unlimited tax free IRA contributions and withdraws only taxes income that is spent on goods, not borrowed money that is spent on goods.

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  11. This is silly. What's the point of all this if not to maximize national utility?

    Why prefer a consumption tax over a savings tax? Poor people consume, but they do not save. Wealthy people save more relative to their consumption. That's how wealthy people get wealthy to begin with.

    A flat-wealth tax would be progressive. A flat consumption tax would end up taxing poor and wealthy alike. This results in a distribution of wealth that is far from maximizing national utility.

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  12. Steven Landsburg had a similar idea, back in 2008, in a Slate.com article:

    http://www.slate.com/articles/arts/everyday_economics/2008/01/huckabees_tax_plan_is_brilliant.html?wpisrc=newsletter

    A quick excerpt:
    "So, one way to mimic the effect of a sales tax is to let you deposit every dollar you earn directly into an IRA. As far as your family—or any family—is concerned, the effects are identical. A sales tax is the exact equivalent of an income tax with a provision for unlimited IRA contributions (and no withdrawal penalties). The merits and demerits of the Huckabee tax plan are identical to the merits and demerits of a vastly liberalized IRA policy.

    A lot of economists, myself included, think that there's a lot to be said for unlimited IRAs. Any conceivable tax system discourages work, which is unfortunate but unavoidable. But the current system also discourages saving, which is avoidable. A liberalized IRA policy—or, equivalently, a sales tax—eliminates that problem. The downside is that when IRAs grow, there's less income to tax, so tax rates must be higher—which increases the disincentive to work. But for the past decade or so, the macroeconomics journals have been rife with papers arguing—on highly technical grounds—that the terms of that tradeoff are well worthwhile.

    Bottom line: Unlimited IRAs, coupled with somewhat higher tax rates, have advantages and disadvantages, but the advantages are bigger. And whatever can be said about unlimited IRAs coupled with somewhat higher tax rates can equally be said of a national sales tax."

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    1. Manfred,

      "Any conceivable tax system discourages work, which is unfortunate but unavoidable."

      That is the argument against progressive taxation, that each hour of additional work could be taxed at a higher rate as your total income increases and your tax bracket changes. And so people work fewer hours to avoid higher tax brackets.

      I have never heard the argument that monetary taxation of any kind discourages work.

      http://www.presidency.ucsb.edu/ws/?pid=38697

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  13. I would certainly be in favor of this idea, but you don't really get out of the problem of trying to define what is an investment and what is consumption. To the extent you don't get the definitions right, you end up creating incentives to misallocate resources toward artificially tax-advantanged investments.

    Here are some examples:

    -- I want to make an investment by buying a boat to rent out as a business. Assuming I can't buy the boat in my IRA, I get taxed on the dollars to make that investment even though it is not consumption. In contrast if I deposit funds into an IRA to buy a publicly trade boat rental company, I pay no tax on those dollars.

    -- So maybe we let people deduct contributions made into LLCs that then use to conduct business (and only tax them on distributions)? If I end up not renting the boat as much as I thought and use it myself on weekends, then I have avoided tax on what is really a consumption item.

    Again, I think this is a worthwhile road to go down, but you can't really avoid the complexity associated with definitions when so much turns on those definitions. (Reminds me of regulations relating to the assets held by banks!)

    So you are rally

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  14. The basic issue I have with Consumption based taxes is that Consumption is the largest contributor to the United States Economy. If people face a strong tax (disincentive) to consuming goods and services, they may in fact, choose to consume less goods and services. Taxing Income doesn't really create a disincentive for earning money. People will always want more and more income, but they won't always want to consume more and more goods and services.

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  15. Any thoughts on how the New Dynamic Public Finance literatures relevence here? Isn't one of its controversial results that it is often efficient to tax capital income?

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  16. So you argue it would be more efficient to not tax capital income. Any thoughts on the New Dynamic Public Finance literature which argues that it is sometimes optimal to tax capital income?

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  17. Just curious: what would you suggest the VAT tax rate should be to keep the Government running?

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    1. If the govt is going to spend 20% of GDP, then 20%.
      In the end, spending drives tax rates.
      The opposite view only leads to huge deficits.

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    2. John,

      During a recession GDP falls by 5% and government should do what?

      Cut spending by 5%?
      Raise the VAT by 5%?

      Unless of course you believe that tax policy has no dynamic effects (no VAT Laffer Curve), that only monetary policy needs to be adjusted for the business cycle, and that government should act in a pro-cyclical fashion.

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    3. Good point. And it's a point in favor of separating the tax code from the rates. The government should be able to renegotiate the rates without renegotiating the whole tax code.

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    4. Glad you liked it, but my point was far deeper.

      Can Congress be trusted to make appropriate effective real time changes in tax policy (whether it be an income or consumption tax) through multiple business cycles?

      My analogy is the Federal Reserve. Can Congress be trusted to make real time changes in monetary / credit policy through multiple business cycles?

      Obviously not or we would still be using U. S. Treasury currency instead of Federal Reserve Notes.

      If Congress can't get monetary policy right all the time, every time, why do you believe they can get tax policy right?

      And it really has nothing to do with the intelligence / lack there of for individual members of Congress. It has to do with:

      1. Expediency - the Central Bank can agree to interest rate changes over a one hour meeting and implement them shortly after. It can takes months / years before a bill can be passed by both Houses of Congress.

      Care to wait around for 18 months while Congress deliberates on the new VAT tax rate that won't take effect until 2 years from now?

      2. Accumen - The Fed is staffed with people who for the most part are economists by trade. Congressmen and Congresswomen for the most part come from the legal profession and are not in a good position to argue the pros and cons of economic policies (including tax policy).

      3. Short terminism - Congressmen and women are under the pressure of running for office every 2-4 years and so lack the incentives to focus on long term objectives.

      We can debate the pros / cons of an income vs. consumption tax till we are blue in the face but I think this misses the bigger picture -

      How should tax policy be adjusted for changes in the business cycle and who should be responsible for those adjustments?

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    5. It looks the Government is currently spending about 34% of the GDP. I don't think you can tax food or medications at this rate. Also, the GDP includes Government spending (I don't think you can tax that). So to keep the Federal Government running, you would need in my estimation VAT rate of at least 40-45% or maybe more. Assuming the states do the same, I think the VAT rate (Fed + states) needed would be about 50%. To make it progressive, the checks would have to go to less affluent every month, otherwise they could quickly run out of money. Therefore, I do not think VAT as the only tax is a plausible solution.

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    6. It would be far more transparent for govt (state & fed) to charge only a VAT of 30-50% (plus a few specific service taxes, pollution taxes etc), and drop every single other tax out there.

      And it would be far more palatable to people to pay 40% VAT if all taxes on income, capital, and wealth were outlawed altogether (enshrined the constitution sort of outlawed). If you disagree then that really just showing govt spending is absurd and we should all advocate a hard limit on govt. spending (in hell or high-water kind of limit).

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    7. John,

      "Good point. And it's a point in favor of separating the tax code from the rates. The government should be able to renegotiate the rates without renegotiating the whole tax code."

      Considering that the rates and the whole tax code are determined by the same group of people (Congress), I don't see how you separate them unless you delegate one set of responsibilities to a 3rd party insulated from the political pressures of Congress.

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  18. Any thoughts on how the New Dynamic Public Finance literatures relevence here? Isn't one of its controversial results that it is often efficient to tax capital income?

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  19. A VAT (Value Added Tax) isn't a sales tax as we know it in the U.S.. It is far more administratively complex with the VAT being assessed at each stage of production and the final consumer paying the full amount. It is subject to significant manipulation, e.g., intermediate stages of production pay the tax immediately--the baker pays the VAT on flour---but then reclaims his payment when the wholesaler buys the baker's bread and pays his (the wholesaler's) VAT to the baker. It's easy to see how five or more intermediary steps finally work up to the consumer buying the loaf of bread and paying the 20% VAT. European countries all have VAT's as well as every other type of tax and it's easy to see how the U.S. would slide down that same path. I vote for no new tax innovations. Period! Eliminate itemized deductions and lower the current income tax rates.

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    1. VAT is absurdly simple to administer in comparison to the myriad of capital, income, city, payroll, insurance, imports, estates, gifts, interest, excise, property, healthcare, and corporate taxes. Not to mention duties, licensing, tourist......

      VAT can normally be accomplished without an accountant for most small businesses. Not so with the others.

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  20. Estonia has turned their enterprise tax into a consumption tax, putting it on a cash paid out basis. This created very strong business savings for a number of years. Since all legal persons were taxed the same, on a flat deferred basis, they also adopted a fringe benefit tax to discourage using these entities as a personal slush fund. This avoids the OVER mediation that would result in huge IRA balances, but really there is no good way to raise a large percent of GDP.

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  21. I think the main advantage to a consumption tax is ease of collection -- no tax forms or tax accountants. This advantage wouldn't exist with unlimited IRAs, even if the economic effect is the same.

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    1. Boomer,

      And there is also no with holding when a consumption tax is used. And so any progressiveness regarding low income or over consumption would be done through end of year adjustments. This could put a huge end of year strain on the U. S. Treasury.

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    2. "no tax forms"

      Dreams are free. I work for a company that does about five million dollars per year in revenue. Tracking the Canadian VAT (the GST/HST) is as much book keeping work as tracking income and expenses and we have to file a monthly tax return.

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  22. A flat rate consumption tax has the advantage that everyone pays it at retail. This gives everyone an incentive to limit Government. You might counter that if the Government redistributes, that will remove the apparent incentive. However, that presumes a level of understanding by voters that may not be lacking. My preference is for a flat rate VAT with no Government redistribution. Leave the latter to Charities. If you counter that charity will not provide enough, my counter is that that is the message - Do advocate theft or not?

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    1. Bob,

      "A flat rate consumption tax has the advantage that everyone pays it at retail. This gives everyone an incentive to limit Government."

      Limit Government in what sense and who is everyone?

      1. Spending? - Government can borrow instead of direct taxation
      2. Regulation? - A government can institute a myriad of regulations while collecting little in tax revenue
      3. Other???

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  23. I would take it the other way to solve our retirement savings issue: lower taxes on IRA/401K withdrawals to a maximum of 10% for the first $3mil (or $5mil), indexed for inflation. Then you could actually means test Social Security as a significantly higher number of people would be able to retire without Social Security.

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  24. I didn't have time to read all comments, but maybe a simple way to make a consumption tax system progressive would be to exempt food from the sales/VAT tax. Its although rich people can eat more, I doubt they would eat 100x more than poor people, if one exempts food in markets and supermarkets, not restaurant food...

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    1. Anonymous,

      "I didn't have time to read all comments, but maybe a simple way to make a consumption tax system progressive would be to exempt food from the sales/VAT tax."

      So taxes should be assessed equally on $1000 suits and $30 pairs of jeans?
      So taxes should be assessed equally on $250 tickets to the opera and $10 tickets to the movie theatre?
      So taxes should be assessed equally on a $250,000 sports car and a $25,000 four door sedan?

      This is the whole problem with a progressive sales / VAT tax.

      You start arguing over what types of goods a poor person would buy and which a rich person would buy.

      You also start arguing over whether a rich person buying 100 pairs of $30 jeans should be taxed the same if they buy three $1000 suits.

      This leads you down the path of a tax code more complex than what we have now.

      The false assumption is that a VAT or national sales tax is in and of itself simpler or less complex than an income tax.

      If you want a simple tax system, then fine - eliminate the distinction between corporate, personal, and investment income and go to a single rate flat income tax. Otherwise, you are just re-arranging the furniture.

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    2. Thanks Frank. I was hoping someone else would come to help poor Anonymous. It's important, as most VATs and sales taxes try to be progressive by guessing what poor people buy and lowering the tax rates. But mucking with prices is always a terrible way to transfer income.

      And we do it already and will probably continue to do so. Food stamps, for example, subsidize food for poor people (50 million now). Let's not double down on the subsidies for food.

      What Frank left out is the alternative -- use the proceeds of a flat consumption tax to transfer income as you wish. Write checks to voters. The government is pretty good at that. How much is a discussion for another day. Here, we're talking about the mechanism. And on budget transfers are a better mechanism than a complex set of good specific sales taxes.

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    3. John,

      "What Frank left out is the alternative -- use the proceeds of a flat consumption tax to transfer income as you wish. Write checks to voters."

      I didn't leave it out. I simply don't agree that a consumption tax (either progressive or flat) is the right approach to either achieve simplicity in the tax code or to maximize productivity or real economic growth.

      I don't agree that financial contracts - as an income generating and transferrable good - should be exempt from taxation. I believe this because the federal government provides legal services to those holders of financial contracts (fraud protection as an example) and as such those holders should be subject to taxation.

      If you want to eliminate taxation on financial contracts (stocks, bonds, etc.), that's fine. Then I would also expect you to promote the elimination of legal protections for holders of financial contracts including

      U. S. Bankruptcy Law
      https://en.wikipedia.org/wiki/Title_11_of_the_United_States_Code

      As well as the Securities and Exchange commission and the acts that it is required to enforce:

      https://en.wikipedia.org/wiki/Securities_Act_of_1933
      https://en.wikipedia.org/wiki/Securities_Exchange_Act_of_1934
      https://en.wikipedia.org/wiki/Trust_Indenture_Act_of_1939
      https://en.wikipedia.org/wiki/Investment_Company_Act_of_1940
      https://en.wikipedia.org/wiki/Investment_Advisers_Act_of_1940
      https://en.wikipedia.org/wiki/Sarbanes–Oxley_Act
      https://en.wikipedia.org/wiki/Dodd–Frank_Wall_Street_Reform_and_Consumer_Protection_Act

      Under a consumption tax I would also eliminate patent, trademark, copyright, and trade secret protections if the transfer / sale of those goods will be excluded from taxation under a VAT:

      Patent law
      https://en.wikipedia.org/wiki/Title_35_of_the_United_States_Code

      Copyright Law
      https://en.wikipedia.org/wiki/Title_17_of_the_United_States_Code

      Trademark Law
      https://en.wikipedia.org/wiki/Title_15_of_the_United_States_Code

      Trade Secrets Law
      https://en.wikipedia.org/wiki/Title_18_of_the_United_States_Code

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  25. Broad consumption taxes are great, but I'm troubled by the tax-free income from savings idea as a means to introduce this, and achieve progressiveness. The idea that income from savings and labour are ultimately distinguishable seems to be dubious at best. Some friends and I own a bar/cafe, which we built with savings/borrowings, and a lot of blood sweat and tears of our own, (yes we scrubbed walls, built furniture, everything that didn't need a license), and some of us still work in it while it's operating. So we saved some labour, and some money, to invest. We also work there, or some of us do, and how well/much we pay ourselves now is directly connected to how much we record as 'profit' from our company, which we distribute through shareholdings. Is our income now 100% from savings, or labour, or somewhere in between?

    The more I think about it, the more I think that this isn't a peculiar case-study that just needs more guidelines to satisfy. In every small-business and start-up (which can become big business), the entrepreneur's labour and capital are both essential ingredients that need to be poured into the crucible, often in lumpy and unpredictable volumes. Hopefully one day a steady-ish flow of profits comes out. But I think the idea that incomes become cleanly distinguishable between income from capital (savings) or labour is an approximation of reality which only emerges as realistic in medium-large, well established companies. And even then, the remuneration for management or involved owners blurs the lines again. (Or rather, shows how the lines are quite artificial in the first place)

    Of course, the approximations we derive from those larger companies seems have become orthodox terms used by economists to describe and divide flows in the economy. (Sadly. It puzzles me why are so few economists are entrepreneurs.) But I think it's dangerous to prescribe policy with terms that are actually approximations that only hold well for larger established firms. The formation process is key, and we could start driving all sorts of distortions at the 'crucible' stage of business formation when labour and capital are necessarily and deliberately intertwined.

    Should all our chefs quit their jobs, pour their 'savings' into capitalising small 'catering companies' with appropriate capital equipment (knives, aprons) which restaurants like my own them commission to 'cater' in our own premises? The free-market, small government guy in me says 'why would you, but why not?' Declaring income from savings tax-free gives the chef a reason why, and the government a reason why not, since such businesses would have a spectacular return to capital, depending on the cost of 'labour' that the owner charged.

    Inviting the government to come in and arbitrate just how valuable the time of a small-business owner is, and measure how much they put in, sounds like a disaster that brings over-regulation and bureaucracy to a whole new level. Government will have to systematically monitor and count entrepreneurs expenditure of minutes, as well as dollars.

    So unless you can remove the distortion by not taxing any income of any form (possible, but long shot) I don't think it's a good idea to create such a gulf between the way we tax income from savings and labour.

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Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.