This paper was written by me on April 29, 2007 as a part of a graduate tax policy course for Johns Hopkins University’s Masters Degree in Applied Economics and was circulated at the Treasury department and to students in the same course in subsequent years. The original paper was in the format of a mock memo to the then Secretary of the Treasury, Henry Paulson. Subsequently, in 2009 it is surprising that Emmanuel Saez of University of California, Berkeley was awarded the American Economic Association’s (AEA) John Bates Clark medal for his work on applied public economics, particularly for his contributions to comprehensive tax reform.
The proposed reform takes a gradual approach to shifting the tax base toward a largely consumption tax. The ensuing tax structure would completely replace the current tax code which has become inordinately complex to both comply and administer while raising questions about its effectiveness to serve the future needs of government revenue as well as economic growth.
The suggested tax structure is expected to broaden the current tax base while being fair across the income distribution, both as a positive tool in eliminating the current complexity and as a normative tool in enabling poverty reduction, equal opportunity and equitable distribution of income and wealth. It preserves and enhances the ability of the government to use tax policy as a macroeconomic stabilization tool.
The tax structure that this reform proposal envisions to result from the culmination of the reform process would be a combination of a flat consumption tax on goods and services in the form of a value added tax (VAT) and a progressive-flat income tax comprising of six tax brackets and no deductions. Only income net of all saving and investment in a given tax year, U.S. or foreign earned of all U.S. persons, would be subject to the income tax. Any draw down on savings and returns on investment not reinvested would also be subject to the income tax. That is, all the income people choose to consume would be subject to a combination of income and consumption tax. Such a tax structure would be biased in favor of saving and investment which the country needs as competition for global savings increases in the coming years. The current corporate tax would be completely eliminated, and so would property taxes and estate taxes. For tax purposes all tax payers would be filing as individuals. Tax advantages or penalties for marriage would be eliminated. The EITC would be replaced by a mandatory, time limited, human capital development ‘learn at work’ (LAW) program that pays a living wage equal to the poverty threshold for an individual, under a public-private sector arrangement between corporate and non-corporate private sector entities and the government. The program would provide the skills necessary for obtaining sustained gainful employment in a dynamic economy and would not allow recidivism. This would necessitate reforming the social safety net to cover only those who cannot work and have no other independent means to rely on. All incomes in the lowest tax bracket will not be subject to either an income tax or a VAT. All services would be taxed, including financial services. This is critical to preserving the tax base as even a larger share of the economy is expected to be service-oriented in the future.
The innovative feature of this proposal is to subject income to taxation as it is earned (‘pay taxes as you earn and consume’) at the applicable marginal tax rate for cumulative income at the time of taxation. In other words, every additional dollar earned would be taxed at the applicable marginal rate for that marginal dollar. Both income taxation and the VAT therefore, rely on a sophisticated electronic tax administration system that we do not currently have. However, the current market trends point to a gradual shift to electronic payments from cash transactions. Therefore, such a system is technologically feasible to implement with available technology, subject to future upgrades as technology improves, and hence the need for the gradual nature of the reform process. Such a tax administration system would significantly ease the burden of compliance and collection and narrow the tax gap substantially. It is anticipated that a biometric national identification card for provisioning all government services in lieu of social security identification would be a critical building block of the new tax administration system. This would also have the added benefit of almost completely eliminating identity theft and aid any immigration reforms. It would also facilitate consolidation of all government social welfare programs under a single government department of the Executive branch. Though the tax reform should not be predicated on the availability of a better technological tax administration system, it would substantially benefit from such a system to realize the full benefits of the reform. Further, a gradual change of the current tax code based on a politically pre-committed reform path permits to adjust to reform realities within a broadly agreed upon framework for reform to a largely consumption tax based system.
A radical but gradual overhaul of taxation and the associated government social programs that are dependent on tax revenue would (a) make revenue sharing among the states and the federal government transparent to the tax payer; (b) increase private sector participation in the provision of all but nearly pure public goods; and, most importantly, (c) accomplish these objectives over time allowing for a generational transition between the current system and the future system. It would also significantly improve the business climate in the United States increasing the competitiveness of the U.S. economy. The VAT would adapt the tax structure to the increasingly global nature of U.S. business operations. Variations in the VAT by good or service type would give the government the ability to incentivize the production of certain goods and services. The VAT would be inherently progressive, in the sense that even at a flat rate on all goods and services, the consumption of expensive goods and services would result in a larger tax. In summary, with consumption taxation tax policy shifts focus to the demand-side of the global supply/value chain to reflect the changing modes of global production while serving as an effective consumption smoother and innovation enabler.
These are difficult times of transition not only for the U.S. economy but for many economies around the world. In the United States, just as in many advanced and emerging countries around the world, income disparities are rising, and ensuring an equitable distribution of not only the benefits of economic growth but the capabilities to continue to grow are challenging leaders and policy makers. Therefore, the government has the duty to create a business, economic, political and social environment that makes this transition less painful and stable and yet more productive and rewarding for Americans while bolstering U.S. competitiveness in a world that has become more competitive, as we have always wished it to be. The tax structure is an important component of carrying out this obligation.
The most recent comprehensive tax reform in 1986 secularly followed the lead of reforms since the Kennedy administration in reducing the marginal income tax rates and providing incentives to U.S. corporations to expand their operations around the globe. Along with the changes in the regulatory structure and the structural changes in the economy, these tax changes have made U.S. corporations more profitable and the average worker more productive and better rewarded for his or her work, with U.S. productivity peaking in the mid-to-late 1990s, while enabling the country to play an active role in preventing the crises in global financial markets from reaching our shores. Increased capital flows into U.S. financial markets have enabled the United States to balance the budget after the end of the Cold War. The resiliency of the U.S. economy combined with a pro-growth fiscal policy of the current administration has enabled the country to withstand the shocks of 9/11 and the contagion of corporate misconduct. However, as the tax cuts of 2001 and 2003 approach sunset, the rising budget deficits primarily caused by the wars in Afghanistan and Iraq in the short run and budget obligations from entitlements in the long run, and the explosive trade imbalances are all together necessitating serious thinking not just about modifications to the tax code but about a comprehensive reform of U.S. taxation to suit the state of the world we are in today and to better prepare the country for the future as previous tax reforms have done.
The exigencies of reform do not allow us put it off any longer, but the realities of democratic governance and politics dictate that when we undertake such major reforms we have to get them right, as we have done for most part in the past. This requires careful and deliberative thinking about the reform process. The president has commissioned a tax reform panel with this intent, and the panel, after hearing from a wide range of people, has provided a useful set of recommendations to serve as a basis for further dialog.
The proposal for reforming the current U.S. tax system to a more fully consumption-based tax system is primarily motivated by the necessity to have a tax structure that more faithfully reflects the current structure of the economy and its most likely future evolution. The explosive growth in the information and communications technology (ICT) and the financial services industries has enabled the rapid economic globalization of the past quarter century with the United States leading the charge. As a result the share of the various sectors of the U.S. economy has shifted considerably. Today, the services sector contributes a majority share of the national income, with the remaining coming from agriculture and manufacturing. The agriculture sector, being relatively immobile and protected from international competition to some extent by government subsidies, has also benefited from low cost labor immigration and efficiency gains in both production and distribution arising from mechanization and transportation. This has placed the most burden of the structural change in the economy on manufacturing, which is now carried out around the globe by U.S. multinational corporations to reap the gains from differentials in the costs of the factors of production. In the coming decades, closer economic integration enabled by greater international trade that is in turn facilitated by the global supply chain is expected to impose similar burdens on the services as well as the agricultural sectors, with technological progress causing changes in the comparative advantage and employment structure of the United States.
The objectives that are expected to be achieved by the tax reform are:
• A Pro-growth tax structure.
• Be forward looking.
• Revenue neutrality.
• Broadening the tax base.
• Ease of compliance.
• Ease of administration.
• Preserve and enhance the effectiveness of tax policy as an instrument for macroeconomic stabilization.
The changes from the current system are:
• All tax filers will be considered individuals. No marriage benefits or penalties.
• All sales of services are treated as consumption and would be subject to the VAT.
• ‘Pay taxes as you earn and consume.’
• No payroll taxes.
• No separate state and local taxes. A single tax would be collected and shared administratively between the federal government, states and localities.
• No deductions.
• No property taxes.
• No taxes on saving and investment. Only income realized in current tax year from saving and investment will be taxed.
• No estate taxes.
• No corporate tax.
• Replaces EITC with non-recidivist human capital development programs to integrate the poor into the broader economy and reduce welfare dependency.
The U.S. tax structure would conform to the following initial, intermediate and final rates in stages 1, 2 and 3 respectively of the reform process:
Income tax liability on a pay as you earn basis for annual income of $230,000 in stage 1 of the reform:
(45000-0)*0.00 + (90000-45000)*0.00 + (135000-90000)*0.075 + (180000-135000)*0.15 + (225000-180000)*0.225 + (230000-225000)*0.30 = $21,750.
Assuming a 15% savings and investment rate on the same income, the consumed income would be: 230000*0.85 = $195,500. A 7.5% flat consumption tax on this income would be $14,662.50.
The total tax paid by the individual = $21,750.00 + $14,662.50 = $36,412.50
A back-of-the-envelope revenue estimate of revenue from a 7.5% consumption tax on 66% of U.S. GDP of $13 trillion = 0.075*0.66*13,000,000,000,000 = $643,500,000,000 or approximately 2/3rds of a trillion dollars. Assuming an average income tax rate of 15% on the same national consumed income, the total annual tax intake of all federal, state and local governments combined under this proposal would be approximately = 0.075*0.66*13,000,000,000,000+ 0.15*0.66*13,000,000,000,000 = $1,930,500,000,000 or approximately 2 trillion dollars. The positive feedback multiplier effects from the untaxed savings and investment and greater private sector provisioning of many government services through the development of competitive markets would boost GDP, which in turn would boost consumption to increase the tax revenue.
• Revenue neutral.
• Progressive and flat. Simple. No two-tier tax structure as with the AMT.
• Encourages saving and investment.
• Gradual, allowing for generational transition, phasing in over three stages and three decades. Makes it politically palatable. The new tax structure would be completely in effect by approximately 2040 allowing for parallel reforms in entitlement and other social welfare programs.
• Reduces tax gap substantially by implementing tax collection at point of income and consumption by employing a de jure electronic biometric national identification system to replace the current de facto social security national identifier.
• Forward looking to reflect the shift toward a cashless society.
• The VAT, tax administration and poverty reduction broadens tax base.
• Provides impetus to reform and/or consolidate and streamline the various government social welfare programs, including public education and health, to be administered under a single government department of the Executive branch. Reallocates government spending to nearly pure public goods through increased private sector provisioning in all others by encouraging the creation of competitive markets especially in education and healthcare.
• Eases compliance and reduces compliance costs by eliminating tax returns.
• Significantly reduces administration costs. Tax payer gets an invoice from the IRS at the end of every tax year giving a detailed breakdown of taxes paid and their distribution between federal, state and local governments. Improves accountability of government spending by reporting to the tax payer a breakdown of how the tax dollars were spent in the previous fiscal year.
• Preserves tax policy flexibility through variations in the VAT for certain types of goods and services and behaviors that the government wants to encourage or discourage.
• Eliminates Tiebout sorting, requiring reforms in public education and financing.
• Eliminates tax competition among the states as growth diffusion across the country from continually decreasing transportation and communication costs would not require such tax incentives.
• Eliminates hidden tax expenditures in budget allocations and contributes to budget process reform.
• Requires political commitment. Associated reforms of the current welfare system could be politically difficult to accomplish though not impossible given the reform exigencies. Requires concerted and strong political leadership. Otherwise, the outlook between 2040 and 2075 could be dim for dealing with both public debt and economic growth.
• A biometric national identifier requires legal safeguards against potential violation of civil liberties and may require a carefully orchestrated public awareness campaign.
• The establishment of a point of income and consumption tax collection infrastructure to eliminate filing requirements requires pilot programs before it is adopted nationwide.
• Requires bargaining with the states to eliminate direct administration of separate state and local taxes.
• There could be one time price effects because of the VAT, though the distribution of the same overall tax burden between income and consumption taxes could potentially offset these price effects.
Reallocation of government expenditures among productive activities that add to national income is a crucial function of the structure of raising tax revenue. A combination of an income and consumption tax as proposed in this memo, albeit political challenges in making it happen, appears to be the best solution toward both tax simplification and the reform of government expenditures. The associated reform of tax administration ensures that taxes are collected and the tax gap is reduced significantly. The elimination of taxes on savings and the corporate income tax prevents tax avoidance and evasion behaviors while permanently boosting investment in the United States. The reform exigencies make a strong case for time-consistent political commitment for gradual reforms.