We have become accustomed to thinking that taxes, like hemlines, can only go up or down. This isn't true. Over the centuries changes in the form of U.S. taxes have been at least as dramatic as changes in the rate of taxation.
For instance, most federal revenues now come from personal and corporate income taxes, and from the payroll taxes that fund Social Security and Medicare. But most government revenues originally came from excise taxes on luxury items such as tobacco, spirits, and sugar, and throughout much of the nineteenth century the bulk of federal revenues came from tariffs on imported manufactured goods. In fact, the federal income tax, which we tend to think of as an eternal fixture, was introduced as an emergency measure during the Civil War, and did not become permanent until the Sixteenth Amendment was ratified, in 1913. Even then income taxes were levied on only the richest Americans. Not until World War II did the income tax metamorphose into something we would easily recognize today: a mass tax that reached the middle class.
Our tax system has continued to evolve in the postwar era. The second half of the twentieth century witnessed a decreased reliance on progressive taxes (those that, like the income tax, charge higher earners at a steeper rate) and an increased reliance on regressive taxes, such as payroll and sales taxes.
In analyzing the tax system we need to look not just at rates but at the forms that taxes take. There are three basic questions to consider: Is the system fair? Does it encourage efficiency? Does it raise enough to pay for government spending? Let's take each question in turn.
Are today's taxes fair? In some ways this is the hardest of the questions to answer, because it requires a definition of "fairness." This could be rephrased as: To what extent is one's overall tax burden commensurate with one's ability to meet it? In this regard taxes are much less fair than they were a generation ago, because over the past several decades tax reformers have focused on reducing the federal income tax while ignoring the explosive growth of other, more regressive taxes.
In a sense the federal income tax remains one of the most progressive taxes there is: half of all the revenue it generates comes from workers earning more than $200,000 a year. But income-tax rates are actually not nearly as progressive as they were several decades ago: the top marginal income-tax rate has declined since the Kennedy Administration, from 91 percent in 1960 to 35 percent in President George W. Bush's plan. Meanwhile, the corporate income tax—whose effects are felt more directly by shareholders than workers—has contributed less and less to overall federal revenues, as changes in the tax code have allowed corporations to shield more and more of their income. At the beginning of World War II the corporate income tax provided almost 50 percent of federal revenues; today it accounts for only 10 percent.
Decreasing the progressivity of certain taxes, and relying more on regressive taxes, shifts the tax burden down the income scale from the rich to the middle class and the working poor. This is exactly what has happened over the past several decades. Since the end of World War II state and local taxes—which are far less progressive than federal taxes—have more than doubled as a share of the American economy, while total federal tax revenues have slightly decreased as a percentage of GDP.
Social Security and Medicare payroll taxes, also regressive, have grown to the point where they are the largest federal taxes that most American families pay. Though the basic structure of the federal payroll tax has hardly changed in fifty years, its rate has been raised repeatedly. Today it is 15.3 percent, and all earners, whether they make $25,000 a year or $250,000, pay it on the very first dollar of earnings. But the 12.4 percent Social Security tax applies only to wage earnings below $87,900—meaning that the $25,000-a-year earner (every dollar of whose income is taxed at 15.3 percent) pays a higher effective tax rate than the $250,000-a-year earner (most of whose income is exempt). And investment income and employer benefits—which accrue disproportionately to high-income earners—go completely untaxed, making the system still more regressive. People who live entirely off inherited wealth pay no payroll taxes at all.
Of course, reasonable people—and even reasonable economists—can disagree about how the tax burden should be distributed; a tax system's relative progressivity can affect how efficiently an economy functions and how quickly it grows. (More on this in a moment.) But current economic realities suggest that we should be making taxes more progressive, not less. For instance, the benefits of recent productivity growth—the result of rapid technological advances—have not spread evenly through American society; most of the gains have flowed to investors and high-income professionals. The result? A degree of economic inequality not seen in this country since before the Depression. If fairness means taxing people in accordance with their ability to pay, it is unfair to shift taxes away from the few who have benefited most from the New Economy and toward the many who have benefited much less (or even been hurt). But that is exactly what many of the tax reforms of the past several decades have done.
Is today's tax system efficient? In other words, does it send the right signals to individuals and businesses, and promote economic growth? Not really.
The dominant economic themes of our time have been globalization and technological change. Both these forces have intensified international competition, particularly in the manufacturing sector—a fact that has enormous implications for our tax system. Globalization has made it easier for multinational corporations to follow the lowest labor costs and tax rates around the world; countries that can keep their tax burdens low have a competitive advantage over those that can't. During the past two decades efforts to reduce taxes on dividends and capital gains have all been aimed at lowering the cost of capital—and thereby encouraging investment and boosting competitiveness—in the United States. This is a sensible strategy as far as it goes—but its application has been only piecemeal, and has produced uneven effects.
Furthermore, the number of elderly people as a percentage of the overall U.S. population will rapidly increase in the decades ahead. Common sense dictates that our tax system encourage saving—both to boost the economy and to help pay for the Baby Boomers' retirement. The current system, however, favors consumption, which is one reason why we have one of the lowest saving rates among advanced industrialized countries. As a consequence, we are staring at not only trillions of dollars' worth of payments we cannot afford to make to future Social Security and Medicare recipients but also a growing international debt. At some point we will finally have to finance the retirement of millions of Americans and pay off the foreign investors who have lent us money over the years—a task that will be made much easier if we start saving now.
Given increased global competition and our graying population, it is very important that our tax system not only encourage saving but also discourage harmful consumption. Too many behaviors that impose "negative externalities"—social costs that are not factored into the direct accounting figures—go untaxed. For instance, Humvee owners don't have to pay taxes for the environmental destruction wrought by their vehicles. Moreover, many of the indirect costs of the country's dependence on oil—such as the expense (including national-security expenses) of shipping oil from the Middle East, along with the damage it does to the environment— go untaxed. A more efficient tax system would discourage this waste, and provide incentives for more-productive investment.
Are our taxes sufficient? The fundamental requirement of any tax system is that it raise enough revenue to pay for government expenditures. Although it's defensible—and even desirable, given the stimulus effect—to run short-term budget deficits during an economic downturn, this borrowing should be offset by surpluses during the boom period that follows.
By this standard our tax system is a failure. Last year, in large part because of recent tax cuts, federal tax revenues as a percentage of GDP were lower than they have been at any time since the Eisenhower Administration, falling for the third straight year—an unprecedented occurrence when the economy is coming out of a recession and we are at war. Meanwhile, spending on government programs grew by nearly nine percent—more than the average growth rate during the 1990s. The result is the largest federal budget deficit in American history.
Meanwhile, the states are in a fiscal mess that stems from several factors: state tax cuts throughout the 1990s, increased spending on government programs, escalating health-care costs, and the dampening effects of the nationwide recession. But state deficits have been made worse by the fact that many state income taxes are tied to the federal tax code and thus rise and fall with federal taxes.
Neither the federal government nor state governments are doing enough to redress these structural deficits. In light of the inevitable expansion of public pension and health-care programs that will accompany the retirement of the Baby Boom generation, we should have been building up either government reserves or individual savings. Instead we have been allowing our personal savings to fall and have been cutting taxes and increasing spending, thereby locking ourselves into deficits for decades to come. This is like kicking a live grenade down the road—and then walking up to it and kicking it again.
What if we decided to fix the tax system, to make it fairer, more efficient, and sufficient to pay for government outlays?
Only four basic things can be taxed: total income (including earnings from investment and other sources), wages, consumption, and wealth. Currently the federal government heavily taxes earnings, both wages and total income, while state and local governments rely more on taxing spending and wealth (mainly in the form of real estate). Roughly three quarters of all taxes are raised from what people earn, and only 15 percent comes from what they spend.
With these facts as our starting point, what reforms should we make? Let's start with how to make the system fairer. There are two options. We could make already progressive taxes even more progressive—for instance, by boosting marginal rates on the highest income brackets. Or we could eliminate the payroll tax and replace it with a more progressive tax. In recent years most left-leaning reformers have promoted the first option. That's the wrong choice. The purpose of the tax code should not be to punish rising incomes or wealth creation; besides, there are limits to how much we can tax income and capital gains without undermining our competitive position in the world. A better approach, therefore, would be the second. To begin with, we should reduce taxes on wages by eliminating the regressive payroll tax that currently funds Social Security and Medicare. A payroll tax might make sense as a way to fund individual medical-savings or Social Security accounts—that is, an individual's payroll deductions would go directly into that same individual's retirement account. But as a means of financing a redistributive universal social program, the payroll tax too often ends up funneling the wages of middle- and working-class Americans to affluent retirees.
Eliminating the payroll tax would have other advantages as well. For example, it would free employers from matching employees' Social Security contributions, which would encourage them to create new jobs. It would also effectively increase wages, making it easier for workers to save their own money for retirement. And it would produce a substantial political benefit, one that would make it easier to solve long-term problems with Social Security and Medicare. Currently the payroll tax creates the misconception that people have a "right" to their Social Security and Medicare benefits. Not only is this false as a matter of law, but it makes it extremely difficult to reform these struggling programs—for example, by subjecting benefits for affluent retirees to a means test.
Eliminating payroll taxes could make the system much fairer at a stroke. But absent the payroll tax, how would Social Security and Medicare get funded? The ideal replacement would be a tax that boosted the saving rate, helping to increase productivity and build the capital to fuel the long-term growth we need. There are two approaches that might be effective in encouraging a higher saving rate. The first is to increase incentives for saving by reducing taxes on income and capital gains, while creating targeted tax breaks for saving, such as tax-sheltered IRAs. The second is to punish consumption more heavily—especially unnecessary consumption. We have already gone about as far as we can with the first approach; further reducing taxes on income and capital gains would further compromise the fairness of the system. But we have not ventured far at all with the second approach, which would allow us to discourage consumption without impairing the economy or making the system less fair.
It is true that state and local governments, which rely heavily on sales taxes, already do levy taxes on consumption. But these taxes tend to be highly regressive: proportionally, they take the biggest bite out of the smallest paychecks. There is an even bigger problem, too, in that sales taxes do not apply to most services. Not only does this penalize the manufacturing sector (because its products are taxed), but as the service sector becomes a larger share of the overall economy, the tax base shrinks. Furthermore, Congress has thus far exempted Internet commerce from taxation, thereby depriving states of substantial potential revenues. Simply increasing existing consumption taxes, in short, would not make the economy more efficient or the tax system more fair.
But what about a different kind of consumption tax—one that is both efficient and fair? Imagine a "progressive consumption tax" levied not on individual purchases but on total spending, as measured by the difference between what you earn and what you save. It might work like this: no tax at all on the first $25,000 you spent, a 10 percent tax on spending from $25,000 to $100,000, and a 15 percent tax on all spending above $100,000. In effect, basic necessities would not be taxed, and luxuries would be taxed at higher rates. This plan would be simple to execute. Each year taxpayers would calculate their total income from wages, investment income, and other sources, just as they do now. But then they would take a second step, subtracting the value of all their savings that year—such as savings accrued in a bank account, through a 401(k) plan, or through an investment fund (all of which are easily tracked, meaning that it would be hard for cheats to escape detection)—from their total income. The resulting figure would be the base amount to which the consumption tax would apply, at progressive rates. The less you spent, the lower your tax rate would be. Low-income earners would for the most part be taxed less onerously, since they spend less; and middle- and high-income earners would have an incentive to save their money, preparing for retirement and bolstering the country's long-term economic prospects. A national progressive consumption tax would go a long way toward recouping revenues lost from the elimination of the payroll tax, and it would make the system fairer, too.
Last we come to the question of how to ensure that tax revenues are sufficient to pay for government expenditures. Even if the economy continues to recover from recession, the recent tax cuts and spending increases almost guarantee that the federal government will be deep in red ink for decades to come.
Once again we have two broad choices: we can increase the rates on what we already tax, or we can broaden the revenue base by taxing new things. The latter approach will yield both greater fairness and greater efficiency.
We can begin by eliminating a lot of "tax expenditures"—better known as tax loopholes. Many forms of income—including government entitlements and employer-provided health benefits—are sheltered from taxation by exemptions, deductions, or credits. For every one of these dollars we don't tax, we have to impose higher rates on the dollars we do tax in order to raise the same amount of money. This can be both inefficient (since higher marginal tax rates discourage work) and unfair (since two people earning the same amount of income through different kinds of compensation—or spending the same income in different ways—can pay dramatically different amounts in taxes).
We should turn next to slashing corporate welfare. Most industry-specific tax benefits insulate certain companies from competition that would force them to be more productive. If we stopped treating farming—to take just one example—as a favored industry, we would save $20 billion annually.
Next we should rethink the estate tax. Despite outcries over the "death tax," transfers of wealth through bequests largely escape taxation. But the estate tax in its current form may not be the fairest way to derive revenue from such transfers. Consider two families—one in which a wealthy patriarch leaves $10 million to a single heir, the other in which the same amount is divided among twenty-five heirs. Under current law all the heirs' inheritances would be taxed at the same rate, no matter the amount received—whether $10 million or a small fraction thereof.
A fair approach would be to repeal the existing estate tax and treat inheritance income and wage income the same way. This would simultaneously broaden the federal revenue base and lower the top rates at which heirs can be taxed.
Even if we subjected entitlements to a means test, closed tax loopholes, cut corporate welfare, and made all inheritance transfers subject to income tax, the government would still face a long-term deficit. Thus we need to find some other sources of revenue. One possibility is to levy taxes on pollution and the use of nonrenewable resources—a perfect example of taxing what you don't want in order to avoid taxing the activities you want to encourage. Another possibility is spectrum user fees. Rights to the public airwaves, which are valued at hundreds of billions of dollars, are practically given away. We should charge annual fees for the right to use and profit from publicly owned airwaves.
Radical tax reform won't happen overnight. In the past the impetus for major reform has almost always been dire need—either the need to pay for wars and other unplanned events or the need to shift tax burdens when growing income disparities have led to political discontent. So far the shifting of the tax burden from capital and the rich toward labor and the middle class has yet to produce the sort of populist rebellion the nation has witnessed in the past. But it may soon do so. Even if it doesn't, another strong incentive for reform—a fiscal crisis caused by mounting deficits—looms not far in the distance.
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