The case for tax reform can be made very simply. As a result of a long string of past "reform" efforts, the U.S. tax system has become complicated, full of loopholes and unfair in the sense that it treats equals differently. It also contains distortions that impede capital investment and encourage the misallocation of whatever funds are devoted to investment. Changes should be made, even if these changes do not make the short-term macroeconomic situation immediately better.
One suggested revision is the flat tax, of which President Reagan has spoken favorably. It involves eliminating all or most tax preferences, itemized deductions and tax credits, thus greatly broadening the tax base. It also involves taxing all income above a specified exempt level at a uniform flat rate. The base-broadening features have long been favored by both liberals and conservatives as a way to reduce unintended distortions in the tax system, improve equity and allow for lower marginal tax rates.
This much is fine, if perhaps politically infeasible. But the flat-rate part of the proposal, while it does reduce the demand for lawyers and accountants, also implies a very large drop in marginal tax rates for upper-income taxpayers. Simulations of this feature done at the Congressional Budget Office imply quite massive shifts in the tax burden away from upper-income taxpayers and toward low- and middle-income taxpayers. All those who feel that Reagan's Economic Recovery and Tax Act of 1981 was a rich person's tax bill "ain't seen nothin'" yet. Of course, one can imagine modified flat-rate proposals that simply widen tax brackets and reduce their number; these proposals might be good as far as they go, but they drop the very feature that gives the flat tax its name.
The other major reform proposal is the expenditure tax, about which the president's chief economic adviser has made complimentary remarks. Under the expenditure tax, taxpayers would file annual returns, just as they do now under the income tax. Moreover, the expenditure tax could and should be progressive. Those taxpayers with the greatest ability to pay taxes should be taxed at the highest rates.
The fundamental difference between the expenditure tax and the current income tax would be in its treatment of savings. Under an expenditure tax, taxpayers would be allowed to deduct their net savings in any given year, but would be required to pay tax on their net withdrawals from savings. Thus if a taxpayer received income of $30,000, bought $3,000 worth of stock, put $250 into a savings account, and withdrew $1,000 from her money market fund, her expenditures (receipts minus savings) would be $27,750, and she would pay tax on that amount (minus any personal exemptions). In this way, the expenditure tax eliminates the double taxation of savings.
Traditionally, the major argument in favor of income taxation is that income provides the best possible measure of a taxpayer's ability to pay for government services. However, a case can be made that consumption, which is the tax base under the expenditure tax, is a superior measure of ability to pay. For most households, consumption varies much less from year to year than does income. The reason for this is obvious--households make some estimate of their resources over the long term and then adjust their consumption to appropriate levels. When they have an unusually good year, they save or repay debt; in a bad year they will borrow or draw down savings.
Seen in this way, the expenditure tax is an ingenious device by which taxpayers in their own behavior are allowed to determine how well off they are. But there is one important caveat to this argument. If bequests are exempt from tax under an expenditure tax, there will be an incentive for taxpayers to amass fortunes that could then be passed on tax-free. The obvious way out of this problem is to treat bequests like any other expenditure--and levy a tax according to the expenditure tax schedule on taxpayers' estates.
A second advantage of the expenditure tax is that changing rates of inflation are far less troublesome under it than under an income tax. Under the current income tax, there is substantial mismeasurement of income because (for example) depreciation allowances are based on the original cost of the assets that are being depreciated. Under the expenditure tax, there is no such problem--the original purchase of the asset is savings, and is thus exempt from tax. There is no need for depreciation allowances, and all receipts derived from the asset will be taxed as they occur. There are similar advantages for the expenditure tax with regard to capital gains and losses, and the bedeviling problem of integrating personal and corporate income taxes.
The expenditure tax is not without its difficulties. One major one is defining saving in a way that doesn't encourage wealthy people to disguise a good deal of consumption--such as racehorses, art collections and the like--under that rubric. Another is that the rates on consumption must be more progressive than the rates on income now are to raise the same revenue.
Then there is the problem of housing, that Achilles' heel of all tax systems. The expenditure tax would attempt to eliminate the distortion that now favors housing as against other forms of investment, essentially by removing the deductibility of mortage (and other) interest. From the standpoint of economic efficiency and economic growth, this proposal is a clear winner, and has long been favored by almost all economists. From a political standpoint, such a change may not be so easily digested. Some compromises with the clear standards of the expenditure tax may be made as the proposal goes through Congress, but it is hard to imagine these compromises being worse than what we have now.
Thus if there is interest in tax reform, the expenditure tax is a worthy candidate. It can be made as progressive as Congress desires, it is better than the income tax in dealing with inflation and integrating corporate income, and it removes distortions that now penalize and misallocate investment. It won't solve all of our economic problems, but it will solve some.