The U.S. tax system has become a worst possible solution to a problem: the government needs funding, but using a complicated personal income tax system involves 6.6 billion hours a year and as much as 20% of revenue for compliance.  Between the Alternative Minimum Tax and nearly a century of Congress using income tax law to fund pet ideas, like home ownership and employer medical insurance, our current system has devolved into a national embarrassment.  With record deficits and ballooning entitlement costs as the Baby Boom retires, it will be necessary to increase government revenue, yet the current system is unwieldy and Congress has not passed a tax increase since Clinton's 1993 budget.  In order to make increased government revenues palatable to conservatives significant changes to the tax system will be necessary; scrapping the current system entirely will push the reset button on tax complexity and allow a more efficient system to replace the current labyrinth of exceptions, deductions and cascading penalties.  In an ideal world, the government would tax activity it wanted to discourage- that's why a pack of cigarettes in "Daddy Knows Best" Bloomberg's New York costs ten bucks- and government shouldn't want to discourage income.  A better designed tax will encourage better behavior from taxpayers, even while it possesses enough ideas that are attractive both sides of the of the ideological spectrum to become law.  I believe that the foundation of such a tax comes from Robert Frank, who proposed an annual consumption tax to replace income taxes.

In a May 2009 article on Five Thirty Eight, Robert Frank outlined an idea for replacing income taxes with an annual consumption tax.  Consumption taxes are superior to income taxes, because increasing income is unequivocally a good thing, yet progressively increasing income taxes remove some of the benefits of making more money.  Liberals misplace their populist outrage when they target income, instead of conspicuous consumption.  After all, Bill Gates is not the worst person in the world just because he has the most money.  A better alternative would be to shift the burden of taxes onto consumption to give people an incentive to save money and live within their means, and to penalize consumption that exceeds reasonable ratios of investment to enjoyment.  We have advocated for a value-added tax (VAT) several times here, but given the political difficulty of raising taxes in this country, Mr. Frank's consumption tax makes more sense because could be adapted to include selling points for both conservatives and liberals.  

Usually, consumption taxes are charged on the point of sale, but the consumption tax, as Mr. Frank described it, would be collected annually like income taxes but the amount subject to taxation is income minus savings.  He also allowed for a large standard deduction, something like $30,000 for a family of four.  Allowing further deductions for capital investments, spending on medical expenses, excluding voluntary procedures; down-payments on houses, with a maximum deduction equal to median state housing prices; charitable donations, again with a maximum; and college tuition would further improve the tax.  All of these deductions make the tax more complicated, but legislating that citizens receive annual reports on their credit, savings and investments is its own reward because a more informed citizenry should behave more rationally.  This tax if correctly implemented would allay progressive fears about consumption taxes and provide conservatives with several tax victories all while providing most of the benefits of a V.A.T.

 

Liberals have traditionally opposed a consumption tax imposed on sales since it would disproportionately tax the poor, who tend to save less of their income.  Annual consumption taxes, however, would be progressively scaled to create equity.  Mr. Frank actually wants a top marginal tax rate of 100%, so a dollar in spending above say $1,000,000 a year would incur a dollar in taxes.  While consumption taxes are not subject to the Laffer curve - in that a 100% tax would still raise some revenue, since the very rich could afford to spend above their income - I believe a tax of this type could not pass Congress.  Since consumption taxes have a smaller revenue base than income taxes, consumption tax rates should top income tax rates, but blatantly bleeding the rich will make conservative opposition pro forma.  A top rate over 50% might not even maximize revenues due to sharply decreased consumption.  A gradually increasing rate that tops out at 50% for the very highest consumers will provide large revenues without appearing to "redistribute" the wealth.

Providing an exact estimate of how large revenues from a hypothetical tax will be is impossible, but I can provide a rough and dirty projection. I assume that consumption would decrease due to the tax, that's kind of the point after all.  No country has a tax of this sort, so knowing exactly how much consumption will decline is difficult, but European consumption levels, where a VAT has a similar effect on consumption, are about 58%.  Let's say U.S. consumption declines to 60%, from its current 70%.  Next, lets account for the standard deduction, which will be untaxed: $6,500 times roughly the U.S. population of 300 million equals about $2 trillion.  The GDP, $14 trillion, times the consumption minus the deduction is the tax base, about $6.5 trillion.  From here I have to rely on strict guesswork because I don't have access to detailed information about personal spending quartiles and savings rates, but to some extent that does not matter if the tax just brackets spending.  If the bottom half of the tax base had a 20% tax rate, the next quartertile was 30%, the next twenty percent was subject to a 40% rate and the top 5% had a 50% rate then revenues would be about $1.83 trillion, or nearly double current income tax revenues and $700 billion more than the highest income tax revenues in 2007.  Allowing deductions will shrink those revenues, but clearly this tax can provide significant increases in revenue if enacted.  Fortunately for future federal balance sheets, both parties can find reasons to support this type of reform.

 Liberals, who believe that prudent government policy can improve the lives and choices of citizens, will cheer the most important side-effect of consumption taxes: the stimulation of savings.  The U.S. saving rate actually dipped into the negative in 2005, as debt financed consumption above income.  An underreported part of the massive increase in personal savings during the financial crisis was that most of the savings came in the form of paying down credit card debt.  From an investment standpoint, this is a superior strategy, since the difference between repaying a credit card with a 15%+ interest rate or saving money at perhaps a 1% interest rate represents an arbitrage opportunity of 14%.  This tax will further increase the advantages of paying down debt, which will be treated as savings, and discourage new debt-financed consumption since it will be subject to taxation.  When deciding whether or not to buy a 80 inch Plasma on a zero down Best Buy credit card, the tax payer would be aware that an additional bill will be due to Uncle Sam at the end of the year.

Liberals can champion the protection this tax gives to vulnerable constituencies.  The poor or sick would not see their taxes increase under this system and if they respond to incentives to save they will actually benefit.  For the working poor, the tax could simulate “negative taxes” like the Earned Income Credit, by making the standard deduction refundable.  Thus a family of four with income of $20,000 would have a taxable consumption of negative $10,000 and at the lowest tax rate of 20% they receive a refund of $2,000 above any taxes they paid.  Even better, this would give poor families a 20% return above interest on any savings, since every dollar of savings that moves them further into negative consumption would be refunded 20%.  This mechanism could also help poor families faced with sharply increased medical spending, which would be indistinguishable from savings, and thus provide a 20% government subsidy to medical costs for poor families.  Not exactly socialized medicine, but definitely a benefit.

Conservatives, meanwhile, will like how the personal saving rate can be further increased through an improvement in the collection mechanism.  Tax refunds technically constitute an economic loss, due to the opportunity cost of getting no return on capital essentially borrowed at zero interest.  In a perfect tax system, savvy tax payers could choose to invest their taxes and receive a dividend on that capital until it is due.  Since income is not subject to tax, our new tax would allow this.  However, many tax-payers do not have any particular investment savvy and would find annual lump sum tax payments onerous so the default option under the new tax will be a payroll deduction like the current system.  However, rather than keeping the economic gains of excess capital, the government will withdraw expected taxes from payroll and hold the money in interest accruing escrow until taxes are due.  Whatever tax liability the taxpayer has comes out of this account and the rest is returned, along with any interest earned.  Tax payers could opt to not participate and instead invest more aggressively, but this system would be a dramatically more fair than the current system.

This increased efficiency is only one of many things conservatives can rally around in this tax.  For example, not only does this tax necessitate the elimination of income taxes but it would also make estate taxes unnecessary.  "Death taxes" could simply be incorporated into consumption taxes.  One line on a tax form would require disclosing any inheritance income, but if all of that income is saved- and often inheritance income is saved since it is received as a large lump sum - it would not incur any taxes.  Since currently only inheritance in excess of $3.5 million is subject to taxes, this new system will increase the total taxes on estates, but in a way that is more broadly fair and will not force inheritors to break up family estates and properties unless they cash out.  In the long run consumption taxes increase equity because the wealthy either save and invest more, benefiting everyone, or the social loss incurred by their excess consumption is recouped as taxes.

Perhaps the best selling point for both parties, of the new tax is how it would treat investment.  Giving tax payers credit for money spent on investment is a prime example of something for everyone.  Conservatives get a more efficient tax system that doesn't punish behavior that should be encouraged, a classic example of supply side economic incentives.  Liberals get a mechanism for tracking income that comes from investments and taxing it when it is cashed out.  This fixes the "Warren Buffet's secretary has a higher tax rate than he does" problem because it treats all income equally. By stimulating investment, which will be treated like savings, the tax will grow the economy.  This will mean that small business owners will have to itemize business investments, but they have to do that in the current system already.  Investment is the most important part of growing the economy and this tax will stimulate fresh investment, both personally and through the financial system in the form of an increased pool of savings for banks to reinvestment.