Alan Viard ’84 is a resident scholar at the American Enterprise Institute specializing in federal tax and budget policy. He served as a senior economist at the Federal Reserve Bank of Dallas, and has worked for the White House’s Council of Economic Advisers, the U.S. Treasury Department’s Office of Tax Analysis, and the Joint Committee on Taxation of the U.S. Congress.
The Politic: You recently published Progressive Consumption Taxation: The X-Tax Revisited. Could you explain to our readers what the X tax does?
The X tax is a two-part tax system. There’s a tax on households, and there’s a tax on business firms. The tax on households applies only to the wages that people earn. There’s no tax on any capital income such as interest, dividends, or capital gains. Wages are taxed under the X tax at progressive rates. People with higher wages are in higher brackets, people with relatively low wages pay no tax, and just like today, there could be refundable tax credits to put money in the pockets of the lowest-wage workers. The second part of the tax is a tax on business firms. The tax applies not to their income, but to their cash flow. Their cash flow is computed by letting them immediately deduct the full cost of all of their investments, whether it be equipment, buildings, inventories, or land. There’s no depreciation over a number of years, it’s just a straight-up deduction in the year that the investment is made, and then a full tax of any proceeds from the investment. Neither business firms nor households have to report their financial transactions, so business firms would not be deducting interest expense on their debt, for example. The tax rate on the business cash flow would be equal to the highest tax rate that applies to wages, or in other words, the rate that’s paid by the highest-wage workers. So you could imagine that rate maybe being 35 percent, or maybe being higher depending on how much revenue you were trying to raise and how progressive you felt the tax system needed to be.
The Politic: You propose that the U.S. implement a progressive consumption tax in place of the current income tax system. Why is our system of income tax so problematic that we should do away with it entirely?
The primary reason is because the income tax system puts a significant penalty on saving. People who save are taxed twice, in effect – they are taxed when they earn their wages and then taxed again on the return to their saving. So it’s an inescapable feature of income taxation that it penalizes saving, and that has a number of effects. One is that it distorts the allocation of people’s spending within their lifetime, discourages them from leaving wealth to the next generation, reduces the national saving rate and capital accumulation, and undermines long-run growth.
There are a number of auxiliary problems with income taxation. One is that it is very hard to measure income correctly. Inevitably there is disparity between different assets in how they’re taxed, so we’re not only taxing someone who saves more than we tax someone who consumes, but we’re also taxing different types of saving at different rates. So we’re discouraging saving overall and also discouraging some types of saving relative to others – we’re reducing the total volume of saving and interfering with the proper allocation of the saving that occurs.
All of these problems vanish under consumption taxation. Assuming the tax rate is stable over time, consumption taxation is neutral between someone who consumes today and someone who saves for future consumption. All forms of saving face a zero effective tax rate – there’s no extra tax because a person has saved – and so you automatically have neutrality across the different types of saving without having to measure any of the difficult income-type stuff.
The Politic: America remains the only developed country without some form of national consumption tax. Why do you think that is?
That’s a very good question. Part of the answer has to be the fact that we are a low-tax country compared to most countries in the world. Resistance to taxation has always been part of the American experience I think, going back to the Boston Tea Party. One of the objections to having a consumption tax alongside the income tax is that with two major taxes of that kind it would be easier for the total volume of taxation and the total volume of government spending to increase. So given that we are a low-tax country, a country that’s averse to taxation, it’s maybe not surprising that we have only one instead of both of these major taxes. I’m not sure if there’s an easy explanation for why the one that we have is the income tax and we have no consumption tax as opposed to the other way around. The standard experience internationally is to have both, and so the book of course recommends something different from that. In a sense it recommends that we remain a relatively exceptional country, but in a different way. Instead of having only an income tax we would have only a consumption tax, so in some ways there’s really less precedent for that, but from an economic perspective I think the arguments for it certainly seem relatively compelling.
The Politic: On the subject of marketing the progressive consumption tax, under what grounds could Democrats and Republicans come together on this?
Logically it should appeal to both parties. I don’t think that anyone wants to penalize saving as an end in itself. In other words, the primary reason why we tax saving is in order to make sure we have progressivity, which we know we can’t get with a sales tax or a value added tax. If people realized that you could keep progressivity without taxing saving, it seems to me that would satisfy the objectives that Democrats have. Republicans are not trying to make the tax system less progressive as an end in itself, but trying to minimize the economic damage that it does. Much of that economic damage comes from taxing savings, so you can achieve the key goals of both parties if you keep your progressivity, but if you tax consumption.
The Politic: Has there been any political movement on proposing an X tax?
The president’s Tax Reform Panel in 2005 recommended two plans to the president, one of which did propose largely replacing the income tax system with an X tax. The X tax had a 30 percent top rate, so that was the rate that the highest-wage workers paid on their wages and that the firms paid as a flat rate on their cash flow. But it did keep a 15 percent tax on interests, dividends, and capital gains, and that was largely to address the Buffett-Romney problem … it wasn’t called that then, I guess. A majority of the panel apparently supported it, but the panel as a whole did not recommend another variant which would have done a complete replacement that would not have kept the 15 percent tax on interests, dividends, and capital gains, and the rate then would have been 35 percent at the top under that X tax. The tax reform panel’s proposals, however, sunk without a trace.
U.S. Rep. Devin Nunes, R-Calif., wrote an op-ed recently in which he said that he plans to introduce a bill that will change the business tax system in the United States to a cash-flow tax. In other words, he would allow all investment to be expensed immediately as it would be under a cash-flow tax as part of the X tax system. So it would effectively switch the business part of our tax system over to X tax principles. However, it would retain most of the current individual income tax system, so individuals would still pay taxes on capital income, interest, dividends, and capital gains. In that sense it actually is relatively similar to the option that the president’s Tax Reform Panel recommended, particularly since we do have a 15 percent rate on dividends and capital gains today. So that option may get some discussion as things go forward. But, I think it illustrates the political difficulties of trying to switch over completely to an X tax that the tax reform panel certainly blinked and kept this 15 percent capital income tax.
The Politic: One last question, on a different subject. How much will ending the high income tax cuts set to expire soon help us to face the approaching fiscal cliff?
They don’t do that much, and that is part of the problem in how some people are thinking about this issue. The president and congressional Democrats obviously favor letting the high-income tax cuts expire, and they point out rightly enough that of course that would help in addressing the fiscal imbalance. The high-income tax cuts total approximately 1 trillion dollars over the next decade, but it’s worth noting that the so-called middle-class tax cuts – the tax cuts for people below $200,000 or $250,000 for married couples – amount to 3 or 4 trillion, depending on how you count the interaction with the alternative minimum tax. Both parties at this point are talking about making the 3 to 4 trillion tax cuts permanent. The debate is about whether to let this 1 trillion expire. So even if you just confine your attention to the Bush tax cuts, these high-income tax cuts are only one-quarter or one-fifth of the total, which is something that I think many people don’t realize.
On the question of why the surpluses that had originally been projected to occur from 2001 to today turned into deficits – an $11 trillion cumulative swing in the budget balance over those years – part of that change was due to the economy being weaker than expected, but part of that change was due to legislative action, and legislative action was a mix of spending increases and tax cuts. Of the tax cuts, the Bush tax cuts were the largest. But when you look at the numbers the Congressional Budget Office has put out and some analysis that the Committee for a Responsible Federal Budget had done on them, the high-income tax cuts actually accounted for about 7 percent of that swing that increased the deficit and a somewhat smaller fraction of the total because part of it was a change in economic projections. So it really has been a minor factor. Of course it’s true that if you did end the high-income taxes or scale them back it would help with the fiscal imbalance. When the two parties come together to address the fiscal imbalance, there can be little doubt that of course taxes of high-income people are going to be on the table as part of that solution. But it is just fantasy to think that raising taxes on the top 2 or 3 percent of the population will be sufficient to address the fiscal imbalance.
The problem is that raising taxes on this group under an income tax regime does significantly increase the taxation of saving and investment. Although addressing the fiscal imbalance will help with long-term growth, penalizing saving and investment will go in the opposite direction. So I just fear that we have a flawed strategy here of where we will impose one tax increase after another on this group at the top, further and further penalizing saving and investment in this somewhat futile effort to solve the fiscal imbalance without addressing middle-class entitlements and middle-class taxes. It would be a completely different story, of course, if there were some tax increases on the top 2 or 3 percent as part of a comprehensive solution that also included cutting middle-class entitlements and raising middle-class taxes and which really did solve the fiscal imbalance. You could easily imagine that package being beneficial even if it has some increased penalty on saving and investment, but I think this approach that assumes you can do it just at the top is really flawed.
David Lawrence is a sophomore in Calhoun College.