The Constantly Progressive Consumption Tax
Every now and again in the discussion of the US tax system, a major reform proposal gets kicked around - not a measly Bush-style bracket readjustment or anything like that, but a real major reform. A consumption tax. A flat tax. A simplified tax. Most of the time they are looked at for a moment and then tossed aside, since heavy lifting like this is totally unrealistic to pass through two houses of Congress with the dreaded filibuster still breathing in the Senate. But thinking about tax reform is a good exercise anyway, because it does let us examine where the strengths and weaknesses of our current tax system lie.
When I looked at the aforementioned proposals, I wanted to think about what each one meant for the US income distribution, for revenue, and for growth. For reference, here's the breakdown of the current US tax code (without accounting for the benefits it doles out via deductions and credits, since these are equivalent to expenditures):
I'll take a second to explain the charts, since I'll be using this format throughout the post. The first column is the tax bracket division (the minimum income required for the corresponding marginal rate). The next column shows the marginal rate within that bracket. The third column shows the average tax rate paid so far, and the fourth column shows the tax-adjusted income for someone at the noted pre-tax income level. On the chart, the dotted line shows tax-neutrality, that is, a point on the line means that no net taxes are paid, a point above it shows net gains from the tax system, and a point below shows net tax liabilities. It is important to have most points below the line so that the revenues can fund the actual operations of government.
Now let's look at some alternative systems. First up is the flat tax, a conservative favorite. It suggests a single rate of 20% that comes into effect above $30,000 (for a family of four) and continues on at that flat rate for any level of income. Here's the breakdown:
As we can see, the average level of taxation is very, very low. At lower levels of income, this is less progressive than the current tax system since a family can never receive a net benefit; at higher levels of income the flat tax has the same effect, since both the average and marginal rates on top earners are dramatically reduced. Clearly, the tax is taking from the poor to give to the rich, but that's consistent with conservative social values. Not much else to say here.
Next, Megan McArdle has proposed a drastically simplified version of the tax system, including constant progressivity (including a negative tax rate for very low earners, replacing the current system of deductions and exemptions), removal of the distinction between income and capital gains, removal of the corporate income tax, and so on. I greatly appreciate the simplification that the system offers, but I feel that the actual part about taxation is not as fully thought out as the simplifications.
For example, a negative income tax does not max out at a nominal rate; the nominal rate goes to infinity if there is even a dollar of benefits given to a totally unemployed person. If it is the marginal rate McArdle is referring to in her post, then it is nearly impossible to raise revenues at all through taxation, even if the marginal rate peaks fairly quickly:
The last proposal is the straight consumption tax. I won't go into this in detail, but the options are generally to tax at checkout (European-style) or to apply it as an income tax where some or all savings are exempt (certified by a W-whatever form from your bank or investment adviser, just as income is certified by a form from your employer). This latter form has the added benefit of allowing progressivity. What I've decided to do here is combine McArdle's suggestion for the constantly progressive tax (with some bracket adjustments) and the savings-exempted consumption tax.
The way this would work is by first reporting two things: income (wages + capital gains) and annual net savings (at the bank or investment firm). First, the savings would be deducted from the income to report total consumption. Then, the consumption would be taxed at a rate determined by the total level of income. The chart below shows how this might work, assuming nobody saves anything (a best-case revenue scenario).
As you can see, the marginal tax rates are fairly high, and there is a small safety net (about $100/wk, much less than unemployment benefits pay now) built in at the very bottom of the bracket. The marginal rates also kick in very quickly at the $34,000 bracket. The purpose here is to encourage savings even from mid-level earners, while still raising a good deal of revenue from the reduced tax base. The system also leaves a great deal of room for tax-based stimulus in hard times because of the high marginal rates, and it ensures that any needed stimulus will go largely to consumption. I like it. What do you think?
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