Monday, January 25, 2016

The Devil is in the Details

I have been thinking about taxes recently and actually had a couple of potential posts noodling around in my mind and my notes for the past few months. Good thing I waited. No, you didn't miss news of hell freezing over and a sensible tax code being adopted in the U.S. But you did miss me stumbling through what John Cochrane very simply Nadia Comaneci'd.

My notes on the potential posts began with: "I propose a major tax compromise: slightly higher taxes now in exchange for dramatic tax simplification. We take the existing tax code today and replace it wholesale with a consumption tax. We'll have the debate/fight at a later time about how big the tax burden should be, which is really a debate about how big the government should be. For now let's just remove the deadweight loss that comes from the complexity and the cronyism of the tax code."

Here is the full post from The Grumpy One's webpage. Allow me to extract a few key sentences:
Left and right agree that the U.S. tax code is a mess.
The first goal of taxation is to raise needed government revenue with minimum economic damage. That means lower marginal rates—the additional tax people pay for each extra dollar earned—and a broader base of income subject to tax. It also means a massively simpler tax code.  
... A simple code would allow people and businesses to spend more time and resources on productive activities and less on attorneys and accountants, or on lobbyists seeking special deals and subsidies. And a simple code is much more clearly fair. Americans now suspect that people with clever lawyers are avoiding much taxation, which is corrosive to compliance and driving populist outrage across the political spectrum.
... the government should tax consumption, not wages, income or wealth.
Wise politicians often bundle dissimilar goals to attract a majority. But when bundling leads to paralysis, progress comes by separating the issues. Thus, we should agree to first reform the structure of the tax code, leaving the rates blank. We will then separately debate rates, and the consequent overall revenue and progressivity.
Scott Sumner heaped rightful praise on the piece while noting a few considerations. I had similar thoughts. Again from my notes: "The many complications of any tax scheme: defining consumption goods versus investment assets, not penalizing transactions (you want to tax activity as it is more traceable and definable, but you don't want to do so in a way that stifles or distorts gains from trade), not inadvertently taxing capital (capital is ideas; when you tax textbooks, you are effectively taxing capital; when you tax computer sales you are taxing both Minecraft users and the 'next Minecraft' creator), etc."

Some additional thoughts: It is important to understand that ultimately ALL taxes are consumption taxes. The only difference is how efficient they are. When you tax savings, you are taxing future consumption (encouraging current consumption, which is shameful). And this taxation is usually on income that has already been taxed, but that isn't the central reason it is despicable. To savings taxes (including investment and corporate and capital gains, etc.) I say, "You're Despicable!" because that taxation compounds making the tax disincentive for savings worse the longer it is deferred (i.e., saved).

If structured properly, the disruptive effects of taxes on consumption can be minimized. If not, they can be quite dramatic and quite limiting. Of course, the current incumbent is not a high hurdle to surpass on this last point. Consider this very conservative estimate of the gains from simplification:

Let's assume the estimates of man-hours devoted to tax preparation and compliance of 3.2 billion (many estimate it is closer to 6 billion) are way off. Let's assume it is only 1 billion man-hours. Let's further assume away any other costs (capital investment distortions, rent seeking, labor tied up in compliance/avoidance work (lawyers, accountants, internal corporate departments, etc.), enforcement, etc.). Let's finally assume we can only reduce the man-hours by half (500 million). The average U.S. wage is about $25 per hour. Just this conservative estimate yields a wealth gain of about $12.5 billion dollars every year.

PS. Will tax cheating (intentionally under-reporting tax liability) or perhaps more likely tax fraud (filling fraudulent returns to garner other taxpayers' refunds) force us to simplify the tax code? Will they force us to remove Milton Friedman's unfortunate innovation (no refunds, no fraud)? Will they force a rethinking about identity verification at least in regards to the government (even less anonymity)?