As mentioned previously, I would like to briefly sketch out an approximation of what a terrifically better tax system would look like. This is a second-best solution since I start with the assumption we need a tax burden so massive as to accommodate a government nearly as massive as the one we have today.
If I were asked, "explain taxes to me like I'm a four-year old," I would struggle. Ron Swanson (below) does a decent job striking the emotional chord many of us feel, but this is obviously an emotional appeal designed around the tight confines of satirical comedy. For if it were a comprehensive approach, the tax code would come out looking much worse.
Swanson only gets at the raw theft of it all. He leaves out the destructive properties of bad incentives and resources wasted in compliance and avoidance and evasion.
If we have to have a taxes, we at least should have them with minimal impact both direct and indirect. Directly we waste resources complying and seeking to avoid. Indirectly the effects are much more severe. By taxing capital, we discourage work, risk-taking, and saving. By taxing consumption, we discourage work, risk taking, and consumption. By taxing work, we discourage work, risk taking, consumption, and saving. Work, risk taking, consumption, and saving are all desirable things. But saving has added desirability as it creates opportunities for more of all the other desirable things. Saving is deferred consumption. The reward for the deferring is more later. So it should be obvious, but sadly is not to too many that taxing (discouraging) saving has a compounding negative effect. Which brings me to my proposal for greatly improving upon this fine mess of a tax system we have.
First, we must eliminate all capital taxation (capital gains with its ridiculous long-term/short-term distinction, dividend and interest income, estate taxation, et al.). A flat-income tax would be a big, BIG improvement over were we are today. But we can do better still as this would still be an income tax with the associated negative effect on saving.
Here is the idea (not at all original to me): tax consumption (a sales tax). Let's assume the rate is 20%. We will apply this rate to the purchase of all final goods and services. Income taxes and payroll taxes (save for a new one outlined below) are gone. No longer will we need to turn in an annual term paper on our income to the IRS. No more manipulations of charitable giving and loss carry forward. No more shelters, loopholes, deductions, exemptions, forms 8166 sub A worksheet nine, math that you never can get to add up to the same total twice. Buy something and a tax is built in (this is preferable rather than being added on after the fact). The business submits sales data and taxes due. Most of this infrastructure is in place already. And notice how little opportunity there is for tax evasion save for the ever-dwindling cash side business.
"But what about the poor?" I hear you say. We rebate to every adult the amount of consumption tax that a spending level near the poverty level would imply. Let's target $20,000 (about $5,000 below the official poverty level of income). 20% of $20,000 is $4,000. That amount is payable to every adult American citizen.
"But what about poor children?" I hear you cry. We rebate to every adult claiming a unique dependent (someone cannot be claimed twice as with the current regime) some amount of consumption tax an incremental amount of spending would imply. Let's target $10,000. 20% of $10,000 is $2,000.
"But what about the 'rich' who are now getting checks from the government?" I hear you shriek. That's where the low-impact payroll tax comes in. I think of it as "low impact" because it will be handled by employers similarly to how they handle payroll taxes now. We will maintain the benefit of not having individuals have to play guess how many toothpicks are on the floor with Uncle Sam. The payroll tax will be a marginal rate of say 10% applied to total compensation (wages and benefits) starting at $100,000 with this threshold indexed to inflation.
The structure is the major source of the benefits. The rates and levels are negotiable. Here is what it looks like for a family of four:
Notice that it is progressive. Notice that it is straightforward. Notice that it is not of this world . . . yet.
Update: Some might ask how housing should be treated: as a capital good excluded from taxation or a consumption good subject to taxation. The answer is it depends but can work well in either case. As a capital good making the assumption (probably a bad assumption, that housing is always an investment), it would be excluded. As a consumption good, it would lower the overall tax rate necessary to generate appropriate revenues. The most logical treatment in my mind is to treat any sale or rental of real property as a capital good. Although this increases the tax rate otherwise applicable to consumption, it is a much more straightforward and less manipulable arrangement.
As we continue to hurtle ourselves toward the fiscal cliff as the Mayans predicted, the prospects for meaningful tax reform dwindles. I thought I'd take a second to reflect on some brief ideas about what good tax reform should encompass.
Simplification - this is the lower-hanging fruit. We need fewer exemptions, deductions, rates, categories, etc. Unfortunately, this reform has some of the biggest obstacles since so many vested interests are at stake.
Eliminating the worst tax policies from an economic-desirability standpoint - this is where economics needs to trump emotion. We need to stop taxing capital--capital gains (both individual and organizational), dividends, interest, corporate profits, etc. These taxes are economically destructive. They discourage savings and lower the trajectory of economic potential. The economic distortion from taxation is no where more insidious than in capital taxation. There is certainly crossover between this reform group and the next.
Eliminating the worst tax policies from a justice/fairness standpoint - this is where justice and ethics need to trump envy. We need to stop taxing estates. Death should not imply an additional tax liability. Not only does this tax unfairly tax wealth that has been repeatedly taxed already, but it also causes economic resource distortions as people go to great lengths to avoid the tax. Additionally, we need to stop taxing so progressively. Taxation that compounds as success increases assumes that property rights have a diminishing marginal validity. I fail to see how that can be a reasonable principled position.
In a later post I plan to sketch out my idea of the tax policy I would most like to see replace our current nightmare.
In a few hours from my writing this post the winner of the 2012 Heisman Memorial Trophy will be announced. The mythology and atmosphere of the prize are perfect for what the Heisman is, a beauty contest, but they mislead the many into believing there is an objective order at work. Kevin Gemmell at ESPN.com has a great article defending the Heisman, and I have to agree with many of his points. However, he stops short of a meaningful understanding of the key difference I believe I have identified. Namely, that we are recognizing someone who has lucked into winning the beauty contest rather than definitively achieved the status of "outstanding college football player in the United States"--the trophy's official meaning.
Here are my main faults with the Heisman:
It is ironic that in the most quintessentially team team sport, the most celebrated individual award at the college level is bestowed. We should already be suspect that there is less meaningfulness in the award than conventional wisdom holds.
There is certainly an element of Keynes' beauty contest going on in the voting where voters are attempting to vote a ballot they expect others will respect. The easiest way to do this is to vote congruently to the perceived typical ballot.
But at the same time there is rampantly poor voter performance including nearly fraudulent behavior. Leaving candidates off ballots because including them hurts the chances of a voter's preferred candidate undercuts the legitimacy of the award. Voting early is also a problem. The bias in voting cannot be overlooked when evaluating if the process is flawed.
The criteria is unclear and inconsistent. Gemmell holds this as a feature, not a bug. He may be right, but it still argues against the idea that this process produces an objective result. Running with that a little more, we have to recognize that statistics drive this award. And not just any stats, cumulative and simplistic stats. Stats that have little to do with a team winning football games but a lot to do with an individual winning awards. Stats that are highly correlated with winning but that have weak casual or predictive effect on winning. That is a very key distinction. Do you realize that most teams who lead the game at half time go on to win the game? If you find that meaningful, reread the sentence again until it fails to impress you. Coffee is for closers. If stats are your guide to Heisman immortality, they should be stats that indicate contribution more than just participation.
The pretentiousness of the prize must also be mentioned. For all the reasons above, we cannot be so pious when considering the prize.
If we gave a Heisman Trophy in business, Apple would win for its beauty narrowly edging out Wal-Mart who is a finalist based on size. Yet, the goal of business is to make a profit. Both of these firms are very profitable, but Microsoft achieves about 50% more profit per dollar of revenue than does Apple and Exxon Mobil is more profitable than Apple and Wal-Mart combined. The goal of a football team is to win games and the objective of an individual football player should be to contribute to his team's winning. Just as our hypothetical Heisman Trophy for business is recognizing the wrong firms, the real Heisman Trophy is flawed in process such that the recognition fails to be very meaningful.
Oklahoma coaches describe the award as the highest honor an OU football player can receive while playing for the Sooners. The Don Key Award is the only individual award given in Oklahoma football. It goes to the player who best exemplifies the many superior qualities of Key, both on the field and in the classroom.
That award is subjective, but it is limited to the subjectivity of a highly informed coaching staff. It goes to the player or players who contribute to the team and achieve individual success almost as a byproduct.
In a surprising and somewhat hopeful development, SEC member Luis Aguilar has told the WSJ (gated) that he has now changed his position on allowing money market mutual funds to have prices different than $1 per share. Technically, the net asset value (NAV) of money market funds are currently pegged to a fixed unit value. Investors put a dollar into a fund, are paid interest on that dollar (recently as low as .01% but not too long ago more like 2-3%), and then can redeem their investment at any time to be returned exactly one dollar. If the value of the fund's investments ever falls below $1 per dollar invested, the fund has "broken the buck" and goes to time out . . . and the financial world comes to an end, or so Federated Investors among others would have us believe.
Federated has been a vocal incumbent fighting these reforms. The firm started one of the first money market funds back in 1974. It has a lot at stake here. The dollar peg restriction acts as a check on entrants into the industry.
I applaud the idea of a floating NAV for money market funds. As a money manager for hundreds of investors of very wide and diverse liquidity needs, I understand what is at issue with a floating NAV. It probably makes my job a little harder at least initially. But it will make the market deeper and more informative.
One major benefit of the change could be that the moral hazard that comes from the "guaranteed" dollar value of money market funds is reduced. Investors, especially institutional investors like myself, will have to be more diligent in selecting money market funds. But with that will come more choices and richer choices as competition increases.
Another benefit would be the choice investors would have between funds that aim for a continuation of the dollar peg, but without the legal obligation, and those that allow a wider range of value. Couple this with another important potential reform--allowing funds to gate or block investors from making redemptions on demand. Again, this means more choice for investors allowing them to trade off between liquidity and performance.
Before we get too carried away with this sudden move by the SEC to rationalvania, let's wait to see what actually emerges. The SEC probably hasn't freed itself of the public choice capture that has long plagued it. The exact quote by Mr. Aguilar was, "I'm not fundamentally opposed to including a properly structured floating net asset value as part of a proposal." There is wiggle room there. Still, this seems to be a promising development. Someone somewhere is probably complaining, "This country is going to the dogs. You know, it used to be when you bought a politician, that S.O.B. stayed bought."
Update: Just in case anyone is out there trying to make 2 + 2 = 7, I am not implying there has been any literal purchasing of regulators in Mr. Anguilar's case or any other.
Arnold Kling writing at his new blog (I join many others in welcoming his return to blogging) calls to task those of us who uncharitably describe our ideological opponents in this excellent post. This opened my eyes a bit to my own uncharitable attitudes.
But that wasn't the thing I liked most about the post. The highlight was his characterization of what drives ideologies. I recently was sketching out my own theory as to what the essence of political and ideological beliefs are. Here is my theory:
Most people from all political positions base their beliefs primarily out of a desire to mitigate if not eliminate their fears.
Progressives fear free market outcomes from three respects:
Perceived inefficiencies (too many cereals, three gas stations at one intersection, streams of failed businesses, et al.)
Perceived uncertainties (again failing businesses, uncertain future investment & retirement values, fluctuating prices, job losses or changes, et al.)
Perceived inequalities (different pay scales, different growth rates of income, consumption, wealth, etc., varying levels of quality/quantity for goods and services, et al.)
Conservatives fear disorder from three respects:
Perceived indulgences (gluttony, sexuality, et al.)
Perceived freeloading (unnecessary welfare, shirking of duty, et al.)
Perceived radicalism (morality without God, challenge to authority, breaking of protocol or decorum, et al.)
Libertarians fear corrupt control from three respects:
Perceived economic restraint (property rights violations, reordering of economic outcomes, reversals of earned fortunes, et al.)
Perceived intolerance (personal life decisions like who to marry, methods to find pleasure from drugs to sex to music to travel to thoughts, et al.)
Perceived association prohibitions (where and with whom to live, to work, to trade, et al.)
Maybe I've been reading Kling so long that we are mind melding, or perhaps great minds independently think alike. I look forward to the essay he says in the post is forthcoming on this topic.
P.S. Another way of looking at these three groups might be that progressives worry about who wasn't invited to the party, conservatives worry there will be a party, and libertarians worry the progressives and conservatives are going to ruin the party, TOGA! TOGA! Yes, this is probably uncharitable.
I recently took the family to the 36th annual Oklahoma City Train Show. Since my 3-year-old son thinks trains are the reason for man's being, this event was a big hit. Several of the displays were quite impressive. It is always amazing to me how diverse and intense human interests can be.
Looking at the various model towns and layouts, I couldn't help but think how much these models look like the real world but are in fact so very different. There is a lesson here for economics. Our models are vague facsimiles of what human existence looks like. They are not complete representations. We zone and plan cities as if we were designing a model train set rather than establishing incentives/disincentives in relative darkness.
The human world is filled with incredible complexities no individual or group can possibly know, understand, or fully appreciate. The train set world is a design-able project aimed at satisfying one train enthusiast or at most a small group. The human world must evolve over time with many random, chaotic elements interceding. The train set world is fixed.
There is no cause and effect in designing model train layouts aside from the designer wanting something and then acting to bring it about. But cause and effect is multidimensional and phenomenally jumbled in the human world. Of course this inconvenient fact need not stop our attempts at assigning cause to effect. Hence, renters and multi-unit housing cause higher crime rates and lower home values. Good urban planning causes successful restaurants and profitable entertainment districts.
Yet again I hear Hayek:
The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
