A Competitive Tax Plan for America
Coalition for a Prosperous America Educational Fund Issues Forum
Speaker: Michael Graetz, Yale Law School
May 8, 2008 from 10:00 until 11:30 at WIley Rein, LLP
Memo by Carolyn Avery, IAS Group
* Introduction: The Imminent Tax Train Wreck
The IRS Code is now six times larger than War and Peace and not nearly as easy to read. Our tax system is broken, complex, and costly. We are not taking advantage of our status as a low-tax country because we are not a low-income-tax country.
There is a train wreck around the corner, coming down the tracks in the form of:
1) The 2010 expiration of the Bush tax cuts that were enacted in 2001 and 2003.
2) The AMT, which is set to affect 40 million people in 2010.
Our current system’s instability is best exemplified by the estate tax, which this year has an exemption of $2 million that, next year, will increase to $3.5 million per person, with a top rate of 45%. Then, in 2010, the tax will be repealed altogether, only to come back the following year in its pre-2001 form, with a $1 million exemption and 55% rate. As it is not possible to let such instability persist, Congress will have to make some fundamental changes to the tax system fairly quickly.
* Drawbacks of Other Consumption Tax Proposals
Two major consumption-tax plans that have recently been proposed are the flat tax and the president panel’s Growth and Investment Tax. Both are subtraction-method value-added taxes that apply taxes to the difference between a business’s sales and purchases. In contrast to the addition-method value-added tax proposed by Graetz, these consumption taxes:
- Would be levied on an origin basis, meaning that domestic goods and services would be subject to full taxation, while imports would only be taxed on the domestic retail markup.
- Would not be border-adjustable.
- Would require the renegotiation of the GATT and all 86 of our bilateral trade treaties
* Money In, Money Out
• Federal Receipts and Expenditures over Time Facts
- U.S. federal receipts and expenditures are low compared to the rest of the world, historically averaging 18.6% of GDP.
- We have had only two years of surplus in recent history (in ‘69 and the 90s).
Conclusions:
- We do not have a short-term fiscal problem: we have deficits coming up, but they are not of extraordinary size. The economy itself is currently soft, at a minimum, so this is not the moment to be raising taxes.
- However, the longer-term fiscal picture is not nearly so rosy and we should have a tax system that is capable of addressing the issues facing the U.S. going forward.
• Federal Tax Receipts by Source
- The individual income tax has accounted for the bulk of federal revenues – about 50% – for a long period of time.
- Meanwhile, the payroll tax has grown dramatically, becoming the highest federal tax paid by most American families.
- The distinguishing feature of the U.S. federal tax receipt structure is the absence of sourcing from consumption taxes.
• The Illusory Tax Cure-All Facts
For over a decade, Congress has regarded the income tax as a cure-all for any societal or economic problem. Congress regularly enacts “tax expenditures,” or tax-favored activities, that result in lost revenue to the government.
- Congress responded to the problem of financing higher education by enacting a series of eight benefits into the tax law, including credits, deductions, and exclusions for higher education savings. These benefits are poorly coordinated and confusing. For example, you can be eligible for one of the credits if you have been convicted of drug offense, but not for others.
- The same scenario applies to healthcare. Congress’ favored solution to deal with the forthcoming increases in expenditures on long-term healthcare for an aging population is a tax credit.
- We have disruptive, contradictory, and unpredictable energy-related tax incentives.
Results:
- Despite the flurry of tax measures, one would be hard-pressed to argue that we have dramatically improved the situation for Americans struggling to finance higher education.
- Americans pay more for healthcare than anyone else, U.S. healthcare costs are the most rapidly rising ones, and the U.S. has more uninsured people than any of its OECD peers.
- Energy tax benefits have been promoted in lieu of forging an effective national energy policy. All we have to show for them so far is higher prices.
Conclusions:
- These tax-based “solutions” are false ones, but they are extremely popular on a bipartisan basis. Republicans like any tax cut, while Democrats can claim to solve problems that they could not directly address in Congress because of budget process constraints and other political reasons.
- One of the greatest advantages of moving away from an income tax-based system is to get Congress out of the business of stuffing the tax code with these kinds of unworkable provisions.
*Corporate Income Taxes
• Highest Rates of Income Tax: U.S. and Selected Trading Partners
Facts:
- Our personal income tax rates are not high compared to the rest of the world, but our corporate tax rate has become the second highest in the OECD.
- Over the past decade, statutory tax rates have declined in the rest of the world, ironically because countries were following the U.S.’ lead in the 80’s.
Conclusions:
- High corporate tax rates are especially problematic now that we are operating in a global economy. In the period following World War II we were able to grow our economy at a robust pace despite very high individual and corporate tax rates because we had all of the money in the world. Europe and Japan were devastated and we had no worldwide competition. Today however, we are competing not only with Europe and some Asian countries, but also with the BRICs (Brazil, Russia, India, and China). A low statutory corporate rate is the key to creating American jobs.
- Most economists think that corporate taxes are bad on principle, yet they are very popular politically. A low corporate rate of 15-20% would help solve many of the difficult technical issues in international taxation such as transfer pricing, whereby MNCs shift income to low-tax countries and deductions to the U.S., even if they don’t shift any real plants, equipment, or jobs. A lower rate would also make us more attractive to both domestic and international investors and companies.
* Why We Need a VAT
The U.S. is isolated in its non-VAT status. If we want to lower income taxes to take advantage of our status as a low-income country, while embracing a system that fits well with the international economy, we should join the 140+ countries that have already adopted VATs. Our biggest trading partners have VATs: rates in Europe are roughly 19-20% and Canada has a 7% goods and services federal tax, in addition to provincial taxes. China’s in 17% The countries we hail for their low taxes, such as Ireland and the Baltic states, all have VATs.
A VAT will allow us to:
- Get Congress out of the business of implementing social policy via the tax code.
- Simplify the tax code for individuals.
- Lower corporate tax rates.
- Responsibly finance our government.
The Long-Term Fiscal Problem Congressional Budget Office projections of future revenues and expenditures show a dire picture. While the social security gap can be fixed without major dislocations, the health insurance gap cannot. As the population ages and healthcare costs continue to rise, our projected revenues will not suffice to pay for Medicare, Medicaid, and Social Security alone, much less the cumulating interest on federal debt, defense, homeland security, infrastructure, and anything else.
* Who Pays
Facts:
- The income tax is mostly collected from high-income taxpayers today. The top quintile pays more than 80% of federal taxes, the top 10% pay two thirds, and the top 5% pay more than half.
- Lower-income taxpayers are essentially zeroing out their taxes. The number of taxpayers who are excluded from income taxes has grown dramatically since 1969, when Congress announced the principle that nobody at or below the poverty line should pay income taxes. Today, a family of four with over $40,000 in income (double the poverty line) pays no taxes.
Conclusion:
- We are moving back towards our pre-World War II tax system, which relied on consumption taxes and high-income taxes.
- This is a positive development, except that this time around, instead of relying on economically distorting tariffs as a consumption tax, we should implement a VAT.
* Globalization Facts
- Investment inflows have become extremely important to us economically because we have twin deficits and a negligible savings rate.
- U.S. corporate profits from foreign sources have been rising.
Conclusion:
- When the 1986 tax reform plan was being considered, the internationalization of our economy hadn’t taken place yet, so we could think of domestic tax policy divorced from international tax policies and arrangements. We cannot do this today.
* The Competitive Tax Plan
• Four Essential Pieces
1. Enact a VAT at a 10-14% rate on a broad base of goods and services, exempting all businesses with revenues of less than $100,000/year from collecting the tax.
2. Exempt the first $100,000 of family income and lower the individual income tax rate to 25%.
3. Lower the corporate income tax rate to 15%
4. Replace the EITC and give families VAT tax relief through payroll tax offsets and “smart” (actually, debit) cards
• Key advantages
- Essentially revenue-neutral in its initial stage (see attachment). Over time the dynamic effects on investment and production would yield additional revenue
- Eliminate 100 million tax returns, thus simplifying the system and reducing administrative and compliance costs
- Encourage savings and investment in the U.S.
- Mitigate international tax policy issues with regard to multinational corporations
- Ease the transition to a consumption-tax-based system
- Allow the IRS to focus on its job
- Reduce incentives for politicians to tinker with the tax system
- Facilitate international coordination
- Enhance the competitiveness of American-made goods in the U.S. and foreign markets
Click on the following link to view a chart of the Competitive Tax Plan's Costs and Revenues