Smarter Type of Tax
Paul O'Neill, the US treasury secretary, has announced a campaign for tax
reform to follow the November congressional elections. The timing is
reminiscent of Ronald Reagan's announcement in May 1984 that he would propose
a tax reform after that year's autumn elections. Confounding the sceptics, Mr.
Reagan signed the epoch-making tax reform act of 1986 into law two years
Mr. O'Neill has emphasised that the Bush administration's proposals for tax
reform would be revenue neutral, so that the federal deficit would not be
affected. This was a key objective of the tax reform act of 1986 and insulated
the two-year debate over reform from the contentious issue of the federal
deficit. Other than this detail, we know very little about Mr. O'Neill's
Nevertheless, the outlines of the coming debate are clear. In January 1993,
the Bush administration issued a detailed proposal for a business transfer
tax. Business investment would be "expensed" or written off against
business income, shifting the tax base from income to consumption.
The first stage of the debate this time around will undoubtedly rehearse
the arguments for taxing consumption rather than income. This would solve one
of the most glaring deficiencies in the existing US tax system: discriminatory
taxation of corporate income through the corporation income tax. Because
consumption, rather than income, would be the basis for taxation, business
income from all sources would be taxed at the same rate - zero.
Another advantage of a consumption tax is a low marginal tax rate, the rate
that applies to the last dollar of consumption. This would provide powerful
new incentives for work and saving. Under a popular consumption tax proposal
known as the Hall-Rabushka Flat Tax, the marginal rate would fall to 19 per
cent. The US corporate income tax rate is currently 40 per cent, combining
federal, state and local taxes; corporate dividends and interest are also
taxed through the individual income tax.
The Achilles heel of proposals to shift the tax base from income to
consumption, at least so far, is the redistribution of tax burdens. Recipients
of business income, including holders of corporate bonds and shares, are
generally much more affluent than recipients of income from work. Excluding
this business income, or property-type income, from the tax base would shift
the burden of taxation from the rich to the poor.
As a result, the second phase of the debate is likely to focus on reforming
the income tax system. The objectives would remain the
same, namely, to treat all sources of property-type income in the same way,
reduce marginal rates and avoid redistribution. While this may sound rather
like trisecting an angle, these objectives can be accomplished by what I have
called Efficient Taxation of Income.
Efficient Taxation of Income is a new approach to tax reform that would
introduce different tax rates for property-type income and earned income from
work. Earned income would be taxed at a flat rate of 10 per cent, while
property-type income would be taxed at 30 per cent. Big gains in economic
efficiency would result from making the tax treatment of income from
corporate, non-corporate and household property the same.
Under Efficient Taxation of Income each dollar of new business investment
would generate a credit against taxes on business
income. The rates for these credits would make tax burdens on all income
sources the same. Taxes on new investments by households would be collected by
car dealers, real estate developers and other providers. These would not apply
to existing home owners and would protect property values. This is the key to
getting the system accepted, as 68 per cent of households own their homes and
home owners are voters.
Efficient Taxation of Income could be enacted today and implemented
tomorrow with no cumbersome transition rules. The tax treatment of Social
Security and Medicare contributions and benefits would be unaffected, as would
the treatment of private pension plans. I estimate that the total one-off gain
from Efficient Taxation of Income would be a huge $4,900bn, while adoption of
the Flat Tax would yield only $2,060bn. The gains underscore the benefits of
shifting investment to higher-yielding assets. They also reflect greater
investment and faster economic growth.
Tax reform proposals, like cherry blossoms, are a hardy perennial of the
Washington scene. Occasionally, a new approach to tax reform appears and
changes the course of the debate. Mr. Reagan's proposal of May 1985 is the most
recent example of a new approach to tax reform. Like Efficient Taxation of
Income, this retained the income tax rather than shifting to a consumption
tax. This is still the most fruitful direction for reform.
Jorgenson is professor of economics at Harvard University. This article is
based on his recent testimony before the Committee on Ways and Means of the US
House of Representatives