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Election 2004


A 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 later.

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 plans.

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.

Dale 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