Old taxes are the best taxes.

A Legislator's Proverb

Just how efficient and equitable are the important taxes now used by our federal, state, and local governments?

Personal Income Taxes

One flaw of progressive personal income taxes is that rising marginal tax rates create disincentives that discourage investment and work effort. Another is that our complex Internal Revenue Code creates loopholes that allow individuals and corporations to legally avoid taxes. Tax avoidance is legal, but high marginal rates also provide huge incentives for tax evasion: the illegal nonpayment of taxes. Disincentives, tax evasion, and legal loopholes erode the tax base and cause legislators to raise tax rates. For example, if erosion of the base causes a tax rate of 50% to be applied to only half of potential untaxed income, then the rate could be dropped to 25% if all income were taxed.

 

Our five-step progressive income tax system is an example of an ability-to-pay tax, but loopholes erode its progressivity. Several studies indicate, however, that even after allowing for the heavier exploitation of loopholes by high-income families than by low-income families, the incidence of our income tax is, on average, mildly progressive. Not all loopholes, however, are designed only for the rich. For example, mortgage interest is deducted by more than 90% of all families who itemize deductions. The idea that loopholes offer huge advantages for those who use them is grossly exaggerated, primarily because artificially stimulated competition causes overinvestment in tax-sheltered areas.

 

You know how complicated computing your federal tax liability can be if you have ever filed a Form 1040 (the long form). Some state income tax computations are even more complex. Most economists favor eliminating almost all exemptions, credits, and deductions except for necessary business expenses. Then tax rates could be lowered substantially and still yield the same tax revenues. This would eliminate much of the vertical and horizontal inequity in income taxes and would substantially reduce the inefficiencies caused by preferential tax treatments for some sources of income.

 

For all the flaws of our income tax system, there seems to be widespread support for income taxation with some degree of progressivity. Few Americans favor abolishing the Sixteenth Amendment, which authorized income taxes. The major bone of contention is how to simplify income taxes and make them fairer.

 

The 1986 Tax Reform Act represented the most complete revamping of our tax system in decades. Income taxes were eliminated for most low-income families, and the bill replaced the 15 tax brackets under the old system (ranging from 11% to 50%) with two basic brackets (15% and 28%), and a temporary surcharge (an extra 5%) that applied primarily to upper-middle-income taxpayers. Revisions in 1990 intended to help limit the soaring federal budget deficit converted this surcharge into a permanent third bracket of 31% that applied to higher incomes. The Omnibus Budget Reconciliation Act of 1993 added two new brackets; taxable income above $115,000 for individuals and $140,000 for couples will be taxed at 36% and all income above $250,000 will be taxed at 39.6%. Table 2 details the current tax rates for various filing categories.

 

The 1986 tax reform was not intended to lower most people s taxes. Its major advantages are consistency and (alleged) simplicity. Major loopholes were closed, allowing sharp cuts in individual and corporate tax rates. Consistency (loophole closure) was expected to rebuild public confidence that people in similar circumstances pay similar taxes (horizontal equity), and that high-income families pay their fair share (vertical equity). Simplicity reduces the need to keep detailed accounting records. (Some studies report that such accounting absorbs resources equal to 1% to 2% of personal income.)

 

Most income is now taxed more uniformly, regardless of source. Loophole closure refocused investments toward real values instead of a frantic search for loopholes. The new law, however, largely retained deductibility for real estate interest and property taxes, the two major middle-class loopholes. Pressure from state and local governments also caused interest income from state and municipal bonds to remain tax exempt. Nevertheless, most public finance experts perceived the 1986 tax reform as a major step in the direction of efficiency and equity. Unfortunately, taxes remain about as difficult as ever to calculate (although slick computer programs have simplified filling out forms by taxpayers who are computer literate).

Social Security Taxes

You may be surprised to learn that the Social Security tax is expected to be the single largest source of federal revenues by the year 2000. Social Security taxes, unemployment compensation, and workmen s disability taxes are payroll taxes; that is, they are based primarily on the payrolls that firms pay. Try this multiple-choice question: The Social Security tax is borne by (a) workers, (b) employers, (c) consumers, (d) a 50/50 split between workers and employers, (e) a 50/50 split between workers and consumers.

 

The idea that Social Security taxes are split 50/50 by employers and employees is a myth. This is the legal incidence of the tax, which requires employers and employees each to pay 7.65% of the first $57,600 in wage income for Social Security. In addition, both pay 1.45% of the first $135,000 in wage income for Medicare. Table 3 shows how this tax has changed over the years.2 The simple fact is that the full tax is probably borne by workers. Here is an example to show why.3

 

Suppose that you work for ABC Corporation and your marginal revenue product is $800 weekly. If there are no other employment expenses to consider, competition forces ABC to pay you $800 weekly. Now suppose you insist that ABC send $50 to your Aunt Mary each week. The firm, however, will not retain your services unless you agree to allow them to deduct it from your check; if the law dictates that they send checks for $50 to the widowed aunts of all employees, they will cut wages correspondingly. It makes no sense to keep an employee worth only $800 if total employment costs exceed $800 weekly. Likewise, if money also must be sent to Uncle Sam because you are employed, you will bear this full burden: your gross salary will shrink by the amount of the tax.

 

Social Security has been pay-as-you-go for decades. Thus, current workers taxes cover benefits to retirees. Even the entry of baby boomers into labor markets did not ease the growing tax burden, as the ranks of older Americans have swollen. Burdens on younger workers may become horrendous when boomers begin reaching age 65 in 2011.

 

Critics are dismayed that 65-year-old retirees who draw $100,000 in investment income can extract transfers from 18-year-old dishwashers working for minimum wages. Among many reform proposals are (a) raising the minimum age for retirement benefits, (b) eliminating benefits to the wealthy or subjecting Social Security payments to income taxes, (c) having all revenues come from general revenues, and (d) replacing Social Security with a negative income tax plan whereby people receive payments if they earn below a certain level of income. Pressure will mount to modify the system as the population of older people continues to grow, raising payroll tax burdens.

Sales and Excise Taxes

Sales taxes are percentage taxes broadly levied on dollar sales volumes, primarily by state and local governments. If sales taxes cover all goods, they are reasonably neutral and efficient. Sales taxes are not neutral, however, to the extent that they exempt items such as food, housing, or labor services. They distort relative prices and economic behavior.

 

Excise taxes are selectively applied to items like telephone calls, utility bills, and gasoline. Some excise taxes, called sin taxes (e.g., on cigarettes and liquor), are especially popular ways to raise revenues. Again, price distortions create economic inefficiency. A 10% tax on luxury cars and yachts was enacted in 1991. The tax on yachts was rescinded in 1994 after yacht sales plummeted, leaving thousands of workers unemployed (many of them relatively unskilled).

 

Sales and excise taxes are widely attacked as regressive because the proportion of income spent on taxed goods is higher for the poor than for the rich. Consequently, such basic necessities as food are often tax-exempt. Those who attack tax regressivity often advocate soaking rich corporations. Unfortunately, this strategy may backfire.

Corporate Income Taxes

Corporate accounting profits are taxed at the rates shown in Table 4 and, when initially levied, are borne by stockholders. However, consumers bear much of this tax burden in the long run, because corporate income taxes apply to accounting profits, which are largely normal profits, not economic profits. This tax raises costs and ultimately prices because normal profits are a long-run production cost. Moreover, even a tax on pure profit may ultimately be borne in part by consumers because aggregate investment is squelched; a reduced capital stock drives up prices in the long run.

 

The tax distorts prices to the extent that it is forward shifted; that is, the prices of goods manufactured primarily by corporations are raised relative to the prices of goods most often produced by unincorporated firms. A sad irony is that if, relative to rich people, poor people devote larger shares of income to the mass-produced goods supplied by corporations, the tax burden is regressive. People who think that corporate income taxes soak the rich are probably wrong.

 

People will buy corporate stock reluctantly if the tax is backward shifted. (Firms cannot truly pay taxes; only people in this case, stockholders can.) The corporate sector will shrink relative to noncorporate firms until after-tax rates of return are equalized.

 

The inefficiency of the corporate income tax makes it extremely unpopular among most economists. One proposed reform is to eliminate corporate income taxes and allocate corporate profits to stockholders, who would then pay normal personal income taxes on their shares of corporate profits. Economists from across the political spectrum differ little in their dislike of the corporate income tax, but politicians almost universally favor it because their constituents often see the tax as a way for the little guy to get even with big business.

Property Taxes

The supply of land is perfectly inelastic. Thus, land taxes are relatively neutral; a tax on pure land rent has almost no effect on rental rates for land relative to other resources or goods. People often mistakenly apply this reasoning to property taxes, which are, however, among the least popular levies of all.

 

A property tax is based on the value of landholdings plus capital improvements. The supply of land may be perfectly inelastic, but improvements are very elastically supplied in the long run. Suppose you own prime land in an area with high property taxes. If you put a new building on it, you will pay higher taxes. Thus, the property tax is a disincentive to development. Similarly, if you are a slum landlord with tenants whose poverty limits the rents you can charge, will you repair or modernize your buildings if your tax bill jumps substantially as a consequence? Unlikely! Many students of the urban scene attribute part of the decay of central cities to high property taxes.

Inheritance and Gift Taxes

The Federal unified inheritance and gift tax rates are presented in Table 5. These taxes are progressive, but the first $600,000 on an estate and the first $10,000 of any gift annually are tax-exempt. You might think that inheritance taxes could be avoided by giving your heirs the money, but gift taxes plug that loophole.

 

Extremely wealthy individuals avoid some of the inheritance tax in other ways. For one thing, they can establish irrevocable trusts that delay disbursements of estates until long after a person s death to, say, their great grandchildren. This is one of several loopholes that make the inheritance tax an  optional tax in the words of some critics. One proposed reform of the income and inheritance tax systems is to merge them. That is, any inheritances or gifts would simply be treated as taxable income.

Tax Reform Proposals

Rankings of the fairness of various taxes yield similar responses from both the public and tax experts. Virtually no taxes are thought fair. Our overview suggests that flawed taxes have historically outweighed equitable and efficient taxes. Widespread discontent (addressed in Focus 2) has led to some proposed reforms to harmonize our tax system more closely with widely accepted tax principles: equity, neutrality, and simplicity.

Value-Added Taxes

Our tax system warps incentives, stifles economic performance, and, at times, has been so loaded with loopholes that large parts of it should probably be abandoned. Social Security and corporate income taxes are among possible targets for abolition. But what might replace revenues generated by these taxes? A favorite contender is the value-added tax.

Value-added taxes (VATs) resemble sales taxes but apply only to differences between a firm s sales and its purchases from other firms.

Thus, a VAT is a fixed percentage of a firm s payments for resources and is not applied to intermediate products the firm purchases from other firms.

 

A major virtue of the VAT is that it is reasonably neutral. Another is that tax evasion is extremely difficult, which partially accounts for its use in much of Europe. A drawback is that VATs are largely hidden; final customers may be unaware of the VAT embodied in the price of a product. A normative objection is that, like sales taxes, VATs may be somewhat regressive. Finally, VATs require more cumbersome accounting than sales taxes because VATs must be paid at several levels of output. Nonetheless, value-added taxes are probably more efficient and less inequitable than corporate income taxes, Social Security taxes, or a number of other levies in the government s toolbox.

Flat Rate Taxes

See Henry George

Many critics claim that attempts to make income taxes highly progressive are self-defeating. They argue first that high marginal tax rates discourage investment and so, in the long run, actually hold down the incomes of most  working stiffs, or those whose productivity would be enhanced were they working with more capital. The obsolescence of British manufacturing and the comparatively slow growth of British wages from World War II through the 1970s are cited as examples of this problem. (The British economy began its recovery after tax rates were sharply reduced in the early 1980s.)

 

 

A second difficulty is that high marginal tax rates increase the payoff from lobbying for new loopholes, which can reduce the true progressivity of the tax system to a mere shadow of the nominal rates. Few high-income individuals fail to exploit loopholes. Progressivity has been combined with complex loopholes so that even tax experts have often been uncertain as to how much they owed. A third problem is that high marginal tax rates are incentives for (illegal) tax evasion.

 

One proposed answer for all these problems is the flat rate tax. Some analysts have suggested that a flat income tax of roughly 20% with no exemptions or deductions would (a) generate more revenue than the current tax system, (b) eliminate most tax evasion, (c) cut the amount of paperwork required from firms and households, and (d) cure the ulcers and headaches common around April 15 of each year. Critics of this proposal fear that a flat income tax system would be an inequitable retreat from society s fight against poverty.

 

However, one variant of the flat tax proposal that could retain substantial progressivity would entail merely enacting substantial standard deductions that would be similar to those in current income taxes. Figure 8 illustrates how a flat tax rate of 20% would be progressive after a $10,000 deduction. Zero taxes are paid at the $10,000 income level (point a), but $2,000 in taxes are collected at the $20,000 income level (10% of income at point b). At a $40,000 income, the tax would be $6,000 (15% of income at point c). For people with a $100,000 income, the tax would be $18,000 (18% at point d). As you can see, this approach combines the simplicity of a flat tax with progressivity, which most Americans seem to favor.

Consumption Taxes

Other critics argue that the major flaw in our current tax system is that, in a shortsighted quest for greater equality, progressive income taxes kill the goose that lays the golden eggs. These critics view disparities in consumption levels, not income, as the root of social inequity. They argue that resource use (consumption) is more appropriate as a measure of ability to pay than are potential claims to resources (income). Major drawbacks to taxing income are the severe disincentives to save and invest. The critics solution is to allow all saving as a deduction from taxes, effectively replacing income taxes with a tax on consumption alone. Consequently, people with incomes of $1,000,000 per year would be taxed on the full amount if they spent it on Rolls-Royces, furs, jewelry, and other extravagances. Investing almost all of a $1,000,000 income, on the other hand, would result in negligible taxes.

 

A consumption tax could be as progressive as any income tax system, so problems of regressivity are not necessarily raised. Moreover, according to the advocates of this approach, the resulting increase in saving and investment would greatly enhance labor productivity, and technological breakthroughs would allow substantial economic growth.

 

We have looked at the types of government activities that can be rationalized as proper cures for market failures and have examined various tax structures. Questions about why government spending and taxes so frequently depart from the ideal have been addressed only peripherally, however. Many of these questions are answered when we look at the political dimensions of policymaking.