The Optimal Tax System

The American Family Gazette

Vol II, 1210

 

The definition of an optimal tax system depends upon whether you are a tax payer or a tax collector. In the real world, both parties have to be considered. So far, I can’t recall hearing of a proposal that totally satisfies either party. What does seem apparent to someone on the outside looking in is that tax policy is primarily considered from the tax collectors perspective. Obviously, it takes money to run government.  In today’s world what we generally see is big government, which means they require big tax collections. And in a country like ours with a social welfare bias and a hegemonic inclination, taxes raised are never enough.  Our government has decided to spend, almost continuously, more than it raises in taxes.  Hence our big, and climbing national debt.

A perusal of the academic (theoretical) literature on optimal tax systems is, pragmatically, not all that helpful.  First of all, it is not unified.  There are differences in approaches, assumptions and outcomes.  As with most theoretical economic matters, it tends to simplify—possibly to oversimplify—its real-world environment, and average, and homogenize its taxpayer bases.  It reaches theoretical conclusions in this regard, but it is apparent that most of these have not been translated into real world tax policy by most authorities.  Still, there are features worth considering in looking for an optimal tax system.

In November a study group in the UK headed by Sir James Mirrlees, a Nobel-prize winning founder of the modern theory of optimal taxation presented its recommendations to the UK authorities. It urged governments to do more than tinker at the margins of their tax systems as they look to recover from the negative revenue effects of our current world-wide recession. In plain English, governments need more money!  A similar debate is going on here in America as we ponder just how to reduce our out- of-sight national debt.  The alternatives seem to be, (1) raise more money, (2) cut spending, or (3) some combination of the two.  I haven’t heard of a 4th alternative, if you rule-out simply inflating the debt down to nothing, or defaulting on your national obligations.

Among the Mirrlees commission recommendations for up-dating the tax system (the UK, specifically) to collect more revenue, several stand out (these are available on-line in the form of a preliminary report, at www.ifs.org.uk/mirrleesreview, and the Economist—November 13, 2010 issue—has a good if brief presentation of the issue): first, that taxation always imposes economic costs, both because money is needed to collect taxes and because it distorts people’s consumption and work choices. Most governments, they stress, could find a way to raise the amount of money they need from the tax system while imposing much lower costs (to collect it) than they currently do (an example of spending less).

Given the above, the economists propose a tax system with three main guidelines:  It would be progressive, that is it would place a larger tax burden on richer people.  It would not discriminate between income earned in different ways.  Finally, it would be simple.

Taking these considerations and applying them to our own situation, a couple of things seem self-evident:  Our tax system is anything but simple.  With a Tax Code that currently runs to about 66,000 pages of often incomprehensible tax laws to comply with, supporting some 526 separate forms to be filled out, I believe few would argue with that.  Our system does discriminate between incomes from different sources, hence a corporate tax, a capital gains tax and a wages tax.  Yes, it is somewhat progressive, but with the myriad of exemptions, deductions and such the degree of progressivity projected is overstated. And finally, while the IRS will tell you how little (as a percent of collections) it spends, most would probably contend we spend a lot of money to collect our taxes and to administer and police our tax system.

Chapter 13 in The Gathering of the Clan is devoted to the issue of taxes.  It’s devoted to reforming our tax system, and it clearly and consistently follows the above guidelines necessary for, if not an optimal tax system, a significant improvement to what we are living with currently. And, most importantly in my view, it’s a tax policy proposal that starts from the premise that the tax payer incur minimum time, effort, burden and cost when paying his taxes.  It should at the same time minimize the opportunity to evade paying them.  It is a tax proposal that does not tax earned income (wages and salary), except at the highest levels, but one that taxes general consumption on a non-discriminatory and progressive—not regressive— basis (reflects an ability to pay).  One where all pay the same rates be they rich or poor or somewhere in between (it does not distort spending decisions).  It is simple to collect:  a point-of-purchase sale tax at the retail level on goods and services which excludes the necessities of life.  No one, rich or poor, pays tax on the basic necessities of life.  It’s not only wrong; it’s immoral for government to attempt to do so.

The proposal is further progressive in that while earned income for the vast majority is not taxed, it does include a high-earner income tax, probably on incomes of about $400,000 per year, and up.  At this level, we are speaking of less than 7% of American households.  Unearned incomes, rents, interest, royalties, dividends would be taxed at a flat rate, on receipts above a certain annual level;  probably on those in excess of $50,000 per annum.  Capital gains are kind of a class by themselves.  Other than for the current tax code, it’s questionable whether these are earnings at all.  Capital gains are really profit or loss on an investment, taxed currently as if they were income. The proposal in chapter 13 would only tax these over a minimum annual threshold, say about $100,000 per year, and then at the same rate as other “unearned income.”

It was not my intent to go into great detail here.  The Chapter 13 purpose is to highlight that reform of our tax system, starting with simplification for the taxpayer, is not only due, but way over-due.  It is again in the public eye with the Presidents committee on how to reduce the deficit. A secondary purpose is to highlight the need to consider taxes from the taxpayer’s point of view, and Chapter 13 is built upon this need, for both personal and corporate taxes.  This is not to minimize the need for government revenue, but it is to highlight that, long term, we only have so much to spend, and it’s time, past time, to bring this simple, basic fact before the American public, and then act to correct this situation. Our tax system is certainly a big part of this issue.

It’s reassuring to see that some of the world’s top economic experts on the issue of taxes support Chapter Thirteen’s approach to tax reform.  We need a change!

 

Thomas Richard Harry
December 2010

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