North Carolina tax reform options

Scott Drenkard and Joseph Henchman of the Tax Foundation outline four tax reform options for North Carolina that are based on a report financed by the Carolina Business Coalition. The link noted in the News and Observer op-ed doesn’t make it to the full report; I will add it and read it when I can find it (update: here is study).

I like the way that the op-ed lays out four options that they claim each raise the same amount of revenue as the current tax code (with the proviso that I haven’t read the full report; I am taking what they say at face value for the time being). As I have written about federal tax reform, the most important decision is how much revenue you intend to collect; then you legitimately move to the issues of fairness, impact on growth, and the like. There is no need touting an idea that cannot raise the revenue being targeted.

The op-ed highlights four options. Again, they say that each will raise the same amount of revenue as the current tax code and they  focus on the growth side impacts; issues of distribution and fairness are also important. I would also note that progressivity/notions of fairness are also influenced on the spending side, so the state’s decision on the Medicaid expansion will become very important in how any tax reform is viewed.

• “Option A” makes North Carolina the most pro-growth tax system in the country, simplifying the personal income tax at 6 percent, lowering the statewide sales tax to 3.5 percent while expanding its base to services, and repealing the corporate income and franchise taxes.

• “Option B” keeps all the major taxes, but simplified and at low rates: a 5 percent income tax, 5 percent sales tax and 5 percent corporate tax. A similar positive reform was adopted in Utah, contributing to its economic success.

• “Option C” would eliminate taxes on individual and corporate income and broaden the sales tax base to services to make up the revenue. The total state sales tax rate would have to be raised to 8.75 percent to fully fund current levels of state spending, but the benefit of this option is that North Carolina would be one of the few states with no taxes on investment or job creation.

• “Option D” eliminates taxes on retail sales and corporate income, paying for these reductions with a single, simple tax on individual income at a flat 10 percent rate.

By the way, if you think all these options sound “easy” read this.

Domenici and Rivlin: extend tax code on way to overhaul

Pete Domenici and Alice Rivlin today suggested the current tax code should be extended beyond December 31, 2012, so long as it was done as a part of a process to ensure more fundamental tax reform. The biggest question is how to get such a process underway that will lead to such an overhaul?

Our current tax debate is focused on the 2001 and 2003 Bush tax cuts that have now been extended. This is fairly limited ground over which to fight out tax policy, and more fundamental reform is needed, at least in part to move away from the either/or nature of the current debate.

The tax code we have is almost 30 years old, with many credits, deductions and expenditures added along the way. The current tax code would best be plowed under and completely redone. If we ever got to the point of actually talking about the policy of doing so, the most important tax reform decision/discussion is determining what proportion of the tax code we will collect in federal taxes? This level of tax collection needs to move toward a level of federal spending at some point out in the future. Want lower taxes, then you have to say how you would cut spending. Want higher spending, you have to be clear about the taxes to pay for it. There are many important issues such as fairness and equity to be addressed through tax reform, but I don’t see how you can fully have such a discussion without having a sense of how much tax revenue will be collected overall.

As  hard as the actual policy debate and reaching an agreement might be, it is even harder to imagine Congress actually taking this on at all.

Progressive consumption tax?

The basic criticism of consumption taxes are that they are regressive–a larger proportion of the poor’s income is subjected to them as compared to the rich. In making policy, this negative attribute must be considered along side the positives, such as ease of collection, difficulty in avoidance and not penalizing savings. The standard tweaks to consumption taxes that address concerns about regressivity, such as exempting food or clothing, rids consumption taxes of many of their benefits. So, they are sold as a panacea by many conservatives, and not even considered by most progressives.

Len Burman reviews a new book by Bob Carroll and Alan Viard Progressive Consumption Taxation: The X Tax Revisited. This book proposes their X tax to replace the current income tax system (based on past work of David Bradford). Here is a one hour video discussing the book. Len Burman is not totally sold on this idea, and he rightly says they need a catchier name (X tax invokes high school algebra and related anxiety!), but he gives the authors high marks for wrestling with the difficult transition issues from our current income tax to the proposed system, that many proponents of big tax changes assume away. I have not read this book, but have read some of the related working papers, and this is not beach reading, but it is important. I will read it and write more later.

update: fixed a blog fail

Adding a VAT

Josh Barro has a piece in favor of a Value Added Tax in Bloomberg. A VAT is a tax levied on business sales minus their inputs or costs, so all companies ‘adding value’ along the production chain pay the tax, but it is collected at the sale of the final consumer good. If you buy a sweater for $50 and the VAT is 10%, $5 of the $50 is the VAT.

In my book Balancing the Budget is a Progressive Priority, I didn’t suggest that we add a VAT, but I do think that it will take a substantial increase in tax revenue as a percent of GDP to ever have a balanced budget again. I suggest 21% of GDP, which is about 3 percentage points higher than the 40 year average, a level that is doable, but won’t be easy. Would a VAT be useful to consider? A key question, and a few thoughts.

• Is the VAT viewed as a supplement to our current system of taxation (payroll taxes, personal and corporate income, excise taxes) or a replacement of some portion? I asked Josh Barro via twitter for his views, and he said he viewed the VAT as supplementing our current federal taxation regime, shown below. Individual income taxes and payroll taxes are the largest source of federal revenue, with corporate and excise taxes being much smaller (in percent of GDP terms).

Barro notes how difficult tax reform that increases revenue will be, whether it is in the individual or corporate income tax, because as much as people claim to support it in theory, most deductions and exemptions benefit those who are powerful. So, one strong positive of the VAT is that it could raise a substantial amount of revenue, and would not be as noticeable and its burden would be spread across all consumers. A negative is that it is a regressive tax (lower income have larger percentage of their income subjected to the tax).

I have suggested ending the corporate income tax, and treating dividends and capital gains as normal income, while raising the top personal income tax rate and thereby making it more progressive. I stand by the notion that the most important tax reform decision is determining what proportion of GDP will be collected in taxes. Within that overall level of taxation, distributional impacts are important. Currently, we have a regressive payroll tax and a progressive income tax as the two largest revenue raisers, so it could raise concerns to add another large regressive revenue raiser. Josh Barro has a follow up post in which he argues distributional/fairness concerns about the VAT are not as big a worry so long as you are not adding a VAT and doing nothing else. This argument makes sense at some level, but I haven’t read all the underlying work he cites, and Michael Linden is lots more skeptical on twitter about this and points to this document (that I need to read).

Whatever we concluded, this strikes me as the type of discussion we should be having; what level of tax will be collected to finance a plausible level of spending? Within that, what mix of taxes will be used? The hardest part of all this is imagining that our dysfunctional political system could ever have a reasoned discussion of these issues. That is demoralizing.

The most important tax reform decision

(This is cross posted at The Reality Based Community blog).

The most important tax reform decision is deciding to collect enough revenue to pay for the spending that the nation plans to undertake.

This basic decision is often lost in the discussion of other (important) issues: marginal rates, tax expenditures, the Buffet rule/fairness, changes in the mix of taxes used to collect revenue, impact on the economy, etc. There are many key decisions to be made if we are to transition toward a sustainable federal budget, but most fundamentally, we must decide what proportion of GDP will be redistributed via government expenditure, and then develop a tax code that can collect the amount of revenue necessary to pay for such spending.

If we are to ever having anything near a balanced budget again, it will require a substantial increase in taxes received as a percent of GDP over the 18 percent of GDP collected on average the past 4 decades or so. Spending has averaged around 20.5 percent of GDP over the same period of time, but that is simply a restatement of the fact that the U.S. has only had 4 balanced budgets since I have been alive.

It is of course mathematically possible to shrink spending to meet the historical level of tax collection. However, it is important to realize that we spent more than 21 percent of GDP (the target for revenue/spending balance in around 2035 suggested by Simpson-Bowles) in 1970, 1975, 1980 and 1985—and the baby boomers were mostly working and paying taxes then, and not moving into eligibility for Medicare and Social Security. And no one has identified a health reform plan that could plausibly be enacted that could slow long range health care spending growth by the degree needed to achieve a balanced budget in the 18-19 percent of GDP range preferred by many Republicans, given other spending realities.

There are technical aspects of tax reform, no doubt. However, the biggest decision is to determine how much revenue is needed to finance the spending programs the country decides to undertake, and to then move to the related issues of reforming our tax collection system. Sometimes the simplest decisions are the hardest to make.

What to do about low effective corporate tax rate?

Maybe we should give up, drop it to zero, and seek to collect taxes on corporate profits via indirect means (dividends and capital gains).

Pat Garofalo notes that many corporations pay a far lower effective corporate income tax rate than the nominal rate of 35 percent–including 30 major corporations that paid no tax, or who had a negative income tax over a 4 year period. The main reason that I think the many calls for corporate tax reform of ‘broadening the base while lower the rate’ are likely to fail, is that a reduction to a rate of say 20 or 25% while removing exemptions and deductions will represent a profound tax increase on corporations who now pay little or not corporate income tax. Presumably they obtained their very low effective tax rate through being effective advocates for themselves, so there is little reason to believe such a reform can withstand the political pressures inherent with such a proposal.

One item that I suggest in my book Balancing the Budget is a Progressive Priority (out in May 2012), is to go ahead and reduce the corporate income tax rate to 0%, make dividends and capital gains normal income, and to then raise the top personal marginal income tax rate. The burden would fall largely (but not wholly) on higher income persons who would accrue most such income. The share of total federal tax receipts produced by corporate taxes has been between 10 and 13% since 1980 (~2% GDP), a precipitous decline since the 1950s. The table below shows federal tax receipts by source. There is lots of evidence that it is very hard to collect a predictable amount of tax from corporations.

If we moved to a 0% rate on corporate income (or very low rate), this would have to be done in conjunction with an overhaul of the individual income tax code that prevented individuals from becoming corporations and paying themselves in ways other than salary, capital gains and dividends. However, we should be able to figure that out. And we could end the strange dance in which some decry the high corporate tax rate while many corporations pay none or a very low effective rate, and it raises a relatively small slice of federal tax receipts.

We could of course redouble efforts to collect more in the way of corporate taxes, but treating dividends and capital gains as normal income and raising the top personal income tax rate seems to me a better way on many fronts.

Will Taxmageddon (aka Jan 1, 2013) spur a deal?

Joe Minarik’s plausible and demoralizing take on what will (likely not) happen in a lame duck session after the November election.

Historical look at top marginal tax rates

Timothy Taylor (h/t @tylercowen) has an interesting post on the revenue raised by different the U.S. tax code from 1958-2009 (total revenue and the distribution). This point in his review of this Tax Policy Center piece caught my eye:

2) Raising tax rates on those with the highest incomes would raise significant funds, but nowhere near enough to solve America’s fiscal woes. Baneman and Nunns offer this rough illustrative estimate: “If taxable income in the top bracket in 2007 had been taxed at an average rate of 49 percent, income tax liabilities (before credits) would have been $78 billion (6.7 percent of total pre-credit liabilities) higher, taking into account likely taxpayer behavioral responses to the rate increase.”

We need a fairly comprehensive tax reform that makes clear about how much revenue we need to raise (which is of course linked to the spending we want), and which not only focuses on marginal tax rates but the tax expenditures that are allowed to remain. We are entering a higher spending period by default given the baby boomers moving into Medicare and Social Security, with a lower-than-average tax code in terms of revenue collected. It seems likely that the effective tax rate will rise for most everyone.

More on frames for tax reform

Austin and Mark Spohr with interesting comments on my post yesterday arguing that you need to pick a level of GDP at to seek a balanced budget to be able to have a meaningful discussion about the important (but I say secondary) goals of fairness and economic growth. They got me to thinking and I try and work through some of it below.

Austin’s most basic comment/question is:

I don’t see why one must decouple and order as you (Don) did: fairness, economic growth, and the level of taxing and spending. What’s the objective (evidence or theoretical) basis for that? Aren’t the choices and framing here just manifestations of personal preference or values?

I don’t think they should be de-coupled, they are linked, but I was giving a rank order of the three frames through which to view tax reform. In terms of choices, preferences and values, I think in the tax reform/balanced budget debate there are a mixture of:

• facts (with no change of current policy we will continue to have large deficits)
• preferences/beliefs that at some point could become facts (if the debt-to-GDP ratio gets too large it will harm the economy). There is some evidence about this and theory as well, but at least some of it is cross national that makes it trickier to apply. This of course says nothing about appropriate level.
• just plain preferences (I would prefer a more progressive tax code, all else equal)
• predictions (without a net tax increase we will never have a balanced budget given any plausible level of spending that will be agreed upon). The key prediction is what is a plausible level of spending in an area, and then in total.

While Mark is correct that in theory we could have a balanced budget at almost any percentage of GDP (and there is tremendous cross-national variation), when thinking about the plausible levels of federal spending what any person is doing is making a series of predictions about spending on defense, health, social security, everything else combined, with interest on the debt being relatively fixed. Once you add the given “plausible spending decisions” to defense, health and social security (and debt service), you are then talking about ~15-16% of GDP in federal spending at minimum.

The most complete “liberal” deficit reduction plan is Center for American Progress that aims for balance at ~24% of GDP, while the Heritage and Senate Republican plans linked to a balanced budget amendment aim for ~18% of GDP.

For me to engage in a debate about fairness and economic growth in the tax code, I would need to roughly know which part of the 18%-24% of GDP range we were discussing. To do so, you have to make predictions about the plausible levels of spending on the big categories. We could have a more abstract discussion about fairness, for example, but I have trouble engaging it or viewing it as important without knowing what level of spending we are discussing, and the many answers to other questions that implies. That is how I think about it.

DT

Three tax reform frames

There are three key frames that are needed to best think about tax reform: math, fairness and economic growth.

First math. Tax receipts must go up if we are ever going to have another balanced budget. There is some consensus that a tax reform that “broadens the base and lowers the rate” is the way to achieve this, and I agree. However, it is important to understand that we must have a net tax increase across all federal tax sources, or we won’t have a balanced budget ever again given any plausible spending scenario. The first frame for tax reform is math.

Second, the components of federal tax receipts could be changed, which raises the key issues of fairness and economic growth. In making trade-offs between these two values, it is useful here to recall the historical share of different sources of federal tax revenue (personal income and payroll taxes, corporate taxes, and all other taxes including excise and estate taxes). From the CBO’s latest report (p. 81):

Corporate taxes have been a relatively small proportion of total federal tax receipts for 30 years (~10-13% of total receipts) while income and payroll taxes have been much larger sources of federal receipts with income taxes being the more volatile of the two. Excise and estate taxes have been small and declining (note: these shares would be very different in 1950, with corporate and excise taxes much larger).

The projected increase in income taxes as a percent of GDP shown in the figure after 2012 is simply the tax code reverting to pre-2001 levels on January 1, 2013, and the dip in payroll taxes and subsequent increase in 2012 is the enactment of the payroll tax cut in 2011 and the sun-setting of same (above it is shown as ending on February 29, 2012 as is current law).

A great deal of discussion of the tax code and tax reform has focused on fairness, which is a key concept, but fairness needs to be anchored to a bottom line percent of GDP to be collected in taxes (the Fiscal Commission suggests 21% of GDP). Once a target percent of GDP to be collected in taxes is set, fairness must be discussed along side the impact of the tax code on economic growth (higher growth is better for the deficit and for jobs). If we are going to develop a plan that can produce a sustainable budget, all three of the following frames must be an explicit part of the tax reform discussion.

• math
• fairness
• economic growth

The bottom line for tax reform if you want a sustainable budget is how will federal tax receipts be increased, not if.

DT