Wrongheaded Tax Policy

At the American Prospect, Michael Lind has a long piece proposing that we allow people who, because their income is too low, to take some of the largest tax deductions (like the mortgage interest deduction) against their payroll taxes. Before explaining why I think this is precisely the wrong direction for tax policy to go in, I should note that I have enormous respect for Lind. His book The Next American Nation had a big impact on me when it came out, and I think he is one of the most creative thinkers in the DC think tank world. Our national discourse would be much worse without him.

That said, this is a crummy idea. Our tax code has three great problems. First, it is outrageously complicated, producing huge dead weight losses by distorting economic behavior and requiring large outlays for tax preparation. Large-scale tax simplification is probably the simplest thing we could do to improve the efficiency of the economy, and probably also the perceived legitimacy of our government, and this goes in the opposite direction–spreading that complexity to the payroll tax. If anything, it would be great if we made the income tax look more like the payroll tax–which is a kind of flat tax on earnings–while reforming the payroll tax by removing the cap on taxable income, creating a standard payroll earnings deduction, expanding the payroll tax to investment income and maybe even taxing earnings at progressive rates.

The second problem is that the tax code doesn’t produce as much revenue as we need. To get more income, we need to substantially increase effective tax rates at the top. That can be done somewhat by raising the top rate, but the most effective way to do that would be to cut back drastically on the opportunities for high-earners to shield income. Lind’s suggestions don’t help with this, and by increasing the coalition to preserve our tax subsidy regime, probably hurts it.

The third problem is that our code doesn’t help much in counteracting inequality. That’s presumably part of what Lind is trying to do here, but I don’t think it will succeed. The best way to counteract inequality is by raising more revenue and then spending it on things that the middle and lower classes need, like national health insurance. Even if you let more of the middle and lower classes into the tax subsidy regime, they still won’t get as much out of that regime as upper-class people do, and you’ll only hollow out the taxation capacity of the national government that all expansions of the welfare state require.

I do think that there is one proposal for tax reform that does do all of these things (especially if modified slightly) and that’s Michael Graetz’s very elegant proposal, described here. Mike’s plan, simplifying the details considerably, would do the following things:

a) Eliminate the income tax entirely for families earning up to $100,000, indexed for inflation.

b) Impose a flat rate tax on income above that level, at a rate of 20-25% (I lean strongly toward the upper end of the range).

c) Impose a VAT tax at a 10-14% rate.

d) Lower the corporate tax, aligning it closely to the new, lower income tax rates (while also forcing corporations to use the same accounting standards when they deal with the IRS and the SEC).

e) Mike would deal with the EITC’s elimination by providing a refundable offset to the payroll tax. I think that my suggestions above could do roughly the same thing, or we could establish some compromise between what I want and what Mike wants.

The important point of Mike’s plan is that it valuably diversifies the tax capacity of the American state, by adding a VAT, something that every European welfare state (which all raise more revenue than we do) has, and that we know how to administer (in sharp distinction to the crackpot proposals for a national sales tax, which are designed to completely replace all federal taxes). It also wrecks much of the political support for tax expenditures, by explicitly limiting them only to those actually in the income tax system–a fairly small group. Therefore, even though Mike’s plan doesn’t explicitly get rid of ANY tax subsidies, it makes them much more vulnerable over time, and suggests that if the rates he suggests aren’t enough, that more revenue will be raised by gradually chipping away at these now-vulnerable deductions. It’s probably also the case that by shifting more of the code over to taxation on consumption, that the code will generally be better for encouraging savings and investment.

What’s really smart about Mike’s plan is that it sidesteps almost all of the usual problems with tax reform, the most important being that they all depend on getting rid of deductions by lowering rates–but as we saw in 1986, it didn’t take long for the deductions to grow back, because of the basic political economy of interest group organization. Mike’s plan just sidesteps all of this, at least in the first instance, but in the process makes it much more likely that subsidies will be reduced in future iterations of the tax politics game. And perhaps most important, his plan gives the American welfare state a much sturdier base for future expansion (esp. since the VAT is less transparent than other forms of taxation), especially since there’s room here to add some form of carbon tax, which is necessary for dealing with global warming and would provide even greater revenue going forward. Finally, the politics of his plan are almost irresistible–he actually succeeds in eliminating the income tax entirely for most families, and in the process drains almost all of the basis of Republican tax populism.

This is a proposal that’s economically sensible, progressive (especially over the long term), politically viable and, most important, sustainable. The answer isn’t to expand the tax subsidy regime–it’s to kill it–and this is the most politically feasible way to do it. Any Democrat looking for an ambitous and politically viable signature proposal would be smart to look very closely at Mike’s plan.

[Note: another oar dipped into this issue by Mike here.]

Author: Steven M. Teles

Steven Teles is a Visiting Fellow at the Yale Center for the Study of American Politics. He is the author of Whose Welfare? AFDC and Elite Politics (University Press of Kansas), and co-editor of Ethnicity, Social Mobility and Public Policy (Cambridge). He is currently completing a book on the evolution of the conservative legal movement, co-editing a book on conservatism and American Political Development, and beginning a project on integrating political analysis into policy analysis. He has also written journal articles and book chapters on international free market think tanks, normative issues in policy analysis, pensions and affirmative action policy in Britain, US-China policy and federalism. He has taught at Brandeis, Boston University, Holy Cross, and Hamilton colleges, and been a research fellow at Harvard, Princeton and the University of London.