Tuesday, November 16

A Surprising Key to Unlocking U.S. Job Growth & Global Competitiveness

"Once we open up to the inevitability of our demise, we can lighten up about it and begin to transform the situation"
                                                                                       -Zen proverb

The United States is suffering through a very serious economic challenge. Unemployment is nearly 10%. State and local governments are facing bankruptcy. Consumer confidence is low, and probably heading lower. And the federal government's debt trajectory means the U.S. will soon be spending $1 trillion a year in just interest.

How is the U.S. going to lift itself from this morass? One surprising key to restoring U.S. jobs and economic competitiveness is a complete overhaul of the tax system.

Many people believe that any proposal to overhaul the tax system is politically DOA; there are simply too many special interests lined up to oppose major (or even minor) changes. Yet interestingly today came news of a bipartisan proposal to substantially alter federal tax policy by reducing income taxes and moving towards a consumption based tax system.

The Fundamental Problem with Income Taxes

I've long argued that taxing income is suboptimal economic policy. When an individual generates sufficient income, that individual is able to cover their own expenses. In contrast, when an individual does not earn enough income then financial assistance must be obtained from others. On the whole I believe society is better off when individuals are income self-reliant. This goal may not be achievable by everyone (e.g., disabled), or at all times (e.g., recession). But it is nonetheless a goal for which society should generally strive.

One way society can help individuals achieve this goal is through the elimination of as many disincentives to earning income as possible. The income tax creates several disincentives, some of which are illustrated in the following example:
Imagine you have a job which pays an annual income of $40,000, and one day you are offered the opportunity to earn an extra $1,000 for completing a project. However, the government will tax this $1,000 at a rate of 99%, meaning your take home pay from this project would be only $10. You would also need to keep the receipt for the project and report the project on your income tax return. If the only thing that appealed to your about the project was the amount of money you'd take home (e.g., no work experience benefit or other perks), would you take the project? I imagine most would probably pass. 
What if the government instead taxed the project at 75%. You'd probably be more likely to take the project now, but you may still pass if you're only going to net $250 of the $1,000. What if the tax rate was lowered to 35%? We're getting warmer now. Would you take the project if the tax rate was lowered to 0%? Perhaps most now would. But for those who still wouldn't: if the extra filing requirement was eliminated would that seal the deal?
The key takeaways from this example are:
  1. Tax rates and ancillary requirements, like record keeping and reporting, can affect our decision making when it comes to income
  2. Individuals possess different tax rate and hassle thresholds
In the real world precise measurements of just how much of a disincentive the income tax is is difficult to obtain due to individual preferences. However, we can see logically from the example how disincentives do exist at a variety of tax rates and reporting requirements.

A simple summarization of the above: don't tax things, like income, that you want to encourage.

Tax Code Complexity Stifles Job Growth

If you think the U.S. tax system isn't all that complex, check out the below video of Treasury Secretary Tim Geithner.

Not even Tim Geithner, who's job as Treasury Secretary includes overseeing the IRS, can navigate the complexity of the U.S. income tax system!

A powerful job growth argument for moving away from the U.S.'s current income tax based system is that doing so would eliminate significant bureaucratic complexity. Tax simplification would help individuals and small businesses, who often have difficulty dealing with the 65,000 pages of the U.S. tax code without hiring expensive tax accountants. Small businesses have created 65% of new jobs in the U.S. over the past 17 years. Reducing paperwork and filing burdens on this sector of the economy could help generate much needed job growth.

What's the Alternative to an Income Tax?

In contrast to income, society's best interests are not always served by consumption. Put simply, consumption can be a bad thing. This is particularly true in the case of overconsumption, which can lead to a low savings and investment rate as well as over indebtedness. Consumption that generates negative externalities which aren't or cannot be offset is also undesirable. An example of a consumable item which can lead to negative externalities is tobacco. Take the following personal example:
I enjoy the occasional 'victory' cigar. But by smoking cigars I may increase my chances of developing lung cancer. And if I develop lung cancer I may incur significant medical expenses. Under the current system some of my cigar-related medical expenses may end up being paid for by others.  
In a perfectly fair economic world, one coud argue that cigars should be taxed at the precise rate necessary to cover all medical costs associated with cigar related lung cancer. In this way only cigar smokers would cover the costs of cigar related lung cancer.

Some state and local governments have actually created tobacco taxes, which are often referred to as 'sin taxes'. Sin taxes, and your state and local sales taxes, are a form of consumption tax. Sin taxes are often placed on goods such as alcohol, tobacco and other products which generate externalities (like additional health care costs). In some cases the funds raised from sin tax are specifically allocated towards the prevention or costs associated with the 'sin'. For example, tobacco taxes may be used for advertising against smoking.

But should we try and tax cigars at the precise rate necessary to cover the associated health care costs, and then try and allocate those funds towards only cigar related lung cancer costs? The snort answer is no. The complexity and additional bureaucracy of trying to do so would make this effort extremely inefficient and costly.

So does that mean consumption taxes are not viable? Actually, no. Sin taxes, or your state or local sales tax, are not the only types of consumption taxes.

How the 'Fair Tax' Would Address Consumption Tax Criticisms

At the end of the Tim Geithner video there is a plug for the Fair Tax. What is it?

There are numerous arguments against consumption taxes. Below is a list of the main ones along with how the Fair Tax addresses each concern (in parentheses):
  • Consumption Taxes are Regressive: Everyone has to pay consumption taxes whereas those with low income don't have to pay income taxes. Therefore consumption taxes disproportionately impact the less well off. (This depends on how the consumption tax is structured and implemented. The Fair Tax attempts to avoid being regressive through 'prebates')
  • Economic drag: The U.S. economy is driven by consumption and any tax on consumption will make the current economic situation worse. (This would probably be true in the short-term. The Fair Tax recommends a phased implementation approach to mitigate this issue. However, over the long-term a number of policy experts, including former Federal Reserve Chairman Alan Greenspan, disagree that a consumption tax would be a drag. Many economists consider it the ideal tax system for driving economic productivity.)
  • Complexity: trying to determine the exact tax rate to apply to cigars for the medical costs is difficult if not impossible to calculate. (The Fair Tax sidesteps this issue by applying a uniform tax rate across all consumption.)
  • Lobbying: By trying to come up with targeted sales taxes you open the door to endless legislative lobbying by interest groups to tinker with the tax rate.  (The Fair Tax sidesteps this issue by applying a uniform tax rate across all consumption.)
  • Disruption: Hundreds of thousands, it not millions of jobs (i.e., accountants, auditors, tax preparation software companies, lawyers, and lobbyists) have invested their careers in the current income tax system. A complete overhaul of the tax system would create widespread employment displacement.  (Yes, there would be change. But the economy would be better served by deploying these individuals to productive areas of the economy, which is discussed here.)
  • Accomplishes Nothing, Just Replaces One Tax for Another: Switching to a consumption tax would be a distraction from addressing the fundamental budget problem, which is a mismatch between government spending and tax revenue. (The Fair Tax could lead to economic growth, which in turn could generate more tax revenue to help address government fiscal imbalances.)
  • It Will Never Happen: Too many political interests are invested in the current tax code. A fundamental overhaul has too many political enemies. (This is an intellectually lazy approach to argument which attempts to dismiss an idea without addressing its merits.)
That's quite a list! Does a consumption tax like the Fair Tax stand a chance? Is the Fair Tax even the best consumption idea? There are others.

I'm not a Fair Tax expert. But I'm intrigued by what appears to be a very well thought out proposal which addresses many consumption tax concerns.

Looking Ahead

It is easy to get discouraged when contemplating whether seemingly intractable big problems, like the current economic situation or tax reform, can ever be addressed. Thankfully some solace can be found in U.S. history.

At the turn of the 20th century, very few thought the grip on government held by powerful business trusts, such as John D. Rockefeller's Standard Oil, could be addressed. The great trusts of that day simply wielded too much power, or so it was thought. It took over 10 years and a force of personality as strong willed as Teddy Roosevelt, but Standard Oil was eventually broken up.

During the Great Depression in the 1930s, very few thought the powerful bankers which had profited from stock market speculation could be regulated. But along came a relentless prosecutor named Ferdinand Pecora, and his tenaciousness was instrumental to enacting financial regulations. Those reforms ushered in a half-century of financial system stability.

In the current environment, the upshot of running out of tarmac is that the U.S. is close to exhausting all the suboptimal choices; government will soon be forced to do the right thing.

In other words, don't underestimate the likelihood of tax system overhaul and good economic ideas like shifting from the current bureaucratic income tax system to something like the Fair Tax.


  1. Mindless dribble.

    You lose all credibility when your deincentivizing example contains a 99% tax rate.

    Further, you ignore many negatives of the "well thought out proposal", including increased tax fraud opportunities(you can guarantee organized crime will again become big players); the incredible negative effects on consumption for at least the first several years(might as well close down all auto and home manufacturers for a couple of years); the incredible cost of collecting the taxes and disbursing the "prebate checks"(not a chance it does not take more people and money than the IRS currently employs and spends); and the devastation of foreign tourism in the US as everything would increase by 30%.

  2. "You lose all credibility when your deincentivizing example contains a 99% tax rate."

    Were you aware that in the mid-1970s in the U.K. under James Callaghan that the top marginal rate was 98%?

    Has there been a "devastation of foreign tourism" in Europe where VAT taxes run over 20%? Of course not. Part of the reason is because foreigners can apply to have their VAT taxes refunded.

    The one point you make which may have some merit is the prebate mechanism. I too am not sure this is an optimum approach to preventing the Fair Tax from becoming regressive.

  3. What is the relevance of the top marginal rate in the U.K. in the mid-1970's to the U.S. of 2010? And I am sure you are aware that tax rates are not the only basis for determining tax liability. See the U.S. corporate business tax for an example.

    Strange to me that you do not accept the simple fact that the sudden increase of 30% on the price of a new car would devastate the new car market, and the same for a newly constructed home for a minimum of several years.

    Every single economist I have read(including the Fair Tax people's own economist) agrees that the effect of the Fair Tax on the US population would be a reduction of the current tax burden on those making less than $25,000 and on those making more than $250,000, while increasing the burden on everyone else. Do not see how that makes sense or would bode well for the future of the U.S.

    There is one part of the Fair Tax that makes perfect sense that you mentioned, the "uniform tax rate". But instead of devastating the economy while instituting a new tax system that will drive the classes further apart in the US, why not just take our income tax system and stop the "endless legislative lobbying by interest groups to tinker with the tax(rate)" system?

    Give everyone a personal deduction and one for each dependent. Continue the subsidy for the working poor with children to keep children out of poverty. Include all types of income; investment, labor and dividents. And then apply one tax rate for the remaining total.

    I beleive Forbes' flat tax rate was around 19%, and he excluded passive income. So including all income would bring that rate down.

    Now, there is a "fair tax system" simple enough for a child to file without any disincentives for anyone.

    Personally, I do not hold to your "anything can happen" thought regarding such drastic tax changes(I hope I am wrong) being implemented in the U.S. I think insight into the current system and its' problems can easily be seen by figuring out which economic class of the U.S. would oppose my tax system.

    I will give you a hint. It is the group whose tax rate would be reduced.

  4. "What is the relevance of the top marginal rate in the U.K. in the mid-1970's to the U.S. of 2010?"

    You said that using a 99% rate in the hypothetical example caused a loss of "credibility", thereby implying that this type of tax rate is impossible. So the reason I pointed out the U.K.'s previous tax rate was to make you aware of the fact that rates in the 90% (or over 120% effective rates for that matter) are actually not impossible or absurd, but a part of recent tax history. And 90% rate levels aren't the exclusive province of the U.K. or Europe either. The U.S. also had tax rates above 90% as recently as the 1960s, and 70% in the 1980s.

    Having said that, the reason I used 99% in the hypothetical is to point out through an extreme tax rate that rates can and do influence income seeking behavior. The income tax rate threshold, however, is based on individual preference.

    "Strange to me that you do not accept the simple fact that the sudden increase of 30% on the price of a new car would devastate the new car market"

    If you read the full post you'll see that I comment on this issue in the 'Economic Drag' bullet: "Economic drag: The U.S. economy is driven by consumption and any tax on consumption will make the current economic situation worse. (This would probably be true in the short-term...". So, some type of phase-in would probably be necessary.

    Having said that, I believe a tax model which promotes savings instead of consumption is a superior economic model. Looking around the world at the growth rates of the countries which are saving (e.g., China) versus those which are over consuming (e.g., U.S.) provides some validation of this point.

    "the effect of the Fair Tax on the US population would be a reduction of the current tax burden on those making less than $25,000 and on those making more than $250,000, while increasing the burden on everyone else"

    This may be true. As I state in the post, I'm not a Fair Tax expert. Perhaps spending so much time in the post on the Fair Tax gives the impression that I'm pushing for the Fair Tax and only the Fair Tax. Not so. My main point is that a consumption tax makes more economic sense than an income tax, and the transition of the U.S. towards one could drive job growth and economic gains. If the Fair Tax isn't the best consumption tax proposal then let's find a better one.

  5. Hard to "promote savings" when the vast majority of Americans are seeing a decline in real income. Check out US savings rates through the last 30 to 40 years and you can see the correlation between the decline in savings and the decline in income for most of the country.

    I do not see how any kind of consumption tax could possibly not be regressive. Combine those two things and it is hard for me to understand how a consumption tax would promote growth.

    Nothing happens in this world until someone buys something. The reason China is growing is based on people buying things from them, not from the Chinese saving their money. Just look at Japan and their savings rate. Very high when people bought things from them, and now declining as they lose market share(to countries like China). Savings rates are an effect, not a cause.

    I guess it seems like I am some kind of socialist, or greatly favor income redistribution(I hate that term) from my comments. Trust me, I am not. I just see the last three decades and the inane supply side policies we have followed as being the end of the American dream.

    Stagnating incomes for the vast majority coupled with incredible inequality is a recipe for disaster. When 80% of the country is going backwards despite working longer and harder than their parents and grandparents did, there is a serious problem. Sooner or later, bad things will happen. And applying a regressive tax on those people would be adding fuel to the fire.

    On that somber not, have a nice holiday. I have enjoyed the discussion.


  6. EMichael,

    I share many of your concerns and conclusions. For example, if there was no way to prevent a consumption tax from becoming regressive, or at least offsetting its regressiveness through government, then I'd be adamantly opposed to it too. Having said that, I think there is a way to prevent this and would like to add a few more points.

    Like you said, I'm not aware of any research that can definitively link higher savings rates to economic growth (causation). However, there definitely appears to be at least some correlation between higher savings rates and economic growth (Japan 1970s-80s, China now, etc.) and low savings rate and low economic growth (U.S., U.K., etc.).

    Before the Chinese can sell things, they need to invest in plant, property, equipment, education, infrastructure, etc. One source of that investment is savings. The fact that China is a surplus country and can finance its growth through internal savings means that it is more of a master of its own economic fate than the U.S.

    The U.S. has to borrow from foreigners to make up for its low savings rate. Compounding the U.S.'s problem is that much of the borrowed money is going into unproductive or non-investment consumption. Now the U.S. is left with relatively uncompetitive exports, large foreign debt, and high wages. This is similar to Greece, Portugal and other European countries currently providing a preview of what's to come in the U.S.

    Building on this point, I think there are definitely some forms of consumption which society should go out of its way to discourage through taxation. This is one of my main concerns with the Fair Tax. I understand the Fair Tax philosophy and merit of not picking consumption 'winners and losers'. Doing so risks winding up right back where you were with the 65,000 page tax code and endless lobbying for preferential tax treatment.

    However, tax policy could help play a role in disincentivizing consumption which is not in society's overall best interests. Further, perhaps the best way to avoid a regressive consumption tax is to protect basics such as food, healthcare, education, low income housing, etc. for lower income individuals. I haven't thoroughly investigated the Fair Tax's 'rebates' component but I'm aware that it has come under some criticism.

    Overall, transitioning to a consumption tax may entail some type of short-term economic pain, although I believe this can largely be mitigated if it is phased-in. Politicians, of course, try to avoid short-term sacrifice like the plague as it may cause them to get booted from office by a public which doesn't like it much either. However, the U.S. needs to start making good long-term economic decisions. The country has kicked the can down the road for far too long to avoid short-term hardship. The sooner this ends, the sooner the U.S. can get back on track and reduce the risk of permanently losing its privileged global position and all the perks that come with that status (e.g., U.S. dollar as reserve currency).

    I too have enjoyed the exchange of ideas. Happy Thanksgiving and here's hoping that more people discuss and debate different ideas for how to get the U.S. economy and country moving in the right direction again.

    The PolyCapitalist

  7. I hope that we can all agree that capital creates jobs, wealth, and opportunity. Punishing capital gains is a real wealth killer. But, many of the "wealthy" have only capital gains as their main source of income. So, how do we tax them?
    Another concern is the corporate tax. This tax only adds to the cost of production. The VAT tax would do the same thing. Until we rid our companies of the corporate, or VAT, tax, we add to the costs of production. Consumers must pay for these costs.
    The estate tax is straight out of The Communist Manifesto. It was created by those who covet the prosperity of others. The estate tax destroys small businesses, and kills jobs.
    The income tax is collected at the point of a gun. The payroll tax is the most regressive tax we have.
    What plan, currently in Congress, eliminates the income, payroll, corporate, gift, and estate taxes with a revenue neutral tax? It also taxes the wealth of the rich. The FairTax, which has 70 legislators signed on and millions of grassroots supporters.