Ideal Taxes
The Current State of US Taxes
The US tax system is a messy patchwork of taxes that raises revenue inefficiently. This manifests in two ways:
- Distortionary taxes that discourage savings and investment
- IRS regulations that impose high compliance costs
In 2016, the center-right Tax Foundation estimated that the total tax compliance costs to the US economy was approximately 2.18% of GDP. Additionally, Americans spent 8.9 billion hours filing their taxes in the same year. On the Tax Foundation’s tax competitiveness index, the US placed 21st out of 37 countries.
We also suffer from collecting the majority of taxes from inefficient sources. Capital and business income taxes, as implemented now, are the most harmful. Our corporate income taxes are harmful because they increase the cost of capital investments. Capital gains taxes are harmful because they tax future consumption more than current consumption. Furthermore, it’s a double tax when paired with a corporate income tax. We want people to create businesses and invest without artificial penalty. It makes sense to tax the owners of capital after they’ve made their investments and receive profit, but that’s not what our current tax code does.
Guiding Principles
There are some fundamentals we should adhere to when designing a robust tax system. These are:
- Efficiency
- Simplicity
- Neutrality
- Equitability
- Transparency
Efficiency
An efficient tax code is one that reduces the deadweight loss of both the taxation itself and negative externalities. This translates into tax policy in three ways:
- Shifting taxation onto bases (tax sources) with more inelastic demand or supply
- Have a broad base coverage to keep the tax rate as low as possible
- Pigouvian taxes that tax specific goods at a level that integrates the social cost it imposes
Simplicity
A simple tax code is one that is easy to comply with and easy to enforce. Much of the complexity in the tax code comes from the gallimaufry of exemptions, credits, and deductions. While some credits such as the child tax credit and EITC help lower income households, it’s more effective to deliver them as integrated cash benefits outside of the tax code and eliminate nearly all exemptions, credits, and deductions.
Neutrality
Tax neutrality means not unduly punishing nor incentivizing business decisions. The only exception to this is Pigouvian taxes, whose goal is to integrate disintegrated information in the price of something. The implications of neutrality are to avoid preferential tax rates, credits, exemptions, and deductions.
Equitability
Tax Tax equitability means satisfying two conditions:
- Vertical equity
- Horizontal equity
Vertical equity concerns making tax burdens rise with income. Net taxes after government transfers should rise with income because people with more income have a greater ability to pay more in taxes than people with less income. This implies that regressive taxes like head taxes and payroll taxes with income caps should be repealed if they’re not Pigouvian.
Horizontal equity means people with similar income and assets should face similar effective tax rates. Preferential rates as well as certain deductions, exclusions, and credits are responsible for violating horizontal equity in our tax code.
Transparency
Taxes should be visible and expose the cost clearly. Law makers should not obfuscate taxation by using complex taxes that hide the full cost imposed on tax payers. For example, employer-side payroll taxes.
A New Tax Regime
Informed with these principles, we can proceed with creating an effective tax code at every level of government. I’ll cover Local governments, State governments, and the Federal government.
Municipal & County Governments
Most municipal governments fund their operations through property taxes and fees. Larger municipalities and some counties sometimes have retail sales taxes. Property taxes aren’t terrible, but they tax both the land and any capital improvements on the land, such as buildings or a septic system. This discourages productive investments because tax liabilities increase when land owners make improvements to their land. Taxes on unimproved land value incentivize the land owner to economize on their land because they’re financially better off when they use their land efficiently.
Taxes on the unimproved value of land are called Land Value Taxes (LVT). Land value taxes have numerous salient features:
- Virtually impossible to avoid because land is immovable
- Not distortionary because the amount of land is unchangeable
- The tax incidence is directly on land owners
- Discourages land speculation by increasing the cost of holding vacant land
- Highly progressive because land ownership increases with wealth
These features make land value taxes a fantastic option to raise revenue. Counties and cities should replace their existing taxes with land value taxes.
An Aside on LVT
Because land value taxes are non-distortionary, tax rates can be high without causing economic damage. The optimal rate, assuming we replace most other taxes with the LVT, is 100% of the land value. Governments can lower the rate, give cash transfers back to households, or both because a 100% rate may raise far more revenue than most state or local government needs.
This is where the distinction between the varying definitions of value cause confusion. In this situation, I’m not talking about the market value of the land. The value that land value taxes are taxing is the imputed rent. Imputed rent is the amount of money a land owner would theoretically pay to a landlord to use a given piece of land for a fixed time span.
Calculating imputed rent sounds hard, but modern land-appraisal techniques can extrapolate imputed rent from the market value of the land. Zillow’s rent Zestimate is an example of a semi-accurate mechanism that can calculate imputed rent, albeit for residential homes that aren’t for sale rather than unimproved land.
State Governments
State governments use a combination of property taxes, sales taxes, fees, income taxes, excise taxes, and business taxes. Like with municipal and county governments, states should replace nearly all their existing taxes with land value taxes.
The Federal Government
The US federal government collects taxes on:
- Income and payroll from individuals and firms
- Specific goods and activities (excise)
- Imported goods (tariffs)
- The transfer of assets both during life and death (gift and estate tax)
Congress should replace all of these taxes, sans some excise taxes. We should have a unified system of consumption taxation to fund the majority of the federal budget. One proposal that merits consideration is the X-tax.
The X-tax in Detail
An X-tax is a progressive consumption tax with two components:
- A credit-invoice and origin-based Value-Added Tax (VAT) that covers all business transactions, except financial transactions and instruments, with full investment expensing and wage deductions
- An exmployee-side payroll tax with graduated rates
Let’s define the terms for the VAT. Credit-invoiced VATs tax at the point of sale, and businesses receive credits for the VAT they paid for input and services used to construct the final good or service sold. Origin-based, in this context, means that that tax includes export sales and provides a deduction for import purchases. Full investment expensing means providing immediate first-year deductions for all capital investment purchases. The VAT component is effectively a flat tax on business profits.
Some people may balk at the lack of direct capital taxes. It’s important to note, however, that people receiving dividend payments and capital gains pay tax because of the cash flow tax on business profits.
The payroll tax should have a standard deduction and 3-4 brackets. The top payroll tax bracket is equal to the rate of the payroll tax. Tax rates can be higher under the X-tax than the current income tax system without incurring the same economic damage because savings and investment aren’t double taxed.
The X-tax doesn’t ostensibly appear to be a consumption tax. To understand why it is a consumption tax, we must understand what constitutes income. Income can come from two sources:
- Wages and receipts
- Returns on capital
Many people use their wages to finance personal expenditures. An employee-side payroll tax is a consumption tax that taxes the expenditure source rather than individual expenditures themselves. If someone invests part of their wages, they’re not taxed again on the investment return. Owners of capital face no tax on initial investments; they pay indirectly through the business tax on profits. Just like employee-side payroll taxes, profit taxes tax consumption at the expenditure source rather than individual expenditures themselves
The X-tax taxes national consumption because we’re taxing returns on labor and capital while excluding income from savings.
Taxes for All Levels of Government
This section discusses taxes that the previously discussed three levels of government should impose.
Pigouvian Taxes
Governments may want to impose Pigouvian taxes. A Pigouvian tax taxes activities that impose costs on parties not involved in that activity. A well designed Pigouvian tax has a tax rate that mitigates, to the greatest possible extent, the negative externalities generated by the activity it’s taxing. All remaining excise taxes should be Pigouvian. In cases where it’s feasible to facilitate Coasian bargaining, legislators should do that instead of imposing Pigouvian taxes.
LVT to Fund the Federal Government
Theoretically, the Federal government could impose a LVT. Unfortunately, it would require a Constitutional amendment. Theoretically, states could send the surplus revenue from their LVTs to pay for a capitation tax imposed by the federal government. This scenario would be undesirable because capitations must be uniform under Article I, Section IX, Clause IV of the Constitution.
If we amended the Constitution to expressly limit taxes to land value, imputed rent, Pigouvian taxes, and user fees, we’d have an even better taxation regime than I suggest here. For the sake of keeping an iota of pragmatism left, I only proposed taxes that our current Constitution allow.
User Fees
User fees are taxes that charge people for using infrastructure. The most well known example of a user fee is a road toll to pay for road maintenance. All levels of government should impose user fees to pay for transit infrastructure maintenance. Left-leaning policy observers often complain about the regressivity of user fees. Law makers can abate the regressivity by giving reduced rates to poorer people or redistributing more. Generally, fees shouldn’t be used to finance general government operations, such as licensing, permitting, and inspections.
Conclusion
Taxes are necessary to finance public expenditures. We should put in the effort to ensure they raise revenue as efficiently as possible while reducing or even eliminating the economic damage they cause.