Tax and Social Security Reform: Thinking Outside the Box
Thursday, September 29, 2005
by Hans Fehr, John C. Goodman, Sabine Jokisch, Laurence J. Kotlikoff
Table of Contents
- Executive Summary
- Introduction: Five Radical Reforms
- The U.S. Tax System: The Case for Reform
- Elderly Entitlements: The Case for Reform
- Modeling the Effects of Tax Reform
- An Eleven Percent Flat-Rate Income Tax
- A Flat Rate Consumption Tax
- Combining Tax Reform and Social Security Reform
- About the Authors
Introduction: Five Radical Reforms
In this report we consider replacing our current federal income tax system with a completely new system. The five alternative policies considered are (1) an 11 percent flat-rate income tax, (2) a 14 percent flat-rate consumption tax, (3) a 14 percent value-added tax, (4) a 16 percent retail sales tax and (5) a flat-rate consumption tax coupled with Social Security reform.
"We model four ways of replacing the income tax, and consider combining tax reform with Social Security."
In general, we find major long-run output increases from a switch to comprehensive consumption taxation. This finding is consistent with other research. Alan Auerbach finds that output could increase between 2 percent and 9 percent, depending on the particular details of the policy.1 Don Fullerton and Diane Lim Rogers predict increases in output of between 1 percent and 6 percent, depending on how sensitive consumers would be to changes in the rate of return from capital.2 Dale W. Jorgenson and Peter J. Wilcoxen predict an increase in output of about 3 percent.3 Former Congressional Budget Office Director June O’Neill estimates that replacing income taxes with a consumption tax would increase labor supply between 2 percent and 4 percent.4
An oft-repeated objection to previous proposals for fundamental tax reform is that the reforms would benefit high-income taxpayers at the expense of low-income taxpayers. That objection does not apply to any of our proposals. The reason: in each case, we remove the cap on the Social Security (FICA) payroll tax but retain the cap on Social Security benefits. Second, we rebate taxes to the one-third of taxpayers with the lowest incomes to ensure that their aggregate tax burden does not increase. Moreover, under the consumption tax reforms, the economy moves from taxing wage and capital income to implicitly taxing wage income and wealth; that is, consumption taxation effectively taxes wages and wealth because whenever wages or wealth are spent on consumption they are subject to taxation.
Consequently, the reforms we consider are progressive. In each case, those who gain the most from the long-term consequences of the reforms are those with the lowest incomes.