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
A Flat Rate Consumption Tax
This proposal has three elements: (1) replace federal personal and corporate income taxes with a flat tax on all income consumed; (2) rebate the tax to the lowest one-third of income earners, provided they acquire health insurance and invest in cash or in pension accounts, retirement accounts or Individual Development Accounts; and (3) apply the Social Security (FICA) payroll tax to all wage income.
"Welfare gains from a flat rate income tax would be greatest for the lowest-in-come earners."
One disadvantage of the previous proposal is that it makes no distinction between consumption on the one hand and saving and investment on the other. Yet as noted above, there are economic benefits to be derived from taxing consumption as opposed to taxing all income. This proposal differs from the previous one in that it taxes only that part of income that is consumed rather than saved.
There are three ways to implement a flat-rate consumption tax. We will consider each of these in turn.
A Fourteen Percent Personal Consumption Tax. How do we move from a flat income tax to a flat consumption tax? Under a proposal made by Hall and Rabushka,35 it’s not that difficult. Recall that under our flat income tax there are absolutely no deductions, exemptions, exclusions, credits, etc. The same holds true for our version of the consumption tax with one exception: we do not tax income that is saved. Households would be able to deduct their saving, regardless of the form of that saving, but would have to pay tax on all of their dissaving, regardless of its form.
"There are three ways to implement a flat consumption tax."
For example, at the place of work, contributions to pension plans, 401(k) plans and other retirement accounts would not be included in the taxable income of employees. Funds in these accounts would become taxable only when paid out or withdrawn and used for consumption of goods and services. Similarly, on individual tax returns, people could deduct contributions to IRAs and other tax-deferred savings accounts. Funds in these accounts would grow tax free and be taxed only at the point of withdrawal.36
"One way: a 14 percent flat tax."
A Fourteen Percent Value-Added Tax. A second way to tax consumption is with a value-added tax (VAT). This approach taxes business sales minus the costs of a) intermediate inputs and b) net investment in plant and equipment. Since the value of sales at each stage of production incorporates the costs of intermediate inputs used, what is really being taxed is the additional value that has been added. Across all businesses, taxing value added minus net investment is the same as taxing national income minus net investment. But net investment equals net saving (since what is saved is invested), and income not saved is consumed. Hence, the VAT represents an indirect way to tax consumption.
A disadvantage of the VAT is that it is essentially hidden. Since businesses pay the tax, it is included in final retail sales prices. That means consumers never see how much the tax affects the prices of things they purchase. Similarly, employees never see how much the tax affects their take-home pay.37 Against these disadvantages, there is one huge advantage: ease of administration. Instead of 129 million individual tax returns filed every year, the VAT would only require filing by about 20 million businesses.
"Second way: a 14 percent value added tax."
The VAT considered here would not be restricted to what most people regard as “business” enterprises. The tax would also apply to schools, hospitals, churches, nonprofit charities and even state and local governments. Under the current system, the federal government collects employee income tax revenue from all of these entities. If we were to abolish the income tax on wages, we must collect an equivalent amount in the form of a VAT. The mechanics are doable, even though they will strike many people as novel.
Every industrialized country, other than the United States, has a VAT. However, in no country has a VAT replaced the income tax; industrialized countries have used it to supplement their income tax revenues and as a consequence the overall tax burden has risen. Furthermore, the efficiency gains are reduced if some goods are exempted or taxed at lower rates than others. This has occurred in many countries.38
"Third way: a 16 percent retail sales tax."
A Sixteen Percent Retail Sales Tax. The most direct and transparent way to tax consumption is with a retail sales tax. The 16 percent retail sales tax rate effectively equals the 10 percent rate of the previous two consumption tax proposals. The difference between the two rates reflects the way in which they are expressed.
Unlike the VAT, this tax would be visible to consumers when they purchase goods and services. Even fewer entities would need to file returns than under a VAT. Think of the stages of production for a loaf of bread. A VAT would collect from the farmer, the miller, the baker, the wholesaler and so forth. A sales tax concentrates the entire collection at the point of final sale. The advantage is lower cost of administration. A possible disadvantage is increased incentives for evasion and avoidance on the part of retailers and their customers. Like the VAT, a retail sales tax would have to be collected from the nonprofit sector and state and local governments. Although this is doable, most state governments exempt these sectors from their own sales taxes. Any exemptions, however, require a higher tax rate.
"Welfare gains from a flat consumption tax would be greatest fro the lowest-income earners."
Economic Consequences of a Flat-Rate Consumption Tax. In the simulations reported in Table A-II and Table A-III in the appendix, an initial rate of 13.6 percent is required for both the personal consumption tax and the VAT proposals. This rate will rise to 15.7 percent by 2050, but because of higher economic growth will recede to 13.3 percent by the end of the century. As Table A-IV in the appendix shows, the retail sales tax rate required would initially be 15.7 percent, rising to 18.6 percent by mid-century and receding to 15.3 percent by the end of the century. As under the previous proposal, the actual rates could be lower with efficiencies and greater compliance.
Our simulations show that in the face of new tax incentives there would be a substantial increase in the nation’s capital stock. Specifically, the capital stock would be 24 percent higher by 2030 and 38 percent higher by 2050 because of tax reform. A higher capital stock, in turn, would raise real wages and aggregate output:
- National income would be 6 percent higher than otherwise by 2030, and 9 percent by 2050.
- Real wages would be 4 percent higher by 2030 and 6 percent higher by 2050.
Thus, for a $40,000 a year employee, the reform is worth about $2,000 a year in additional pretax wages.
Distributional Effects of a Consumption Tax. As in the case of a flat income tax, low-income families gain the most from this reform at every age level. And there are especially large payoffs for future generations. As Tables IV and V show:
- Among 25-year-olds (born in 1980), the reform promises a 7 percent increase in the lifetime living standard for someone in the lower one-third of the income distribution, compared to only modest increases for those in the middle and at the top.
- For those born in 2000, the lifetime gains are almost 14 percent for the lower third of the income distribution, 4 percent for those in the middle and 2.4 percent for those at the top.
- For those to be born in 2030, the lifetime gains are 18 percent, 6 percent and 3 percent respectively.