The Wall Street Journal (“WSJ”) has recently informed me that it will no longer be delivering hard copy in my neighborhood, leaving the online version as the only alternative. This is a significant blow to the lifestyle of Economic Man. The WSJ is often read while pounding away on the stationary bicycle at my gym. Profuse sweat and digital don’t go well together.
But to compensate, or maybe just to rub it in, the WSJ has just produced its meatiest editorial pages ever, with three pieces on important subjects. The first one is discussed below, with the other two saved for the following posts.
John Cochrane on Radical Tax Reform
The first is by John Cochrane, who, when he isn’t bitch-slapping Paul Krugman, is an economist at Stanford University’s Hoover Institution and the Cato Institute. The article is entitled “Tax Consumption Through a VAT, and Voilá.” Cochrane also discusses this piece in his blog, where, among other things, he disavows the lame and somewhat inaccurate title.[1]
One of the best things about Cochrane is that he thinks from first principles. (I have already covered his views on America’s broken healthcare system, which he attributes to the “original sins” of tax subsidies, which promote over-insurance, and cross-subsidies, which make competition impossible.) In the case of tax policy, Cochrane makes a good case that the “original sin” is the taxation of income instead of consumption.[2] If we want to tax income, we must tax corporations or otherwise they become an obvious method of avoidance or deferral. But this is a bad outcome because the right corporate tax rate is zero, since every penny flowing through a corporation belongs to someone else: a supplier, a worker, a lender or a shareholder. An income tax also leads to taxation of income from capital, such as interest, dividends and capital gains, in order to avoid people hiding wages in this form.
Once you are at this point, you are automatically into complexity and distortions. Once you are into complexity and distortions, you are automatically into politics, rent-seeking and gridlock. The only way out of this morass, according to Cochrane, is radical change. As Cochrane puts it in his WSJ article: “Sometimes when little steps are impossible, big jumps are feasible.”
Before we continue with the discussion, however, a short primer on Value Added Tax (“VAT”) is required for my American readers.[3]
As the name implies, the idea is to tax the value added at each stage in the production process, which then accumulates into a tax on consumption when the item is sold. It does this by charging a tax on each item purchased by a business (“input VAT”) and also on each item sold by a business (“output VAT”), and then allowing the business to offset the input VAT it pays against the output VAT it collects. The net amount is then paid to the government.
Let’s take a simple example, using a 20% VAT rate. Suppose a retailer buys widgets from their manufacturer for $50, a price that includes input VAT of $8.33.[4] The retailer then sells the widgets for $80, a price that includes $13.33 of output VAT.[5] When the retailer goes to calculate his net VAT obligation, which is typically paid monthly, he deducts the $8.33 of input VAT from the $13.33 of output VAT and cuts a check for $5 to the government. This $5 is exactly 20% of the $25 of pre-tax value[6] that he has added to the widgets by providing the retail service.
Note that the price of widgets has increased by the VAT, hence the tax on consumption. Note also that, unlike the sales taxes with which Americans are familiar, each link in the chain of production, including the final seller, has an incentive to make sure that output VAT is collected or otherwise the opportunity to offset input VAT is lost. VAT is largely self-policing.
There are complexities to a VAT, such as whether to charge it on labor inputs, whether to have lower rates for “essentials” such as food, and how to treat investment goods. Cochrane votes for uniformity and simplicity in all of these cases, to avoid politicization and economic distortions. In order to achieve these goals, however, Cochrane wants a nationwide VAT to replace all other forms of taxation, including personal and corporate income tax (including capital gains taxes), estate taxes, payroll taxes, etc. With this change, the only required tax filing would be a monthly VAT return by businesses, which can easily be done electronically since most entities, even the smallest ones, have computerized accounting systems that track inputs and outputs.
Let me emphasize that: no more income tax returns. And a lot fewer accountants and tax lawyers, not to mention lobbyists. This would be a great boon to society, but we will have to be on guard lest these displaced “workers” convert to other forms of crime, perhaps violent.
Getting a rough idea of the required magnitude of the VAT is simple. If the government spends about 20% of GDP, which is broadly the figure for the USA, then a 20% VAT is required. Of course, with some perfectly attainable budget cuts, such as are shown in the Cato Institute’s Downsizing the Federal Government website, this figure could be reduced significantly.
There are three traditional objections to a VAT, one from the Right, one from the Left and one from the Keynesians.
VAT is a bad word on the Right largely because it smacks of European social democracy. This is not as silly as it sounds. It is a historical fact that, until the widespread introduction of VAT in the 1960s and 1970s, government expenditures in Europe were about the same percentage of GDP as in the USA. It was only when the politicians got their hands on this virtually unlimited, and very covert[7], taxing power that socialism could truly bloom in Europe.
That is why Cochrane insists that the introduction of VAT must be simultaneous with the elimination of all other forms of tax. Not scaling them back, which would only invite subsequent backsliding, but their total elimination. This is politically challenging, but as Cochrane says in his blog:
Please don’t bother to comment that we can’t have a VAT because the politicians will just add back the income tax. I know the argument. If our country cannot legislate ‘we put in a VAT, we eliminate the income tax, and that’s it,’ then democracy is doomed already.
The Left objects to a VAT because it is regressive. The poor consume a larger share of their income than the rich and therefore a consumption tax hits them harder. But introducing at least some progressivity is straightforward. It would be easy, for example, to create a zero tax rate for a low amount of consumption (say, the first $25,000, which would cost $30,000 with VAT) by mailing everyone a $416.67[8] check every month. Maybe the next $10,000 chunk of consumption would be subject to a 50% rebate of the VAT, and so on. Although it would be difficult to make too many and too fine gradations of progressive taxation[9], this is perhaps a good thing. The strongest argument for a flat tax is that all citizens should have “skin in the game” – that is, tax exposure – when voting for tax policy. From this perspective, the fewer the bands, the better.
The Keynesian objection is that the shift to VAT will hurt the economy by supressing consumption and increasing savings. This is not the place to discuss the fundamental disagreement between those who think you can consume yourself to wealth and those who think you must save yourself to it. I am in the latter camp.
There is one last point, although this is more subtle. If we shifted from an income tax to a consumption tax like VAT, much of the savings at the time of transition would be taxed twice: it was subject to income tax when it was earned and will now be subject to consumption tax when it is spent.[10] Although you could imagine transition rules to mitigate this effect, Cochrane thinks that, even without mitigation, this is a reasonable price to pay for eliminating the enormous burden of tax returns[11] and creating a simpler, fairer and more pro-growth tax system.
Forever Hillary
Hillary Clinton is getting ready to vent her very sizable spleen in her book about the 2016 elections entitled What Happened? This could produce a book nearly as short as French Military Victories or Fine English Cuisine. The text could simply be:
I’m terrible. The End.
Leaked sections, however, indicate that it will be much less honest and considerably wordier than this.
My favorite excerpt is Clinton complaining about being out-ponied by Bernie Sanders, as shown in the following exchange:
BERNIE: I think America should get a pony.
HILLARY: How will you pay for the pony? Where will the pony come from? How will you get Congress to agree to the pony?
BERNIE: Hillary thinks America doesn’t deserve a pony.
BERNIE SUPPORTERS: Hillary hates ponies!
HILLARY: Actually, I love ponies.
BERNIE SUPPORTERS: She changed her position on ponies! #Which Hillary #Witch Hillary
HEADLINE: “Hillary Refuses to Give Every American a Pony”
DEBATE MODERATOR: Hillary, how do you feel when people say you lie about ponies?
The amazing thing about Clinton is that she can write this passage without the least hint of irony. She doesn’t realize that you could replace “BERNIE” with “ANY DEMOCRAT” and “HILLARY” with “ANY REPUBLICAN” (or, more specifically, “ANY LIBERTARIAN” since, as George F. Will has recently acknowledged, the Republicans are no longer, and probably never were, the party of math) and the scenario would work as well.
Poor Hillary, Bernie interrupted her plan to buy votes responsibly.
But the last word belongs to an anonymous Clinton fundraiser, surrogate and convention worker who was quoted in The Hill to say:
The best thing she could do is disappear. She’s doing harm to all of us because of her own selfishness. Honestly, I wish she’d just shut the f— up and go away.
I’d say that this sentiment is about 16-years overdue, but better late than never, I guess.
Filling the Swamp
Do you remember Donald Trump’s fulsome denunciations of the carried-interest tax loophole during his campaign? No? Well, apparently, neither does he.
Treasury Secretary Steven Mnuchin, whose tone-deaf wife would be considerably less affordable without the benefit of this tax break when he was at Dune Capital, has recently stated that Trump plans to retain the loophole for funds that “create jobs.” If that strikes you as an irrelevant and undefinable criterion, then you are getting the picture.
A libertarian commentator has a rule of politics that states that politicians will keep all bad campaign promises and renege on all good ones. If Trump does an about-face on carried interest, he will conform to the rule.
Roger Barris
Weybridge, United Kingdom
[1] Authors of guest editorials don’t get to choose their titles, as Mitt Romney discovered to his chagrin when the NYT sabotaged him with “Let Detroit Go Bankrupt.”
[2] I raised many of these issues in an earlier piece on tax policy, although I came to a less radical and thoughtful conclusion. There is a huge literature, too extensive to cover here, on why consumption taxes are economically optimal.
[3] More complete descriptions can be found in multiple places on the web, such as here.
[4] $50 – ($50/(1+20%))
[5] You can do the math
[6] ($80/(1+20%)) – ($50/(1+20%))
[7] Europeans often think that the addition of sales tax at the cashier in America, instead of these being embedded in prices like VAT is in Europe, is backward and silly. They miss the point: the last thing we want is invisible taxes.
[8] $5,000/12. Note that this reimbursement of VAT on low levels of consumption would mean that the general rate of VAT would have to increase to restore fiscal balance. In other words, a 20% VAT rate would not longer be sufficient.
[9] The problem is, once to start getting to higher levels of consumption, people may be automatically reimbursed for VAT they never paid on consumption they never reached. The other problem is that maximum level of taxation would be capped at the general VAT rate, which makes really “soaking the rich” a little difficult.
Cochrane has a proposal that exploits the widespread use of electronic payments to create an efficient and flexible system of progressive VAT for all levels of consumption. Clearly, there are some privacy issues here, since it would be necessary to report consumption to the government in order to be properly reimbursed. But the current system of income tax also creates serious privacy issues. It would also be possible to avoid the privacy issues by paying cash and forgoing any possible VAT reimbursement, which would create a type of automatic “sin tax” on shameful consumption. And, of course, above a certain level of consumption, there would be no more reimbursement and reporting would not be necessary.
[10] The economist Laurence Kotlikoff makes a political virtue out of this effect in his “Purple Tax Plan,” which is designed to appeal to both Red and Blue voters. He thinks that it may be possible to sell pro-growth tax reform to economic ignoramuses like Elizabeth Warren and Bernie Sander by telling them that it is a giant, one-time wealth tax.
[11] Estimates are that Americans spend 8.9 billion hours in tax compliance each year, the equivalent of $409 billion dollars.