Friday, March 23, 2012

How I Would Overhaul the U.S. Tax Code - Part I: Summary of Proposed Changes

The United States tax code needs a complete overhaul. An overhaul is necessary not simply because a wide variety loopholes, exemptions, and carve outs have infested the system with unfairness, complexity and inefficiency. Even more importantly, the United States needs a tax structure that will help it confront the economic and environmental challenges of the 21st century in a sophisticated, effective way. Closing loopholes and eliminating special interest giveaways, while appealing and worthwhile, is just not enough good enough in a world of staggering economic imbalances and looming climate catastrophes. We must pursue a more ambitious approach.

We should eliminate the federal income tax and the payroll (or FICA) tax and replace them with more sensible revenue measures to fund the bulk of government expenditure. Basic economic principles indicate that governments should tax activities in order to reduce their incidence. For this reason, governments have so-called ‘sin’ taxes on alcohol, cigarettes and gambling. But sin taxes only provide revenue on the margin.

The largest revenue streams of the federal government tax income. But income is a positive activity. Governments should want more, not less of it. The payroll tax is also extremely regressive, and so it might be more precise to say that it taxes work which is another activity governments should not be discouraging.

This might be a necessary contradiction if there were no other alternatives for raising the amount of revenue needed to maintain the essential government function of a modern wealthy superpower. However, there are fairly straightforward options for raising comparable revenues by taxing more negative activities. Instead of raising the bulk of the federal government’s revenue through income and payroll taxes, we should raise the same (or greater) revenue through taxing excessive consumption and deleterious pollution.

The federal income tax should be replaced by a progressive consumption tax. Under a progressive consumption tax, Americans would report their income to the Internal Revenue Service as they do now but they would also report their annual savings. The difference between these two amounts would constitute taxable consumption. Basic necessities would be exempted in the form of a standard deduction dependent on family size. Rates would start low but as taxable consumption rose, the tax rate on additional consumption would also rise.

The payroll tax should be replaced by a tax on man-made greenhouse gas emissions, primarily carbon. Several countries have instituted a tax on each ton of atmospheric carbon emitted and we could model our tax on the most successful international versions. However, in order to raise as much revenue as the payroll tax does presently, the tax on carbon and other climate distorting pollutants would have to be quite high. This would cause the costs of various goods and services to rise dramatically, but individuals and families will be able to cope with increased costs as their paychecks will be much bigger due to the repeal of the payroll tax. This will also allow consumers to make informed choices by imposing the true costs of energy use on all economic activities. Market discipline will allow consumers to more easily look for alternatives that pollute less or not at all.

There are innumerable reasons for instituting such an admittedly radical reform but the main desirable effects of these proposed changes would be to encourage saving and to make pollution as burdensome economically as it already is on human health in the long term. Given the role that unsustainable debt and overleveraging played the recent financial crisis and subsequent Great Recession, the wisdom of building the tax code around making saving more advantageous should be clear. And the largest burden we are currently building up to leave to future generations is not a fiscal deficit at all. Rather, it is a climate debt of monstrous proportions. We are condemning our grandchildren to a world that is more impoverished, fractious and possible uninhabitable. Replacing the payroll tax with a climate pollution tax is not only good policy, it is a moral imperative.

To supplement these substantial alterations to the current tax system, we should also add a small financial transactions tax, a tax on bank size, and a tariff on imports from countries that do not put a similar price on carbon. A financial transactions tax would mostly afflict speculators while helpfully slowing down the often blindingly fast speeds of financial markets. A tax on bank size would serve as useful cudgel against the persistent problem of “too big to fail” financial institutions. A carbon tariff along the lines of that endorsed by Nobel-prize winning economist Paul Krugman is the only way to level the playing field between countries with responsible climate policies and those without. The considerable additional revenues raised by these supplements could be used both for budget deficit reduction and to finance long-neglected investments in public education and infrastructure.

Continued in Part II.

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