What’s Wrong and How to Fix It, Part 6: Tax Reform

We must get rid of the IRS and the present tax system that goes with it.

Next to money-leaking corporate and union lobbyists paying for politicians’ political ads and the inside-baseball influence of financial-sector plutocrats, nothing tilts the playing field in favor of the wealthy like the IRS code. So it needs to be the third target of reform which, after the first two get traction, might just be possible to accomplish.

Nothing pisses off average Americans more than the IRS. People like to blame IRS bureaucrats for the Kafkaesque nonsense they have to put up with every April, but that is unfair. The IRS as an organization is overworked and understaffed, not to mention verdant with a haze of ambiguous directives. As usual, the problem here lies with Congress, in this case in particular a Congress that has been rented by the plutocracy. We now have a situation, well known historically, where government has become virtually incapable of taxing its own wealthy citizens at anything like remotely fair levels. In many if not most comparable historical examples, say that of prerevolutionary France, this failure ultimately led to fiscal catastrophe and, often enough, violent regime change. Americans generally do not believe that anything like that could happen in the United States. But do we really want to run this experiment to the end?

The IRS code is excessively and even bizarrely complicated. These complications add vast transactional costs to the system, slow everything down (which imposes other very real costs), and increase the rate of error. If there were a compelling reason—concerning fairness, say—for such complexity that would be one thing. But there isn’t such a reason; again, quite the reverse. The complexity of the system advantages those who can afford to hire expensive lawyers, lobbyists and accountants to navigate and exploit it, and that, invariably, is corporate in nature either directly or indirectly: It’s either the company or the high-placed corporate employee who can afford it. As I have already indicated, distorting the tax system is one of the five key ways that plutocracy operates. In the United States today, there is simply no question that the tax system has been suborned to serve plutocratic interests. Congress doesn’t change the system for the better because the interests of most congressmen preclude it—unless, of course, they are actually looking to retire. (And even then, there’s that concern about income after leaving public office…)

Because of this, it is impossible to reform the IRS code section-by-section or line-by-line. Nonprofit organization advocates of a fairer system of taxation will never be able to trump the army of lawyers and compliant accountants that the corporate sector can summon at a fraction of the cost to them compared to the proportional costs facing their challengers. This is why, for example, hedge fund operators get away with designating their profits as capital gains rather than regular income, an aggressive and really outrageous strategy, but one they get away with all the same.

Even more basically, it is equally strange that we tax capital gains at a lower rate than we tax income itself. What is the rationale for that? If it ever had a rationale, it was connected to the trickle-down theory of noblesse oblige capitalism—the idea that rich industrialists would naturally invest more profits in more ventures that would create more jobs. To the extent that this was ever true—and it probably was at least to some extent—it’s no longer as true, when the wealthy prefer to keep their money offshore, invest in manufacturing capacity abroad, invest more in capital (automation) than in labor even when they do invest in the United States, and buy luxury goods and collectibles rather than build social value. The only way to slay the IRS-code dragon is to drive a stake through its heart. Junk the legacy system we have and start over.

Before briefly describing what can usefully replace the current IRS code, which over the past two decades has gone from merely arcane to completely obscene, we need to understand one almost universally overlooked aspect of the problem: tax credits.

The current system of taxation we have dates from around the beginning of the 20^th century. As has become well known, it involved a trade. The temperance movement, which ultimately succeeded in imposing Prohibition, threatened the solvency of the Federal government, which had heretofore financed itself through excise taxes, perhaps the bulk of which came from the sale of alcoholic beverages. The Sixteenth Amendment, making  the income tax constitutional, was understood at the time as a necessary offset for the loss of revenue by dint of taxing booze. This connection was so clear at the time that when it finally looked as though Prohibition would be repealed, a number of people, including Treasury Secretary Andrew Mellon, reasoned that if the Federal government once again taxed alcohol sales, it could dispense with the income tax. But of course that didn’t happen as the swath of Federal government responsibilities had grown apace in the meantime.

The income tax, which originally applied to only a tiny fraction of American households, was meant of course to create on adequate revenue stream for the operations of the Federal government. But before very long, for reasons we will leave aside for now, politicians and Federal officials started to use the tax code as an incentive structure for either encouraging or discouraging certain kinds of behavior. To some extent, this idea was part and parcel of the Progressivist enchantment with early social science in its rather primitive behaviorist incarnation. The idea was simple (and wrong): People were individual value-maximizing decision units, so if you made it worth their while to act one way and not another, they would. This was a conception of social engineering on the cheap.

This has remained a basic principal behind the wild proliferation of tax credits as tools of social engineering ever since. There are tax credits and other tax incentives festooned throughout the IRS code covering everything from historical preservation to agriculture to energy to real estate to…well, really just about everything. It rarely dawns on people that there is nothing Congress can do through the use of a tax credit that it cannot also do directly through the legislative process. If it wants to help NASCAR track proprietors or makers of india ink or orchid growers, it can appropriate money directly. So why use tax credits instead?

The answer is deceptively simple: transparency, or rather the lack thereof. To authorize and appropriate money directly Congress actually has to vote in ways that even half competent citizens can research; it’s easier than ever to look up roll-call votes. But sticking a tax credit on a bill basically having to do with other subjects and that is hundreds if not thousands of pages long is pretty much an anonymous undertaking. It allows politicians to far more easily do special favors for rich people without anyone noticing. Tax credits are a a major method of plutocratic field-tilting, as is evident in the credits and subsidies that go to oil companies, agribusiness giants and others. The ethanol policies of the U.S. government represent a kind of trifecta of pure plutocratic menace: they represent a giveaway to giant agribusiness corporations, a bandaid-scale excuse not to end the petroleum monopoly in transportation fuels, and a tariff-inflected poke in the eye to friendly countries like Brazil that can make and export the stuff far more efficiently than we can.

Most important, tax credits are one of the main means through which corporations loophole their way around the corporate income tax, which is one reason why the percentage of Federal revenue paid by corporations has fallen from about 30 percent of the total in 1951 (chosen at random just because it’s my birth year) to less than 7 percent today. That’s why these credits are so popular, and that’s why the IRS code increasingly functions as a shovel to dump dollars into the pockets of the already super-wealthy.¹

Obviously, not all tax credits favor corporations and super-wealthy individuals. There are tax credits that reward homeowners for installing more energy-efficient windows, for example. But for every sensible such credit there are six dozen or more that roll ever so easily off a tilted table, buried in obfuscative language in impossible-to-understand, thousand-page-long bills. What this means is that the only way to reform the mess of a tax code that we have now is to banish the device of tax credits altogether. It is not possible to pick and choose, because that involves officials in making social policy, and because in the process of picking and choosing, the rich will always end up on top. Their lobbying cannons are bigger than everyone else’s.

Happily, there are plenty of proposals out there to replace the current tax code. Some years ago Senator Richard Lugar premised a failed run for President on his determination to get rid of the IRS, and he had a plan that could have worked. Many have proposed a so-called flat tax that would get rid of all exemptions and the other bells and whistles in the code. A flat tax is too regressive for my blood, but it would be much better than what we have now. A flat tax would be more palatable if additionally we restored the inheritance tax, the most progressive tax in American history, back to its historically normal levels—but, characteristic of the plutocratic swamp in which we now slog about, no one is proposing that. Instead, the truly greedy are on the verge of eliminating the tax—shrewdly if absurdly relabeled the “death tax”—altogether.²

Even better, in my view, is to eliminate the income tax altogether, both personal and corporate, and go to a specially designed form of a valued-added tax on consumption.³ Michael Graetz of Columbia University has proposed such a system in detail. It would work, and I support his design.⁴

Let me say immediately three things, however, about a VAT alternative to the current system.

First, it would be disastrous to add a VAT tax on top of the current system, even a significantly reformed current system. We need to simplify the system, not make it even wackier than it already is.

Second, we must apply the tax in a way that does not make the entire system regressive, as it is in much of Europe. Most observers do not know this, but the American tax system as a whole, for all of its manifest problems, is aggressively redistributionist compared to most of the social democratic states of Europe, and that is partly because American property taxes are vastly higher than those in Europe. VAT taxes, if they apply to basic staples, end up being regressive over all unless balanced by a wealth tax or some other means of maintaining progressive net rates.

And third, any VAT tax we adopt must have a bracket on the outer revenue end, lest it creep into a milch cow for huge government, as it has in many West European countries. A VAT tax has to be in effect means tested. It has to fund a government of an explicitly understood and agreed size, and not be a lure for financing an ever-expanding nanny state. One way to do this is to drive tax collection down to the state level along with more responsibility for the states. That would create more disparities among states, but there is nothing wrong with that—different states desire different kinds and levels of government services, as we see from election result after election result. Subsidiarity can apply to tax policy in this way, and it should.

Using a carefully designed VAT as a main means for financing the Federal government has an additional benefit. As the late Jack Kemp used to say, quite rightly, if you want more of something, don’t tax it, and if you want less of something, do tax it. Right now we tax income, which is tantamount to taxing work and investment, so we get less of them. We certainly get less work above board, actually reported to a government. We don’t tax consumption nearly as much, and we don’t do it in a uniform way state-by-state, so we get more of it.

Much worse, we actually subsidize debt via the tax code. Of course, this arrangement suits plutocrats. Most of their income is not taxed at income rates but as capital gains, and since bankers these days are mainly in the lucrative business of debt creation, what better way to do that structurally than to encourage consumption via the tax system? Speaking of plutocrats, if you think this arrangement is a coincidence, there’s a bridge up for sale in Brooklyn I would like to discuss with you.

If we must have a corporate tax at all—and under a VAT system we could more easily eliminate it altogether—it ought to be designed so that short-term investments are taxed at higher rates than long-term ones. There’s nothing wrong with greed so long as it is long-term and not “flip-it” greed. There’s a difference between wealth creation and getting rich, and the tax code should recognize that difference; it does not do so today. Better, however, as I just mentioned, to get rid of the corporate income tax altogether. It is hard and expensive to collect, and it is based on an anthropomorphic fallacy in the first place.  No corporation, as an abstract noun, has ever paid any taxes. Only people pay taxes, and when you look carefully at who actually pays corporate taxes as the burden to do so “trickles down”, it’s not just CEOs and shareholders, but also consumers and in myriad indirect ways everyone else. The idea that only capitalists pay corporate tax is about as wrong as an idea can get, but that’s what most people seem to assume for lack of having ever thought about it.

But back to the main point: If we stop taxing income and work and thereby get more of both, we might actually be able to reduce the stampede of money flowing out of the country to the Cayman Islands and other offshore money-laundering operations. That would be useful for a whole host of reasons. And if we tax consumption instead, perhaps Americans would save more and buy less junk than they do now. No one can guarantee either one of those outcomes. But it seems sort of foolish not to restructure our tax system in ways to make it more likely. We don’t even have the political sense, or capacity, to tax advertising, which in 2011 amounted to $144 billion, about 1 percent of GDP.⁵

If a VAT system is too hard to achieve politically, and it certainly is for now, there are plenty of other less daunting reforms that could vastly improve the situation. The purposes of all of these lesser reforms are the same: to level the playing field between income and wealth, to favor long-term investment in creating new value and good jobs over short-term speculation and debt creation, and, closely related, to discourage asset inflation.

One thing we could do is to reallocate employment taxes based on gross corporate revenue instead of the current “per employee” basis. If all businesses pay the same 3-4 percent of gross revenue, advantage would flow to those companies whose processes are more labor intensive, all else, notably return-on-investment ratios, equal. That should stimulate job creation and reduce the cost of the dole. We could also combine a 10 percent flat tax (no deductions, period), a 1-2 percent wealth tax (in lieu of a traditional but complex, over-lawyered and hard-to-collect inheritance tax) and an 8-10 percent transaction tax on sales of “valuable items” (specie, fine art, jewelry and the like) to keep too much capital from fleeing into unproductive forms. That combination would be far less regressive than a flat tax alone, could therefore appeal to a bipartisan majority, and, not least, it could raise the 18-25 percent of GDP needed to run the Federal government.⁶

Now compare all this to what Congress has in fact done. It has, at the last minute, made a “deal” over some few tax rates as 2012 drew to a screeching halt. It did nothing else with this wretched mess of a tax code. Nothing at all. Pathetic is much too kind a word to describe the fecklessness and mindlessness with which our Legislative Branch has acted.

To get back to the main point, the one that the vast majority of typical Americans understand perfectly well, if a normal, law-abiding citizen cannot do his or her taxes in a few hours without the aid of a lawyer or an accountant, something is seriously wrong. A recent poll revealed that most Americans would rather go to the dentist than do their taxes. That shocks me, but now that I think about it, it turns out that I’m one of them.

Worse, I think, the $200-$300 that many average-income families have to pay to get their taxes done amounts to another kind of tax, a tax collected not by government but by businesses that have manipulated the government for their own private benefit. This is an outrage, and if I could, I would start a national tax revolt—basically an ultimatum to Congress: Fix this mess within one year or something like fifty million Americans will refuse to file their taxes next April 15. Think the government can arrest, or even fine, fifty million Americans? I’d like to dare it to try.

Past Entries:

Part 1: Introduction, and Globalization/Automation

Part 2: Political/Institutional

Part 3: Corruption/Plutocracy

Part 4: Television and Politics

Part 5: The Financial System

Notes:
¹ See William Nessen, “Credit Where Credit Is Not Due”, The American Interest (November/December 2012).

² For an excellent history and analysis of this issue, see Michael Graetz, “Death (and) Taxes”, The American Interest (November/December 2012).

³ For an analysis from the Left of what’s wrong with a corporate income tax, see Robert Reich, “Dear Mr. Corporation?” The American Interest (July/August 2010). Reich points out that corporations do not actually, literally pay taxes. That is part and parcel of an anthropomorphic fallacy. People actually pay taxes—whether consumers, shareholders, or employees, somebody must foot the bill, as abstract nouns cannot literally do anything.

⁴ See Michael Graetz, “How to Shrink the IRS and Grow the Economy”, The American Interest (November/December 2011). This essay was derived from prior testimony before Congress.

⁵ A few states (Florida, Pennsylvania) have tried, and failed. A few countries have succeeded, one of them being Austria. This is a complex but fascinating subject about which social science research remains inadequate. Does advertising lower consumer costs or raise them, for example? We’re not sure. See Brad Plumer, “Does Incessant Advertising Help or Harm the Economy?” Washington Post.

⁶ I am indebted to Craig Shelton for aid in formulating this package, especially the first item. Personal communication, October 12, 2012.