Tax systems are under scrutiny in many Western countries. Taxpayers complain because tax pressure is high and governments squander their money. Moreover, they deplore the system’s complexity and lack of transparency. For example, nobody really knows what share of the revenue goes to finance the goods and services produced by government agencies, and how much is used to provide relief to low-income residents. General principles are also being reconsidered. For example, the increasing recourse to wealth taxes is prompting people to wonder why past savings should be taxed twice – once when they are earned (income taxes), and again when they have been saved and become wealth. Taxing income on top of consumption also smacks of double taxation.
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Taxation is bad for the economy, since governments are inefficient suppliers of goods and services, especially when they enjoy privileges and can bar entry or prevent privately owned newcomers from competing on equal terms (for example, in the health and education industries). In a word, taxation is a burden on growth and people resent it. It is high time the Western economies reform their tax systems, make governments more accountable, and inform taxpayers about how big a bite the taxman takes from their purchasing power. Numerous proposals are already circulating, and the impending tax reform promised by President Donald Trump’s administration in the United States presents an opportunity to make progress in this direction.
Free-market proposals suggest eliminating personal and corporate income taxes, replacing them with value-added tax (VAT) or a tax on consumption. Progressivity could be maintained by giving all taxpayers a guaranteed, fixed-sum subsidy. In the U.S. context, a VAT rate of about 20 percent would be sufficient to replace revenue from federal income tax.
Governments do not like simple rules and prefer to raise taxation by playing the populist card
Such proposals have considerable merit in two respects. First, they simplify the tax system, since taxpayers would no longer spend time and resources computing their taxable income and finding ways of reducing it by converting expenses into costs (tax avoidance). Second, by adopting a constant marginal tax rate (i.e., the tax base is taxed at the same rate, regardless of its size), individuals are encouraged to produce and consume more. They are no longer penalized for working harder or for coming up with particularly bright (and potentially profitable) ideas.
Regrettably, this sort of tax system is unlikely to become law. Governments do not like simple rules and transparency. Instead, they prefer to raise taxation by playing the populist card. It is true that an across-the-board tax increase that spreads the burden evenly across the entire population would meet considerable opposition. By contrast, projects that promise more progressivity – especially if they involve substantial tax increases for the rich and modest or no burdens for the poor – are more likely to attract support.
Another risk of reform plans involving a new indirect tax is that they could encourage policymakers to supplement, rather than replace, direct taxes on income. In that case, one would end up with a copy of Europe’s complex systems, with VAT loaded on top of personal and corporate income taxes – definitely not a model of efficiency and moderation.
Even if one accepts that radical tax reform is a political nonstarter, it is still important to put forward such projects as forcefully as possible. The reason is that they can serve as a benchmark for evaluating our current dysfunctional tax systems. In addition, these reform proposals can be refined and sharpened in three respects.
First, it helps to be explicit about the purpose of taxation. It is the price an individual must pay for goods and services provided by government, plus the amount of money an individual is forced to contribute to help poor members of the community.
Now, it seems reasonable to assume that the amount of goods and services one buys from the government is proportional to one’s standard of living, and that one’s ability to help the poor is proportional to one’s income. It follows that taxation to finance expenditure on public goods and services should consist of a proportional tax on consumption, while solidarity should be financed with a proportional tax on personal income. All other forms of taxation should be eliminated, including levies on financial income, assets and real estate. Tax progressivity should be banned, since solidarity is expressed through public spending, not taxation.
The cost of personal income tax systems is excessive and a major source of complexity
The second point concerns the administrative cost of managing a personal income tax system. Purely for purposes of financing solidarity, this cost is excessive and a major source of complexity. It would be much more efficient to allocate a share of consumption-tax revenue to finance the solidarity projects promoted by the government. This suggests that a tax regime that combines simplicity and fairness would include only one tax – on consumption.
Third, it is important to understand the difference between VAT and a consumption tax. Both taxes are ultimately paid by the final buyers. However, these buyers are not the same. In the case of VAT, the buyers are producers (including investors) and consumers; while the consumption tax is paid only by consumers. If we wish to stick to the principle that the ability to pay taxes is proportional to one’s living standard, then the only fair tax is a tax on consumption. One should not give in to the temptation to introduce or maintain VAT-based systems.