Taxation: How the Government Funds Itself
Daniel J. Mitchell joins us for a discussion on taxation in America. What’s the best way to run a government on taxes? Is it anything like the system we have now?
What would the American founders think of our taxation system today, given America’s origins? Daniel Mitchell answers this and other questions as we talk about the different kinds of tax schemes and the different incentives they offer taxpayers.
Why is doing taxes so complicated? Why are there so many exemptions, deductions, incentives, preferences, etc. in the tax code? Are the rich paying their “fair share” of taxes? What’s the Laffer Curve and how does it work? What are consumption taxes and why are they better for the long term growth of the economy?
Aaron Ross Powell: Welcome to Free Thoughts from Libertarianism.org and The Cato Institute. I’m Aaron Ross Powell, editor of Libertarianism.org and a research fellow here at The Cato Institute.
Trevor Burrus: I’m Trevor Burrus, a research fellow at The Cato Institute’s Center for Constitutional Studies.
Aaron Ross Powell: Joining us today is our colleague Dan Mitchell, Senior Fellow at The Cato Institute. America got its start in anger about taxes. So what would that founding generation think of our tax regime today?
Daniel Mitchell: I would like to think that they would be very upset. It’s not just that government is so much bigger in doing so many things that are so contrary to the animating spirit of the American Revolution. But the income tax, the way we collect money, the intrusiveness, the nosiness, the way you have to lay your life bare to the IRS, I assume for a generation that had very, very small government, and what little government that did exist back then was financed by a few excise taxes and trade taxes, I would think they would be – they would go ballistic over the income tax.
Trevor Burrus: Well, they didn’t even – what they actually did to the tax collectors, I find this to be fascinating when the Stamp Act and the Townshend Acts – I mean they tore these people’s houses and they went to their – the mob got up, went to their houses, tore them apart by their hands, tarred and feathered people. Not condoning that, but how against taxes they actually were. But then the income tax comes – what year did the income tax come along?
Daniel Mitchell: Well, we had an income tax during the Civil War. I think it lasted from 1862 to 1872. But that was always said to be temporary and it turned out to be temporary. We then had another income tax come in, in 1894. But that was ruled unconstitutional in 1895 and then we got the income tax amendment, the Sixteenth Amendment in the 1913 on a terrible, dark day.
The income tax began. At least the modern version of the income tax began. Well, the top tax rate is seven percent, one two-page tax form, 14 pages of instructions and that has morphed into the monstrosity that we have today.
Trevor Burrus: Yeah. What is that? Let’s talk about the monstrosity. What is the top tax rate? How many tax rates are there?
Daniel Mitchell: How bad is it?
Trevor Burrus: How bad is it?
Daniel Mitchell: Well, probably the simplest thing to look at is it’s 75,000 and changed pages long. If you go to the IRS website, last time I checked, you could download about a thousand different forms and the number of tax rates which actually is a – almost a trivial issue in terms of the complexity of the tax code. The actual number of tax rates I think right now is seven. But that’s nothing compared to all the exclusions, deductions, credits exemptions, preferences. Those are the things that make the tax code the nightmare that it is today.
Aaron Ross Powell: What’s motivating all that nightmare? So taxes can be very high, but they could be radically simpler than what we have now. I mean you want to collect a lot of money. You just write a one-page law that says we’re going to take X percent of whatever you earn. So all those exemptions and loopholes as they’re often called, are those there to raise more money or hide taxes or what’s the motivation behind all of this?
Daniel Mitchell: I think the simple way to think about it is in 1913, we had this relatively simple introductory income tax and it was like a ship going out to sea. Well, 102 years later, there are layers upon layers of barnacles on that ship. In theory, episodes like the 1986 Tax Reform Act were designed to scrape the barnacles off the ship.
Of course they only scraped off about maybe one-fourth of the barnacles and in some cases, they were the wrong barnacles because one thing to understand about all these different provisions of the tax code is sometimes the complicating provisions are designed to mitigate a penalty that shouldn’t exist.
For instance you shouldn’t be double-taxed on income that is saved and invested. Well, I don’t know how many thousands of pages of the tax code are designed to things such as IRAs and 401(k)s but I’m glad those pages are there.
Now what I would prefer to have is no pages because we wouldn’t have any double taxation of income that’s saved and invested. But some of these provisions are better than nothing, but of course many of the provisions are there to put in penalties, to put in loopholes that don’t have any justification and those exist because over decades, the different lobbyists that go to the Ways and Means Committee and the House and the Finance Committee and the Senate, they’ve succeeded in having provisions that benefit their clients.
Maybe these are provisions that lower taxes but only for one very narrow group of people. Well, as a libertarian, I like it when government gets less money. But I don’t really like it if government gets less money just because someone hires a good lobbyist and gets some – gets the playing field tilted in their direction.
Aaron Ross Powell: Is there also an attempt to social engineer via the tax code?
Daniel Mitchell: Well, there’s certainly an attempt to social engineer in the sense of trying to control or steer behavior or bribe people into doing things that politicians like.
So the charitable contributions, deduction and the tax code, well, don’t we all care about churches? Don’t we care about symphonies and ballets and art museums and the Salvation Army? Well, yeah. OK, we all care about those things. Well, do we need something in the tax code to bribe us?
Well, only one-third of people roughly itemize on their tax returns, so obviously two-thirds of people who are giving to charity in this country are doing it even though they’re not getting a charitable deduction.
So I think that a lot of the mess that’s there, people rationalize and decide after the fact. Well, oh, if we didn’t have this provision, nobody would buy a house or nobody would give to their local church. I think that’s nonsensical but it has in some sense been absorbed into the collection consciousness of tax people in Washington.
Trevor Burrus: Now you mentioned the phrase “double taxation” which – can you clarify exactly what that means?
Daniel Mitchell: Yeah. That’s very important economically but it’s a term that requires some explanation. In theory, what we should have is a tax system that doesn’t have any bias between income that you consume today and income you consume in the future.
Now what’s income you consume in the future? It’s just a tax geek way of saying saving and investing. But right now in our tax code, if you consume your after-tax income today – because think about it this way. You earn income. You pay tax on your income and you have some after-tax income. What are you going to do with that?
Well, there are really only two things you can do with it – consume it now or consume it in the future. Consuming in the future as I said is saving and investing. If you consume now, the federal government by and large leaves you alone. I mean if you fill up your tank with gas, there’s a federal excise tax.
But other than a few little penny – anything like that, the federal government doesn’t tax you for consuming income right away. But if you consume your income in the future, we have all these examples of what are called “double taxation” between the corporate income tax, the capital gains tax, the double tax and dividends and the death tax. If you save and invest, you can be subject to as many as four different layers of tax that you don’t get hit with if you consume your income right away.
So obviously there’s a huge bias against savings and investment in the tax code, a huge bias in favor of consumption. Why does this matter? Because every single economic theory, even the Marxists and the Socialists would agree that you have to have capital formation for economic growth. You have to set aside some of today’s income to finance tomorrow’s prosperity and yet our tax system treats people who do that almost like they were criminals.
Aaron Ross Powell: You mentioned earlier though that we – often we tax things that we want less of and we give tax breaks on things we want to encourage. But it seems like saving and investing are things that unquestionably we want to encourage. So why are we taxing them more?
Daniel Mitchell: Ah, that’s because who does the saving and investing? Those evil, bad, awful, rich people. When you have a tax system that is so driven politically at least by a lot of the class warfare discussions, well, we can’t get rid of the death tax because only rich people pay that. We can’t get rid of the capital gains tax because that’s for the rich.
If you go through all the different debates and the discussions we’ve had about the various forms of double taxation in our country, it largely is driven by class warfare. The politicians want to collect a certain amount of money. Who’s the easiest target? Well, those evil, awful, bad, rich people.
Aaron Ross Powell: I mean one of the common things we hear especially from people on the left is that the rich, because they can get accountants who know all of the loopholes or because they’re politically connected, are paying much less tax than they ought to and they’re certainly not paying their fair share. So [Indiscernible] I mean we want the rich to pay their fair share, right?
Daniel Mitchell: Well, from a libertarian perspective, the fair share was that the law should treat everyone equally. Well, what is it that’s [Indiscernible] about the Supreme Court equal justice under law? To me, that’s just a flat tax. Now of course as a libertarian, ultimately I would like to shrink the federal government. So we didn’t need any broad-based tax whatsoever. We got along just fine before 1913 without an income tax.
But if we’re going to have an income tax, I do think it should treat everybody equally. When you look at the treatment of rich people, it’s a bizarre combination. The rich as defined by say the top 20 percent, top 10 percent, however you want to classify it, they do pay a disproportionate share of the tax burden.
Now it depends are you measuring just the income tax. Are you measuring all taxes? But no matter how you slice it, the top 10 percent are paying way more than their share of income and they’re certainly paying a disproportionate share of the overall tax take and a huge share of just the income tax take.
Now that being said, the definition of taxable income matters a lot because when you’re measuring income, what happens is a lot of rich people, if they want to, they can just go into their financial accounts [0:10:00] on a computer. Within nanoseconds, they can change their entire investment portfolio to tax-free municipal bonds. The federal government does not tax municipal bonds.
So you could be a billionaire and your federal income tax can be zero because all your investments are in municipal bonds. So that’s one of the costs of high tax rates. Go back say to the 1950s –
Trevor Burrus: Is that why Warren Buffett paid a less rate than this secretary, that thing? That was going around, Warren Buffett. I paid a lower tax rate than my secretary. Is it because she was paying income tax and he probably wasn’t?
Daniel Mitchell: No. In that case it was because Warren Buffett was bad at math. Actually, I don’t actually think he was bad at math. I think he was just willing to make a political point and prevaricate a little bit because what Warren Buffett wasn’t counting, he was looking at – back then, we had the 15 percent double tax on dividends and capital gains. Warren Buffett was saying, “Oh, look at this. I’m paying 15 percent and my secretary is paying –” whatever it was at the time, 25 or 28 percent and say, “Oh, my tax rate is lower.”
Well, what Warren Buffett wasn’t including is the fact that that capital gains and dividend, that was already taxed 35 percent of the federal level, not to mention there was a 40 percent death tax waiting at the backend.
So he was just being political and not being terribly honest. But rich people, if they want to – I thought you were going to give the example of Ross Perot. When he ran for president in 1992, he was saying, “Oh, my tax rate is very low.” Well, the reason his tax rates were very low, almost all his portfolio was municipal bonds.
The same thing with Teresa Heinz Kerry. That came up a little bit in the 2004 campaign. So rich people, if they want to, can choose to pay zero tax or they can put their entire portfolio in what are called growth stocks. What are growth stocks? Those are ones that don’t pay dividends. Why would somebody buy a stock that doesn’t pay a dividend? Because they expect that the stock is going to rise in value. So it’s called a growth stock.
Well, the one thing the federal government hasn’t figured out how to do yet is to tax unrealized capital gains. So if you’re a rich person, and you’re watching your fortune build up because you’ve bought stocks that are rising in value, until you sell those stocks, the government can’t impose any double taxation.
So they’re not getting any revenue. So rich people, if they want to, if you push tax rates up to the levels we had in the 50s and 60s and 70s, they’re simply going to change their behavior in ways where the federal government doesn’t get any money.
Trevor Burrus: Can you expand on that, on how – the data that we have about how rich people change their behavior in response to the tax rate? I know that has happened a lot in history.
Daniel Mitchell: Well, I think the most persuasive data is from the 1980s. The IRS every year puts out something called the Statistics of Income Bulletin and if you’re a really wonky tax geek, it’s very fascinating reading. You can see by income levels how much different people earn. Not individual people but in terms of the aggregates. How much did people over a million dollars make? How much did people over $100,000 make? How much did people between $30,000 and $40,000 make?
Not only that. You can see the sources of their income. Was it wage and salary income? Was it dividends, capital gains? You can see what deductions they took. How many people in different income classes took the home mortgage interest deduction? And so on and so forth.
So it’s a wealth of data but the one thing I notice as I went back and I looked at that data for 1980 – because that’s when we had a top income tax rate of 70 percent. And you can look at the rich and that – traditionally at Washington, that gets defined as $200,000 or above.
You look at the rich people in 1980 who were affected by the 70 percent top tax rate and you can see how much money they paid. The IRS collected about $19 billion from those people. By 1988, Reagan had lowered the top tax rate all the way down to 28 percent.
A lot of our left wing friends said, “Oh, this is unfair. The rich won’t pay anything. The treasury is going to be starved of revenue.” Well, what does the Statistics of Income Bulletin from the IRS showed? Rich people, again, making more than $200,000 a year or above, in 1988 at a 28 percent tax rate paid five times as much money to the treasury.
Now it’s not all because of the lower tax rate. Some of it was because of inflation, population growth. Who knows how many different factors were involved? But there’s no question. We had a steroid version of the Laffer curve going on in the 1980s because rich people decided, “Hey! At a 28 percent tax rate, I’m going to earn more income.” I’m going to – and this is critical. I’m going to report more income and the IRS wound up getting a lot more money.
So if you want to soak the rich, keep tax rates reasonable so that they don’t have incentives to pile their money into municipal bonds and just do tax-motivated types of investing.
Aaron Ross Powell: You mentioned the Laffer curve. Can you tell us what that is?
Daniel Mitchell: The Laffer curve is simply the notion that if you have a zero percent tax rate, the government is not going to collect anything. If you have a 100 percent tax rate, well, guess what. The government is probably not going to collect anything because outside of – unless you’re maybe a genetic communist, that the government is going to steal every penny you make. You’re not going to make any money.
So the notion of the Laffer curve – and by the way, even Paul Krugman would agree that there’s a Laffer curve. The whole debate on the Laffer curve is where – what’s the shape of the curve? In other words, somewhere between zero and 100 percent is a tax rate that will maximize revenue.
Now by the way, I should stress I have zero interest in maximizing revenue for the government. I want the tax rates set at the growth maximizing point, which is going to be a very, very low rate, which is necessary to finance the few legitimate functions of the federal government.
But the whole point is, is that the Laffer curve is simply an intuitive way telling people that hey, a hundred percent tax rate is going to be too high. Ninety percent too high, eighty percent too high. Maybe at 70 percent Paul Krugman raises his hand and says, “Oh yeah, I think that’s a good idea.” But most sensible people, you’re going to get down around 40, 30, 25 before they say, “OK, that’s where you maximize revenue in the long run,” and then people who actually care about freedom and liberty and economic growth are going to say, “Oh, but let’s go down to a tax rate of five percent or ten percent because that’s what’s going to maximize growth and freedom.”
Trevor Burrus: Has that changed a lot in the sense that – the kind of tax rates we have had in the past, 90 percent I think before Kennedy took office and 70 percent before Reagan took office. Are those really discussed anymore? Have we kind of won the battle for over 50 percent tax rates being a good idea?
Daniel Mitchell: I would like to say yes but at several times in my adult life, I thought we won the battle against Keynesian economics. But it’s like a Freddy Krueger movie. It comes out from the grave, whenever there’s a downturn and politicians have an excuse to spend money.
On the notion of very high tax rates, let me give you an example of why I’m worried. This whole Thomas Piketty book, where he is explicitly arguing that you should have tax rates of 70, 80 percent and wealth taxes and death taxes and of course lots of double taxation on top of that.
The Paul Krugman types of the world say before that – Obama has never been asked, “What do you think is the highest tax rate anybody should ever pay?” But I wouldn’t be surprised if in his heart of hearts he thinks it should be way up at that level, because for every question he has ever asked, it could be a question about, “What do you think of the sunny weather today?” he says the rich should pay more. I’m exaggerating but only slightly.
So I do think that there are – on the left, we had made a lot of progress in the 1980s where they – we hadn’t won them over on the issue of double taxation but we had won them over on the issue of tax rates. So you had Bradley and Gephardt and other sort of reasonable centrist democrats. I mean even Bill Clinton sort of said, “Well, you don’t want tax rates to get up too high.” I’m not sure that Hilary Clinton or Barack Obama today would be able to pinpoint when tax rates get too high.
Aaron Ross Powell: Just to clarify something. We talked about we have graduated income taxes. We’re talking about these really high rates, the 90 percent or the 70 percent. Do we mean like if there was the 90 percent tax rate in the past, that people making a lot of money paid a full 90 percent of everything that they earned?
Daniel Mitchell: They paid 90 percent of their taxable income above wherever the income tax bracket kicked in. But they didn’t earn and report nearly as much taxable income. One of the reasons that Reagan supposedly became a supply-sider is that back when he was a movie star, he learned that if you made more than a certain number of movies a year, there was no benefit because there probably weren’t that many effective tax shelters when you were a movie star. So you get up to that 90 percent tax bracket. What’s the point?
Aaron Ross Powell: We see that when professional athletes, free agents, will sign a – for a lower amount in a low tax state because it comes out to more than a much bigger contract in a higher tax state.
Trevor Burrus: But is that something that people really do? Some people would be thinking, OK, look, you say – we talked 70 percent of your income above $300,000 a year. Well, if you’re a salaried employee, you don’t have the ability to stop working on whatever, November. Yeah, and just be like, well, the rest of my year is going to the federal government. So I’m going to go to Tahiti. That’s not how salaried employees work. So does that kind of dissuading actually come in for people who aren’t hourly employees or picking up work on …
Aaron Ross Powell: Well, it’s not just that you would stop working. It’s that – I mean even at 90 percent, you’re still taking home 10 percent of that. So if your boss says, “Hey, I would like to give you a raise,” I mean even 10 percent of that raise getting kept is better than not taking the raise, right?
Daniel Mitchell: This is something, when I first got involved in tax issues, I confess I wondered about too because I was getting my salary. OK. Well, if my tax rate goes up, I’m not going to be happy. What am I going to do? My tax rate goes down. I’m going to be happy. But it’s not like I’m going to type faster when I’m writing [0:20:00] a paper about fiscal policy.
But here’s the thing I eventually learned. The rich are not the same as the rest of us or at least not the same as me. Maybe you two are millionaires and you should be buying me dinner every night. But if you look at – again, that same IRS Statistics of Income Bulleting that I talked about, you look at that data and what you find is that rich people don’t rely on wage and salary income.
For those making more than a million dollars every year, two-thirds of their income is from business and investments and when you get business and investment income, guess what. You do have a lot of control over the timing, level and composition of your income.
So you can decide, OK, it’s November. I’m going to go to Tahiti. Now, I can’t decide that working for Cato, not to mention the fact that the people on the seventh floor might say, “Where’s Dan Mitchell?” But it doesn’t save me anything on taxes because OK, I got the salary and certain amounts being taken out by the IRS and I don’t have any flexibility.
But if you’re one of these people making over a million – or heck, over $10 million, 81percent of your income – the last time I checked anyhow and I can’t imagine it would have changed – is from non-wage and salary sources.
So you’re one of those people who can get on to your computer to your financial accounts and invest in municipal bonds. If you have business income, you have tremendous ability to accelerate and defer and then re-characterize and you can decide, OK, I’m going to take this pile of money and invest it rather than declare it as income, which by the way is a perfectly legitimate thing to do because if it’s being invested, it’s no longer income going to you but the point is that you have all the flexibility. So yes, you can respond in a very significant way to changes in tax policy and it really has a big effect on savings and investment decisions for the economy.
Aaron Ross Powell: So far most of what we discussed has been stuff that’s bad for rich people. But does the tax code, the high level of taxes, those 75,000 pages, harm low-income Americans as well?
Daniel Mitchell: Low-income Americans don’t really pay federal income tax. A matter of fact, they get a wage subsidy called the earned income credit through the federal income tax. So it’s like a negative tax for them.
For lower middle income and middle income people, they’re by and large wage and salary people. So a lot of them can file like a 1040EZ. It’s not overly complicated for them. It probably does cost them stress and anxiety because even if you have a simple tax return, people just tend to get very nervous. Well, am I missing something? Is the IRS going to come after me?
So even people like that will go to H&R Block or TurboTax or something like that just because they’re nervous about what the tax system holds for them. I would say the main reason that lower and middle income people are hurt by the tax code is not what’s happening to them in terms of their direct tax liability. It’s what’s happening to the economy in terms of long range economic growth.
It seems like the economy grows three percent next year instead of two percent or two percent instead of three percent. We don’t think of that as being a big thing and actually if we’re planning on dying next year, it’s not a big thing. We probably wouldn’t notice the change to our living standards if the economy grew two versus three or three versus two.
But when you go out a couple of decades and with the power of compounding, it makes an enormous difference. If the economy grows say one percent a year – let’s say you’re France or Italy. You’re growing one percent a year. It takes you 70 years to double your GDP. On the other hand, if you have 3.5 percent growth, which is what America almost averaged from much of our nation’s history, you double your GDP in 20 years.
Now think about it from the perspective of a lower income person. You’re not comfortable. You have to work every day or at least five days a week. You can’t really afford to take a lot of breaks. If your economy is growing one percent a year, 20 years down the road, that’s an enormous difference versus an economy growing three or four percent a year.
So I think we don’t appreciate how important economic growth is. I sometimes use examples of this. If you go back to 1964 – and this staggers people. I didn’t believe it when I first saw it. But I checked the numbers.
You go back to 1964. Singapore and Jamaica had the same level of per capita GDP.
Trevor Burrus: Singapore and Jamaica.
Daniel Mitchell: Singapore and Jamaica.
Trevor Burrus: Wow.
Daniel Mitchell: And now Singapore is well above the United States and their per capital GDP is something like 15 times as high as Jamaica. Why? It’s simply the difference of compounding of five to six percent economic growth year after year versus one to two percent economic growth year after year.
So when I think lower and middle income people and I think about the tax code, I think about the fact that we are shooting ourselves in the foot with high tax rates and double taxation and that’s slowing down our rate of growth.
Even though in an advanced, mature, industrial economy like ours, it might only be the difference between 3.5 percent growth and 2.5 percent growth. In the long run, it adds up to a lot for people’s living standards.
Trevor Burrus: Is that data pretty clear in the sense that – we look at a place like Scandinavia where there’s lower growth rates but higher taxes. I mean is it a pretty open-and-shut case that higher taxes kill growth rates and higher government spending is not good for growing the economy? Is that a pretty open-and-shut case?
Daniel Mitchell: Well, I think it’s an open-and-shut case. But here’s the reality of it. If you look at the – say the Economic Freedom of the World index published by Fraser in conjunction with Cato and other think tanks around the world, you will notice that they have five major categories for what determines a nation’s prosperity.
Fiscal policy is only one of them and it only counts 20 percent of your grade. You also have rule of law and property rights. You have trade policy, regulation policy and monetary policy.
So if you’re Sweden or Denmark, you get a very bad score on fiscal policy. But you get a very high score on the other categories. As a matter of fact, countries like Denmark usually score above America on these non-fiscal policy measures.
So I think that Sweden and Denmark and some of these other Nordic nations, I think they’re hurting themselves with high tax rates and a big welfare state. But they tend to be very free market in other areas.
Now it’s still hurting them. If you go back to 1970, Sweden was one of the richest countries in the world, in the top five. Maybe in some cases top 10, depending on who’s doing the measuring. Well now Sweden has dropped about 15 places, not because they’re poor today than they were in 1970 but because they’ve been growing two percent a year and other countries have – like Hong Kong and Singapore five to six percent a year. But other countries, say three to four percent a year.
So you will slowly fall behind other countries once you adopt the big government, the high taxes, the welfare state.
Now I will say at least Sweden and Denmark did it right. They did the wrong thing in the right way. They got rich first when government was small and then they adopted the welfare state.
Now if you’re already rich and you adopt the welfare state and you start growing only one to two percent a year, compared to three to four percent a year, well, you’re a rich country. It’s still nice to live in Sweden and Denmark. They’re very civilized places. They have actually better rule of law and property rights than we have in America. It might get a little bit cold in the winter but no one is going to complain about living in Sweden and Denmark if your other choice is to live in Paraguay or Botswana.
Trevor Burrus: You mentioned previously – I think it was related to this or it might be just an entirely different topic. In terms of growth and you mentioned the corporate tax rate, which you called “double taxation”. So now as we hear about the corporate tax rate being either extremely high for America, which is bad for growth – one of the highest in the world, if not the highest in the world.
Other people have argued that the corporate tax rate maybe shouldn’t even exist at all. How does that – what is your take on corporate taxation?
Daniel Mitchell: Well, the bad news is that we do have the highest corporate tax rate in the world.
Trevor Burrus: That’s taxing the profits of corporation.
Daniel Mitchell: Taxing the profits of corporation. Some people sometimes say, “Well, no, no, it’s really the United Arab Emirates.” But that’s a tax only – it’s only a severance tax on oil companies. If you have a – some regular company, there’s zero percent corporate income tax.
So we have the highest corporate income tax in the world. We used to be second but Japan lowered their rate. That’s a bad thing unquestionably because corporations are mobile. Corporate investment, business investment, it can cross borders relatively simply.
But then of course we compound the damage of the high corporate tax rate because we then double tax dividends and capital gains and of course I already mentioned we have the death tax on top of that.
Now, having said that, assuming you have an income tax, I do think business income should be taxed. But I think it should be taxed only one time. So you can make a choice. Well, do you tax that income one time at the level of the company or do you follow it to shareholders and tax it one time at the level of the shareholder?
Administratively speaking, it’s easier to tax the company rather than track down in some cases hundreds of thousands of shareholders. But you could do it either way.
But don’t do it both ways and whatever way you choose to do it, have the rate be competitive and low.
Aaron Ross Powell: While we’re on the topic of corporations who can move, can shift to countries that have lower taxes, one of the things you’ve written about in the past is tax competition.
Daniel Mitchell: Tax competition is simply the notion that especially in a globalized economy, labor and capital, jobs and investment can cross national borders. I think this really kicked off in a big way back about 1980 when Reagan and Thatcher cut individual income tax rates.
You saw a change in global investment and migration patterns. But then it really began to also take effect on corporate taxes where Ireland deserves a lot of credit. They used to have a corporate tax rate way up at 50 percent. Then they lowered it to this bifurcated 30 and 10 system. The European Union said, “Oh, that’s unfair to have a bifurcated [0:30:00] system.” So Ireland sort of stuck a finger in their eye and said, “OK. We will just have one low rate for everything of 12.5 percent.”
You saw big benefits for Ireland with that and other countries were forced not only to lower their individual income tax rates because of Reagan and Thatcher, but they were forced to lower their corporate income tax rates because of Ireland and then heck, it’s even applied to things like dividend taxes and capital gains taxes. Because if you’re a well-to-do investor in Europe and you’re being taxed at very high rates and being double taxed, what are you going to do? You’re going to move your investments to Switzerland or Luxembourg or Miami or Cayman or something like that. So countries had to lower their double taxation. A lot of countries got rid of their wealth taxes, the death taxes.
Heck, the richest person in Sweden had moved to Switzerland, the head of IKEA, the founder of IKEA. And guess what. Sweden recently got rid of their death tax and wealth tax. He moved back.
So that’s just an example with one person where it makes a difference in terms of what your tax policy is. So I think tax competition is a very important liberalizing force in the global economy because it sort of handcuffs politicians. It tells them you may want to rape and pillage rich people but guess what. The geese that laid the golden eggs can fly away if you’re mistreating them too much.
I think what we saw from 1980 until about end of last decade was a very positive cycle of tax competition. What worries me now is operating through international bureaucracies like the OECD. High tax governments have gotten together to try to constrain tax competition. They want to create something akin to an OPEC for politicians.
Trevor Burrus: I’ve heard you often say that one of the most important characteristics of a tax code is that it’s neutral. What do you mean by it being neutral?
Daniel Mitchell: Well, I suppose I should first say there’s no such thing as a neutral tax code because if you’re going to tax people for earning income, you’re obviously changing the tradeoff between labor and leisure.
That being said, you should minimize the distortions in the tax code so that you are as close to neutral as possible. Now we already talked about double taxation. Well, what’s that about? It’s about creating neutrality between income that’s consumed today and income that’s consumed in the future. That’s why you want to get rid of double taxation on saving and investing.
But you also want neutrality in the sense that you don’t want politicians saying, “OK, if you earn money as a carpenter, you have zero tax. If you earn money as a plumber, you get taxed 50 percent.”
Trevor Burrus: We have way too many carpenters then.
Daniel Mitchell: That’s a hypothetical example of a distortion. But in that 75,000-page tax code, we have lots of real world examples of distortions. Sometimes these distortions are very technical, dealing with the so-called depreciation schedule for one type of business investment versus another type of business investment.
Sometimes it’s distortion as I said in the form of double taxation. Sometimes it’s – well, actually, one of the worst and biggest distortions and absence of neutrality in the tax code is the healthcare exclusion. If you had Michael Cannon or Mike Tanner here, they would wax poetic about how this causes a third party payment – payer problem because people have this artificial incentive to get as much of their compensation as possible in the form of tax-free fringe benefits.
That has messed up the healthcare system in addition of course to Medicare and Medicaid and other government interventions. But you want neutrality because you want – if you want growth and prosperity, you want people making decisions on the basis of what makes economic sense, not on the basis of what minimizes their tax bill.
But if you have high tax rates at a complicated system, guess what. That’s what people are going to focus on, at least to some degree.
Aaron Ross Powell: Would a flat tax be better than what we have now?
Daniel Mitchell: It would be infinitely better than we have right now because everyone thinks the flat tax is about having a low rate and yes, that’s part of it. But really the biggest part of the flat tax is neutrality because it gets rid of not only all the double taxation. But it also gets rid of all the loopholes, preferences, deductions, credits, exemptions and so on and so forth.
So obviously if you have some type of income tax with a rate above zero, it’s not going to be perfectly neutral. But for whatever amount of money the government is going to raise, the flat tax does it in the least damaging, least distortionary, most neutral way possible, which of course is why politicians don’t like it because they like having that power.
I mean the whole reason politicians spend their lives in Congress trying to get on the Ways and Means and Finance Committees is because you don’t even have to hold fundraisers.
Lobbyists come up where they throw checks at you. PACS [0:34:29] [Phonetic] seek you out to give you money, whereas if you’re on the post office and Civil Service Committee, nobody cares about you. Well, the reason that those tax rating committees are so powerful is because we have this complicated but very important, very intrusive, 75,000-page tax code.
You get rid of that, replace it with a flat tax and guess what. Ways and Means and Finance turn it to harmless oversight committees.
Trevor Burrus: I’ve heard too sometimes libertarians talk about – economists in general but a consumption tax would be better. What is a consumption tax and would that be better than an income tax?
Daniel Mitchell: A consumption tax is simply any tax system that doesn’t double tax savings and investment. Now normally we think a consumption tax is something that you pay at the cash register, like a national sales tax. Well, that is a consumption tax because there’s no double taxation.
A value-added tax, you don’t pay it at the cash register. It’s paid at each stage of the production process but it’s the consumption tax. Why? Because there’s no double taxation. The flat tax is a consumption tax. Why? Well, it has sort of a vaguely similar approach to our current tax system that you file an annual tax return to be a postcard instead of a thousand different forms.
But it’s the consumption tax because there’s no double taxation. So what a consumption tax really means – because that’s a public finance term. What it really means is simply a tax system where income is taxed only one time.
Now why is that consumption? Because over your life cycle, the amount you earn tends to be the amount that you spend. So it’s a consumption tax.
Now some people say, “Well, hold on a second. What if you leave some money to your kids?” Well, your kids are going to consume that. So at some point, any income you earn is going to get consumed and if you tax that income only one time, you’re taxing consumption one time.
Aaron Ross Powell: Among the consumption, the kinds of consumption taxes, what do you think of a national sales tax or a value-added tax?
Daniel Mitchell: If – this is a giant “if”. If we could take the Sixteenth Amendment, repeal it, and replace it with something so ironclad that even Ruth Bader Ginsburg and John Roberts couldn’t decide an income tax was ever constitutional again, yes. A national sales tax or a value-added tax would be better than our current system just like a flat tax is better than our current system.
They’re all in theory low rate, neutral, no-double taxation tax systems. The reason I tend to be especially suspicious of a value-added tax is because most politicians who talk about the VAT, they’re talking about adding it on top of the income tax.
Well, what do you get there? You simply give the government more money to spend. I think that’s one of the reasons why when Europe adopted the VATs in the late 60s, early 70s, I think it led to an expansion in the size of government. I’m very glad we don’t have a VAT because I suspect our politicians would do the same thing.
Trevor Burrus: Do you see that’s a real possibility though? Does that come up in a serious way? Is it something you fear on having a VAT within 20 years, 30 years?
Daniel Mitchell: I view that as the Armageddon battle of fiscal policy and I do think it will take place sometime soon. As a matter of fact, I’m actually afraid it’s more likely to come about when Republicans are in office because if you’re a Republican especially if you sort of tend to be a big government Republican, you’re looking at the corporate income tax and you’re looking at our current income tax. You have some vague understanding. Boy, this system is kind of anti-growth.
But you’re also thinking because you’re not a committed small government person. Well, we do need to raise more money because we have all this Medicaid and Medicare and ObamaCare and social security spending and the baby boom generation retiring.
So boy, we want to raise more money but we don’t want to do it with this tax system that we already have that’s very bad for growth. So let’s put in this other tax system because somewhere I thought I heard somebody telling me that consumption taxes aren’t as bad for growth.
OK. That’s right. They’re not as bad for growth. But that doesn’t mean that they’re good for growth. They’re just not as bad for growth. When you add them on top of a system that’s already very anti-growth, well, then you become France.
Aaron Ross Powell: It seems like a national sales tax or value-added tax would be particularly harmful to lower income Americans though because right now, they’re not paying much of anything in federal income tax. But they also spend a huge chunk of their income on retail goods, on food, on various things that would suddenly cost a lot more whether they’re paying a higher sales tax or the cost was baked into the retail price.
Daniel Mitchell: Yeah, that unfortunately is why democrats have been a little bit hesitant about pushing a VAT. I mean I think most democrats at the end of the day will want the VAT because they’re going to want to – they’re not going to want to reform entitlements and something is going to have to give.
So they will decide, OK, let’s get this new source of revenue. But they’re reluctant or at least they express reluctance because they say they don’t want poor people and lower middle income people being subject to tax.
Now, the people who propose the national sales tax as a replacement for the income tax and those are people I actually view as allies, they have something called a “prebate”. Now it’s called a “prebate” because the government would send a check to households once a month based on projected sales tax revenue on spending up to the poverty line.
That would in effect be sort of like the family-based allowance that we have in the current system or the family-based allowance that’s in the flat tax.
So everyone gets to earn a certain amount of money to keep hearth and home together before taxes kick in. If you have a national sales tax, you can only really do it through a prebate system.
Under a value-added tax system in Europe, they don’t really have anything to protect low income people. [0:40:00] So if you’re one of these – in one of these countries like Denmark or Sweden, where the value-added tax is 25 percent, it’s hidden from you. You don’t know you’re paying that much because you never see it on a sales register, a receipt or anything like that.
But boy, does that have a negative effect on living standards for everybody, but of course it’s especially hard-hitting for people with low incomes.
Trevor Burrus: So what does the ideal tax policy look like then? A lot of these that we’ve thrown out, it needs to be neutral and not double taxation. And other than not wanting that much taxation and in terms of policy, what is the best way to run any size of government with taxation?
Daniel Mitchell: Well, as I said, in my fantasy world, we have the central government back where the founding fathers envisioned, where you don’t need any broad-based tax, whatsoever. But my fantasies usually don’t come true, I’m sad to say.
So if we have anything even approaching the current government we have now or God forbid the Leviathan that’s sort of baked into the cake because of poorly-designed entitlements and demographic change, some sort of lowest possible rate, consumption-based tax is the least damaging way of raising any particular amount of money you’re trying to raise.
Now obviously if you have a government like France that’s consuming 57 percent of GDP, that’s still going to be a very damaging tax system. On the other hand, if you’re Hong Kong and your government is consuming 18 percent of GDP, well, then you can probably raise money without having it – have too much of a negative effect on growth.
Trevor Burrus: So you would be looking to the lowest one where you’re balancing the budget [Indiscernible] revenues over time even if it’s 57 percent of GDP. But that’s still going to hurt growth, as you were saying. Like that – to balance those revenues would be – would still hurt growth.
Daniel Mitchell: Yes. Well, for several reasons, first of all, government spending in it of itself hurts growth because you’re diverting resources from the productive sector of the economy and usually when governments are spending money, they’re doing things like subsidizing people for not working. So a lot of government spending – maybe not physical as human capital spending. The economic evidence on that tends to be more mixed but transferring consumption spending as public finance economists categorize these things, those types of outlays definitely have a negative effect on the economy, even if tax revenues sort of floated down from heaven. You didn’t have to have a tax code. That type of government spending would still be bad for growth.
But then in the real world, because money doesn’t float down from heaven, at least not that – it has never come into my pockets, when you have a tax code, well, it’s simply a question of how much damage you’re doing on top of the damage caused by the government spending.
If you have the lowest possible rate, consumption-based tax – and of course in France it would still be a very high rate. But if you try to raise revenue in the least damaging way, well then the additional damage on top of the damage caused by the government spending is going to be X whereas if you raise your tax system with a class warfare tax code with lots of double taxation, then the economic damage might be 3X or 4X.
Trevor Burrus: In 1986, we had this – we mentioned a couple of times. We had a very good reform that turned – I think it was like 14 tax brackets into 2 basically, right? Twenty-eight percent and 14 percent is the top rate. Now, it has been creeping up in different ways with George H.W. Bush and now we’re sitting at about 39 percent or so. We have books like the Piketty book and we have national debt of substantial size and we have this idea of a coming social security entitlements crisis and like a loss of the consensus possibly that low taxes are good and always more and more spending, the possibility of a VAT.
So are you – what are you going to see? What are we going to see in the next 10, 20 years? Are you expecting a real push for higher taxes because of the – where the left is moving, a real push from a revenue where all these things is – is it going to get worse before it gets better?
Aaron Ross Powell: Or is it just going to keep getting worse?
Trevor Burrus: Yeah.
Daniel Mitchell: Well, if I had to bet money, I think it will keep getting worse. Like a lot of libertarians, I tend to sometimes be dour and pessimistic about – because you just look at the public choice incentives of politicians to make government bigger and bigger. But on an operational day to day basis, I try to be optimistic because I do think there is still a streak of independence and libertarian type thinking among the American people.
You look at these cross-country polls where they ask people, “Is it government’s responsibility to give you a job, a house?” and so on and so forth. Americans do answer those questions in a much more favorable way to liberty than say Europeans will answer those questions.
So I do think that it’s not hopeless and I come to work every day at Cato because I think the fight is very much worth having and I think it is possible to win.
But winning that battle means we have to at some point reform the entitlement programs. We have to at some point figure out how to decentralize programs back to the state and local governments because they don’t belong in Washington and we’re never going to achieve these spending reforms if politicians think there’s new revenue coming to Washington.
That’s why fighting the value-added tax – I referred to it earlier as an Armageddon battle. I really think it’s an Armageddon battle because if the other side gets a VAT, then not only will I sort of have the usual libertarian pessimism about corrupt politicians, big spending politicians. But then I will think, oh my god, we’ve just given these alcoholics the keys to the liquor store.
At that point, OK, well, let’s see. Do I move to Australia? Estonia? Cayman Islands? What could I do? Because I would really, really be pessimistic at that point.
Here’s the little – the dirty little secret about fiscal policy and taxes. Behind closed doors, I think a lot of leftist politicians actually understand you can’t raise that much money with class warfare taxes.
They talk about it. They demagogue about it, but they understand to some degree that if you put in place these 1970s style tax rates of 70 percent or going back to the 1950s, 90 percent, they know people are going to change their behavior.
So if they want to finance the giant welfare state, that’s sort of baked into the cake, they better come up with a VAT. But it doesn’t mean they won’t also try to increase other tax rates as well. But they know on the other side that a VAT is the only way we can have a European-sized government in the US.
Aaron Ross Powell: Thank you for listening. If you have any questions, you can find us on Twitter at FreeThoughtsPod. Free Thoughts is produced by Evan Banks and Mark McDaniel. To learn more, find us on the web at www.Libertarianism.org.