An Unthinkable Tax Code

WASHINGTON--Pity the politician who tries to take a serious look at our federal budget and tax mess and come up with a fix.

Pity, for instance, Mitch Daniels, a Republican in his second term as governor of Indiana. He received the Herman Kahn Award at a Hudson Institute dinner here last week, and quoted remarks made by Kahn (1922-1983), who founded Hudson almost half a century ago.

Kahn said: "It would be most useful to redesign the tax system to discourage consumption and encourage savings and investment. One obvious possibility is the value added tax and a flat income tax, with the only exception being a low standard deduction."

Mr. Daniels, referring to redesign of the tax system, added, "That might suit our current situation pretty well."

I was at the Hudson dinner, and did not hear Mr. Daniels' comments as an endorsement for a new national value added tax. Yet several commentators interpreted Mr. Daniels to support a national value-added tax, which he does not.

Mr. Daniels told me on Wednesday, "Of course we should never consider the VAT on top of today's taxes. But today's tax system should be considered unthinkable. What I'm for is a pro-growth tax policy which looks like someone designed it on purpose, not today's anti-growth rent-seeking goulash."

The larger context for Governor Daniels' remarks is the idea of taxing consumption instead of income, as economists have been recommending for decades. Hoover Institution senior fellow Alvin Rabushka, Stanford University professor Robert Hall, the late Princeton professor David Bradford, and Columbia University professor Glenn Hubbard have all proposed consumption taxes. Harvard professor Gregory Mankiw wrote in 2006, "Ideally, I would use consumption, rather than income, as the tax base for purposes of raising revenue and redistribution."

The logic is this: when the government taxes something, people use less of it. Right now our system taxes income from work, so people are discouraged from working. If we could replace income taxes with levies on consumption, or shopping, then we would not discourage work, and we would have more savings, more work, and less consumption.

Our federal tax system has been built around income taxes. Kahn was known for thinking the unthinkable, such as abolishing the income tax and replacing it with a tax on consumption. He didn't let practical politics stand in the way of his thought experiments, and many of his predictions-such as that one day Americans would throw away appliances rather than repair them-have come to pass.

Today, with shrinking the federal budget deficit ever more urgent, politicians are unlikely to get rid of the income tax and replace it with the VAT. Instead, as has happened in European countries, they are talking about keeping the income tax and layering the VAT on top of it.

This would be a terrible idea, because once in place, VATs are money machines, used to expand the size of government.

When imposed in 1967, Denmark's VAT was 10%; it is now 25%, in addition to a top income tax rate of 51%. In 1968, Germany levied a 10% VAT. Germans are more fortunate; their VAT has risen "only" to 19%, and their highest income tax rate is "only" 45%.

Thirty OECD countries have VATs, and only three- Canada, Japan, and Switzerland -apply rates under 10%. The others impose rates of 10% or more and 13 have rates of 20% or higher. The notion that a VAT will be a small, single-digit tax is not supported by other countries' experience. In many countries the VAT is the largest source of revenue.

It's politically unrealistic in the United States to expect that a VAT would be a substitute for the income tax, so it would end up being an additional levy, one that enlarges the government's claim on the rest of the economy. Putting a VAT in the hands of Congress would be like giving an alcoholic the keys to the wine cellar and saying he's welcome to drink just one bottle.

But that does not mean that we have to abandon the idea of moving our tax system towards a consumption tax. What is not consumed reverts to savings (and charitable contributions), so rather than taxing consumption, we can achieve the same results by making savings tax free.

Should Congress wish to move towards a consumption tax in order to encourage savings, it could take the myriad of tax-preferred savings accounts we have now-529 college savings plans, 401(k) retirement plans, traditional and Roth Individual Retirement Accounts, Health Savings Accounts, Simplified Employee Pensions, etc.-and meld them into one large tax-free savings account and place no limit on annual contributions. Income going into this omnibus savings account would not be taxed, so de facto we would have a consumption tax, since the only money subject to income tax would be money spent.

Congressman Paul Ryan, a Wisconsin Republican, has proposed to favor savings in his tax reform proposal described in his plan "Roadmap for America." The plan eliminates capital gains and interest and dividend taxation for the new two-rate simplified tax he proposes. This would greatly incentivize savings and investment and boost long-term job creation and productivity in the economy .

Corporate income taxes would be replaced by an 8.5% business consumption tax and capital investment would be entirely deductible from taxable income in the first year; now, the deduction is spread over many years.

To disarm the opposition, Mr. Ryan would give taxpayers a choice. Within 10 years of enactment of his bill, they could choose today's system, with its multiple rates and deductions; or they could adopt the two-rate simplified Ryan system, giving up the deductions.

A bipartisan tax bill, sponsored by Democratic Senator Ron Wyden of Oregon and retiring Republican Judd Gregg of New Hampshire, would also move the tax system towards a more efficient consumption tax by including generous Lifetime Savings Accounts and Retirement Savings Accounts, allowing the vast majority of Americans to save entirely tax-free. Canada implemented similar tax-free savings accounts on Jan. 2, 2009.

The Wyden-Gregg bill would replace the present six corporate tax rates with one, 24%, lowering the top rate from 35%. In contrast to individual deductions, the bill takes a more aggressive approach to broadening the taxable income base by repealing several deductions, especially for energy production.

With high unemployment, a weak recovery, and individual tax rates set to rise across the board on January 1, 2011, it's the right time to be discussing fundamental tax reform. Governor Daniels shouldn't be criticized for taking a serious look at an important subject.