What If We Had Overhauled Our Tax Code?

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One of the biggest economic policy decisions facing our nation this year will be whether to extend the Bush tax cuts come December 2012. Ominously labeled "Taxmageddon," a host of tax policy changes are set to occur at year-end, and there truly is much at stake: $3.67 trillion of additional tax revenue over 10 years from the Bush tax cuts alone.

Many Democrats point to the expiration of the tax cuts as a chance to limit income inequality. They also believe that the reversal of the tax cuts would slow the growth of America's massive deficits, while preserving government programs that many Americans cherish. Republicans worry incessantly about the deficit, but recognize that increased spending will likely absorb any increase in tax revenues. They also argue that our current system tends to discourage hard work and saving, and that higher tax rates exacerbate existing inefficiencies. Both sides talk past each other, making the same arguments over and over.

The substantive differences between the parties are causing gridlock and massive policy uncertainty. If we are to end this uncertainty, and its deleterious effects on economic growth, we need to fundamentally reboot the conversation. What if instead of fighting over the Bush tax cuts, someone in government offered a big solution that both Democrats and Republicans could support?

It turns out that a game-changing, constructive solution exists, one that could bring in over $100 billion a year in extra revenue without having the government consume a bigger slice of the economic pie.

That solution is progressive consumption taxation. It has historically received support from liberal and conservative intellectuals alike and it boasts a multitude of other benefits. Economic studies, including one by economists Alan Auerbach, David Altig, Laurence Kotlikoff, Kent Smetter, and Jan Walliser, have shown that such a fundamental tax reform could easily boost the size of the economy by 3 percent in the mid-term while maintaining progressivity and offering relief to smooth the transition for those who rely on cutouts in the current code.

The most polished reform proposal for consumption taxation is the so-called X tax, put forth by the late Princeton professor, David Bradford. There are three important features of the X tax. First, workers pay taxes on wages only, not on any income from saving, and a progressive tax schedule ensures that workers with higher wages pay higher taxes. Second, firms are allowed to immediately write off their investments rather than depreciate them over many years, so the marginal tax rate on new investments is zero. Third, rates can easily be set to keep revenues stable as a share of the economy, and tax expenditures, which we discourage, could be eliminated (or kept) on a case-by-case basis. This combination of features creates a progressive, pro-growth reform plan that should appeal to both the right and the left, unlike many proposals.

What if Congress and President Bush, rather than simply cutting taxes ten years ago, had implemented a progressive consumption tax in the first place? Applying the estimate discussed above, GDP might be $16 trillion this year rather than a likely $15.5 trillion, and the budget deficit accumulated over ten years would be over a trillion dollars lower. The government would have an extra $72 billion of revenue in 2012 alone, and the gains would continue to grow for many years. That's 4.5 times the Buffet Rule's haul, and it would come from boosting growth rather than hiking taxes.

What could the government do with this extra revenue? First off, we could use every penny to reduce the 2012 deficit by $72 billion. If that's not a priority, Republicans and Democrats might argue over whether to do one of these:

1. Double the education budget, or give every teacher an $18,600 raise.

2. Increase spending on national defense by 13 percent, or buy 11, brand new, Nimitz-class aircraft carriers.

3. Give every family in poverty $7800 and lift 47 percent of them over the national poverty line.

4. Write a check to every family in America for $600 to spread the benefits equally.

5. Or fly the space shuttle Discovery across America 6000 more times for everyone to see.

All of this is just the federal government's take from a bigger U.S. economy. Individuals and business would benefit as well, as results from the study mentioned above suggest (including an additional one by economist Alan Auerbach). Labor income gains would be up on the order of 2 to 3 percent, and job creation would surge as businesses move back to the United States and expand in response to the zero percent marginal rate on new investment. Savings would also skyrocket once the reform was passed, with the savings rate likely increasing 2 to 3 percentage points at first and bringing a comfortable retirement within reach for more Americans.

Wouldn't it be nice if Congress took it upon itself to enact a comprehensive reform rather than continuing to squabble over the current inefficiencies and worrying excessively about winners and losers? It takes a lot of political courage to propose drastic changes to the status quo, but it's about time someone found the guts to do it. Ten years from now all of us could be better off.


Matthew Jensen and Veronika Polakova are economic researchers at the American Enterprise Institute. 

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