Economists have long been attracted to consumption taxes because, unlike an income tax, they do not penalize saving. The Achilles Heel, however, has been that consumption taxes tend to be regressive—hitting lower-income people proportionately harder than higher-income folks. The reason is simple: low-income people spend all their income (or more) while those with higher incomes save a substantial portion. Thus, the sales tax or the VAT tend to be most burdensome on those struggling to get by. Sometimes the regressivity is lessened by exempting necessities like food, clothing, and medicine or taxing them at a lighter rate, but that makes the tax more complex, opens new avenues for tax evasion, and reduces the efficiency advantages of the tax.
In 1981, economists Robert Hall and Alvin Rabushka proposed a less regressive kind of VAT called the Flat Tax. Businesses pay a flat tax rate on revenues less expenses (cash flow) and workers pay the same flat rate on earnings above a basic exemption level. The tax base is exactly the same as for a very broad-based VAT except for that exemption. The other key difference is that businesses cannot deduct wages, shifting the statutory obligation for that portion of the VAT onto workers, which is what makes the exemption work. (Hall and Rabushka’s book, updated in 2007, is available for free on the Hoover Institution website. I explained why a flat tax is economically equivalent to a VAT on this blog.)
But even with a very generous exemption, a flat tax is much less progressive than the income tax. The late Princeton economist, David Bradford, extended the flat tax idea by incorporating progressive tax rates on wages. Bradford was a brilliant economist, but not a marketing genius, and he called his proposal the X tax, guaranteeing that it would frighten away the majority of Americans who are still recovering from the trauma of high school algebra (“solve for X”).
Nonetheless, academic economists have long understood that the X tax could, in theory, solve the principal defect of the flat tax/sales tax/VAT. But the idea has never caught the public’s imagination like the Flat Tax or the “FairTax” (a national retail sales tax that sounds great, but is neither fair nor feasible).
Tax experts Bob Carroll and Alan Viard are trying to rectify that with their new book, Progressive Consumption Taxation: The X Tax Revisited, just published by the American Enterprise Institute. (Video from an AEI book launch event is here.) The book is a careful, comprehensive, clear explanation of the X Tax and all of the issues that would be involved in implementing it. It’s not exactly light reading, but the authors made a heroic and largely successful effort to avoid jargon and technical analysis that would put off intelligent lay readers.
Also, perhaps surprisingly for a book from the conservative American Enterprise Institute, the book takes “fairness” very seriously (and doesn’t rely on the convenient wishful thinking of assuming that trickle down would deal with all distributional issues). The book cites President Bush’s tax reform panel, which concluded that a very comprehensive X Tax could mimic the distribution of tax burdens under the current (circa 2005) income tax with rates ranging from 15 to 35 percent so long as there are refundable tax credits to replace the EITC and child tax credit. The authors also acknowledge that rates would have to be higher if tax breaks for homeownership, health insurance, and charitable contributions are preserved. Thus, it is easy to make the case that a fair X Tax is feasible, at least in theory.
There are numerous implementation issues, only some of which I had thought of before reading this book. One issue is transition from an income tax to an X Tax, which is very complicated. The economic literature blithely concludes that switching cold turkey from an income tax to a consumption tax is efficient because it creates an implicit lump-sum tax on existing capital. (For example, unused depreciation deductions go out the window.) Carroll and Viard reasonably conclude that this is infeasible and undesirable in the real world, and suggest ways to deal with existing assets without undue hardship. (They don’t talk about what to do about tax-exempt bonds, which would presumably become much less valuable once all kinds of capital income are tax-exempt.) The book discusses other gnarly issues such as the handling of international transactions and financial services, as well as laying out a wide range of other details. And it considers alternative ways of lightening tax burdens on capital (including my favorite, which is a VAT dedicated to paying for healthcare). Not surprisingly, they conclude that the X Tax is the best option.
I’m not entirely won over to this position. The X Tax would be susceptible to the same kinds of vandalism that has eroded the income tax base, and that would require much, much higher tax rates (since savings are exempt). The concerns about equity that produced the Buffett Rule would apply in spades—Warren Buffett and Mitt Romney would get huge tax cuts since capital gains and dividends would be tax-free. Carroll and Viard can explain until they turn blue in the face that the millionaires are paying a tax on their spending, but if they can get that lesson on economic incidence across to the average American, they are the best economics teachers in history. And I am worried about the potential accumulation of enormous largely tax-exempt fortunes in family dynasties. (I’d be more supportive of the proposal if it included large inheritances in the tax base.)
But I really appreciate Carroll and Viard’s just-the-facts style of presentation. They don’t overstate their case or make stuff up. They acknowledge, for example, that exempting saving from the tax base doesn’t magically simplify the tax system (since taxpayers would have a huge incentive to make taxable earnings look like tax-exempt savings). They say what almost all economists know, but few consumption tax advocates admit, which is that switching to a consumption tax—even with a border-tax adjustment—would not represent a subsidy to exports, and they recommend against the border adjustment on simplicity grounds. (Alan has an excellent short essay explaining this point on the AEI website.)
Bottom line: this book makes David Bradford’s intriguing X Tax proposal accessible and not so scary. People interested in tax reform will find it invaluable, and it would make a nice supplemental text for courses on tax policy or undergraduate or masters level courses in public finance.
However, the X Tax still needs a better name.
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