TAX WHAT YOU DON'T WANT, NOT WHAT YOU DO:

A Tax Code for Tomorrow: We need to encourage investment, not penalize it. (Josh Barro, Autumn 2011, City Journal)

A better tax-reform plan would cut tax rates on capital, rather than simply cutting tax rates broadly. A key principle of this approach: all income would be taxed only once, so that people's and businesses' decisions would be distorted as little as possible.

There are a few ways of achieving such neutrality. One, recommended by staff at the Treasury Department in the 1990s, is the adoption of a comprehensive business income tax (CBIT). Under this system, businesses would no longer be allowed to deduct their interest expenses from their taxable income, but individual investors and bondholders--the people ultimately receiving that business income, whether from stocks or from bonds--wouldn't have to pay taxes on it. So the money would be taxed just once. Further, because the CBIT would apply equally to corporate debt and corporate equity, it would remove companies' incentive to borrow too much. However, a CBIT would make it impossible to tax capital income progressively: since the single tax would be paid at the corporate level, wealthier shareholders and bondholders couldn't be made to pay more.

Another option, widely used in other Western countries, is an "imputation-credit" system. Corporations would still pay income taxes, but those who received dividends from those corporations would then deduct the corporate taxes from their taxable income. In many cases, such a rule is the equivalent of eliminating taxes on dividends.

A third option would be to stop taxing income entirely and to tax consumption instead. New York University professor David Bradford has suggested a system called the "X tax," in which both businesses and individuals would pay an income tax--but individuals, crucially, would pay no tax on interest, dividends, or capital gains. Since people can do only two things with their income--invest it or spend it--a government that taxes income without taxing capital is imposing the equivalent of a consumption tax. The businesses, meanwhile, would pay taxes on the revenue that they took in from customers--again, this would be a consumption tax--but subtract from their taxable income whatever they bought from other businesses, as well as what they paid their employees. Though its operation is significantly different, the base of the X tax is the same as that of a value-added tax (VAT). But unlike with a VAT, the government could levy tax at lower rates for lower-wage individual earners, introducing progressivity and potentially drawing some Democratic support to the plan.

Posted by oj at November 21, 2011 6:27 AM
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