February 25, 1993 | Lecture on Taxes
Norman B. Ture is President of the Institute for Research on the Economics of Taxation. He spoke at Ile Heritage Foundation on October 27, 1992, as part of theW.H. Brady Lecture Series on Defining Conservatism. ISSN 0272-1155. 01993 by T-he Heritage Foundation.If one is to play the numbers game, one should at the least be at pains to identify what the num- bers are and what they are intended to show. Presumably, the a im of these exercises is to measure the effect of government's fiscal interventions on the distribution of income, year by year. For the moment, let's ignore the question of why we should care. To pursue this objective, clearly, we need to start with an a p propriate definition and measurement of income, distributed by whatever intervals are deemed to be appropriate, that exclude the direct effects of the fisc. In essence, this income consists of the claims that are generated by current production activity i n each year. It excludes, among other things, government transfer payments, irrespective of their purpose, as well as taxes. It also excludes capital gains, either realized or accrued. It must allo- cate income originating in corporate businesses to the in d ividual owners of the corporations. It must include as part of personal income that part of compensation committed to pension and similar retirement plans and the current earnings of the plans, while excluding pension benefits actually received. And so on . To capture the distributional effects of fiscal intervention, this in- come should be compared with that resulting from the addition. of government transfer payments and the subtraction of taxes. My colleague, Steve Entin, has produced a soon-to-be-relea s ed study of the conceptual and measurement requirements of meaningful statistical analyses of income distributions and of the extraordinary shortfalls of congressional efforts. One of his most important conclusions is that the data requirements of the cor r ect analyses are daunting and that the "studies" that are now produced and that so titillate liberals and the media - forgive the redundancy - come nowhere close to overcoming these difficulties, hence produce grossly misleading results. Virtually all of t he various statistical exercises find that the distribution of (mismeasured) pre- tax, pre-transfer income became more unequal during the last decade or so. One of the most seriously mistaken conclusions drawn from these gravely flawed statistical analyse s is that the measured pre-fiscal-intervention income distributions are the result of the bad fiscal policies of the Reagan and Bush Administrations. Never mind the fact that for the most part, the actual fis- cal policy developments year by year often did not closely reflect the Administrations' policy preferences. If one is to assert that the Reagan and Bush tax and spending policies shifted pre-tax and pre-government spending income to the rich and away from the poor or middle income people, one must sho w how this happened. I need hardly call to your attention that no such demonstration has been forthcoming. This raises an important question in connection with virtually all discussions of tax fairness, to wit, is the fairness issue concerned with the dist r ibution of tax liabilities by income classes or does it address the structure of the tax system and how it assigns tax burdens among individuals with differing amounts of income? Perform with me a simple arithmetic exercise, taken from a paper by my colle a gue Roy Cordato, to illuminate the distinction between these concerns. Consider an income tax under which the first $25,000 of a person's income is taxed at 20 per- cent, while the tax on the next $25,000 is imposed at a rate of 10 percent. In the structu r e sense, this tax would be characterized as regressive; its marginal tax rate on the higher income is lower than that on the lower income. But suppose the population consists of two people, one with $25,000 of income and the other with $50,000. The $25,00 0 -income person pays $5,000 in tax while the $50,000-person pays $7,500, or 60 percent of the total. On the basis of shares of total tax, the tax system would be characterized as progressive. Comparing tax share and income share, the tax system would again be described as regressive. Quite obvious to anyone who has followed the fairness debates, the distributional measure that is selected by the debate participant is the one that confirms his or her preferred result.
2Similarly, lacking any objective standard against which to assess the fairness of the tax system, what is one to make of the often-heard assertion that the "rich" should pay their "fair share" of taxes? The share of total income taxes now paid by the "ric h " is vastly disproportionate to their numbers in the population and to their share of total income. In 1990, for example, the top one percent of federal income tax returns reported 14.3 percent of total adjusted gross income and 25.6 percent of total inco m e tax liabilities. Making allowance for the limitations of the adjusted gross income concept, in what sense do these numbers suggest that the "rich" are underpaying their fair share? How much larger must this share be to persuade policy makers that the ri c h are at last bearing their fair share of the tax burden? The implication, unstated by those who play the fairness game, is that income distribution is a zero-sum game, so that if the income of the people in one or another income interval increases, that o f people in one or more other intervals must fall. But in a fire society, relying on free markets with voluntary exchanges, it simply is not true that the rich are rich because they've taken from the poor or that the poor are poor because the rich have de p rived them of part of their income and wealth. With few exceptions, one's income closely approximates one's contribution at the margin to total output. Moreover, one's income, with few exceptions, also at least roughly equals the costs one has incurred to attain the level of productivity for which that income is the reward. And it must be kept in mind that no one earns his or her income in isolation. Unless the laws of production, prevailing ever since Adarn and Eve were sent out of the Garden, have been r e pealed, the greater one's productivity and the higher, therefore, one's income, the greater are the output and incomes of the owners of the other production inputs with which one's services are combined in production activity. ,An even more fundamental co n sideration in examining tax fairness is the basic ethical issue in the context of our American heritage. Borrowing from my colleague, Roy Cordato, let me point out that an essential element of that heritage is that in all relevant respects we are supposed to stand equal before the law. In one area of societal concern after another, we have been at pains to ensure that the equality of rights is identified and respected. The single most distressing excep- tion has been the differential treatment of individua l s based on the amount of their property rights, reflected in their income or wealth. It has become widely accepted that fairness calls for imposing taxes at increasingly heavy marginal and effective rates the greater one's income and wealth. Our income ta x es, in particular, impose increasing excise taxes on - increasingly raise the opportunity cost of - increasing one's productivity. In simple truth, this means that the greater is one's productivity, i.e., the greater is the amount of one's property rights embodied in human and physical capital, the greater is the tax erosion of the value of those rights, hence, the lower is one's standing before the law. If this is fairness, let's all strive for unfairness in taxation. Against this standard, which I believ e is far more compelling than any ability-to-pay notion, any redistributional tax policy is unfair. Fairness, instead, calls for imposing taxes at a fixed mar- ginal rate on a correctly defined tax base, the subject of the second lecture to which I now tur n. The Ideal Tax System for America At the outset, let's get over the oxymoronic hurdle in speaking of an "ideal" tax system. We do better, I believe, to focus on a tax system that performs the essential function of taxes with the least damaging economic e ffects. This focus identifies the two sets of considerations to which we should direct our attention in seeking to come up with a far better tax system than we now have. The basic tax function As I have elsewhere and often noted, the essential function th at taxes should perform is to in- form the body politic about the cost of government services. This tax function is uniquely appropriate for free societies in which the public has both the opportunity and responsibility, 3
through the political process, of determining what functions and services it wants its government to perform and in what amounts. This determination cannot be effectively made without knowledge of the opportunity costs of those services, without knowing the value of the other uses of t he society's production capability that must be foregone to obtain those government ser- vices. In a society as large, complex, and dynamic as ours, with governments that have such huge inventories of activities, undertaken in enormously diverse ways, mee t ing these informa- tion requirements activity by activity is virtually impossible. It is not feasible to cost out each of the things that our governments do, most of which most of us are not even aware of. The best we can do is to try to determine the cos t s of differing inventories of government activities, and on that basis determine a preferred aggregate level of such activities, assigning our policy makers the responsibility for allocating that aggregate in the most satisfactory way among those diverse a ctivities. Moreover, we cannot precisely identify and measure the opportunity costs of any given bundle of government activities. We need a proxy that at least roughly approximates those costs. That proxy is the amount of taxes needed to fund any such set of government services. Several conclusions are obvious, given this function of taxes. First, except in extraordinary cir- cumstances, aggregate government outlays should not be planned to exceed planned aggregate tax revenues. The difference between the t wo aggregates-the deficit, however widely reported and known by the public-has no real information content. No one has a meaningful sense of the cost of the government activities that are covered by borrowing, because the borrowing invol- ves a voluntary e xchange between the government and the lenders. Only taxes can come close to informing the public about the cost of those activities. Finessing the question of budget process, the information content of taxes must act as the economizing constraint on spen d ing decisions. Clearly, taxes can't perform this essential function if people aren't conscious of their tax liabilities. This dictates relying only on taxes that are paid directly by individuals. It rules out, therefore, corporate taxes. It also rules out taxes that are more or less hidden by virtue of the in- stitutional arrangements for their imposition and collection. Sales taxes and even selective excise are, on this basis, to be rejected. Unless, moreover, one believes that only certain groups in the p opulation are to have the responsibility for determining how much cost government is to im- pose, taxes must be imposed on the broadest possible part of the population, not confined to the "rich" or disproportionately imposed on them. And, finally, taxes s hould be imposed as uniform- ly as possible with respect to the properly defined base. Relevant economic considerations As suggested before, the taxes we rely on to perform the fundamental function of taxes should be as least economically damaging as poss i ble. Here, too, the consideration of economic efficien- cy is relevant only in a free society that relits on private markets to perform the basic economic functions. In the performance of those functions, markets generate relative prices that reflect the p references of market participants engaging in voluntary transactions. These price relationships provide the clues to market participants for optimizing the allocation of their resources and in- come. In their very nature, taxes distort the price relations h ips that the market system would other- wise cast up. Every tax ever invented has the effect of changing the price of the thing that is taxed relative to the prices of other things, and policy makers should not aspire to the fashioning of a tax utterly de v oid of these excise effects. The policy goal, instead, should be to minimize these distortional features, to make the tax system as nearly neutral as possible. In the context of our present tax system, this policy dictum calls for / eliminating the corpor ate Income tax; of eliminating the transfer - the estate and gift - taxes;
4eliminating payroll taxes; of eliminating selective excise taxes; V recasting the individual income tax to minimize its differential excise effeds-. The fiscal offenses committ ed by the corporate income tax are well known. Briefly sum- marized, the tax is the equivalent of an excise tax on doing business in corporate form. It is also a stiff excise on saving committed to corporate businesses; as such, it severely accentuates th e anti-saving bias inherent in traditional income taxation. Income generated by corporate busi- nesses should be attributed and taxed to the individuals who own them. Estate and gift taxes are similarly additional excises on saving. If one rejects income r e distribu- tion as a tax policy objective, it is impossible to justify the incremental bias that these taxes impose on saving relative to consumption uses of income. By all odds, the most blatant tax distortion in the revenue system today is the severe exc i se im- posed by payroll taxes on the supply of and demand for labor services. The tenuous, at best, connection of these taxes to employees' Social Security benefits does not offset their severely punitive effects on employment. Nor can they be justified a s essential for the financing the So- cial Security system, which should in any event be phased out and transformed into a means-tested welfare system. Selective excises, too, have no appropriate role to play in the tax structure of a free society relying o n private markets. In their very nature, such taxes lead to allocations of resources that diverge from those that would be preferred by market participants freely exercising their choices. The rationale for these taxes boils down to the view that people d o n't know what's good for them and that it's the responsibility of public policy makers to make better choices for them. In truth, this elitist rationale is a cover for the fact that excises are "easy" revenue raisers that allow policy makers to assign rev e nue burdens that should be generally borne to people who can be characterized as naughty. Finally, the basic guiding rule in recasting the income tax should be to define taxable income as the excess of one's revenues over the costs incurred to obtain them . To this end, every effort should be made to minimize the tax bias against saving and in favor of consumption and against market-oriented personal effort and in favor of leisure uses of one's time, energy, talents, and so forth. On the first score, a univ e rsal, unlimited IRA should be introduced, allowing everyone to deduct from taxable income the amount saved out of current income, while including in taxable income all of the gross returns on that saving. The second goal is far more difficult to achieve, b ut the bias against effort may be substantially reduced by allowing deductions for the costs of education, training, skill attainment and honing, etc. Moreover, the tax should be imposed at a flat rate on taxable income in excess of whatever minimum amoun t of income is deemed to be an appropriate zero-rate bracket. Many, if not most, of the current discussions of tax reform stress the potential of such reforms for promoting economic growth. For a free society, relying on an effective market system, this go a l of reform is irrelevant, at best, and potentially hazardous at worst. With the most nearly non- intrusive or neutral tax system as possible, the rate of growth that emerges from the market's .operation is necessarily that which conforms most closely wit h the preferences of the public. It is difficult, to say the least, to come up with a justification for public policies that set that judgment aside.
5The approach outlined in my discussion is not likely to be implemented in the foreseeable fu- ture. We can, nevertheless, realize substantial gains if we treat it as a guide, allowing it to indicate to us the directions in which we should move toward a tax system more nearly con- sonant with the requirements of a free, progressive society in the coming ce ntury.