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WebMemo #873 on Taxes

October 5, 2005

A Misguided Tax Reform That Would Do More Harm than Good

By and

Most tax reforms being considered by the President's Advisory Panel on Federal Tax Reform would stimulate economic growth and do a lot of good for all Americans, including providing more people with the special kind of freedom that goes with the ability to save, invest, and become a capitalist (small, medium, or large).

 

However, some tax reforms would do far more harm than good. One such tax reform scheme-the proposed two-track system-is being promoted under the false flag of tax simplification, and should be rejected outright by the advisory panel. The proposal is that only high-earning Americans be required to file annual tax returns and pay income tax. Everyone else (about 90 percent of all eligible voters in the United States) would be "free at last"-free from the annual ritual of filing tax returns and, in their own minds, free from having to pay tax. They would, of course, not be free from tax at all. The proponents of this scheme also propose a high-rate value-added tax (VAT) of the type used in Europe, which is a hidden tax on wages, dividends, and consumer purchases.

 

A Hidden Tax

Just because a tax is hidden does not mean that it does not exist. Under the VAT scheme, most Americans would pay as much or more tax than they do now. The difference would be that for the most part they would be unaware of it. Without filling out an annual tax return, they would not know how much tax they paid during the year and therefore would not know the price that they are paying for all the ostensibly "free" government services.

 

Filling out a tax return and paying some amount of tax-even if it is small-is an important rite of citizenship, and knowing how much government is actually costing oneself personally is an absolute right of every American. That right should never be taken away under the guise of tax reform.

 

According to proponents of the two-track scheme, the total amount of tax collected by the Treasury from all Americans as a group would be about the same as now and the top tax rates would never be more than a modest 20 percent or so. It should be obvious that once a majority of voters have been bamboozled into thinking that government services are "free," they will demand more of them, and Congress will gladly oblige. Thus, the two-track system is a prescription for enormous expansion of government and escalating tax rates. The increasing taxes will especially burden the minority of voters subject to income taxes as well as the VAT.

 

Class Warfare

The proposed two-track system is repugnant to basic principles on which American democracy rests. It would intentionally divide Americans into two classes: those who knowingly pay their taxes as full citizens and those of a lower status who simply have their pockets picked by the IRS without knowing when, why, or how much.

 

From a civics perspective, categorizing Americans as taxpayers and non-taxpayers is an open invitation to the kind of "soak the rich" political demagoguery that has on occasions in the past torn the social fabric and might do so again.

 

Discouraging Economic Growth

The two-track system will also negatively affect the economy. It would place a surtax on hard work, productivity, and success. Not only would it penalize Americans who have already climbed the ladder of success, but it would discourage others from even attempting to succeed. For example, a person at an income level below the income tax threshold would face a strong disincentive against working harder and producing more if the increased personal income would push him over the threshold at which point he would have to start filing income tax returns and paying income taxes.

 

This is especially true for those near the income tax threshold. If an individual could dramatically increase his income by working harder and producing more, he might decide the increased income is worth the inconvenience of filing returns and financial burden of paying income tax. However, for most Americans, this will not be the case. Hard work and increased production are more likely to yield a substantial, but not enormous increase in income. A reasonable person would likely decide that the increased income is not worth losing his exemption from the income tax and, in his view, having to start "paying taxes" for the first time. The inevitable phenomenon of people deliberately adjusting their activities to remain just below the income tax threshold will only retard economic expansion, to the detriment of all Americans.

 

For those already above the threshold, the laws of economics dictate that increased work and investment would be discouraged as rewards are reduced by higher taxes. Moreover, this perverse incentive for these higher-income individuals to reduce their efforts would disproportionately affect the economy, since such individuals tend to provide most of the capital and high-value skills that drive economic growth. As they reduce their own efforts, the ripple effect would inevitably lead to fewer and lower-paying jobs and fewer and less profitable investment opportunities for all Americans. Lower economic growth, or even outright stagnation, would result.

 

Conclusion

Given all the good, simple, and pro-growth tax reform options available, there is no place in tax reform for a proposal that is both economically unsound and contrary to basic principles of American democratic government.

 

Ernest S. Christian is the Executive Director of the Center for Strategic Tax Reform, and Gary Robbins is a Visiting Fellow at The Heritage Foundation.

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