This is a draft and is not intended for distribution. If you have questions or comments about it or suggestions on how to improve it, please send them to me!
For an outline of the book, go here: Rebuilding America: Getting Serious About Poverty, Inequality, and Economic Growth.
For more details on the secure ID and banking system mentioned in this chapter, a rundown on that system can be found here: Secure ID and Banking
To skip directly to the outline of the tax and welfare system, click here.
To skip directly to a sample Federal budget based on these reforms, click here.
To skip directly to the expected impacts of the proposal, click here.
Tax and Welfare Reform
Wicked problems are not new. Even the ancients recognized that a problem could become so snarled up that there were no loose ends to tug on or use as a starting point in order to patiently unravel the knot. Thus the popularity of this account of a famous mythic solution:
When Gordius became king of Phrygia, he dedicated his chariot to Zeus and fastened it to a pole with a large and intricate knot. The ends of the cord were hidden inside the knot and it was supposedly impossible to unravel it. However, an oracle predicted that whoever untied the knot would become king of Asia.
Many individuals came to Gordium to try to untie the knot, but all failed. Then the Greek conqueror, Alexander the Great, visited the city in 333 BC. After searching unsuccessfully for the hidden ends, Alexander drew his sword and cut through the Gordian knot. Alexander then went on to conquer Persia, northern India, the Middle East, and Egypt, thus fulfilling the oracle’s prophecy.
Moral: Some stubborn problems resist all gradual, step-by-step solutions and can only be solved by a bold stroke that cuts through the whole problem at once.
[Adapted from the account at: http://www.mythencyclopedia.com/Fi-Go/Gordian-Knot.html#ixzz3xjG6otVF.]
There is no question that the American system of taxation and welfare has become a Gordian knot. It is immensely destructive, with inefficiencies, disincentives, and deadweight costs that reduce our GDP by more than 1.5%*. Fixing it would be – without any question – the fastest way to move the U.S. economy from its recent anemic growth levels of less than 2% back toward more robust historic levels. [*Based on The Economist’s estimate of 1.3% of GDP wasted by the tax system, plus a >.3% estimate for losses from a badly designed welfare system.]
Yet it has resisted all attempts at major overhaul. Every reform effort has been aimed at fixing a few conspicuous inefficiencies and inequities, without dealing with the fundamental problems. In spite of all attempts to streamline and reform the system, it has ended every decade more complex and burdensome than it was ten years before.
The blessings of governmental continuity are great. The U.S. has had over 220 years of continuous democratic government without being conquered or overthrown, and no one who has studied the horrors inflicted on countries by conquest or governmental collapse would wish otherwise.
But one consequence of such prolonged continuity is being stuck with the accumulation of decades, even centuries, of short-term patches and piecemeal changes, piled one upon the other, on top of a foundation that has long since become obsolete and inappropriate as economic, demographic, and technological conditions have radically changed.
Without a revolution or catastrophe, it is extremely difficult to scrap such a system and start over with a clean design. This is true of any governmental structure, but it has proven to be especially true for our tax and welfare system.
Once any system becomes so complex that only an expert can understand it, a priestly class of such experts comes into being and can sell its knowledge for a high price. This class has a vested interest in maintaining and increasing the complexity of the system beyond all utility, and it uses its considerable wealth and influence to that end.
Since all incremental reforms require an expert level of knowledge about the old system, would-be reformers are forced to depend heavily on the advice of the experts, people who have a strong vested interest in frustrating any simplification of the system. Thus, every attempt to reform, streamline, or simplify the system mysteriously results in a system of even greater complexity.
Our system of taxation, government finance, and welfare is now so complex that it is effectively impossible to define or measure its true extent. It extends far beyond the large bookshelf containing the tax code and other relevant parts of the U.S. Code. It also includes all of the state tax codes, plus an Augean stable of regulations issued by various agencies, and an uncountable number of often-contradictory court decisions and bureaucratic rulings that attempt to interpret and apply the laws and regulations.
Complying with it is extremely burdensome and expensive. Individuals spend long hours every year keeping elaborate records and attempting to decipher and fill out increasingly complex and cryptic forms. Because of the complexity, individual taxpayers are often forced to pay substantial amounts to experts for assistance, a deadweight loss to the economy and a very real tax that is not included in tax tallies. Businesses must do the same at an even higher level of complexity.
As the IRS itself put it in 2010:
U.S. taxpayers (including businesses) spend roughly 6.1 billion hours per year complying with the requirements of federal tax law. This amounts to 50 hours per household or the labor equivalent of more than three million full-time workers. Per the IRS’s Taxpayer Advocate, these figures do not include “millions of additional hours that taxpayers must spend when they are required to respond to IRS notices or audits.”
If tax compliance were an industry, it would be one of the largest in the United States. To consume 6.1 billion hours, the “tax industry” requires the equivalent of more than three million full-time workers.
[Data from https://www.irs.gov/pub/tas/2010arcmsp1_taxreform.pdf, as reported in http://www.justfacts.com/taxes.asp%5D
Think about that. As a nation, we put more hours of work into complying with the tax code than we put into public school teaching! And nearly all of that huge tax compliance effort is unnecessary and unproductive.
Yet for any tax return above the simplest level, no one can truly say with confidence that a commercially prepared return is correct in every particular. Indeed, the Government Accounting Office’s analysis of the IRS compliance test results has found that 60% of commercially prepared tax returns contain significant errors. To make matters worse, the IRS’s own tax helpline is notoriously inaccurate. Even the experts are forced to make judgment calls and to guess at what is legal or will be allowed, what will be challenged and what will slip through.
Complex, distortive, and inequitable tax systems are negative for growth.
–– Ben Bernanke, former chairman of the U.S. Federal Reserve
Above and beyond the extraordinarily high collective cost and uncertainty involved in trying to comply with the existing system, this situation imposes three important additional costs on our society and economy:
First, it forces people to make economic decisions that are bad for the economy as a whole. If doing something in a convoluted way generates 10% less pre-tax revenue, but 1% more in post-tax revenue, businesses and individuals will do it that way, even though it represents a 10% loss to the economy as a whole.
Second, it generates a climate of aggressive tax avoidance that all too easily shades over into tax evasion. Voluntary tax compliance is crucial in any democracy. If most people are honest and pay their taxes, the cost of tax collection is low and the burden of taxation is shared equitably. But no one wants to be the only sucker who pays full tax when everyone else cheats.
Aggressive tax avoidance by the rich with the help of high-priced lobbyists and tax experts looks increasingly like tax evasion to most ordinary citizens who cannot afford such help. This encourages the widespread belief that all taxes are inequitable and that cheating on taxes is not really immoral, a belief that undermines not just the government, but the whole society.
One of the most important reasons why nations like Greece and Italy remain economically stagnant, while their northern neighbors are comparatively much richer and better run, is that tax evasion is pervasive in the European southern tier. The North-South differences in rates of voluntary tax compliance are large, and track closely with differences in national debt and economic growth and well being.
The IRS rather optimistically pegs tax compliance in the U.S. at 84%. In fact, the tax code is so complex that no one can say how high or low compliance really is. All we know is that the IRS, which is severely understaffed and underfunded for its current task, is able to detect willful cheating on 16% of randomly audited returns. We must still allow for some number of returns in which filers have successfully hidden income and assets from a cursory audit. Private discussions with knowledgeable tax attorneys and tax advisors suggest that the uncounted tally of successful evaders is at least as large as the number of those who get caught.
Tax compliance has been declining over the long term, and even the optimistic 84% number is dangerously near the tipping point, where ever-increasing numbers of people believe that it is okay to cheat because “everyone else is doing it.” If enough people cheat, the IRS will not have the resources to catch more than a few, and juries – which would be increasingly likely to contain jurors who cheat – will refuse to impose harsh penalties.
Widespread tax evasion cripples nations, undermines economic growth, and severely erodes democratic legitimacy (see below). It is easy for a country to slip into the tax non-compliance trap, and very difficult to get out of it. This is a mistake we cannot afford to make.
Third, the system we have is the product of so many corrupt bargains that it is severely undermining the legitimacy of American democracy. There is widespread public awareness that the tax code is riddled with exemptions for the rich and for virtually every wealthy industry and special interest group. The media report constantly on billionaires and giant corporations that pay no taxes.
With inequality at its highest levels in nearly a century and public debate rising over whether the government should respond to it through higher taxes on the wealthy, the very richest Americans have financed a sophisticated and astonishingly effective apparatus for shielding their fortunes. Some call it the “income defense industry,” consisting of a high-priced phalanx of lawyers, estate planners, lobbyists and anti-tax activists who exploit and defend a dizzying array of tax maneuvers, virtually none of them available to taxpayers of more modest means.
Anger and outrage have been growing for decades and have now reached critical levels, yet Congress seems completely under the thumb of big donors and impervious to voters’ desire for fairness and integrity.
This has gone beyond casual cynicism about the influence of wealth on politics and now threatens the nation’s fundamental ability to govern itself. When even people who cannot name the three branches of government are willing to take to the streets and to rally for candidates who want to burn the system down, politics becomes deadlocked and only the angriest candidates win.
The extreme corruption and unfairness of the tax system is only one of the causes of this anger that now pervades politics on both the left and the right. The greater cause is the growing perception that America is no longer a real democracy in any meaningful sense, that the rich and powerful are now completely in charge and have been systematically using their power to skim off all of the increase in wealth created by everyone else.
Operating largely out of public view — in tax court, through arcane legislative provisions and in private negotiations with the Internal Revenue Service — the wealthy have used their influence to steadily whittle away at the government’s ability to tax them. The effect has been to create a kind of private tax system, catering to only several thousand Americans.
The impact on their own fortunes has been stark. In 1992 when Bill Clinton was elected president, the 400 highest-earning taxpayers in America paid nearly 27 percent of their income in federal taxes, according to I.R.S. data. By 2012, when President Obama was re-elected, that figure had fallen to less than 17 percent, which is just slightly more than the typical family making $100,000 annually, when payroll taxes are included for both groups.
The ultra-wealthy “literally pay millions of dollars for these services,” said Jeffrey A. Winters, a political scientist at Northwestern University who studies economic elites, “and save in the tens or hundreds of millions in taxes.”
The widespread and systematic corruption of the tax code has been the most important tool in the process of de-democratization and exploitation by the rich. We will never be able to recover the sense of national democratic legitimacy that we enjoyed in the mid-20th century if we do not radically reform our tax system.
Anger and cynicism now run so deep that even the proposed “grand bargains” of the past, like Simpson-Bowles, which hoped to eliminate some of the most corrupt loopholes in return for somewhat lower tax rates, now seem lame and timid, and would do nothing to restore public confidence. Only a system that is both fair and comprehensible will do.
Politicians have been aware of this reality for some time, so we’ve seen quite a number of simple – and often simplistic – tax reform models, ranging from soak-the-rich surcharges on millionaires (which would just add more complexity and become one more tax to evade) to draconian tax cuts for the rich that would increase inequality and send the deficit through the roof.
The most recent GOP “reform” is in the latter camp. It was pushed through with no attempt at all to build bipartisan support, and it is widely perceived as a one-party raid on the national treasury on behalf of rich businesses and individuals.
It is likely to be reversed – and possibly replaced by an equally radical and harmful measure going to the opposite extreme – by the Democrats, if and when they take back control of the levers of power. Needless to say, this kind of instability and confusion makes long-range planning difficult and encourages individuals and companies to take an extremely short-term approach to economic decisions, with serious negative effects on the economy.
None of these approaches to tax reform have the kind of widespread, bipartisan support needed to endure, and none address the fundamental problems with the existing system. What has been missing so far has been a serious proposal for comprehensive reform that will create a solid foundation for future growth and stability. To do that, it must be clear, fair, and enforceable, and still capable of funding government at a realistic level without damaging the economy.
My goal in this chapter is to describe a realistic proposal for replacing the current system that meets those criteria. In addition, it provides a coherent way to reform welfare and entitlements that is integrated with the tax system, so we don’t have two different systems – taxes and welfare – that frequently work at cross-purposes.
In Chapter Six, I described the many ways the current welfare system is dysfunctional, wastes money and resources, and harms the people it is meant to help. It costs us over a trillion dollars a year, yet leaves tens of millions of Americans in poverty. In particular, we still have far too many children growing up in poverty, many of them in deep poverty, with many of them suffering serious cognitive damage and health deficits before they even reach first grade.
As I described in that chapter, the principal culprit is an opaque, convoluted, and frequently contradictory means-testing system designed to funnel aid only to the “deserving” poor and to limit and control how recipients use the resources they get.
This inevitably means that applicants have to fill out complex forms to beg for aid, and that government employees then need to go over those forms, get explanations, make corrections, verify the important information, and supervise the use of the aid. It’s an expensive and time-consuming process. Like the cost of filing tax returns, it represents a dead loss to the economy, and it prevents many poor people from getting aid they need in a timely manner.
The complexity itself creates widespread incentives for cheating and corruption, particularly if enforcement is lax. For example, the IRS’s own statistical analyses of the Earned Income Tax Credit indicate that around 25% of all EITC claims are fraudulent, yet almost none of these claims are investigated (because, as I said earlier, the IRS is grossly underfunded; they simply don’t have the resources to go after these people). As a result over $14 billion is paid out each year for fraudulent EITC claims and never recovered. And that’s just one of more than 80 federal welfare programs!
Because the requirements for aid are rigid, the aid itself creates real disincentives for employment or self-improvement. People who are on welfare generally face the highest marginal tax rates of all, often far higher than the marginal tax rates faced by billionaires. As we saw in Chapter Six, a single mother can sometimes face a situation where getting a slightly better-paying job or working a few more hours would cause her to lose thousands of dollars in benefits, actually outweighing the increase in wages and leaving her worse off financially, a marginal tax rate of more than 100%!
And because moving to another place means going through the whole bureaucratic nightmare all over again, and typically losing all public housing support for a year or more, welfare tends to reduce mobility. This prevents poor families from moving to places where jobs are more readily available, and it frequently traps them and their children in the worst neighborhoods, where schools are bad, violence is common, and opportunities are scarce.
The desire to limit aid to those who deserve it is natural. During most of human pre-history, our ancestors lived in small, close-knit bands of people who helped and protected each other when misfortune happened. At the same time, tolerating a slacker or freeloader was a threat to the whole group, so we developed a finely-tuned instinct to be generous, but only within limits.
Politically and psychologically, this makes all the sense in the world. Socially and economically, however, it is a large part of why we are spending so much money on welfare for so little result. Our ingrained sense of cautious generosity works against us for one simple reason: we are no longer willing to simply cast unproductive people out and let them starve to death.
For example, the average homeless person can cost local government upwards of $75,000 a year in social services, emergency medical care, and policing costs. Though it seems counterintuitive, it ends up being substantially cheaper to move homeless people into small apartments and provide them with food and medical care than it is to have them on the street, committing nuisance crimes, consuming social services, and running up huge bills by going to the ER for basic medical care.
The whole point of means testing is to keep “undeserving” people from getting aid, but doing this makes no sense if excluding these people from aid at the front end ends up costing us even more in social services at the back end than if we had not gone to all the effort of excluding them.
This robs means testing of its whole purpose. By only giving aid when the need for it is acute, and otherwise distributing it in dribs and drabs to those we deem appropriately worthy, we are actually making the problem worse, not better, and wasting a great deal of money in the process.
In line with that, what I am going to propose below is that we build on the work that has been done over the last half century on a Basic Income, and how it can function as a replacement for the welfare state that fits smoothly into a progressive tax system. As we will see, there are strong arguments in favor of this approach, in terms of greater efficiency and effectiveness. But making it work will require convincing the public that it is better to waste a little money on some very unsympathetic people than it is to expend far more – and do a great deal of unintended harm in other ways – in order to exclude the people we deem unworthy of help.
IMPORTANT DISCLAIMER! In the descriptions that follow, I’m going to use specific numbers for tax rates, brackets, deductions, and credits in order to make the system easier to understand. Unless otherwise stated, these numbers are placeholders. Before any such system is actually enacted into law, the numbers with asterisks would be subjected to intense scrutiny and fierce debate (as they should be) and adjusted to make sure that the resulting system will work as intended. Also, unless otherwise stated, dollar amounts should be understood as being in estimated 2020 dollars, assuming roughly 2% inflation.
An Integrated Tax & Welfare System
Many state and local taxes and nearly all existing federal taxes, deductions, tax credits, subsidies, and welfare payments will be replaced by the following …
Income and consumption taxes:
- A very broad 20% goods & services tax (GST) [includes salaries]
- A 5*% tax on net income over $75,000*/person
- An additional 5*% tax on net income over $200,000*/person
- An additional 5*% tax on net income over $500,000*/person
- Brackets for married couples are double the above brackets
- Capital gains are subject to GST, but not income tax
Asset and business earnings taxes:
- A 1.5% annual tax on net household assets above $100,000*/person
- A 1.5% annual tax on net business assets above $100,000*/full-time employee
- A 15*% earnings tax on all non-pass-through businesses & corporations
- A $10* or higher federal minimum wage, indexed for inflation
- Applies to everyone, including gig workers and tipped employees
- An escalating carbon tax, starting at $40*/tonne of CO2, with a matching tariff
- The existing excise taxes (e.g., gas, tobacco, alcohol)
- Excise taxes on any legalized recreational drugs, at the maximum rates that do not create a black market
- A 0.05% financial transactions tax (e.g., $5 for a $10,000 stock sale) and a 0.005% tax on derivatives
Tax credits and distributions:
- $1,000*/mo refundable tax credit for each adult citizen (CTC)
- $40/month refundable carbon tax rebate for each adult resident (CTR)
- $300*/month paid to local governments for each adult resident (LTP)
- A $1,500*/mo health, nutrition, and education voucher for children (CDA)
- For purposes of these programs, the dividing line between “child” and “adult” is the 20th birthday.
Social Security adjustments:
- Social Security recipients receive the CTC in addition to SS payments.
- All pension and SS payments are subject to GST and income tax.
- Medicare for retirees costs $700*/month, paid automatically out of the $1000 CTC.
- There will be a one-time bump to SS payments to adjust for any change in the cost-of-living caused by the introduction of the GST.
Gift and estate taxes:
- The current gift tax exemptions are retained.
- Givers of non-cash assets must pay GST (20%) on all unrealized capital gains.
- The estate tax is eliminated; bequests are treated as gifts.
- A bequest may be spread over five years for tax purposes, thus potentially using five years’ worth of gift tax exemption.
- Minor children can spread a total bequest over the period up until age 25; trusts for the severely handicapped and disabled have no age limit.
- Gifts and bequests in excess of the gift tax exemption are treated as income earned by the recipient, and are subject to GST & income tax.
*Starred numbers are approximate, based on a hypothetical 2020 implementation date, assuming roughly 2% inflation. All starred dollar figures should be indexed for inflation after that, using the chain-weight GDP deflator.
Here’s a very rough idea of how the tax and spending portions add up, using the most recent available data:
This would achieve all of our anti-poverty goals, including universal health insurance and universal access to childcare and early childhood education, in addition to streamlining the economy and lowering corporate and personal taxes, while still reducing the current federal deficit by ~$600 billion.
As of late 2016, that deficit was an estimated $666 billion. If all the base figures were from 2016, the Federal net revenue would be somewhat larger, eliminating the deficit entirely and slightly reducing the national debt. Barring a recession between now and then, reasonable projections for 2020 would also indicate a small revenue surplus in that year.
The massive tax cut passed by the GOP in late 2017 will make the deficit question even more crucial. The (highly optimistic) official projections say that the extreme tax cuts will increase the annual deficit by around $150 billion a year. But the bill also opens the door to greatly increased tax avoidance as high wage earners convert themselves into pass-through businesses for tax purposes.
If this happens as broadly as most tax experts expect, it will reduce government revenues even further, raising the annual deficit to around $850-950 billion and increasing the national debt by at least $8.5 trillion over the first decade. This would represent a massive increase, pushing our level of debt and debt service to unprecedented levels.
Excluding the money owed by one part of the government to another part, a bookkeeping fiction, the U.S. national debt was over $15 trillion at the end of 2017. Under the GOP tax bill, it is projected to grow to more than $23 trillion by 2027, an increase of more than 50% in just 10 years. You don’t need to be a deficit hawk to understand that this is financially irresponsible.
By comparison, the reforms proposed here would reduce the deficit to less than $50 billion per year, reducing the projected increase in the national debt by approximately $8 trillion over the first decade. This will make a major difference in the economic health of our nation.
[Errata: the tax and welfare spreadsheet above assumes that the carbon tax rebate goes to adults only. In fact it should go to all legal residents. This would increase the population base to 325 million, and increase the total outflow from ~ $115 billion to ~ $156 billion. ]
Here are the notes:
Keep in mind that the $1.7 billion transferred to local schools and local government would allow local communities to substantially reduce sales taxes and property taxes, if they choose to do so, or to expand spending on schools, police, public services, and infrastructure maintenance and repair.
In addition to the major benefits to local government, the states will save substantial amounts on education, health, welfare, and unemployment, money that can be returned in lower state taxes, invested in infrastructure, and used to stabilize state pension systems.
That’s the overview. Now let’s look at what this would mean in greater detail:
I. A Very Broad 20% Goods & Services Tax, or GST
This is a very broad tax on all goods and services, but one that allows businesses to deduct nearly all relevant expenses, including payroll. It is thus more like a business cashflow tax than a conventional VAT or sales tax.
The GST applies to salaries (like a payroll tax) and also applies to the realized increase in value from the sale of assets (like a capital gains tax).
For purposes of discussion, I am going to stipulate that:
- The rate for this tax will be 20%, without exception. (This is roughly equivalent to a national 12% sales tax.)
- There are no exemptions or reduced rates for education, health care, clothing, food, or other things. (Yes, this is extremely regressive. We will deal with that in other ways. See the section on the CTC, below.)
- This tax is paid by the seller, not the buyer. This leads to a number of other conditions, such as the next one.
- By law, the advertised “sticker price” is the tax-inclusive amount, the total price paid by the buyer. Instead of advertising a product for a base price and then adding the sales tax and charging the customer more, a seller under this system must advertise the tax-inclusive amount. The customer pays the actual amount in the ad or on the price tag.
- The GST is similar to a value-added tax, but is closer to what is sometimes called a destination-based business cashflow tax. With a 20% VAT, if a store buys socks at wholesale for $10 and sells them at retail for $15, it will pay 20% of the $5 difference, or $1 in tax on each pair of socks sold. With the GST, the store can also subtract payroll, electricity, advertising, and other costs of doing business, so the actual tax would be quite a bit less than $1.
- Everyone pays this tax. There are no tax-exempt accounts for businesses to keep track of, and a seller does not have to treat different buyers differently. There is also no way to evade the tax by faking an exemption since no one is exempt.
- Even sales to and by governments are taxed. If a city buys a truck, the dealer still sends the tax authority 20% of the difference between the dealer’s costs and what the city paid. If the city sells water or power at a profit, it pays the GST on the “value added.”
- Employees pay GST on their salary and benefits. They are selling their services to their employers. If you make $6,000 a month, you will pay $1,200 a month in GST to the government (and receive back $1,000/month in CTC, for a net tax of $200/month). Because this replaces most of the income tax and the entire 15.3% payroll tax that is currently split between the employee and the employer, it will mean a net tax reduction – and therefore an increase in after-tax income – for most employees.
- When you are hired, you will know your monthly take-home pay and will not need to deal with fluctuating amounts of tax withholding and take-home pay during the year. The rules are simple: take 80% of your salary and add $1,000/month. For example, if you are hired at a pre-tax salary of $75,000/year, you will know from the outset that your annual take-home pay will be $72,000. (Why? Because 80% of $75,000 is $60,000. And $60,000 plus $12,000 for the CTC, is $72,000.)
- The GST on salaries replaces both halves of the federal payroll tax (FICA), the part paid by employees and the part paid by employers.
- Employers will no longer be responsible for the paperwork and other problems involved in withholding income taxes, collecting FICA, and forwarding the proceeds to the government, significantly reducing the administrative burden on small businesses.
- Because the GST replaces both parts of the current payroll tax, it represents a reduction in the effective wages that employers pay to employees. To compensate, employers will be required by law to pass that savings through to employees via a one-time wage increase equal to the employers’ former FICA payment. Currently, for all employees making $118,500 or less, that would amount to a one-time 7.65% salary increase. This simplifies the payroll process for employers, but it does not change their net payroll cost at all. It simply requires them to take what has been the employers’ share of the FICA payment and redirect it to their employees instead of the government.
- The full 20% GST will be charged on imports and the GST already paid on export goods will be refunded at the border. (These border adjustments are standard and necessary for all value-added taxes. Every other developed country already does this.)
- The GST also applies to capital gains and replaces the existing capital gains tax. If you sell real estate or financial assets that you have owned for more than a year, you can adjust the purchase price for inflation when calculating your GST. If you paid $8,000 for some stock (adjusted for inflation) and you sell it for $10,000, you pay 20% of $2,000, or $400 GST. Losses can be subtracted from gains and carried forward to later years if necessary.
- The GST will not be charged on interest, dividends, royalties, or rental income, which are considered returns on capital. They count as income, but are not considered sales of goods or services for purposes of the GST. That also means that amounts paid in these categories are not deductible as expenses when calculating GST payments.
- Part of the GST will be transferred to local governments on a per capita basis. Specifically, each adult resident of the U.S. will receive from the Federal government a $300*/month local tax payment (LTP), routed automatically through the recipient’s bank to the city/county in which that person resides.
- Most of the funds directed into the Child Development Accounts (or CDAs, described below) will go to local public schools.
Note: There is a good economic and political case to be made for setting the GST rate at 20% and locking it in place. Calculating it is simple, even for those with few math skills. In addition, a widely-known round number has the advantage of being much harder for politicians to increase.
Changing 20.3% to 20.5% might not get much notice. But if the 20% figure becomes established over a decade or more, then any political move toward “breaking 20” would likely create a lot of resistance precisely because it would be seen as cutting the tax rate loose from an important anchor value.
Calculating the tax: European-style value-added taxes work on the “invoice method,” where the tax is assessed on each item based on the purchase price and the sale price. This requires the seller to keep track of all of the individual invoices showing how much VAT has already been paid on every item, and then to calculate the tax on each individual item sold.
This requires a great deal of paperwork, especially when different rates apply to different items. It also creates complications and many opportunities for deception. For example, consider a situation where the seller is selling both an item and a service combined, such as a machine that comes with installation and training. Using the invoice method requires the seller to accurately divide the price, which invites tax evasion, since the seller can easily sell the item at cost and charge more for the services, or vice versa, depending on which is taxed at a lower rate.
Since we are using only one tax rate for everything, however, there is no need for all that complexity. Instead, the GST proposed here is closer to what is sometimes called a “subtraction-based VAT.” At the end of each month, a business adds up all of its sales and subtracts all of its expenses on which GST has already been paid, and then pays the GST tax rate on the difference. This means that a car dealer, for example, can subtract not just the wholesale cost of the vehicles it sells, but the money it spends on payroll, electricity, advertising, and so on, as long as GST has already been paid on all of those goods and services.
If you think about it, this is much simpler. The business just keeps track of its cashflow – something it needs to do anyway – and (with a few minor adjustments for rent, interest, and non-business expenses) it pays tax on the net increase in cash, if any.
And, in fact, another name for this kind of tax is a “destination-based cash-flow tax.” For PR reasons, Congressional Republicans preferred this name for a similar proposal they made recently.
Isn’t 20% high for a VAT or sales tax?
It’s crucial to understand that this version of a goods & services tax is NOT a 20% sales tax or a 20% VAT. Because labor costs are deductible from the sales price at every stage in the supply chain, the 20% ends up being levied only on the non-labor portion of the cost. In practice, this means that this particular 20% GST or business cashflow tax is very roughly equivalent to a normal 12% VAT.
Why 12%? Because total compensation (wages, salaries, commissions, and tips – the stuff that goes on a W-2) in the U.S. amounts to roughly 40% of total GDP. (In 2014, for example, W-2 income totaled around $6.8 trillion, or 39.2% of $17.35 trillion in GDP.) And compensation is deducted at every level before the GST is calculated. So the actual tax is 20% of the other 60%, or around 12% of the final price.
In practice, this also means that goods and services created with a higher than usual labor input get taxed less and goods and services created in a capital-intensive way will pay a slightly higher effective tax rate. This creates a small economic incentive for keeping people on the payroll instead of replacing them with robots or machines.
Furthermore, because of the way it is calculated, this version of the GST is a tax on the profit margin, not the actual sale price. This means that it creates a higher effective tax rate on high-margin goods than on low-margin goods. The effective sales tax rate on Rolexes, Roll-Royces, and other high-margin goods would therefore be higher than average, while the effective sales tax rate on low-margin, labor-intensive goods would be much lower, typically around 1% or even less.
Who really pays the GST? And how much will it increase wages and prices?
It turns out that these are complicated questions. Economists generally agree that the cost of any business tax, sales tax, or payroll tax is divided between the buyers and the sellers, but the particular split varies widely, depending on the nature of the item or service being sold and the dynamics of the marketplace. A few sellers (including some employees) will be able to pass the entire amount of the tax through to their customers/employers. The vast majority will not.
It’s important, however, to recognize that the overall change in after-tax prices and the overall change in after-tax income should be roughly similar as long as there are no other forces creating either deflation or inflation. Other things being equal, prices can’t go up more across the board than after-tax income does.
It’s true that individual businesses can usually increase prices when there’s an increase in the cost of a single item. But the economy as a whole doesn’t work that way when costs increase across the board. Barring a change in the money supply, any general increase in prices that is greater than the increase in after-tax income will leave some goods unsold, leading sellers to discount those goods in order to sell them. But if buyers buy discounted goods, that means other goods are left unsold, so they get discounted in turn, and this ripples through the whole economy, pushing prices back down again.
In this case, real after-tax incomes will be going up, since for most people the total tax they pay on income will go down under the proposed system. That is, more than 80% of all workers currently have more money deducted from their paychecks for the total of FICA plus income tax than they will pay for GST minus the Citizens Tax Credit.
(In case it isn’t clear from the information so far, the proposed tax system represents a tax cut for most people and will create a modest increase in after-tax income for nearly all Americans.)
The important point to keep in mind when trying to estimate the effect of the GST on consumer prices is that the GST is not being added on top of existing taxes. Instead, it is replacing those taxes, and it often represents an actual tax reduction.
Corporate income taxes, for example, will go down from a maximum of 21% to just 15% under this proposal. Even if you added half of the 12% true value of the GST to that 15%, the maximum tax rate would still be only 21%. Thus in most cases there will be no tax increase to pass on to the customer, and therefore no pressure for a price increase. It’s just a change in the way the tax is being collected.
The GST on the labor component of any product or service also simply replaces existing payroll and income taxes. Those taxes have already been incorporated into the existing prices, so there is little or no tax increase on that share of the production cost. In fact, in many cases there is a net reduction, since most workers will get a net increase in their after-tax pay.
Consumers pay a large portion of the existing corporate tax already, and as I’ve indicated, there is good reason to believe that price levels will not rise by more than the general increase in after-tax incomes.
Note: For the purposes of modeling the effects on individuals, I have assumed, very conservatively, that
- The minimum wage will rise to $10/hr, with minimum take-home pay of $8/hr.
- A full-time (2000 hrs/yr) minimum-wage worker will net $28,000 after taxes and CTC, a “living wage” that is effectively an after-tax take-home pay rate of $14/hr.
- Pre-tax real wages above the minimum wage will rise to the extent of the employer’s contribution to FICA (7.65% of the first $118,500).
- After-tax income will rise by about 8% for the bottom 80%.
Given these conditions, my best guess is that tax-inclusive consumer prices will rise by roughly 4-8% after the GST goes into effect. However, I would welcome input from economists who have delved deeply into both the theory of tax incidence (aka tax burden attribution) and the actual historical behavior of prices after other such taxes have been introduced.
What about tiny businesses?
Most countries exempt very small businesses from an invoice-type VAT because of the paperwork burden. In this case, however, the burden is essentially gone because businesses don’t have to keep track of large numbers of invoices and receipts. Moreover, the owners of sole proprietorships (like a mom & pop store) can easily zero out the GST on their businesses if they choose, simply by writing themselves a salary check for the amount of any positive cashflow. This lets them pay the GST as part of their own income if they prefer. The amount of the tax is the same either way.
Note that this is one of the advantages of having the same rate (20%) applied to payroll, self-employment, capital gains, and goods and services. The traditional tax dodges that involve moving income from one category to another no longer save any tax money. This reduces fraud and makes accounting and tax planning much simpler.
II. Three Tax Brackets for Net Income over $75,000*, $200,000*, and $500,000*/Person
This is a straightforward 3-bracket tax on net income, in 5*% increments. The 5% bracket will start at $75,000* per person per year, the 10% bracket will start at $200,000* per person per year, and the 15% bracket will start at $500,000* per person per year.
Married couples are allowed to average their income and assets in this system. In effect, this means that the brackets for couples are simply doubled, with the 5% bracket starting at $150,000* per couple, the 10% bracket starting at $400,000* per couple, and the 15% bracket starting at $1 million* per couple.
[*Reminder: These are round numbers for purposes of illustration. The eventual tax rates and thresholds may well be different. Whatever the starting numbers, the bracket thresholds should then be automatically adjusted every year for inflation to avoid “bracket creep.”]
Income for tax purposes includes: salary, bonuses, benefits, in-kind transfers, and self-employment income; gifts and bequests greater than the gift tax exemption; royalties, rental income, interest, and dividends; and so forth. It does NOT include capital gains that are subject to the GST.
As indicated above, non-exempt gifts and bequests to individuals and non-qualified organizations are treated as earned income by the recipient for GST and income tax purposes. The new basis price for an asset received as a gift or bequest will be the declared value on which tax was paid at the time of the transfer.
Real and necessary expenses incurred in the course of generating income are deductible, but interest, dividends, rent payments, royalties, and other fees for the use of capital are not deductible.
III. A 1.5% Annual Tax on Net Household Assets Above $100,000*/Person
Individuals and families will pay 1.5% of their net worth in excess of $100,000*/person. In return, rent, royalties, interest, and dividends are excluded from the GST.
Taxing wealth directly – instead of taxing the return on wealth – is fairer, avoids the problem of taxing illusory inflation gains, and ensures that owners of great wealth pay something, even if they arrange their investments so that they appear to have no income.
“Net taxable assets” includes the value of everything you own – house, car, furnishings, stocks, bonds, cash, business interests, etc. – plus whatever is owed to you, minus everything you owe, minus $100,000*.
Members of the same household can combine and average their net taxable assets. A “household,” in this case, includes all adults and children functioning as one single family and economic unit with pooled finances and shared use of assets. Examples would include a single earner or a two-earner couple, along with their dependent relatives.
For example, using these rates, a family of four with $2 million in assets and $600,000 in debts would pay a $15,000 assets tax on the $1 million worth of net assets they owned above the threshold. ($2 million in assets, minus $600,000 in debts, minus $100,000 x four people = $1 million in net taxable assets, and 1.5% of $1 million = $15,000.)
Note: Undeclared assets can be seized under this system. If a particular asset isn’t declared as owned by anyone in a given year’s tax filings, then no one has standing to object if the government claims it. Hiding assets would be risky!
So would understating their value. Selling assets for substantially more than their declared value would raise obvious questions and a potential action for back taxes if there is no reason to believe that the value suddenly increased. In addition, as security against fraudulently low declarations, the government should have the right to challenge any valuation.
In most cases, it should be easy to show what the reasonable market value of an item was as of the tax declaration date. But if a settlement is not reached and there is no practical way to determine value, the government should have the right to auction the asset, and sell it if the high bid is at least 25% over the declared value, paying the owner 75% of the declared value and keeping the rest.
The 1.5% tax rate is low, and in general it should be in most people’s best interest to put an accurate value on their assets. In addition, I would expect Congress to come up with “safe harbor” rules for valuation, such as the average stock price for the previous month or quarter, to eliminate uncertainty and disputes.
A special note: The U.S. Constitution currently has two clauses that make direct Federal taxation of wealth problematical. This is similar to the problem that existed in establishing an income tax, which was ultimately resolved by passing the Sixteenth Amendment. We will address this issue in Chapter 23, Implementation, including a way to collect this tax indirectly without raising constitutional issues. For now, please simply assume that a good workaround exists.
[*As before: $100,000 is a round number for purposes of illustration; the eventual number may well be different. Whatever the starting number, it should then be automatically adjusted every year for inflation.]
IV. A 1.5% Annual Tax on Net Business Assets Above $100,000*/Employee
Corporations and other business entities will also pay a 1.5% tax on net assets – aka owners’ or shareholders’ equity – in excess of $100,000* per FTE (full-time equivalent) employee. This means that a small business with $1 million in net assets and 10 full-time employees will pay no assets tax. On the other hand, a shell company or holding company with $1 billion in net assets and 2 full-time employees will pay $14,997,000 in assets tax.
Note: This approach to taxing assets can result in taxing some assets more than once. This is intended to create a disincentive for using nested chains of shell companies to hide assets and income, and generally to discourage complex and cumbersome corporate structures that are difficult to tax accurately.
This approach also creates a small disincentive for using contractors to replace employees, because each full-time employee saves an employer $1,500/year on the assets tax. And it creates a small disincentive for multi-billion dollar companies that pile up cash internally and pay little or no taxes.
Important Note: The 1.5% tax on assets (for both individuals and businesses) is balanced by a major reduction in the tax on profits, rents, royalties, interest, and dividends, the normal returns on capital. It’s important to understand that this is a change in the way capital is being taxed, not a sudden extra tax on wealth.
Currently, a wealthy person may face a combined state and federal tax rate of 45% or more on “passive income” like rents, royalties, interest, and dividends. Under the current proposal, that is lowered to a 15% maximum federal tax rate, plus state tax, plus 1.5% of the value of the capital itself.
When inflation is low, that can work out to a very similar amount of tax paid. But when inflation rises, investors are put in the position under our current system of paying taxes on illusory income, and may well end up with a negative after-tax return. Under the proposed system, the tax on purely inflationary gains would be greatly diminished or eliminated.
V. A 15*% Earnings Tax on Businesses & Corporations
*As before, this tax rate is a placeholder, but I expect that the final rate will be between 15 and 18%. It needs to be high enough (at least 15%) to discourage wealthy individuals from incorporating themselves as a tax dodge, or at least make it tax-neutral when they do. It also needs to be low enough not to discourage the use of the corporate form or give U.S. companies an incentive to move overseas or sequester foreign profits.
This tax applies to all “non-pass-through” entities. It is assessed on the firm’s net profit, defined as the gross income, minus other taxes and all legitimate overhead and other necessary costs of producing income. Research and development costs and other capital investments can be expensed, and losses can be carried forward. The same 15% rate applies to foreign income of U.S. companies, with adjustments as provided under existing tax treaties to avoid double taxation.
This replaces the recently-adopted nominal 21% corporate tax and the previous 35% rate, which was far above the norm for other countries and which caused some corporations to leave the U.S., or to move income overseas and hold it there to avoid U.S. taxes. The 35% rate was also so high that it created a major incentive for businesses to lobby Congress to create loopholes, corrupting the political process, and greatly increasing the complexity of the tax code. Most companies paid substantially less than 35% as a result, which made the high nominal tax rate pointless.
The 2017 GOP tax reform brought the rate down, but did not deal with the thousands of loopholes or the extreme complexity of corporate tax law. The proposed plan would reduce the rate even further, but broaden the base and create some important simplifications. For example, it would allow immediate expensing of capital investments, a major boon to growing industries and an incentive for increased investment, with the additional advantage of eliminating much of the the existing complexity and inconsistency governing amortization and depreciation.
In return for reducing the tax rate by 28% (from 21 to 15) and allowing instant deduction for capital investments, the proposed plan would eliminate deductions for rents, whether of money, capital assets, intellectual property, or real property. The goal is to eliminate the unequal treatment of dividends (which are not deductible) and interest, royalties, and rental payments (which currently are). This will remove the existing incentives for businesses to borrow and lease as much as possible instead of raising capital through stock offerings.
There was never any sound economic or policy reason for privileging interest over dividends, and the current system encourages excessive leverage, which makes our whole economy more fragile and prone to abrupt swings and crises.
Rents, royalties, and licensing fees are included in the change for three reasons:
First, doing so prevents people from gaming the system. Allowing deductions for rents and royalties, but not for interest, would invite a blizzard of deals in which non-deductible interest payments are mutated into deductible rents. (E.g., do I borrow the money to buy this machine, or do I get the lender to buy the machine and rent it to me instead, with some sort of complicated lease-to-buy arrangement that amounts to the same thing?)
Second, it prevents the easy transfer of taxable revenue from a U.S. company to an affiliate in a tax haven. Far too often, U.S. companies have transferred the ownership of properties and patents to foreign affiliates and then had the affiliates “charge” the U.S. company exorbitant rents and royalties. This will end that practice.
Third, it creates internal consistency, by treating all returns on capital alike for tax purposes. Thus, for example, all of these forms of income are exempt from the GST; they are returns on capital, which is taxed via the assets tax, and should not be regarded as payments for either goods or services..
Payments that will not be deductible from taxable income include:
- Interest (except for interest payments by financial intermediaries like banks), dividends, rents, royalties, and licensing fees
- Excessive (above market) payments for goods and services received from persons or entities connected in any way by shared or common ownership with the payor
- All payments made to manipulate the value of a company’s stock, including stock repurchases, futures contracts, purchase or redemption of derivatives, etc.
- Transfers of restricted stock, stock options, or other financial instruments that are illiquid or have an inexact or indeterminate present value
- Bribes and other illegal payments
- Gifts and donations (including membership fees, purchases of goods or services at inflated prices, and other dodges for circumventing these rules)
- The cost of lobbying, political advertising, and other activities intended to influence government policy on behalf of the firm
- Fines for illegal activity
- Any other expenses not required for generating present or future income or reducing present or future expenses
Corporations, businesses, partnerships, and other collective entities of all kinds will be required to follow Generally Accepted Accounting Principles (GAAP), modified as indicated above, for both tax and public disclosure purposes. In other words, the era of a business keeping two completely different sets of books and telling investors it has large profits while telling the IRS it actually has a loss for tax purposes is over. The only way a business can be highly profitable and not pay taxes will be if it has large losses to carry forward from previous years.
VI. An Escalating, Fully-Rebated Carbon Tax and Tariff
This has two parts, a tax and a tariff:
A. The carbon tax will start at $40/metric ton of carbon dioxide, and the equivalent for other greenhouse gasses. This rate will then increase by $3 per year until it reaches a scientific consensus value for the external cost of carbon. This is roughly equivalent to a 36-cent gasoline tax, increasing gradually to around 72 cents a gallon over 12 years. It is also equivalent to an increase in the price of coal-fired electricity of approximately 4 cents per kilowatt-hour in the first year, increasing gradually to 8 cents/kwh over 12 years. The equivalent increase for fuel oil will be less than for coal, and for natural gas it will be much less. Since most utilities get their power from a mix of fossil fuels, plus nuclear, hydro, wind, and/or solar, most individuals will see an initial rate rise that is between 1 and 3 cents/kwh.
Even though the level of the tax sounds low, it will generate a considerable amount of revenue. Just as importantly, the certainty of growth in the tax rate will significantly influence investments in conservation and power generation, “bending the curve” toward lower and lower emissions of air pollution, including carbon dioxide and other greenhouse gases.
Best of all, this is the kind of tax that everyone should love, a tax on “bads,” not on “goods.” Unlike normal taxes on income or consumption, these so-called Pigovian taxes have no deadweight cost and actually make the economy more efficient by internalizing an external cost. To the extent that they are returned to residents via a rebate or a reduction in normal taxes, they are highly beneficial, as close to a free lunch as anyone can get in a modern economy.
The rate of $40/tonne is based on the calculations done by the Climate Leadership Council (CLC). This group, newly formed in 2017, is not part of some “left-wing environmental conspiracy.” Its corporate founding members include giant energy and transportation companies like ExxonMobil, Shell Oil, BP, and General Motors, and it has the backing and support of multiple conservative economists, business leaders, and political staffers.
The CLC makes a strong argument for why action is necessary, and why a carbon tax is by far the best way to do it, in The Conservative Case for Carbon Dividends. The conspicuously conservative tilt of the organization and their proposal might raise suspicions about “greenwashing” – creating a faux-environmental program with the goal of deflecting attention – but the plan of action they’ve set forth is one that serious scientists and economists across the political spectrum have long advocated, and the $40/tonne starting level is not a low-ball figure.
I first described such a carbon tax system and the mechanism by which it could become global in an article I wrote in 2009. In earlier drafts of this chapter, I had cautiously proposed starting at a lower price ($25/tonne), with a more rapid escalation rate. But $40 is much closer to the consensus starting value among scientists and economists who have looked closely at the problem of climate change, the damage it can do to our economy and our lives, and the best way to ameliorate its impact.
The CLC’s climate proposal is designed around rebating the entire amount of the carbon tax on a per person basis:
All the proceeds from this carbon tax would be returned to the American people on an equal and monthly basis via dividend checks, direct deposits or contributions to their individual retirement accounts. In the example above, a family of four would receive approximately $2,000 in carbon dividend payments in the first year.
I have done the same thing by adding the carbon dividend (which, coincidentally, starts at around $40/month per person) to the monthly payments to residents in the CTC and CDA. As the rate increases, additional revenue will be divided evenly by the population and distributed through an increase in the CTC and CDA.
[Note: the tax and welfare spreadsheet above assumes that the rebate goes to adults only. In fact it should go to all legal residents.]
One important corollary to a carbon tax is the need to also phase out all fossil fuel subsidies. It is folly to tax something and then subsidize it, and it creates a wide-open invitation for legislative mischief and corruption. We should also consider letting mandates and subsidies for ethanol, solar, and wind power expire, since they will become much less necessary as fossil fuel prices rise. Reducing unnecessary subsidies also reduces government expenditures, allowing other taxes to be lower, a net win for the economy.
A second important corollary is the rollback of energy conservation regulations that tried to achieve the same carbon savings by non-market means. As the CLC put it:
The final pillar is the elimination of regulations that are no longer necessary upon the enactment of a rising carbon tax whose longevity is secured by the popularity of dividends. Much of the EPA’s regulatory authority over carbon dioxide emissions would be phased out, including an outright repeal of the Clean Power Plan. Robust carbon taxes would also make possible an end to federal and state tort liability for emitters. To build and sustain a bipartisan consensus for a regulatory rollback of this magnitude, the initial carbon tax rate should be set to exceed the emissions reductions of current regulations.
That would not mean lifting limits or regulations on polluters for emissions (like arsenic or fine particulates) that harm public health, but it would move greenhouse gasses like carbon dioxide out of the normal pollution category and give them special status as external costs to be reduced entirely by taxation and market forces, not by restrictive regulations.
Management by regulation creates bureaucratic and political uncertainty and imposes large deadweight costs on the economy, whereas a “Pigovian” tax like the carbon tax imposes no deadweight costs and provides a future path that people and businesses can plan for and count on. So eliminating extensive bureaucratic controls in favor of a tax is a large net win for the economy.
B. An escalating carbon tariff will also be levied on all imports in lieu of the carbon tax, except for imports from countries that have adopted an equal or greater carbon tax and a similar border provision. A further requirement for avoiding the carbon tariff will be the elimination of all government subsidies for fossil fuels.
I chose an initial import tariff rate of 2%* that increases by two percentage points per year thereafter. However, if the U.S. adopts a carbon tax and import tariff, I would expect all other nations to follow suit very quickly, and thus very few nations to be subject to this tariff after the first few years.
This 2% rate is preliminary, pending expert review of the trade implications and economic impact. It needs to be set just high enough initially to discourage companies from moving production to countries that have no carbon tax. Then it needs to escalate relatively rapidly in such a way that it will strongly encourage other countries to match our carbon tax.
As the rate escalates and more countries join the U.S. in imposing a carbon tax, the pressure on the holdout countries to join in will increase substantially. If we assume that Canada, Mexico, the UK, and the EU join us in a “World Carbon Tax Treaty” within the first three years, all other exporting nations will essentially be forced to join by the fourth year. Countries that do not join will face a 10% tariff barrier in the fifth year, rising to 20% in the tenth year, making their exports uncompetitive.
This differs from the border adjustment plan set forth by the CLC, which calls for applying that year’s per-tonne carbon tax rate as a tariff on imports and a rebate for exports, based on their “carbon content.” The problem with that scheme is twofold:
First, the “carbon content” of goods and (especially) of services is extremely difficult to determine with any accuracy. This will create limitless opportunities and incentives for fraud and add a great deal of cost and complexity to trade and to the Customs system.
And, second, it would be entirely rational for many poorer countries to continue using cheap coal with no pollution controls for their own domestic production and still pay the U.S. import tax. This would result in countries like the U.S. exporting not just pollution, but jobs as well, to third world countries. It would also seriously reduce the effect of the carbon tax in controlling climate change by letting third world nations effectively opt out and continue to pollute.
A uniform border tax on the total value of goods from non-compliant countries will a) be radically simpler to manage at the border, and b) be frankly coercive, forcing the rest of the world to follow our lead. As a result, we will end up very quickly with a uniform global carbon tax system that will produce a far greater reduction in carbon pollution, with much less distortion of the world economy.
VII. Federal excise taxes on tobacco, alcohol, & other legal recreational drugs
Existing excise taxes (e.g., alcohol and tobacco) should be continued. Marijuana and any other recreational drugs that become legalized should be taxed at the maximum rate that does not create a black market for the same or equivalent drugs.
VIII. A 0.05*% financial transactions tax
This is a small, but extremely efficient tax, and it would bring us more in line with other countries. It includes a derivatives tax of 0.005*% (one tenth of the main financial transactions tax rate). Its primary purposes are a) to reduce the churn rate for stocks, bonds, and derivatives, b) to reduce ultrafast machine trading that is unfair to ordinary investors, c) to stabilize financial markets by making them fairer and less volatile, and d) to pay part of the cost of creating secure and liquid markets for securities.
The tax on a sale of stock or bonds worth $1 million (or derivatives based on assets worth $10 million) would be only $500, not enough to matter to normal traders, yet the tax would generate significant revenue to help cover the government’s cost for overseeing, supporting, and sometimes rescuing the financial system.
IX. A $10* Federal Minimum Wage, Indexed to Inflation
Assuming an implementation date of 2020, I am going to peg this at $10, as that is nearly the minimum level that will produce the same inflation-adjusted after-tax income for a full-time minimum-wage worker. Further economic analysis may suggest a higher one-time increase to $11 or $12.
The basis for the $10 figure is as follows:
A minimum-wage employee currently receives $7.25/hour. Payroll taxes of 15.3% are imposed on that amount to fund Social Security and Medicare. Half of the tax is additive, supposedly paid by the employer, and half is subtractive, taken out of the employee’s take-home pay. As a result, the employer actually pays around $7.80 an hour and the employee actually receives around $6.70 an hour in take-home pay, and the government gets the difference, around $1.10 per hour.
Economists and policy experts all agree that the “employer’s share” is a legislative fiction, intended to disguise the amount of the tax. In reality, the “true” minimum wage is what the employer must spend, currently around $7.80/hour including the payroll tax. This means that the actual subtractive payroll tax rate is $1.10 ÷ $7.80, which is a bit more than 14.21%.
Since the GST functions like a 20% subtractive payroll tax, we can calculate how high the nominal wage (what the employer pays) would need to be to produce the same hourly take-home pay ($6.70 an hour) after deducting the GST. And in this case it would be $6.70/0.8, which is roughly $8.37.
2009 was the last year the minimum wage was adjusted for inflation. Looking ahead to 2020, an estimated compound inflation adjustment of 19.5% since 2009 is a reasonable projection. That would yield an inflation-adjusted pre-tax minimum wage in 2020 of almost exactly $10/hour. This would mean a minimum after-tax wage of $8/hour in 2020.
Compared with the current minimum take-home of $6.70, this is not much of an increase, especially considering inflation between 2009 and (hypothetically) 2020. So a $10/hr minimum wage (= $8/hr minimum take-home pay) should be considered a rock-bottom figure. However, history has shown that it would be better to set a lower number and index it to inflation than to set a higher one that is unindexed and remains unchanged for a decade or more, particularly if inflation increases at some point in the future.
It’s unclear whether the GST will affect consumer prices as well as income. To adjust the minimum wage for this, we would need to know the amount of any possible increase in advance. However, that would be nearly impossible without a crystal ball. Instead, we will be sweeping a small estimated adjustment for the GST into the “Citizens Tax Credit” (CTC), described in the next section. Any increase in consumer prices, whether due to the GST or to normal inflation, will be compensated for in the inflation adjustments to the minimum wage, the CTC, and the CDA at the end of the first year.
It’s important to understand how the CTC radically changes the minimum wage calculations. A single mother of two who is working full-time at minimum wage earns around $15,000 per year before taxes and currently ends up with about $21,600 after payroll taxes, child credits, and EITC. She may also qualify for Medicaid, depending on her state.
As we will see, the combination of a $10 minimum wage and the CTC would raise that to just over $31,000, including after-tax cash income and childcare, education, and child health benefits. She must pay for health insurance for herself out of that sum, so the net gain is lower than it looks, but it is considerable. If her personal health insurance costs $300/month, she comes out $5,800 ahead for the year after the new system goes into effect. Thus there is much less need for a radical increase in the minimum wage to ensure that it is a “livable” wage.
X: A $1,000*/Month Refundable Tax Rebate, or “Citizen’s Tax Credit” (CTC)
The CTC is the principal means for counteracting the regressive nature of the GST, the carbon tax, and other consumption and excise taxes. Along with the CDA, or “Child Development Account,” described below, the CTC plays a critical role in making the entire tax system progressive.
For purposes of discussion, I’m going to set this tax credit at $1,000 per month, or $12,000/year, plus about $40/month ($480/year) per person initially for the carbon rebate. However, this is a sensitive number for many of the calculations that follow, so keep in mind that the final number may need to be changed. And whatever the starting number, it should be indexed for inflation and increased to reflect each rise in carbon tax revenue.
The CTC will be deducted on a monthly basis from the GST each person owes on salary and other income. In the event that the taxes to be paid are less than the CTC, the difference will be paid by the government to the recipient, directly into his or her secure account as a supplement to income. (See Ch. 16 for details on secure accounts.) In this respect, the CTC functions like the Earned Income Tax Credit, but much more smoothly, since the supplement is paid monthly, not annually.
(Note: since the payment system is completely electronic, it’s entirely possible to set it up so that the CTC can be calculated weekly, biweekly, or semi-monthly instead, at the recipients option, to keep it in sync with an employees paychecks. For simplicity, however, I’m going to describe it as if it is always calculated on a monthly basis.)
To receive the CTC, a person must:
- Be a U.S. citizen
- Be at least 20 years old
- Reside in the U.S., or be employed by the U.S. government and required to reside outside the U.S. (e.g., soldiers and diplomats stationed abroad)
- Have a qualified U.S. bank account with a secure biometric identity
- Have qualified health insurance
The CTC and CDA are replacements for a wide range of existing tax deductions and credits as well as more than 80 means-tested Federal welfare programs and some current state programs. As we will see, most people actually end up better off – or at least no worse off – than they would be under the current system, even though the proposed tax/welfare system is approximately “revenue neutral.”
What goes away?
We’ll address this in more detail later, but some of things that get rolled into the GST, the CTC, and the CDA (described below) include:
- All tax credits and deductions, except deductions for necessary costs of earning an income; this specifically eliminates the personal, charitable, medical, and mortgage interest deductions and the education, childcare, and earned income tax credits.
- The alternative minimum tax, removing a much-hated complication for many high-income taxpayers.
- Payroll (FICA) and self-employment taxes; these will be replaced by the GST on income.
- All, or nearly all, “means-tested” welfare programs; these will be eliminated or drastically reduced in scope.
- Free Medicaid and Medicare. Recipients of the CTC who are eligible and choose to enroll in Medicaid or Medicare will be charged $500* or $700*, respectively, per month – still a considerable bargain. Normally this will be taken directly out of the $1,000 monthly amount of the CTC. (I’ll describe the interaction of the CTC with Social Security and its effect on retirees in a later section.)
- The ACA employer mandate. Most employers who provide health benefits will continue to do so, just to remain competitive, but when everyone has fully-funded individual coverage available through the CTC, an employer mandate is no longer necessary or appropriate.
- The ACA individual mandate (a fine for not having health insurance); this is obviously unnecessary when the price of not being insured is losing the entire $12,000 CTC.
States will have the option to place certain individuals under “supervised spending” by requiring the approval of a guardian or supervisory agency for the expenditure of funds from the CTC.
Besides the obvious cases – like individuals who are mentally incompetent or in prison – this might reasonably include individuals on parole or probation, people in drug or alcohol treatment, and people who, for whatever reason, are chronically homeless. So, for example, people who are released on parole might have most of their CTC money diverted to pay for health insurance and room and board at a halfway house, leaving a modest sum for personal expenses. After leaving the halfway house, their parole officers can ensure that appropriate amounts are actually spent on rent and food, not for other things.
I would expect states to experiment with a number of criteria for determining who should be under supervision and a number of ways to provide it. There will probably be wide variations from state to state, at least initially, as states experiment with what kinds of restrictions are acceptable or required. But some sort of supervision will be necessary, particularly for people who are legally incompetent and those who spend the whole CTC on other things and then turn up homeless and hungry.
Requiring a contribution to society
One problem with the CTC is that, if people are careful with their money, it is just barely possible to live on it, at least in lower cost areas, and at least for younger people who pay less for insurance. That’s intentional. We want to provide a minimum level of support for full-time students, people who are unemployed and looking for work, people who are disabled, and people who can’t work for other reasons.
However, the concern of some is that there would be some people who could work who will choose not to do so out of pure laziness if they have even a tiny income to live on. Although this is possible, I doubt that many people would do it for very long. Those who try it will discover that living at the current poverty line is no fun. Most people will want to have things they can’t afford on the $400 – $800 a month they would have left after paying for insurance. And as the cost of health insurance rises with age, even the most determined slacker will have less and less money to live on.
In addition, most people want to feel needed, and the social pressure to accomplish something can be powerful. Someone who is making a genuine contribution to society will always have more dignity and be treated with more respect than someone who chooses to do nothing.
Think about it. If your Uncle Ralph died and left you $1,000 a month in his will, would you quit your job? If you had no investments or other source of income, it’s unlikely that you would. And most research on cash stipends shows that a small side income has very little effect on people’s desire to work. Similarly, very few people would retire early if it meant they would have to live on only ~$500-800/month, after paying the cost of insurance!
Still, there will be a few layabouts, and voters generally hate the idea of letting people like that sponge off the rest of us. So one option for the states would be to expand the idea of spending supervision to include a requirement that everyone who can do something constructive with their lives must do so as a requirement for receiving the CTC.
Let’s take a hypothetical highly conservative state and suppose that once a month each unemployed person has to respond to a brief online questionnaire about their activities. And let’s say that this state has adopted a rule that every unemployed person who is not severely disabled must put in (and document) at least 125 hours a month of effort toward one (or a combination) of the activities on an approved list, such as:
- Education and training (specify degree plan and progress toward goal)
- Looking for work (specify type of work and employers contacted)
- Rehabilitation from a disabling accident or condition (specify progress)
- Self-employment (specify time horizon and plan for profitability)
- Volunteer work for an organized charity, school, government, or public institution
- Caring for one or more dependents (children, parents, or disabled persons)
In each case, the person would have to provide enough information (like names, dates, and times) to allow the state to spot-check claims that seem questionable, just as we do now with the job search requirement for people receiving unemployment.
(Why 125 hours? It’s completely arbitrary, and another state could easily pick another number. I picked it solely because ~30 hours a week seemed reasonable, and also because the minimum take-home pay is $8/hour after tax, and 125 hours x $8/hour is equal to the $1,000 they receive from the government.)
The state could then use software to track progress and identify students, jobseekers, and those doing rehab who are not making timely progress toward employment, so that the system can connect them with counselors or take other appropriate action. It could also connect stay-at-home caregivers and the disabled with opportunities to work or volunteer from home.
But, at least in this hypothetical example, there would always be the requirement to do 125 hours a month of something useful in order to continue receiving the whole CTC.
Personally, I think this degree of supervision would turn out to be unnecessary and counterproductive, but some such system would do several useful things. First, it would increase the legitimacy of the program in the eyes of many voters. Second, it would provide a goad for the timid and the lazy, pushing them to connect to society. Third, it would increase the self-respect of people receiving the CTC as their primary income. Fourth, it would generate a great deal of data about who is not employed and why. And, fifth, it would substantially increase the number of volunteers available to help beneficial organizations (charities, schools, and community programs).
In effect, a state that adopts a service requirement for the CTC is saying that if you are able to work, and you aren’t doing anything else constructive (like education or looking for work), then you must work at least part-time. And then it is asking beneficial organizations to provide the jobs while society pays the minimum wage salary.
Needless to say, this would open up opportunities for scams and there would be pressure on the state to establish rules for beneficial organizations and to check up on them periodically to make sure that claimed volunteer work is actually being done. How much, if any, of this kind of supervision is actually worth doing is a question that should be left up to the states. That will produce a range of programs in different states, so that we can compare the effects of different approaches over time and find out what works best.
XI. A $1,200*/mo Child Development Account, or “CDA”
The purpose of the Child Development Account (“CDA”) is threefold.
First, in combination with the CTC it will break the cycle of poverty by providing every child in the U.S. with – as nearly as possible – the minimum requirements for a basic middle-class upbringing in terms of nutrition, health care, and education.
Second, it will substantially reduce the high cost of childcare and education for working-class and middle-class families, particularly those where all adults work full-time. This is critical for increasing labor force participation rates, increasing productivity, and reducing the existing disincentives for having children.
And, third, it will help equalize educational opportunities across the U.S. by providing a uniform basis for a large part of the funding for public schools.
One primary goal of the CDA is to provide a universal child-care subsidy that allows all parents to work full time if they want to. To make this a reality, all childcare facilities, preschools, and schools that receive CDA funds will be required to be open full-day, five days a week, 52 weeks a year. Indeed, a large part of the point of the generous CDA funding is to compensate schools for extending the school day and school year so that parents can work full time.
Funds will be deposited by the Treasury directly into a CDA for each person under age 20. Each child’s legal guardian(s) can then use the money in the account to purchase services from a state-certified, age-appropriate development services provider (DSP) of their choice.
Depending on state decisions, this can include public and private schools, childcare facilities, an HMO, and a variety of hybrid organizations, like a healthcare provider that also provides health insurance and banking services and subcontracts with schools. The states can determine their own specific rules as long as they comply with broad Federal guidelines for effective and equitable distribution.
For children of different ages and in different places, the primary development services provider (DSP) could be:
- A bank, financial management firm, or health insurance company
- a clinic, hospital, HMO, or managed care organization
- a preschool, school, college, or post-secondary training center
- a composite entity having elements of most or all of those combined into one
- a parent or guardian, if permitted by the state
A DSP can provide all required services directly or contract with others to provide some or all of them, but the primary DSP must be responsible for cost management and quality assurance at all times.
For purposes of discussion, and again to keep the math simple, let’s assume that this payment is for a total of $1,200* per month per child. What it can be used for depends on a child’s age and particular circumstances, but that must include good nutrition and health care and a substantial contribution to the child’s education.
Prenatal care will be covered under the mother’s own insurance. In order to receive the CTC (or Citizen’s Tax Credit), one must be enrolled in a qualified health insurance plan. All qualified health insurance plans must provide for full prenatal care, including prenatal vitamins, maternal education, and other services that have been demonstrated to have a significant effect on the future child’s wellbeing, up to and including delivery and perinatal care.
[Note: this means that the states may end up paying for prenatal services and delivery costs for poor non-citizen mothers without insurance, as they do now through Medicaid. But this group should be small. If Congress wishes to avoid this, there are other ways of structuring payment for prenatal care as an advance on the CDA or by starting the CDA early, before birth. Each approach has advantages and disadvantages.]
The current birth certificate requirements for newborns in all states and territories will need to be updated to a uniform federal standard for biometric information, as noted below.
Each newborn must also have a bank account (the CDA) that is established at birth and linked to a secure biometric identity based on physical characteristics, a footprint, photos, and a blood sample. After birth, the funds deposited to that account can be spent by the DSP chosen by the child’s legal guardian(s) to cover medical care as well as baby expenses and home visitation (or the equivalent) to assist parents in learning to care for their child where necessary.
As the child grows, it will be necessary to update the biometrics whenever the child sees a doctor, which must be at least twice a year. When the child is old enough, the CDA funds can go directly to a daycare/preschool facility to allow the parent or guardian to work. Alternatively, the state may choose to pass part or all of the CDA payment to any parent who homeschools a child or sends the child to a private school and who demonstrates that all of the health, nutrition, and education requirements are met.
States may also implement ways for part or all of the CDA payment to be saved for future use. E.g., the state might opt to give only part of the cash value of the CDA payment to the parents of a child who is homeschooled or attends private school, and to allow the education portion of the CDA payments to accumulate as a college fund instead.
Why make the transition from CDA to CTC at 20 instead of 18 or 19?
First, most students turn 18 before graduating from high school, so setting the transition at the 18th birthday would catch those students before or during senior year, disrupting the payments to schools and jeopardizing senior year.
Second, some students turn 19 before graduating from high school, so setting the transition at the 19th birthday would also catch those students in the middle of senior year.
Third, setting the transition age at 20 will encourage students to get started on some kind of post-secondary education. If we allowed the transition to the unrestricted CTC at 19, some young people would be tempted to drop out. With the transition at 20, any 16-19 year olds who drop out will lose $14,400/year in benefits and face substantial additional costs for food and health care until they turn 20.
Finally, a transition at age 20 will encourage students to continue their education and encourage high schools and other institutions to offer a “post-graduate” year, with either vocational education, remedial courses for those who need them, or both. Alternatively, states could offer students the opportunity to switch from a conventional high school to a 2- or 3-year full-day vocational program after 10th or 11th grade.
XII. Social Security and Medicare
Current SS Recipients
Retirees with Social Security will receive both Social Security payments and the CTC of $1,000/month. However, the Social Security payments will be taxable as income under the GST (and subject to income tax for those retirees whose total income is high enough). Retirees will also have to pay $700/month enrollment cost for Medicare if they are not otherwise covered by health insurance.
For a retiree with Medicare and with an SS retirement income of $1,400/month, about the current average, this results in an adjusted income under the new system of $1,460/month, as follows:
+ $ 1,000 CTC
+ $ 1,400 SS income
+ $40 carbon tax rebate
– $ 280 (20% GST on $1,400 SS income)
– $ 700 (cost for Medicare)
Those with lower SS incomes will gain slightly more; those with higher SS incomes will gain somewhat less.
Eligibility for Social Security
Unless Congress chooses to substantially revise Social Security, I am recommending that workers accrue eligibility for Social Security as they would under current rules, using the first $75,000 of income subject to GST in place of the wages subject to the current FICA payroll tax.
Why $75,000? The maximum Social Security tax paid by both the employee and employer on behalf of an individual worker is currently 12.4% times $118,500, or $14,694. Rounding up slightly to allow for adjustments between now and the time of adoption, this gives us roughly $15,000. And the equivalent under the new system would be 20% of the first $75,000, which again is $15,000.
Other Pensions / Alternatives to SS
Since everyone will pay GST on income, no one will be able to “opt out” of Social Security under the new system. This may force some people to rethink the decision to pay into other kinds of retirement plans that were substitutes for SS in the past.
Benefits from other retirement plans (e.g., private pension plans, annuities, and military, state, and local government pensions) will also be counted as taxable income, just as SS benefits will be. In some cases, individuals with large retirement incomes that have been untaxed or taxed at favorable rates may find that the CTC does not fully offset the increase in taxes, and they may end up slightly behind. In most cases, however, the opposite will be true and individuals with non-SS retirement funds will break even or come out ahead.
Tax-Deferred and Post-Tax Investment Accounts
The new system primarily taxes consumption, not income. It therefore allows for unlimited tax-deferred savings and investments for most people. As a result, special tax-deferred investment accounts will be neither necessary nor beneficial.
Let’s take a married couple making $144,000/yr as an example. The GST of 20% on their salaries is $28,800, which is exactly equal to their $28,800 Citizen’s Tax Credits (CTC), so they pay zero net tax on their salaries.
If they spend 100% of their income, their consumption will include (indirectly) $28,800 in GST on their purchases. If, instead, they spend $100,000 and invest $44,000, they will pay (indirectly) only $20,000 in GST. The remaining $8,800 in tax is deferred indefinitely until they cash out their investments and spend the proceeds.
This provides a substantial incentive for ordinary people to save and invest. It also makes the existing tax-deferred savings and investments schemes that Congress has set up unnecessary and redundant.
New investment in tax-deferred accounts that have been funded with untaxed income, like the employer-sponsored 401(k) and the traditional IRA, will therefore be suspended. Existing accounts will continue under current rules (or whatever rules Congress sets for them). The proceeds from these accounts will be treated as taxable income whenever funds are withdrawn, but no new money can be deposited into an existing account once the new system takes effect.
Roth IRAs and other investment vehicles funded with after-tax dollars will also be closed to new investment. Proceeds withdrawn from these accounts will be subject to tax as ordinary income only after the original investment capital (adjusted for inflation) has been withdrawn.
Individuals can choose to allocate part or all of their $100,000* personal assets tax exemption to cover assets in these pre-existing accounts. Except for what is covered by that exemption, all assets inside of existing tax-deferred investment vehicles will be subject to the 1.5% assets tax, such tax to be paid from the assets within the investment vehicle itself wherever possible.
The goal here is to gradually clean up the profusion of tax-deferred retirement accounts without harming those who have already invested in them. Shifting the primary tax from income to consumption already allows individuals to make a largely tax-deferred investment: money that is invested is – by definition – not spent on consumption, and therefore is not subject to the GST on consumption until later, when one chooses to cash out.
XIII. Gift and Estate Taxes
The current inheritance tax system creates large inequities. To rectify them, I am proposing a change in which there is no free “step up” in basis for assets, but the rate paid on bequests is determined by the recipients’ tax status, not the size of the estate:
- The current annual exclusion governing the gift tax will be retained, as will the exemptions for spouses and for educational and medical expenses. Gifts to individuals and non-exempt organizations above the maximum exempt amount will be treated as earned income for GST and income tax purposes. The responsibility for paying tax on gifts will shift from the donor or estate to the recipient.
- Estates must pay the 20% GST on the unrealized inflation-adjusted capital gains for all assets. (In return, the existing 40% tax on large estates is abolished.)
- Bequests to individuals will be treated like other gifts, but may be spread over five years. (The current gift tax exemption is $15,000 per year for each giver and recipient. Thus, an estate will be able to give $75,000 tax-free to each recipient. Bequests above that limit will be taxed as income to the recipient.)
- If a trust is established by an estate for a dependent who is under the age of 25, payments to or on behalf of the recipient each year will be treated as gifts until age 25 (with the normal gift tax exemptions, including exemptions for educational and medical expenses). The balance of the trust at age 25 will then be treated as a single bequest, which may be spread over five years.
- Trusts for severely handicapped or disabled individuals work as above, but have no upper age limit.
- Gifts to qualified charitable organizations will be neither taxable nor deductible. However, the donor or estate must pay the 20% GST on any unrealized inflation-adjusted capital gains before transferring non-cash assets to a charity or trust.
Ch. 18: Effects of the Proposed Reforms
Effects on Individuals and Families
[Warning! This chapter is in the process of being rewritten, and the sections that follow have not been updated completely to reflect the numbers used in the preceding sections.]
I will analyze the effects of these reforms in greater detail in later chapters, but I think it would be useful at this point to provide a quick overview. The first important question is the effect of having a higher payroll tax (20% instead of 15.3%) in combination with the CTC, and how that compares with the current system of taxation for most Americans in the lower three quintiles.
Note: In the graphs below, the X-axis is pre-tax income, and the Y-axis is the corresponding after-tax income.
As you can see, the green line (after-tax income under the proposed system) tracks above, but remarkably closely with, the red line, which uses multiple tax brackets and complicated tax tables to achieve nearly the same results under the current system.
I have used only the most basic tax deductions to determine current after-tax income (the red line). In practice, most individuals would take advantage of more tax breaks under the current system, and the red line would be even closer to the green one, especially toward the upper end. Some individuals making more than $150,000 a year who use the tax code aggressively currently have after-tax income that is a bit higher than the green line.
The results for childless couples are similar. However, parents who are working full time while raising young children are a different story. They come out substantially ahead if we include the cost of daycare and preschool in our calculations.
For example, the green lines in the following graphs show the results for a single parent and a married couple, each with two preschool children receiving the CDA. The red lines in the following graphs show the results for the same parents taking full advantage of existing deductions, child and child care credits, and the EITC if available:
A crucial point mentioned above is the requirement that childcare facilities, preschools, and schools be open full-day, five days a week, 52 weeks a year if they are to receive funding via the CDA. Thus the substantial increase in the gap between the red and green “after-tax income” lines in these two graphs is due in large part to the CDA allowances that will cover most or all of the current childcare and preschools expenses for these parents.
Except for the relatively short period when children are under 5, the advantage of the current system for parents is much smaller. (I.e., the proposed system would effectively add the value of “wrap around” after school and summer school programs to the incomes of parents with older children.)
We will look at the details in Chapter 21, but, in brief, the goal in doing this is two-fold: first, to substantially increase learning opportunities for children, and second, to provide universal full-day childcare, freeing their parents to work without facing crippling childcare expenses.
With that in mind, here are some examples:
Alan is a 20-year-old full-time student with no job. Under the current system, he receives $8,650 in tuition assistance, food stamps, and low-income education grants, minus $660 in state and local taxes, or $7,990 in after-tax purchasing power.
Under the new system, he gets $12k/year from the CTC and spends it all on tuition, room, board, books, personal expenses, and health insurance. He ends up $1,810 better off in after-tax spending power, but this is almost exactly the cost of his health insurance. So his net gain is that he is now covered by insurance and he no longer has to apply to multiple sources, fill out multiple forms to apply for assistance, and comply with complex rules in how he uses the funds.
To be conservative, I am assuming a 10% price increase as a result of passing the GST. For reasons already stated, it is unlikely to be that high.
Take-home wages: $0
CTC (tax credit) $12,000
Total After-Tax Income: $12,000
GST on spending: $1,200 (10% of $12,000)
Net purchasing power*: $10,800
Net gain in purchasing power*: $3,010
*“Purchasing power” is net after-tax income including benefits, minus the state and local taxes paid under the current system, and minus the GST under the proposed system.
Barb is a single mother of two children, aged 2 and 4. She works a part-time minimum wage job, averaging 26 hours/week. In a year under the old system, she made ~$10k in wages and received ~$12k in cash (including the Child Credit and Earned Income Tax Credit), food stamps, and other benefits from the government. She paid ~$1,450 in FICA and other Federal, state, and local taxes and spent ~$4,500 on babysitting services when she and her sister had overlapping shifts and could not watch each other’s kids. This left her with ~$15,950 in cash and in-kind after-tax income.
Under the proposed system, assuming she doesn’t save anything and doesn’t work any additional hours, she will receive ~$11,040 in take-home pay, plus $12,000 in CTC, or $23,040, minus ~$4,608 GST on consumption.
Under the new system, her children will be receiving high-quality nutrition 5 days/week at preschool or daycare. She spent roughly $1100/child/yr (excluding sales tax) for a barely adequate diet under the old system, so the food subsidy will save her five sevenths of $2,200, which is an additional ~$1,570 in purchasing power a year.
This leaves her with ~$19,200 in after-GST purchasing power for food, rent, and everything else, a net gain of $4,244.
Take-home wages @ $8/hr: $11,040
+ CTC (tax credit) $12,000
Total After-Tax Income: $23,040
– GST on spending: $4,608 (20% of $23,040)
+ Food savings from CDA: $1,570
Net purchasing power: $19,194
Net gain in purchasing power: $ 4,244
In addition, her childcare needs are entirely met, giving her the opportunity to increase her hours. If she works 2000 hours (40 hours/week for 50 weeks) at $10/hour, she will receive $16,000 in take-home pay, plus $12,000 in CTC, or $28,000 in after-tax income.
If she saves $3,000 and spends $25,000, she will pay $5,000 in consumption GST, leaving her with $20,000 in post-GST purchasing power, plus $1,570 for the food subsidy, or $21,570 of after-GST purchasing power, plus $3,000 of savings, a gain of $6,620. In addition, her chances of moving up from minimum wage will increase substantially when she is working full time.
Whether her hours change or not, she also has gained four important benefits:
- Her kids are getting all of their health care costs paid and are receiving higher-quality nutrition, which can reduce their future health costs. So she will save an unknown amount in present and future medical costs.
- Her kids are now receiving high-quality, full-day, full-year preschool education. They will be much better prepared for school and much more likely to be successful in life, greatly reducing their future burden on her.
- Instead of being immobilized by the amount of time it takes to get subsidized housing and welfare benefits in a new location, she is now free to move to a different neighborhood or an entirely different part of the country in search of a better job and a better place to raise her kids.
- She is now free to marry the father of her children, which she could not do before without losing her housing subsidy and most of her welfare benefits. If she marries him, his income and CTC will add to her household income.
Bo and Barb are Barb and the father of her children, now married and 10 years older. Their kids are 12 and 14. Bo is a security guard making $12/hour. Barb is now making $13/hr at a retail store. Both are working full time. Their combined after-tax income under the new system is ($12*2000 + $13*2000) * 0.8 + $24,000 = $64,000.
It is harder to compare their current situation to what it would have been under the old tax and welfare system because they probably wouldn’t be married or still together and because they would probably still be living in Barb’s original community, with fewer job opportunities and lower wages.
By the most conservative estimate, by joining forces as parents, by moving to a better location, and by being able to work more hours, they are financially better off by at least $24,000/year under the new rules than they would have been. More importantly, their kids are growing up in a middle class environment with much greater chances of finishing high school, of going to college or getting technical training, of marrying and staying married, and of having good careers.
Carl and Cassie are married and have a 3-year-old and a 6-year-old. Last year, Carl, a 29-year-old skilled welder, made $36,000 and Cassie, a 28-year-old retail assistant manager, made $32,000. They put $10k into their 401(k)s, paid $10k on their mortgage, spent $12k on childcare, and paid $8k in Federal, state, and local taxes after all deductions and credits. After subtracting those expenses, they had $18,000 in disposable income, enough for food, clothing, transportation, and necessities, but not much else.
Under the proposed system, they would each receive a 7.65% pay increase as their employers are no longer paying for 50% of FICA, giving them a combined gross income of $73,202. This will translate into after-tax take-home pay of ($73,202 x 0.8 +$24k) or $82,562. Subtract $20k in investments ($10k for a stock fund and $10k for the mortgage payments) and then subtract 20% of the balance for GST and they will have $50,049 in net after-tax purchasing power.
Their former childcare costs are no longer necessary. In addition, we need to add a food subsidy, though it should be smaller on the assumption that their former daycare arrangements provided some meals. Valuing the remainder at $800, minus 20% GST, saves Carl & Cassie another $640 in purchasing power.
They have $40,000 in equity in their home, cars worth $8,000 and $12,000, other possessions worth $10,000, $5,000 in their bank accounts, and no debts besides their mortgage, so their net worth is $85,000 and they owe no assets tax.
All told, Carl & Cassie come out ahead by more than $19,000 in purchasing power, largely because they no longer need to pay for preschool and childcare. Families at the same income level with older children would still come out ahead, but by a much smaller margin.
This illustrates an important point: In addition to helping the poor, the proposed system provides a significant boost to blue collar and middle class families with small children and low-to-moderate incomes. Our current system places a relatively high burden on such families at a vulnerable time, taxing young two-worker families for whom effective childcare is a major expense.
Ed and Eva are 55 and 52, married with grown kids and no dependents. He nets $160k per year as a lawyer and she nets $200k as a surgeon. They have $500,000 in equity in a condo, plus cars and other possessions worth $200,000, and investments worth another $2,000,000, on which they received $25,000 in interest and dividends, as well as a net realized capital gain of $20,000.
Under the current system, they maximized their retirement account deductions at $48,000. With deductions for mortgage interest, medical expenses, donations, etc., they were able to reduce their taxable income from $385k to $241k, plus the $20k capital gain. Their total federal, state, and local tax bill, including income, capital gains, self-employment, property, excise, and sales taxes came to just under $139,000, leaving them with $266,000 in net after-tax income.
Under the proposed system, their income account would look like this:
Net work income: $360,000
Interest and dividends $ 25,000
Capital gain: $ 20,000
Total income: $405,000
Out of that, they will pay:
GST on work income: – $ 72,000 (20% of $360,000)
5% of income >$160k: – $ 11,250 [5% of ($385k – $160k)]
GST on capital gain: – $ 4,000 [20% of $20,000]
1.5% of assets >$200k: – $ 37,500 [1.5% of ($2.7M – $200k)]
Citizen’s Tax Credit: + $24,000
Let’s assume they invest $48,000 (as before), make $42,000 in mortgage payments (not subject to GST), and spend the remaining $214,250. In that case, they will pay an additional $42,850 in GST, leaving them with a total tax bill of $142,400.
Compared with their previous tax bill (~ $139,000 for all taxes at all levels), they end up paying $3,400 more in taxes, but save considerably more than that in tax planning, accounting, and tax preparation costs, including a large amount of their own time saved.
The current tax code provides many tax deductions and credits that become increasingly valuable as you move up in income. Under current rules, Ed & Eva pay an effective rate of less than 20% in federal taxes. And this is by no means extreme, since they have not pushed the envelope in terms of deductions.
The math that favors low- and moderate-income couples with young kids smoothly transitions to higher effective rates. Compared to the current tax system, this will tend to penalize high-income couples with no kids somewhat.
Still, the increased burden is small or negligible for most of the couples in the top 10%, particularly given the reduced cost of tax compliance. In addition, it’s worth remembering that the same couples being taxed a little more at a later stage in life would, under these rules, have benefited from much lighter taxation and a major childcare subsidy when they were younger and needed it more. Most families would prefer to have more help and a lower tax burden in their 20s and 30s and pay a somewhat higher rate in their 50s.
Effects of the Proposed Reforms on Poor Communities
One of the most insignificant-looking parts of this reform package will actually have a major effect on poor communities. This is the LTP, the local tax payment of $300*/person/month to the community in which each adult resides.
Whether we are talking depressed coal towns, poor rural communities, rust belt cities in the Midwest, or poverty-stricken suburbs like Ferguson, MO, the common denominator is a community trying to make ends meet with a tax base that cannot support even minimally adequate schools and community services.
The result is typically a community with bad schools, run-down facilities, inadequate policing, and high levels of crime, pollution, and corruption. Many of these communities resort to “policing for profit” in desperation, focusing the police and municipal courts heavily toward collecting fines and fees and confiscating property because it is the only way to keep the lights on at city hall. But this creates a spiral of hostility that further depresses property values and often chases away those residents who can move, reducing the tax base still further.
In many cases, these communities are attempting to provide adequate police protection and municipal services on total revenues of less than $1,000 person per year, and it can’t be done, especially in smaller communities. No amount of police reform or anti-corruption enforcement can change that as long as the tax base is simply not there. And as long as the municipal system is underfunded and failing, the tax base will remain low because no one wants to live in dangerous communities with poor services. (School financing is a separate issue, one I will deal with later.)
The difference the LTP makes can be considerable. To use a fairly obvious example, in 2016 the City of Ferguson, MO had a population of around 21,100, of whom approximately 14,500 were 20 years old or older. It was sliding toward bankruptcy even before Michael Brown was shot in 2014. Its 2016 budget forecasts revenues of less than $18 million and expenses of more than $24 million, in spite of stringent cuts to all departments. (For comparison, the average revenue base for a city this size is around $76 million.)
City revenue from fines was slashed more than 50% because of a consent decree with the Justice Department, settling the charge that the city had been engaged in “policing for profit” in illegal and abusive ways. If Ferguson continues on its current path without substantial help, it faces continued deterioration to infrastructure and services, which will reduce its tax base still further. [https://www.fergusoncity.com/DocumentCenter/View/1849]
Under the proposed reforms, the city will receive $3600 per year per adult resident in LPT as its share of the GST revenue. That means that, with 14,500 people aged 20 or more, the city will receive $52.2 million in revenue from the GST and lose some or all of its sales and property tax revenues of around $8.6 million.
Depending on how Missouri chooses to revise its rules for intergovernmental (IG) taxes and transfers, the city could lose as much as $1 million in that category as well.
Since most of the residents of such communities are poor, the CTC and CDA will result in increased after-tax income for most residents and will generate a comparatively large increase in the cash flowing into the local economy. This will boost sales and business revenues and may have a considerable effect on municipal income. However, these effects are hard to estimate, so in the interests of presenting a conservative balance sheet, I’m going to leave such secondary increases out of the picture.
Using the most pessimistic assumptions, this would result in revised municipal income as follows:
Current estimated income: $17.7 million
Minus sales taxes: $ 6.3 million
Minus property taxes: $ 2.3 million
Minus IG transfers: $ 1.0 million
Subtotal: $ 9.1 million
Plus GST sharing $52.2 million
Total: $61.3 million
Compared with $17.7 million, $61.3 million sounds like a big increase – and, for Ferguson, it definitely would be – but it would still leave the city far below the average revenue per capita for local government in the U.S. (In 2015 an average city of the same size had municipal revenue of roughly $76 million.)
Nevertheless, this simple reform – collecting tax at a national level and distributing a small part of it on a uniform per-capita basis to local government – would make it possible for the first time for cities like Ferguson to provide a level and quality of policing and other city services that most Americans would regard as an acceptable minimum. It would be enough to fix potholes, clean up parks, expand the police force, adopt a “community policing” model, greatly reduce crime, make the community feel livable, and put the city on the path to recovery, reversing its current spiral into ever-deeper poverty.
I’ve used Ferguson as an example because of its recent notoriety, but I could have used any of thousands of other poor communities, including rural towns that are losing population, barrios along the Rio Grande, isolated towns in the Ozarks or Appalachians, and blue collar towns where the mill, mine, or factory has closed.
For example, Keyser, WV has a city budget of around $368 per adult resident. According to multiple websites, it has one of the lowest average per capita incomes and highest crime rates in the state. Like Ferguson and many of these communities, it appears to be sliding toward bankruptcy. Councilman Terry Liller was quoted in a local paper as describing the town’s economic struggles as follows: “The belief that we can somehow economize our way to solvency is a myth…,” he wrote. “Unless we consider drastic measures that will injure the city……like eliminating streetlights, reducing street maintenance or (God forbid) eliminating police protection in the face of ever increasing crime rates, the opportunities are slim.” [http://www.newstribune.info/article/20150821/news/150829924]
Keyser’s revenue base is now about 5% of the national average on a per person basis. With the LTP, it would be roughly 50% of the average – not a lot, but enough to keep the lights on, provide basic services, fix the streets and sewers, drastically reduce crime, and make it a viable community.
A lot of these places are “Trump country.” All of them are in the same trap: the local tax base is too small to support minimally acceptable services, so few people choose to live there if they have the money to move out. That, in turn, depresses property values and total sales revenue, which keeps local tax revenue low and perpetuates the cycle.
Deep, persistent, generational poverty is a matter of poor communities, not just poor families and individuals. The fundamental problem with using local taxes to fund local government is that it allows community poverty to spiral downward into hopelessness and helplessness. To fix the deep inequality afflicting these communities, we need to create a “safety net” not just for individuals and families, but for local governments, to ensure that they have a stable minimum revenue source that is proportional to population and adequate to provide basic services. The LTP will do just that.
The benefits of comprehensive tax and welfare reform on this scale will be immense and far-reaching. The increased efficiency and reduced deadweight cost of tax compliance alone would make it worthwhile in terms of increased economic growth. But, as I’ve shown here, the effects on inequality will also be profound.
Poverty, as we currently define it, would be eliminated at a single stroke. Poor and middle class families with children would be able to manage much better. And children of all economic classes would have access to the basics of a middle class upbringing, from quality early childhood education to health care, good nutrition, and year-round opportunities for learning.
Best of all, the numbers actually do add up. We can do this without “busting the budget,” increasing the debt, adding yet more bureaucratic government programs, or dramatically increasing taxes. We are already spending over a trillion dollars a year on ineffectual bureaucratic welfare programs. The cost is closer to $2 trillion if we count the cost of tax compliance and tax-incentivized inefficiency. We should not be surprised that designing a coherent system from the ground up yields better results than the accumulation of a century of contradictory and expensive “fixes” that were created piecemeal, without any coherent plan.