Thursday, November 11, 2010

Game On!

Wow.  The Presidential Commission on Reducing the Public Debt released its draft proposal today and it really puts a lot of options on the table.  Here's a New York Times article summarizing some aspects of the plan.  This could be the start of a very large discussion that changes the fundamental operating parameters of tax-and-spend government.  Or else it could be a flash in the pan like President Bush's bi-partisan, blue-ribbon tax panel in 2005.

Will the new proposal actually be the catalyst for serious change - or will it operate much like the Bush panel - proposing great, practical ideas that are really for the best long term interest of the country, but get summarily ignored because politicians don't want to risk telling voters that they will actually have to pay for the benefits that they are getting?  Let's take a look below.

From the beginning, we note that the Obama commission plan goes far beyond the mandate of the Bush plan.  The Bush plan was limited to taxation.  The Bush commission had two mandates: 1) tell us the best tax structure for economic growth, and 2) tell us the best structure that still maintains the "progressive" nature of the current tax code that taxes harder working people more.  The Bush panel reported (in agreement with commonly accepted economic principles) that the best tax system for economic growth was a tax on consumption, not on income - for example a national sales tax or a Value Added Tax (VAT).  For those that don't know, a VAT is similar to sales tax, but while a sales tax only imposes a single tax on the transaction from retailer to consumer, the VAT imposes smaller taxes on the increases in the value of the product as it moves through the supply chain.  For example, if the eventual product is a stick of gum, the manufacturer will be taxed based on the difference between the commodity prices it pays and the prices of the goods it sells to the distributor.  The distributor is then taxed on the difference between what it pays the manufacturer and the price it gets paid by the retailer.  The retailer is then taxed on the difference between what it paid the distributor and what it charges the consumer.  In operation, a VAT acts much like a sales tax, but it minimizes much of the tax fraud associated with a sales tax so that the actual tax imposed on the consumer is slightly lower.

However, even though that system would increase our economic activity - making a bigger "pie" for everyone - it is politically dangerous because our current political system uses the "progressive" nature of the tax code as a political myth that the "rich" are paying more in order to make average taxpayers more comfortable.  As for me, I am behind whatever is best for the country as a whole in the long term - and I very much believe in treating people equally.

Taking a look at the current proposal, I note that it has several aspects that are very reasonable.  It also is careful to postpone implementation for a couple of years until we are on firmer financial footing.  In this regard, I note that every dollar that we "stimulus" away now is going to have to be paid for with interest in the future - and I grind my teeth in frustration about that - but the negative consequences of allowing the economy to fall into deflation are really, really bad - in virtually every example, it creates a self-reinforcing downward economic spiral that yields great pain for decades.  Consequently, I know it is expensive now - and I certainly don't agree with the particulars of several stimulus plans - but I agree in principle that we need to use government intervention to prevent a deflationary meltdown.

As I mentioned above, one thing that is well known is that consumption-based taxes are economically better than income-based taxes.  So if you value the long-term health and growth of the US, you should be favoring consumption-based taxation.

In this regard, I see several aspects that are appealing:
  1. Upping the Federal gasoline tax from 19 to 34 cents/gallon in order to make the Department of Transportation revenue-neutral.  As you can see, this is obviously a consumption-based tax.  In that regard, it replaces the funding that the Department of Transportation would have received from income-based general revenue with consumption-based taxation, which is a move in the right direction.  Also, it seems more balanced because the bulk of the DoT's spending is subsidies to states to build and maintain roads and highways.  The question of whether the DoT should operate the way it does is a larger issue, but at least this seems like a step in the right direction.
  2. Elimination of the "Earned Income Tax Credit".  This provision is really a welfare provision hidden in the tax code wherein some people get back far more than they actually paid in taxes.  If you want to implement welfare, do it separately.  This just distorts the tax code and moves us away from consumption-based taxation.
  3. Cutting defense spending - We spend 10-50 times as much on defense as comparable first-world countries.  We spend far too much.  Additionally, while there is some continuing economic benefit in that research for defense may be used to design products that are useful elsewhere (like GPS), overall the bulk of our current spending does not produce an economic return.  Cut defense spending at least in half - keep the research.
  4. Eliminate Farm subsidies - Like defense spending, there is some limited economic benefit, but overall farm subsidies have been pitched as payments to small farmers (and were in the beginning - and were useful to prevent massive labor displacements away from the farm - and unemployment - when commodity prices shifted).  However, the payments are increasingly not economically justifiable with the substantial elimination of the small farmer and the global connection of the commodities market. 
The plan also includes some provisions for Social Security reform, but that's a story for another post!


  1. There is a reason Lawyers do not come from econiomics. Consumption taxes disproportionately hit the poorest and lead to greater disparities in wealth -- not good for social stability.

  2. 1:17 - Thanks for the comment! This should be a lively debate. I acknowledge that your comment - that consumption taxes hit the poorest disproportionately - is the commonly stated argument against them. However, if everyone pays the same tax when they buy their box of corn flakes, it's hard to say that the tax itself is disproportionate - it's absolutely equal for everybody. One argument that the tax is disproportionate is that poorer people actually spend 100% of their income while others may only spend 90% of their income - so some of their income thus escapes (immediate) tax!

    In reality, many countries have a VAT and are able to manage it while still maintaining great social stability - for example the Nordic countries. Here's a link to wikipedia's page on it:

    I am open to discussions about implementing some sort of program that reimburses all citizens for a portion of VAT taxes - or taxes different classes of goods at different rates. However, none of that changes the essential aspect of a VAT - that is it consumption based and that it is equal for all citizens.

    It's working pretty well in a lot of places in the world - why not here? Also, if we are going to bash the idea because I am a lawyer - well, how are the majority of people in our congress any better equipped to make these decisions than I am? Or you are?

  3. Some thoughts:

    (1) Reading your earlier post, I favor either an increase in capital gains taxes (esp. given how hedge fund managers are compensated), or more tepidly, eliminating the distinctions b'ween income/capital/wealth in the tax code altogether. Alternatively, I've heard interesting things of wealth taxes (never popular) and land value taxation.

    (2) An alternative to VAT vs. income tax is to combine the best of both. Years ago I read a proposal that suggested instituting VAT but starting the lowest income tax brackets at, like, $75,000 per year. The benefit is both progressive income taxation and less work preparing returns for working class Americans and the IRS. There'd be issues around the $75k break-point, however.

    (3) I'm curious to see how much Congress would willingly reduce military spending. One sore point I have (aside from occupying two foreign countries for trillions of dollars) is how defense contractor executives and directors can make multi-million dollar salaries when some make 90% of their revenue from the federal government.

    (4) While there are other issues that could be resolved (e.g. publicly funded drug research or better government-funded healthcare), one thing the deficit commission overlooked is the US's balance of trade. Trade Deficit = Budget Deficit + Private Spending. Steps to reduce the trade deficit, i.e. a weak dollar, would produce more national savings for both the private and public sectors.

  4. Hi LSTB,
    Interesting comments! With regard to your first point, I still favor a consumption vs. an income tax due because it seems pretty clear to be better for the economy in the long run. However, if we had to stick with an income tax, I can see the equality in taxing all income the same - salary income and investment income. I don't really like the idea of a wealth tax, though. If someone lives below their means and saves money when someone else spends it, I don't feel right that we should tax away that money. It just doesn't seem to send the right message.

    With regard to your second point, I think that it would depend in part on how it was exactly structured. For example, if 95% of the tax collected is still consumption based, but 5% is income based, then it seems like we still have the advantages - but if that's the other way around, then we don't.

    With regard to your third point, I am less irritated with what they take home in salaries and more concerned with the long term benefit to the country as a whole. It seems like we are paying in a lot of money, but it doesn't raise our GDP because the products are mostly only sold to the government. Tax dollars go to build businesses to sell things that are only bought with tax dollars. Instead, we need tax dollars going to build businesses that sell things overseas or increase our domestic productivity.

    With regard to your fourth point, I think that you are very much right that the trade deficit is a huge issue - and it is not directly addressed by the proposals. With the US's trade deficit as it is, hundreds of billions of dollars are leaking away from the country every year. However, it might be taking it a little far to postulate that the weakening dollar would produce more savings - especially in the private sector. Also, there are so many factors in play with the trade deficit that I think it is beyond the panel's mandate.

  5. Yes, nordic contries have a VAT -- some are over 25%. But they also have an income tax that is substantial. The enactment of VAT was to address a culture of tax evasion. Consumption taxes are inherently unstable, rising in good times contracting in bad, another reason to avoid thier use.
    I can defer purchasing a 36ft sailing sloop or purchase it overseas in a place of lower sales tax or none at all. A poor person spends all his income on lentils. I win, the poor is catfood.

  6. Wow - stop there folks. VAT is basically regressive, not because it is equally charged to the poor, middle class and rich, but primarily because the poor don't pay income taxes. With VAT they will start to pay their 'fair' (? - TBD) share - a higher marginal tax per additional dollar of income.

    I believe that VAT is the fairest tax, because the individual pays taxes to the extent that they spend money, not to the extent that they make money. Even the poor should pay tax, even when their expenditure is entirely funded by Social Security.

    VAT is an expenditure tax pur sang.

    That is the reason why the Nordic countries have a high VAT rate - the VAT entirely funds the excellent Social Security system (including healthcare) there.

    So yes, a significant chunk of the Social Security spend is recouped as VAT. (Not 25% of the Social Security, because there is no VAT on housing.)
    Because the poor pay no or little tax, the government can not provide income tax credits to cushion the regressivity of VAT. The proposed "VAT reimbursement" should work through Social Security.

    It would be nice if the income tax for 'lower' income (< $250,000) would decrease, so that income tax works contra-regressive to VAT.

    Managing Partner, VAT is not at all a tax on businesses - a manufacturer, distributor is not "taxed" by VAT as you note in your post. Only the individual end consumer bears the burden of the tax - the VAT 'flows through' the supply chain. Compliance and reporting, however, is all on the businesses' nickel. No doubt that a US VAT will cost billions to US businesses - but that are compliance costs, not the tax itself. From my perspective, the major difference with sales tax is that VAT captures all supplies, goods and services, with narrow if very few exemptions. Sales tax is a mess / hodgepodge of rates, exemptions and pork - VAT is the big equalizer.

    Have a look at and my blog at if you are interested.


  7. Hi Mark,
    Thanks for the great comment! Having VAT work through Social Security is also an interesting idea. With regard to the VAT - you are certainly more knowledgable than I - and I agree that the net effect of the tax is felt by the higher goods prices to the consumer - like a sales tax. Forgive me if my example was simplified or wrong, but it's my understanding that companies have to pay the difference between what they collect in VAT vs what they spend in VAT to the government, no? I certainly agree that the VAT seems like a great equalizer.

  8. Hi MP,

    Thanks for the swift feedback. Yes, you're correct in saying that companies have to pay the tax man the difference between the VAT on their sales (output tax) and the VAT on their purchases (input tax).

    Don't forget however that the VAT is added on top of the net sales price. Say that a widget is sold for $100 - with 15% VAT the output VAT will be $15 and the total price payable to the seller will be $115. The seller reports the $15 as output tax (and pays the tax man $15 if there is no input tax credit).

    The buyer, if it's a business, will reclaim the $15 he paid to the seller as input tax. The widget will appear in the buyer's inventory with a $100 value. VAT is thus a flow-through - not a tax cost to the businesses in the supply chain.

    At the end of the supply chain is the end consumer. He will pay $200 for the widget and $30 VAT on top of it to the retailer. He is not a business, so no input tax credit.

    Alternatively, if the widget is exported from the US, no VAT is due (the export VAT rate is 0%). When the widget is imported in the country of arrival, import tax is due and the supply chain continues, as does the flow-through.

    The interesting thing though is that at any point the business has to manage a VAT flow that can be up to 30% of the sales (15% VAT management on the purchases and 15% on the sales). So when your annual gross sales are say $10 million - there is $3 million worth of VAT running through your books. Still, VAT is not a cost!