The Ramble: A balanced approach to balancing the budget (Part 2)

This is the second of a 2-part post about how I think we should balance the federal budget.  Part 1 dealt with cutting federal spending, and you can find it here.  This post looks at raising taxes.


Taxes.  What a terrible word.  I instantly think of endless and incoherent forms, mixed with the feeling that someone is taking my money from me.  It's a terrible cocktail of frustration and anger.  Because we are so easily riled up, I think we tend to hear a lot of sound bites about taxes, rather than serious discussions.  Let's start this out with a couple of tax sound bites that I seem to keep hearing recently:

1. About half of all Americans pay no income tax at all.
2. Warren Buffett pays a lower percentage of his income in taxes than his secretary.

Of course, republicans are fond of trotting out #1, while democrats are quick to promote #2.  But when they are both put up there right next to each other, how are we to make sense of them?  #1 seems to be saying that the richer half of the population is completely supporting the poorer half.  But, #2 points out that the rich (or, at least the super rich) are not being taxed nearly enough.  The problem is, both factoids are so misleading that they do not help us understand the real issue at all.

Here is what these two points are both missing: they only focus on income tax.  And why not?  That's what we all care about, because we see the withholding from our paychecks and, come April, we have to fill out the 1040s and settle with Uncle Sam.  Since income tax feels so much like the government stealing our hard-earned money, it's easy to get us all up-in-arms about it.  I'm angry just thinking about it!

So, take a deep breath.  Relax.  Let those awful emotions leave your body, and let's have a calm discussion about what to do about taxes.  Ready?

The truth is that even the poorest Americans are paying taxes, they just might not be income taxes.  And, Warren Buffett might not end up paying a huge portion of his income in taxes (because most of his income is capital gains, which are taxed at a lower rate), but because he is a business owner, all of those business profits are being taxed by the government before they even get to him, at which point they are taxed again.  It's pretty likely that Buffett is paying over 30% of his income in taxes overall, it's just not all coming in the form of income tax.

We do ourselves a disservice when we ignore all other taxes and only talk about income tax.  What about corporate tax, sales tax, property tax, estate tax, payroll tax, etc. etc. etc.?  The thing with many of these taxes is that we don't feel them quite as sharply as income tax.  Take the corporate tax, for instance.  Corporations pay that, right?  Well, yeah, but corporations are really people (Mitt is spot on on this point), meaning that any tax we levy on a corporation ultimately results in either (a) lower dividends for the owners (shareholders) of the company, (b) lower wages for the employees of the company, or (c) higher prices charged by the company.  Thus, we all bear the burden of corporate tax, really, and so leaving it out of the equation gives us a really distorted view of the total tax burden we all pay.  So it is with the other taxes I listed.

Luckily for us, the Tax Policy Center does a great job of compiling the numbers for us:

Ah-ha!  Now we can clearly see that individuals in the highest tax bracket (the Warren Buffett crowd) pay about 30.4% of their income in total taxes, not 17% like Buffett claimed.  Individuals at the median pay less than half that: 14.1%.  And those in the lowest bracket only pay about 1.6% of their income in taxes. (Source: Tax Policy Center).

So, that's how things currently stand.  Before we can make much progress in determining what we need to change, we have to understand the impact that taxes really have on the economy.  Let me walk you through how I think about it.

First, we need to understand that there are really two decisions that go on with tax policy.  First, we need to decide how much tax revenue the government needs to raise in order to perform all of the things we want it to do.  I'm pretty much working under the assumption that we need to raise taxes from where they are now.  Looking at the current budget deficit, I think that it's clear that's the case, because we can't cut enough spending to balance the budget.  So, that means we need to raise taxes.  The second question is, then, what is the best way to do it?  In order to answer that, let's look at the problems that taxes cause and the problems that they can potentially solve.

In a perfect market, taxes cause all sorts of problems.  If you tax people based on their income, they choose to work less, and the economy struggles.  If you tax goods purchases, they purchase less, and the economy struggles.  Economists call this a deadweight loss--taxes don't just transfer wealth (from you to the government), they destroy it completely.  This is why true capitalists hate taxes.

Of course, in the real world markets aren't perfect.  We lack full information, there are externalities, and the market just isn't fair to everyone either.  Taxes can potentially solve these problems.  In particular, we can use taxes to punish negative externalities, and we can tax the rich more in order to help out the poor who were unlucky.  Taxes will still cause some deadweight losses, but that is kind of a wash if they solve some other problems along the way.

So, the takeaway from this is that we should try very hard not to tax behavior that we want, and we should instead charge taxes for behavior that is harmful.  Seems straightforward, right?  In practice, though, I don't think we have a great track record of following this simple rule of thumb.  My recommendations for raising taxes focus mostly on fixing areas where I think we've gone awry in skewing incentives the wrong way.

Alright, that's enough groundwork,  I think.  How should we raise taxes?  Here are a few ideas that I like, in order of how much I like them:

1. Institute a consumption tax.  Why do we tax income so much more than spending?  Which do we want to encourage, and which do we want to discourage?  In my opinion, if anything American consumers have a problem with over-spending, not over-earning.  So, I would like to see a consumption tax, such as a VAT.  A VAT isn't perfect, but it's the lesser of two evils if we're choosing between taxing income and consumption.
2. Get rid of the mortgage interest tax deduction.  A long time ago, we decided in the U.S. that having a lot of homeowners was good.  It's the American Dream.  As part of that decision, the government did many things to try to encourage homeownership, one of which was deduct all payments of mortgage interest from taxable income.  Unfortunately, there's no strong evidence that homeownership is actually a good (or bad) thing.  If anything, I think we currently have too many homeowners in the U.S., not too few!  So, we should get rid of the mortgage interest tax deduction--it would raise tax revenue, and discourage overindebtedness, all at the same time.
3. End the Bush tax cuts on the wealthy.  The richest individuals in the U.S. have enjoyed relatively low marginal tax rates for the past 25 years.  Today, their marginal tax rate is 35%.  In 1945 (the peak) it was 94% (Source: Wikipedia!):
   
   (IMPORTANT ASIDE: It's always the marginal tax rates that matter.  Buffett was quoting his overall tax rate, but that's irrelevant.  The reason?  Suppose you were deciding whether to work one more hour for $15 or not.  If you are being taxed at 3% on average, but this $15 is going to be taxed at 90%, which rate matters to you?  The marginal rate of 90%, since it means you would only get to keep $1.50 for your efforts.)  Given that the rich truly are paying relatively low marginal tax rates, it probably makes sense to raise their rates a bit.  Sorry, rich friends!  I still love you, and hope to be one of you someday.  ;)
4. Simplify the tax code.  The tax code is incredibly complex, as we all know.  This makes it so that sophisticated taxpayers, who are typically better-off, are able to find loopholes while unsophisticated individuals don't find them.  That seems kind of unfair to me.  I would be all for simplifying things, which makes it much easier to detect tax fraud and much harder to find loopholes.
5. Broaden the tax base.  This should not be done right now, but once the economy does start to recover, we can probably charge a small of amount of tax to some of those households who currently pay no income tax.  Having half of the population paying no income tax seems a little extreme to me.  The good news is that by doing the other things I've listed, it won't need to be much.

Obviously, these steps would all need to be taken slowly and carefully.  Quickly implementing any of them would likely cause people to get blindsided by the changes.  The good news is that Congress never does anything quickly.  Regardless, in the long run these are the types of reforms that need to happen to balance the budget.

Congratulations!  You've just completed Ben's two-part course on balancing federal budgets!  You deserve a break from all of this boring old public economic mumbo jumbo.  I'll try to lighten things up in the next Ramble.  In the meantime, ponder this question:  Imagine that Mr. Average who lives in Normalville found $1 on the sidewalk.  What would make Mr. Average better off: paying that $1 to the government, or keeping it?  If you answered, "keep it, Mr. Average!" you believe that taxes are too high right now, not too low.  If you answered, "give it to the government," what if it was you who found the dollar instead of Mr. Average?  Would your answer change?  This is why raising taxes is so dang hard!

As always, let me know what you think in the comments!