Second, the government should tax consumption, not wages, income or wealth. When the government taxes savings, investment income, wealth or inheritance, it reduces the incentive to save, invest and build companies rather than enjoy consumption immediately. Taxes on capital gains discourage people from moving or reallocating capital toward their most productive uses. . . .
All the various deductions, credits and exclusions should be eliminated--even the holy trinity of tax breaks for mortgage interest, charitable donations and employer-provided health insurance. The extra revenue, over a trillion dollars annually, could finance a large reduction in marginal rates. This step would also simplify the code and make it fairer.
Imagine that Congress proposed to send an annual check to each homeowner. People with high incomes, who buy expensive houses, borrow lots of money or refinance often, would get bigger checks than people with low incomes, who buy smaller houses, save up more for down payments or pay down their mortgages. There would be rioting in the streets. Yet that is exactly what the mortgage-interest deduction accomplishes.
Similarly, suppose Congress proposed to match private charitable donations. But rich people would get a 40% match, middle class people only 10%, and poor people nothing. This is exactly what the charitable deduction accomplishes.
Zeroing out deductions, credits, and corporate and investment taxes matters--for permanence, for predictability and for simplicity. If the corporate rate is drastically reduced, or if deductions are capped, it seems that the economic distortions go away. But the thousands of pages of tax code are still in place, the army of lawyers and accountants and lobbyists is still in place, and the next administration will itch to raise the caps, and the rate.
Why is tax reform paralyzed? Because political debate mixes the goal of efficiently raising revenue with so many other objectives. Some want more progressivity or more revenue. Others defend subsidies and transfers for specific activities, groups or businesses. They hold reform hostage.
Wise politicians often bundle dissimilar goals to attract a majority. But when bundling leads to paralysis, progress comes by separating the issues. Thus, we should agree to first reform the structure of the tax code, leaving the rates blank. We will then separately debate rates, and the consequent overall revenue and progressivity.
Consumption-based taxes can be progressive. A simplified income tax, excluding investment income and allowing a full deduction for savings, could tax high-income earners' consumption at a higher rate. Low-income people can receive transfers and credits. I think smaller government and less progressivity are wiser. But we can agree on an efficient, simple and fair tax, and debate revenues and progressivity separately.
We should also agree to separate the tax code from the subsidy code. We agree to debate subsidies for mortgage-interest payments, electric cars and the like--transparent and on-budget--but separately from tax reform.
Negotiating such an agreement will be hard. But the ability to achieve grand bargains is the most important characteristic of great political leaders.
Some people claim that it's pointless to call for tax reform, because it will never happen. I don't agree with that view. We'll never have a perfect system, but it's useful to first figure out which direction we want to go, and then see what's possible. Because the current system is so inefficient, there are potential compromises that benefit a wide range of income levels.
I see two big roadblocks to achieving Cochrane's vision, both of which may call for a bit more compromise that he would prefer:
1. How to disentangle labor and capital income.
2. Cognitive illusions in tax incidence and inequality.
If we eliminate all taxes on capital income, as most sensible reformers advocate, then we need to make sure that labor income is not disguised as capital income. One compromise is to have the IRS err on the side of treating entangled income as labor income. Examples:
If a contractor buys an old house, fixes it up, and sells it without using it as his primary residence for at least X years, treat the gain in property value as labor income. If a hedge fund manager receives any income from managing a hedge fund, treat it as labor income, even if it is structured to look like capital income. Treat all meals as consumption, without exception. Even business lunches. If "consuming" meals isn't consumption, what is? Cap business travel deductions at the coach class rate.
I believe that advocates of a clean consumption tax have to show good faith, by showing a willingness to aggressively go after tax shelters, especially shelters that re-label labor income as capital income.
As far as cognitive illusions, the current tax system looks far more progressive than it actually is. Eliminating taxes on capital won't make it all that much more regressive, but it will look far more regressive to the average progressive economist. So we need to be willing to compromise on progressivity, to make a grand deal feasible.
Fortunately, the benefits of true tax reform would be so great that even with some compromises, it would be a win-win situation for both libertarians and progressives. Pity about the people in the tax preparation industry.
Seriously, if Cochrane's plan were actually implemented, the loss of jobs in health care would be at least 10 times greater than in the tax preparation industry. That's the biggest political hurdle to clear. And the biggest benefit from reform.