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Professor Richard Epstein

We Need Flatter Taxes, Cleaner Rules

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The Trump administration released a thumbnail sketch last week of its much anticipated tax plan, which has generated opposition and support from all the usual suspects. The critics of the plan take the view that the program will generate windfall subsidies for the rich and increase deficits while doing nothing for growth. Its defenders, including Treasury Secretary Steven Mnuchin, claim that the anticipated growth from lower tax rates will override any objections about increasing income inequality.

It is, of course, difficult to make predictions on matters such as economic growth. The overall effect of any tax plan depends not only on the plan itself, but on other government actions, such as spending rates, which have risen inexorably since the end of World War II, and interest rate increases by the Federal Reserve. It puts the cart before the horse to think about growth and deficits before getting the right tax structure into place. Once that is done, the needed response to changes in economic and financial conditions can be handled solely by changes in tax rates. The enhanced stability of the tax structure itself should be positive for growth. And on tax design, the Trump plan offers a mixed bag.

Politics aside, the best tax plan is also the simplest: I have long advocated that the sole source of general revenues should come from a flat tax, preferably on consumption and not income. A consumption tax eliminates the enormous difficulties of separating out capital gains, which are typically taxed at a lower rate, from ordinary income, taxed at a higher rate. If a consumption tax is unattainable politically, a relatively close substitute would be to defer capital gains taxes on any profits that are reinvested in other capital assets. No other forms of ad hoc taxation, such as the notorious medical device tax, should be used to raise general revenues.

Low flat taxes are intended to stimulate economic activity. They would also work to eliminate the strategic advantage for taxpayers to divide their income among various entities, such as trusts, foundations, and family partnerships. Flatter taxes would also reduce administrative and compliance costs dramatically. Finally, they would make it more difficult for large political majorities to target wealthier individuals for large transfer payments, a feature of the current tax plan that creates an unstable political dynamic. It is just this approach that explains why Estonia, which adopted this system in 1994, has the “the most competitive tax system in the developed world.”

Unfortunately, Trump’s proposal deviates from this simple plan. For one thing, it advocates expanding the child tax credit, which introduces needless complexity into the system. For another, it didn’t eliminate the interest deduction on home mortgages, which distorts the choice between owning and renting a home. That was a missed opportunity to simplify the tax code.

On the positive side, Trump proposes to end the deduction for state and local taxes, which has predictably generated a firestorm of opposition from Republicans and Democrats alike in high-tax states like New York, New Jersey, California, Connecticut, and Maryland—all of which, not coincidentally, have major fiscal problems. We can improve national productivity by eliminating the major cross-subsidy that high-growth states like Texas and the Dakotas have to pay to allow high-tax states to cling to their profligate ways. This move won’t remove the large disparities in the level of aid received from the federal government to help low-income citizens, but it should put pressure on high-tax states to improve their local systems of taxation and regulation.

Trump is also right to keep the charitable deduction in place, even as its value would, and should, go down as tax rates are flattened. Charitable deductions encourage transfers that promote access to critical public goods, like healthcare and education. In effect, the deduction means that government offers matching grants to decentralized programs that can attract private support, which are more efficient alternatives than direct public assistance.

On the matter of tax rates, the Trump program treats tax simplification as a major goal, which results in a reduction in the number of tax brackets, from seven to three (10 percent, 25 percent, and 35 percent). This is an important step towards a flat tax. But as Trump moves the nation toward flatter tax rates, critics are objecting that his tax plan creates a massive “windfall” that would go to the wealthiest citizens, Trump included.

This frequent but misguided objection relies on the assumption that the current rate structure has some conceptual and moral legitimacy. Indeed, that faulty assumption is explicitly accepted by Trump, whose plan keeps open the possibility of raising the rates “to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the tax burden from high-income to lower- and middle-income taxpayers.” Unfortunately, this position introduces a deadly one-way ratchet into tax policy. Even though the Trump administration may not fancy major tax hikes at the top end of the distribution, the next Democratic administration surely will. That new skew will then become the new normal, even if the rates in question make the overall tax system less efficient than it previously was. Any effort to get back to the previous state of affairs will then be announced as yet another sop to the rich, paving the way for additional rounds of selective tax increases.

Within the classical liberal tradition, the primary function of taxation is to fund public goods and essential government functions, not to engage in redistribution, which dulls incentives for production for both those who pay and receive the transfer payments. To be sure, economic changes have led to an increase in income for the wealthiest. And oddly enough, the entitlement state depends on keeping the rich rich, given that 40 percent of all tax revenues are paid by the top one percent of earners, who garner about 20 percent of the nation’s income.

The country runs a major risk of fiscal and social instability when so much is demanded from so few. Rather than engage in over-taxation, a far better approach is to attack the expenditure side by eliminating the built-in subsidies from which some rich people gain a real advantage. Agricultural subsidies, including ethanol subsidies, are a good place to start, followed by subsidies for wind and solar energy. The revenue side can be made more rational if the expenditure side is purged of undeserved goodies.

The Trump administration should also be praised for its effort to rationalize the taxation of corporate income, by seeking to bring the United States in line with international norms. Right now, our system of punitive double taxation—on profits earned both at home and abroad—encourages American firms to park literally trillions of dollars in profits overseas, revenue that could stimulate domestic investment if brought home. And while the current corporate tax rate of 35 percent may have been competitive in the 1980s, it is far too high in the current global market where the worldwide average is now 22 percent. At this point, of course, the question arises of how to make up the shortfall from cutting the corporate tax rate. In the end, we are driven back to the most difficult problem of tax reform: how to set the rates in a consistent matter.

On this issue, Trump is guilty of his usual excessive optimism when he predicts that jobs will come “pouring in” to the United States under his plan. But by the same token, it is easy to underestimate the importance of durable tax cuts to economic growth. The five states that receive the largest subsidy for deducting local and state taxes are in the worst fiscal shape. States like Michigan and North Carolina show how cutting state personal income tax rates by a couple of points can substantially improve a state’s overall economic position. Forget Trump’s unfortunate “America First” rhetoric: globally, the huge attraction of tax simplification and low rates in one jurisdiction spur similar reforms elsewhere. Let’s hope that sensible tax reform can be contagious.