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October 21, 2014

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The X Tax is the answer

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In 1986, Democrats and Republicans came together and enacted a tax reform measure that closed loopholes and lowered tax rates. That was a great achievement. The ’86 act has shaped thinking ever since. Now when people talk about tax reform, they instinctively say, “Let’s do another ’86-style act.” When they debate tax ideas, they inevitably fixate on the two levers that were central back then: closing loopholes and changing top marginal rates.

The problem is that it’s not 1986 anymore. We have a different set of problems. The two levers highlighted in that earlier reform are not powerful enough to help us address the issues we face today. The 1986 paradigm has become an intellectual straitjacket, foreclosing considerations of the things we actually have to do.

Unlike in 1986, the Baby Boomers are in full retirement mode. The aging population means more government spending, even if we get entitlement programs moderately under control. It also means slower growth. The United States grew at about 3.2 percent a year for the five decades after World War II. It is projected to grow at only 2.2 percent over the next few decades.

We need a tax reform that will raise revenue and significantly boost growth. The 1986 model is poorly designed to do both those things.

Let’s say we closed loopholes or capped itemized deductions at $50,000, as many of the current proposals would do. That would raise, at most, about $760 billion over 10 years. And it would produce much less than that if we started carving out exceptions for the charitable deduction, as we should. That revenue wouldn’t be close to covering the trillions in new debt.

Let’s say we raised the top tax rates back to where they were under President Bill Clinton. That wouldn’t come close to raising sufficient revenue either. It might raise $82 billion a year, according to the Joint Tax Committee. That’s small potatoes compared with what’s needed.

Let’s say we closed the loopholes and raised rates all at once. That might theoretically produce enough revenue if you hit the middle class, but it would decimate growth.

Even the 1986 reform, which closed loopholes and lowered rates, didn’t do much to increase growth. Even after the reform was passed, people were paying the same amount in taxes, so they faced the same basic incentives.

If you closed loopholes and raised rates, as we’d have to do this time around, you would make the incentives worse. Raising top tax rates may not be as cataclysmic for the economy as some have argued, but this is still one of the most growth-killing ways to raise revenue.

In other words, if we’re going to simultaneously address our two most pressing needs — raising revenue and boosting growth — we’re going to have to break free from the 1986 paradigm.

That means asking the basic question: What is the single biggest problem with the tax code? It’s not the complexity, bad as that is. The biggest problem is that it rewards consumption and punishes savings and investment.

You can’t fundamentally address that problem within the 1986 paradigm. You can address it only through a consumption tax. This idea is off the table right now, but reality will inevitably drive us toward it. We have to have a consumption tax if we want to both grow the economy and reduce debt.

But isn’t a consumption tax regressive since poor people spend a bigger share of their incomes than rich people? The late David F. Bradford of Princeton University effectively solved that problem with his so-called X Tax, which has recently been championed by Alan D. Viard of the American Enterprise Institute and others. Under the X Tax, you wouldn’t pay the consumption tax at the cash register. Businesses would be taxed on their cash flow, taking an immediate deduction for investments rather than depreciating them over time. Households would pay tax at progressive rates on their wages but would not pay tax on income from savings.

The X Tax effectively taxes the money you spend right now and rewards savings and investment. The government could raise a chunk of revenue this way and significantly boost growth with little or no change in how tax burdens are distributed between rich and poor. Most economists vastly prefer consumption taxes to income taxes.

The other complaint is that a consumption tax is politically impossible to get passed. There are, indeed, political difficulties. But there would be huge political difficulties if we try to do another 1986-style act next year. Every special interest will fight every loophole closing. And after all that, the country would get very little benefit in return. The political barriers to an X Tax are no greater, and we would actually address our problems.

It’s time to break out of the 1986 paradigm. It’s time to explore consumption taxes. Let’s think about X.

David Brooks is a columnist for The New York Times.

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  1. Mr. Brooks illustrates an excellent point with regard to economic theories and policies. They are never a one size fits all as the Krugmans of the world would have us believe. Times and events change. They are not static. What worked before oftentimes doesn't and won't work the same way again. Sadly, when our political leaders don't understand this simple truth of economics, they make the same mistakes over and over again. Just look at Europe for the proof.

    CarmineD