Mises Daily Articles
The Tax-Reform Racket
I come to you from a state with a Republican governor, elected to cut government but who, in 2003, attempted to pass the largest tax increase in the history of the state. In the same bill, which the state constitution required be submitted to public vote, the governor sought to change the constitution to make it easier on every future governor to raise taxes.
The governor invested every bit of political capital he had. During the push, he enjoyed the plaudits of the press and the fawning of the public sector. Of course he was heralded for his steadfast courage, his refreshing honesty, his hopefulness in the face of cynicism, and all the rest. They even tolerated his religious right vocabulary, given his claim that Jesus wants higher taxes.
The proposal failed by a vote of 2 to 1. It doesn't take a political scientist to understand why. People figured that they fork over quite enough to the government and they didn't want to give any more money to these birds to build their nests. This was one of the most inspiring moments I can ever recall in politics.
Interestingly, the governor was careful not to call his bill a tax increase. He called it a tax reform. He claimed that he was not raising taxes. He was making them more fair. He wasn't increasing the burden. He was lightening it on the neediest among us, while asking the richest to attend to their civic obligations.
But people saw through this rhetoric.
It used to be said that the Democrats were the evil party and the Republicans the stupid party. My impression of late is that these monikers have switched. However, not even a conservative Republican who claimed to be devoted to freedom and limited government could pass off an attempted heist as an act of benevolence. There are important lessons here for all of us, which I would like to apply to tax politics at the federal level.
The Real Point of Reform
It's the second term for the president and his friends, take two on Republican control of the executive branch, and there is no obvious project brewing on the horizon to serve as a convenient lever to prod the donor base. After the first term, there is always the reelection, and the legal bribes that come in the form of campaign contributions. The Bush administration did better at this than most previous second termers, but the strategy of using elections to raise money isn't unique to Republicans or Democrats. It is just part of the business of party politics.
But the second term is another matter. It tends to be the period when the big issues die down and the solid excuses for demanding more from the partisan donor base tend to dry up. After all, a political party can't live on tax receipts alone. It needs the hundreds of millions donated to the party apparatus by corporations and individuals. We aren't talking about charity here. The money arrives along with an expectation that the quid will call for plenty of quo in terms of legal favors from the ruling party.
It is just when the goose starts losing enthusiasm for laying any more golden eggs that the policy farmers begin to poke them with a tried and true stick: tax reform. We saw this in 1984, in 1996, and again in 2004. In each of these years, the second-term administration announces that the current tax code needs to be tossed out and a new one put in its place. And so, right on cue, the Bush administration has named a 9-member panel to look into what should be done to reform taxes, with the goal of legislation in 2006.
The Bush panel is chaired by former Republican Senator Connie Mack, and the vice chair is former Democratic Senator John Breaux. Other members mostly lived off government in one capacity or another, and now live and work in the more-or-less private sector. And so the institutions represented include Brookings, Stanford, MIT, the Carlyle Group, and Charles Schwab. What they recommend is neither here nor there. The main function of the group is to kill time while the process grinds away, and the interest groups get organized.
Bush himself summed up the spirit: "I am firm in my desire to get something done." What this means is he has every intention of rewriting the tax code, a process that always and everywhere involves winners and losers. Who ends up winning and losing is not arbitrary. It depends greatly on making one's presence felt within the political process.
But that is the underlying message. The public campaign does not speak of these matters. Instead, they claim that they will make taxes less complicated and more fair. The reform promises to increase incentives to save and invest, and to stop punishing people for doing things they should do and start punishing them for things they should not do. It promises to stop rewarding lawyers and tax preparers, and to permit people to plan their finances on their own. It must also promise not to raise taxes on the middle class. It must also reassure the rich and not punish the poor. It must not repeal beloved deductions, but it must hammer abuses.
What all this means in practice is anyone's guess. And truly the point is not to contrive a precise plan or even to pass a plan that does all of the above. In fact, there is no way all these promises can be kept. There is no simple, fair, non-distorting way to collect $2 trillion per year from a population by force. The politicians tell us that they will find a way, that the problem is not so much the goal but the means and the process, that if we can just replace the current ways and means with a new ways and means, that $2 trillion will appear without pain or suffering. As the vice chair of the Bush panel said: "our tax code should not scare people, should not threaten people, should not confuse people." Well, you can try this at home: go collect $2 trillion, while offering not much in return, without threatening, scaring, or confusing.
Thus do we hear two messages at such a time. In the first, we hear about how bad the current tax code is. It is this message that compels us. There is more bad to say about the current tax code than could be said by all the politicians in the world. It is the second part of the message where the trouble comes: the proposal to replace what we have now with something new.
Here is the part that is troubling. The magic tax reform machine that grinds and grinds over the next two years will net billions for the political class, as every lobbyist, special interest, and pressure group ponies up to make sure that their point of view gets a hearing and their special benefit is either preserved or created. In the end, however, the average taxpayer will have nothing to show for it. This is my prediction, based on experience, and based on the logic of the political situation.
Yes, Taxes Are Terrible
But let us focus on the first part of the tax reform message, the part that is undeniably true: the current tax code is a disaster. The tax panel that Bush appointed will surely conclude this, and hardly anyone can disagree.
Now, if you read the economics texts, they will tell you that there is such a thing as a neutral tax, one that does not distort the operation of the market economy. But the neutral tax is a myth. In one way or another, every tax punishes productivity in both seen and unseen ways. It should be obvious that the money individuals pay to Washington could be put to better use in the household budget, whether it is save or spend or some combination thereof. The double taxation that comes from corporate taxes constitutes a direct hit on production.
But as Murray Rothbard shows, even excise taxes that supposedly tax consumption are really nothing more than taxes on production. Producers have no way to pass on the cost of the tax to consumers. To the consumer, the price plus the tax is just a price, and the decision to buy or not buy follows on that basis. When you go to the pump to purchase gasoline, you do not make a buying decision based on the price of $1 and then reluctantly cough up another $1 to pay the taxes. No, we consumers make a decision about whether to buy and in what quantity based on the full price, which is to say the market price plus the tax. The two are not easily separated because the price is not determined by the cost, but rather by the interaction of supply and demand.
The tax, then, cannot be passed on to the consumer any more than any other price hike can be passed on to the consumer. If the consumer is not willing to pay the higher price, he or she will not pay it, regardless of the source. To be sure, taxes cause prices to increase, but the quantity purchased responds to the will of the purchaser. And those purchasing decisions respond to the law of demand, which is to say that people will demand more at a lower price than a higher price and vice versa. When consumers purchase less, they are punishing producers, who enjoy less revenue for profits, dividends, and investment. So we can see that the idea of a consumer tax is something of a myth. It is paid at the retail end, but the effects shoot back through the entire structure of production, from the final seller to the most remote producer.
The same is true of residential property taxes. The tax is figured into the price of the home, and the judgment of what size house to buy in what neighborhood is made via a calculus that includes everything that goes into the price. The tax is not easily passed on. An increase in the property tax is a tax on the production of houses. There is no such thing as tax shifting.
What is interesting to me is how we seem to intuitively understand this in some sectors but not in others. We understand that the cigarette tax is not only a tax on users but on cigarette makers and finally on tobacco growers. And yet we talk about increasing the tax on homes, luxury goods, liquor, and gasoline with little thought concerning the effect on builders, gas stations, drillers, and other producers, to say nothing of the spillover effects on workers and their families.
Murray Rothbard's book Man, Economy, and State undertakes an analysis of every conceivable form of taxation to demonstrate every way in which this occurs. I won't march through his detailed and sweeping argument, but suffice it to say that he covers: income taxes, corporate taxes, sales taxes, excise taxes, property taxes, capital gains taxes, withholding taxes, inheritance taxes, and every other form you can imagine. There are many books I would recommend, but I would put this section of Rothbard's treatise at the top of the list for the political class. If they are going to plunder us, they should at least be denied the luxury of believing that it is for our own good.
The point is that there is no such thing as a neutral tax, and no such thing as a tax that is nondestructive to the production process. They all harm the ability of individuals to create wealth, trade, and produce. This means fewer resources available for investing in the future, for donating to charity, for spending on leisure, and cultivating the garden of civilization itself.
It is nothing short of a miracle of our times, and of all times, that wealth and civilization continue to be built despite the unrelenting assault on our lives and property by the political class. It is a living testament to human ingenuity and the creative entrepreneurship of the merchant class that they can function so well despite the advance of the tax state. It is to this class that we owe our wealth, freedom, and all the improvements in health, art, and culture generally.
We live amidst a great revolution in technology and living standards, and daily we see being brought to market the most stunning improvements in information technology, transportation, medical care, and so many other areas. Let us be clear that we owe this not to the taxers but to the creators, not to those who live off others but to those who make their own way and dedicate themselves to the improvement of humankind.
At the Internal Revenue Service's main entrance in DC, you will see a sign that says: Taxes are the price we pay for civilization. It is based on a Hobbesian theory that in the absence of taxes, there would be a war of all against all. Actually, all of history shows that taxes are a leading cause of the breakdown of civilization. The higher the tax, the less wealth there is to create and sustain civilization. We have civilization despite taxes, and it is this fact which is the most notable.
Is there a need to reform taxes? Most certainly. Always and everywhere. You can always make a strong case against all forms of taxation and all tax codes and all mechanisms by which a privileged elite attempts to extract wealth from the population. And this is always the first step in any tax reform: get the public seething about the tax code, and do it by way of preparation for step two, which is the proposed replacement system.
Of course, this is the stage at which you need to hold onto your wallet.
Bait and Switch
Hardly a day goes by when I don't receive an email from someone who has a grand plan to reform the tax code, replacing the current system completely, with something else. That something is usually the Value Added Tax or the National Sales Tax. The people promoting this plan long for a world in which they are permitted to keep all the money they make and only the purchasers of goods and services pay.
Now, there are many grave problems with the VAT or the NST, not the least of which is that it would have to be more than 20% or perhaps as much as 40% in order to raise “enough” revenue. Then there are the problems of enforcement. The US would instantly become host to the world's largest underground economy, which in turn would give a rationale to the central state to invade our businesses, homes, and bank accounts like never before. It would be essentially unenforceable and lead to even more a war of the government against all, complete with more spies, agents, and entrapments of all sorts.
But there is another danger to promoting a VAT or a NST. It might actually convince someone in Washington to give it a try. And instead of replacing the whole tax code, the politicians might try to introduce the new one at the seemingly low rate of 1 percent or 3 percent. If they ever get away with this, look out. It will inch up year by year as the political class discovers yet another way to loot us.
This points to a general danger of the idea of a replacement tax. I hear of these plans all the time. People say, let's get rid of the tax I don't like and replace it with one I do not pay. So people will propose getting rid of the capital gains tax and instead increase taxes on inheritance. Or they say, let's get rid of inheritance taxes and put a higher tax on Americans working abroad. You can think of many of your own variations on this. The danger here is not in advocating the repeal of one tax. That is something we should all favor. The danger comes from advocating a new tax to take its place. If you know the way politics works, you know that the new tax will be enacted and the old one not repealed.
Another favorite plan that is constantly floating out there is the idea of a flat tax. Steve Forbes was the last prominent politician to advocate this. His idea was to completely eliminate all loopholes and replace them with an across-the-board 20% tax (or whatever would be necessary to retain revenue neutrality). The story of how his political career melted as a result has not really been told.
What happened was this. Every time Forbes said, "flat taxes," voters heard: this crazy man wants to eliminate the deductions I get for children, charitable giving, and mortgage interest. Forbes quickly protested that while it is true that he would eliminate these, his plan was to cut taxes elsewhere. But voters were a bit too sophisticated to buy into this, for long and bitter experience suggests that deductions are eliminated but the new and wonderful cuts somehow never appear.
Never Trust a Thief
This is good thinking actually. Imagine that a criminal came by every once in a while to steal the furniture on your porch. Whenever you would leave it out, the criminal would nab it but, for whatever reason, he left all potted plants alone. Then the criminal rings the doorbell one day and proposes a deal. He suggests that if you leave your furniture out, he won't steal it but instead will steal the potted plants. Overall, he says, you will be better off. Now, if you go for this deal, you probably deserve to have both your furniture and your plants stolen.
Forbes found himself in the position of the criminal who proposed to start taxing you here in exchange for which he will stop taxing you there. This is not a deal voters are drawn to, anymore than they are drawn to politicians who propose to increase taxes at all. This is quite wise.
For my part, I'm a champion of loopholes, as was Ludwig von Mises. He was attending a conference in the 1950s, at which economists were all denouncing loopholes and he rose to their defense. "Let us be grateful for the fact that there are still such things as those the honorable gentleman calls loopholes," he said. "Thanks to these loopholes this country is still a free country and its workers are not yet reduced to the status and the distress of their Russian colleagues."
A loophole is nothing more or less than a chance to keep your own money. It is not a subsidy. It is not tax spending. It is not corporate welfare. It is not a special privilege. It is just a window of freedom. Loopholes should be expanded as much as possible. There should be ever more of them. A completely loopholed economy, where there were maximum opportunities for not paying tax, would finally arrive at the idea of freedom.
Thus do I suggest we never bite when someone dangles on a hook the idea of closing loopholes. And this raises the question of precisely what we should support.
The Lower Tax
The only tax plan anyone should trust is the most simple possible: the one that proposes to lower existing taxes. I really must say this again because it is the most important single point you can remember when evaluating whether to support a tax reform or not: the only trustworthy plan is that one that proposes a lowering or elimination of an existing tax, period. That is the bare minimum. An ideal reform would also propose equivalent spending cuts. In fact, in the most strict sense, there can be no tax cut without spending cuts since we must all pay, one way or another, for the burden of government as measured by spending. But we must leave that aside for now.
As we think about the Bush tax reform, remember to measure it by the strict standard of whether it cuts an existing tax. If it does not, or it proposes to raise other taxes along with the cut, to support is to entrust your future to a political class that has about as much interest in your well-being as that criminal who steals your porch furniture. You are taking a major risk to take his word on anything.
Let us examine the proposal to create what are called private investment accounts within the Social Security system, since this is a major feature of the Bush administration's tax plan. As everyone knows by now, the idea creates a world-class fiscal headache because it diverts the revenue stream flowing from payers to beneficiaries. This is the problem of the transition cost. If the cost were to be picked up by the general revenue, and otherwise payers were free to do with their money what they wanted, I think every free marketer would support this.
If we pursued this idea to its end, what we would be doing is abolishing Social Security as we know it and leaving in its place a straight-out welfare program for older people who need or expect money from the government. I would be for this too, since it would get rid of this idea that somehow Social Security is an insurance program. It is not. It is a transfer program. I would even be for going this route in baby steps. A 50% cut in the payroll tax would be great. A 10% percent cut in this tax would also be great. Even a 1% cut in the payroll tax would be a great thing, because it would mean that people would control more of their own money, businesses would face a lighter burden, and there would be more wealth available for people to prepare for their older years via savings and genuine insurance.
There have been so many innovations in the financial industry in recent years that the private sector would be in a perfect position to meet the needs of every citizen, without having to be prodded and browbeaten by the federal government. Never before has it been easier to save and prepare, balancing known and unknown factors in our individual futures through a combination of insurance and investment and savings plans, ones that not only provide an income stream for our own lifetimes but work to assist our loved ones and the causes we care about after our death.
But I'm sorry to report that this is not what the Bush administration proposes. Instead of actual private accounts, the Bush administration is proposing to create a brand new national program of mandatory savings. And it wants to create this new program—which would have been regarded as socialistic in 1900 and fascistic in 1920—at the expense of the existing Social Security structure.
This, I submit, is not a good idea. Call it private accounts or individual retirement accounts if you want, but from the point of view of individuals, it is still a tax because it is money that cannot be controlled. It is taken on the promise that it can be returned at a certain point in the future, and in a certain way.
Now, notice how the campaign to reform Social Security is taking a familiar route. First the administration makes a strong case against the status quo. When it comes to any tax, that is the easy part. They have rightly said that the program is unstable, unsustainable, discourages investment, and is a bad deal. That's certainly true, not only of Social Security but of every other government transfer program.
But what about the replacement? Is a new program for national forced savings a good idea? Is it smart to require that young people fork over to a quasi-private system? Is it going to invite a great deal of intrusiveness to the markets that was never entailed by Social Security? Government will tell you what funds you may or may not invest in, and how and when you may withdraw the money. There will develop a symbiotic relationship between preferred financial groups on Wall Street and the collection bureau for the private accounts—which means a great deal of potential for corruption. There will be a floor put on the accounts so that they will never be allowed to fall below a certain minimum, thus introducing a too-big-to-fail doctrine. People can reasonably claim that it was not their choice to save this money, so the federal government should take some responsibility for guaranteeing the investment.
The Red Flag of Reform
To those of you who think this proposed system is a good idea, I might ask this question: why isn't the Bush administration simply cutting the payroll tax? I can't see that that plan is any more or less viable than a proposed national savings plan. The answer is that the Bush administration genuinely believes in creating a new forced savings scheme. It desires such a thing. To observe this is simply to observe that these people do not understand markets, do not accept a basic postulate of the free market idea, and do not trust people to manage their own money. That's the reason.
Of course, what you have just heard does not fit with any analysis you have ever heard. The left claims that the Bush administration has a secret plan to rob older Americans, while the right wants you to believe that the creation of private accounts is fiscally sound and consistent with the freedom to choose. But this is what you get in tax reform time. Partisans sign up on all sides and you can no longer trust what you read or hear. To make matters worse, it is a very long time before you will ever know what is in the legislation. The White House makes a proposal, it is hammered out in congressional committees, brought to a vote in both houses, and then finally we arrive at the really crucial stage that civics texts never talk about: the conference committee. This is where all the crucial decisions are made. It is also the stage that the press cares least about because most of the main drama is over.
What is the end result of tax reform? Well, we have had reformed taxes frequently in the last century, and you need only look at the rise in federal revenue to see where this has gotten us: ever more of our earnings going to Washington, ever fewer choices on how we use what remains.
Let me close with a proposal that we abolish the income tax. It took in $873 billion last year. If we cut the budget by that amount, we would end with a completely gutted federal budget, right? Actually, that is not true. We would end up with a federal budget of about $1.5 trillion, where it was in the last year of Clinton's second term. If anyone thinks that the federal government was too small back then, I can only recommend a complete education in economics, politics, and the truth about human freedom.
Thus do I end this talk with a call, not for reform, but for an end to the income tax. It should be replaced with nothing at all. In any case, that would be a good first step.