Tuesday, September 14, 2004

Consumption taxes 

The Elder asked me on the air today about the Kerry tax plan and his claim to grow 10 million jobs. I've said several times that Kerry's set a fairly mediocre expectation -- 10 million new jobs would be a growth rate for employment of about 1.7% per year, which isn't terribly unusual (you can go here to play with the data.) Last night I got a comment on one of Friday's posts asking my opinion on this Business Week article on Bush's tax plan. The gist of the article is that Bush may be considering a consumption tax. If he is, he's being awfully vague about this, because there's nothing on his campaign site that suggests it as I can find. (Corrections welcomed.) All I see is this:
President Bush will work with Congress to make the tax code simpler for taxpayers, encourage saving and investment, and improve the economy's ability to create jobs and raise wages.

The only difference here from John Kerry would probably be the "encourage saving and investment", which in Kerry's version seems more focused on making sure that the investment comes from overseas revenues of U.S. multinational firms. Indeed, Kerry's plan, which is argued to be a tax cut for corporations, isn't when you see how it's paid for.
The Kerry-Edwards plan saves an average of $12 billion annually from eliminating the ability of companies to defer taxes on foreign income and closing corporate loopholes. These savings are all used to cut corporate tax rates by 5 percent.

Now, this is not a bad idea -- lowering rates and flattening tax bases is consistent with the types of reforms in the 1986 tax act passed by Reagan and the Congress. It might make firms more efficient, but it's not clear to me at all why incentivizing firms to pay for investments by cannibalizing their international operations is a sound economic plan.

In contrast, according to the Business Week article, there are whisperings that a second Bush administration would operate on individual taxes by allowing greater deductions for savings. Jim DeMint in South Carolina is running on a platform that includes a national sales tax. Reading former Bush Council of Economic Advisors Chair Glenn Hubbard's editorial in the WSJ last week sounds like someone else is thinking the same way.

Tax policy can play a significant role in encouraging--or discouraging--entrepreneurial risk-taking. It is startling how many entrepreneurs starting a business are subject to the individual income tax (as sole proprietorships, partnerships, or S corporations). Because entrepreneurship is a risky undertaking, prospective entrants evaluate possible after-tax returns from success and failure in deciding whether to start a business. The income tax weighs in because the government is not an equal partner in success and failure. While the government does not grant a complete offset for business losses, the progressive income tax imposes a "success tax" on a good outcome. If this success tax is high enough, a
prospective entrepreneur may forego a risky venture to continue working for
someone else.

How important is this effect. Using data on U.S. households, William Gentry and I found that the "success tax" has a potent negative effect on entry into entrepreneurship. We estimated that President Clinton's 1993 tax increase, which raised substantially the top individual income-tax rate, reduced the probability of entry for upper-middle-income households by as much as 20%. Should Mr. Kerry reverse the president's tax cuts, that estimate suggests an important hit to new
entrepreneurial activity.

Skeptics should wonder why Bush is being vague about this, if this is indeed in the second Administration's plans? Two reasons occur to me. First, it will attract a lot of flack from Democrats. There is an argument that national sales taxes are less progressive than income taxes, which the BW article points out. States have long understood this: In Minnesota this is handled in no small part by exempting items like food, clothing, or prescription drugs. And DeMint is taking some heat for his proposal.

Second, implementation would be quite radical. I remember a conversation over twenty years ago when, as a grad student working as a driver for a conference on Reaganomics, I took Jerry Jordan to the airport. Jordan at that time was on Reagan's CEA. I asked about proposals for value-added taxes in the States. (These proposals have been around for nearly fifty years.) He replied it was a political problem: Good policy would be to replace the individual income tax with the VAT, but he feared the Congress -- controlled by Tip O'Neill at the time -- would accept the VAT but not repeal or adjust the income tax. Better not to bring it up at all.

Again this is all speculative, but if Bush has such a plan in mind it would be as revolutionary to economic policy as the Bush Doctrine has been to foreign policy.