November 09, 2004

How Not to Design a Consumption Tax

I've been trying to explain my problem with the Bush administration's vision for tax reform, and have had no luck, so here's another shot. (Warning: wonk at work.) The general principle behind the administration's tax reform schemes is laudable—they think they've found a way to boost national savings and encourage investment via tax policy. They'll do this via consumption tax or flat tax or whatever. There's the question of the regressivity of such schemes, but set that aside. The basic goal, as I say, is laudable, since they are ultimately trying to raise living standards and raise the rate of economic growth now and forever. But the thing is, it doesn't work. It hasn't worked. It likely won't work anytime soon.

So what happened? Well, for starters, there's the fact that large federal deficits do not, obviously, increase national savings. But leave that aside. That's not the only problem with tax reform, Bush-style. The problem I want to get at is that the favored tax reform tools of this administration—namely, (1) increasing the value of existing assets and (2) savings accounts that are really tax shelters—are inherently counterproductive to the goals of tax reform.

First, point (1). Take a look at tax cuts on capital gains and dividends that Bush passed in 2002 and 2003. Those cuts basically increase the value of already existing assets—namely, stocks. So there's no incentive to save more. Alan Auerbach, I think, showed a while back that consumption taxes work most of their magic by decreasing the value of existing assets, thus making people start panicking and ultimately saving more, thus boosting investment, thus making everyone a happy camper. But Bush's tax cuts don't do this. And whatever tax reform scheme his administration eventually comes up with probably won't do this either. No one wants to take a hit on the assets they already have, least of all Bush campaign contributors. So we'll probably see even larger capital gains and dividend tax cuts, precisely of the kind that don't have much effect on overall patterns of savings (right now), and don't have much effect on economic growth.

(The same principle holds for savings accounts, about which more below—They only encourage people to shift existing assets into the new tax-free accounts, there is no necessary transition cost.)

Okay, point (2). This is a point I think I saw Gale/Orszag make recently, although for the life of me I can't find the paper. Apologies; this blog is sloppy. But here goes: the Bush administration is big on savings accounts. You've got your retirement savings accounts (RSAs) and your health savings accounts (HSAs) and who knows what else. But under various current proposals, you are allowed both to claim deductions on money you put into the account, and also withdraw the money tax-free. That doesn't make sense at all. You want a well-designed income tax? Then tax the income from the account. You want a consumption tax that encourages saving? Then get rid of the deductions for putting money into the accounts. But you have to tax one of the two aspects. Otherwise you just have a bona fide tax shelters, and you've effectively narrowed your tax base. Doing so, of course, reduces government revenues and puts more of the tax burden on people who earn wages. And that, I'm afraid, is not laudable at all.

-- Brad Plumer 1:04 AM || ||