Graetz promotes a tax-mix on income, wages and wealth to ensure progressivity, and a VAT for revenue.
The principles of tax reform emphasise its effects on equity, efficiency of resource allocation and revenue productivity. Michael Graetz, in his recent book, 100 Million Unnecessary Returns, proposes for the US a Competitive Tax Plan (CTP) to ensure these objectives. He reveals widening income and wealth gaps. Between 1979 and 2006, the incomes of the richest 1 per cent nearly doubled, while that of the middle class grew 11.5 per cent. Wages of the lowest decile increased 4 per cent, while at the top they grew 34 per cent. Regarding wealth, the wealthiest 1 per cent owns a third of all wealth. The bottom 50 per cent holds 2.25 per cent. The average net worth of the top 10 per cent of families is 30 times that of the middle 50 per cent. Graetz rightly cautions that any tax reform should not worsen distribution.
The prevailing tax burden is not regressive, however. More than two-thirds of income tax is paid by the top 10 per cent of earners; more than a third by the top 1 per cent. An exclusive consumption tax, as proposed by the Flat Tax and Fair Tax, would not retain progressivity. Yet the income tax alone would offer an inadequate revenue base, given increasing international factor mobility and flight. A mix of taxes on income, wages and wealth, with high thresholds, is needed to ensure progressivity while a consumption VAT would provide revenue.
The US is not a high tax country. Federal, state and local taxes represent 25 per cent of GDP in contrast to 40 per cent for EU (before accession) and 36 per cent for OECD. The US relies on income and payroll taxes to contribute 92 per cent of federal revenues. US income tax is comparable to Europe—13 per cent of GDP, as opposed to 14 per cent for EU. The difference reflects consumption taxes.
A VAT of 10-14 per cent could finance the cost of exempting income-tax payers with family income of $100,000, and reduce the income (IT) and corporate tax (CT) rates. US goods would become more competitive by enabling a low CT rate, and prevailing negative household savings should improve.
On income tax, until 1932, the top 5.6 per cent of the population filed tax returns. In 1940-41, new legislation quadrupled the number of returns to 28 million, and by 1943 (reflecting the War effort) to 50 million—70 per cent of the population. Compliance costs are high. Two-thirds of returns are completed by paid preparers. By excluding those earning less than $100,000 from the income tax, CTP would help diminish administrative burdens of IT on IRS, the tax authority.
Only 4 per cent of taxpayers paid the Alternative Minimum Tax in 2002, while 20 per cent are expected in 2010 as lower tax rates on income, capital gains and dividends trigger AMT calculations. In India, MAT applies only to businesses. Graetz wants AMT to go. India cannot afford to let MAT go, reflecting a finance ministry analysis that reveals an inequitable CT burden across businesses.
Reagan dropped the top IT rate from 70 per cent to 50 per cent in 1981 and 28 per cent in 1986. Bush Sr agreed to raise it to 31 per cent, and Clinton raised it further to 39.6 per cent in 1993. It was reduced to 35 per cent in 2001 by Bush Jr. Capital gains tax rates have also reduced to 15 per cent. Graetz recommends 25 per cent. The dividend tax rate was also reduced to 15 per cent in 2003 to reduce “double” tax on income. Graetz is critical since these reductions did not safeguard revenue from previous taxation of these incomes at the corporate level. He finds that dividend payout consequently increased, while reinvestment suffered.
The overall rate reduction affected income distribution adversely. For the top 0.1 per cent, it grew from 3.3 per cent to 10.5 per cent. And the amount needed to join this group grew from $234,000 to $1,278,000; ie it quintupled. Interestingly, the shift in income distribution has resulted in a higher proportion (two-thirds) of income tax being collected from the top 10 per cent of earners despite lower tax rates. In contrast, Graetz’s CTP proposes to return IT to its pre-World War status: low rate falling on a thin top slice of high income earners—above $100,000.This would eliminate the standard deduction, personal exemption, and child credits, and eliminate special income tax credits and allowances.
Graetz’s sole justification for having a CT is that its absence encourages spurious corporations. High CT rates favour debt to equity financing; and the burden is likely to be passed to labour. The 1986 reform reduced CT from 46 per cent to 34 per cent while scaling back deductions, thereby improving revenue and enabling the lower IT rate of 28 per cent. Clinton in 1993 got a 1 per cent increase, to 35 per cent. Graetz favours a low 15 per cent—or a maximum 20 per cent—reflecting global competition, with matching capital gains and dividend tax rates. He also proposes simplification—yet sharpening—of disclosure rules to combat complex tax avoidance schemes for international business income. He eschews increasing penalties. These are also burning CT issues in India today.
Graetz says that the Social Security Tax (SST) has to stay. The payroll tax has grown from 10 per cent of the total budget in 1953 to 40 per cent today. The 1935 SST Act fixed the rate at 1 per cent of wages. Today it is 15.3 per cent up to a maximum wage income. For most families, the payroll tax is higher than income tax. Although SST is regressive, the social security benefit system is progressive.
SST’s problems have re-emerged. As the US becomes older, its fastest growing cohorts are those above 85. 16.5 workers supported a retiree in 1950, 3.3 workers do it currently, and 2.1 will do it by 2040. Only a 5.5 per cent SST rate hike would cover the gap 50 years hence. Therefore Graetz recommends retention of SST, while increasing the retirement age (though he does not specify how the elderly will find jobs).
Graetz guarantees progressivity through wealth taxation. He recommends increasing estate tax, which yielded 11 per cent of revenue in 1946 but only 1 per cent today. He also recommends an inheritance tax.
In sum, Graetz’s CTP package meets the three objectives of tax reform. Nevertheless, CTP is essentially federal and excludes sub-national concerns. His chapter, “Bring the States Along”, alludes to states piggy-backing the federal VAT using its advanced information technology. Today US state and local governments use retail sales taxes (RST), with 7,579 RST jurisdictions. Large multi-state companies file more than 200 RST forms every month, with high compliance costs. Thus Graetz feels states should naturally adopt a VAT, but provides no framework. A national US VAT design is needed, specifying federal and state VAT chains, minimising cascading, removing distortions from interstate trade, and ensuring predictable federal-state revenue effects. India consolidated central VAT and introduced service tax in 1995, introduced state VAT in 2005, and has a roadmap for a national—central plus state—GST in 2010. Hopefully, a sound indirect tax structure will be finally put in place.
The opinions expressed are the author’s and not of any government, institutions or individuals unless indicated
