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Tax theory is full of cognitive illusions. Things are never as they seem. Here are some examples:

1. In the long run it doesn’t matter how the payroll tax is split between workers and companies. Right now the split is 50-50 in the US, but this has no bearing on the actual incidence of the tax. If the tax were set up where 100% was paid by workers, it would not “favor” business in the long run (although it would in the short run, due to sticky wages.)

2. AFAIK, most countries levy VAT on imports, but not on exports. US politicians and pundits will sometimes demagogue this issue, claiming that this tax regime “favors” exports. It doesn’t. As far as I know all public finance experts agree on this point. It’s trade neutral. (In all of these cases there are obviously possible real world complications with second order effects—my point is the demagogues prey on the public’s tendency to use a common sense approach to taxes, which is almost invariably wrong.)

3. The VAT applies to consumer goods but not capital goods. Again, this is to avoid double-taxing the part of consumer goods that represents the cost of capital. In no sense does this mean the VAT system “favors” capital goods over consumer goods.

4. A flat 10% VAT and a flat 10% wage tax are essentially identical in the long run (ignoring enforcement problems.) At first glance the payroll tax seems to tax “labor” while the VAT seems to tax “consumption.” But that’s an illusion. They are both wage taxes and they are both consumption taxes. They are essentially identical.

Here’s what annoyed me so much about the Solow quotation in the previous post. Yes, there are a number of articles that provide some (weak) justification for a tax on capital income. These involve everything from risk/insurance, to enforcement/evasion problems. So I’m not claiming there are no arguments at all for some sort of capital income tax. But the baseline you start from is a zero tax, not a capital income tax equal to the wage tax. When Solow talked about our tax system “favoring” capital income he was clearly pandering to the public’s ignorance of tax theory. If Warren Buffett says he pays a lower tax rate than his secretary, that’s going to look unfair to almost everyone, even to GOP voters.

I think I have a better way of explaining all this, which might convince some commenters who were confused by the previous post. Many people are aware of the 401k pension plan in America. You contribute money you have earned, and do not pay tax on that money until it is withdrawn at retirement. If you allowed unlimited 401k contributions, and then taxed the amount only when it was withdrawn for consumption purposes (by your or your heirs) then you would have essentially converted the income tax into a pure consumption tax. AFAIK, this claim is completely uncontroversial among tax experts.

Now let’s think about a world of unlimited 401ks, with no taxes on capital income, just a 50% wage tax. You earn $100,000, and save $20,000 in the current year. That means you pay $40,000 in tax today, and consume $40,000 today. The other $20,000 goes into a 401k, where it grows to $60,000 over the next two decades. Then you take the money out and spend it. How much tax do you pay at that point? The answer is $30,000, as the wage tax also applies to funds removed from the 401k. You can think of that tax as having two parts:

$10,000 of the tax is a deferred tax on the $20,000 that you failed to pay tax on when you put the money into the 401k.

$20,000 is the tax paid on the capital gain of $40,000 that you earned on your invested money.

Thus to the average person it looks like the 401k account is not “tax free” but rather “tax deferred.” A politician or pundit would have a difficult time demagoguing that issue. Suppose they claimed that 401k holders were paying zero taxes on their investment earnings. Outraged 401k holders would say; “Wait a minute, I am paying the full income tax on all my investment gains when I take the money out and spend it. And even the wage tax I initially avoided is only deferred, I still must pay the full wage tax in the future.”

Under this 401k approach it looks like both wage earners and investors are paying the exact same 50% tax rate. No one in their right mind could claim this tax system “favored” capital income over wage income.

And yet our current tax system taxes capital income at a higher rate (relative to wage income) than the system just described.

You’d get the identical result if you applied the 50% wage tax to the full $100,000 (i.e. $50,000 in tax), if you assume they spent $40,000 on consumption today, and then invested the other $10,000 for 20 years, consuming $30,000 at that time, with no capital income tax. But the 401k approach looks much “fairer,” as it “seems” to tax capital income at 50%.

Of course Solow is a brilliant economist who certainly understands basic tax theory. Whenever I see smart liberal economists argue that our tax system favors capital income I immediately suspect them of pandering to the ignorance of the public. Tax theory is counterintuitive. A neutral tax system will often appear to favor capital, and European exporters, and businesses, and also appear to punish workers and consumers and domestic firms competing with European exporters. But these are cognitive illusions, and it’s about time we stopped pandering to these illusions.

If people want to make sophisticated arguments for special capital income taxes where evasion is rife (say hedge funds or entrepreneurs) then do so. But don’t use that as an excuse to double tax the money saved by ordinary working Americans. At a minimum they should remove any contribution limits on 401ks. Recoup the revenue with higher payroll taxes on upper income Americans.

And don’t liberals claim that working people can’t afford to save very much? Then my proposal shouldn’t cost much revenue.

PS. Some commenters wrongly think all this is some weird idea I concocted. Not so. I’ve seen Yglesias and DeLong discuss progressive consumption taxes. They certainly understand the points I’m making, even if they may not agree with all my policy preferences.

Prove me wrong and there’s a Nobel Prize waiting for you in Stockholm.

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This entry was posted on April 24th, 2014 and is filed under Misc.. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



