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Here Comes the Tax Man

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eye on the news

Here Comes the Tax Man

We need to raise more tax revenue, but how we do it matters. June 22, 2021
Economy, finance, and budgets
Politics and law

Like it or not, we need to raise more tax revenue. Both Democrats and Republicans spent the last few decades running up the debt, and it’s getting worse. Despite a vigorous recovery, the Biden administration plans to exceed a 100 percent debt-to-GDP ratio for the next ten years and add new entitlements. And this estimate doesn’t even include existing unfunded entitlements. This can’t go on forever. When it comes to raising taxes, the real question isn’t if, but when—and most importantly, how.

Biden’s budget plan raises taxes on high earners and corporations, seemingly fulfilling his promise that no one earning less than $400,000 a year will pay more. Given the volume of government spending, though, this will not be enough. Even more troubling: some kinds of taxes do more harm to the economy than others, and the ones that Biden and the Democrats are proposing will cause the most damage. Another cause of concern is Democratic rhetoric about taxes as a tool to punish the privileged, rather than a necessary evil to raise revenue.

It’s wishful thinking to presume that we can increase the size of government to 25 percent of GDP and not expect everyone to pay for it. Economists who study taxes argue that the ideal tax system isn’t fixated on what Jeff Bezos pays; rather, it aims to raise revenue while causing as few distortions as possible—including discouraging work or investment, or interfering with how people structure their work and where capital flows. Bad incentives can mean that capital does not flow where it should, and that prices become less meaningful, both of which are bad for growth. We tolerate some inefficiency for a government that provides (and pays for) services and a safety net for the most vulnerable. But good tax policy aims to raise revenue while minimizing waste.

Such considerations don’t factor into the Biden plan, however. High corporate and capital gains taxes are distortionary. And if Biden listens to some voices from the left, the distortions may get worse. Last week, both ProPublica and the New York Times joined Senator Elizabeth Warren in arguing for taxing the wealth of billionaires. They want to go after earnings from billionaires’ assets, regardless of whether these are sold or even liquid. This approach would resemble a wealth tax and would pose many of the same challenges.

Economists generally prefer (in order of desirability) consumption taxes, then income taxes, and, finally, taxes on wealth. Wealth taxes are the hardest to collect and create the most distortions because they have the biggest impact on behavior. Unless taxes are extremely high, people generally will work, but investment decisions and risk-taking are highly sensitive to tax rates. Wealth taxes lower returns to investment and can even force wealth holders to sell their assets.

We do tax capital income—that is, income realized from the sale of an asset. These taxes are less distortionary because the taxes are relatively low (for now, anyway) and are levied only when assets are sold. But taxing accrued wealth causes more distortions and is hard to implement. For example, wealthy people often own privately held assets, like their own companies, artworks, or private equity. But valuations are easy to game—companies can make themselves look more or less valuable in various ways, thus affecting how much they pay in taxes. So private equity would become even more attractive if we begin taxing accruals.

Even taxing accruals for publicly traded assets would pose many challenges. Markets are volatile, so the timing of when a tax is assessed and when it is paid is important. Is your tax bill based on annual gains at the end of the year, but paid in April? What if the market crashes between the assessment and Tax Day? Would everyone sell their assets at the same time? Do investors get a credit in years when asset values fall? The wealth-tax proponents don’t address these concerns, or they assume that better IRS enforcement will solve these problems.

Accrual taxes are also unpopular. This may be because people know that they make no sense, and that such taxes, though often initially levied on a small population, expand over time to apply to almost everyone, like the income tax.

We need to have a conversation about raising tax revenue, but one that’s more honest about the level of financial obligations we’re taking on. We shouldn’t pretend that only the wealthiest will pay more and devise plans to extract as much of their wealth as possible. Tax policy should balance fairness with what will be the most effective and least harmful option for the economy: a federal, progressive consumption tax. Democrats boast that they listen to experts and follow science, but when it comes to tax policy, they sound like populists.

Photo: Feodora Chiosea/iStock

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