How should the US reform its tax system?

Senator Russell B. Long, chairman of the Senate Finance Committee during the late 1960s and the 1970s, once remarked that efforts to reform the tax system worked under principle of “don’t tax me, don’t tax thee, tax the man behind that tree.” When U.S. politicians try to restructure the tax system, the pressure is always there to figure out a way to raise revenue on some ill-favored group or reduce the tax burden of citizens who have curried favor.

In order to combat this instinct, some economists and policymakers propose moving to a flat income tax, where every earner in the country pays a fixed percentage of his or her income, regardless of how much they make. Others argue that a consumption tax would be a better way to structure the tax code, with everyone paying taxes only on what they consume. A combination of these two plans are often bandied about, too.

But the straightforward and seemingly fair idea of taxing everyone at the same rate or for the same activity isn’t so simple. Having every earner pay the same share of their income seems fair at first glance, but abolishing the U.S.’s progressive tax structure would radically increase the amount of income inequality in the United States.

Today’s progressive tax structure helps reduce what economists call “post-tax-and-transfer income inequality” by taxing the wealthy at higher rates. That federal income is then used to pay for government programs that help alleviate economic inequality, among them supplemental nutrition assistance and medical insurance. Since the 1980s, however, the federal tax system has become less progressive, accomplishing less and less to reduce income inequality. These tax reductions on high-income earners are pitched as growth-boosting reforms. But, research shows that tax cuts targeted toward low- and middle-income earners are more effective, and that previous tax cuts for the wealthy have led to higher inequality, but not stronger growth.

There’s a distributional issue with consumption taxes as well. Again, taxing everyone at the same rate for the same activity also seems quite fair, but only if you don’t think too hard about it. Everyone might pay the same sales tax, for example, but low- and middle-income households consume a larger fraction of their income, so they would bear more of the burden of the taxation. We can see this playing out already in state tax systems, which rely more upon sales taxation. The government of Washington State uses sales and excise taxes quite a bit. The result is that households with incomes in the bottom 20 percent of earners pay, on average, 16.8 percent of their income in state and local taxes. The top 1 percent pays only 2.4 percent of their income to state and local government.

Sometimes flat-tax and consumption-tax plans are combined together. These ideas reached a recent apotheosis in the “9-9-9” plan proposed by former presidential candidate Herman Cain in 2011. His proposed reform would have created a tax system with three taxes all levied at 9 percent: a national sales tax, a business tax, and an individual tax. The combined three taxes would be equivalent to a 25 percent national sales tax, according to the Tax Policy Center. The result of such a plan, according to the think tank’s calculations, would be an incredibly regressive tax system. U.S. taxpayers with incomes below $200,000 a year, approximately 90 percent of the country, would see a tax increase on average, while those above would see a tax decrease.

Simple and eloquent doesn’t necessarily mean efficient or fair, at least when it comes to tax systems. More research needs to be done by proponents of the flat tax and the consumption tax, taking into account whether and how such reforms would affect income inequality and economic growth.

This article is published in collaboration with Washington Center for Equitable Growth. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Nick Bunker is a Policy Analyst with the Washington Center for Equitable Growth. 

Image: U.S. 1040 Individual Income Tax forms are seen in New York. REUTERS/Shannon Stapleton