A Surprising Key to Unlocking U.S. Job Growth & Global Competitiveness

"Once we open up to the inevitability of our demise, we can lighten up about it and begin to transform the situation"

                                                                                       -Zen proverb

The United States is suffering through a very serious economic challenge. Unemployment is nearly 10%. State and local governments are facing bankruptcy. Consumer confidence is low, and probably heading lower. And the federal government's debt trajectory means the U.S. will soon be spending $1 trillion a year in just interest.

How is the U.S. going to lift itself from this morass? One surprising key to restoring U.S. jobs and economic competitiveness is a complete overhaul of the tax system.

Many people believe that any proposal to overhaul the tax system is politically DOA; there are simply too many special interests lined up to oppose major (or even minor) changes. Yet interestingly today came news of a bipartisan proposal to substantially alter federal tax policy by reducing income taxes and moving towards a consumption based tax system.

The Fundamental Problem with Income Taxes

I've long argued that taxing income is suboptimal economic policy. When an individual generates sufficient income, that individual is able to cover their own expenses. In contrast, when an individual does not earn enough income then financial assistance must be obtained from others. On the whole I believe society is better off when individuals are income self-reliant. This goal may not be achievable by everyone (e.g., disabled), or at all times (e.g., recession). But it is nonetheless a goal for which society should generally strive.

One way society can help individuals achieve this goal is through the elimination of as many disincentives to earning income as possible. The income tax creates several disincentives, some of which are illustrated in the following example:

Imagine you have a job which pays an annual income of $40,000, and one day you are offered the opportunity to earn an extra $1,000 for completing a project. However, the government will tax this $1,000 at a rate of 99%, meaning your take home pay from this project would be only $10. You would also need to keep the receipt for the project and report the project on your income tax return. If the only thing that appealed to your about the project was the amount of money you'd take home (e.g., no work experience benefit or other perks), would you take the project? I imagine most would probably pass. 

What if the government instead taxed the project at 75%. You'd probably be more likely to take the project now, but you may still pass if you're only going to net $250 of the $1,000. What if the tax rate was lowered to 35%? We're getting warmer now. Would you take the project if the tax rate was lowered to 0%? Perhaps most now would. But for those who still wouldn't: if the extra filing requirement was eliminated would that seal the deal?

The key takeaways from this example are:

1. Tax rates and ancillary requirements, like record keeping and reporting, can affect our decision making when it comes to income
2. Individuals possess different tax rate and hassle thresholds

In the real world precise measurements of just how much of a disincentive the income tax is is difficult to obtain due to individual preferences. However, we can see logically from the example how disincentives do exist at a variety of tax rates and reporting requirements.

A simple summarization of the above: don't tax things, like income, that you want to encourage.

Tax Code Complexity Stifles Job Growth

If you think the U.S. tax system isn't all that complex, check out the below video of Treasury Secretary Tim Geithner.

Not even Tim Geithner, who's job as Treasury Secretary includes overseeing the IRS, can navigate the complexity of the U.S. income tax system!

A powerful job growth argument for moving away from the U.S.'s current income tax based system is that doing so would eliminate significant bureaucratic complexity. Tax simplification would help individuals and small businesses, who often have difficulty dealing with the 65,000 pages of the U.S. tax code without hiring expensive tax accountants. Small businesses have created 65% of new jobs in the U.S. over the past 17 years. Reducing paperwork and filing burdens on this sector of the economy could help generate much needed job growth.

What's the Alternative to an Income Tax?

In contrast to income, society's best interests are not always served by consumption. Put simply, consumption can be a bad thing. This is particularly true in the case of overconsumption, which can lead to a low savings and investment rate as well as over indebtedness. Consumption that generates negative externalities which aren't or cannot be offset is also undesirable. An example of a consumable item which can lead to negative externalities is tobacco. Take the following personal example:

I enjoy the occasional 'victory' cigar. But by smoking cigars I may increase my chances of developing lung cancer. And if I develop lung cancer I may incur significant medical expenses. Under the current system some of my cigar-related medical expenses may end up being paid for by others.  

In a perfectly fair economic world, one coud argue that cigars should be taxed at the precise rate necessary to cover all medical costs associated with cigar related lung cancer. In this way only cigar smokers would cover the costs of cigar related lung cancer.

Some state and local governments have actually created tobacco taxes, which are often referred to as 'sin taxes'. Sin taxes, and your state and local sales taxes, are a form of consumption tax. Sin taxes are often placed on goods such as alcohol, tobacco and other products which generate externalities (like additional health care costs). In some cases the funds raised from sin tax are specifically allocated towards the prevention or costs associated with the 'sin'. For example, tobacco taxes may be used for advertising against smoking.

But should we try and tax cigars at the precise rate necessary to cover the associated health care costs, and then try and allocate those funds towards only cigar related lung cancer costs? The snort answer is no. The complexity and additional bureaucracy of trying to do so would make this effort extremely inefficient and costly.

So does that mean consumption taxes are not viable? Actually, no. Sin taxes, or your state or local sales tax, are not the only types of consumption taxes.

How the 'Fair Tax' Would Address Consumption Tax Criticisms

At the end of the Tim Geithner video there is a plug for the Fair Tax. What is it?

There are numerous arguments against consumption taxes. Below is a list of the main ones along with how the Fair Tax addresses each concern (in parentheses):

• Consumption Taxes are Regressive: Everyone has to pay consumption taxes whereas those with low income don't have to pay income taxes. Therefore consumption taxes disproportionately impact the less well off. (This depends on how the consumption tax is structured and implemented. The Fair Tax attempts to avoid being regressive through 'prebates')
• Economic drag: The U.S. economy is driven by consumption and any tax on consumption will make the current economic situation worse. (This would probably be true in the short-term. The Fair Tax recommends a phased implementation approach to mitigate this issue. However, over the long-term a number of policy experts, including former Federal Reserve Chairman Alan Greenspan, disagree that a consumption tax would be a drag. Many economists consider it the ideal tax system for driving economic productivity.)
• Complexity: trying to determine the exact tax rate to apply to cigars for the medical costs is difficult if not impossible to calculate. (The Fair Tax sidesteps this issue by applying a uniform tax rate across all consumption.)
• Lobbying: By trying to come up with targeted sales taxes you open the door to endless legislative lobbying by interest groups to tinker with the tax rate.  (The Fair Tax sidesteps this issue by applying a uniform tax rate across all consumption.)
• Disruption: Hundreds of thousands, it not millions of jobs (i.e., accountants, auditors, tax preparation software companies, lawyers, and lobbyists) have invested their careers in the current income tax system. A complete overhaul of the tax system would create widespread employment displacement.  (Yes, there would be change. But the economy would be better served by deploying these individuals to productive areas of the economy, which is discussed here.)
• Accomplishes Nothing, Just Replaces One Tax for Another: Switching to a consumption tax would be a distraction from addressing the fundamental budget problem, which is a mismatch between government spending and tax revenue. (The Fair Tax could lead to economic growth, which in turn could generate more tax revenue to help address government fiscal imbalances.)
• It Will Never Happen: Too many political interests are invested in the current tax code. A fundamental overhaul has too many political enemies. (This is an intellectually lazy approach to argument which attempts to dismiss an idea without addressing its merits.)

That's quite a list! Does a consumption tax like the Fair Tax stand a chance? Is the Fair Tax even the best consumption idea? There are others.

I'm not a Fair Tax expert. But I'm intrigued by what appears to be a very well thought out proposal which addresses many consumption tax concerns.

Looking Ahead

It is easy to get discouraged when contemplating whether seemingly intractable big problems, like the current economic situation or tax reform, can ever be addressed. Thankfully some solace can be found in U.S. history.

At the turn of the 20th century, very few thought the grip on government held by powerful business trusts, such as John D. Rockefeller's Standard Oil, could be addressed. The great trusts of that day simply wielded too much power, or so it was thought. It took over 10 years and a force of personality as strong willed as Teddy Roosevelt, but Standard Oil was eventually broken up.

During the Great Depression in the 1930s, very few thought the powerful bankers which had profited from stock market speculation could be regulated. But along came a relentless prosecutor named Ferdinand Pecora, and his tenaciousness was instrumental to enacting financial regulations. Those reforms ushered in a half-century of financial system stability.

In the current environment, the upshot of running out of tarmac is that the U.S. is close to exhausting all the suboptimal choices; government will soon be forced to do the right thing.

In other words, don't underestimate the likelihood of tax system overhaul and good economic ideas like shifting from the current bureaucratic income tax system to something like the Fair Tax.