U.S. tax supremacy
Neil Joseph | Tuesday, February 7, 2017
Throughout the world, there are a variety of tax bases that are used to collect revenue for governments. Many countries use both a personal income tax, others use a consumption tax and some (like the United States) use a combination of both. There are positives and negatives to all options, and governments have to decide which is best given the effects on each tax base. The United States’ current hybrid system is the best option for a tax base because of its characteristics: It allows the tax system to avoid regressivity and promote progressivity if it would like, while also encouraging certain types of saving and investment.
First, the current system of taxation in the United States allows the government to avoid burdening the poor more than the rich. If the United States switched to a pure consumption tax, there would be a heavier burden on the poor. The poor consume a larger portion of their income (in some cases, close to all of their income) than the rich do. Because of this, a much larger percentage of their income in each year would be subject to taxation than the rich. Although this does encourage saving, some families just cannot afford to save — and a pure consumption tax would likely have a larger effect on them. With the hybrid system we have today, there is no problem with regressivity — the government can tax different levels of income at different rates. They are able to (and do) alleviate the burden on poorer families by considering what all people consume in the context of what they make. Due to this, the government is able to choose to not burden families who can barely take care of themselves. This is an important feature, as it essentially puts dollars back in a family’s pocket that would’ve been given up in taxes under a consumption tax.
In light of the aforementioned problem with the consumption tax, one must consider why the personal income tax is not the simplest alternative. It does allow for progressivity and prevent regressivity.
So why is the hybrid system better? The personal income tax, unlike the hybrid system we have today, taxes all income equally. As a result, the taxes that are imposed on things such as dividends, interest and capital gains lowers the benefit of savings compared to consumption in the present. The personal income tax also lowers the incentive individuals have to invest (by taking the tax before individuals invest), thus creating less interest. This discourages saving and raises the value of consumption in the present. With the hybrid system, however, the federal government can choose to reduce the penalty of certain types of saving. Things like IRAs, which are beneficial to an investor’s futures, can be exempt from taxes — which reduces the penalty for consumption in the future. The hybrid system also allows certain investments to be given preferential treatment, such as capital gains. Although in a consumption tax no saving is taxed, the personal income tax would be far too harsh on taxing before-saving income — in turn, dis-incentivizing saving.
The hybrid system we have today is most effective because it takes the best of the consumption and personal income tax and combines them into one policy. The consumption tax is good because it encourages saving: The hybrid will incentivize and encourage select investment. The personal income tax is also beneficial because it is not as regressive as the consumption tax and is able to be progressive; the hybrid system does this also. It doesn’t go as far as either plan, however, which may be a good thing. The hybrid system allows the government to choose what sort of saving and investment it should encourage. For example, in today’s system, the saving that is encouraged is picked by what the government exempts from taxation. At any time, the government could change the tax code to incentivize different saving, depending on what economic analysis indicates is best. This allows the government to be especially flexible. Furthermore, although the hybrid system may ask for more financial information than the other tax systems, that information can also be useful. Some of the different tax credits and deductions are targeted at certain groups of people who really need help. This allows the government to pinpoint where individuals are spending their money and give aid where needed. The hybrid system encourages saving, is not regressive and allows for government flexibility, making it the best option for a tax system.
The views expressed in this column are those of the author and not necessarily those of The Observer.