In this week’s Grumpy Economist Weekly Rant, John Cochrane considers how the government can raise revenue while minimizing long-run economic damage. He argues that the current tax code does the opposite: it combines high statutory marginal rates with a complex array of deductions, credits, exclusions, and special provisions that distort economic decisions without generating commensurate revenue.
Cochrane proposes replacing taxes on income, businesses, investment returns, wealth, and estates with a broad consumption tax applied at a single rate. By taxing the largest possible base at the lowest possible marginal rate, he argues, such a system would reduce disincentives to work, save, invest, and form businesses while limiting the proliferation of deductions, exemptions, and special provisions.
Transcript
Hi. I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist’s Weekly Rant. Today, I’m gonna rant about taxes. How should we fix the tax code?
Now, as usual, I like to start with the long-run goals, not some little tweak that might get through Congress this term, because if we never talk about the promised land, we surely are never gonna get there. I also like to state the question before we dive into the answers—an unusual habit in our policy debates.
So let’s start with this question: How should the government raise revenue while doing the least amount of long-run economic damage?
My answer: The government should eliminate income, corporate, estate, excise, and all other taxes. It should tax consumption instead. It should tax every good at the same rate, with no special deals. Fighting the special-deal Swiss cheese is, in fact, the most crucial aspect of tax reform.
Now, the overall tax rate is set by overall spending, and economics really doesn’t have much to say about who should pay more and who should pay less. Economics cares about incentives, and incentives drive me to this answer.
So economics is pretty clear: Charge the lowest possible marginal rate—the amount of taxes you pay on an additional dollar that you earn, which generates the disincentives—on the largest possible tax base to make up the revenue. Tax everything just a little bit.
If you just tax strawberries, people switch to blueberries, and you don’t make much money. Tax all consumption—or income, if you must—at, say, 30%, rather than exempt half of it and then tax the rest at 60%.
Make sure that the all-in marginal tax rate—including federal, state, local, sales, excise, property, estate, and corporate taxes, as well as income-based benefit phaseouts—stays in the reasonable range, so that work, saving, investment, and business formation are still worthwhile.
Our tax code achieves about the opposite. It doesn’t raise much revenue and creates large economic distortions. It combines very high all-in statutory marginal tax rates with a Swiss cheese of deductions, credits, exclusions, and complex deals, so that it doesn’t end up raising that much revenue. And it biases what people consume a lot.
Now, when you tax anything, you get less of it—but some things more than others. So, ideally, the government would tax things that people will still buy and still produce despite the higher taxes. And it would tax less the things that people easily do without or refuse to produce when they’re taxed.
The English famously used to tax windows, and people promptly boarded up their windows. Don’t do that. Steve Goldman, who taught me macro at Berkeley, once put it: “Tax dialysis machines.” If you need a dialysis machine, you’ll pay anything to get one.
Now, we don’t do that, and for good reasons. The government, in fact, gives away dialysis for free. If anything, the government follows the opposite principle to try to redistribute income.
Most of all, then, if we open the door to taxing each good at a different rate, each industry will come pleading for a special tax break, and we’ll get exactly back to the mess that the income tax is in. Political economy trumps optimal tax theory here.
But that principle still applies to investment. That’s what gets me to the consumption tax. We don’t want to tax investment returns. There should be no taxes on dividends, interest, capital gains, wealth, or estates. We don’t want an artificial incentive to consume now rather than invest and consume later.
If you tax investment, you get less investment and, eventually, less capital, less income, and no more tax revenue. People board up all of those windows.
“Why do governments do it?” you might ask. Ah, well, taxing capital is an eternal temptation because the government makes money in the short run—until the capital’s all gone.
Income just isn’t a meaningful economic concept. We tax income because that was easier to implement in 1913, not because it makes any economic sense.
A consumption tax can be really simple. It can raise stupendous amounts of money. You can’t avoid consuming. There’s little real way to game it, so it’s actually more clearly fair.
This isn’t just promised-land nirvana. The 1986 tax reform dramatically lowered marginal rates and broadened the base. It can happen again. There was a FairTax proposal to replace the income tax with a national sales tax, and that was actually introduced in Congress. Many countries have value-added taxes. That’s easy.
I suspect we’ll get a value-added tax on top of our current tax system sooner or later, which would be a shame. European taxes contribute to nonexistent European growth.
I’ll be back with more next week, including answers to lots of your objections. Thanks for listening. And if you enjoyed this weekly rant, please click to subscribe.
John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.
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