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In this week’s Grumpy Economist Weekly Rant, John Cochrane argues that the tax code cannot be fixed one deduction or credit at a time. High marginal rates sit atop a web of deductions, exclusions, credits, and tax-favored investments that distort economic choices and reward tax avoidance.
His alternative is a clean break: replace the income tax with a broad consumption tax applied uniformly across goods and institutions. If government wants to subsidize particular activities, those subsidies should appear as explicit spending rather than remain buried in the tax code, making both taxes and subsidies simpler, more transparent, and easier to evaluate.
Transcript
Hi. I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist Weekly Rant.
Today, I’m gonna rant some more about taxes. Last time, I advocated a consumption tax. Today, how should we do it? I think it’s important to throw out the income, corporate, estate, and other taxes in favor of a value-added tax. A national sales tax would work almost as well, but many other proposals aim to reform income taxes in an investment-friendlier direction.
Now, I think it’s vital to throw all that out and start over because it’s the only way to get rid of the rotten Swiss cheese of deductions, exclusions, special deals, and so forth. Now, it seems easy to see that taxing all your consumption or your income at 30% is better than exempting half of it and then taxing the rest at 60%. Oh, and then 80% once you react to the disincentive and you work less.
But each provision of the tax code has an affected industry, influential taxpayers, and an army of lawyers, accountants, and lobbyists, and they’re determined to fight for it. And rightly, one at a time doesn’t pay for itself in lower marginal rates. You have to do them all together.
Now, for example, healthcare and health insurance, home mortgage interest, educational expenses, and charitable distributions are all deductible. That adds up to a lot. It also means we spend far more on houses, education, and the sometimes questionable activities of nonprofits than we otherwise would do.
Tax deductions are also regressive. The top federal plus state marginal tax rate in California is 54%. So, a $100 tax deduction is worth $54 to a California millionaire. But it’s only worth $12 to a Florida couple who earns $100,000. When that Californian gives $100 to a nonprofit, other taxpayers have to pay 54 more dollars to the federal government.
The Florida couple’s gift gets a much smaller match, if any at all. It’s funny, both left and right want a more progressive tax code. Tax the rich, but nobody seems to complain about this regressive aspect of deductions. There’s a big lesson in there. The tax code hides skullduggery. Don’t fight it there; bring it out in the open.
The tax code is also riddled with spending and subsidies in disguise. Here are a random few: the residential green energy credit, the energy-efficient home improvement credit, the earned income tax credit, the child, family and dependent care tax credit, the American opportunity tax credit for education expenses. I know, it goes on and on.
I found a PwC study that listed hundreds of corporate tax credits. I’ll start at the top just for fun: the work opportunity credit, the alcohol fuels credit, the research credit, the low-income housing credit, the disabled access credit, renewable electricity production credit, Indian employment credit, tip credit, orphan drug credit, new markets tax credit, small employer pension plan startup cost credit, employer-provided childcare credit, railroad track maintenance credit, and it goes on and on like this.
Too many businesses pay more attention to avoiding taxes than to making products. Nonprofits, which employ about one in 10 workers and include most hospitals and educational institutions, pay no taxes at all.
Our taxes on investment are particularly dysfunctional. The government sort of recognizes that taxing saving and investment is a bad idea, but rather than reduce the high rates, it offers a smorgasbord of tax-sheltered investments, each with its own complicated rules. The 401, the 526B, the IRA, the Roth IRA, life insurance carve-outs, and so on and so forth.
Capital gains taxes lead people to hold on to investments too long, and they charge taxes on inflation. Taxing corporate profits and then dividends adds up. The estate tax is particularly rotten. It pretends to tax 40% of wealth above $11 million once a generation, but it raises almost no new revenue. The tax code seems deliberately set up to charge high rates and then invite people to plead for exemptions.
Maybe it is.
Now, a great politician in a functional government like President Ronald Reagan working with Speaker Tip O’Neill can get everyone together and say, “Look, each of you is gonna lose your own special deal, but you all make it up on the lower rates. Eh, good luck with that today.”
But if we get rid of the income tax, it all goes away on its own. No tax, no deduction, no fight.
Of course, these well-oiled interests will try hard to keep their subsidies in other ways. What do we do?
So, first, it’s vital to make sure we don’t go down the same road as the income tax. Everyone pays the consumption tax, including universities, hospitals, nonprofits, and so on. Every good pays the same tax, including food, electric cars, childcare, and whatever else the government wants to subsidize.
Second, admit that our government wants to subsidize various sectors and activities.
So, move all of that to a separate subsidy code. Do you want to offer millionaires a $54 matching grant on their mega-mansion mortgages, health insurance, and gift of the Sierra Club? Fine. Write checks annually allocated on budget where voters can see them.
In fact, I’d offer a deal. Put all the current subsidies written up as spending, and then we’ll fight about it later. There is no need to fight about each deduction. Keep the tax code clean; subsidize by visible spending. The economy will grow, and the spending will take care of itself.
Now, I’m sure you have many more objections. I’ll be back next week. Thanks for listening, and if you enjoyed my 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.