Optimal Tax Policy

Matt Yglesias has made a mediocre post on optimal taxation. I'll try to hit some points that do a better job.

1. Taxes should not distort economic decisions that would have been made in their absence unless we are distorting those economic decisions on purpose in furtherance of intended policy goals. For example, the tax system: 

* should not prefer debt over equity financing (e.g. dividends and interest on loans should result in comparable combined taxation), 

* should not prefer subordinated debt over insurance mechanisms for protecting investors from risk (e.g. mortgage insurance as well as second mortgage interest should have similar tax treatment for home owners),

* should not prefer renting over owning (e.g. there should be a rent deduction comparable to the deduction for mortgage interest and property taxes)

* should not prefer tangible capital or financial capital over human capital (e.g. education expenses should be deductible), and

* should not prefer income from property over income from labor (e.g. capital gains and qualified dividends and "carried interests" should not received favorable tax treatment).

2. Intentional distortions of economic decisions to mitigate negative externalities with taxes should involve tax burdens comparable in magnitude to the harm caused by the externality. These taxes should also, ideally, be earmarked to mitigate the externalities caused. For example:

* Vehicle taxes should approximate the wear and tear on infrastructure that the vehicle creates (a per mile odometer tax adjusted for vehicle weight and owed when a car is registered may make sense).

*  Carbon taxes should approximate the harms caused by fossil fuel pollution.

3. Intentional distortions of economic decisions to encourage conduct with positive externalities with tax subsidies should involve subsidies comparable to the benefit the positive externality generates. These subsidies should be treat as expenditures in the budget process. Tax subsidies should be used only when direct spending is significantly less efficient and should regularly be reviewed for efficiency in generating the desired benefit. There are lots of dubious tax expenditures in the Internal Revenue Code that should be scrapped.

4. Taxes should be linked to means of determination that are transaction driven and hard to dispute, to the extent feasible, rather than based upon theoretical values.

* Cash flow based taxation for businesses (with what are now capital expenditures being deductible, loan proceeds being income, principal payments on loans being an expense, and no depreciation, amortization or depletion deductions) would be preferable to the current system of capital investments and loan proceeds that are not taxable and depreciation, amortization, and depletion deductions that are expenses without cash outlays. This eliminates the need to track capital gains tax basis and maintain depreciation and amortization schedules.

* C-corporation, trust and estate style taxation of distributions to beneficial owners when actually made is preferable in taxation of entity income to passthrough taxation. Pass through taxation should be limited to income allocable to unlimited liability owners of a company (treating a limited partnership as a partnership between a general partnership and a corporation made up of the limited partners).

* Taxes requiring property valuation should be disfavored in cases where there is not a well established market price for the thing valued, but can be attractive when a market price is easily established from many current and comparable transactions.

5. Taxes should be hard to defer with a preference for paying now rather than later. Indefinite tax deferral has a comparable economic impact to non-payment of taxes. For example:

* The deferral of gain in like-kind exchanges of investment real estate pursuant to IRC § 1031 should be eliminated.

* Multiple year carry forwards or carry backs of losses should be disfavored.

* A corporate entity level tax (or immediate passthrough taxation) is necessary to prevent taxation of income earned at the entity level from being indefinitely deferred.

6. Taxes should be paid to the geographic governmental subdivisions closest to where the underlying economic activity that gives rise to what is taxed occurs. In the case of intangible income, this should usually be the place the the transactions generating it occur and not the places where it is received. In a related point, taxes should be designed to address the fact that there are multiple levels of taxation in a federal system and that we have an open economy that includes interstate and international business. For example:

* Intellectual property royalties and sales taxes from the sale of intangible serviecs like streaming software should be subject to taxation when sales generating the royalties take place, or where the goods or services are delivered if this is not as "hot" and subject to manipulation.

* Retirement income should be taxed by the jurisdiction where the retirement funds were earned.

7. Taxation of non-profits should minimize the interactions between the tax collection system and non-profits. But this should not open up loopholes that undermine the taxation of the for profit tax sector. For example:

* Charitable deductions should be eliminated for income tax purposes, so that tax officials are not tracking who contributes charitably to whom and whether the charity is worthy. This is already the case for the tens of millions of taxpayers who do not itemized their deductions (especially homeowners in states with low taxes and renters).

* The 501(c)(3) tax exemption should remain but investment income and payrolls should continue to be subject to taxation. This would protect non-profits from most kinds of audits intrusions.

* The exclusion of charitable gifts from gift and estate taxation should be retained since the gift and estate taxes are taxes in lieu of income taxation on the person receiving it and non-profits are not taxable on the income that they receive.

* The minister's housing exemption should be repealed.

* Sales tax exemptions particular to non-profits should be repealed. This way vendors don't have to treat non-profits differently from other customers.

*  Property tax exemptions for non-profits owning ordinary taxable property should be repealed although special valuation rules or taxes in lieu of property taxes may need to be established for property that has a very thin market in which the transactions that do take place are often not at arms-length like churches.

* The exclusion from income for municipal bond income should be repealed.

8. The overall tax system should not be regressive. It should be flat or progressive. High rates of marginal taxation of lower incomes should be avoided, and for this purpose, the phase out of means tested benefits should be considered. In a related point, taxes should not tend to push someone from not being in poverty to being in poverty. For example:

* Integrating a universal basis income into the tax system can avoid the complication of phase outs of means tested benefits.

9. The taxes used to pay for public spending should be commensurate with the characteristics of the tax. For example, these characteristics include the geographic equity, business cycle patterns, changes with economic growth, and magnitude of what they pay for, to the extent feasible.

10. Taxes should be imposed in a manner sensitive to tax related transaction costs so that the transaction costs are not unreasonable relative to the revenue generated by taxes. One important subset of transaction costs is tax planning for the purposes of reducing taxation in ways not in furtherance of intentional policy goals. Loopholes are undesirable in part because they encourage wasteful tax planning.

* One of the big offenders here is the Medicaid Cost Recovery System which is basically the poor man's estate tax, impose an immense planning and economic burden on the assets of people who die after having received state subsidized, means tested nursing home care.

11. Aggregate taxation levels from all types of taxes should be sufficient to pay for all long term average public spending, both on goods and services that are more desirable to purchase governmentally than privately and also on transfer payments as necessary for reasonable equity in society without eliminating incentives to earn income or be profitable in activities that are socially desirable on a net basis. We shouldn't run annual deficits in ordinary times but should use debts to buffer the economy in bad times, and should set aside rainy day funds in good times. 

On balance, in the U.S. we err on the side of underinvesting in public spending, resulting in less efficient private sector attempts to address the same issues that could be addressed with public funding, which means higher taxes to pay for that and to reduce the long term average annual budget deficit (not the national debt itself) would be a good thing.

12. Taxes should be designed and administered in a manner that keeps the "tax gap" between taxes imposed and taxes collected small. For example:

* Third-party information reporting should be established in areas where the tax gap is large.

* Excessively complex provisions like the "earned income tax credit" should be redesigned or eliminated to reduce the vast number of audits it creates. The Obamacare tax credit is similarly absurdly complex.

Criticism of Proposals From Matt Yglesias

1.  Yglesias is a proponent of a "Land Value Tax", which purports to be good because the supply of land is fixed so it is hard to evade and investments in its can't increase or decrease the supply of land. But, a Land Value Tax doesn't tax land, which is fixed in supply, it taxes "Land Value" which is not fixed in supply. Land value, in reality, is indirectly a product of the buildings built in the neighborhood of the land being valued. But it does puts arguably counterfactual theoretical analysis (since few sales actually involve land alone) between market comparable values and the quantity being taxed. 

It also arguably puts too much pressure on the owners of vacant land to develop it despite the fact that it doesn't generate any revenue, or in the alternative leads to tax sales, because the development value of vacant land doesn't generate income and hence doesn't generate an ability to pay this tax.

A better way to think about property taxes is as a tax in lieu of an income tax on the fair market rental value of use property that isn't taxed in an income tax since income taxes usually don't tax imputed income from property ownership. 

In this analysis, it isn't obvious that it makes sense to impose property taxes on real property that is a factor of production (like agricultural land) as opposed to use property, any more than it does to impose sales taxes on both the full amount of wholesale sales and the full amount of retail sales, effectively giving rise to double taxation.

Any kind of property tax or Land Value Tax is also a troublesome way to finance a good or service like public education that needs to be delivered to people statewide or nationwide, partially though local taxes, since there is so much variation in tax base of real estate in different areas. Only a couple of very low population rural states have statewide property taxes.

2. Yglesias makes a half-hearted case in support of consumption taxes while also favoring strongly progressive consumption taxation and arguing the the source of income should matter. His proposal looks a bit like a value added tax or sales tax analysis. But, mechanically, it is difficult to make that kind of consumption tax progressive or even flat, and the alternative to a VAT or sales tax is usually an exemption for income from property (sometimes in the form of a generalized IRA with no contribution or withdrawal limits whose gains aren't taxed until withdrawn, effectively deferring income taxation but not eliminating it).

Essentially all consumption taxes are regressive and are especially regressive with respect to the very rich, in whose case even basically consumptive purchases are easy to reclassify as investments. He admits himself that:

The economic case that consumption taxes increase economic growth in the case of real world consumption tax proposals are also based upon pretty feeble macroeconomic analysis that isn't rigorously and unequivocally supported empirically.

He and I agree that a carbon tax or greenhouse gas emissions tax makes sense, even if the right dollar amount per ton is not something that can be scientifically determined down to the last dollar (Biden is proposing $51 a ton, he points to studies that suggest something more like $258 per ton.) The best is the enemy of the good and I'd be glad to see anything done.

He thinks that:

With respect to alcohol taxes, the current amounts are so small that they barely justify the costs of collection and vastly higher alcohol taxes would have a pretty regressive effect (although less than one might expect because really poor people don't drink much alcohol).

With respect to Marijuana taxes, he's smoking something, because marijuana is already extremely heavily taxed at the federal, state, and local levels, for example, due to IRC § 280E.

With respect to sweeteners, the studies that have been done to date are a mixed bag and we don't really understand the causes of obesity well enough to be making tax policy based upon it. And, there is a basic cost-benefit issue since even a high sweetener tax would still generate not that much revenue for high collection costs.

He may have had better proposals in the gated portion of his post, but if so, he didn't put anything in his introductory discussion to suggest that they were coming.