Thursday, October 20, 2005

Wonky Post of the Week: The X Tax, Not My Pony

by Tom Bozzo

A couple weeks ago, Mark Thoma had picked up a Bloomberg article by Kevin Hassett of the American Enterprise Institute speculating that the Bush tax reform commission might recommend the ominously-named X Tax as a sea change in the tax system. At the time, I was in a wonky mood and had started, but never fully developed, an X Tax post; subsequent news seemed to have rendered Hassett's prediction about as operative as Dow 36,000 (Hassett's bubble-era work of fiction co-authored with Tech Central Station meister James K. Glassman) — apparently John Breaux has indicated that total exemption of investment income is a non-starter from the center-right on leftward — but TaxProf Blog quotes Bill Gale of Brookings suggesting that the commission may yet propose relatively far-out changes among its alternatives.

Some of the taxprof bloggers got pretty excited at the prospect of the X Tax being recommended as an option for the real tax code, e.g. Victor Fleischer at The Conglomerate (also the source for the TaxProf Blog link). Fleischer suggests that progressives might want to support the X Tax, and at a minimum shouldn't autonomically reject it. In that spirit, I'll recover a portion of my X Tax musings from the Island of Lost Posts.

Hassett called the X Tax "a brilliant redesign of the famous flat tax that delivers most of the economic benefit of the tax, while allowing policy makers to maintain the progressivity currently in the code." It was devised by the late David Bradford. Fleischer notes correctly that the X Tax really isn't a flat tax at all on the individual side, contending that it's a "progressive consumption tax." From my reading of some of Bradford's papers, I don't agree. Unless I'm missing something, the X Tax isn't really a consumption tax either.

The quick version of Bradford is that the X Tax would tax transactions in the "real economy," so businesses would pay a flat tax on their net final sales of goods and services, less compensation costs, while individuals would pay tax at graduated rates on wages and salaries. Financial transactions are outside the tax base, and Bradford noted that taxing financial institutions is potentially problematic. The top rate for the compensation tax would equal the business tax rate.

So the X Tax is really a progressive payroll tax on the individual side, and I'm not convinced that progressivity sweetens the deal when individual investment income is totally excluded from (individual) tax.

The usual progressive consumption tax formulation, in which investment income is at least subject to tax when it's consumed, at least discourages heirs and heiresses from extremes of profligacy, which Robert Frank has suggested may have broader benefits if you happen to think rampant consumerism needs to be restrained.

Still, there are ways to formulate the basic tax fairness question in which progressive consumption taxes don't seem likely to fare well for liberals. For instance, if the consumption tax fairness question is posed as, "is it fair to tax someone who must spend X the same as someone who chooses to spend X but could spend Y which is (possibly a lot) more than X," would you say yes? Or, to put it slightly differently, does ability to pay count? The answer pretty clearly is a matter of normative outlook, but an affirmative doesn't seem to be a slam dunk for political progressives. For the X Tax, you have to go further and offer an affirmative to the question of whether it's fairer to tax someone who spends X out of wage or salary income higher than someone who spends X out of investment income.

Fleischer notes:
Liberals must recognize that our current system fails to tax a lot of investment income, so don't defend the status quo for the sake of defending the status quo. More importantly, the X-tax would eliminate some important economic distortions that don't help poor people very much, like the home mortgage interest deduction.
Fleischer's first point is fair, though it doesn't follow that the failure of the current tax system to get all investment income into the tax base implies that the optimal tax rate is zero. Just what the optimal rate might be resides at the not at all clean boundary between positive and normative economics. That is, it's a fundamentally normative judgment that the social welfare function should assign very small social benefit (utility), on the margin, to the last dollars of income of the very rich. It is also possible to deny that there is even such a thing as a "social welfare function," however much I and most mainstream economists might be inclined to believe in one.

On the positive-economics end of things, I don't find the suggestion that relatively low tax rates on the income would discourage much investment. A zero rate on investment income implies more labor supply distortion for a given revenue yield, as Bradford himself noted. (I'm just old enough to remember when some conservative economists cared about labor supply distortions.) It's also a stretch to suggest that increasing the after-tax price of owner-occupied housing is a good way for progressives to help the poor. Irrational stigmatization courtesy of Frank Luntz types aside, taxing the wealth transfers of the very rich deceased would seem to be a lot more effective under a reasonable social welfare function.

Overall, the X Tax doesn't sound very appealing from a politically progressive perspective since, on the face of it, it doesn't even try to meet ordinary consumption taxes' minimal fairness standard of taxing actual consumption in its entirety. It really looks like a tax that heirs and heiresses will love a lot more than everyone else, and I will not cop to the fairness of taxing the idle rich less than everyone else.
Thanks for writing about this.
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