Summary of my views on the ideal tax system

Government programs (expenditures, mandates, regulations) should be evaluated for their benefits and these compared with their costs. The resulting level of government expenditures politically prioritized and determined (hopefully on this basis) should be financed in the most economically neutral, equitable, and efficient (costs of compliance, collection and enforcement) ways possible. The following proposals are based on these assumptions and objectives. Stress is placed on the high compliance costs and enforcement difficulties of existing taxes in an increasingly globalized world.

Very simply stated, the ideal taxes in terms of neutrality (minimal distortion of relative prices) are either a comprehensive income or consumption tax. A comprehensive consumption tax is more neutral than an income tax, which distorts the choice between saving and consumption by taxing saving. For some, however, an income (the return for what you give society) tax is more equitable and for others a consumption (what you take from society) tax is more equitable. Use taxes (such as tolls or gasoline taxes for the use of highways), which are generally considered both neutral and equitable and thus desirable when feasible, are not otherwise considered here.

However, the ease of avoidance and costs of compliance are very different for income taxes (whether based on the residence of the tax payer or the territories in which the income is produced) than for a consumption tax, which necessarily applies to the territory in which consumption occurs.[1] U.S. efforts to prevent income tax evasion (both business and personal) by hiding income abroad have become increasingly costly, intrusive, and obnoxious to foreign governments. For these reasons, and the reasons of neutrality and equity, I favor a comprehensive consumption tax (VAT) combined with a rebate (negative income tax) to every man, woman, and child legally resident in the U.S. and the abolition of all income, wealth, and wage taxes.

Taxes on business income violate almost every standard of good taxation and contribute most to political controversy and to business costs aimed at reducing evasion. With increased globalization, efforts to define business income within the tax jurisdiction and to detect taxation evasion by moving income (as apposed to actual economic activity) abroad are becoming more difficult and invasive into the policies of other countries. The taxation of business income should be totally abolished.

Payroll (wage) taxes used to finance pensions might be thought of as a use tax. However, in the case of the payroll tax, which is nominally linked to the Social Security pension in the U.S, the pay-as-you-go financing of the Social Security pension makes the link weak. Furthermore, payroll taxes are very regressive.

The primary appeal of an income tax over a consumption tax rests on the public’s perception of fairness. Why should income from clipping bond coupons be taxed less than hard labor? A preference for an income tax may also reflect the desirability of limiting the accumulation of wealth and income inequality even potentially at the expense of less investment and thus lower incomes for everyone. An often overlooked drawback of income taxation is the relative ease with which the wealthiest can evade taxation via various off shore (or even on shore) vehicles for hiding it. IRS efforts to find all income earned or sheltered abroad raise similar problems for international cooperation and relations as do such efforts with regard to the corporate income tax. Defining and measuring properly net income subject to taxation can also be problematic as is the fairness of taxing U.S. citizens living and earning their income abroad. None the less, under the existing tax code those with incomes in the top 1 percent paid 40 percent of all income tax revenue in 2006 and earned only 22 percent of all income, the top 10 percent paid 71 percent and the bottom 50 percent less than 3 percent.[2]

I support a comprehensive consumption tax (Value Added Tax) for all residence in the U.S. When combined with cash rebates to all legal residents equivalent in value to the consumption tax paid on purchases of essential goods and services by every man, woman and child, the tax becomes modestly progressive and satisfies a sensible notion of fairness. As I also think a minimum level of retirement saving[3] and medical insurance should be mandatory as part of making our social safety net more efficient and equitable, the per person cash rebate should be large enough cover these mandatory minimums. To insure compliance with these mandatory payments, these amounts could be deducted from the cash payments and invested in a standard retirement fund or health insurance policy for anyone unable to document that they have satisfied these requirements.

Residents would support government services in proportion to what they take (consume) from the economy rather than on the basis of what they give (produce). By every calculation of actual tax collections, the wealthy would pay more than they do now with existing taxes. Its collection and enforcement would yield enormous simplifications and compliance cost savings. The IRS could stop chasing money around the world. A tax rate of 23 percent on after tax consumption (which makes the rate comparable to an income tax (i.e., 30 percent of pre tax consumption) is estimated to raise the same revenue as existing federal income taxes, including, personal, estate, gift, capital gains, alternative minimum, Social Security, Medicare, self-employment and corporate taxes.

[1] This is a simplification. A good may be purchased in another state or country and carried across borders to be consumed at home. Border tariffs for the difference in the foreign and the local consumption tax rates would be needed.

[2] Wall Street Journal, “Their Fair Share”, July 21, 2008 p A12

[3] Funding private pension plans attached to individuals rather than through companies in place of the existing, pay as you go social security system.


About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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One Response to Summary of my views on the ideal tax system

  1. member55 says:

    I just read your post and was glad to find that someone else had thought of almost the exact same ideal tax system I thought of many years ago, (and continue to believe it is the most efficient). You provide a very thoughtful and clear way to describe it. Thank you. Here are a few things I would add to the system:
    1. Taxing consumption regardless of where it happens. If the sales tax of that item, service or product in the foreign country is less than in the US, that person must pay the difference to the IRS. If the foreign tax rate is higher, that person does not pay any additional tax. The problem if you do not do this is that you would get rich people to buy yachts, houses, and planes outside of the US, in places like Monaco, Cayman Islands, etc. Although there would be some policing required (which is costly) it would still be less than today given there would be a transaction somewhere. Moreover, because of the direction the world is moving to, digital records would likely exist for most transactions. In the same manner that the US currently expects every US citizen to pay taxes even on income abroad, the US should expect to tax every consumption, regardless if it happens inside the US or not. Plus, I would add a very high penalty that should deter the vast majority from cheating. As an example, if the consumption tax was 25%, the penalty should be 125%.
    2. Every legal US resident (man, woman or child) gets an automatic deduction, received as a direct deposit on a bank account, of up to X amount (like $50,000 adjusted every year to some inflation basket). I would pay it in quarterly installments to provide some ‘ongoing’ safety flow. I believe this would be smart because psychologically, people would see the government as ‘giving them’ money even though that is not the case (goods and services are being taxed before). And two, people at the bottom who are struggling and trying to rise by working, investing, or starting a business, should not really pay much tax. Since the auto deduction would be given to everyone that is legally in the country, everyone would want to be in the system (there would be some spillover positive effect on cracking down on illegal immigration as they would not get the $50,000 deduction, and thus in comparison to legal us residents, it would be costlier to live here).
    3. [I know this is more controversial] 50% of taxes paid by each of us are allocated by the government (as it is currently done) and 50% of taxes are allocated based on monthly digital voting by each of us in proportion to how much each of us pays. In other words, if John paid $100,000 in consumption tax and Mary paid $150,000 in consumption tax, John would decide how $50,000 should be spent and Mary would decide how $75,000 would be spent (categories like senior care, cancer research, environmental, military, infrastructure, local roads, etc.) There could be a simple quarterly voting mechanism. I believe this to be important, because I feel most people do not understand the concept of limited resources. Yes, it would be great to save every animal at risk of extinction. But is that worth more than investing in cancer research, education, or infrastructure? Everyone would answer that question with their dollars. Whoever does not vote, is allowing the government to decide on their behalf. Three additional benefits from this solution: a) it would educate the population about where taxes are being spent, b) it would spark innovation as to how to solve issues in more effective ways, and c) it would reduce the need for lobbying. The reason I would not recommend 100% allocated by individuals is because there are issues that cannot be left to a vote – as examples research about defense technology and counter terrorism may seem like an unnecessary distant necessity until something really bad occurs.

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