March 10, 2005, 10:48 a.m.
Another Look at Taxes
Before we reform, we must ask why and how.

Ever since the institution of taxes, especially the income tax, governments have tinkered with the size and shape of tax reform in order to accomplish a potpourri of social and economic objectives. President George W. Bush is at the leading edge of tax reform these days. So far his administration has implemented a number of major changes in the tax code — primarily to provide stimulus to an economy that was languishing in the shadow of a technology-industry meltdown in 2001. But now, in his second term, the president intends to institute landmark changes in the tax code.

Will he do it? I wouldn’t bet against him. The question, though, is how he does it.

Headlining Bush’s second-term reform agenda is a plan to restructure the Social Security system by allowing for the allocation of some payroll taxes into personal savings accounts that will accrue to the benefit of savers. Once this restructuring has been completed, Bush will move to a milestone commitment: simplifying the tax code.

Early this year the president appointed a commission to examine options that would simplify the tax code and increase economic output while maintaining a fair tax system. By July 2005, this commission will present a preliminary list of options to the president for his consideration. Last week, in congressional hearings, Alan Greenspan supposedly endorsed one such option, a consumption tax. Shortly thereafter, in a Wall Street Journal editorial, Laurence J. Kotlikoff, chair of the economics department at Boston University, broadly endorsed a consumption tax as a “fair tax.” A consumption tax is the equivalent of a national sales tax, or it can be a “value added tax” imposed at each level of production.

Before the commission heads down the path of restructuring the tax code, it should first determine the basic purposes of taxes. One important question to ask is: Why does the government tax in the first place?

“Taxation is part of the process of obtaining the resources needed by the government,” wrote Warren B. Mosler in Soft Currency Economics (1994). “The government has an infinite amount of its fiat currency to spend. Taxes are needed to get the private sector to trade real goods and services in return for fiat money it needs to pay taxes.”

A new tax code should then be designed to minimize intrusion into the production and consumption of goods and services in the private sector. Arthur Laffer, famed supply-side economist, demonstrated this relationship when he created the Laffer Curve, a pedagogic device that demonstrates how rising tax rates can produce lower, not higher, tax revenues as people will avoid or even evade paying taxes by both legal and illegal means.

While a consumption tax may offer many advantages, as pointed out by Kotlikoff in the Journal, there are also many drawbacks — not the least of which is the ability for consumers to change spending patterns that can have an enormous negative impact on real output.

Compare that potential volatility with a national real-estate tax, one that would be almost impossible to avoid, would provide stable tax liabilities not unlike the real-estate taxes paid to finance state and local government today, and would not discourage consumption of the goods and services we want the economy to produce. Such a tax could also easily be made progressive, as desired, to target distributional issues. A national real-estate tax would also accomplish a fair distribution of the tax code by minimizing taxes on the poor — those least able to afford a consumption tax and those who do not usually own real estate — and maximizing taxes on the rich, or the wealthy who can most afford to pay taxes. Don’t jump to conclusions that a national real estate tax is the best alternative — let’s just get it on the table.

What’s fairer than that?

The tax commission should also consider the rationale for other purposes of taxation such as discouraging certain types of behavior. The sharp increases in taxes on cigarettes may be going a long way toward lowering the consumption of tobacco, the measure of success being how the tax take from smokers shrinks over time. But then it may also be creating a heck of a black market in cigarettes, thus bringing in the whole concept of using taxes to influence behavior.

Finally, taxes can also be levied to minimize or reduce the consumption of real resources. Maybe the government had it right when necessity created the corporate average fuel economy standards (CAFÉ) back in the 1970s. Without such legislation and the attendant tax penalties, our vehicles could still be getting 10 miles to the gallon and gas prices would be $5 or $6 a gallon!

President Bush will have an historic opportunity to restructure the tax system to keep the U.S. economy as the number one economy in the world. Let’s watch how he does it.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.

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