Tax Analysts Blog

Business Should Lead on Deficit Control and Tax Reform

Posted on Jul 26, 2010

America's tax system faces two great challenges in the 21st century. It must generate enormous amounts of revenue to prevent the national debt from spiraling out of control, and it must generate that revenue in a manner that will interfere least with the market economy.

The nonstop antitax bluster from Republicans in Congress has smothered all rational discourse about raising taxes. Sure, that approach is a smart opening bid in the great partisan debate with progressives about America's fiscal future. And for many it is a matter of political survival as tea partiers threaten any Republican suspected of being soft on taxes. But as conservative economists will privately tell you, there is no realistic scenario in which federal finances are put on a sustainable path without tax increases.

If we try to inflict all the pain on the spending side, that would require a 13 percent cut across the board -- including Medicare, Social Security, and defense. That's for 2015. Over time, even larger cuts would be needed. Even if Ron Paul became president and Oklahoma's James M. Inhofe became majority leader in the Senate, this would still be an impossible dream. So for just a moment we would like to calmly discuss tax increases without being branded liberals with a secret agenda. The big question that needs answering is this: If there must be big tax hikes, what form should they take?

Rate increases to the income tax, like those proposed by President Clinton in 1993, would please most liberals but would only amplify existing inefficiency and compliance problems. They are the antithesis of tax reform. From an economic perspective, they're a total cop-out.

Broadening the income tax base, as President Reagan did in 1986, is a far superior approach. But possibilities for significant revenue increases are limited without digging into the big three individual tax breaks: the mortgage interest deduction, the deduction for state and local taxes, and the deduction for charitable giving. That's an extremely tough haul (and most likely Congress would move to raise rates instead). Those looking for a repeat of the 1986 political miracle must remember that even Reagan was able to pull that off only by insisting on a revenue-neutral bill. Revenue-raising tax reform would be exponentially more difficult.

Income taxes are inherently biased against saving and capital formation. Consumption taxes are not. The most economically sound path for raising revenue is a new federal consumption tax. The rest of the world has figured that out. As shown in the figure, among the largest economies, the United States is least reliant on consumption taxation. All other large countries have VATs. This is the obvious starting point for debate about a consumption tax for the United States.

But a new VAT would not help the economy. It just does less harm than the alternatives. To improve competitiveness, we need to be thinking about reducing, rather than raising, income taxes. The component of the income tax that should be first on the chopping block is the most economically pernicious: the corporate income tax.

So here is an outline for a deficit-cutting, pro-competitive fiscal future: Impose a broad-based VAT at a rate of about 7 percent. Use half of that new revenue for deficit reduction and half to replace the revenue lost from repealing the corporation tax. This is not a wimpy sellout to tax-and-spend liberals. The plan would still require gut-wrenching, across-the-board spending cuts of about 7 percent to achieve fiscal sustainability.

Liberals will complain that it is an unjust shift of the tax burden from rich to poor. Conservatives will howl that we should be starving the big-government beast, not building a stealth "money machine." (Gee, everybody hates the idea. We must be doing something right.) But those objections are fueled more by knee-jerk populism than the pragmatism we will need to face our looming fiscal collapse.

It will be up to American business to lead on this one. It has the credibility on economic issues to get the conservatives to listen. It has the clout on Capitol Hill to get the bills introduced and debate started. To the objections of the right, business can argue that the tax could be made transparent to voters by requiring it to be stated on all receipts and invoices, as in Canada, where Prime Minister Stephen Harper recently reduced VAT rates by 2 percentage points. As an additional reminder, estimates of the annual VAT paid could be sent to each family after they file their income tax returns.

To the objections of the left, business can point to recent economic research showing that the burden of the VAT is less regressive and the corporate tax is less progressive than conventional analyses have shown. Remaining concerns about shifting the burden down the income scale should be handled on the spending side -- for example, by means-testing of Social Security and Medicare.


Consumption Taxes Around the World, 2008
as a percentage of GDP



Source: OECD, available at http://stats.oecd.org/Index.aspx?DataSetCode=CSP2010.

But first business must convince itself. That should not be too hard: It is entirely in its self-interest. If there is no end in sight for the debt crisis, Congress will relentlessly nickel-and-dime business with loophole-closing tax increases every time it needs a few billion dollars of extra revenue, as evidenced in the latest jobs bill now eking its way into law. And how can business build for the future when the economy's foundation is washed away by an unceasing gusher of government debt?

Why are American businesses hesitant? First, there are tough political problems within the business community. For example, retailers abhor the VAT. As usual, some concessions for winners must be made to losers. Second, there are critical financial accounting issues to be worked out, starting with the debilitating write-off of tax assets that will result under current accounting rules if the corporate tax is eliminated. Most of all, the business community does not want to suffer the barrage of criticism from a public inclined now more than ever to demonize it.

In normal times these problems would be deal-breakers. But these are not normal times. Compared with the looming federal fiscal crisis, these are small potatoes. To get our debt on a sustainable path, we must go through holy hell one way or the other. We might as well choose policies that lead to the most economically sound results.

For years Japan's business lobby has been advocating a reduction in that country's high (40 percent) corporate tax rate and an increase in its low (5 percent) VAT. It appears this advocacy is paying off. Japan's new prime minister -- as well as the major opposition party -- is calling for a VAT rate increase, perhaps to 10 percent, to shore up long-term finances. And Japan's powerful Ministry of International Trade and Industry is advocating a corporate rate cut. American businesses should emulate their Japanese counterparts and do them one better by pushing for complete repeal of the corporate tax. This bold move would provide financial and symbolic benefits that would catapult America to undisputed leadership in competitiveness among the nations of the world.

This Economic Analysis first appeared in Tax Notes on July 6, 2010.

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