The income tax’s anniversary has led to a lot of premature eulogizing. At a New York Law School symposium on October 3, USC law professor Edward Kleinbard argued that the United States is a low-tax country that is too focused on how revenue is collected rather than on how government funds are spent. The United States has the most progressive tax system in the world, but our Gini coefficient is among the worst, he pointed out. Kleinbard’s solution is to raise taxes and increase government spending. He argued that regressive tax systems (particularly those with VATs) are fine as long as the money is spent to subsidize the lowest quartile.
Kleinbard also believes the U.S. tax system overly subsidizes the middle class. In 1979, 80 percent of the wealth transfer from the top quartile of taxpayers went to the lowest quartile. That number is 60 percent today. “It's outcomes that we should care about,” Kleinbard said. “The purpose of taxation ultimately is to spend money, not to collect money artfully.”
While Kleinbard’s arguments make a lot of sense, his position that only outcomes matter would shock many economists. How you collect revenue is at least as important as how you spend it. Conservatives and others never fail to point out how corporate income taxes inhibit growth. Economists bash the income tax system because it deters saving. Other forms of taxation, particularly excise levies, are even more universally deplored. Taxes shouldn’t be structured in a way that lowers overall wealth, regardless of how the money collected is eventually spent. It is true that by most measures, Europe has less income inequality than the United States, while having far more regressive taxation schemes. But that doesn’t mean Europe should be held up as the model for global taxation.
Despite its regressiveness, the VAT is often worshipped as the ultimate form of taxation. It’s efficient, easily raises revenue, encourages savings, and taxes consumption. Many economists would love for the United States to supplement its income tax system by adding a VAT or even to scrap the income tax altogether (or at least the corporate component) in favor of a national consumption tax. In defense of this holy grail of taxation, many argue that rebates can be given to the poor or that direct spending can be increased to offset the regressivity.
But is that really how a U.S. VAT would play out? Congress loves to give rebates and tax credits -- the multitude in place now is largely what’s wrong with the income tax. However, each rebate, exemption, or credit that exists within a VAT lowers the efficiency gains the tax is supposed to produce. The further the levy drifts from a pure VAT (such as the one in New Zealand), the less desirable it becomes as an alternative to the income tax. And while Congress might love tax credits, it has become very averse to direct, discretionary spending. Even an increase in entitlement spending would run aground in the current environment, when a very left-of-center president has made it clear that he is willing to curb entitlements in exchange for tax increases.
Hidden within Kleinbard’s arguments and those of the pro-VAT crowd is the implicit idea that the middle class needs to pay more in taxes. The country’s income tax regime, particularly after the Reagan and Bush tax cuts, has supposedly been very favorable to the middle two quartiles of taxpayers. A VAT would capture more of that wealth, which presumably would be used to preserve or expand the social safety net. But it’s not exactly clear how beneficial that would be.
The U.S. income tax system is progressive because we tax the wealthy at higher rates. A VAT is regressive because it generally benefits higher-income taxpayers (who consume proportionately less of their income and wealth). There is no good reason to reverse the tax-friendly policies for the middle class that the United States has adopted over the last 35 years.
So it’s on 100th birthday, let’s not blame the income tax system for increasing wealth inequality. Let’s instead focus on the holes in the system (tax expenditures and, most importantly, the preferential rate for capital gains) that should be plugged to keep it a viable regime. Europe’s regressive, bloated fiscal systems are not the standard that the United States should be aspiring to.