Tax Analysts Blog

Questioning the Longevity of the Income Tax

Posted on Mar 1, 2013

The federal income tax turns 100 years old this year. Landmark anniversaries are useful occasions for both reflection and critical analysis. It was in that spirit that Tax Analysts recently convened a policy forum at the National Press Club which openly questioned the income tax's future role as our nation's primary revenue tool. You can watch the video here.

The key attribute the income tax has going for it is a progressive rate structure, which asks those earning higher incomes to pay proportionally more than those less fortunate. Progressivity is part of the modern social compact. The American populace will only buy into our system of governance so long as they regard our taxing and spending profiles as possessing a substantial degree of fairness — although reasonable minds often differ on how much progressivity is appropriate. One man's fairness is another's class warfare.

We can conclude that the income tax is "good" in the political sense, but there's more to the discussion. Arguably the income tax is "bad" in the economic sense. Its flaws include market distortions that discourage personal savings and adversely affect our nation's capital stock, which feeds growth, innovation and productivity. Rare is the economist who argues the income tax is a model of efficiency.This is particularly true of the corporate income tax, which seems to serve a quasi-regulatory purpose that is distinct from raising meaningful amounts of revenue.

Along with almost every other country in the world, we tolerate the inefficiencies of the income tax for the sake of the fairness it enables. And speaking of other countries, there's a curious phenomenon taking place before our eyes: the race to the bottom.

Taxing income implicitly requires that a tax be imposed both on income from labor (which is relatively immobile) and income from capital (which is relatively mobile). Generally speaking, the global tax burden on income from capital has been falling in recent decades. This is due to competitive pressures. If a nation were to tax the return on investment too heavily, capital would flee to greener pastures. This process should be viewed as a force of nature, the same way that rivers always flow toward the sea.

Capital flight is especially pronounced in the age of globalization. This trend of lightly taxing income from capital is not limited to tax havens or jurisdictions that pride themselves on the mantra of low-tax/small-government. We observe the same patterns in high-tax/big-government jurisdictions that embrace the social welfare state. In short, tax competition is bigger than politics.

What are these countries doing if they're decreasing their reliance on the income tax? They are not necessarily collecting less tax revenue. There are many instances of a country's income tax burden falling at the same time the public sector is expanding as a share of GDP. Governments are learning to rely on alternate (less mobile) revenue sources. Those sources are typically labor, consumption, and to a lesser degree property.

Unlike the income tax, both VAT and the carbon tax are viewed as "good" taxes economically. The VAT is pro-growth and efficient; the carbon tax captures an externality. That said, it must be noted their enactment would dramatically change the distribution of the tax burden. Even where the adoption of VAT is revenue neutral, it will never be distributionally neutral unless other corresponding adjustments are made. That explains why we don't see other governments repealing the income tax altogether when they adopt an alternate revenue vehicle. They purposefully retain the income tax for it's progressive elements.

Dare we attempt to guess what the income tax might look like in another 100 years?

Personally I think it will still exist, but it will have company. The big question for policymakers is whether it should operate as a "mass" tax — as it strives to do today — or whether it will function as a "class" tax that applies only to the upper income strata. Given that roughly 47% of American households currently don't pay the income tax (distinguished from payroll taxes, which almost everyone pays), one could argue it is already starting to resemble a class tax. Perhaps the future is already here.

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