A Competitive Tax Plan Counterfactual

Michael Graetz won’t like this, but I just re-read the book-length version of 100 Million Unnecessary Returns, in which he details the case for his brilliant tax reform proposal. I’ve been an advocate of a payroll tax holiday, but the idea has many weaknesses — it really would be very hard to implement, it complicates and potentially undermines the entitlement reform process. The same goes for any sweeping tax reform, but, as a thought experiment, I like the idea of introducing Graetz’s Competitive Tax Plan … but phasing in the VAT. That is, put the generous income tax exemption — $100,000 for couples, $50,000 for single filers — in place now, and phase in the 10-14 percent VAT over time. Oh, I know this is probably unworkable. But I do wonder how this would work out in terms of revenue loss. In the book, Graetz writes that

A 10 percent VAT should raise somewhere between $735 billion and $850 billion annually, depending on what goods and services are subject to tax. Each additional point would produce an additional $70-$85 billion per year.

So we were talking about a $900 billion stimulus and we wound up shaving it. My sense is that it is a two-year package. We good thus replace the income tax for the vast majority of Americans with a 14 percent VAT, but levy it at the rate of 7 percent for the first two years and steadily raise it to 14, depending on the business cycle.

Actually, as in Alan Blinder’s proposal for “depoliticizing” the tax regime, we could give some kind of Fed-like appointed fiscal policy commission the right to adjust the VAT within a band of 10 to 14 percent in response to changing economic circumstances.

For context, the increase in the income tax exemption would cost between $575 billion to $650 billion annually.

The big reason this is a crazy fantasy: there’s no way you’re going to overhaul the tax code over a few weeks. Just like a lot of Iraq hawks, however, I can’t help but yoke my hobbyhorse to a national emergency — the only time things ever get done with urgency.

To continue with the thought experiment: what if you want Feldstein-style consumption-goosing?

Instead, the tax changes should focus on providing incentives to households and businesses to increase current spending. Why not a temporary refundable tax credit to households that purchase cars or other major consumer durables, analogous to the investment tax credit for businesses? Or a temporary tax credit for home improvements? In that way, the same total tax reduction could produce much more spending and employment.

One approach might be to skip the “VAT holiday” and return the revenue in the form of “consumption vouchers” that have to be spent on major consumer durables — i.e., we take your income and give you constrained dollars. This is deeply, deeply unattractive for lots of reasons, but it does address the anxiety over the temporary tax-cut money being (gasp!) saved or used to pay down debt.

Does this place too heavy an emphasis on tax-cutting? Perhaps. We definitely needed to increase unemployment insurance and aid to hard-hit states. But as Bhidé* observes,

What’s more, subjecting projects to scrutiny conflicts with a strategy of sparking the economy with a jolt of new spending. We may get the worst of all worlds — savvy and well-connected operators get funding while good projects languish.

Better to take the Rivlin approach: increase public works spending, but do it in a deliberative, transparent fashion. We could create an Investment Commission to focus on long-term infrastructure projects, as John de Figueiredo recommends.

*I’ll note briefly that though Bhidé has been characterized as a Keynes critic, he is actually a Keynes admirer.