3 Myths about “Tax Reform”

Conservative pundits are supposed to be hard-nosed and economically savvy, but when it comes to tax reform they can be as emotional and misguided as progressives.

The question of tax reform may be a moral issue, but it only makes sense to discuss reform if the conversation is grounded in economics.

Unfortunately, when discussing “tax reform,” American pundits on both the Right and Left often ground their analyses on simple fallacies. I’ll expose three widespread myths about tax reform.

Myth 1: The economic damage of a tax is measured by the amount of revenue it raises for the government.

You see examples of this myth all the time. For example, the Congressional Budget Office (CBO) will “score” a tax bill based on how much revenue it will raise compared to the status quo, and then the bill’s opponents might vilify it as “the biggest tax hike in recorded history!” Or, going the other way, a politician might promise to cut taxes and “return that money to the citizens.”

The reality is that there are different ways to raise, say, a million dollars in tax receipts. They are all damaging economically, but some are more harmful than others. This is because the structure or form of a tax has a great effect on how much it alters incentives, even holding the dollar amount fixed.

Suppose the government wants to raise $1 billion and has to choose between two methods of doing it. Using method A, the IRS sends a bill for $100 to 10 million randomly selected adults. Using method B, the IRS imposes a surtax of $10 million on each of the first 100 companies that hire new employees.

Even though both approaches would raise an extra $1 billion for the government, clearly the first method — relying on a modest lump-sum tax distributed over many people — would disrupt the economy much less than the second method, which would introduce absurd bottlenecks into the labor market and cause employers to engage in a game of chicken.

Myth 2: Tax reform should reward saving and risk taking.

This second myth is especially popular among conservative writers. The grain of truth here is that the tax code should not arbitrarily penalize saving and investment. Yet many writers go beyond this correct statement and end up recommending that the government actively promote these activities through tax incentives.

The “correct” amount of saving, in terms of economic theory, is that which people choose in a free market. People have underlying preferences for present versus future consumption, and they engage in mutually advantageous trades — guided by interest rates — to rearrange the timing of their income and consumption.

It is true, as many critics complain, that the income tax imposes a “double tax” on labor income if it is saved and invested. However, the real problem here (from the point of view of resource allocation) is that a tax on dividend and interest income imposes an artificial penalty on future consumption versus present consumption. This is the sense in which a flat income tax of 10 percent will cause more economic inefficiency than a flat consumption tax of 10 percent, and it is the basis of many proposals to reform the tax code.

Yet, the problem here isn’t the government’s failure to reward (or encourage) saving; the problem is that the income tax artificially punishes deferred consumption relative to immediate consumption. Because it reduces the (after-tax) interest rate, an income tax makes future consumption more expensive than it would be in a tax-free world, and therefore unnecessarily alters people’s intertemporal consumption choices. This distorts the economy more than it needs to, just as surely as if the government had levied a tax of 11 percent on Coke and 9 percent on Pepsi, rather than a 10 percent tax on both.

Myth 3: It’s always economically beneficial to move in the direction of “tax bads, not goods.”

A recent column by Washington Post opinion writer Charles Krauthammer epitomizes this third and final myth. Krauthammer calls for a $1 per gallon hike in the federal gasoline tax, citing benefits such as reduced climate-change damage, less conventional air pollution, and an elbow in the side of hostile regimes dependent on oil exports.

But as a good conservative, Krauthammer doesn’t want the extra revenue feeding Big Government, so he also calls for a dollar-for-dollar refund of Social Security taxes. As Krauthammer summarizes: “The point is exclusively to alter incentives — to reduce the disincentive for work (the Social Security tax) and to increase the disincentive to consume gasoline. It’s win-win.”

There are different layers to unpack in Krauthammer’s case. Those who wish to delve deeply into the technical details can consider my critique of the “textbook” case for a carbon tax. Those who are really brave they can read about the “tax interaction effect,” which shows how the prior existence of distortionary taxes (such as an income tax) reduces the benefit of bringing in a new tax on a “negative externality,” even if the revenues are fully used to offset the original tax.

For the purposes of this article, however, let me try something much simpler. If you read Krauthammer’s column, you will see that there is nothing special about $1 for his recommended gasoline tax; he clearly pulled that amount out of the air. Moreover, he doesn’t even hint at the downside of his proposal. So why not impose a gas tax of $10 or $100 per gallon? Think of how much money could be refunded in Social Security taxes, and how many jobs would be created, while we really stuck it to Russia and Iran!

Even if we stipulate for argument’s sake the mainstream economics concept of “negative externalities” that require a penalty tax, it is still important to get the size of the tax right. The “economically optimal” level of gasoline consumption, and carbon dioxide emissions, is not zero, even if we concede the popular computer models about global warming. Krauthammer does not show any evidence that he even is aware of how an economist actually weighs the pros and cons of changes to the tax code.

Krauthammer is not alone; plenty of writers make the same mistake he did, as well as fall victim to the earlier myths I addressed. To paraphrase Murray Rothbard, it is no crime to be ignorant of the economic analysis of tax reform, for it is a technical subject. But such people should stop writing about the topic.