Capital Commentary is the weekly current-affairs publication of CPJ, written to encourage the pursuit of public justice.
April 15 Is Tax Day -- and It’s Time for Tax Reform
By John Anderson
April 13, 2015
During tax season, the presence of the federal income tax becomes palpable as we rush to pay our taxes before the deadline, or eagerly await our refunds. We wonder whether the fiscal foundation of our country is solid. As Christians concerned with sound public policy, we are also confronted with the question of whether the present tax system can be made more consistent with biblical principles of stewardship and justice. In order to provide both fiscal sustainability and a more biblically sound system that enables human flourishing for all, we need fundamental reform of the tax system.
How Should We Think About Taxes?
Because taxes are a means by which government is financed, our thinking about taxes should be based on an understanding of the proper roles of government. Scripture makes clear that in a fallen world, God mandates that the state should preserve order and restrain injustice. Those are the two fundamental roles of the God-ordained human institution of government.
Both of those roles are ultimately grounded in the reality that God created humans to live in community, a living reflection of the triune God existing in community eternally. Human communities need a wide range of institutions to provide a supportive context for full human flourishing--including families, churches, civic organizations, and governments. Within that wider context, government must honor the dignity of all its citizens and guard the independence of the other non-government social institutions. Additionally, a biblical view of the role of government must also be consistent with the creation mandate of stewardship that calls for using resources wisely and efficiently. Furthermore, as government works to ensure justice in society, it must do so not only at a specific point in time, but also over time and for all generations.
The Demands of Stewardship
The demands of wise stewardship of creation require that our government institutions be run for the benefit of all and be financed in ways that are responsible, sustainable, and do not dissipate resources. The two essential financing mechanisms used by governments are taxes and borrowing. When tax revenues fall short of expenditures, the government runs a deficit that must be covered with borrowing. Some see the financing choice as one of using taxes or borrowing. But in reality, borrowing requires tax revenues in the future, so the choice is really between taxes today and taxes tomorrow. That choice is an inter-temporal issue as it has implications for intergenerational justice. Christians committed to the biblical principles of stewardship and justice are called to care for the flourishing of our nation and its citizens today and in the future. The grand arc of the biblical narrative (creation, fall, redemption, re-creation) makes us acutely aware that God is at work over many generations to accomplish his purposes. We suffer from a type of inverse chronological snobbery (adapting the C.S. Lewis phrase) when we believe our time is superior to future times. We must resist thinking that our current needs and desires are the most compelling and therefore justify borrowing from future generations.
The latest budget projections released by the Congressional Budget Office (CBO) give cause for concern as they indicate that the federal debt as a share of gross domestic product (GDP) will resume a continuous upward trend in just a few years. The president’s budget offsets new spending with additional revenues in the short term, but it does not put the debt trajectory on a sustainable path in the long run. The baseline projection assumes that current laws remain in place over the forecast period while estimates for the president’s budget reflect the assumption that all of the president’s proposals are implemented. Both scenarios are highly unlikely, but they are instructive and indicative of the reality that the US fiscal trajectory is unsustainable. Under either the president’s budget or a business-as-usual scenario, we will be passing a growing fiscal burden on to future generations, which is a far cry from the vision of stewardship outlined in Scripture
How Should the Tax System be Reformed?
Reform of the public finance system, including our various taxes and borrowing, is essential because the present system is unsustainable, and it violates the biblical principles of stewardship and justice.
Economists measure the economic cost of a tax in terms of both the revenue generated by the tax and by the so-called excess burden of the tax. Excess burden is the reduction in a taxpayer’s economic wellbeing over and above the revenue that the tax generates. The tax causes individuals and firms to change their behavior, making them worse off than before the tax was imposed. A general rule in tax policy is that the excess burden of a tax is proportional to the square of the tax rate. So, doubling the tax rate causes the excess burden to quadruple. Or, cutting the tax rate in half reduces the excess burden to one-quarter of its previous level. Hence, the fundamental policy prescription is to broaden the tax base and lower the tax rate, thereby improving social welfare even if no more revenue is generated. This is often called “closing the loopholes.” As a fundamental matter of stewardship with the goal to waste as few resources as possible and provide maximal opportunity for human flourishing, we should advocate for broad tax bases and low tax rates. This policy prescription also improves the justice of a tax in that it assures that all taxpayers are treated with equity. Loopholes for special interests are eliminated, enhancing the equity of the tax.
Fundamental reform of both personal and corporate income taxes is necessary. The current level of complexity, inefficiency, and arbitrariness must be remedied, and the sooner the better. While some exemptions and deductions are merited in the tax code, it is riddled with obscure and unjustified provisions, many of which benefit particular groups or only a few favored taxpayers. The personal income tax, for example, allows for a deduction for home mortgage interest paid by homeowners who itemize. While the policy intent is to encourage homeownership, the deduction is not designed well for that purpose. Beyond encouraging a renter to buy a home, the deduction provides a strong incentive for current owners to purchase larger, more expensive homes that the federal government subsidizes through the tax code (mortgages up to one million dollars are covered under current law.) A reasonable tax reform should convert the misdirected and overly generous deduction to a capped credit, as one example of a base broadening reform.
The current corporate tax system also creates huge distortions in the economy. The Treasury Department estimates that the effective marginal tax rate on equity-financed investment for a corporation is 27.3 percent, while that on debt-financed investment is minus 38.9 percent. This extreme divergence in effective tax rates encourages corporations to fund investment using debt rather than equity—distorting corporate investment decisions. Corporate tax reform has been proposed by the Obama administration with a focus on reducing the top rate of 35 percent (the highest statutory rate among OECD countries) down to 28 percent and strengthening provisions to ensure that multinational firms cannot avoid taxation. This is classic base broadening that enables rate reduction which reduces the economic cost of the tax (measured by its excess burden). The sticking points will be how to broaden the tax base. One person’s loophole closing is another person’s cherished tax break.
Taxes and Intergenerational Justice
While the US fiscal deficits have been shrinking in recent years as economic growth has improved revenue collection, gross federal debt now exceeds 100 percent of GDP—a level not seen since the immediate post-World War II era of the late 1940s. The public finances of the United States must be put on a more sustainable trajectory. That requires not only reform of the tax system, including both the individual and corporate income taxes, but also reform of all the existing entitlement programs.
As Christians using the lens of stewardship to consider the intergenerational effect, we can see that even temporary government deficits or surpluses have redistribution consequences. A deficit this year results in redistribution from the younger generation to the older generation. A temporary tax cut, for example, provides a benefit to the older generation as they gain more from today’s tax reduction than they lose from the subsequent increase in taxes. The effect on the younger generation is just the opposite. It may well be that the older generation compensates the younger generation via private bequests, but that outcome is in no way assured. The older generation has a higher marginal propensity to consume than the younger generation. A deficit then increases aggregate consumption, lowers aggregate savings and investment, and thereby reduces the capital stock, significantly harming long-term economic growth. A budget surplus has the opposite effects.
Many of our entitlement programs are funded with pay-as-you-go (PAYGO) financing schemes by which current workers pay taxes that fund benefits paid to current recipients. A PAYGO program generally operates with deficits in the early years and requires higher taxes in later years if benefit levels are to be maintained for later recipients. Social Security is a prime example of a program that redistributes in a wide range of ways. Designed in the 1930s, Social Security desperately needs fundamental reform. Without modifications, it is unsustainable in the face of the demographic reality that the number of workers currently paying payroll taxes is insufficient to fund the benefits promised to retirees. With the current program design, either the payroll tax must rise, or benefits must be trimmed, or a combination of both must occur.
But, more importantly, the program fails to provide justice. It requires workers to pay taxes that bear no resemblance to the benefits they receive. Some people receive far more in benefits than they pay in taxes, while others pay taxes for benefits they never receive. For example, working single parents are required to pay for spousal and survivor benefits that they cannot receive. Steurele (2014) documents that a single mother may receive up to $100,000 less in lifetime benefits than someone who does not work, has no children, and pays less in social security tax. The system also needs to be reformed to reflect new realities flowing from improved health care and longer lives. Extended longevity means that a married couple may receive up to $300,000 more in lifetime benefits than when the system was established. Forecasts indicate that within a decade, nearly one-third of the adult population in the United States will be collecting social security benefits for at least one-third of their lives. Eugene Steuerle recently testified before Congress saying, “There is no financial system, public or private, that can provide so many years of retirement for such a large share of the population without severe repercussions for individuals’ well-being in retirement and the workers upon whose backs the system relies.”
Alternatives to the present system have been proposed, including a partially privatized system in which personal accounts are established and individual workers’ tax payments are accumulated to pay for eventual retirement benefits, complementing the collective social security component of the present system. An entirely privatized system is neither desirable nor politically feasible, however. A social insurance component of the system is necessary to ensure that a safety net exists, recognizing human dignity for all. Hence, reform solutions that create a hybrid system with both private and social components are the best alternative. We should be thinking even more broadly to include roles for non-governmental institutions to help preserve human health and dignity for the elderly (as outlined in Gawande (2014)).
Bold Tax Reform
Beyond mere tinkering with the existing tax system, there is merit in serious consideration of more fundamental reform. Two options are worthy of policy makers’ attention. First, there is general agreement that future economic growth would be enhanced by a shift away from taxing income toward taxing consumption. The income tax causes distortions in many ways for individuals and firms. It alters decisions on labor supply, savings, and risk taking, to name a few. Consumption taxes create fewer distortions and enhance long-term capital accumulation, fostering greater economic growth thereby supporting wise stewardship.
Furthermore, a move away from the current personal income tax system can enhance justice. Under the current personal income tax system just over half of households pay income taxes (56.7% of households in 2013, according to the Tax Policy Center (2015)). Taking into account both taxes paid and transfers received, the Congressional Budget Office (2014) reports that average net tax rates, after government transfers, are negative for the bottom three quintiles of the income distribution (-35%, -28%, and -14% in the first, second, and third quintiles, respectively), approximately zero in the fourth quintile (0.7%), and a positive 19% in the top quintile. Hence, only the top 20% of households in the income distribution are net payers. Rather than prey on one group or generation in order to provide benefits for others, a tax system that recognizes human dignity requires a fundamentally different approach. Moving to consumption taxation is one possibility—and the best option considering the alternatives. That can be accomplished in several ways. One is to adopt a tax reform which converts the existing income tax into a progressive consumption tax (e.g. the 2005 proposal for a Growth and Investment Tax, or what tax policy wonks call the X-Tax). Distributional fairness concerns are addressed with a progressive consumption tax, thereby avoiding problems of regressivity that overburden the poor.
Another approach is to reduce reliance on the current income tax and supplement with a federal value-added tax (VAT). Michael Graetz (2008) of Yale has proposed specific policy changes to accomplish this shift. Such a policy reform would be an efficiency-enhancing improvement in the tax system overall. The VAT is broad-based and capable of generating significant revenue at a relatively low rate. In this way, it is consistent with stewardship principles. It also supports justice in the sense that it applies to all forms of consumption, requiring all citizens to participate in the support of government services. Complications abound, of course, with concerns over the administration of such a federal tax and the potential for it to be a “money machine” due to its broad base and strong revenue generating potential. Another notable issue is the patchwork system of existing state and local sales taxes and the question of how a federal VAT could be configured to complement or replace those sales taxes.
A second fundamental reform to consider is the adoption of a federal carbon tax. This would have two potential benefits. By pricing carbon emissions, the current misallocation of resources in the marketplace can be corrected. At present, individual consumers and firms do not face the full cost of their use of hydrocarbon-based energy sources. Carbon dioxide and other greenhouse gases are discharged into the atmosphere imposing costs on everyone in society. With these externalities currently unpriced, the market mechanism generates too much use of fossil fuels and too much atmospheric pollution. A carbon tax would correct that misallocation and do so in an efficient, market-based, and non-distortionary way. It would also, potentially, generate revenue that could be used to reduce reliance on other forms of distortionary taxation, such as the income tax. This is the so-called double dividend. We can fix the atmospheric pollution problem, creating the first dividend, and use the revenues to make our tax system more efficient, yielding the second dividend. This is clearly consistent with Christian stewardship of creation—improving the environment and avoiding dissipation of resources.
So, tax reform is imperative, but a biblically grounded approach is not simplistic. We need tax reform that first recognizes the fundamental roles of government to preserve order and restrain injustice. That requires focus and attention to first principles and avoiding the distractions of many less important objectives our political system imposes on us. We need tax reform that supports the human dignity of all citizens and is consistent with the principles of stewardship and justice. That requires creative thinking about the existing tax system and alternative modes of taxation. Rather than advocating tax reform plans on the basis of their marginal tax rates, for example, we should promote and support plans that are most consistent with the biblical principles outlined here. That is more difficult and nuanced, but it will ultimately be more successful because it aligns the God-ordained institution of government and its financing with the creation order.
Questions for Reflection:
should the tax system be reformed?
- Do we need an additional new tax such as a carbon tax or a value-added tax?
- Can the existing system be adjusted to get by? If so, how?
- How do we balance concerns for both efficiency and equity?
should entitlements be reformed?
- Is a fundamental redesign of Social Security necessary?
- Can the existing system by adjusted to get by? If so, how?
- How do we assure intergenerational justice?
the federal fiscal debt really an issue?
- Isn’t it smart to borrow when interest rates are at historically low levels?
- Does the federal debt actually have to be paid off—ever?
- If additional debt is incurred in order to provide productive assets that are passed on to future generations, is debt so bad?
- John Anderson is the Baird Family Professor of Economics at the University of Nebraska-Lincoln.
Congressional Budget Office. 2015. The Budget and Economic Outlook: 2015 to 2025. Washington, DC: Congressional Budget Office.
Congressional Budget Office. 2014. The Distribution of Household Income and Federal Taxes, 2011. Washington, DC: Congressional Budget Office. Accessed April 6, 2015, at: http://www.cbo.gov/publication/44604
Council of Economic Advisers. 2015. Economic Report of the President. Washington, DC: Executive Office of the White House.
Gawande, Atul. 2014. Being Mortal: Medicine and What Matters in the End. Metropolitan Books/Henry Holt & Company.
Graetz, Michel J. 2008. 100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States. New Haven, CT: Yale University Press.
Steuerle, Eugene. 2014. “What Every Worker Needs to Know About an Unreformed Social Security System.” Statement before the Subcommittee on Social Security, Committee on Ways and Means, United States House of Representatives. July 29, 2014.
Tax Policy Center. 2015. Who Pays No Federal Income Tax?
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Capital Commentary is a weekly current-affairs publication of the Center for Public Justice. Published since 1996, it is written to encourage the pursuit of justice. Commentaries do not necessarily represent an official position of the Center for Public Justice but are intended to help advance discussion. Articles, with attribution, may be republished according to our publishing guidelines.”