Some taxes work better than others. Good taxes do little damage to the economy and are difficult for taxpayers to avoid by changing their behavior. And if you look at America's long-term budget projections, we're going to need more taxes in the future, so we should be extra sure that we're choosing good ones.
This morning, I wrote that estate taxes and capital gains taxes are both inherently troubled: They encourage taxpayers to jump through hoops to avoid taxable transfers. But if we can't rely on these sorts of taxes, which ones should we rely on?
Here is a list of five good taxes. They are "good" for one of two reasons: they are hard to avoid, and therefore do little to distort economic behavior; or they distort behavior in ways that make the economy more efficient. Either way, these taxes are excellent ways to finance the government, and we should raise them as a part of tax reforms that reduce deficits and cut other taxes.
1. Wage taxes or consumed income taxes: While capital income can be deferred, for example by holding onto assets that have appreciated, wages are hard to hide. The payroll tax is a quiet and efficient revenue generator for the federal government -- it's so quiet people are often surprised to learn it raises almost as much revenue as the federal income tax.
One concern with wage taxes is that high earners may convert wages into capital income in an effort to gain favorable tax treatment. We can close this loophole by taxing consumed income instead of wages. Like a wage tax, a consumption tax won't penalize people for saving instead of consuming. Unlike a wage tax, it would make issues like the carried interest loophole moot.
Taxes on wages or consumed income can and should be strongly progressive, especially because most of the other efficient taxes are regressive. This is why tax reformers are misguided when they focus on bringing down the top marginal tax rate on wages. Instead, we should broaden the tax base while keeping the top rate the same, in order to bring in more revenue. The added revenues should be divided among deficit reduction, tax relief for lower wage earners and reforms to eliminate the repeat taxation of capital.
Alternatively, the payroll tax could be increased and uncapped (currently, it applies at a much reduced rate on incomes over $110,100) while the personal income tax is greatly shrunk so it applies only to the affluent. The key barrier to base-broadening income tax reform is that it is difficult to eliminate politically popular income tax deductions, such as one for mortgage interest. The payroll tax already lacks most of these deductions and so makes an easier starting point for an ideal income tax.
2. Property taxes: Everybody hates property taxes because they are hard to avoid. But that's a good thing -- it means property taxes are relatively non-distorting. In fact, taxes on land are completely non-distorting: Raising them won't cause any reduction in the amount of land. Taxes on improvements do distort the economy (they discourage the construction of buildings) but not as much as some other taxes. After all, once a house exists, you can't easily move it in response to tax changes.
In practice, property taxes appear to be the least economically damaging of the major categories of taxes collected, less than sales tax, personal income tax or corporate income tax. This makes sense given a related finding: The mortgage interest deduction, despite its vast cost, does little to encourage homeownership. Use of real property appears to be fairly insensitive to tax favorability, which makes it a good thing to tax.
Property taxes have a reputation for being regressive. In fact, they are close to distributionally neutral (see graph on page 4) though taxpayers in the top 1 percent do pay a smaller share of their income than the rest of the population. (You can only use so much real estate). The main reason property taxes can be regressive in practice is how their proceeds are spent: Instead of going into a statewide pool, they get plowed into high-quality services in the jurisdictions where a lot of tax is collected.
But that problem can be fixed. One way is to impose a statewide property tax, as in New Hampshire, so that residents of low-income jurisdictions share in the tax proceeds from high-value property. Another option, used in many states, is to use the state income tax to plug holes in the budgets of municipalities where the property tax base is weak. Homestead exemptions (fixed shares of property value that are excluded from tax) can also increase progressivity.
Local government can't be financed solely with property tax, but the choice of many states (especially California) to back away from property tax over the last four decades has been a mistake. Property taxes are an efficient and effective way to finance government, and we should learn to love them.
3. Gasoline taxes:These taxes are designed to act like a user fee. They fall on people who use roads and go into dedicated funds for road construction and maintenance. But the federal gasoline tax hasn't been increased since 1993, and a third of its value has been eaten away by inflation. This has led to federal and state governments dipping into general revenue to pay for roads, an effective subsidy for driving which should be eliminated by raising the gas tax.
Gas taxes are also economically efficient because gasoline purchasers are not very sensitive to price. If gas prices rise by 20 cents a gallon tomorrow, you aren't likely to immediately buy a smaller car or change your commute. And to the extent that people do change their behavior based on higher gas prices, many of the effects are beneficial: lighter traffic and less pollution.
In addition to raising the gasoline tax, states should subject gasoline to the general sales tax. Currently, nearly all states exempt gasoline, which leads to an implicit subsidy for driving over other kinds of consumption.
4. Carbon tax: Gasoline taxes are supposed to offset the cost of building and maintaining roads. An additional tax is needed to offset the cost of carbon pollution. This is the best kind of tax: a "Pigouvian tax" whose distortions are economically beneficial. Without the tax, people consume too much fossil fuel, enjoying individual benefits but producing pollution which harms others. The tax reduces fossil fuel consumption to the ideal amount while producing tax revenue. It's a win-win.
5. Other "Sin" Taxes: While a carbon tax is the most important kind of Pigouvian tax we need, there are other opportunities to raise revenue while improving economic outcomes. We should particularly raise alcohol taxes, which appear to be below the socially ideal level even in the states with the highest taxes. (Alcohol consumption, while fun, leads to all sorts of ills including violence, accidents and socially-borne health care costs). States with low cigarette taxes should raise those, too.
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