Balancing Act IV: A smarter way to tax

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Fourth in a series

Hey, big spender!

Have we got a tax plan for you. It would sweep away the insane cost and maddening complexity of the current federal income tax system. It could be as progressive as lawmakers want it to be. It would encourage working, saving and investing. It would undercut the power of lobbyists. And it would help roll back the nation's trade deficit.

Of course, if you're really a big spender, you won't like this plan, because spending is the only thing it would tax. Then again, it's unlikely to be adopted, so even the biggest spenders needn't worry much.

And that's a shame. Everyone agrees that America's income-tax code is an abomination, a fickle and many-tentacled monster that takes with one hand even as it gives away with the other. Some of the nation's finest minds earn a living helping clients battle this crazy beast. Yet in all likelihood it will be too hard politically to do the thing everyone really knows we should -- which is to slay the thing outright and start afresh.


A consumption tax

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Still, it can help us improve the current system to think about what a truly great tax system would look like -- one that, in place of the perverse incentives that mar the current arrangement, actually encourages people to work, save and invest. That's where our tax on spending comes in. In policy-wonk parlance, it's known as a consumption tax, and because there's so much to like about it, it's just the sort of plan to give an economist goose bumps.

A great example was put forward in 1995 by then-Sens. Sam Nunn (D-Ga.) and Pete Domenici (R-N.M.), back in the days when such public-spirited lawmakers were more than willing to reach across the aisle to work for the common good. Their plan, which was supported by several other senators and investor Warren Buffett, was called the Unlimited Savings Allowance Tax System -- the USA Tax plan, for short.

The essence of the plan was simplicity itself. Instead of paying a tax on income, you'd be taxed each year on the difference between what you earned and what you saved. The difference between those two is what you spent, and while that would be taxed, your savings would be exempt. There could still be withholding, perhaps at the outset based on an estimate of what you'd owe, after which it could be adjusted based on the prior years' tax. Such a plan isn't so far-fetched; in our current system, money saved in an individual retirement account (rather than spent) is sheltered from income taxes. Sales taxes are another consumption tax, but they hit harder at those who earn less and must spend most of what they make.

That's the trouble with proposals for a flat tax -- a set percentage that everyone would pay, regardless of earning or spending. GOP presidential hopefuls Herman Cain and Rick Perry have laid out such proposals, both of which would cut taxes on the rich while the middle class struggles. In a time of pronounced income inequality, a flat tax would only make things worse.

By comparison, the USA Tax could have been made quite progressive, charging higher rates on higher spending without discouraging working or investing. To protect low earners, it had an ample exemption for basic family spending and a credit for the Social Security tax.

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The USA Tax proposal was strongly pro-saving and investment; indeed, all business investment would be immediately exempt from the spending tax. That's a great feature because saving and investment are the economic lifeblood of a modern economy. Investment in new factories, equipment, bridges, research and other such improvements raises productivity, which makes us all richer. Higher domestic savings would fuel such investments -- a great way to boost long-term economic growth.

More growth would make it easier to fund government services, thereby reducing the pressure on state and local budgets. Economists believe increased savings would even help reduce the nation's trade deficit, reducing imports by dampening demand for them, making exports cheaper, or both.


A system that rewards saving

In our current economic doldrums, of course, the problem is too little spending. At such times, thrift isn't necessarily a virtue. But our tax plan could help with that too. If a consumption tax were announced for the coming year, after all, just imagine the burst of spending that would result as shoppers rushed to get in under the wire.

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After that one last fling, a consumption tax would reward saving. The current tax code, by comparison, encourages overspending -- particularly on the costliest home you can buy, since mortgage interest and property taxes are deductible from your income taxes. Overspending helped drag us into the financial crisis of 2008 and the worldwide recession that followed. In the period before the crisis, our savings rate was essentially zero.

The Nunn-Domenici plan, which unfortunately never got very far in Congress, is enjoying a bit of well-deserved revival lately, at least among the commentariat. But it's not the only consumption-tax system that could make sense. Others have proposed a national sales tax, or a European-style value-added tax. Either could work if made sufficiently progressive through tax credits and the like.

In truth, it's not hard to choose a system simpler than the one we have. Just tape them to the wall and throw a dart. But if you hit one labeled "consumption tax," bull's-eye!

Thursday: Plugging the loopholes

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