How to tax

and how not to tax

So far, it appears to be necessary to impose taxes for some purposes. (What the appropriate purposes are will be left for another essay.)

Yes, I know about anarcho-capitalism. Libertarians argue that "the government that governs best governs least. Anarcho-capitalists further note that the government that governs least is no government at all, and therefore the best government is no government at all. An interesting argument, but ultimately for me an unconvincing one; I haven't managed to figure out how some things would be taken care of in an anarcho-capitalist society.

So, having disposed of that appealing but impractical solution, we're still left with the problem of taxes. What should we tax? How much tax should we charge? Nobody seems quite happy with the existing system (except perhaps tax accountants, who do lots of business because of the complexity), but what would be better?

My biases

I'll say something about my biases here. My belief is that tax policy should be as lifestyle-neutral as possible, except when we choose to offer specific subsidies or penalties. When we do choose to use subsidies or penalties, they should be as clear as possible, rather than hidden in other forms. This means that many of the things we do now are wrong.

For instance, we frequently favor things by offering tax deductions or credits for them. There are at least two problems with this approach. First, by burying the subsidy in our tax policy, we obscure it. Second, deductions don't work equally for all; poor people who don't pay much tax get little benefit from deductions.

Another wrong-headed thing we do comes from the wish to charge different rates of property tax for residential and commercial property. But instead of doing that, we instead disguise it by assessing each type of property at a different percentage of its value, then charging them the same tax rate. This makes it harder to figure out whether properties are being taxed fairly.

Bottom line: if we want to encourage people to do something, just give them money to do it. If we want to discourage them, charge a fee for doing it.

In addition, tax policy should change behavior as little as possible, except when the express intent is to change behavior. For example, high sales taxes fail this test, because they encourage the formation of black markets. Tax exemptions for IRA deposits do not fail this test, because they have the explicit intent of encouraging saving for retirement.

Sales taxes

One system I have seen suggested is a national sales tax. If this were to replace the existing income and Social Security taxes, the tax rate would have to be substantial (25% or more). But there are some real problems.

The biggest one can be stated in two words: black market. A tax that high would cause a lot of people to go to a lot of effort to avoid it. It may work acceptably in the relatively orderly societies of Europe, but Americans have traditionally had a more adversarial relationship with their government. For instance, Germany routinely uses automatic speed-checking devices as a method of enforcing speed limits. Here, they're illegal, on the grounds that you can't prove that the operator of the vehicle was the registered owner. (One toll road attempted to do automatic enforcement based on the time stamps on the tickets; since the collection was done the same day on exit from the road, it avoids the problem of proof of operation. But it was ruled to be entrapment, because the drivers are forced to accept the toll tickets!)

There are additional problems, though. In most sales tax systems, the things that the poor and middle class spend their money on (food, housing, and so forth) get taxed, while the things that the rich spend money on (investments) don't, so the effect is to tax the poor more heavily than the rich. But imposing sales tax in investments would be even worse...

Another problem with sales taxes is that they encourage people to retain property that they currently have, rather than exchanging it for property that might be more suitable.

Property taxes

Property taxes have been popular over the years. Mostly, they get charged on real estate (land and buildings), but taxes on other sort of properties are not unheard of. (For example, Massachusetts charges an "excise tax" on car ownership; since the amount you pay depends on the value of your car, it's really a property tax.) To some extent, they make sense; supporting police and fire departments by property taxes, for example, since people with more property are more likely to need their services. Still, basing these taxes on the value of the property isn't necessarily quite right. Paying for schools with property taxes is even more dubious.

Property taxes, of course, have a big problem with non-lifestyle neutrality: they discourage ownership of the types of properties that are taxed. Given that problem, I believe that their use should be limited to raising funds for services that are directly related to property ownership.


Fees aren't technically taxes, but governments raise a lot of money with them, so they're worth looking at here as well. Fees that pay the costs of a particular service, of course, are just fine (although in some cases we might discuss whether we want to subsidize that service by paying for it out of other tax revenue instead). But fees that exceed the cost of offering the service that they ostensibly pay for is a hidden penalty on that service. This fails the tests of maximum clarity and lifestyle neutrality.

Income taxes

We're now down to the biggest federal revenue producer (as well as in many, but not all, states), and the one that causes the most controversy: the income tax. The Social Security and Medicare taxes as they currently exist are also really income taxes, so I will include their impact in this discussion as well.

If the Social Security tax really were a pension plan, where the benefits were paid out of the revenue collected from the recipient, it would be a different story.) The existing Social Security tax (12.4%) is, in fact, regressive (that is, the rich pay it at a lower rate than the poor do), because you pay it on only your first $65,400 of income (in 1997; this number is gradually increasing with the cost of living).

The income tax system we currently have is incredibly complex. People routinely spend hours or even days preparing their tax returns each year, and millions of dollars on experts to prepare their returns for them. The actual rate of tax you pay is buried in a morass of complicated deductions, exemptions, and penalties. But, as I pointed out earlier, the total effect isn't all that far from a flat income tax.

The system, however, does radically fail the tests of clarity and lifestyle neutrality. And even the well-intentioned attempts at non-neutrality can have horrible unintended consequences.

Income taxes aren't perfect either, of course. If the rate is too high, they act as a deterrent to making more money and/or to pursuing arcane tax shelters to avoid the tax. And the black market can exist in labor, too, though it's not as big a problem as with sales taxes.

My proposal

On balance, I think that an income tax is the best of the available taxes, supplemented with limited property taxes and fees that are self-supporting but no more.

Furthermore, the income tax I favor would be a flat tax. With no deductions except for an exemption on the first few thousand dollars on income (to ease the lives of the very poor). That's right - no deductions at all. Not for mortgage interest, not for children and other dependents, not for health insurance - nothing. No joint returns. And no special rate for capital gains - income is income no matter how you make it.

The people favoring special rates for capital gains will squeal about the fact that some of these so-called "gains" are just compensation for inflation. I agree. But instead of a special rate, a better solution would be to index gains for inflation. That is to say, if you made a 20% gain on a stock in three years, but there was 10% inflation during that period, you would only have a 10% taxable gain. And if you only broke even on your stock sale, you would have a 10% loss. This solution gives you exactly the right correction for inflation (well, within the accuracy of the Consumer Price Index, but that's a discussion for another day), no more and no less. (As things stand, you get much too much benefit for assets held for only a year or two, but not enough for really long-term investments.)

This proposal passes the tests of neutrality and clarity with flying colors. It's so simple, most people (anyone who got all their income from wages) wouldn't even need to file a return; the government would already know everything it needed to know. Of course, H&R Block would hate it.

No deduction for (name your favorite thing)?

It's a lifestyle choice. (Yes, having children is a lifestyle choice.) We want the system to be lifestyle-neutral. Live with it.

Road use taxes

Another big current tax is the gasoline tax, which mostly goes to pay for highways. It's good as far as it goes, but it doesn't go far enough; most of the costs of road building and maintenance are paid from other taxes. (The gas tax doesn't pay for routine operation, and it doesn't pay for local streets at all.)

Better would be a gasoline tax designed to pay for all the costs caused by road use: road building, road repair, traffic law enforcement, removal of abandoned vehicles, injuries (not paid for by the perpetrator) caused by vehicle accidents, and so forth. True, this would increase the cost of driving considerably; in Europe, where similar taxes are used, gasoline costs US$4 per gallon or more (though, of course, it's normally sold by the liter there).

One useful consequence of this would be to level the playing field somewhat between forms of transportation. As things stand, it's hard for railroads to compete, because their competition (private cars and buses) get such a big subsidy in the form of road construction. I will have more to say on this in another rant.

What about corporate taxes?

For the most part, I would favor taxing businesses in the same way as individuals: same flat rate, same lack of deductions and credits. I would make a few major changes in the way things are done now, though:

Depreciation: The whole concept as it exists is silly. Get rid of it. If you spend the money, it's an expense. If you sell the asset, the money you get is income. End of story.

Dividends: As things stand, there is a huge incentive for companies to keep all their profits and get bigger, rather than distributing them to their shareholders as dividends. If you keep the money and invest it, you pay no tax now, and your stockholders pay the lower capital-gains tax when they sell the stock. If you pay dividends, you pay tax on that income now, and so do the shareholders who get the dividends. I've already gotten rid of the special rate for capital gains, so the other half of the fix is simple: dividends are deducted from income as a corporate expense.

Of course, all this means that corporations won't actually pay much income tax at all; the only money they'll pay tax on is cash they keep and don't invest. So be it.

You might also say that there is a bias here in favor of distributing profits to shareholders, rather than keeping them and expanding the business. I disagree; there is just the absence of a bias for keeping the profits. Once again, lifestyle-neutral.

Appropriate investments: Another necessary fix is to restrict what investments are appropriate for a corporation to make. (Otherwise they'll tend to just keep all their profits and grow ever bigger.) Again, the basic rule is simple: only investments within your company's line of business are deductible.

Of course, that makes it impossible to create a conglomerate. Good.

Estate taxes

As things stand right now, a lot of capital gains never get taxed at all. If you hold an asset until death, it is subject to estate tax - but unless your estate is large, you don't pay any estate tax at all. Furthermore, there are various ways of evading estate tax by putting assets into trusts before your death. The result is that stocks, real estate, and other assets can get passed along for many generations without the gains on them ever getting taxed.

This is wrong, wrong, wrong. It's yet another way the rich get richer, and everyone else resents it. At death, any appreciation on the estate should get taxed just like income. Capital gains, of course, will be indexed for inflation as usual.

It's true that, in some cases, this might cause family businesses to get broken up, because the heirs might have to sell some of the business to pay the taxes. Tough noogies. What is special about keeping a family business in the family forever?

One tough case is the inheritance of a primary residence. Charging the income tax on it at the time of death of a spouse might throw the proverbial widows out on the street. I suspect that life insurance is the ultimately the right solution for this, but we might have to have special tax treatment of this case for a while, because too many people don't have the necessary insurance now, and some of the relevant people would currently be too old to get it.