Tax Policy Versus Tax Rates: A Look Inside the Republican Tax Reforms

Tax written on a calculator
Tax written on a calculator

Too often discussion of tax reforms focuses only on the tax rates, especially the top tax rate. To some extent this stems from the left's intellectual framework: income is something the government controls in its entirety until it "gives" tax breaks to one constituency or another. But it also stems from the right's focus on the distortions introduced by tax rates -- changes in work, saving, investment, portfolio composition, tax compliance, and other decisions that are become more tax-driven as rates rise.

But a tax rate alone does not a tax reform make. Instead, perhaps the most important aspect is what is put in, or left out, of the tax base. The proposals being offered by the Republican field are instructive in this regard.

Take, for example, Rand Paul's proposed flat tax. The rate is 14.5 percent, but the interesting part is the business tax: "I would also apply this uniform 14.5% business-activity tax on all companies--down from as high as nearly 40% for small businesses and 35% for corporations. This tax would be levied on revenues minus allowable expenses, such as the purchase of parts, computers and office equipment. All capital purchases would be immediately expensed, ending complicated depreciation schedules."

At flat tax on revenues would simply be a sales tax -- a tax on the final sales of a firm. A tax on the difference between revenues and purchases from other businesses excludes the value produced by those other firms and focuses on the value added by the firm being taxed. It is a value added tax. Importantly, though, all of the firms are being taxed. So for the system as a whole, the value added tax is equivalent to a sales tax. It is a tax on household purchases or consumption.

Importantly, consumption taxes exclude from the tax base the return to saving and investment -- dividends, interest, capital gains -- and thus provide tremendous incentives for saving, investment, innovation, and growth. They also exclude from the business tax base any of the financial decisions that firms make: dividend payments, stock issuance or buybacks, interest payments, debt issuance or retirements and so forth. Accordingly, they eliminate incentives to have too much leverage or to game the system with tax-motivated financial transactions.

Interestingly, a pro-growth consumption tax is the foundation of the Cruz plan. It is the foundation of the Bush plan. It is the foundation of the Rubio plan. It is the foundation of the Kasich plan. As part of an agenda to restore American growth, Republicans are moving toward taxing consumption instead of income.

Of course, such a move for the tax system as a whole depends on the provisions of the household tax. Rand Paul's 14.5 percent household tax would be "applied equally to all personal income, including wages, salaries, dividends, capital gains, rents and interest." This is a flat tax, but it is a tax on traditional income -- labor plus capital income. Put differently, it can be thought of as a comprehensive consumption tax at a rate of 29 percent -- one half collected from businesses; one half collected from households -- and a 14.5 percent surtax on capital income. And, although the rates differ, the same can be said of the Bush, Cruz and Kasich plans as well.

The real outlier is the Rubio plan. Much attention has been focused on Rubio's top marginal tax rate of 35 percent. Or his new refundable child tax credit. But the real news is that his proposal is consumption tax oriented at its core.

Importantly, this is not compromised by the recent news of one-time tax on capital gains because all future capital gains will be exempt from tax. Instead, only past capital gains will be taxed and this tax will be deferred until the assets are sold. This, again, is part of a larger phenomenon that occurs with the switch to a consumption tax: the taxation of existing wealth. Wealth is used to finance consumption purchases -- in the extreme it is the sole source of financing -- so taxes on consumption are implicit taxes on wealth. Because the rich have the wealth -- both sides agree on that -- consumption taxes are much more progressive than they might appear by shallow examinations of the structure of tax rates.

America has a growth problem. In the postwar period the standard of living doubled roughly every 30 years. At current projections it will take nearly 50. Tax policy should support better growth and there are a number of interesting proposals to do so.