America Needs a Tax System that Reflects its Values

With President George W. Bush's Tax Commission about to issue its recommendations--opening up a rare opportunity for fundamental tax reform--we would do well to remember one of the iron rules of economics: whatever we tax, we will get less of and whatever we do not tax, we will get more of. In other words, we should tax what is bad, not what is good.

By this logic, America's current tax system is as wrong-headed as it is backward: it discourages savings, job creation and higher wages, while encouraging energy consumption, waste and environmental degradation. Sadly, the Tax Commission has decided to ignore many of these perverse incentives. This is unfortunate, because reversing them could not only help to solve many of our nation's most pressing problems, but also yield a tax system that better reflects American values.

If there is a tax that deserves to be eliminated, it is the payroll tax that funds Social Security and part of Medicare. This is the largest tax paid by more than 70 per cent of working American families. Yet it would be difficult to design a more socially detrimental source of revenue. Because the payroll tax falls exclusively on wages, it creates a powerful disincentive for job creation. It also depresses take-home pay, especially for low- and medium-income workers. Finally, it is the model of a regressive tax because it relies on a flat rate, kicks in from the first dollar earned and its Social Security portion is capped at Dollars 90,000 (Euros 74,500). Getting rid of it would do wonders for job creation, take-home pay and small businesses.

To make up for this lost revenue, the US should introduce two new forms of taxation: a progressive consumption tax and pollution taxes. The former is designed to promote savings, while avoiding the regressive features of most sales or value-added taxes. A progressive consumption tax should be calculated based on the difference between an individual's annual income and savings. By exempting all consumption below Dollars 15,000 from taxation and applying a progressive rate from there, this new tax would favour low-income families--the demographic that has been falling behind in recent years. It would also create a strong incentive for personal savings, thereby strengthening the US economy while helping to rebalance the world economy.

The other new source of public revenue should be pollution taxes or other market-based policies designed to decrease both America's energy consumption and its emissions of greenhouse gases. Raising revenue in this manner would strengthen our economy over the long term. There are several ways to structure market-based environmental levies: a straight carbon tax, a cap and trade system in which emissions permits are auctioned, or a counter-cyclical gasoline tax to compensate for swings in energy prices while keeping the cost of fuel to the consumer at a target price. Any would be a big step in curbing our energy consumption, boosting productivity and combating climate change.

Combined, a progressive consumption tax and pollution levies could raise enough revenue to replace the payroll tax and then some. Substituting the former for the latter would alter the incentives that guide both individual behaviour and our overall economy. Suddenly the US would have a progressive tax system that is pro-savings, pro-growth, pro-environment, pro-job creation and pro-small business.

Politically, the most intriguing aspect of this proposal may be the novel coalitions it could give rise to. The small business lobby--which lists payroll tax relief among its top legislative priorities--would be a pillar of support. How often does the small business lobby find common ground with the environmental lobby? Likewise, this plan provides a bridge between the interest of Wall Street--where our anemic savings rate is a big concern--and main street--where job flight overseas and falling wages top the concerns. Who knows, it could even forge a new alliance between evangelical Americans, who are fond of infusing moral principles into the public policy realm, and liberals, who are searching for new ways to combat poverty and climate change.

For Mr. Bush, who has made tax reform one of his top second term priorities, embracing the concept of "tax bads, not goods" could do wonders for his faltering presidency. Not only would it offer him a strategy for achieving bi-partisan success on one of his key campaign pledges but, more important, a whole new way to tackle many of the most daunting challenges facing the country.