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Should Obama consider proposing a progressive consumption tax?

Today's New York Times reports on trial balloons from the Obama Administration concerning the possibility that he might propose fundamental tax reform, presumably in his State of the Union address.

Needless to say, as a professional matter I'd be delighted if he did this. And it's potentially great policy, given all the awful things that the Internal Revenue Code does relative to a streamlined alternative with lower rates and a broader base. But I have expressed skepticism about its political prospects to be as popular and transformative as the trial balloonists may hope. Not only does repealing popular tax preferences that offer targeted benefits make it potentially "not that good an issue," as Dick Gephardt put it, but it really has to be a bipartisan deal to have good political prospects, and I just don't see that happening even after the deal announced earlier this week.

A further conundrum in this area is that, if you propose to take away all of the big tax preferences, you get people really mad instead of just somewhat mad. But if you save a couple of the big ones just because they're sacred cows, you invite cries of hypocrisy regarding the ones you do propose to get rid of.

A lot of the really big money in repealing tax preferences, by the way, involves 3 main things. The first is home mortgage interest, which is a horrible rule but politically sacred. And even if one could repeal it, doing it smack in the middle of a housing crisis with widespread mortgage defaults might not be the best time. The second is employer-provided health insurance. Unwise to take this away entirely when the employer-provided element is such a huge part of overall health insurance and we're at least ostensibly in the middle of a transition to implementing healthcare reform. The fight over healthcare reform offered a reminder concerning the political difficulties of trying to make the preference smaller and better-targeted. And the third is pensions and retirement saving, which isn't even a tax preference if (like me) you don't have tax discouragement of saving, a key feature of income taxation, as part of your normative baseline.

But let me offer a suggestion that might dramatically transform the optics while also (in my view and that of many other people) improving the substance. I don't think it would be enacted, at least not right away (and I've been a skeptic about the longer term as well), but it would make people sit up and take notice in a way that the usual style of proposed tax reform would not.

Why not recommend replacing the income tax with a progressive consumption tax? This could either be of two models:

(a) the David Bradford X-tax model, which is essentially a VAT with wages being deducted and included so that you can build in lower rates for lower-income individuals. The flat tax is a version of this, except with only 2 brackets. So individuals (in addition to businesses) file tax returns, but individuals only include wages.

(b) a consumed income tax in which all saving is deducted and all borrowing included in "income."

One advantage of a new and untried system is that at least it doesn't have all the barnacles. Preferences are still being effectively repealed, but the optics are different when you're eliminating one system altogether and announcing the creation of a new one. And I really don't see why the X-tax should be considered a radical experiment set in uncharted waters, when we have VATs all over the world and are also used to having wages deducted and included.

It's hard to see how good faith Republicans could fail to be intrigued by the idea of switching to a consumption tax. But the thing can be distribution-neutral, except perhaps at the very top (where income tax planning is often very effective anyway). And while Obama is already on thin ice with the liberal base, there are a number of people relatively on the left (academics, bloggers, etcetera) who like the progressive consumption tax. We're not exactly powerful politically, but in this setting we might offer a bit of cover.

Enacting a consumption tax can also function as a transition hit on old wealth, adding to progressivity on a one-time basis. And deferred enactment can be stimulative by suggesting that consumer prices will rise when it takes effect (creating an incentive to consume now).

What does Obama hope to accomplish by proposing fundamental tax reform? Enactment is an extreme long shot no matter what, but he wants to press the re-set button, signal where he wants to go, and reframe public debate. A progressive consumption tax strikes me as well worth considering on these grounds if he is doing tax reform at all, in addition to being genuinely better policy.

Full post as published by Start Making Sense on December 10, 2010 (boomark / email).