From the September 2012 issue of Research Magazine • Subscribe!

A Bold New Direction

The election’s winner will face economic trouble and congressional stubbornness. Here’s a way through.

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On Jan. 21, 2013, either a re-elected President Barack Obama or a newly elected President Mitt Romney will be celebrating his Inauguration. In either case, as the champagne corks pop, this much is certain: He’ll have plenty of problems.

The economy, of course, will be troubled. Even if there are signs of an upturn in early 2013—and there may well not be—this will be occurring against a backdrop of longstanding poor growth and high unemployment. Much improvement will be needed over recent baselines to create a widespread sense of recovery, let alone prosperity.

The nation’s fiscal problems will loom large, however policymakers have handled—or not handled—the end-2012 fiscal cliff of automatic spending cuts and tax hikes, and the recurrent issue of raising the national debt ceiling. The lame-duck Congress’s temporary solutions—if any—will not have addressed the problem of chronic fiscal deficits or the prospect of even greater shortfalls over coming decades.

The president inaugurated in 2013 will be dealing with a Congress bitterly divided over taxes, spending and many other issues. There is a good chance at least one chamber will be controlled by the opposition party. Even if one or the other party sweeps the White House and Congress this November, the legislative majorities do not look to be large; a determined minority might retain significant ability to block legislation.

Furthermore, the newly inaugurated president will have some weaknesses in his personal standing and influence. If he is President Barack Obama, he will be a second-term lame duck with recent approval ratings below 50%. If he is President Mitt Romney, he will have been elected largely because of disapproval of the incumbent. In either case, he will likely have won by a narrow popular-vote margin, and certainly will have been on the receiving end of numerous negative ads and uproars over real or alleged gaffes.

Also, if the campaigning as of summer 2012 is any indication, he will have won a race that was not highly focused on policy specifics. This will limit his ability to claim an electoral mandate for existing proposals—but it also means he will have flexibility to come up with new proposals—bold and innovative ones.

So, what should he do?

The new president should put forward a plan that offers far-reaching economic and fiscal benefits, while also shaking up the polarized political debate. This proposal should contain ideas that have not yet had a high profile politically but have received attention and support among economists and policy analysts. It should be sweeping and dramatic—enabling the president to set the agenda, rather than Congress—and have aspects that appeal to both sides of the political aisle.

Here is a brief sketch of such a plan. Its aim is to remake the U.S. tax system.

Replace the Income Tax

The federal income tax has few enthusiasts among either taxpayers or experts on tax policy. Besides being complex, burdensome and inefficient, it has the inherent disadvantage of creating disincentives for work, saving and investment.

Much political debate, though, has taken place within the framework of an income tax—where to set the top rate, what deductions should be allowed and so on. This has led to an acrimonious deadlock, with one party pressing for lower rates (and in some cases a flat income tax) and the other wanting a steeper structure of progressive taxation.

A fundamentally different alternative would be some sort of consumption tax. A national sales tax, or Fair Tax as it has been dubbed, has been touted by some politicians as a replacement for the income tax. A value added tax, or VAT, is a favorite of many policy analysts as a way to raise revenue—but also could be added to an income tax to create a high-tax system such as exists in many countries that have a VAT.

Moreover, consumption taxes are generally regressive (since the rich normally consume smaller shares of their incomes than do the poor) and that has been a key obstacle to their implementation, particularly for replacing a progressive income tax. Redistributing income upward is a hard sell politically.

If there were a type of consumption tax that could get rid of the income tax, reduce the tax system’s drag on the economy, help balance the government’s books and not pit income classes against each other, it would make a powerful centerpiece to a new president’s agenda. As it happens, there is such an alternative, and it goes by an intriguing if not particularly informative name: the X tax.

X Marks the Spot

First devised in the 1980s by the late Princeton economist David Bradford, the X tax has gotten renewed attention in policy circles lately. A recent book making a detailed case for such a system is Progressive Consumption Taxation: The X Tax Revisited, by economists Robert Carroll and Alan D. Viard (American Enterprise Institute, 2012).

An X tax is a VAT that has been revamped so as to maintain progressivity. As with any VAT, tax is due at every stage of production or distribution. However, as with a progressive income tax, household wages are taxed by brackets; also business cash flow is taxed at that scale’s top rate. The burden falls squarely on consumption. Firms can deduct their business investments, and households pay no taxes on interest, dividends and capital gains. All savings, in effect, are getting the advantage of being in a Roth IRA.

As proposed by Carroll and Viard, the X tax would be a broad transformation—replacing personal and corporate income taxes, estate and gift taxes and the Unearned Income Medicare Contribution Tax. It would, however, leave in place other federal taxes, notably the payroll tax (as the authors’ focus is on eliminating taxes that penalize saving).

If the new president wants to achieve a truly historic legacy, he might go one step further: replacing the payroll tax with a carbon tax.

Pricing Carbon

Climate change has been a subject of heated political controversy in recent years, but the approach favored by many policy analysts to reduce climate risks—a carbon tax—has been relatively peripheral in the debate. Rather, contention has focused on the importance or reality of the problem, and on the merits of a cap-and-trade system as a solution.

 Carbon taxation has some advantages over cap-and-trade in being a simpler policy approach and one that produces revenues. However, a carbon tax also carries the political liability of being unmistakably a tax. As such, its political downside could be limited by using the revenues to cut taxes elsewhere. In addition, a president proposing a carbon tax could stress that it would enhance national security by promoting alternatives to dependence on oil from unstable regions and reducing revenues to hostile states.

There would be concerns about a carbon tax’s regressive effects, such as higher gas prices’ impact on low-income rural residents dependent on cars to get to work. Such concerns may be lessened dramatically if some other costly burden for low-income workers—such as the payroll tax—were to be eliminated as part of the bargain.

To sum up, the president inaugurated Jan. 21, 2013, could be the man who got rid of the income tax and payroll tax, improving the nation’s economic and fiscal prospects while aiding the environment and national security in the process. Not a bad way to navigate a stormy sea.

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