Mitchell, Daniel J., “Tax Reform to Encourage Growth, Reduce the Deficit, Promote Fairness,” Senate Budget Committee Hearing, 03/01/12

Dr. Daniel J. Mitchell, Senior Fellow, Cato Institute

“The internal revenue code is needlessly punitive and complex. Some of its major flaws are:

1. High tax rates – Marginal tax rates on additional increments of productive activity are too high, discouraging people from productive behavior.

2. Biased treatment of income that is saved and invested – Because of the capital gains tax, the corporate income tax, the double tax on dividends, and the death tax, there is pervasive double taxation on capital, causing very high effective marginal tax rates.

3. Distorting loopholes – Many provisions of the internal revenue code are explicitly designed to encourage economically irrational choices.

4. Worldwide application – The United States have the world’s most onerous tax system for international activity.

5. Corruption – While in most cases technically legal, the common practice of swapping favorable tax policies for political support is corrosive.

6. Complexity – Nearly 100 years of tax changes have produced 72,000 pages of law and accompanying regulation.

Tax reform has the potential to reduce, or perhaps even eliminate, these problems. But it also could make them worse. To ensure the best possible outcome, lawmakers should be guided by these principles.

A. Tax rates should be as low as possible – Taxes are a price, and it doesn’t make sense to impose a high price of work and entrepreneurship. . The tax system should not discriminate against capital formation – Since every economic theory, even Marxism and socialism, holds that saving and investment is a key to long-run growth and higher living standards, it doesn’t make sense to impose extra-high tax rates on capital.

C. Government should not tilt the playing field with preferences or penalties – Luring people into making economically inefficient choices makes the economy less productive.

D. Territorial taxation – This is the good-fences-makes-good-neighbors approach to tax policy. Disputes with other nations become trivial if each nation is in charge of taxing economic activity inside its borders.

The ideal system, based on the above principles, is a low-rate, consumption-base, loophole-free tax.

The best-known tax meeting these criteria is the flat tax, as developed by Professors Hall and Rabushka at Stanford University’s Hoover Institution.

But the value-added tax is also satisfies these principles – assuming it is replacement rather than add-on tax. And a national sales tax also shares these theoretical qualities.

All of these tax regimes have different collection points, but the tax base is identical. All economic activity is taxed, but only one time and at a low rate.

If lawmakers want to improve growth, particularly in a competitive global economy, where labor and capital can cross borders in search of pro-growth fiscal policy, they should seek to reform the tax system so it fulfills these principles. Economists will not agree on how much additional growth such a system will generate, but they generally will agree that a low-rate, consumption-base, loophole-free tax is the way to minimize the damage caused by taxation.”

Lindsey, Lawrence B., “The Budgetary Case for Fundamental Tax Reform,” testimony before the Senate Budget Committee, 02/02/11

The third major problem with our income based system is that it encourages economic activity to go abroad. An item that is manufactured in China but purchased in America has a cost structure that involves no U.S. income or payroll taxes on its labor content and virtually no U.S. corporate tax on the capital involved in the production. Of course China does have an income tax, but it is quite low compared to ours. The Chinese Individual Income tax produces revenue equal to just 1.2 percent of GDP compared to roughly 7 percent in the United States. The largest component of the Chinese tax system is the Value Added Tax, which generates roughly one third of all Chinese tax revenue. But Value Added taxes are rebated on exports, so this tax does not apply. Conversely, an item built in America and then sold to China involves labor costs that pay both income and payroll taxes and capital costs that involve the whole panoply of U.S. taxation. When they arrive in China the import cost is subject to Chinese Value Added Tax. And this is not just the Chinese. Throughout Europe Value Added Taxation has increasingly replaced direct taxation on personal and corporate incomes over the last couple decades and under World Trade Organization rules it is perfectly legal for them to rebate the tax on exports and impose it on imports.

We complain a lot about the advantages the Chinese give themselves through
manipulation of their exchange rate. At the same time we induce this massive self inflicted wound on ourselves in the form of our income based tax system. And whenever someone advocates raising rates within our current tax regime they are implicitly calling for these distortions to be larger and therefore for Chinese goods to become even more competitive here and our goods to become even less competitive overseas.