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What liberals could learn from Ted Cruz’s flat tax

"Imagine a simple flat tax…"
"Imagine a simple flat tax…"
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Ted Cruz has developed a reputation as the most conservative of the major 2016 Republican presidential candidates, but he hasn't taken many specific policy positions to earn that moniker. One exception? His longtime support for a flat tax.

The flat tax dramatically lowers the top tax rate and exempts capital gains and dividends from taxation. It's astonishingly regressive: the rich pay far less, hedge fund managers and private equity types like Mitt Romney would pay literally nothing, and while the exact rate varies from plan to plan, it's certainly not going to be as low as 10 or 15 percent, meaning the plan would likely raise taxes for middle-class people currently in those brackets.

Cruz's flat tax proposal, as you would expect, drives liberals crazy. "It's a fiscal fantasy for people who wish the US existed as it did before FDR was president," writes Wonkblog's Matt O'Brien. "It's not an agenda for anyone who's interested in governing the country as it is today."

But liberals should take at least some of the ideas in the flat tax more seriously. Just as a monomaniacal obsession with growth has made conservative tax policy into a regressive disaster, an obsession with progressivity above all else is becoming an anchor on progressive tax thinking. It's easy to come up with a flat tax–like plan that's not crazily regressive but still benefits the economy, and the result would be substantially better than most of the tax plans Democratic politicians promote.

The problem with America's tax code

When thinking about tax policy, you first have to ask what you ultimately want the taxes for. Sometimes — as with alcohol or carbon taxes — the tax does good in and of itself by deterring people from bad behaviors. But mostly you want taxes to pay for worthwhile programs, and liberals in particular need a tax policy that can raise a substantial amount of money to fund a large welfare state. And the experience of most European social democracies is that to do that, you can't just soak the rich. You need broad-based consumption taxes, such as value-added taxes (VATs), that everyone pays.

In his book Growing Public, economic historian Peter Lindert notes that high-budget welfare states in general tax investment income less and consumption more. His argument is that European social democrats realized that income taxes of the scale they'd need to fund a comprehensive welfare state would have a deleterious effect on growth, and that the only way to sustainably pay for universal health care, generous education and pension systems, and so forth is to move toward more broad-based, pro-growth tax schemes.

Which brings us back to Ted Cruz's flat tax.

What liberals miss about flat taxes

day trader stocks

Shutterstock

Yeah, get excited day trader, the flat tax means no more income taxes for you! (Shutterstock)

The term "flat tax" is mostly misleading. It makes people think the flat tax is just an income tax, but with one rate instead of many. It's not, really. Rather, it's a kind of consumption tax — very similar to a VAT of the kind social democracies depend upon.

VATs work by taxing the difference between what a company paid on materials to make a product and what it sells that end product for: the value added, in other words. As the Tax Policy Center's Len Burman explains, the corporate tax side of a flat tax is just a VAT that also lets companies deduct the cost of wages. Individuals then pay taxes on those wages themselves.

Economists tend to find that consumption taxes are better for the economy than income taxes, because income taxes discriminate against savers.

To see why, imagine you make $50,000 in wages and there's a flat 20 percent tax on all income. You'd pay $10,000 in taxes on your wages. That leaves you with $40,000.

Now you've got a decision to make: do you want to take $5,000 of the $40,000 you have left and invest it, or do you want to take that $5,000 and spend it on a really awesome television? If you invest it and make money off the stocks, then the thing you bought with your money — the profits those stocks made for you — will get taxed again. If you just buy the TV, the government doesn't tax you a second time.

Under standard economic models, eliminating this double-taxing of savings promotes investment and thus boosts economic growth. And it's not just conservatives and libertarians arguing this; a highly influential model by Anthony Atkinson and Joseph Stiglitz, both noted lefties, gives this result. A widely cited 2001 paper by David Altig, Alan Auerbach, Lawrence Kotlikoff, Kent Smetters, and Jan Walliser estimates that switching from income taxation to consumption taxation boosts growth in the long run by 1.9 to 9.4 percent, depending on how you do it.

The empirical evidence is murkier. UC Berkeley's Danny Yagan found that the 2003 dividend tax cut — meant to reduce double taxation of savings, just like consumption taxes — didn't do anything to help the economy. But a recent paper by Tulane's James Alm and the IMF's Asmaa El-Ganainy found that in 15 EU countries, increases in VAT rates decreased consumption and boosted savings — exactly the result you get from the models. The matter isn't open and shut, but at the moment the weight of the evidence suggests consumption taxes are preferable for growth. That gives credence to Lindert's argument that to raise taxes enough to fund a welfare state without hurting growth too much, you need to move to consumption taxation.

Taxing consumption can be progressive

Life in Sweden

A child in Stockholm enjoys the bounty produced by Swedish social democracy. (Christian Science Monitor/Getty Images)

The problem with consumption taxes is that they're usually regressive. VATs are sales taxes: they make everything more expensive by a set percentage, and because poor and middle-class people spend more of their incomes than the rich do, the end result is that the VAT hits them more than it does the rich. But there are a variety of ways to tax consumption without making the poor worse off.

The simplest way would be to do take a flat tax but make it not, y'know, flat. Recall that the main feature of the flat tax is its business component — again, it's like a VAT that subtracts out wages. It's totally possible to pair that with a progressive tax on wages, rather than a flat tax on wages. The result is still a consumption tax, but it's a progressive one.

This idea — known as the X tax and originated by the late Princeton economist David Bradford — has been promoted in recent years by the American Enterprise Institute tax expert Alan Viard, who along with Robert Carroll wrote an excellent book outlining a detailed X tax proposal. The 2001 simulation by Altig et al. found that replacing the income tax with an X tax would be better for growth then even the flat tax.

The big problem with the X tax is that it doesn't touch capital income. Mitt Romney wouldn't pay a thing. So, alternatively, you could simply amend the income tax so that all savings is tax-deductible. This would effectively turn the income tax into a consumption tax, and do it in a way that makes sure capital income still gets hit.

But the most reliable way to make a consumption tax progressive has nothing to do with the tax itself and everything to do with what the money it generates is used for. Europe's flat VATs are not themselves progressive, the way an X tax or personal consumption tax are, but they pay for transfer payments that are larger, relative to income, for lower- and middle-class people than for the rich. The overall system is progressive even if the tax isn't.

What will be liberals' flat tax?

graetz tax plan

Columbia law professor Michael Graetz's Competitive Tax Plan is one way to introduce a VAT without making the tax code less progressive. (Amazon)

So there's a way to change the tax and transfer system so that it's still progressive but doesn't punish savings, and the change would likely boost economic growth. Why aren't Democratic politicians jumping all over this?

They flirt with the idea occasionally. Then–House Speaker Nancy Pelosi (D-CA) stated that a VAT was "on the table" for funding health-care reform in 2009. President Obama expressed openness to the idea in 2010 after his adviser Paul Volcker signaled support. Volcker's comments provoked Congressional outrage, and the Senate voted 85–13 to condemn the idea as "a massive tax increase that will cripple families on fixed income," but all but one of the 13 senators opposing that move were Democrats.

But years of Republicans promoting flat taxes and sales taxes have left a residual distrust for consumption taxation among liberals. More to the point, supply-siders' insistence that marginal tax rates are the main determinant of the course of human history has done a lot to discredit, among liberals, the idea that taxes have much of an effect on growth at all.

That's fair so far as the recent debates in American tax policy go: the idea that cutting the top tax rate from 39.6 percent to 35 percent could boost growth by any significant amount is nutty, as are claims that big tax cuts like Ted Cruz's or Marco Rubio's would boost growth so much they'd pay for themselves. But the result of the backlash is that progressivity has become the only criterion by which many left-of-center people judge tax proposals, and more credible cases that tax reform could boost growth are ignored. That's really too bad, especially for those who want a dramatically larger welfare state. Realistically, that increase has to be paid for, and consumption taxes are the obvious way to do it.

To quote Paul Krugman, "if I can trade a somewhat regressive VAT for guarantees of decent retirement and universal health care, I’ll take it."

Correction: This post originally said that all 13 senators opposing an anti-VAT amendment were Democrats. Twelve were; the 13th was then–Sen. George Voinovich (R-OH).

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