Carroll Robert - Progressive consumption taxation: the X tax revisited

Robert Carroll is a principal with Ernst & Young LLP's Quantitative Economics and Statistics group. Before joining Ernst & Young, he was deputy assistant secretary for tax analysis at the U.S. Treasury Department, a visiting scholar with the Congressional Budget Office, and a senior economist with the President's Council of Economic Advisers. He was also recently on the faculty of American University's School of Public Affairs and a senior fellow with the Tax Foundation. Mr. Carroll has written on a wide variety of tax issues.

Alan D. Viard is a resident scholar at the American Enterprise Institute (AEI). Previously, he was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also worked for the Treasury Department's Office of Tax Analysis, the President's Council of Economic Advisers, and the Joint Committee on Taxation. Mr. Viard has written on a wide variety of tax and budget issues.

This book could not have been written without the financial support of the American Enterprise Institute's National Research Initiative. We are grateful to the NRI boardChristopher DeMuth, Kim Dennis, and the late James Q. Wilsonfor approving this project. We thank NRI director Henry Olsen for his patient and steadfast encouragement of our work.

We are grateful to Alan Auerbach, Leonard Burman, Alex Brill, Julie Anne Cronin, Jane Gravelle, Chad Hill, J. Andrew Hipolit, Emily Lin, Jay Mackie, Susan Nelson, Thomas Neubig, Jim Nunns, Laura Power, Amy Roden, Jason Saving, Dan Shaviro, Andrew Smith, Eric Toder, David Weisbach, and George Yin for helpful comments and to Matt Knittel for providing data. We also thank Laura Harbold for her thorough and diligent work on this manuscript.

In this book, we have outlined how a progressive consumption tax, in the form of the Bradford X tax, can be used to completely replace the income tax system and end its inefficient penalty on saving and investment without adverse distributional consequences.

As outlined in chapters 3 through 9, we propose an X tax, consisting of a flat-rate firm-level tax on business cash flow and a graduated-rate household tax on wages. The tax would completely replace the individual and corporate income taxes, the estate and gift taxes, and the Unearned Income Medicare Contribution tax slated to take effect in 2013. We have used 35 percent as an illustrative top tax rate on wages and 38.8 percent as an illustrative flat tax rate on business cash flow, while noting that the actual rate could be higher or lower, depending on various decisions about the details of the tax.

In those chapters, we outlined a number of design features that the X tax should employ. We recommend that the tax generally ignore public and private transfer payments, except for tax relief for charitable contributions. To distinguish wages from business cash flow when owners work for firms, we recommend a unified reasonable-compensation rule that applies to firms organized in different ways and governs both the X tax and the payroll tax. To prevent the tax on investment that would arise if firms could not receive tax relief for negative cash flows, we recommend a carryback period of at least five years and unlimited carryforward with interest.

We propose that transactions between financial intermediaries and household customers be taxed under a cash-flow method that integrates real and financial transactions, and that transactions between intermediaries and business customers not be taxed. To prevent a wealth transfer from Americans to foreigners, we recommend that the tax not be border adjusted. To mitigate transfer-pricing problems that can arise in the absence of border adjustment, we propose to tax transactions between firms and related foreign parties on a cash-flow method similar to the method we recommend for financial intermediaries.

We recommend that firms receive transition relief for the unclaimed cost basis of their capital stock, including inventory, and propose transition rules for a variety of other situations. We recommend that owner-occupied homes and consumer durables be taxed under a prepayment method that effectively exempts these assets from the business cash-flow tax. We similarly recommend that governments and nonprofit institutions be exempt from the business cash-flow tax.

As we explained in chapter 1, the removal of the income tax penalty on saving should promote economic efficiency and long-run growth. A number of simulation models have been used to estimate the magnitude of the economic gains. Space precludes a full discussion of this issue, but we highlight results from leading studies and discuss some of the uncertainty surrounding these estimates.

Auerbach (1996, 62) estimated a long-run output increase of 2.0 to 8.9 percent from various proposals to replace the income tax with a consumption tax, and Altig et al. (2001) estimated long-run output gains of 1.9 percent to 9.4 percent for various proposals. Diamond and Zodrow (2008, 239) estimate a 4.9 percent long-run output gain from switching to a Hall-Rabushka flat tax with no transition relief. A significant part of the long-run gains come at the expense of short-run consumption. Because these simulation models are stylized, they can yield only rough and uncertain estimates of the effects of the reforms. Nevertheless, the results indicate that moving to consumption taxation can produce sizable economic benefits.

Two patterns emerge clearly from the studies. First, the long-run output increase is diminished if the consumption tax is more progressive; as with an income tax, greater progressivity pushes up marginal tax rates for many taxpayers and tends to reduce labor supply. Second, the long-run output increase is also diminished if the tax on old capital is lower, due to either the application of a lower tax rate to business cash flow or the provision of transition relief. These two factors have conflicting implications for the gains from moving to the X tax. While the progressivity of the X tax tends to diminish the output gain, the relatively high tax rate on business cash flow tends to increase the output gain.

Altig et al. (2001, 587, 591) offer a more concrete perspective on this question because they specifically examine an X tax option involving a 30 percent tax rate on cash flow and high-wage workers. For this option, they estimate a long-run output gain of 6.4 percent, resulting from a 21 percent increase in the capital stock and a 2 percent increase in labor supply, with a 4.4 percent increase in hourly wages. Households throughout the income distribution share in the long-run gains. Because our proposal includes transition relief, whereas the option specified by Altig et al. apparently does not, the gains from our proposal could be somewhat smaller. The President's Advisory Panel on Federal Tax Reform (2005, 190) estimated that the Progressive Consumption Tax Plan that it considered, which featured a switch to an X tax with transition relief, would yield a long-run output gain of "up to 6.0 percent."

As federal spending grows in upcoming decades, pressure for additional revenue will intensify. Turning to the income tax system for this revenue will place heavier marginal tax rates on saving and investment, an outcome that can be averted by moving to consumption taxation. Yet, the most prominent potential consumption taxes, the retail sales tax and value-added tax, have the drawback of regressivity. In this book we have argued that the Bradford X tax is a progressive consumption tax that can be used to completely replace the income tax system and its economic flaws. In short, we have sought to point the way forward to an efficient, fair, and simple tax system that will ensure a prosperous future for the American people.