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AFP's Four Principles of Optimal Taxation

March 05, 2013 J

By Casey Given

This current legislative session, no less than seven states are considering comprehensive tax reform. As is too often the case, their proposals are a mixed bag of good and bad economic policy. While states like New Mexico and North Carolina ponder pro-growth policies like eliminating all income taxes, they are also considering destructive options like instituting or expanding a gross receipts tax. In this critical time of reform, Americans for Prosperity would like to outline our four principles of tax reform so citizens can hold their elected officials accountable to implementing the optimal tax climate for economic growth.

To facilitate prosperity, a proper tax code should have:

1.      Low Rates

Low taxes allow individuals to save, spend, and invest in the private sector to provide for themselves and their families how they see best, fueling the engine of prosperity. Every marginal increase in taxes has real effects on people’s lives and the economy as a whole. An increase in the corporate tax could cause a company to lay off employees to comply with the added cost – leaving the newly unemployed workers with less to spend thereby become more dependent on government.

Indeed, the negative impact of taxes on investment and growth is almost universally accepted in economics. One recent literature review by the Tax Foundation’s William McBride found that “every study in the past fifteen years” that has been published in peer-reviewed academic journals found “a negative effect of taxes on growth.” Even President Obama has acknowledged the adverse effect of taxes, having proposed a 7% cut to the top federal corporate income tax rate of 35%. If states truly wish to stimulate their economies during these tough economic times, they would do best to lower such uncompetitive income taxes on both the personal and corporate side. Or, better yet, eliminate them completely like New Mexico, Nebraska, North Carolina, and Louisiana are currently considering.

2.      Flat Structure

Ideally, a tax code has few different rates and very few targeted deductions and exemptions.  Unfortunately today, most taxes discriminate on an individual’s ability to pay by levying different rates for different income brackets – which consequently come with a number of unintended consequences. Economically, such unequal levels of taxation sometimes deter taxpayers from earning more income to avoid the added charge. Furthermore, highly progressive tax structures usually don’t have a major effect on how much revenue the government collects. Indeed, despite the fact that the top individual income rate has historically been as high as 92%, the federal government’s tax collections have remained steady at 19% of GDP since the 1940s – a phenomenon known as “Hauser’s law.”

On the other hand, the tax that has proven to be the most stable in collecting revenue and beneficial to economic growth is the sales tax. Since consumption of goods and services continues even in tough economies, sales taxes have proven to be the least volatile in collecting revenues over recent years – as confirmed by several studies on the subject recently conducted by the Federal Reserve. Since sales taxes are flat and do not discriminate on one’s ability to pay, they have proven to be the least destructive to economic growth – as seen in several studies comparing the tax climates of developed countries. States would do best by shifting their revenue sources from progressive income to flat consumption taxes – as Louisiana is currently considering.

3.      Simple Design

If you’ve ever filed income taxes, you’ve experienced the mind-numbing complexity of the United States’ tax code firsthand. State and federal taxes not only charge several sources of income, but are littered with numerous credits and deductions that distort the real rate of taxation. For example, while the top federal corporate tax rate is 35%, the effective rate is actually 27% after applying all the breaks (which is still uncompetitive). Indeed, compliance with such complex tax codes is a tax in and of itself, as residents and companies spend hours of labor filing taxes or hundreds of dollars hiring accountants to do so for them. According to the Small Business Administration, this compliance cost amounted to a $159.6 billion in 2009. Such an incredible mass of money spent simply on filing taxes, which breaks down to a loss of $49.77 per hour for businesses and $31.53 per hour for individuals, could have been more productively invested in the private sector by, say, saving for a child’s college education or investing in a new employee.

An optimal tax code would be as simple as possible to minimize the cost of compliance. Fortunately, the tax reforms that Nebraska, New Mexico, North Carolina, and Louisiana are considering do just that – by eliminating the income tax completely!

4.      Neutral Base

An optimal tax is neutral between saving, investment, and consumption, not discriminating one activity over another or taxing capital more than once. Unfortunately, as many businesses’ incomes decline during these tough economic times, several state governments have taken a liking to broadening their tax base in a manner that violates neutrality and is thereby economically destructive. Specifically, eight states have levied a gross receipts tax (GRT) over the past decade, taxing businesses’ net revenues instead of their income and thereby taxing goods multiple times. While corporate income taxes subtract companies’ cost of business, levying the tax only on profits, GRT’s charge every transaction a business makes with other companies. As a result, complex goods like a pencil are taxed multiple times throughout its stages of production – first for its wood shaft, a second time for its rubber eraser, a third time for its metal tip, a fourth time for lead individually, and a fifth time for the pencil as a whole – effectively levying a higher tax on it than simpler goods and services.

Unfortunately, New Mexico is considering expanding its GRT while North Carolina contemplated implementing a similar tax, negating much of the growth they would experience through their otherwise positive reforms. Instead, these states and others would do best by considering neutral taxes that don’t charge a good or service more than once, such as those for sales or property.

These four elements of a competitive tax code matter. As I explained in a blog post last month, the ten states with the most competitive tax climates as judged by the Tax Foundation grew 36% faster in personal income, 58% in real gross domestic product, and 142% in population over the past decade than the ten least competitive states. Most tellingly, the top ten gained 1,199,100 private sector jobs while the bottom ten lost 760,200. The statistics speak for themselves: states attract more citizens and commerce by keeping their tax rates low, flat, simple, and neutral.

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