Wednesday, January 4, 2012

The VAT, a libertarian dilemma

Dan Mitchell wrote an interesting op-ed in the Wall Street Journal (Cato link for those without WSJ access), highlighting a great libertarian dilemma: is a consumption tax (VAT or similar) a good thing?

Every bit of economic analysis says yes. Economists hate distortions, taxes that lead to bad economic behavior. Our tax system is full of them.  Broaden the base, lower the rate, tax consumption not savings, dramatically simplify the code, and you can get the same revenue with much less economic damage.

A political argument disagrees: An efficient  tax code can also raise a lot more revenue. Dan opposes the VAT (and similar consumption taxes) on that grounds. Yes it looks good to start, but politicians will soon raise the rate to the sky and spend the results. (Becker and Posner have also tackled this one several times.) 

It's a strking dilemma: should we keep an atrocious tax system to limit the size of government?  Is there no way to get an efficient tax system and a limited government?

Implicit in Dan's argument is a deeply pessimistic view of our Government: sooner or later, Congress will get to the top of the Laffer curve of a given tax structure. (The top of the Laffer curve is the point where the government is getting the most possible tax revenue. If the government raises tax rates any more, people work less, hire lawyers and lobbyists to evade taxes, businesses move offshore or just don't get started, and so on. The government can end up with less total money even though tax rates are higher.)

Most economists seem to disagree that we are at the top of the Laffer curve. They think Congress has not squeezed every drop out of the current tax code, so they would place more hope in future Congressional restraint. In their view, Europe first decided on a welfare state and then decided how to fund it, not the other way around.

I'm almost as pessimistic as Dan. Sure, raising tax rates can generate more revenue for a few years.  But most economic analyses don't look at the long-run, growth effects of tax distortions. The full disincentive effects don't show up for years. If taxes just lower growth a few fractions of a percent, that soon compounds to drastic reductions in income and tax revenue.

The U.S. Federal income tax seems to take in about 18% of GDP with top rates anywhere from 35% to 90%. And the disincentives are bigger than you think. They result from the full sum of federal, state, local, estate, sales, etc. taxes. Greg Mankiw figured his marginal tax rate at 93% -- and he forgot sales taxes.  (A bit more on long-run Laffer curves on p. 20 here)

But I'm not not quite that pessimistic. Perhaps I'm just being soft hearted, but I surely hope our political system is not quite so broken. On the other hand, it seems naive to simply count on self-restraint to keep spending under control if the Laffer curve all of a sudden is less painful.

This whole question begs for a lot more serious thought:

What is the long-run Laffer curve tradeoff, really? How much do distorting taxes affect growth, and hence long-run revenues? Is our government really close to the top of the long-run Laffer curve?

Economic distortions are not exactly the same as revenue reductions. If we accept the dark view of Government, how do we design a tax system that minimizes economic distortions, yet keeps the top of the long-run Laffer curve at, say, 20% of GDP?  That is a fun optimal-taxation optimization problem. Surely the current abomination is not the answer to that question!

In one sense the top-of-the-Laffer curve view is demonstrably wrong. Dan argues that the government grabs as much revenue as it can given the current tax system, but it can't easily change the tax system. If so, it would have already enacted a VAT!  Is there hope for similar hard-to-change constraints on overall tax revenue within a better system? Can we pass an effective law that says revenue may be no more than 20% of GDP? 

What are the relative welfare effects of a government that is too large vs. a distorting tax system? Maybe firing all the tax lawyers accountants and lobbyists is worth putting up with a slightly bigger welfare state?

Any PhD students out there looking for thesis topics?