More than three years have passed since then-treasury secretary nominee Paul A. O’Neill made one of the first of his now-famous public exposés. To the smug applause of the U.S. Senate Finance Committee and muffled chortling, he boldly exclaimed during confirmation testimony that he was not planning simply to reform the corporate income tax; he wanted to eliminate it altogether. To these elder statesmen, it was as if Mr. O’Neill had the audacity to utter the equivalent of the innocent child’s observation in the famous Hans Christian Andersen fairy tale.
Today, Secretary O’Neill has been abruptly returned to the private sector, while the U.S. corporate tax not only survives but has been elevated to the fourth-highest corporate rate (35 percent) among developed nations—higher even than those of Sweden, Germany, and France and almost triple Ireland’s 12.5-percent rate. No one has seriously pursued legislation to implement Mr. O’Neill’s recommendation.
The problem was not bad timing—the Enron era, with its anticorporate backlash, had not yet begun. Nor were the senators blind to his point. They knew O’Neill’s observation about our broken tax system was as right as it was blunt. Corporate taxes are just a convenient way to disguise the true tax burden that the consumers of corporate goods and services (that is, you and I) ultimately pay and to make tax lawyers wealthy. Some of the same members of Congress who profess bewilderment as to why American firms expatriate know the naked truth is that corporate taxes burden citizens, not corporations.
They also know several other things. They know that our assumptions about who actually pays corporate taxes make all the difference in the world to the political viability of corporate tax reform—not to mention the political longevity of those brave enough to suggest it. They know that attempting to repeal corporate taxes would be perceived as pro-business and anti-poor. They know that the modern version of Andersen’s Imperial Court Weavers will conclude that the repeal of corporate taxes (double taxes) will only help wealthy investors. They know that a proposal to repeal corporate taxes is dead on arrival because no elected official would be accused of such craven and heartless attacks on the poor. They know that the naked truth is not enough to change tax policy in Washington because the modern Imperial Court Weavers cloak bad ideas with an array of incomplete assumptions to ensure that no policymaker will expose the truth for fear of being labeled, as were the courtiers in the fable, “unfit for his office.”
Who are today’s Imperial Court Weavers? They are unelected government officials whose estimates of the revenue costs of proposals and the distributional effects are accepted as gospel by Congress. They are the ones, for example, who officially estimated that repealing the death tax would cost two-and-a-half times what it is projected to raise. They are the ones who officially estimated the revenue gain from a 100-percent confiscatory tax on incomes of more than $100,000 (responding to a tongue-in-cheek request by a Senate finance chairman) at several billion dollars per year.
These officials weave a colorful embroidery of assumptions that serve effectively to condemn any criticism of the existing system as “unpardonably stupid.” Often dismissed as mere technicalities, the assumptions they choose literally determine the cost of reforms and their political viability, and they function as a bulwark against any constructive change.
Let us assume, for example, that we were seriously to try to repeal the corporate tax, as O’Neill and others have suggested. The seemingly simple question Who benefits? would soon be raised by politicians who want a three-sentence reply to a pesky constituent’s letter; TV commentators who will demand six-second soundbites to match their audience’s attention span; trade groups who want to rile their members; journalists seeking to answer the question within the confines of an 800-word essay; and advocates who want to commit the equivalent of a fly-by policy shooting.
The “technical” question will be referred to the Imperial Court Weavers, who will draw a very big “official” assumption. They will tell king, courtier, and townspeople alike that it is the shareholders who pay corporate taxes, not consumers or wage-earners—and, further, that lower returns to shareholders have no deleterious effect on their level of investment.
The naked truth about the question of “incidence” is that the one who writes a check to the IRS does not necessarily pay the tax, ultimately. Rather, when a tax is imposed on a corporation, it is like a hot potato, which the business tries to pass along to someone else. Taxes are paid by consumers in the form of higher-priced goods and services, in wage reductions as companies pay workers less, or in reduced returns to shareholders (who are often also the consumers and workers, if they hope to retire on more than Social Security). If we were to admit that corporate taxes are ultimately paid by consumers or wage-earners, then we would realize that their repeal would benefit consumers or workers. If we recognized that taxing corporate investment lowers investment returns, then we would also realize that it lowers both investment and, ultimately, real wages. Nobody really knows who is stuck with the potato, but the modern-day Imperial Weavers are not plagued by such doubts: Those who support corporate-tax repeal, they say, are “villains.”
Assume, instead, we want to reduce marginal tax rates. Economists believe that lower marginal rates result in much higher rates of economic growth. Unfortunately, the Imperial Weavers will assume that tax burdens should be viewed on an annual basis. By providing Congress charts depicting distribution only on this basis, they ensure that flatter marginal rates are assumed to hurt the poor and to benefit the rich, even if they are the same people at different stages of life. Supporting a single rate, therefore, “merely prove[s] one very stupid and unfit for his office.”
If we were, instead, to analyze the tax burden as taxes paid over the course of a lifetime, then the distribution of flatter taxes may look as progressive as our current income tax but without the disincentives toward work and savings. Consider, for example, an imaginary economy with only two taxpayers—a father and son—and two tax rates, 40 and 10 percent. Now consider a proposal to level the rate to 25 percent. Both father and son earn precisely the same lifetime income. It should not really matter to the government or to them if we imposed a flat rate of 25 percent on each. The truth is that major biases result from gauging tax burdens annually. A very large share, perhaps substantially over half of the income-distribution inequalities in our economy, are simply a function of the fact that more experienced and older workers earn more than their younger counterparts. In fact, it would be misleading to characterize these normal changes in income over peoples’ lifetimes as class-based income inequality.
If we analyze the tax burden as taxes paid over annual income (i.e., if we look at the father and son as a snapshot in time), the temporarily “affluent” father will get a huge tax cut; the temporarily “poor” son, a huge tax increase. The implicit public policy recommendation of the Imperial Court Weavers is this: The only way to be fair is to impose a publicly enforced increase in allowance by taxing the father to make transfer payments to his son. Therefore, supporting a single lower marginal rate, even though beneficial to the economy, “merely prove[s] one very stupid and unfit for his office,”
There is more. Imagine a nominee for treasury secretary bold enough to support a consumption tax. Consumption taxes, for each dollar raised, are far less damaging to the economy than taxes on capital, let alone less damaging to privacy or civil rights. Even though the former chairman of the powerful House Ways and Means Committee was purportedly a supporter, Washington has not yet enacted a consumption tax. Indeed, all the Democratic presidential hopefuls are proposing tax increases that would fall largely on capital rather than on consumption, and to great applause. When they advocate destructive “taxes on the rich”—such as higher marginal tax rates on upper-income people and higher tax rates on capital gains, dividends, and corporations—they are, in fact, calling for higher taxes on productive saving and investment. These higher taxes would depress investment, productivity, and wage growth, making workers bear the ultimate cost. They are, in effect, praising the embroidery on the fictitious robes.
What politicians have to fear from supporting consumption taxes is that here, too, the distribution charts will show that they wish to steal from the poor, who consume a disproportionately higher amount of their income. That is because the Imperial Weavers assume taxes paid over income is the only measure of the “ability to pay.” In the view of defenders of the income-tax system, this method provides the “right” answer—that the income tax is the “fairest” system because the more we increase taxes based on income, the more taxes are paid. Anyone who thinks otherwise is “unfit for office.”
In truth, income is just a surrogate of the “ability to pay” and a rather poor one at that. Intellectual arguments for consumption taxation can be traced to Thomas Hobbes, who argued some 350 years ago that “the Equality of Imposition consisteth rather in the Equality of that which is consumed, than of the riches of the persons that consume the same. For what reason is there, that he which laboureth much, and sparing the fruits of his labour, consumeth little, should be more charged.” Is it not possible that consumption is a better measure of one’s ability to pay than income is? Could it be that what we consume for personal gratification is a better way of defining our ability to pay taxes than what we earn in a given year, because what we do not spend we simply defer for future consumption, invest, or give to charity? Is it not as much a political decision—not a scientific one—to measure distributional equity by taxes paid over income earned in a given year rather than over consumption? If tax distribution were measured as taxes paid over consumption, supporters of a consumption tax would be the heroes of the poor.
As the Imperial Weavers weave their cloaks of deception, they function as a closed group that chooses the authority on which they will rely. Few oversee their workshop. They need not publish their findings or their methodology or their math. They can choose to write a report or to estimate legislation or not to do these things almost entirely at their own discretion. In fact, members of Congress—even Ways and Means members—must cajole them to perform estimates. From their edicts, there is neither review nor appeal. As a result, their body of conclusions, like the clothes of the emperor, not only go unchallenged but are admired. As in the fable, they ensure that “no one—from the king, to his ministers—really has the courage to say what their eyes tell them.”
To make real progress, tax reformers must learn simply to question the words of the Imperial Court Weavers. Before they can enact a consumption tax, repeal the death tax, impose a territorial tax system, increase the ability of the middle class to save, rid us of the Alternative Minimum Tax, and lower tax rates so that our manufacturers do not expatriate, they must confront the Imperial Court Weavers who develop and sustain the false and misleading assumptions on which bad tax policy is based.
Next time you hear an innocent exclaim, “But he has nothing on!” remember that, in the fairy tale, the people ultimately did begin to whisper to one another what the child had said. Then, they said it louder and louder. “A child says he has nothing on!” Soon, all the people were saying aloud, “But, he has nothing on!” And, in the end, the emperor heard what they said, and he shivered, for he knew that their words were true.
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