How to cut taxes and raise tax rates

How can you cut taxes but raise (distorting, marginal) rates at the same time? Add a deduction, but phase it out with income. Then people below the income limits pay less taxes. But as the income limit  phases in, the marginal tax rate is higher than the previous rate. The new (and old) tax code is full of this perverse result.

For example, suppose you start with a tax code where everyone pays 50% of income. Then, add a deduction, credit, or exemption so people who earn, say, less than $100,000 of income pay no taxes. But phase it out over the next $100,000. Thus, people who earn $200,000 pay the original 50%, or they pay $100,000 of taxes. People who earn $100,000 pay no taxes. So, we have engineered a 100% marginal tax rate for people between $100,000 and $200,000 of income -- each dollar is completely taxed away!

In my example, we gain a 0% (down from 50%) marginal tax rate for people below $100,000 of income. But if the $100,000 is a fixed deduction or credit that does not scale with income, even that benefit is lost.

"Tax cuts" are not necessarily good for growth! It is possible to cut taxes and raise marginal rates, reducing growth.

This came to mind while reading the interesting "Games They Will Play"

Individuals who provide “specified services” (such as lawyers and doctors) must have taxable income of less than $315,000 for a married couple (or half that for a single individual) to be fully eligible—with the benefit phasing down over the next $100,000. 

"Games they will play" makes no mention of this or any other marginal rate. As is common in tax analysts they are great on disincentive margins to game tax payments by reclassifying income, but not so good on these marginal incentives.

I would love to see a true marginal analysis of the tax proposal. What are its actual incentives and disincentives, when you put it all together,  not the constant who-gets-what commentary.

"Games They Will Play" is good reading if you have half a mind to pick up your pitchfork and join the other peasants in rebellion. It's phrased as problems with the new tax code, but it gives you a great condensed sense of just how rotten the old tax code is.


These are essentially unavoidable complications resulting from an income tax.  Once you have an income tax you must have a corporate tax at roughly the highest individual tax rate, or people incorporate. "Games they will play" focuses on this margin with respect to pass-through businesses, and the hopeless quest to separate investment in pass throughs from what is essentially wages. Once you have an income tax you must have a capital income tax, or people turn wage income to capital income -- take stock options rather than wages. Once you have capital income taxes you have to tax capital gains, or companies don't pay dividends and instead pay capital gains.

"Income" is a very poorly defined concept, once you get past the basics of people who earn wages and consider professionals, top management and small business owners.

And so on and so on. This is what leads me to a uniform VAT instead of an income tax. It really is the only way to get rid of the mess. That really is the lesson of the current tax bill. 31 years of waiting (since 1986), thinking, writing papers, opeds, blog posts, think tank reports, articles, and we get... this. It must be inevitable given a few basic starting points, and a progressive income tax is that starting point.

When you object, consider, is this apparently unavoidable mess,  insane complexity, and obvious politicization worth whatever benefit you see from taxing income rather than consumption?

I agree with the WSJ editorial page, in the context of the income tax, the only sensible way to reduce the pass through corporate rate is together with a much lower -- it mentions 28% -- top individual Federal tax bracket. Then soak the rich by getting rid entirely of mortgage interest, charitable, employer health care deductions, electric car credits, and so forth.   

There is much discussion on the left that once you allow companies to completely expense investment, you can have a large corporate tax without disincentives to invest. I'm not convinced, as this sets an army of tax lawyers out to define what is an expensable investment and what is not. Obviously, if companies can deduct "investment" in stocks and bonds, then there is nothing left to tax. The tax lawyers who write the code are smart enough to stop that. But really, how different is it to "invest" in a forklift than to buy stock in another company? (And then rent the forklift out to someone else.) To "invest" in a fleet of company Ferraris, jets, apartments, and so on? On the other side, much corporate investment these days is in "intangible" capital, including software. If I hire people to build out a new IT system, or a better inventory management system, this is economic investment. I don't see how to expense those, and leave anything behind to tax. 

So what is the idea? Somehow, the gnomes will separate "rents,",pure profits, from normal returns to capital and still tax the "rents" leaving untouched the incentives to invest in actual measurable and unmeasurable capital. 

That seems pretty hopeless.  A low (zero) corporate tax seems much simpler. Tax people when they spend the money. 

from The Grumpy Economist http://ift.tt/2BiCkSY