The Independent Market Observer

3/5/13 – Let’s Talk About Taxes

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 5, 2013 8:39:31 AM

and tagged Politics and the Economy

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Part of our conversation yesterday revolved around the tax increases we saw early this year and the spending cuts that took effect yesterday. As I mentioned, these are both positive developments, but they’re only the first steps on a long road. What remains to be done is a multiple of what’s been done so far.

Politically, both moves are problematic. But, in my opinion, the tax increases are by far the more difficult. Everyone seems to be in favor of both tax increases and spending cuts—they just can’t agree on whom to tax or what to cut! Taxes, however, are more challenging in that they require taking something away from people that they already have. In many cases, spending is more nebulous, and defense spending cuts won’t mean I have fewer dollars in my paycheck.

For most people, battles over spending cuts are fought in the abstract. (Of course, that’s not true for people who directly benefit from programs on the chopping block, a topic we’ll touch on tomorrow.) Tax increases, on the other hand, are concrete, immediate, and personal.

Because of that—and because few people will agree that they or their friends should pay more—raising taxes will be a roadblock in any comprehensive deal, even more than spending cuts.

This is actually exciting rather than discouraging, as it forces both sides to reexamine how governments raise revenue. We need to raise the money, and there’s no question that, if we were starting fresh, we wouldn’t design a system that looks anything like the present one. There’s nothing sacred, or particularly efficient, about the mix of income, payroll, sales, and other taxes we now pay. What would a more economically efficient and more equitable system look like?

Depending on whom you ask, you’ll get very different answers to that question, but the states are trying to figure it out. Oklahoma and Kansas have already started to lower income tax rates, and the governors of Louisiana and Nebraska, along with Kansas, are looking to eliminate the state income tax entirely. Revenue would come from sales taxes, energy royalties from the fracking boom, and other non-income sources.

The basic idea here is that lower income taxes, and lower taxes on workers in general, will attract investment and talented workers, spurring growth. Many other factors are in play, obviously, but at the margin, this idea does seem to work. The question is whether, for each individual state, the tax factor will outweigh the others.

Such changes will also create many challenges—the foremost being whether the new tax structure will raise the same amount of money. The other major problem is how and whether to adjust for different spending patterns in different income cohorts.

The primary argument against consumption-based taxes is that lower-income people end up paying more in taxes, as they spend a greater percentage of their income. This can be and is adjusted for—for example, by exempting certain goods such as food or clothing—but that eliminates some of the system’s simplicity and opens it to manipulation again.

The federal government isn’t likely to move away from income taxation completely, however valid the arguments. It is likely, though, that lessons learned from the state-level experiments will translate into federal action. We’re now thinking collectively about how to craft a tax solution that will meet today’s needs—and doing it across both parties, at all levels of government.

Ultimately, that is how the problem will be solved.

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