The U.S. tax system: sacred cow or bum steer?

One of the FEW benefits of a major financial crisis is that it gives policy makers the chance to drive sacred cows to the slaughterhouse. In the last month we've seen politicians, business leaders and academics posit ideas that heretofore bordered on political blasphemy. Grass-root, rural Republicans are calling for bank nationalization. Anti-corporate, urban Democrats are opening up the government coffers to buy reams of corporate paper. Global investment gurus are calling for tighter regulatory oversight, and environmental champions are calling for domestic drilling to ease energy prices.

As the financial crisis extends into an economic one, hopefully we’ll begin to cull the herd of sacred economic policies. One possible output could be a complete reevaluation of our national tax system. In this presidential election, the battle over taxes between Obama and McCain has rarely evolved beyond locker room comparisons (see: "My tax cut is bigger than yours, part I"). One can only hope that severity of the times will force us to go deeper, and perhaps question some of the underlying tenets of our tax system:

-Are interest tax shields too generous? In particular, have mortgage interest tax shields helped to fuel the residential real estate bubble?
-Is the corporate/personal tax burden weighted appropriately, or should it be inverted?
-Is a progressive income tax system the right approach for funding the federal government, or like state governments do we need to utilize a mix of income, consumption and property taxes (the so-called "three-legged stool") to more equitably distribute wealth without impeding its creation?

On this last point, it is worth touching on the WSJ’s discussion of the marginal tax rates offered by Obama’s plan.

Their analysis highlights one of the underlying deficiencies of a progressive income tax system coupled with wealth redistribution programs- the marginal disincentive to work. Starting from the middle, as individuals move towards the right end of the curve the increasing tax rate provides a marginal disincentive to work. Starting on the left, as individuals move towards the middle and price themselves out of social welfare programs, they face a similar disincentive. Republicans have traditionally fought to decrease the right hand slope of the curve, while Democrats focused on flattening the left hand side of the curve. The Obama and McCain tax plans reinforce this trend.

While battle has raged on the poles, the equator has remained remarkably stable. The tax rate for median income households has remained relatively constant over the last 40 years, ranging from 25-28%. (It should be noted that despite the mutual animosity between the poor and the rich, both groups have proven remarkably adept at gaming the system through political influence; rich constituents press their Senators to create tax loopholes that violate the spirit of the tax code, while poor constituents lobby their Congressmen to expand and extend spending programs well beyond their original purpose).

Fast-forward to our current crisis. Over the last decade, the greatest relative decrease in earning power has been felt by the middle class. Stagnant growth in real wages, coupled with increased costs of living and the recent collapse in the value of homeowner's equity has left the middle class scrambling to bridge the gap between their lifestyle and their income. The prevailing reaction- largely from Sen. Obama and the Democratic party, but joined by an ever-increasing chorus of Republicans- has been to ante up on our progressive tax system. Crank up marginal tax rates on the rich while raising the threshold used to qualify recipients of wealth redistribution. Get as much money as you can (either from the rich or off of the Fed’s printing presses) and pump it into Peoria. While the short-term, Keynesian effects will likely reduce the depth of the recessionary trough we are sliding into, the long term consequences will be dire.

Those consequences are two-fold. First, increased upper-income tax brackets will create the aforementioned marginal disincentive to work for wealthy individuals. In reality this will be manifested in a small but noticeable exodus of the most productive employees to countries with better tax structures. While the “brain-drain” threat is real, it will likely be concentrated in the financial sector. Frankly speaking, that sector can afford to lose some weight.

The second, much more deleterious effect will occur as the welfare pool (not to be confused with the welfare class) expands. Households making $40,000 a year might suddenly find it economically advantageous not to work longer hours or take on another job to move their income to say, $45,000. In doing so they may decrease their government program eligibility by greater than the salary increase of $5,000. This is precisely what occurred prior to welfare reform that took place in 1996. The record shows that people- irrespective of tax bracket- act rationally to maximize their income, even if that means working less.

But in a time when the productivity of the American middle class is decreasing relative to the rest of the world, we can scarce afford to encourage working less. This could force a destructive cycle, with ever-increasing benefits needed to maintain the same quality of life. The middle class could eventually become a welfare class, a frightening proposition for a country whose economic, political and cultural identity is built on an aspirational middle class.

This is in no way meant to suggest that McCain's proposed tax plan would prove any more effective. The idea that the fruits of wealthy American's labor will- taken alone- sustain economic growth throughout the rest of the economy has been disproven over the last two decades. As the U.S. Gini coefficient sprints towards .5, we find ourselves leaving behind a pack of peer nations and joining the company of such prosperous oases of egalitarian opportunity as Mexico and Brazil.

With the tax plans currently on the table, American middle class voters have the dubious privilege of choosing to become a welfare queen or a member of the working poor. Hopefully, whomever emerges victorious from this election will think about alternative taxation policies, policies that promote savings, discourage conspicuous consumption and asset speculation, reward workers who create real economic value and limit social safety nets to those Americans who truly need a helping hand.

Something radical needs to be done, but as of yet we have not heard any new ideas. The public's negative perception of the federal government seems to suggest that the solution, whatever “it” is, will require turning a few sacred cows into hamburgers.

Weekend Update expresses this sentiment perfectly. (Go to 4 minutes in on this clip)