Litho X Tax cover 4/17/12 11:17 AM Page 1 CARROLL, VIARD PROGRESSIVE CONSUMPTION TAXATION PROGRESSIVE “Progressive Consumption Taxation carefully lays out the rationale for adopting a progressive Progressive Consumption Taxation Progressive consumption tax system in the United States and shows how such a system can be adopted. Carroll and Viard provide the motivating ‘big picture’ arguments but also tackle the many thorny details that confront this tax reform, including the appropriate treatment of financial intermediaries, international transactions, and transition from the income tax. The book is ONSUMPTION accessible to those with a policy interest, but it will also enlighten tax experts.” CONSUMPTION —Alan J. Auerbach, University of California, Berkeley “Although consumption-type taxes like the Flat Tax and FairTax are beloved by GOP presi- dential candidates, they have never won political traction because they are widely perceived as unfair. Bob Carroll and Alan Viard take fairness considerations seriously and explain how TAXATION a modern version of the X Tax could address them while preserving the efficiency advan- tages of a consumption tax. The book provides a comprehensive and accessible analysis of progressive consumption taxation and should be on the reading list of anyone interested in fundamental tax reform.” —Leonard E. Burman, Syracuse University and the Urban Institute The X Tax Revisited Robert Carroll is a principal with Ernst & Young LLP’s Quantitative Economics and Statis- tics group. Previously, he was deputy assistant secretary for tax analysis at the U.S. Treasury Department, a visiting scholar with the Congressional Budget Office, and a senior econo- mist with the President’s Council of Economic Advisers. Alan D. Viard is a resident scholar at the American Enterprise Institute. Previously, he was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He also was a visiting scholar at the Treasury Department Office of Tax Analysis, a senior economist with the President’s Council of Economic Advisers, and a staff economist with the Joint Committee on Taxation. ROBERT CARROLL ISBN-13: 978-084474394-3 ISBN-10: 084474394-1 ALAN D. VIARD Progressive Consumption Taxation CCarroll-Viard.indbarroll-Viard.indb i 44/17/12/17/12 99:52:52 AMAM CCarroll-Viard.indbarroll-Viard.indb iiii 44/17/12/17/12 99:52:52 AMAM Progressive Consumption Taxation The X Tax Revisited Robert Carroll Alan D. Viard The AEI Press Publisher for the American Enterprise Institute WASHINGTON, D.C. CCarroll-Viard.indbarroll-Viard.indb iiiiii 44/17/12/17/12 99:52:52 AMAM Distributed by arrangement with the Rowman & Littlefield Publishing Group, 4501 Forbes Boulevard, Suite 200, Lanham, Maryland 20706. To order, call toll free 1-800-462-6420 or 1-717-794-3800. For all other inquiries, please contact AEI Press, 1150 Seventeenth Street, N.W., Washington, D.C. 20036, or call 1-800-862-5801. NATIONAL RESEARCH NRI INITIATIVE This publication is a project of the National Research Initiative, a program of the American Enterprise Institute that is designed to support, publish, and disseminate research by university-based scholars and other independent researchers who are engaged in the exploration of important public policy issues. Library of Congress Cataloging-in-Publication Data Carroll, Robert. Progressive consumption taxation : the X tax revisited / Robert Carroll and Alan D. Viard. p. cm. Includes bibliographical references and index. ISBN 978-0-8447-4394-3 (cloth)—ISBN 0-8447-4394-1 (cloth)— ISBN 978-0-8447-4395-0 (pbk.)—ISBN 0-8447-4395-X (pbk.)— ISBN 978-0-8447-4396-7 (ebook)—ISBN 0-8447-4396-8 (ebook) 1. Spendings tax—United States. 2. Value-added tax—United States. I. Viard, Alan D. II. Title. HJ5715.U6C28 2012 336.2’7140973—dc23 2011050811 © 2012 by the American Enterprise Institute for Public Policy Research, Wash- ington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the American Enterprise Institute except in the case of brief quotations embodied in news articles, critical articles, or reviews. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not neces- sarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. Printed in the United States of America CCarroll-Viard.indbarroll-Viard.indb iviv 44/17/12/17/12 99:52:52 AMAM Contents LIST OF ILLUSTRATIONS ix ACKNOWLEDGMENTS xi INTRODUCTION 1 1. WHY TAX CONSUMPTION? 6 Removing the Income Tax Penalty on Saving 6 Gains from Reform 10 Consumption-Tax Features in the Current Income Tax System 14 Conclusion 17 Box: The Trade-off Fallacy 18 2. THE CASE FOR THE X TAX 20 The Retail Sales Tax and the Value-Added Tax 20 The Two-Part VAT 24 The X Tax: A Progressive Two-Part VAT 29 Comparing the X Tax to the Personal Expenditures Tax 33 Conclusion 39 Box: Optics of the X Tax and the PET 39 3. MAINTAINING PROGRESSIVITY 40 Tax Rate Schedule 40 Assessing the Distributional Effects of the X Tax 45 Conclusion 50 Box: Zero Revenue from Taxation of Risky Returns 51 4. FRINGE BENEFITS AND TRANSFER PAYMENTS 53 Fringe Benefits 53 Financing Social Security and Medicare 56 Public and Private Transfer Payments 59 Conclusion 65 Box: Taxation of Gambling 66 v CCarroll-Viard.indbarroll-Viard.indb v 44/17/12/17/12 99:52:52 AMAM vi PROGRESSIVE CONSUMPTION TAXATION 5. BUSINESS FIRMS 68 General Issues 68 Distinguishing Wages from Business Cash Flow 72 Firms with Negative Business Cash Flows 74 Conclusion 80 6. FINANCIAL SERVICES 81 Neutral Tax Treatment 81 The Problem of Mislabeled Transactions 82 The Search for a Solution 87 The R+F Cash-Flow Method 92 Accounting Methods 98 Special Cases 100 Conclusion 101 7. INTERNATIONAL TRANSACTIONS 102 The Border Adjustment Question 102 The “Competitiveness” Illusion 104 Giving Wealth Away without Really Trying 109 Above-Normal Returns and Transfer Pricing 111 Other Cross-Border Issues 115 Conclusion 115 Box: Border Adjustment with Fixed Exchange Rates 116 8. THE TRANSITION 118 Transition Burden on Existing Capital 118 Normative Issues 124 Outline of a Transition Policy 128 Macroeconomic Policy During the Transition 134 Conclusion 134 9. THE NONBUSINESS SECTOR 135 Owner-Occupied Housing and Consumer Durables 135 Production by Governments, Nonprofits, and Households 145 Patrolling the Boundaries of the Business Cash-Flow Tax 148 Fiscal Federalism under the X Tax 151 Conclusion 153 Box: Taxation of Home Resales 154 CCarroll-Viard.indbarroll-Viard.indb vivi 44/17/12/17/12 99:52:52 AMAM CONTENTS vii 10. THE VAT ALTERNATIVE 156 Subtraction and Credit-Invoice VATs 156 The Superiority of the VAT to the Retail Sales Tax 159 Recent Discussion of VAT 161 Using the VAT to Replace Other Taxes 163 The “Easy” Stuff 164 Monetary Policy and Other Transition Issues 166 Governments and Nonprofits 171 Implications for Social Security 172 Combating the “Money Machine” 174 Conclusion 177 CONCLUSION 178 NOTES 181 REFERENCES 185 INDEX 195 ABOUT THE AUTHORS 207 CCarroll-Viard.indbarroll-Viard.indb viivii 44/17/12/17/12 99:52:52 AMAM CCarroll-Viard.indbarroll-Viard.indb viiiviii 44/17/12/17/12 99:52:52 AMAM List of Illustrations Figures 2-1 Four Ways to Tax Consumption 23 3-1 Distribution of the Federal Income Tax Burden under 2015 Law and under the 2005 Tax Panel’s Progressive Consumption Tax Plan, by Income Percentile 41 Tables 3-1 Distribution of the Tax Burden by Household Income and Household Net Worth 48 6-1 Taxation of Bank Transaction under Alternative Tax Systems 84 8-1 Stocks of Credits, Net Operating Losses, and Remaining Basis Carried into Tax Year 2013 129 10-1 Different but Economically Equivalent Ways to Tax Consumption 158 ix CCarroll-Viard.indbarroll-Viard.indb ixix 44/17/12/17/12 99:52:52 AMAM CCarroll-Viard.indbarroll-Viard.indb x 44/17/12/17/12 99:52:52 AMAM Acknowledgments This book could not have been written without the financial support of the American Enterprise Institute’s National Research Initiative. We are grateful to the NRI board—Christopher DeMuth, Kim Dennis, and the late James Q. Wilson—for approving this project. We thank NRI director Henry Olsen for his patient and steadfast encouragement of our work. We are grateful to Alan Auerbach, Leonard Burman, Alex Brill, Julie Anne Cronin, Jane Gravelle, Chad Hill, J. Andrew Hipolit, Emily Lin, Jay Mackie, Susan Nelson, Thomas Neubig, Jim Nunns, Laura Power, Amy Roden, Jason Saving, Dan Shaviro, Andrew Smith, Eric Toder, David Weis- bach, and George Yin for helpful comments and to Matt Knittel for provid- ing data. We also thank Laura Harbold for her thorough and diligent work on this manuscript. xi CCarroll-Viard.indbarroll-Viard.indb xixi 44/17/12/17/12 99:52:52 AMAM CCarroll-Viard.indbarroll-Viard.indb xiixii 44/17/12/17/12 99:52:52 AMAM Introduction The United States is alone among industrialized countries in having no broad-based consumption tax at the federal level. Yet, as we will explain in chapter 1, economic analysis reveals that consumption taxation has an economic advantage, relative to income taxation, because it does not penal- ize saving and investment. In recent years, a number of proposals to adopt some type of consumption tax have been advanced. As revenue needs increase due to the growth of Medicare, Medicaid, and Social Security in future decades, there is likely to be renewed interest in finding better ways to raise revenue, prompting further consideration of consumption taxes. Several concerns have blocked a move to consumption taxation, how- ever. On the key question of whether a consumption tax should replace all, or only part, of the income tax system, each approach has drawn strong objections.