Have you been concerned over the rising national debt, now over $16 trillion? Sadly, our children are not as well off as we were. In fact, it appears the 20th century may be on its way to be the Golden Age of American democracy and economic strength. Many politicians say we must cut spending to solve our massive 21st century deficits. But an equal number of economists know that draconian cuts in spending may not be the answer. Republican presidential candidate Mitt Romney has just proposed a massive income tax reform, but tax reform on income tax may not be the answer either. The answer in my view is deeply embedded in “economics of tax,” a quantifiable theory of tax elasticity. Elasticity is simply how a tax behaves once Congress enacts the tax. Analyzing the elasticity of tax can assist the U.S. government to quickly analyze its tax infrastructure, the physical operation set up by Congress to create or abolish a tax, to collect, enforce and adjudicate the collection of a tax and to measure its effectiveness.
Let’s take income tax as an example of how economics of tax works. Americans have always been taxed, but income tax is a relatively new type of tax. In our 236-year history income tax has only been around since the early 20th century. Indeed, excise and sales taxes were the only taxes we had for a hundred years. Economics of tax asks: Is it possible that the culprit in our increasing national debt is the income tax?
If we take the income tax as a percent of GDP we will see that after World War II, tax collections for the last 60 years have been constant. However, as GDP rises so should tax revenue. If GDP rises with tax collections we have an “elastic” tax. When GDP rises and tax collections remain constant, than we have what I call an inelastic tax. If the current income tax is inelastic, tax collections will not increase with GDP, causing massive annual deficits as we are experiencing now. Income tax has a very low elasticity score. On the other end of the spectrum a national sales tax has a very high elasticity score. Therefore, if Congress developed infrastructure to support different types of taxes perhaps tax collections would rise with GDP. For example, let’s take a more flat and lower income tax of say 10% and combine that with a national sales tax of say 10%. I believe this combination of taxes would raise sufficient revenue to begin to wipe out the deficit and keep our current spending levels within annual balanced budgets. Even the national debt could begin to be over time paid down with a national sales tax supplementing a reformed income tax.
To those critics who contend that we would then sacrifice tax fairness, I ask this question: Are we as a nation willing to sacrifice a progressive rate structure of taxation in order to allow for continued high spending levels for entitlements and dramatically higher tax collections while wiping out annual trillion-dollar deficits? Like it or not, history shows there was never any fairness of tax in America. In the late 18th century and for almost another 100 years, the only taxes we had were sales and excise taxes. American taxes are not constitutionally mandated to be fair and economics of tax theory finds no basis for a progressive rate structure once the tax in question becomes inelastic.
In conclusion, short of dramatic immediate cuts in government spending, Congress must consider changing our national tax infrastructure to allow for collection of different types of elastic taxes to increase annual revenue collections and to raise sufficient funds to better fit the 21st century American lifestyle. We must do this or face the possibility of a national financial disaster of such magnitude that our nation may never attain again the Golden Age of the 20th century.
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