Two tax solutions that would actually “Make America Great Again”

Congress is about to pass a major change in our federal taxes, which President Trump will surely sign as part of his plan to “Make America Great Again.” Sadly there has been little debate about what the tax bill entails, even by the lawmakers voting on the bill.

Rather than parse the details of the final tax bill, I will suggest two much-needed tax reforms that indeed can make America better.

1. A Federal Consumption Tax

The savings rate in the United States is very low relative to our major trade partners. For example, China’s savings rate is close to 50 percent of its G.D.P. while that of the United States is less than 20 percent. Even with differences in accounting procedures and measurement error, that is an extremely large imbalance. The way to rebalance global trade (and thus create a favorable net-export position and more jobs at home) is to increase the savings rate in the United States.

One way to do that is to tax individuals for the resources they take out of society (in the form of consumption) and not on the basis of the resources they contribute to society (in the form of work and investment). Americans visiting European countries, especially in Scandinavia, experience the shock of 20- to 30-percent sales taxes, called V.A.T. (value-added tax) or G.S.T. (general sales tax). Some consumer items like alcohol, tobacco and gasoline are taxed at even higher rates, for health or environmental reasons.

Certainly higher consumption taxes would go a long way toward simplifying the tax code and promoting more saving in the United States. Higher taxes on consumption coupled with lower taxes on income would also increase labor force participation. One of the great drawbacks of the progressive income tax code is that it penalizes families when a spouse enters the work force, since part of the family’s income is pushed into a higher tax bracket. When two-income families factor in the increased cost of day care for children, the tax code acts as a disincentive for spouses to enter the work force until much later, when children no longer need day care.

With today’s low gasoline prices, it would be an optimal time for higher taxes at the pump, both to fund public transportation infrastructure and to spur the development of affordable and efficient electric cars.

The most compelling argument against consumption taxes rests on equity. Lower- and middle- income families spend a higher proportion of their budget on consumption goods than do high-income families. The consumption tax is effectively a regressive tax, which means that the lower-income groups pay a higher percentage of their income in taxes than do high-income groups.

But a consumption-based tax can be made progressive, as Japan has taught us. The consumption tax is not levied at the time of purchase of goods and services but levied in the same way as income taxes. Simply put, households deduct their savings from their gross income when filing their tax returns. The tax rate can be made progressive in the sense that lower-income groups have a lower tax rate on their savings-adjusted net income than higher-income groups.

The key to long-term American prosperity is a rebalancing of the trade account. This means increasing saving rates, full stop, and one way to do that is to make consumption more expensive.

2. Incentivize Long-term Investing

There was a time in the United States when families actually held stocks in firms for life and even passed on these stocks to their children. They prided themselves on having ownership of thriving companies and took interest in reading reports of company performance, if not participating in shareholder votes. Such households held shares for the long term. Day-to-day fluctuations were of minor concern.

Such a time, for most investors, is long gone. Companies pay out only a small proportion of their profits in dividend payments, since such payments are highly taxed. Investors buy shares based on expectations of increases in the price over short intervals in order to sell the shares and capture profits through capital gains.

The taxation of dividends contributes greatly to the growth of speculative investment and with it the ongoing cycle of stock market bubbles and crashes. The horizon for these investments is decidedly short-term, even ultra-short-term. Sophisticated algorithms based on machine learning or neural networks are used for forecasting short-term increases in any company’s share price. Little attention is paid to the longer-term growth potential or added social value of particular companies.

One way to undercut the growth of this speculative sector is to cut or even eliminate taxes on dividends. Give households incentives to hold shares for the long term and give firms incentives to pay out higher dividends to attract such shareholders. Such a tax reform would go a long way toward promoting overall stability in the financial sector.

The Political Reality

We are about to get another tax change; some will pay more, others less. There are going to be winners and losers and debates about fairness and equity. But this tax bill, like so many others, does little to address the nagging questions of the savings-trade imbalance and the need to promote financial stability in the United States. As such, it will do little to make America great again.