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Marcelo Giugale

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Why Is It So Difficult to Agree on Tax Reform?

Posted: 07/27/11 01:11 PM ET

We see it today in the U.S. We saw it in India in 2010. In Mexico in 2007. And almost everywhere else in the past two decades. Around the world, comprehensive tax reform has been difficult -- if not impossible. Rich or poor, countries have rarely managed to clean up their tax "codes" -- the thousands of pages through which sales, income, property, value added, inheritance and many other taxes are imposed on all of us. At most, governments have added patches to what was already a patchwork of previous attempts at reform. Why? Don't we need taxes to pay for public schools, hospitals and roads? Can't we just agree on a system that is simple, fair and sufficient? Well, it's complicated. When you design a tax system, you are trying to hit six -- sometimes contradictory -- objectives at the same time.

First, you want every tax to actually raise significant revenue. Why go through the administrative and political pain of having a tax if the money collected will be puny? Yes, you can put a tax on twelve-year-old whiskies or on twelve-cylinder luxury cars. But how good is it if so few people consume those goods that, at the end of the day, the revenue from the tax is spent chasing cheaters? You want taxes to be "broad-based", that is, to cover a wide range of consumptions or incomes. [By the way, a good rule-of-thumb is that the total collection from all taxes together should not be less than a fifth, and no more than a third, of the value of the total production in the economy.]

Second, you do not want to alter people's behaviors too much. In technical parlance, you want your tax system to be "efficient", that is, not to push investors, savers, employers, workers and consumers to do things they would not do if there were no taxes. The typical case is the entrepreneur who opens a factory in the middle of nowhere just to benefit from a tax break that is only given there. But think also of the couple that gets married only because it is "better for tax purposes". Or the lone widow that trades up into a bigger house just to claim the "mortgage interest break". Seriously, taxes can make you do crazy things.

Third, equity. Notice that it does not say "equality" -- it says "equity". You want those that have more, to pay more. But not just dollar for dollar. You want them to pay proportionally more. If you earn a hundred thousand dollars, you pay 25 percent. If you earn a million dollars, you pay 40 percent. The tax rate goes up with your income. That is called progressivity and, of course, it is one of the most contentious aspects of any tax system. The left loves it, the right hates it. (More on this below).

Fourth, administrative simplicity. This is the one condition everyone agrees on -- and usually the one we fail to meet. Imagine a flat, 10 percent income tax for everybody on all sources of income -- no thresholds, exceptions, discount, credits or loopholes of any sort. Such a tax would be very simple to calculate and collect. The corresponding law could fit onto a single page -- not to mention the tax return. And being only 10 percent, there would be little incentive to dodge it. But, it would probably generate plenty of social tension and resistance. Why are the ultra poor paying at the same rate as the ultra rich? Why do you get the same deductions -- that is, none -- whether you have one child or five? In other words, simplicity and equity can clash.

Fifth, federal consistency. At any point in time, there are several governments trying to tax you. In addition to the federal taxman, you need to consider taxes paid to your state, your county, and even your city. The last thing you want is for them to all tax you for the same thing -- "double" or "triple" taxation. So the various levels of government have learned to share "tax bases" according to their respective capacity to administer them. For example, it is easier for your municipality to know how much your house is worth and bill you for your property tax -- the assessor probably lives close by -- than for the federal government a thousand miles away. But only the federal government can track the income of a corporation that operates in many states, let alone many countries. You get the point.

Finally, a tax reform needs to pass through the legislature. Political feasibility is the minimum threshold. Here is where the economists' rubber meets the voters' road. At least in democracies, people's preferences and perceptions matter more than technical beauty. A crystal-clear example: it is technically preferable to apply the value added tax (VAT) to every good and service, without exemptions. This avoids "identification" problems -- who says that a bottle of champagne is less "food" than a bottle of milk, or an injection of Botox is less "medicine" than an injection of antibiotics? But most politicians, especially in developing countries, would think twice before allowing food and medicine to be subject to VAT. They say that it would hurt the poor. They are right: food takes up a higher portion of a poor family's budget. The theoretical solution is to compensate those in poverty through direct social assistance (read: cash transfers), and let the VAT be as "universal" as possible. In practice, food and medicine remain untaxed in many -- if not most -- countries.

So, there you have it: revenue generation, economic efficiency, social equity, administrative simplicity, federal consistency, and political feasibility -- all need to be achieved at the same time. Is it possible? Yes, but it needs a lot of public education and communication to explain why everyone has to be inside the tax net and why some have to carry a heavier burden than others. It needs a strong civil service that can speak true to political power without fear. And, most importantly, it needs politicians who are not polarized, and who can negotiate tradeoffs. But don't blame politicians: they just reflect -- or should reflect -- the wishes of citizens. The real reason comprehensive tax reforms are so rare is that not many societies have come to agree on a vision of what they want from government -- that is, which public services should be provided and who should pay for them.

 

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