One can say what one wants about Elon Musk, but he is able to pinpoint in a single tweet some of the most dysfunctional aspects of our federal government. He recently noted that “Simplifying the tax code will increase productivity, instead of incentivizing bizarre tax-avoidance behavior.”

He’s correct. If President-elect Trump wants to have a lasting impact, he should not simply extend the provisions of the 2017 tax reform; he should use the opportunity for further serious reform.

The American tax system could be used to teach a masterclass on inefficiency, complexity and distorted incentives. The high cost of complying with our tax code encourages wasteful tax-avoidance strategies and creates what we economists call significant deadweight losses by distorting work and investment decisions.

This complexity doesn’t just hurt taxpayers, business owners and innovators. By reducing economic growth, it hurts us all.

At the heart of the problem is the definition of income developed by Robert Haig and Henry Simons in the 1920s and ’30s, which provided a theoretical foundation for modern taxation. 

It defines income as the sum of a person’s consumption plus the change in his or her net worth over a given period. Put in practice, Haig-Simons creates a tax bias against saving and investment.

Decades of trying to correct these flaws have set the tax code on a path to extreme complexity, thanks to a resulting maze of exceptions, special treatments and differential rates — all while lots of double taxation, which undermines both efficiency and fairness, stayed in place.

How? Imagine someone who earns $100 and saves it. This person first pays tax on the earnings. If the savings generate enough interest, dividends or capital gains, the saver pays again, though at a reduced rate. 

If the asset is left to heirs, the same income might be taxed a third time through estate taxes. In contrast, someone who earns the same $100 and consumes it immediately only pays the first tax.

Moreover, different types of capital income face wildly different effective tax rates. Corporate equity faces multiple tax layers, including corporate income tax on earnings and then individual taxes on dividends or capital gains. 

Debt receives more favorable treatment, since interest is deductible. Some capital gains get preferential rates while others don’t. Some investment income in retirement accounts is tax-deferred or tax-neutral but only within strict limits and complex rules.

Major distortions are created also by the code’s attempt to tax business income. While businesses can fully deduct labor costs immediately as current expenses, investments in capital must be depreciated over time, delaying the tax benefits and creating a bias against investment in physical assets.

This bias disproportionately affects capital-intensive industries, such as manufacturing, compared to those relying on intangible or labor-intensive operations. Moreover, effective tax rates vary significantly across industries due to differences in asset composition and financing structures, exacerbated by targeted tax incentives favoring certain sectors.

A shift to a consumption-based tax instead of Haig-Simons would solve most of this mess. Take one form: a flat tax. It would replace our entire complex tax system with just two simple postcard-sized forms: one for businesses and one for individuals.

Businesses would pay taxes on their total revenue minus wages paid and materials and investments purchased. Individuals would pay a tax on their wages minus a basic personal allowance. Both would use the same single tax rate, say 19 percent. 

No double taxation, no deductions, no credits, no alternative minimum tax, no special treatment of investment income. Just a simple calculation that takes minutes rather than hours — or days — to complete.

A family of four, for example, might get a $30,000 personal allowance and pay 19 percent on wages above that amount. This radical simplification eliminates most IRS paperwork, removes opportunities to game the system through loopholes, treats all economic activity the same while removing double taxation of income, and encourages business investment through immediate expensing.

In this example, savings are treated similarly to today’s Roth IRAs. The income is initially taxed, but later, when the savings plus the money they generate are consumed, no taxes are applied. 

Nor is any reporting needed, which means greater privacy from Uncle Sam.

That’s why it’s called a “flat” tax. It flattens both the rates and the complexity of the system into something anyone can understand.

The political challenges are formidable but worth it. The benefits from such a change — including increased saving and investment, reduced compliance costs, fewer economic distortions and a simpler system for both individuals and businesses — are enormous.

Creators.com