Increase Tax Compliance with a Practical Tax Code

There are two ways that taxes can be unfair:

1. We could argue that taxes are unfair to the degree that they are levied disproportionately to the ability of individuals to bear them, or to the degree that the costs and benefits of tax revenue are asymmetric.  [I will address this in a future essay.]
2. The tax system is also unfair if it does not enforce compliance evenly across the individuals subject to it — i.e., if some people get away without paying their “fair share,” while others — either altruistically, or due to selective enforcement — comply more fully.

The problem with a complex tax regime like we have in the United States is that the complexity itself practically guarantees unfairness on both counts.  Today the WSJ Editorial Board addresses the second problem, “The ‘Tax Gap’ Myth“:

The “tax gap” is the difference between what the Internal Revenue Service thinks taxpayers should be paying and what it collects. The IRS currently estimates this at about $290 billion a year.

To put the tax gap in perspective, consider that the IRS took in tax receipts in fiscal 2005 of more than $2.2 trillion and that the overall U.S. tax compliance rate is about 85%. … Nina Olson, the IRS’s taxpayer advocate, told Congress last year that IRS auditors have found that an estimated 94% of noncompliance is the result of honest mistakes by tax filers who simply don’t understand the 17,000-page beast of a tax code.

Not surprisingly, the key to a more fair tax system is simplification: making it easier to understand and comply.

All voluntary tax compliance systems have their limits. Under today’s tax code, the only way the feds can raise compliance is to place extraordinary burdens on taxpayers. Most of those financial and social costs also end up being borne by those who already dutifully pay their taxes, in the name of catching the few who evade the law. The tradeoff for higher tax collection is less liberty, as we learned only a decade ago when Congress held much-hyped hearings on abusive IRS tactics and audits.

There is a better way. The more complicated a tax system, the more likely taxpayers won’t understand, or will try to dodge, the rules. Simple tax regimes, such as a single flat rate, encourage compliance and efficiency, not to mention economic growth. This has been the experience of many Eastern European countries after they imposed a flat tax, and the U.S. had similar jumps in reported tax income from “the rich” following the 1986 tax reform that cut rates and closed loopholes.

The Insular U.S. Legal Profession

Woe unto you, lawyers! for ye have taken away the key of knowledge: ye entered not in yourselves, and them that were entering in ye hindered. – Luke 11:52

The U.S. legal profession is a snooty club, where the price of admission is three unproductive years in law school and $120k. You cannot practice law in this country without undergoing this initiation. There are pretenses of this bar protecting consumers and the legal system. But the legal bar associations — like most lawyers (and, it seems, better business bureaus generally) — are more concerned with protecting their own reputations than with ensuring the quality of legal services available to consumers or the integrity of justice. (As Jesus would tell them, “[ye] make clean the outside of the cup and the platter; but your inward part is full of ravening and wickedness” Ibid:39.)

Cameron Stracher turns toward this elephant in the court in his essay, “Meet the Clients.”

There appears to be an emerging consensus that although law schools may teach students how to “think like a lawyer,” they don’t really teach them how to be a lawyer. It is hard not to agree. One of the biggest problems with the current state of legal education is its emphasis on books rather than people. By reading about the law rather than engaging in it, students end up with the misperception that lawyers spend most of their time debating the niceties of the Rule Against Perpetuities rather than sorting out the messy, somewhat anarchic version of the truth that judges and courts care about. When they graduate, young lawyers rarely know how to interview clients, advocate for their positions, negotiate a settlement or perform any number of other tasks that lawyers do every day. In short, they are woefully unprepared to be lawyers, despite the outrageous hourly fees charged for their services.

In addition to misleading students, the current system harms clients who often assume that their lawyers have more experience than they do.

The state bars profess interest in protecting the public, but none seem to care whether new lawyers can actually do the tasks with which they will soon be confronted.

The legal profession is a trade, for which we need masters and apprenticeships — not degrees and bars. This is not to say we shouldn’t have legal academics. Let them roam the halls of private universities and think tanks along with ethicists, artists, and historians. Just don’t make them part of the initiation requirements for every legal craftsman.

Law is not brain surgery. It is a skill that can be acquired through practice and repetition.

Bad Regulation is Isomorphic to Taxation

Gary Becker and Richard Posner have an excellent essay in today’s WSJ, “How to Make the Poor Poorer,” exposing just how bad an idea is a minimum wage.  They reason that a minimum wage “has the same misallocative effect as monopoly pricing.”  And all of the pandering politician and union arguments to the contrary, “The losers are therefore likely to lose more than the gainers gain; they are also likely to be poorer people.”

However, my favorite line is the more general observation that “most people don’t understand that regulatory laws can have the same effect as taxes.”  Let me take that one step further and suggest that we can define a Bad Regulation as one that could be implemented through some scheme of taxation.  To some this may be self-evident: Taxation is the confiscation of property by government for unrelated purposes — properly to serve the “public good,” but corruptly to serve special interests.  Since we know government thrives on feeding special interests, so we also know that government has every incentive to obfuscate these corrupt transfers of assets by embedding them in opaque regulations instead of (generally) more explicit taxes.

The “minimum wage” is nothing more than a tax on low wages that is immediately transferred to the people earning those wages. I don’t know if it helps illustrate the absurdity of the proposition to imagine the government going to every business and saying, “We’re going to tax you $2.10/hour on all your least-productive employees.”  What about other bad regulations?  If you’re a small business that wants to raise funds in our public markets, we’re going to levy an enormously regressive tax on you and give it to accounting firms (Sarb-Ox).  If you want to sell a life-saving pharmaceutical in this country, the price of entry for each drug is a one-time tax of something like $1 billion (FDA).  The reader is invited to map other bad regulations to functionally identical taxes.

It is also straightforward but still illuminating to consider all taxation as nothing more than bad regulation, invariably distorting the marketplace, discouraging productive activity, and subsidizing special interests.

Bounties Spur Innovation

Interesting column by David Wessel today discusses prizes offering a unique incentive for innovation.

The U.S. and other modern capitalist economies rely on a handful of approaches to stimulate innovation.

Big corporate research-and-development shops invest shareholders’ money in the search for future profit. Small entrepreneurial start-ups do the same with venture capital.

Academics toil in big universities, sometimes for profit, sometimes for glory. Open-source software wizards mend and tend shared software that no one owns, the high-tech equivalent of a barn-raising. Government steps in where private money fears to tread.

Now, a proliferation of prizes is attracting bright minds to stubborn problems.

One Small Step for the Tax Code, One Giant Leap in Reducing Healthcare Spending

One could argue that most of our country’s healthcare cost inflation is due to the third-party model of healthcare payment, and furthermore that that model is entirely a product of the disparate treatment of healthcare costs in the tax code: Healthcare can be purchased by an employer with pre-tax dollars, whereas individuals practically always have to purchase any form of healthcare with post-tax dollars.  Thus the optimal tax arrangement has employers contracting health management out to third parties, insulating the actual healthcare consumers from the costs.  This arrangement has become so commonplace that some people now think it is immoral for employers not to pay for healthcare.

President Bush’s initiative to remove this tax anomaly could do more to fix the supposed “healthcare crisis” than any government intervention.

Granted, when it comes to tax code the devil is in the details.  Bush apparently couldn’t just come out and exempt healthcare spending from taxation.  Instead taxpayers have to file for a refund, which in his proposal is limited to $15,000 for families and $7,500 for singles.  Guessing from the language of his proposal this would end up being implemented as an extension to the “standard deduction” (i.e., you would have to own health insurance to qualify for this higher standard deduction).  Which means it is probably subject to the AMT, and also that the benefit versus the current tax code could be reduced or eliminated if you itemize deductions.  So the proposal may remove a terrible disparity in taxation, but it doesn’t look like it will make the tax code any less complex.

Valuation Models for Government

What makes a good government?  Andy Grove in today’s WSJ has an interesting article suggesting that society does a terrible job strategically managing its governments, and he starts with a good analogy:

If business’s task is to generate revenue and profits for its owners, what is the equivalent task for a nation and its government?

It is an apt analogy: A nation has shareholders (generally all are minority shareholders, but there are to this day degenerate cases like North Korea where there is a majority holder) who elect trustees (e.g., the judiciary) and a CEO (e.g., the President).  And the CEO can have an enormous impact on whether the government achieves its objectives.

What are government’s objectives?  This is a normative question: Communists may say that it is to maximize human equality.  Islamists may say it is to spread Islam and destroy all unbelievers.  I like Grove’s suggestion that just as the measure of a company’s value is its risk-adjusted earnings stream, so the measure of a nation’s value is its risk-adjusted GDP.  I believe a country that maximizes that number will maximize the net welfare of its citizen shareholders.

It would be a big step forward to agree that this is the purpose of government, and to explicitly evaluate government in these terms.  Fortunately, the markets provide many instruments for estimating the risk-adjusted GDP of a country.

What we are left with is the same problem shareholders face when evaluating a CEO: There are many exogenous factors — completely outside of the CEO’s control — that affect a company’s profitability.  Incompetent CEOs can get lucky, and brilliant ones can still suffer calamity.  Likewise, a country may be resource-rich, or it may be prone to natural disasters of various sorts.  Just as with CEOs, we may never be able to make a literal A-B comparison.  But we can discern the characteristics of good government just like we can show the principles of good corporate management.  And we should seek governments that enhance risk-adjusted GDP.

(Note that, just as corporate governance is frequently undemocratic, it is possible that the best national governments by these standards are not necessarily purely democratic.  Fareed Zakaria, in an otherwise rabid article, makes the valuable observation, “The basic problem confronting the developing world today is not an absence of democracy but an absence of governance.”)

Department of Unintended Consequences – Part II

There are potential moral hazards associated with a human organ market.  I believe they all reduce to the problem of creating an incentive for stealing organs in order to resell them.  In this regard, the organ market is like any other market: Its moral integrity depends on governments ensuring that property rights are respected.  I.e., government has a proper role in ensuring that ownership of human organs is maintained, and that only voluntary transactions between an organ owner and a purchaser are allowed.

Previous articles have addressed the socialist system our goverment has contrived to control the human organ market.  This month Forbes brings us a fascinating article on the gray market that has sprung up to compensate for the lack of a white market here. 

Return of The Bell Curve

12 years ago Charles Murray and the late Richard Herrnstein published the landmark book The Bell Curve, which documents the existence of an innate and largely immutable intellectual ability (formally called g, but corresponding to what is popularly called “IQ”), which is distributed across the human population with a non-zero standard deviation.¹

This week Charles Murray published an important series of essays in the Wall Street Journal expounding on this simple observation of the distribution of human ability in order to challenge our institutionalized assumptions about how people should be educated and how they can best achieve their potential.  For anyone interested in maximizing both human productivity and the efficiency of our education institutions, these are essential reads.  Highlights:

Microsoft Illustrates the Difference Between Man and Machine

This is so very amusing: A search engine with a human front-end.

Synthetic Cracks in the Diamond Cartel

Technology is finally threatening the DeBeers cartel for gem-grade diamonds.  Two U.S. manufacturers are ramping up production:

Last year, 400,000 carats were produced in the U.S. for gem use, compared with 130 million carats mined annually around the world.

To make its gems, Apollo Diamonds exposes shirt-button-sized diamond fragments known as seeds to carbon particles, which latch onto them under high temperatures. Diamonds then start to form, one crystal at a time. A look through the window of one of the lab’s submarine-like machines reveals two dozen glowing chips that will grow to be one carat in about two weeks. Apollo can now use its own stock of small diamond chips as seeds, rather than relying on seeds from mined diamonds.

In Sarasota, Fla., competitor Gemesis relies on high pressures to mimic what happens underground. Its machines essentially crush carbon under 58,000 atmospheres of pressure at 2,300-degrees Fahrenheit until the material crystallizes into yellowish or orange diamonds.

DeBeers is launching an aggressive yet amusing defense of “natural” diamond. 

It says on its diamond information Web site, adiamondisforever.com. “Adding to the mystery and aura of what make diamonds so sought-after” is the fact that “approximately 250 tons of ore must be mined and processed in order to produce a single, one-carat, polished, gem-quality diamond.”

You can’t blame them for trying to protect their cartel, but “diamond” is literally nothing more than crystallized carbon.  The fact that you have to devote such resources to find big carbon crystals in the ground seems like more of an indictment than an endorsement.  All you get with natural diamonds is impurities — and the most expensive natural diamonds (“investment grade,” as they used to be called) are the ones that minimize impurities, which interfere with sparkle and can also make a crystal more susceptible to fracturing.  In contrast, synthetic diamonds can be nearly perfect:

For example, because there’s virtually no nitrogen in Apollo’s stones, they tend to be more transparent in ultraviolet light than all but the rarest mined stones. Under more powerful, short-wave UV beams, they tend to emanate a strong blue to orange fluorescence.

In very rare cases natural impurities lead to brilliant colors in mined diamond, which have resulted in some of the most valued gems in the world.  Now that synthetic diamonds can be intentionally grown with impurities to produce color, mainstream jewelry should get both cheaper and more interesting.

Department of Unintended Consequences – Part I

Why does government have such a chronic inability to anticipate the consequences of its schemes to tax, spend, and regulate?

• Subsidizing tuition with low-interest loans, grants, and tax breaks — intended to make college more affordable — instead makes college more expensive in absolute terms.  (Oops … guess we need to work on increasing the supply of the service instead of the supply of its consumers!)
• Regulating public capital markets — intended to increase the efficiency, liquidity, or safety of the markets — just squeezes capital into less regulated areas, like private and foreign capital markets.
• Increasing taxes — intended to raise government revenue — actually increases incentives to evade taxes and avoid taxable activities (typically, productive ones), often causing revenue to actually decline.
• Criminalizing goods or services — intended to discourage vices — generally produces or shores up a black-market for that behavior, along with all the negative accoutrements and externalities of black markets.
• And as David Henderson notes today in his essay on “Terminatorcare”:

Why doesn’t increased government power tend to solve the problem of the uninsured? There are two main reasons. First, when government provides health insurance, many people who take advantage of it drop their own privately provided health insurance. In a 1996 article in the Quarterly Journal of Economics, Harvard economists David M. Cutler and Jonathan Gruber found a 50% “crowding-out effect.” As the federal Medicaid program expanded, for every two people who gained insurance through Medicaid, one dropped private health insurance. Although this is a net addition of one, the costs to taxpayers are much higher than expected because now half of the newly covered, instead of paying their own way as they previously did, become wards of the state.

This is such a frequent theme I’ll just start cataloging examples under this title.

Wasteful Lifestyles of the Rich and Famous

Many wealthy pundits and celebrities chastise Joe Sixpack for driving an uncessarily big automobile, or consuming insufficiently recycled/renewable products.

I suspect that some of these same scolds are among the elites that would spend $5000/hour to hold a party on a private “plane to nowhere”.  Or to send out 75,000 Christmas cards and pay for them to be mailed back for recycling.  These expenditures aren’t just lavish: they represent significant consumption of real commodities — e.g., fossil fuels, productive time of many paid employees — that have a real opportunity cost.

All spending represents some combination of resource-consumption and luxury-rent (which is the premium you pay just to keep something scarce and exclusive).  For example, with low-margin goods like lumber or gasoline the price you pay includes the labor and raw materials costs of finding, pumping, harvesting, refining, and transporting the finished product to a retailer, and then the retailer’s costs.  Luxury spending can be broken down into demand-based rents (e.g., there is a fixed supply of something, like original fine art or vintage wine, and therefore the luxury premium is based entirely on competing demand for a limited supply) and brand-based rents (e.g., a clothing designer produces handbags for $100 but sells them for $1000, and people pay that difference as a signal that they can, or something…).

Therefore, behind all non-luxury consumption is a share of our resources — people and energy.  At present the energy is largely backed by fossil fuels, so if you don’t favor consuming those then you shouldn’t feel good engaging in non-luxury consumption (again, meaning the purchase of anything except luxury rents).  People are also a limited resource, and though I’m not sure what the opportunity cost of service consumption is, I would note that the people you’ve tied up mowing your lawn or tending your yacht can’t spend their time finding a cure for cancer.

Replace Taxes with Sales of Public Goods

Today’s breaking views notes that the Pennsylvania Turnpike could be worth as much as $30BB in a lease to private firms. Contrast this to annual state revenue of $12BB, which comes from taxing productive activities like Personal Income, Sales, and Corporate Profits.

Government could claim a lot more legitimacy if it derived its revenue from public goods instead of confiscating private property and enterprise. Consider the extensive and valuable public goods that can be tapped for public revenue:

• Radio Spectrum
• Fisheries
• Logging on public land
• Fossil fuels and minerals

At present there is some public revenue derived from these resources, but if such commons were a significant source of funds for government operations — and traditional taxes were correspondingly lowered or abolished — they could certainly generate a lot more money. For example, we know from Europe that people can adapt to paying $4/gallon in gasoline taxes. If people were freed from sales and income taxes they may readily assent to paying many times more for raw materials and cell phone bandwidth. Especially since it seems more morally parsimonious to charge for access to limited public goods than to arbitrarily tax private property.

Government could also create public revenue by auctioning off naming rights to public works and public places — which could include everything from streets to parks to hard currency. For example, maybe Ted Turner wants to make a substantial contribution to the federal government in exchange for his portrait appearing on the $20 bill. Maybe San Francisco would agree to go by the name “Cisco” if Cisco Systems funded their police and roads.

Another opportunity is to establish premium levels of access to public goods in exchange for payments to the public purse. For example, there is some number of people who would pay almost any amount of money for an exclusive speed lane for commuting, airport security, etc.

Auctioning off public goods in this fashion has the added benefit of economically optimizing their allocation. Consider public roads as an example: Right now they are essentially rationed by queue. People or corporations who would be willing to pay significant sums to jump the queue have no way of paying others to get out of their way. If access to a restricted express lane were sold on commuting highways it could very well pay for the entire road, thereby subsidizing all the other users who do not want or need to pay a premium for unfettered travel.

[Addendum: It probably would have been more accurate here to use the term public assets, not public goods.  Public goods need to be produced, and conventional wisdom suggests that only government can reliably produce public goods.  However, Alex Tabarrok proves that Assurance Contracts are a plausible mechanism for enabling profit-seeking entrepreneurs to efficiently provide public goods.]