November 10, 2004

Before all the advertising during the last election has been blocked from our memories, I would like to re-examine two subjects that were prominently mentioned in the past campaign.  They are the estate tax (called the death tax in some ads) and the conversion to sales taxes from income and payroll taxes for federal receipts. 

I believe most economists would admit that prior to the 2001 tax act, the $600,000 exemption from estate taxes had become woefully inadequate.  Over the years, inflation and strong returns on investments had substantially increased the value of even the very smallest family businesses and farms. 

However, the tax act of 2001 uniformly increases the exemption until it reaches $3.5 million in 2009.  Then estate taxes are eliminated under current law in 2010 before being restored to a $1 million exemption in 2011. 

Most economists would agree that the ratcheting up of the exemption to the 2009 rate and then adjusting subsequent exemptions for inflation would protect the small business and family farm.  It would not protect all family owned business activities, some of which run into the hundreds of millions of dollars.  However, those businesses, if not the ownership, could remain intact through incorporation if an estate tax continued at $3.5million in the next decade. 

Actually, there is a substantial problem created by eliminating the estate tax.  The next generation will receive substantial command over resources without having produced them.  In some cases, we are talking about tens of billions of dollars for a few households. 

The strength of a market economy is that economic power is accepted as fair (having been earned).  A problem develops because we are not sure that value was created in contemplation of leaving an inheritance or whether the creator of that value would have done so even without heirs.  (Historical cases for the latter behavior far exceed those of the former.)

As many 19th century economists observed, the accumulation of economic power by people who did not earn it creates serious social and economic problems over time.  Moreover, the loss of revenue from eliminating the estate tax is substantial for the next decade, when our government insurance programs begin falling into cash flow deficits.

I certainly would not cause the $3.5 million exemption to revert back to $1 million after 2010 and I certainly would index that level for inflation.  But there is a strong economic efficiency argument for some estate taxation and the federal government certainly will need the revenue. 

On the issue of a consumption based tax replacing income and payroll based taxes, even the Wall Street Journal editorial page seems to assume that the attack ads in South Carolina were sufficiently effective to kill any hopes of such legislation. 

Claims that Senator elect Jim Demint wanted to add a 23 percent sales tax on top of the 5 percent already paid to South Carolina had people quaking in their boots.  Such an additional tax would be so economically devastating that no sane person should support it. 

But that is not what Senator elect Demint proposed.  He argued for a 23 percent sales tax to replace all income and payroll taxes, as well as provide a check to each household sufficient to insure that those below the poverty line would be able to offset any sales taxes they paid by the amount of that check. 

This is a change in taxation, not additional taxes.  I have argued for such a program in my columns because of the simplification in tax compliance and record keeping that would be created.  Moreover, a substantial allowable trade benefit would be achieved by all American exporters while imports would suffer the same tax consequences that their domestically produced competition faces. 

The tax required is 23 percent (and it could be significantly less if taxable transactions exceed GDP, as some studies show, and if the release of resources from tax compliance to alternative activities and the improvement in American competitiveness leads to increased domestic growth).  This is what is necessary to pay for all federal government activities. 

The government already extracts that amount from the private sector through its other taxes.  Thus, the cost of government currently is hidden in that million pages of current tax code.  The new tax would more clearly show the cost of federal government but would not raise that cost.  In effect, we are substituting one cost for another.  While we would explicitly pay a 23 percent tax, what households pay for goods and services would converge on the same expenditures as before.

Indeed, to the extent that tax compliance costs are reduced, total outlays required for the same goods and services should even fall. 

None of this was mentioned in those attack ads.  The average South Carolinian would not be paying more for goods and services after this change in taxes was completed.  Most likely, they would be paying less.  Unfortunately, if the Wall Street Journal believes these attack ads were effective, then we may never see the results that such a change in the tax codes could create. 


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