The Road to Freedom

by Arthur C. Brooks

  To reiterate the central point: If politicians do just one thing to help get America’s fiscal house in order, it should be entitlement reform. And if there is just one entitlement reform, it should be Medicare. Without this single reform, nothing else will solve our debt and deficit problem.

  ISSUE 5: REFORMING THE TAX CODE

  Some believe that taxation is a dry topic with no moral significance, but nothing could be further from the truth.

  The current tax system is hobbling American free enterprise. It penalizes earned success by taxing productive activity at rates that are internationally uncompetitive. It unfairly picks winners and losers in the economy with thousands upon thousands of special deals and loopholes for well-connected companies and individuals. It weakens American citizenship by exempting half the working population from paying any federal income taxes.

  The status quo system is confiscatory, unfair, needlessly complex, and at odds with all of the elements of a moral system. Major tax reform should be a top priority for reasons that extend well beyond simple economic efficiency.

  We have already looked at a number of the disheartening facts about our tax system, but here are the key ones to remember in any debate:

  •Although two-thirds of Americans believe that everyone should be required to pay some amount to fund the government, in 2011, 46 percent of households had zero or negative federal income tax liability.63 Even when payroll taxes are added in, 28 percent of households had zero or negative federal tax liability.64

  •In 2010, before any of President Obama’s policies were implemented, 60 percent of families received more from the government than they paid in taxes. That number is inching toward 70 percent, as the president pushes through various pieces of his agenda.65

  •The complexity of the system has significant costs. Americans spend 6.1 billion hours a year in preparing their personal taxes.66 The cost of complying with the individual and corporate income taxes in 2008 amounted to $163 billion, or more than $500 per person.67

  •The U.S. top combined corporate tax rate, which includes both federal and (average) state taxes, is 39.2 percent, the second highest in the industrialized world.68

  Figure 7.4. While other developed countries have lowered their corporate tax rates, the U.S. rate remains uncompetitively high. (Source: OECD Tax Database. Available at www.oecd.org/ctp/taxdatabase. Note: The rates shown are the top statutory combined corporate tax rates. The average of developed countries represents the OECD average.)

  In thinking about how to reform the tax system, there are four principles to keep in mind.

  First, taxes should never be used to pursue social engineering objectives. The point of taxes is to raise the revenues necessary to operate the government America wants, not to reward the politically well connected or increase income equality.

  Second, taxes should distort productive activity as little as possible. That means lowering marginal tax rates and closing tax loopholes for special interests—even if they are good for us or our friends.

  Third, the tax system should not harm citizenship by making government effectively free for a large part of the population. In addition to closing loopholes, the base of people who pay income taxes should be broadened. Everyone should pay something, even a small amount, so they remember that the government is not free.

  Fourth, a major factor in the current economic crisis is that Americans tend to consume too much and save too little. The tax system should not penalize savings and investment.

  AMERICA IS HORRIBLY IN DEBT, as we have seen over and over again in this book. All “fairness” arguments aside, many sensible people believe that tax rates need to rise because the government simply needs more money. But readers can reject that argument for two reasons: (1) the country has a spending problem, not a revenue problem; and (2) it is demonstrably wrong that raising income tax rates will necessarily raise government revenues.

  A simple tax principle is that if the income tax rate is zero, income tax revenues will be zero. If income tax rates are 100 percent, income tax revenues will still be zero. Why? Because with a 100 percent tax rate, nobody will bother to work and companies will not produce—at least, not officially. Somewhere between zero percent and 100 percent lies the tax rate that brings in the most tax revenue. This idea is often referred to as the “Laffer Curve,” named after Reagan administration economist Arthur Laffer.69 Laffer noted that if taxes were high enough, we could lower rates and get more tax revenues, because people would work more, invest more, and produce more.

  Where is the U.S. on the Laffer Curve today? If the U.S. raises taxes, will it drive revenues up, or down? For corporate taxes, the evidence suggests the latter: there would be more revenue with lower rates. AEI economists have estimated that if the corporate tax rate were lowered from 35 percent to 26.4 percent, the expanded production and investment by firms would bring in $748 billion in extra revenues over the next ten years. Obviously, this would also mean faster growth and lower unemployment.70

  Defending high corporate taxes is easy for politicians. All they have to say is that corporations are not people and that they make a lot of money. They forget that all corporate income ultimately goes to people, so corporate taxes are a double taxation on personal incomes. Whose incomes? “Millionaires and billionaires,” as the president often refers to them.

  Actually, it’s not the millionaires and billionaires who pay most corporate taxes. If you want to see who really pays, look in the mirror. Corporate taxes are expenses for firms. When they go up, firms cut back on production and other expenditures. This means less demand for labor, and downward pressure on wages. In other words, corporate taxes are—at least partly—passed on to workers in the form of lower pay. Economists find that up to 75 percent of the real burden of the corporate income tax falls on workers, not capital owners.71 The primary beneficiaries of a decrease in the corporate tax rate would be wage earners, not “corporate fat cats.”

  Lowering personal income taxes is important as well, because it will induce people to work and invest more than they otherwise would, resulting in higher growth.72 Economists estimate that a top marginal personal income tax rate of 20 percent (compared to 35 percent today, and 39.6 percent, proposed by President Obama) would maximize long-run economic growth.73 An even more direct way to increase savings and investment is to lower taxes on capital gains, interest, and dividends.

  THE U.S. TAX CODE is 16,845 pages long.74 Why, you ask? The answer is that it is a rather detailed document. There is, for example, a special provision for the favorable tax treatment of racehorses. And not just any racehorses—only those two years old or younger. Section 68(e)(3)(a)(i)(I) creates a special investment depreciation schedule for those fine creatures.75 Somebody with an interest in young racehorses most likely got a politician to write this provision into the tax code and probably saved a bundle on his taxes in the process.

  This is called a “tax loophole,” or what economists euphemistically call a “tax expenditure.” The tax code is a Swiss cheese of these details. The racehorse loophole may cost the Treasury and taxpayers only a little; others cost a lot more. These loopholes have to be eliminated to make the tax system fairer and less distorted.

  That’s easier said than done, of course. You may not benefit from the racehorse loophole, but you probably do benefit from others. For example, the top two personal income tax loopholes are the exclusion of employer contributions for health premiums, and the deduction for mortgage interest on homes. In the first case, you don’t have to pay taxes on your health-care premiums. That can easily save you $1,000 a year or more. In the second instance, you don’t have to pay taxes on the money you spend on mortgage interest, which can easily save you several thousand dollars (if you own your house). These two policies alone make up 35 percent of all taxes lost to loopholes. Without them, government revenue would increase by approximately $1.1 trillion over five years.76

  These two loopholes will be difficult to reform, to be sure. But A
mericans need to realize that both are hurting the country in a way that goes far beyond money. One distorts health markets by making insurance a non-taxable benefit and thus look cheaper than it really is. The other helped create the conditions for the housing crisis by subsidizing home ownership. If you dislike the mess the housing and health-care systems are in, in part you can blame these tax loopholes.

  Corporate loopholes are no better. The top five make up 55 percent of all corporate tax expenditures and will cost the economy about $218 billion over the next five years.77 Getting rid of these programs would make the economy both fairer and more efficient.

  Without loopholes, won’t taxes automatically rise? Not necessarily. The tax rates could be lowered by an amount that offsets the value of loopholes, so money isn’t taken from taxpayers to fuel government expansion.

  THE REFORMS I’VE PROPOSED are based on the assumption that the current tax code is worth saving and fixing. But what if we could replace the whole system? What if we pulled the system up by its roots and replaced it with one that is simpler, better, and less corruptible? What would such a system look like?

  Many reformers favor a flat tax with no deductions. Slightly more complicated but better, in the view of some economists, would be a move to a true consumption tax. That means people would pay taxes on what they spend to consume, not on what they save or invest. Estimates by the Treasury Department suggest that a switch from the current system to a consumption tax (with rates similar to the current income tax) would add about 4.5 percent to the national income over the next twenty years (about $657 billion).78

  In sum, there are huge opportunities to improve our tax system from the current monstrosity to one that better matches our values and needs.

  AS I STATED AT THE OUTSET, my goal in this chapter was not to provide a full policy platform, but to demonstrate the right way to set up arguments for policy reform, using today’s key policy dilemmas as case studies. Every section could be expanded into full studies, and for that reason the website for this book (www.aei.org.arthurbrooks) contains expanded references and further reading sources on each policy area.

  There are many facts and figures in the previous sections because free enterprise must make sense empirically if it is to make sense at all—and we can be confident that it does. But let’s not forget the main point of this book: that free enterprise is a matter of the heart even more than the head. Whether we’re discussing taxation or Medicare, deficits or jobs, public policy should first and foremost be an expression of values. As free enterprise advocates, we can take comfort in knowing the facts and data are on our side, but we must first show that the moral arguments are on our side as well if we want to prevail.

  THE ROAD TO FREEDOM

  Our country faces a lot of choices today.

  We are deciding between monetary policies, tax systems, and political parties. These things are important and we need to get them right. But the most important choice we face is deeper than any individual policy or election. It is a choice between two ideas of America.

  The first idea is that the key to our success as a nation resides with the government. Practically, the government will restart our economy with more stimulus, more taxes, and more borrowing. Morally, the government holds the secret to fairness through more income redistribution and taxation of the wealthy. The government will lift up the poor and disadvantaged. We need government programs in order to pursue our happiness.

  The second idea of America is that the key to our success lies in free enterprise—the system our Founders left us to maximize liberty, create individual opportunity, and reward entrepreneurship. Free enterprise creates the opportunities our ancestors came to America seeking—the opportunities that allowed them to pursue their happiness in a new land. It is the free enterprise system that treated them fairly for the first time; instead of being penalized for lacking a noble birth, they were rewarded for their hard work and personal responsibility. Free enterprise made a country of immigrants into the most powerful, prosperous nation in the history of the world.

  This second idea is not antigovernment. It does not hold that government employees are bad, that we all should make our own rules, or that we should dismantle the state. The entrepreneurial idea for America simply limits the government to its proper role. The government offers one tool to help provide a minimum basic safety net and solve some of the market failures that act as a barrier to private enterprise. Good government is only large enough to do these things.

  The choice between these two very different ideas of America has dramatic consequences for our future: Will we see growing bureaucracy or more entrepreneurship? Will we be a culture of redistribution or a culture of aspiration? Will we be a nation of takers or a nation of makers?

  Politicians who pretend that we do not have to choose between these two ideas of America are mistaken or less than honest. They want us to think that statism and free enterprise are ultimately compatible; that bureaucracy is not antagonistic to self-government; that we can remain exceptional when our system is indistinguishable from collectivist systems around the world. But this is deceit. Not choosing is effectively just the choice for big government. Unless we actively choose free enterprise and make the tough choices to limit the government, we will slip down the road toward European-style social democracy. We know this to be true because it has been happening for nearly a century.

  To be honest, big government is an easier choice than free enterprise. In the short run, it allows us to avoid sacrifice. Politicians who ask for sacrifice face a tough battle with voters, so they tend not to. But this laziness—on our part and on the part of the governing class—endangers all of us in the long run. It will mean the end of our Founders’ vision for our country. It will end any hope of limited government. And it will saddle our children and grandchildren with crushing debt.

  Free enterprise can seem like an especially tough choice at the present moment for America. It requires us to make hard decisions about spending and borrowing, just as we struggle to end the Great Recession. It means doing without some things and saying no to powerful claimants, cronies, and sometimes even our friends.

  But as I hope this book has shown, the rewards of free enterprise dramatically outweigh any costs. Free enterprise teaches us to earn success, not learn helplessness. It rewards merit, which is the fair thing to do. And in the end, it is the only system that can improve the lives of literally billions of poor people—here and around the world.

  These are the reasons I believe free enterprise is the only moral choice for America.

  ACKNOWLEDGMENTS

  MANY PEOPLE made this book a reality, and I’m grateful to a lot of people for their help. To begin with, my executive assistant Michael Threadgould kept me organized and on track throughout the project. And the book would have been impossible without excellent research assistance from Chad Hill and Lori Sanders.

  While all errors are my own, expertise and generous advice on this project came from AEI’s great scholars and staff, including Joe Antos, Rachel Ayerst Manfredi, Jason Bertsch, Andrew Biggs, Karlyn Bowman, Alex Brill, Josh Burek, Kayla Cook, Robin Currie, John Cusey, David Gerson, Ken Green, Kevin Hassett, Steven Hayward, David Holtkamp, John Makin, Matthew McKillip, Thomas Miller, Sophie Oreck, Veronika Polakova, Daniel Rothschild, Toby Stock, and Alan Viard. Special thanks go to Charles Murray and Nick Eberstadt, AEI scholars whose work has deeply influenced mine and who carefully read drafts of this book. Likewise, AEI trustees Tully Friedman and Frank Hanna gave me invaluable advice all along the way.

  Beyond AEI, I would like to express gratitude to a number of key individuals who gave me suggestions or material for this book. In particular, I would like to thank Christopher Chandler, Bernie Marcus, Chuck Schwab, John Mackey, Mark Stoleson, Alan McCormick, Kevin Lewis, Ed Crane, Pete Wehner, and Jon Haidt, as well as my friends at AEI’s sister organizations and in the media who provided important feedback on early versions of the manuscript.

  I would
like to thank my editor Lara Heimert at Basic Books, and my literary agent, Lisa Adams, at the Garamond Agency. Several of the key ideas here were developed in articles published on the editorial pages of the Wall Street Journal and the Washington Post, for which I am grateful to Paul Gigot, Howard Dickman, Rob Pollock, and Carlos Lozada.

  I am humbled by the trust and support of the outstanding members—past and present—of AEI’s Board of Trustees and National Council. For support on this project, all of us at AEI would especially like to thank the Anschutz Foundation, the Douglas and Maria DeVos Foundation, the Kern Family Foundation, the Charles Koch Foundation, Legatum, the Marcus Foundation, Jack and Pina Templeton, and the Triad Foundation.

  As always, I am particularly indebted to my intellectual partner (and wife), Ester Munt-Brooks, who—as an American by choice instead of by birth—constantly reminded me why our free enterprise system is a moral one at its core. And thanks to our three children Joaquim, Carlos, and Marina, who endured being told many times to leave Dad alone because he is working on his book.

  All royalties from this book go to support the work of the American Enterprise Institute.

  NOTES

  CHAPTER ONE

  1Lydia Saad, “Americans Express Historic Negativity Toward U.S. Government,” Gallup.com, September 26, 2011, http://www.gallup.com/poll/149678/Americans-Express-Historic-Negativity-Toward-Government.aspx?utm_source=tagrss&utm_medium=rss&utm_campaign=syndication.