Jason Furman sent me an email that I think provides some good background on the economics of taxation. So let me welcome his “guest blog.”Jason Furman writes,

I’m still puzzled by Arnold Kling and, years after the fact, Jane Galt. They both appear to have some atavistic aversion to anything labeled a business-level tax. Granted many of the arguments for business-level taxes are flawed and incoherent, but as far as I can tell all of the arguments against them are premised on a fundamental confusion.

To clarify, we’re not debating the optimal tax rate on time-value-of-money income. Arnold Kling appears to believe it is zero, or equivalently that we should have a consumption tax. Others believe the time-value-of-money income should be taxed at the same rate as labor income, or equivalently that we should have an income tax. Both of these are respectable positions and, it turns out, not that different in terms of efficiency or distribution. (The reason that income and consumption taxes do not differ very much is that they both tax much of capital income – including the risk premium, the ex post realized risk, rents, and the return to sweat equity – in the same manner.)

But the debate over taxing time-value-of-money returns is not the same as the question of whether we need a business level tax. In theory, you could implement a consumption tax entirely at the business level or you could implement an income tax entirely at the individual level.

The decision about whether to tax income at the business level does not hinge on any fundamental economic principles. Instead it depends on your answer to two questions: how best to administer your tax base in the real world and how best to transition to the new tax base.

Pretty much every tax expert I’ve ever met has come to the conclusion that the administratively best way of taxing either consumption or income would include a business-level component. As I noted in an earlier post, even the flat tax or its more progressive variant (the X tax) include a cash flow tax at the business level. Moreover, as I noted, both a flat tax and an X tax would require constant patrolling of the business-level tax to ensure that the tax rate on the time-value-of-money income was not slipping below it’s intended level of zero.

The transition to the new tax system also provides a rationale for a business-level tax. In particular, the efficiency gains from a consumption tax derive from some combination of lowering the tax rate on new capital (so that businesses decide to undertake more investment in the future) and raising the tax rate on old capital (because this investment was already made so taxes on it are not distortionary). Get that transition wrong – by for instance conferring a windfall gain on old capital that necessitates higher levels of distortionary taxation going forward – and you could end up reducing efficiency. And eliminating business-level taxation is one of the surest ways to get that transition wrong.

I don’t claim any expertise concerning how to administer a tax system. To my untutored eye, it would seem that the way to implement a consumption tax would be to add up each person’s labor income and capital income (interest, dividends, and realized capital gains), then subtract savings to get consumption. There are plenty of issues with reporting. How does the lunch that my company paid for get reported as income? My use of the company car for personal purposes? And so on.

I’m willing to concede for the sake of argument that there are administrative advantages to collecting taxes at a business level for the purpose of implementing a consumption tax. However, I personally do not see what those advantages might be.

In addition to administrative issues, there are two other considerations that I think should come into play. One is transparency and the other is rent-seeking.

Transparency means that it is clear to every citizen what is being taxed. Frankly, I think hardly anyone really understands what is being taxed with the corporate income tax. I think most ordinary people have the impression that the corporate income tax is somehow a way of getting at rich people who are otherwise not paying their fair share under the personal income tax. But my understanding is that most economists model the corporate income tax as if it were a tax on capital investment in the corporate sector. If the economists have it right, then all of the non-economists who shape the corporate income tax, including legislators and political activists, are operating under a distorted and misleading impression of what the tax is all about.

Rent-seeking means that lobbying groups incur large costs attempting to manipulate the system. Moreover, many of these manipulations are enacted, leading to significant lost output from distortions and inefficiences.

The corporate income tax draws rent-seekers the way a fetid swamp draws mosquitoes. Corporate tax favors provide concentrated benefits to small, distinct coalitions, which facilitates the formation of lobbying organizations. The lack of transparency of the tax makes it difficult to use well-recognized standards of efficiency or equity to counter lobbyist work.

If we suddenly abolished the corporate income tax, I personally would not have any regrets over how the transition affected “old capital” vs. “new capital.” I’d just be glad to get rid of the swamp.