It’s Time the US Abolished the Income Tax

A century of cat and mouse

The income tax has led to a century of cat and mouse. Suppose we tax direct income and realized capital gains. Well, it’s reasonably easy to turn actual income into an unrealized gain. Suppose you have some income stream, and you don’t plan to spend it right away. You want to reinvest it. Rather than pay income tax on the income, and then additional income tax on the interest or dividends over time, and then more income tax on any appreciation when you finally sell it, create a corporation or other entity and let the income flow into the corporation, which reinvests it. The “corporation” could just be a shell to receive income and put it in a mutual fund. Yes, you’ll still pay capital gains tax when you sell, but that’s a lot less. And delaying taxation is always great.

Now you know why we have a corporate income tax at all. There is no economic point to corporate taxes. Having “corporations pay their fair share” is nonsense. Every cent of corporate income tax revenue comes from higher prices, lower wages, or lower payouts to stock and bondholders. We should tax those people. And if you want redistribution—taxing the “right” people—that’s a lot easier to do when you tax people. But if there is no corporate tax, lots of people will incorporate to avoid income taxes. So we tax corporate income and then your payout.

Thousands of pages of tax law and regulation have followed to plug one hole after another. After 100 years of patchwork, including some taxing of unrealized gains, we’d managed to maintain some degree of balance in the system, a sort of equilibrium of not overdoing it.

But people keep inventing new ideas to shield income from taxes, and the concept of income has grown in complexity along with the global economy. Moore v. United States involves domestic owners of a foreign corporation and the treatment of the income received into that corporation abroad. By itself it’s not a big deal.

But the pro-tax arguments before the court reveal that the government has already stepped over the line to taxing a good deal of unrealized income. And plans to greatly increase wealth taxation are already on their way. Not overdoing it, obeying norms and gentlepersons’ agreements, is going out of style these days. As the Wall Street Journal editorial board argues:

The Ninth Circuit’s opinion opened up a freeway to tax wealth and property. And wouldn’t you know, President Biden’s budget this year includes a 25% tax on the appreciation of assets of Americans with more than $100 million in wealth. . . .

Justice Samuel Alito asked: “What about the appreciation of holdings in securities by millions and millions of Americans, holdings in mutual funds over a period of time without selling the shares in those mutual funds?” Ms. Prelogar replied: “I think if Congress actually enacted a tax like that, and it never has, that we would likely defend it as an income tax.”

Well, it’s also called an estate tax, and it exists already!

There you have it. The Biden Administration believes the Sixteenth Amendment lets Congress tax the unrealized appreciation of assets. As Justice Neil Gorsuch noted, when the Supreme Court opens a door, “Congress tends to walk through it.” The Justices should close the wealth-tax door.

Moore v. United States brings up another uncomfortable question. The couple behind the case invested their money, and then the Internal Revenue Service changed the rules and told them to pay taxes now on decades’ worth of past earnings. Surely if they knew this rule, the couple would have arranged their business differently.

Here there is an awkward truth of taxation. Unexpected, “just this once and we’ll never do it again” wealth taxes are economically efficient. The problem of taxation is disincentives. If you announce a wealth tax in the future, people respond by not accumulating wealth. They go on round-the-world private jet tours instead of investing and building companies. But if you tax existing wealth, and nobody knew it was coming, there is no disincentive.

This is, however, one of the most misused propositions in economics. That “just this once and never again” promise isn’t credible: if the government did it once, why not again? And it feels horribly unfair, doesn’t it, grabbing wealth willy-nilly? Unpredictability is not something responsive, rule-of-law democracies can or should do.

In any case, as with corporate income, taxing investment income also makes no sense. You earn money, pay taxes on it, and invest it. If you choose to consume later rather than now, why pay additional tax on it? One of the main don’t-distort-the-economy propositions is that we should give people the full incentive to save by refraining from taxing investment income.

So why do we tax investment income? Again, because once you tax income, you have to start plugging holes. Many people can shift labor income to investment income. If you run a business, don’t take a salary but pay yourself a dividend. If you’re a consultant, incorporate yourself and call it all business income. In the 1980s, even cab drivers incorporated to get lower tax rates.

A more meaningful tax

The income tax is the original sin. Taxing income made no sense on an economic basis. The government only did it because it was easy to measure and grab, at least before people started inventing a century’s worth of clever schemes to redefine “income.” It has led inescapably to more sins, such as the corporate tax and the tax on investment income. And now the repatriation tax on accumulated foreign earnings.

What’s the solution? Well, duh. Tax consumption, not income or wealth. Get the rich down at the Porsche dealer. Leave alone any money reinvested in a company that is employing people and producing products. Now we can do it. And we can then throw out the income tax, corporate tax, and estate tax.

Income is really meaningless. You earn a lot of income in your middle years, but little early and late. The year you sell a house, you’re a millionaire, but then you’re back to low income the rest of the time. Yet the US government hands out more and more benefits on the basis of income as if it were an immutable characteristic. It is not. Consumption is a lot more meaningful.

Consumption taxes inspire common objections, but they are easily addressed. One is that the tax rate would have to be very high—in excess of 40 percent to fund current federal, state, and local spending. But if the government spends 40 percent of GDP, taxes have to be 40 percent of GDP. That’s what you’re paying now; we’re just making it more efficient. And a bit more transparent, where voters can decide if this is really what they want. Spreading tax revenues out over numerous different taxes doesn’t make taxation less costly, only more complicated.

Retirees and other long-time savers will complain that they have already been taxed on their income and would now be taxed on the consumption of their savings. But that double taxation is offset by some benefits, such as the absence of the capital gains tax and estate taxes, and the likely market boom if the US were to replace our current tax code with a consumption tax. If the tax is figured into the Consumer Price Index, Social Security will also be adjusted up to account for it. And older people have benefited enormously, at the expense of younger people, from booming house prices, soaring stock prices, and benefit increases. Still, cash heals all wounds. If, on balance, retirees end up being penalized by the implementation of a consumption tax, the government can offset the harm.

A flat consumption tax is not progressive. But it’s easy to make consumption taxes progressive. And not every element of federal policy needs to be separately progressive. If flat taxes pay for immense subsidies, the system as a whole can be as progressive as you like.

Thus, I hope that the Supreme Court does blow up the income tax system. It’s a bloated crony-capitalist mess. Most people suspect that others with clever lawyers are getting away with murder, which is corrosive to democracy. If the friends of the court are right that the tax system will not survive a narrow definition of income, that might be a great thing, not a disaster, as it might force a fundamental reckoning.

We need reform from the ground up. Not every decision taken in 1913 has to last forever. Let the income tax implode, and bring on a consumption tax.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and was previously a professor of finance at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.