Tag Archives: Alvin Rabushka

What is a loophole?

In the Pathology of Privilege, I had this to say about “accelerated depreciation,” an artifact of the corporate tax code that many consider to be a loophole:

If income is the base of taxation, it makes sense to allow firms to “write off” expenses necessary to earn that income. For capital items that wear out over time, expenses should be written off as the items wear out. Some provisions of the tax code, however, permit firms to write off big capital expenses in one year rather than gradually as the items depreciate. These provisions privilege those firms that happen to make large capital purchases.

The idea that “accelerated” depreciation is a loophole can be traced back to Stanley Surrey, the Harvard law professor whose work in the 1950s, 60s, and 70s influenced many tax reformers, including Senator Bill Bradley and officials in the Reagan Treasury Department. When the Congressional Joint Committee on Taxation began cataloguing loopholes in their annual “tax expenditure” list in 1972, they too called accelerated depreciation a loophole. Here is how Leonard Berman and Joel Slemrod describe the issue in Taxes in America:

Why not let businesses write off their investments right away? It would make the process of determining taxable income easier, as businesses would no longer have to keep track of depreciation schedules for long-lived capital goods. The problem is that it would mean abandoning the attempt to tax business income, or at least part of it. Only a small fraction of the cost of a factory that will last twenty years is really a cost of earning income this year. (p. 72, emphasis original).

This thinking persuaded me to list accelerated depreciation alongside other tax loopholes as a privilege. In conversations with friends and colleagues over the last few weeks, however, I’ve come to change my mind on this one. Why?

To begin with, it is not obvious that generality requires corporate taxation at all. Though much maligned, Mitt Romney’s famous statement that “corporations are people” is—in some form or another—taught in just about every economics 101 course. When a government levies a tax on a corporation, some combination of the following three groups pay it: customers, investors, or employees. All three, it goes without saying, are humans. Moreover, as every student of economics knows, the statutory incidence of a tax is not the same as its economic incidence. Even if legislators earnestly want investors (or managers) to bear 100 percent of the tax, it is supply and demand, and not legislator intent which ultimately determines who pays. Each of these groups is already taxed in some other way, through sales, payroll, income, or capital gains taxes. So when a government levies a corporate income tax, it is imposing an additional levy on someone and this, by itself, is a violation of generality.

Second, if we are going to tax businesses, it isn’t clear that the tax base should be corporate income. Note that Berman and Slemrod say that immediate expensing would mean abandoning “the attempt to tax business income.” That’s because it would essentially turn the corporate income tax into a corporate consumption tax. And that may be a good thing. Capital taxation is notoriously inefficient. This is one reason why Robert Hall and Alvin Rabushka permitted immediate 100 percent expensing in their famous flat consumption tax (which, by the way, would apply to all businesses, not just corporations).

Setting these concerns aside, doesn’t accelerated depreciation privilege capital-intensive firms over labor-intensive firms? This is an argument often made against accelerated depreciation. But if you think this through, it’s not a particularly strong argument. Labor-intensive firms (appropriately) get to write off the salaries that they pay their employees as they make payroll. That makes sense. So long as we are taxing income, we shouldn’t penalize those that have to incur expenses in order to earn that income. Why shouldn’t capital-intensive firms also get to expense equipment when they cut the check for the equipment? The rate at which equipment breaks down bears no relation to the expense of buying it. In fact, one could go a step further and argue that any measure requiring capital-intensive firms to write off their expenses over a long period of time amounts to a privilege to labor-intensive firms.

I am always open to new arguments and in light of my changed view, I’ve decided to update the paper and remove these lines.

What is Economic Freedom and What Can it Say About Prosperity?

My post in the NYT’s Room for Debate blog elicited a good number of comments and questions. So today I thought I might elaborate on the most-important of these questions: What exactly is economic freedom and what do we know about the way it affects prosperity?

First, its impact. The economists Chris Doucouliagos and Mehmet Ali Ulubqasoglu recently reviewed 45 studies examining the freedom-growth relationship. They concluded:

[R]egardless of the sample of countries, the measure of economic freedom and the level of aggregation, there is a solid finding of a direct positive association between economic freedom and economic growth.

Studies also find that economic freedom tends to be associated with a whole host of other factors that humans tend to value such as:

  • Higher income levels: Faria and Montesinos (2009) Dawson (1998), De Haan and Siermann (1998), De Haan and Sturm (2000), Cole (2003), Gwartney et al. (2004) and Weede (2006);
  • Lower poverty levels: Norton (2003);
  • Less volatility in the business cycle: Dawson (2010);
  • Better environmental outcomes: Norton (1998), ch. 2);

even:

  • Fewer homicides: Stringham and Levendis (2010); and 
  • Greater levels of reported happiness: Ovaska and Takashima (2006)

But what is economic freedom?

The concept is quite old, dating back to well-before Adam Smith. For his part, he called it “a system of natural liberty” and gave us a view of what he meant by it when he wrote:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.

This, however, is still pretty vague.

So in the last quarter-century, a number of economists have focused on defining and—importantly—measuring economic freedom. There are now a number indices of economic freedom at both the national and sub-national levels. Among academics, the most-widely cited of these is the Economic Freedom of the World index, the latest of which is authored by Professors James Gwartney, Joshua Hall, and Robert Lawson. This index grew out of a series of conferences initiated by (Nobel Laureate) Milton Friedman and the Fraser Institute’s Michael Walker in the mid-1980s to early 1990s. Other attendees included economic luminaries such as “Lord Peter Bauer, Gary Becker, Douglass North, Armen Alchian, Arnold Harberger, Alvin Rabushka, Walter Block, Gordon Tullock, and Sir Alan Walters” (a number of whom have either won Nobel prizes in own their right or are likely to in the years that come). Out of these conferences, a consensus began to emerge that the four cornerstones of economic freedom were:

  • Personal choice,
  • Voluntary exchange coordinated by markets,
  • Freedom to enter and compete in markets, and
  • Protection of persons and their property from aggression by others.

From these conceptual cornerstones, the authors of the index began to gather data with an eye toward objectively measuring the degree to which the laws of different nations permit (or don’t) the exercise of economic freedom. Their index includes factors such as government consumption spending as a share of total consumption, top marginal income tax rates, the degree of judicial independence, growth in the money supply, taxes on international trade, and regulation of private sector credit (among 17 other components). The index now covers more than 140 countries, with data on many going back to 1970. And now there are literally hundreds of peer-reviewed articles that are based on this index or one of many others like it.

Since the publication of this index, a number of others have gotten in on the game. There are now indices that measure freedom at the sub-national level, the most-recent of which is Sorens and Ruger’s Freedom in the 50 States, published by Mercatus (the next addition of which is coming out soon). 

As I have recently noted, these state level indices suggest that economic freedom is a powerful predictor of prosperity.

So that, in a nutshell, is economic freedom.

The Flat Tax Debate in New Jersey

The Wall Street Journal writes that the Republican primary race in New Jersey is the center of contentious debate over the flat tax. Frontrunner Chris Christie rejects rival Steve Lonegan’s proposal to flatten New Jersey’s highly progressive income tax rates (which run from 1.47% to 8.97%) to 2.98%. Christie claims it will raise the taxes on “70 percent of working families.” Lonegan argues it will only raise taxes on 40 percent of working families, by about $300. But more importantly, as the Journal notes,  if  implemented the flat tax represents a $1000 reduction in taxes for the average New Jersey income taxpayer.

Should the state decide to go this route, they will not be alone. Alvin Rabushka who proposed a national flat tax with Robert Hall back in 1981, traces the advance of the flat tax in the last 25 years around the world  (including Russia and Estonia) and in the states. Colorado, Illinois, Indiana, Massachusetts, Michigan, Pennsylvania all have flat taxes. Rhode Island and Utah, have an optional flat tax (taxpayers must pay the higher of the AMT or the regular income tax).

If any state could use tax (and institutional) reform  it is New Jersey.

As my colleague Frederic Sautet notes at The Austrian Economists, the ideas of James Buchanan and of the Austrian economists – fiscal prudence- are immensely relevant to New Jersey’s (and many other states’) fiscal crisis.  For more on how these ideas are driving emerging policy prescriptions in New Jersey, watch the debates here. As Frederic rightly concludes, the liklihood of true reform will ultimatley depend, not on the merit of the ideas, but politics.