Tax changes can save US from critics

Pre-election, post-election. Any time is a good time to bash the US over its savings rate. Thus early in the month Jean-Claude Trichet of the European Central Bank warned that the US must "correct this lack of savings". Yet more warnings about the delinquent US saver were conveyed to John Snow, Treasury secretary, when he crossed the Atlantic last week.

The nasty current account deficit and the sliding dollar, Mr Snow was told, represented proof the US was in the wrong. Mr Snow smiled his big smile. The savings rate mattered but perhaps not the dollar.

Economically speaking, the critics are right - except about the dollar, about which more later. After all, as Alan Greenspan, the Fed chairman, noted when he chimed in on the topic at the weekend, the US does spend more than it saves or invests. Foreigners rush in to fill the gap and invest in the profitable US. There are two ways to address this imbalance. The first is for other nations, especially those doing the bashing, to make their economic cultures more attractive for investment. The second is for the US to save more.

One way to get that increased saving is for America to switch to a consumption-based tax system from its current archaic income-based arrangement. The Bush administration is not going to reform the tax code tomorrow - Social Security, the national pension plan, likely comes first - but it is looking at a number of proposals to move the US towards a consumption system.

The worst of them would damage America's civic culture, the same culture that generates that much-envied growth. The best would strengthen the US, both politically and economically.

Start with the flashiest idea, a national sales tax on retail purchases. The idea is to replace America's old income tax in one dramatic step - and to annihilate the Internal Revenue Service, the country's hated tax authority, in the process. In some versions, social insurance - Social Security, Medicare - are also included in the sales tax. Economists are willing to consider the sales tax, since it is clearly a consumption tax - only spending is taxed. And, politically, it is seen to be a big winner. After all, "Nuke the IRS" and "Kill the Code" are slogans that go over fabulously with voters - especially in now-famous red states such as Georgia or Mr Bush's own Texas.

Manufacturers tend to believe that a sales tax regime will put them on a better footing with their competitors in Europe, although it is not really clear this is so.

But all in all the idea of a national retail sales tax is foolish. To pull in enough revenue, the tax rate must be more than 20 per cent. The Fair Tax Act, one version that legislators have put forward, sets the rate at 23 per cent. This levy comes on top of state taxes, so consumers would be confronting something like a 30 per cent effective rate. Even Americans, admired the world over for their rate of tax compliance, would balk at forking so much over at once. The authorities would have to create a tax police more aggressive than the IRS.

It would be a bitter irony if the tax cut enthusiasts among the Republicans ushered in a system that replicated the very sort of intrusive bureaucracy they claim to detest. But that is the kind of thing that happens when you let your tax policy be written by focus groups.

The second proposal is a value-added tax, levied at every stage of production. Again, economically, this makes wonderful sense. What is more, VAT alleviates the problem of price tag shock and to a great degree, evasion. Indeed, the trouble with VAT is the opposite of the trouble with the sales tax: VAT works too well. With a VAT, you vastly increase the size of the government relative to gross domestic product before you know it. At least that is what happened in Europe.

Two other taxes that foster saving are under review. The first is magazine owner Steve Forbes's flat tax, a postcard levy of 17 per cent that allows taxpayers to deduct dividends and interest, so they are taxed on salary alone. The flat tax is popular - in 2003, five flat tax bills were introduced in Congress, mostly with rates of around 20 per cent.

The last reform on the table is a gradualist one: simply continue the cuts to taxes on capital and investment that Mr Bush began in his first term. The goal would be gradually to expand tax protection devices for savings until only income is taxed. Both this approach and the flat tax would improve the business climate and restore some of the faith lost in government.

They would also, needless to say, push up the savings rate.

What they would not move is the exchange rate. For the dollar will continue to weaken until two things happen. The first is that the US overcomes the negative consequences of inflation by the Federal Reserve in an election year. The second is that Mr Snow stands up for the dollar instead of reiterating the need for more currency flexibility from the Chinese.

Still, if the US changes its tax structure, it will improve its savings rate. It can also improve its savings rate by privatising some share of social security, a change that is likely to come even before a tax reform. In either case it will then be up to its trading partners to do their part by expanding faster. Over to you, gentlemen.

© Copyright 2004 Financial Times

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