Page Created:
        March 18, 2012
Last updated:
        March 18, 2012


by Jay Starkman, CPA

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Jay Starkman argues that good tax policy was a major reason the United States rebounded after World War II and that it's time to invoke taxation for prosperity again.

Copyright 2012 Jay Starkman.
All rights reserved.

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Four prominent tax policy specialists testified before the Joint Economic Committee on November 17, 2011, to answer the following question: Could tax reform boost business investment and job creation?1 Their lively debate addressed the many challenges facing tax reform. The witnesses gave conflicting advice and proposals, but their testimony was instructive.

Seth Hanlon, director of fiscal reform at the Center for American Progress, told the committee, "Tax reform simply cannot address the central economic challenge facing the United States right now -- the severe and prolonged job crisis, which is a product of lack of demand."2 Dan Mastromarco, principal of Argus Group, promoted the insidiously named FairTax as the panacea for our economic woes.3

Hanlon told the committee that federal tax revenues, now less than 15 percent of GDP (historically at 18 percent of GDP), should be raised to more than 20 percent by seeking a "fair share," a term also used in Mastromarco's written paper. Stephen J. Entin, president and executive director of the Institute for Research on the Economics of Taxation, complained that the "income tax is heavily biased against saving and investment" and that the "burden of higher taxes on capital formation falls largely on labor in the form of lower wages and hours worked."4 Chad Stone, chief economist at the Center on Budget and Policy Priorities, advised that "tax reform is unlikely to be an effective tool for speeding up economic growth in the short run" as he endorsed pending job legislation proposals.5

The tax catchphrase since Adam Smith has been "ability to pay," generally meaning for the upkeep of government. The current obsession with "fair share" is code for raising taxes on the rich to pay for entitlements. An alternative interpretation is that the rich should simply pay more than the poor.

For example, France imposed an income tax in 1355 to finance the Hundred Years' War. Rates were set at 4 percent on the rich, 5 percent on the middle class, and 10 percent on the poor. This was considered only fair because at 4 percent, a rich man would pay far more tax than a poor man at 10 percent. The Isle of Man today has a tax cap on the rich. After personal allowances and deductions, it imposes income tax rates of 10 and 20 percent, with a maximum tax of £115,000. French taxation led to revolution, while the Isle of Man is a sought-after tax refuge. (The Isle of Man also imposes a 20 percent VAT and zero corporation income tax.)

In 70 pages of combined submitted testimony, no one explained how tax reform could be a major help to the economy in the short run. It can and they should have.

Randolph Paul

Better advice was given to a prior generation by Randolph Evernghim Paul.6 He was the architect of our modern income tax system, founder of the eminent law firm Paul Weiss Rifkind Wharton and Garrison, a coauthor of Merten's Law of Federal Income Taxation, and Treasury counsel during World War II. He wrote two books for the public, including Taxation for Prosperity, published in 1947.

Paul complained about the tax laws Congress was passing. "Our tax laws are a series of extemporized responses to immediate pressures with no long-term objectives," he wrote. He proposed a planned tax and fiscal program that would "contribute to financial stability, jobs for all, and a rising standard of living."

This was not a simple suggestion when he wrote it. The United States had just won World War II. GDP was $175 billion, of which $100 billion was from the government sector. The national debt stood at $260 billion. A $30 billion deficit was projected for 1946. In a nation of 145 million people, we were anticipating 10 million munitions workers suddenly being laid off and another 12 million service members demobilized and sent into the workplace. We also feared the looming possibility of raging inflation.

Paul drew optimism from the nation's previous precarious fiscal situations, such as financing World War I:

    Deficits in millions became deficits in billions. The total appropriations in the calendar year 1917, $19 billion -- which included $7 billion of loans to the Allies of that day -- approached the total cost of the Federal Government from 1791 to 1917, $26 billion, including the expense of three foreign wars and one internal war. This one-year cost was three times the cost of the Civil War, which had lasted four years.
    . . .
    Government expenditures would produce a deficit of $9 billion by the end of the fiscal year 1918.7

He proposed a model for taxation for prosperity, and it worked, bringing us about 60 years of prosperity.

Now we need a new taxation for prosperity. Here are some ways to do this and methods to avoid.

Value Added Tax

Some claim we have placed ourselves at a great disadvantage by relying on income taxes without a VAT. Most countries use some form of consumption tax denominated a VAT or goods and services tax.

VAT countries can be divided into three groups, based on the reason that each adopted a VAT:

  • European Union. A VAT is a requirement for membership in the EU, and it has been adopted by EU candidates.
  • Developing nations. Countries with immature or evasion-ridden tax systems have adopted a VAT because it's relatively easy to establish and administer. South Korea, for example, adopted a VAT in 1976 because its existing tax system couldn't adequately police other forms of taxation.
  • Other reasons. Some countries use a VAT to fund social programs (Australia), to maintain fiscal stability (Canada and Japan), or to incentivize relocation of foreign export businesses (China).8

All those who complain that our corporate income tax rate is the highest among all OECD nations fail to acknowledge that those countries impose a VAT. The U.S. overall tax burden, absent a VAT, is lower than that of other OECD nations.

Former House Ways and Means Committee Chair Wilbur Mills explained that Europe adopted a VAT as a substitute trade barrier, because it was needed to compensate for the revenue loss from tariff reductions caused by liberalized trade with the United States:

    We didn't say anything, publicly, at least, about the fact that the European Common Market adopted such a system. They did it to offset the concessions, which they had given, in a trade agreement to us in the way of reduction of duties. We didn't say anything about it, even though the Value Added-Tax did make it more difficult for us to export into the European Common Market.9

Zenith Radio Corp. made concerted attempts from 1970 to 1986 to address the trade disadvantages it was experiencing. The company tried to have the 5 to 40 percent VAT rebates that foreign competitors received on export declared a "bounty or grant."10

Success would have required Treasury to levy a countervailing duty equal to the amount that had been rebated in accordance with a law that originated in 1897 and was upheld by the Supreme Court in 1903 in Downs v. United States.11 That statute was still in effect in 1976 when the Zenith case was filed. It provided that whenever a foreign country pays a bounty or grant on the exportation of a product, customs is required to levy a countervailing duty, "equal to the net amount of such bounty or grant" on importation of the product into the United States.12

In an 1898 case, the Supreme Court held that a German tax rebate on export should be included in calculating the cost of an import subject to tariff because the merchandise couldn't be purchased without paying the rebated tax in the country of origin:

    It is "a device resorted to for enabling a commodity affected by taxes to be exported and sold in the foreign market on the same terms as if it had not been taxed at all." But the laws of this country in the assessment of duties proceed upon the market value in the exporting country, and not upon that market value less such remission or amelioration as that country chooses to allow in accordance with its own views of public policy.13

In Downs, the Court held unanimously that a complex Russian tax rebate on exported sugar was subject to a countervailing duty because "every bounty upon exportation must, to a certain extent, operate as a bounty upon production, since nothing can be exported which is not produced, and hence a bounty upon exportation, by creating a foreign demand, stimulates an increased production to the extent of such demand."14 A later case upheld a countervailing duty for a three-pence and five-pence British tax rebate on distilled spirits. The Supreme Court declared that as a result of the rebate, "we have the fact of spirits able to be sold cheaper in the United States than in the place of their production."15

The Zenith dispute centered on this country's commitment to the General Agreement on Tariffs and Trade (succeeded today by the WTO). GATT prohibits levying duties to offset border adjustments like VAT rebates. The United States adopted GATT in 1947 to the fullest extent not inconsistent with existing law.

The government argued that since at least 1951, Congress has been well informed of Treasury practices regarding VAT rebates and has consistently failed to countermand them. Thus, Congress must be deemed to have implicitly approved the administrative interpretation.

The U.S. Customs Court in 1977 decided in favor of Zenith and ordered Treasury to assess countervailing duties on all Japanese consumer electronic products specified in the petitioner's complaint.16 Treasury appealed.

In a 3-2 decision, the U.S. Court of Customs and Patent Appeals reversed the lower court and held in favor of the government out of deference to Treasury and the dearth of prior case law, and because the 1897 law and the 1903 Downs decision were ancient.17 The court observed, "Post Downs, the world has seen two world wars, an industrial revolution, a science revolution, and a flight from Kitty Hawk to the moon. Customs duties, though large, are not our sole source of government funds, as they virtually were prior to 1916."18

The dissenting judges wrote a lengthy dissertation on trade, questioning whether a court could ignore the law just because it was old, especially because Congress last visited it in 1970. They quoted a 1967 JEC study:

    The European Common Market practice of rebating their own indirect taxes on their exports and levying these same taxes on imports -- a practice sanctioned, incidentally by the rules of the GATT -- constitutes a conspicuous form of discrimination against U.S. exports. Moreover, similar border adjustments by the United States would be an ineffective weapon, neither mitigating nor offsetting the discriminatory process, because the tax structure of the United States places relatively small emphasis on indirect taxes.19

The Supreme Court held that deference was owed the administration's position and that VAT rebates were not bounties or grants.20

Zenith pursued an additional lawsuit asserting that it was denied access to Japanese markets by exclusionary trade practices, and lost again in the Supreme Court in 1986.21 Not coincidentally, Zenith Radio filed for bankruptcy in 1992.

Writing in a 1970 Harvard Business Review article, Stanley S. Surrey, assistant Treasury secretary in the 1960s who coined the concept "tax expenditures," opposed a VAT as "just a general retail sales tax collected in a different way." He wrote that adoption of a national sales tax would make the U.S. federal tax system "distinctly worse."22

Regarding international trade, he argued that a national sales tax would not bring any advantages to the United States. Finally, he argued, "if a national sales tax were ever deemed desirable in the United States, it should take the form of a retail sales tax and not a value-added tax."23

Rather than study implementing a VAT or national sales tax, Congress should study remedies against the unfair competition caused by a VAT.24 Our corporate income tax may be the highest among the OECD countries, but our zero VAT is the lowest. That's one reason foreigners flock to our shores, to purchase products exported from their own countries tariff free and VAT free, cheaper than at home.25 A prior generation called it "dumping."


The Franklin Roosevelt administration initiated free trade as the dominant American tariff policy with passage of the Reciprocal Trade Agreements Act of 1934. Paul had a Rooseveltian trade liberalization attitude and a pre-Roosevelt appreciation for tariffs:

    Customs duties were the principal source of government revenue in the nineteenth century and the first 15 years of the twentieth century, though it should not be forgotten that they have traditional purposes beyond the revenue -- to foster American industry and protect it from low-priced foreign competition, to maintain a high standard of living for labor and to sustain the price of agricultural products. Today customs have been reduced to but a small fraction of their former estate as a revenue producer, so that they are hardly as important in this capacity as estate and gift taxes. Their future is problematical, but they are not on the list of important governmental fiscal supports. If we are to have a high national income and full employment, imports should increase since part of our expanded consumption will include foreign goods. But high tariffs may defeat this tendency. In the long run, any revenue derived from Customs must have charged against it the adverse effects which duties have on the volume of world trade.26

The infamous Smoot-Hawley Tariff has often been blamed, perhaps unfairly, for exacerbating the Great Depression. It has largely been replaced as the culprit by the gold standard: Federal Reserve Chair Ben Bernanke in his book Essays on the Great Depression27 blames the gold standard and does not mention tariffs at all.

Nineteenth-century American tax policymakers considered it an article of faith that high tariffs brought prosperity to this nation. Today that has changed to a virtual fetish for free trade. So-called bilateral free trade treaties are mostly around 250 pages long, plus 900 pages of tariff schedules and multiple side agreements.28 Others are granted most favored nation (MFN) trade status, which includes reciprocal low tariffs and high import quotas. Most countries are members of the WTO, so those without free trade agreements still abide by its nondiscriminatory trade rules to benefit from low trade barriers and from the requirement to accord each other MFN status.

William McKinley published a 300-page book in 1896 (the year he ran for president) in which he explained why he favored a protective tariff:

    The American workingman was from two to four times better paid for the same labor than his European competitor, while against his Asiatic or Australasian competitor there was scarcely any comparison possible, so great were the advantages in favor of the laborers of the United States.29

James G. Blaine was a senator, speaker of the House, and secretary of state before losing to Grover Cleveland in the 1884 presidential race. He wrote in the North American Review in 1890, "free-trade tariffs have always ended in panics and long periods of financial distress."30

Whether high tariffs actually fostered economic growth during the late 19th century remains controversial. That they fostered high wages compared with other countries was a good slogan in an era of overworked, underpaid, exploited, and abused labor, which included child labor, unsafe working conditions, and attacks on union organizers.

Nineteenth-century thinking on tariffs was a purely domestic matter. There was little or no thought of their effect on other countries, such as creating unemployment abroad. Until recently, most free trade involved simple finished goods, like textiles. Today we trade in almost everything, including components and services. Boeing is touted as the nation's top exporter. Overlooked is the fact that Boeing is also a major importer, because many aircraft parts and subassemblies are manufactured abroad.

Both protective tariffs and free trade have alternately been credited with prosperity and blamed for depressions. History seems to have demonstrated that protective tariffs in a globalized economy have an overall negative impact. Free trade has not yet been proven to be a solution, nor a revenue tariff condemned as harmful, in the quest for economic prosperity.

Proponents of free trade cannot explain away our huge trade deficit and the downward pressure on wages, both of which are directly linked to free trade. Indeed, free trade creates winners and losers in the U.S. job market because some industries are destroyed by new foreign competition and others benefit from new foreign markets. Any negative effect would not be so severe if free trade merely encompassed David Ricardo's 1817 theory of "comparative advantage," which holds that both parties gain from trade if, in the absence of trade, they have different relative costs for producing the same goods. But that's not what's happening.

The movie industry may gain promises of piracy protection while free imports permit our companies to relocate abroad or become "virtual" manufacturers that contract out all manufacturing abroad, secure in the knowledge that the domestic market remains theirs. The Commerce Department recently reported that U.S.-based multinational corporations added 1.5 million workers to their payrolls in Asia and the Pacific region during the 2000s, and 477,500 workers in Latin America, while cutting payrolls at home by 864,000.31

This offshoring and "factoryless production" approach to manufacturing has spread far and wide from appliances and electronics to luxury goods, resulting in job losses throughout the United States.

With that transfer of production goes high-tech know-how. The Apple iPad is a technological marvel and an ultra-high-quality machine built in China. We may now lack the capacity to build it in the United States. General Electric has transferred its GE Healthcare Global X-Ray division to China. Once such a high-tech industry is sent abroad, it becomes nearly impossible to bring it back.

Global tire manufacturers announced almost $10 billion in capacity expansions in the last 12 months, with $5 billion going to China, and just $1 billion in investment in the United States. That includes Goodyear Tire, which is building a $700 million plant in China, and Cooper Tire, which is spending $116.5 million there. These two U.S.-headquartered companies are planning no U.S. expansions.32 The 35 percent duties the United States imposed on Chinese tire imports in September 2009 reduced U.S. imports of Chinese tires by 30 percent, but there was a 29 percent increase in tire imports from other countries.33

When U.S. companies build plants abroad instead of in the United States, they are shifting production and jobs abroad. Free trade means importing the fruits of foreign lands, not moving the farm abroad. Only a tariff can mitigate that.

Many speak of the need for "fair" trade. Non-trade barriers and currency manipulation might be negotiated in a trade agreement; the transfer of production and technology abroad cannot. We must reconsider the effect of our trade policy on jobs and develop ways to protect American wages through judicious use of tariffs. We have always imposed tariffs to protect agricultural jobs -- why not protect manufacturing jobs, too? The challenge is levying new tariffs without starting a trade war, and the argument must be based on offsetting the unfair advantage of VAT rebates.

Capital Gains

"Why should capital gains be treated more favorably than any other kind of income?" asked Paul. The justification is that it's a crude form of income averaging so that tax on income realized over a long time should approximate the lower rate brackets it would have been subject to had it been marked to market annually, as he notes:

    This may be true of an evenly developing real estate gain, or a stock gain arising from the steady accumulation of profits in a corporation. It is not true of a real estate gain that arises from a sudden community boom, or that stems by chance from some local improvement. It would not be true of many stock gains which reflect abrupt new expectations of enhanced future profits.

    . . .

    Another argument for special treatment, frequently advanced, is more vulnerable. The contention is that capital gains merely reflect a general rise in the price level, so there is no real increment at all in terms of purchasing power. They may be no more than a manifestation of inflation. Therefore, say the advocates of special treatment, capital gains are illusory. But this argument proves too much. . . . No tax law can do absolute justice along all the line in an economy of shifting dollar purchasing power.34

Before 1922, capital gains were taxed the same as any other income. The pre-1922 mitigating factor was that the cost basis of most capital gains was the 1913 fair market value of the asset (or some legislated higher basis, such as "discovery value" allowed to the oil industry). Under Paul's assessment, there is less justification for favorable treatment of capital gains when the taxpayer would always be in the highest income tax bracket to begin with.

For a few years after 1986, Congress abandoned the rate preference while retaining all the definitional baggage for the day the rate preference might be restored. At a 1990 conference on tax simplification, the late celebrated tax attorney Martin D. Ginsburg told the audience, "We plumb the depths of the obvious. Of course a special capital gain/loss taxing regime adds significantly to the complexity of an income tax system."35

Defining capital asset and holding period is complex. Ginsburg suggested the possibility of recognizing gain on a gift of appreciated property or annual mark to market. Those proposals or repealing the tax rate preference might cure Warren Buffett's loudly lamented 17 percent income tax rate woes because his taxes would increase exponentially, and donation of untaxed appreciated stock would no longer offset his 35 percent bracket income.

Capital gain remains a sacred cow. Most Republican presidential hopefuls support a zero capital gain rate, although Mitt Romney would limit a zero rate to middle-income earners.36 Others argue that it's not income.37

Paul asserted that fairness in U.S. income taxation has been designed around ability to pay and rate progressivity. Its design should take advantage of the fact that lower-income individuals spend almost all their income on consumption while higher-income individuals are the source for most savings and investment. A consumption tax will reach all lower-income earnings, while an income tax is the only tax that will reach higher-income earnings. If the cure for this Great Recession is increased consumption, preferential taxation of savings and investment income isn't the solution.

A zero rate on capital gains would benefit mainly the rich. All the silly arguments that a zero rate would "liberate" productive capital, encourage domestic investment, and create jobs are unprovable theories. The current 15 percent rate is practically the lowest in history. It is zero for lower-middle-income taxpayers, and there are exemptions for gains on the sale of a primary residence and small business stock. Higher rates and 80 years of taxing capital gains didn't deter investment in the past. A zero rate would cause a serious revenue shortfall and make our tax system much less progressive. It would aggravate Buffett's problem, whose income tax rate would fall to zero. His fortune, pledged to the Gates Foundation, would increase and eventually fund good causes in Africa. How will that help America?

By setting a relatively low maximum tax rate, there is little reason to exempt or grant a rate preference to capital gains. Most states no longer grant preference to capital gains. The Tax Reform Act of 1986 experience proved no harm to capital formation.

Permanent repeal of the capital gains rate preference and definitions would eliminate ordinary-to-capital-gain income conversion tax shelters and promote simplicity and progressivity while permitting overall lower tax rates.

Tax Proposals

Historical statistics show that regardless of whether individual tax rates are set at 28 or 92 percent, federal tax receipts generally fall in the 18 to 20 percent range and don't exceed 20 percent of GDP for long. Setting high rates won't contribute to federal revenues unless it can be shown that high tax rates promote growth. Hanlon contends that federal receipts today have fallen below 15 percent, which makes a strong case that taxes may be too low. Or this could simply be another sign that spending financed by borrowing is unsustainably high.

Any revision to our tax system brings the opportunity for great improvement. I hesitate to use the term "tax reform." Most Americans want the Internal Revenue Code plowed under, not merely reformed. I believe they would be satisfied with a system that relieves them of the burden of filing and paying the income tax and that recovers the lost revenue with some other levy.

Congress has rejected the recommendations of the December 2010 National Commission on Fiscal Responsibility and Reform (the Bowles-Simpson commission)38 and the solution proposed in July 2011 by the "Gang of Six" in response to the U.S. debt ceiling crisis.39 There are other proposals.

The New York State Society of CPAs proposed the Simple Exact Transparent Tax under which everyone files but not everyone pays.40 Prof. Michael Graetz of Columbia Law School has proposed cutting 100 million individual returns from the tax rolls and replacing the lost revenues with a VAT.41 House Ways and Means Committee member Paul Ryan, R-Wis., proposed a comprehensive tax reform and entitlement plan.42

I have written about the feasibility of cutting two-thirds of individual returns from the tax rolls because they raise too little in revenue from a complex tax when the lost revenue can be easily replaced with alternative levies.43

The earned income tax credit is basically a $2 subsidy on the minimum hourly wage. As a complex and refundable tax, it fosters frequent large errors and massive frauds. The IRS devotes about 30 percent of its resources toward EITC issues. Converting the EITC to an employer-administered refund could greatly simplify taxes and reduce fraud.

M. Carr Ferguson, former chair of the American Bar Association Section of Taxation, recently wrote an article titled, "How to Save the Corporate Income Tax."44 He recommended transparency in publicizing the authorship and intent of tax provisions; elimination of loopholes, which might even justify a revenue-neutral tax rate as low as 15 to 20 percent; and writing terser provisions of broader application. He suggested we could trust the commissioner and the courts to interpret and apply the provisions sensibly. After tax breaks and deductions, Hanlon, citing Citizens for Tax Justice, noted that corporations pay an average effective rate of 18.5 percent rather than the 35 percent statutory rate.

The Congressional Budget Office reports that for fiscal 2011, corporations paid income tax of just 12.1 percent on profits earned from activities within the United States.45 Corporations have proven adept at avoiding high tax rates. For the past three years, Google paid U.S. income tax at just 2.4 percent using the "Double Irish" and "Dutch Sandwich" tax schemes.46 The tax reduction devices used by many corporations are familiar to tax policymakers, so a significant reduction in the top rate might be politically feasible by broadening the tax base. Much Google-type planning results from manipulating conflicting tax codes between different countries so that taxes are paid nowhere.

The current estate and gift tax exemption of $5 million per individual (which expires at the end of 2012) with portability for married individuals and a limited step-up in basis is a very workable regime. It frees all but the wealthiest individuals from most estate tax planning while retaining the progressivity that estate and gift taxation brings to our tax system.47

Here's a low-hanging fruit ripe for taxing, but with powerful political opposition: There is no longer any constitutional prohibition against taxing municipal bond interest income. A legislative exemption has been in effect since the earliest days of the income tax because of an 1895 Supreme Court holding that such a tax was unconstitutional. The Court has since rejected the argument that the tax exemption for state and local bonds is constitutionally protected.48 That removed the constitutional constraint against federal taxation of municipal bonds.

This is a very brief list. There are many avenues to broaden the tax base, lower tax rates, and simplify taxes, all while raising more revenue. The goal is for tax revenues to increase as the tax structure stimulates the economy.

The FairTax

Much confusion persists among proponents of this 30 percent national sales tax proposal. It is usually misrepresented as a 23 percent tax. (A pretax item selling for $100 would cost $130 with FairTax. That's (130 - 100)/130 = 23 percent!) At the JEC hearing, Rep. John Campbell, R-Calif., who is a CPA, expressed concerns about the temptation for evasion when faced with a 40 percent combined FairTax and 10 percent California state sales tax.

Stone told the hearing that almost all the efficiency gains touted by FairTax supporters come from taxing existing capital. Those with savings who have already paid income taxes must pay again under the FairTax. He compared it to a natural disaster that knocks down a building which destroys wealth. The FairTax "prebate," a monthly check to everyone that functions as a personal exemption, would be an administrative nightmare, since it would require keeping track of the current address and status of every individual in the country. Ultimately, FairTax is regressive, because it would reduce the tax burden of the wealthy, who don't spend all earnings, or may spend much of them abroad.

A federal sales tax, a serious legislative proposal by the Hoover administration in 1932, failed and sparked a revolt against congressional leaders. It may have cost House Speaker John Nance Garner the presidential nomination, and he instead became Franklin Roosevelt's vice president.

It was again proposed in 1942 by Republicans as a war measure, but was defeated by the Roosevelt administration when Treasury Counsel Paul compromised with Congress by slashing the personal exemption. This subjected tens of millions to the income tax for the first time. Paul explained:

    We went through the war without a Federal sales tax. But it would be most unsafe to say that our postwar Federal tax structure is immune from sales taxation. The sales tax never lacks advocates.

    . . .

    A sales tax hits heaviest the low income groups, all of whose incomes are spent on consumers' goods. It would bite deeply into the incomes of millions of people who depend upon fixed low wages, pensions or allotments, or checks from governmental agencies, and who have been hard-pressed by the rises in the cost of living.49

He also explained that once exemptions are added, such as for food and medicine, projected sales tax receipts decline dramatically. The sales tax is regressive, and it should remain the province of the states. As former governor of New York, Roosevelt understood this in making his effective opposition to the 1932 and 1942 proposals. There is still no good reason for, and many reasons to oppose, implementing FairTax or a national sales tax by any other name.

The Size and Role of Government

Perhaps our current high unemployment rate is not primarily caused by the usual suspects: weak demand, the global financial crisis, the real estate bubble, offshoring of jobs, taxes, and overly burdensome regulations

Race Against the Machine is a much-praised new 60-page essay in e-book format from MIT economists Erik Brynjolfsson and Andrew McAfee. The basic thesis challenges two crumbling economic laws: that growth will create jobs and that rising wages will follow rising productivity. Economist W. Brian Arthur calls this "the second economy"50 -- a digital one.

As Brynjolfsson and McAfee explain, today's computers perform tasks that only humans could once perform: language translation,51 speech, and pattern recognition aided by robotics; online commerce; and instant communication between remote computers. This has allowed machines to rapidly move beyond factory jobs to the service sector, which until now has provided most new job creation. Physical jobs are disappearing because of the digital economy and may be dwarfing job losses from other causes.

For example, airport check-in computers issue boarding passes and luggage tags, assign seats, adjust aircraft weight distribution, and check your name with the Transportation Security Administration and passport control (on international flights) -- all in seconds without human involvement. Shipping and inventory are now tracked by radio frequency identification tags. Our factories are highly automated. Google fitted a computer to drive a Toyota Prius. Lawyers are using computers to find relevant data in mountains of trial documents far more cheaply than new hires. Truck and taxi drivers, medical professionals, and accountants are all at risk of being replaced by machines.

This digital economy will certainly provide growth and prosperity, but it may not provide enough jobs, thus limiting prosperity for many. Creating new jobs that incorporate working with computers is this generation's special challenge. Otherwise, we may wind up distributing prosperity instead of producing it. Another challenge is devising a tax system that harmonizes with a digitized economy.

Much of the battle for ideas between supporters of the Tea Party and Occupy Wall Street concerns the size of government. At the JEC hearing, Rep. Sean P. Duffy, R-Wis., said he had heard $98 trillion as one estimate of our nation's unfunded liabilities (in addition to our $15 trillion national debt). Hanlon explained that we must balance our fiscal priorities, particularly spending for the workforce, education, and investment in infrastructure.

His answer ignored that we can no longer afford to finance the welfare state by taxation or borrowing. We are in a superior position to Greece and Italy, where tax evasion is a national pastime. But even if taxes were to be raised, they would remain insufficient to fund ever-growing government spending, which in recent years has involved borrowing up to 40 percent of revenues. Government accounting, which considers a reduction from an original expenditure proposal to be a spending decrease, is not ready to face reality and cannot be trusted with new tax revenues.

Washington sorely needs a reality check. In his State of the Union speech, President Obama suggested, "take the money we're no longer spending at war, use half of it to pay down our debt, and use the rest to do some nation-building right here at home." Writing in the Financial Times, Christopher Caldwell scoffed, "the money spent for U.S. wars can't pay down the debt -- it is the debt."52

Social Security began as a 1 percent tax and was supposed to max out in 1949 at 3 percent of the first $3,000 of wages. It was intended to prevent destitution but has become a primary retirement system to many Americans. Expanding benefits, including Medicare, have been financed by increasing Social Security taxes by 3 percent per decade until it reached 15.3 percent in 1990. While the wage base has risen exponentially, we may have reached the limit on raising the payroll tax rate.

To hide the size of the federal deficit resulting from the Vietnam War, President Lyndon Johnson in 1968 changed the budget presentation by including Social Security and all other trust funds in a "unified budget."53 Because Social Security was in surplus, it made the deficit look much smaller. That was a great help to President Ronald Reagan in his deficit-plagued administration.

Reagan repeatedly said that he wanted to lower taxes and cut government spending. In 1981 Congress gladly obliged with tax cuts that greatly exceeded his original proposal. But the spending cuts never materialized, resulting in a major 1982 tax increase to stop the revenue hemorrhage.

The Clinton administration's claim to four years of balanced budgets is a myth. Once Social Security is removed from the budget presentation, it was in deficit for three of those four years. The fourth year appears to have shown a surplus, aided by alternative minimum taxation of stock option gains just before the dot-com bubble burst. The tax debts of those taxpayers had to be forgiven after the value of their dot-com shares fell below the AMT they owed, because they had no means of paying it. Quantifying that revenue loss might make the fourth Clinton surplus year a deficit too.

This illustrates that our budget has not really shown a surplus in decades, and it may not be necessary to show an actual surplus.

The Republican insistence on avoiding tax increases has made compromise difficult to achieve. So has the Democrats' refusal to make serious spending cuts, particularly for entitlements. Unfortunately, President Obama has shown himself to be a weak negotiator and conciliator in tax matters. Perhaps rightly, the Republicans believe that tax increases would only continue to allow Democrats to avoid painful spending cuts.

Entin advised the JEC not to "look only at the federal budget effects of tax proposals, and forget about the economic consequences, [because] we will miss what is most important -- the public welfare -- and we will get the budget numbers wrong."54 A solution indeed requires careful craftsmanship.

Today's government gridlock over financing our nation could lead to ruin. Turmoil over finances contributed to the French Revolution. The South might have won the Civil War had it been able to collect taxes needed to finance the war,55 just as responsible finance helped the North win.56

Our triumph in the Cold War resulted largely from our ability to collect taxes to fund a military buildup, and the Soviet Union's inability to do the same. American prosperity, power, and the strength of our democracy begins with the ability to manage our fiscal affairs.

Relying largely on China (of all places) to buy our bonds for funding unsustainable deficits is a recipe for disaster. The solution requires slashing spending, transfer payments, and entitlements. In an overall plan of taxation for prosperity, tax revenues should return to their historic 18 to 20 percent of GDP.

Paul concluded Taxation for Prosperity with the following advice:

    The task of building a sound tax system will be hard and long. It is not a partisan job; it is not a job that will be completed by any one Congress. There will always be things left to do, if we have the wisdom to benefit by the new insight which experience can bring to open minds, and if our tax system is to fit the changing economic and social needs of each succeeding generation. Every American citizen shares in the responsibility. Some will be pessimistic as to the outcome of the application of the democratic process to so complex a subject as taxation. Some will be full of complacent optimism resting on satisfaction with things as they are. The useful attitude will be a determination that what is wrong now will be set aright, fortified by an unswerving confidence that the final compromise of all conflicting forces will be a tax system intelligently designed to make a continuously prosperous America.57

The charge to members of Congress is that they must challenge their own dogmatic ideologies. Perhaps it is naive to expect Congress to risk constituent wrath to bring this nation continued prosperity with intelligent taxation and responsible spending; but that is what is required if we are to avoid disaster.

Monetary policy is mired in a liquidity trap. Keynesian stimulus spending has proven ineffective. We faced much gloomier prospects following World War II. Good tax policy was a major part of the formula that brought us prosperity then. It's time to invoke taxation for prosperity again.


1 See Michael M. Gleeson, "Tax Reform Will Not Reduce Unemployment, Economists Testify," Tax Notes, Nov. 21, 2011, p. 968, 2011 TNT 223-6. Video available at

2 JEC hearing testimony of Seth Hanlon (Nov. 17, 2011), 2011 TNT 223-41.

3 JEC hearing testimony of Dan R. Mastromarco (Nov. 17, 2011), 2011 TNT 223-44.

4 JEC hearing testimony of Stephen J. Entin (Nov. 17, 2011), 2011 TNT 223-43.

5 JEC hearing testimony of Chad Stone (Nov. 17, 2011), 2011 TNT 223-42.

6 See Joseph J. Thorndike, "Historical Perspective — Profiles in Tax History: Randolph E. Paul," Tax Notes, Oct. 25, 2004, p. 529,2004 TNT 208-14.

7 Randolph E. Paul, Taxation for Prosperity 24-25 (1947).

8 See Tax Analysts' The VAT Reader: What a Federal Consumption Tax Would Mean for America (2010): Susan C. Morse, "How Australia Got a VAT," at 291; Martin A. Sullivan, "VAT Lessons From Canada," at 283; Paul Previtera and Brandon Boyle, "Japan's Consumption Tax: Lessons for the United States," at 312; Xu Yan, "China's VAT Experience," at 319.

9 Wilbur D. Mills, "Tax Legislation -- A Look Into the Future," 38 N.Y.U. Inst. Tax. on Tax'n 31 (1980).

10 See Zenith Radio Corp. v. United States, 437 U.S. 443 (1978).

11 187 U.S. 496 (1903).

12 Section 303(a) of the Tariff Act of 1930, as amended, 19 U.S.C. section 1303(a) (1976 ed.). Repealed by P.L. 103-465, Title II, section 261(a) (Dec. 8, 1994).

13 United States v. Passavant, 169 U.S. 16, 23 (1898).

14 Downs, 187 U.S. 496, 512.

15 G.S. Nicholas & Co. v. United States, 249 U.S. 34, 39 (1919).

16 Zenith Radio Corp. v. United States, 430 F. Supp. 242 (Cust. Ct. 1977).

17 562 F.2d 1209 (C.C.P.A., 1977).

18 Id. at 1212.

19 Id. at 1225 (quoting JEC, "The Future of U.S. Foreign Trade Policy," 90th Cong. 1st Sess., at 5 (1967)).

20 Zenith, 437 U.S. 443.

21 Matsushita Elec. Industrial Co. v Zenith Radio, 475 U.S. 574 (1986).

22 Stanley S. Surrey, "Value-Added Tax: The Case Against," 48 Harv. Bus. Rev. 86 (Nov.-Dec. 1970).

23 Id.

24 Example: In Japan a base Toyota Prius starts at ¥2,170,000 (about $27,820). See or [To read these in English, enter the URL into a Google search, then click on "Translate this page."] It lists for $23,520 in the United States ( This is not the result of recent currency manipulation. In 2009 a Prius in Japan cost ¥2,450,000 (about $25,750) and $22,000 in the United States. See American Institute of Certified Public Accountants, "Tax Reform Alternatives for the 21st Century" at 100, n.155 (Oct. 2009).

25 Frank Langfitt, "Made in China Doesn't Mean Cheap in China," NPR, Morning Edition (Nov. 23, 2011).

26 Paul, supra note 7, at 260.

27 Ben Bernanke, Essays on the Great Depression (2000).

28 Read them at

29 William McKinley, The Tariff in the Days of Henry Clay and Since: An Exhaustive Review of Our Tariff Legislation From 1812 to 1896, 84 (1896).

30 James G. Blaine, "Debate: Free Trade or Protection?" 150 North Amer. Rev. 27, at 37 (Jan. 1890).

31 David Wessel, "U.S. Firms Keen to Add Foreign Jobs," The Wall Street Journal, Nov. 22, 2011.

32 Peter Lee, "U.S. Drivers Pay Steep Price for China Tire Tariff," Asia Times, Sept. 10, 2011.

33 "China loses WTO appeal against U.S. tire tariffs," Reuters, Sept. 5, 2011. The WTO's report is available at A possible explanation for the 29 percent offset is illegal transshipping of Chinese tires to a false country of origin to evade quotas or tariffs.

34 Paul, supra note 7, at 272.

35 Martin D. Ginsburg, "Income Tax Complexity: Capital Gain and Loss Issues," in Proceedings of the Invitational Conference on Reduction of Income Tax Complexity, A Joint Project of the American Institute of Certified Public Accountants and the American Bar Association Section of Taxation, Tax Management Education Institution, Jan. 11-12, 1990, I-V-1.

36 Richard Rubin, "Republican Investment Tax Cutters Top Bush," Bloomberg, Sept. 1, 2011; Editorial, "Why Cut Taxes for Wealthy Investors?" USA Today, Sept. 18, 2011.

37 Bruce Bartlett, "Why the Capital Gains Tax Rate Should Be Zero," National Center for Policy Analysis, Study No. 245 (Aug. 31, 2001).

38 The National Commission on Fiscal Responsibility and Reform, "The Moment of Truth" (Dec. 3, 2010), Doc 2010-25486 2010 TNT 231-35.

39 "A Bipartisan Plan to Reduce Our Nation's Deficits."

40 The Simple Exact Transparent Tax, New York State Society of CPAs.

41 Michael J. Graetz, 100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States (2008).

42 "Roadmap for America's Future 2.0."

43 Jay Starkman, "Tax Simplification: Just Get Rid of 89 Million Unnecessary Returns," Tax Notes, Aug. 15, 2005, p. 823, 2005 TNT 157-26.

44 Tax Notes, Aug. 29, 2011, p. 951, 2011 TNT 167-6.

45 "With Tax Break, Corporate Rate Is Lowest in 40 Years," Wall Street Journal, Feb. 3, 2012, at B1.

46 Jesse Drucker, "Google 2.4 Percent Rate Shows How $60 Billion Lost to Tax Loopholes," Bloomberg, Oct. 21, 2011.

47 Under the Civil War and 1894 revenue acts, inheritances were taxed as income. The most frequent question I am asked by new heirs to modest estates is how much income tax they will owe on their inheritance, because they expect some liability.

48 South Carolina v. Baker, 485 U.S. 505 (1988).

49 Paul, supra note 7, at 390-391.

50 W. Brian Arthur, "The Second Economy," McKinsey Quarterly, Oct. 2011.

51 See Google example translating a complete Japanese website into English, supra note 24.

52 Christopher Caldwell, "Politicians Take Note: Class Warfare Need Not Be Taxing," Financial Times, Jan. 28, 2012, p. 7.

53 Social Security Administration, "The Social Security Trust Funds and the Federal Budget".

54 Entin testimony, supra note 4.

55 Starkman, The Sex of a Hippopotamus: A Unique History of Taxes and Accounting, 120, 151-154 (2008).

56 Thorndike, "What the Civil War Can Teach Us About Tax Reform," Tax Notes, Nov. 21, 2011, p. 944, 2011 TNT 224-3.

57 Paul, supra note 7, at 418.



Jay Starkman, CPA is a sole practitioner in Atlanta. This article was originally published in Tax Notes, February 13, 2012.