A New Understanding of Tax

Written by: Edward J. McCaffery


A. Loomings

Perhaps we should blame it all on Mill. A great deal and possibly all of the mind-numbing complexity of America’s largest and least popular tax follows from the decision to have a progressive personal income tax[2] Proponents wanted an individual income tax notwithstanding — indeed, in large part because of — such a tax’s “double taxation” of savings. This double-tax argument is an analytic point generally attributed to Mill’s classic 1848 treatise,Principles of Political Economy.[3] Historically, much of the support for the Sixteenth Amendment, ratified in 1913, came from Southern and Midwestern, progressive, agricultural interests, who wanted, in general, to implement a redistributive tax and, in particular, to collect some tax from East Coast financiers.[4] After all, the Supreme Court had ruled that the income tax of the late nineteenth century was unconstitutional only insofar as it fell on the fruits of capital; no constitutional amendment would have been necessary to retain or implement a national wage or sales tax.[5] The legal raison d’etre of the income tax was to get at such returns to savings as dividends and interest.

To this day, liberals and moderates insist on retaining the structure of an income tax precisely because it gets at the returns to saving in addition to labor earnings[6] Consumption taxes of all sorts are set in contrast to the income tax, on another side of a great divide, as taxes that fail to get at the yield tocapital — that deliberately avoid Mill’s “second” tax.[7] Prominent commentators on the case for consumption taxation — both those in favor and those opposed — continue to cite, as the “best” or “most sophisticated” argument for adopting a consumption-based tax, the analytic facts that consumption taxes do not overly burden capital or its yield, and as such do not distort the savings-consumption decision, or, equivalently, do not favor present over deferred consumption.[8] The literature for and against consumption taxation is strewn with stock “horizontal equity” models, comparing savers and spenders, Ants and Grasshoppers: the idea is that income taxes punish savers, like the mythical Ant, vis-à-vis spenders like her friend Grasshopper.[9] On the other side of the great divide, supporters of redistributive taxation argue that retaining an income tax base is a central task of maintaining or obtaining fairness in tax in large part because it, alone, gets at the return to capital, the nearly exclusive province of the economically fortunate.[10]

The idea that income taxes and only income taxes effectively get at the yield to capital, and, as explained further below, that consumption taxes of either of two broad types, prepaid and postpaid, do not, constitutes the traditional view of tax.11 The traditional view has extended well beyond the academy to influence the popular understanding of tax and its possibilities, as well as practical political decision making. This traditional view has generated an impoverished choice set for tax, consisting of a badly flawed status quo on the one hand and a flat consumption tax of some sort on the other. Under the guiding light of the traditional view, we are heading ever closer towards a flat wage tax. The traditional view is wrong.

This Article sets out a new understanding of tax. The key insight is that the canonical understanding of consumption taxes changes under consistently progressive tax rates.[12] No longer are prepaid and postpaid consumption taxes taxes on wages and spending, respectively equivalent. Postpaid consumption taxes can and do burden the yield to capital, and not in an arbitrary, random way. Far from it: A progressive postpaid consumption tax emerges as the fairest and least arbitrary of all comprehensive tax systems, precisely because it chooses to make its decisions about the appropriate level of progressivity at the right time. In doing so, it burdens some but not all uses of capital and its yield, and for normatively attractive reasons. These points follow from a simple statement of the analytics of tax.

This then raises an obvious question from the start: Why has the traditional view persisted for so long, virtually unchallenged? It is true enough that an ideal income tax including all sources of income — both labor earnings, or the yield to human capital, and savings, or the yield to financial capital — is a“double tax” on savings that burdens savers relative to spenders. This is accurate both within the income tax’s own framework, in which savers are treated more harshly than spenders, and also compared to a hypothetical no-tax world, with the income tax destroying the pretax financial equivalence between present and deferred consumption.[13] It is also analytically correct that a prepaid, yield-exempt, or (all equivalently) wage tax categorically exempts the yield to savings, preserving the relation whereby savers and spenders under normal circumstances have equal material resources in present value terms. But under progressive tax rates, a postpaid, cash-flow, or (all equivalently) spending tax is not equivalent to a yield-exempt or wage tax; that is, it is not equivalent to an “income” tax with a zero rate of taxation on savings, which is itself a semantic paradox.14 This is a point that the traditional tax-policy literature has sometimes stated, but only in a passing manner.[15]

On the occasions when scholars have paused to reflect over the idea that varying progressive rates destroy the equivalence of prepaid and postpaid consumption taxes, they have taken one of two subsequent turns.

Some scholars simply note that the interaction of progressive rates and a postpaid consumption tax is more or less random. They state that taxes will goup, and hence there will be a “penalty” for savers if consumption occurs in a higher rate bracket than initial earnings; taxes will go down, and hence there will be a “subsidy” for savers if consumption occurs at a lower level than initial earnings.[16] This language of subsidy and penalty is not helpful: It tends to confuse matters, perhaps because of an innate or intuitive aversion to non neutral sounding rules, a belief that neutrality per se is an end.[17]

More deeply, this first move does not take the analytical understanding of tax far enough. When savings or the yield to capital will decrease or increase a taxpayer’s burden of taxation under a consistent, progressive postpaid consumption tax is not random. The burden of taxation will decrease when a taxpayer uses capital transactions (borrowing, saving, investing) to smooth out the pattern of her lifetime labor earnings, and thereby to consume, in any given year, at the level of her average annual lifetime labor earnings in constant dollar terms. The burden will also decrease when capital transactions result in diminished consumption, again measured against the average annual labor earnings as the baseline. The burden of taxation will increase when capital transactions are used to finance enhanced, or greater, consumption than this level. This pattern is not random, as this Article demonstrates.

Other scholars point out that the potential nonequivalence of the two consumption taxes leads to an argument for flat or proportionate consumption tax rates, because they presume — or presume that consumption tax supporters presume — that the best argument for a consumption tax is one of preserving the “neutrality” between savers and spenders, or of avoiding Mill’s second tax, or, other times, of promoting savings on an individual or social aggregate level.[18] This move puts the cart before the horse: it rests the case for consumption taxation on weak normative foundations. To counter this move, we need to explore portions of the intellectual history of tax so as to develop new arguments for old ideas. It turns out that the best argument for a consumption tax of the right sort is not a simple horizontal equity argument at all, as this Article develops.

The new understanding of tax embraces three, not two, choices of comprehensive tax bases.[19] A consistent, progressive postpaid consumption tax stands between an income tax, which double taxes all savings by including the yield to capital in its base, and a prepaid consumption or wage tax, which never taxes the yield to capital. A consistent, progressive postpaid consumption tax burdens some but not all of the yield to capital, and does so in a principled way, by design. There is no need for ad hoc deviations from an analytically sound understanding of the comprehensive tax ideal to achieve the result, as there is, for an important example, under the “income” tax so as to remove the double-tax sting from retirement (or medical or education-related) savings. A progressive postpaid consumption tax relatively lightens taxation on the use of capital transactions to move uneven labor market earnings into even cash flows in constant dollar terms. But the very same tax falls more heavily on the use of capital transactions to increase one’s lifestyle above this level. There is nothing arbitrary about this.

This analytic theme of the new understanding of tax opens the way for a rethinking of the normative grounding of tax. A consistent, progressive postpaid consumption tax is appealing, in part precisely because it corresponds with widely held and independently reasonable ordinary moral intuitions in regard to the taxation of capital and its yield. To be clear, this is not the only, or even necessarily the best argument for a consistent, progressive postpaid consumption tax: Writing on a blank slate, one might simply cut to the chase and argue that this tax is the fairest, most efficient, and simplest to administer of any comprehensive tax plan.[20] But history and a considerable amount of tax-policy scholarship, at least since Mill, have conflated the case for consumption taxes of any sort with the case against taxing some or all of the yield to capital. Given that this is where matters stand, it becomes important to see that, among all the major alternatives, a progressive postpaid consumption tax best gets at the yield to capital in just the way that ordinary moral intuitions seem to want to get at such yield. The most decisive evidence for this claim comes from an examination of a near century of experience with tax. Looking at tax policy through the lens of the new understanding of tax, with its three, not two, types of tax, we can see that the actual income tax is not an income tax at all because it is inconsistent in its taxation of the yield to savings. But this inconsistency is not without principle. We can see the income tax attempting to differentiate between “ordinary” savings that effectuate smoothing and all else. Coining two further normative terms, the new understanding refers to the idea that those savings that are used to even out cash-flows, such as retirement savings, should not be double taxed as the “ordinary-savings” norm, and refers to the idea that the yield to capital is an increment of value that ought to bear some tax as the“yield-to-capital” norm. The uneasy coexistence of these two norms under the income tax has led to incoherence, inefficiency, and unfairness. But the two norms, by design, come into perfect harmony under a consistent, progressive postpaid consumption tax.

The best argument for a postpaid consumption tax is not, therefore, about the “horizontal equity” of savers and spenders, or about the principled non taxation of the yield to capital. It is not an argument about the aggregate capital stock, or even about the importance of savings on individual or national levels: depending on the choice of tax rates, we can have more, less, or the same amount of savings under a consumption as under an income tax. Rather, the best argument for a consistent, progressive postpaid consumption tax is that the moment of actual consumption represents the best —namely, the fairest and most efficient — time to make the decisions about the appropriate level of taxation, in large part because this allows us to get to some but not all of the yield to capital: only that yield which enhances lifestyles, and no other.

In all this, I more or less posit that progressivity — getting the better able-to-pay to pay more, to some degree, than the less able — is an attractive end for tax. I shall say a few words about this end later. But for the most part, I presume that we want a progressive, redistributive tax system.[21] Partly, this is a matter of ordinary moral intuitions and our collective history, as I read them, as well as independent political and moral theory. But it is also analytic.Under a flat-rate tax, prepaid and postpaid consumption taxes are indeed largely equivalent, and neither reaches the yield to capital.[22] If we do not want progressive tax rates, many far simpler alternatives to the status quo are available; if we do not want to reach the yield to capital, ever, then we can choose a prepaid or a flat-rate postpaid consumption tax. I proceed on the assumption that “we” — at least a good many contemporary citizens and readers — do want progressivity and some taxation of the yield to capital, and in fact that these ends are prior to any preference over more particular forms of taxation. I write to show that a progressive postpaid consumption tax is the best — indeed, the only practicable — way to obtain these goals.

The new understanding of tax paves the way for extensive tax reform and opens up an important line of critique on current political proposals. The real and pressingly practical question for tax is not whether to have an income or a consumption tax, but what form of consumption tax to have. The stakes in this battle are clear and dramatic: the fate of progressivity in tax lies in the balance. Contemporary conservative leaders have signaled a desire to move tax towards a prepaid consumption tax. Such a tax, falling exclusively on wages, jeopardizes America’s historic commitment to at least moderate progression in the distribution of tax burdens. The path towards maintaining that commitment lies in taxing at the opposite time, of ultimate outflow, not inflow — which the postpaid consumption tax model, alone among major alternatives, does. It is time to get the fair timing of tax down right. The rest of this Article makes good on these opening claims.

B. The Road Ahead

Reconsidering tax policy more or less from the ground up has its advantages, for the traditional view has made certain wrong turns along its way. Thus,an intellectual history merges with an analytic discussion of tax to generate a critique of the status quo on the way to a specific programmatic proposal for normative improvement. Here is a brief summary of the path through the argument.

Part II sets out the traditional understanding of the income and both forms of consumption taxes.

Part III begins to translate the analytic facts of tax into a normative theory. It explores some of the intellectual history of tax to lay the foundation for are conceived normative argument structure.

Part IV introduces a new vocabulary and analysis to support the new understanding of tax. Most importantly, it develops more formally two norms about the taxation of capital: the yield-to-capital norm, which holds that the return to capital is an increment of value that ought to be taxed, and the ordinary-savings norm, which holds that savings that merely shift labor earnings within a lifetime or between taxpayers ought not to be excessively burdened.These two norms are in fatal tension under an income tax; in contrast, a consistent, progressive postpaid consumption tax accommodates both norms by design.

Part V begins to look at and critique contemporary practice by explaining that, in reality, the so-called income tax is effectively a prepaid consumption or wage tax.

Part VI continues the examination of tax practice beyond the income tax. The overall skew of the present system towards wage and away from capital taxation becomes more dramatic when other taxes join the mix.

Part VII completes the journey by arguing that the right choice is a consistent, progressive postpaid consumption tax. It sets out a better argument structure for supporting this tax; notes issues of transition, implementation, and objections to the tax; and points out how the new understanding of tax underscores some persistent errors in the popular understanding of tax. The Part, and the Article, concludes by noting why it all matters.


There are three major choices of broad-based tax systems in ideal theory: the income tax, and prepaid and postpaid consumption taxes.[23]

The traditional view of tax has contrasted the income tax with both forms of consumption tax, which forms it has equated. But the traditional view has gone awry in overlooking some of the lessons from the analytics of tax. The new understanding turns on the uniqueness of each of the three forms of tax.It is worth beginning with the basics.

A. An Example

A simple numeric example helps to illustrate the more technical discussion to follow.

Suppose that Ant and Grasshopper each earn $200 in wages, the tax rate is 50 percent (for simplicity), and the interest rate on savings is 10 percent.

Grasshopper, as is his way, spends all of his available money at once. Under any tax — income, prepaid or postpaid consumption — the government takes its 50 percent cut, or $100, and Grasshopper consumes the remaining $100. This illustrates an important point: A good deal of this discussion has no direct impact on most Americans for the simple reason that they do not save.[24] Income is consumption for those who do not save.[25]

Ant, in contrast, does save, as is her way. The choice of tax does matter to her. Suppose Ant saves for two years, at the conclusion of which she consumes all that she has amassed. How do the three different taxes treat her?

An income tax reduces Ant’s $200 to $100 right away, which she puts in the bank. Ant earns 10 percent on her savings, or $10, in Year 1, but the income tax taxes this, too — Mill’s double tax — taking away $5, leaving her with $105 at the end of Year 1. In Year 2, this $105 again earns 10 percent, or$10.50; again the income tax strikes, taking $5.25; this leaves Ant with $110.25 to consume at the end of Year 2. If the 10 percent interest rate simply compensated Ant for inflation — if the cost of goods were rising at 10 percent per year — Ant would be losing real value, or actual purchasing power, overtime under the income tax: $110.25 at the end of two periods of 10 percent inflation is worth — that is, has the same real purchasing power as —$91 at the start of the two periods.[26]

Consider next the two forms of consumption tax. First, the prepaid model: Ant is taxed right off the bat under this system, reducing her $200 to $100. But she is not taxed again: consumption taxes are single taxes, escaping Mill’s double-tax label. The $100 grows by the full 10 percent interest rate, to $110,after Year 1. In Year 2, the $110 grows another 10 percent, or $11, to $121, and Ant is left to consume this much at the end of Year 2. Unlike the case with the income tax, this end of Year 2 consumption is worth the same as $100 at the start of Year 1, under a 10 percent inflation rate.

Under the postpaid consumption tax model, Ant can save her entire $200 because she pays no tax up front. This grows by 10 percent, or $20, in Year 1, to$220. The $220 grows by another 10 percent, or $22, to $242, in Year 2. When Ant goes to consume this, the government collects its 50 percent share,leaving Ant with $121 to consume. The result is equivalent to that under the prepaid model. And what Ant has left is more than what is left over under an income tax. There are no smoke and mirrors here. There are only two critical assumptions needed to make out the equivalence of prepaid and postpaid consumption taxes: that the interest and tax rates have stayed constant in the two periods.[27]

Table 1 summarizes the example. Grasshopper’s consumption at the start of Year 1, set out in the first column, is constant at $100. Ant’s potential consumption at the end of Year 2, set out in the middle column, is $110.25 under an income tax and $121 under either form of consumption tax. The final column converts these values back into constant initial Year 1 dollars, at a 10 percent discount/interest rate. This conversion makes clear that, under constant rates, savers lose real value under a true income tax, whereas a constant-rate consumption tax is “neutral” as between savers and spenders,present and deferred consumption.

A New Understanding of Tax_html_261513bf

The Ant-Grasshopper example stands at the center of the traditional view of tax. The income tax is a double tax on value that is not immediately consumed, which has led many conservatives to oppose it as an unfair burden on the noble Ant, but liberals to support it as a necessary means of capturing some of the return to capital — a benefit that inures almost exclusively to the wealthy. Both forms of consumption tax get put on the other side of a great divide, as not reaching the yield to capital. It becomes a matter of either indifference or administrative convenience which of the two forms is chosen.[28]

B. The Income Tax

This and the following sections present the analytics of the income and consumption taxes more formally than the numeric example of Ant and Grasshopper. The formal analysis helps to reveal some more subtle points.

Traditional income tax theory begins, and sometimes ends, with the Haig-Simons definition of income.[29] Simons took many more words to get the idea across, but his definition is a very simple identity, stating in essence that:

Income = Consumption + Savings. [1]

This is no more and no less than the accounting truth that:

Sources = Uses, [1a]

or, even more simply, the truism that:

All Income is either spent (Consumption), or not (Savings). [1b] This is not profound. But simple principles often underlie complex structures. The Haig-Simons definition of income has been enormously influential in analyzing tax. An especially common use of the definition of income has been to show, by rearranging terms, that a consumption tax does not include savings in its base, while an income tax does:

Consumption = Income – Savings. [2]

The idea here is simple. Since all you can do with your available wealth is spend it or not (Equation [1b]), and since what you do not spend you save — by the semantic definition of “saving” — the government can come up with any particular taxpayer’s consumption for any given period simply by subtracting savings from income. If you know two components of an identity relationship involving three terms, the third can be derived. This leads to the important practical point that a postpaid consumption tax need not proceed along an administrative line requiring tallying up precise consumption items; subtracting savings from income will do the trick perfectly well. Hence, a postpaid consumption tax is sometimes called a “consumed income tax,” blurring the ideal distinctions, while attempting to mute opposition to the “consumption” tax label.[30] Traditional individual retirement accounts (IRAs) and qualified pension plans work this way: as subtractions from (or non inclusions in) what would otherwise be “income.”[31] The unsaved portion of income is — by definition — consumed.

Mill’s criticism of the income tax, quoted in the opening epigraph and discussed in greater detail below, is that any income tax is a “double” tax on savings. To understand this point analytically, consider the basic financial equation defining the future value (FV) of a present value (PV) invested overtime (n) at any given interest rate, (r):

This is a simple relation. Recall the case of Ant. She saved the sum ofA New Understanding of Tax_html_78b33328

$100 for two periods at an interest rate of 10 percent, or .10, per period. After one period, the $100 grew to (100)(1 + .10), or $110. In the second period,this $110, that is (100)(1 + .10), again grew by 10 percent, becoming (100)(1 + .10)(1 + .10) = (100)(1 + .10)2 = $121. And so on.

Consider what happens when the government imposes a tax. A tax takes t away from a taxpayer, leaving her to keep (1 – t).[32] Suppose for example the tax rate were 30 percent; the government would take this, leaving the taxpayer with 70 percent of whatever was being taxed. A fundamental principle of economic “neutrality” is that tax should not distort the nontax allocation of resources or the relative price system.[33]

So we would expect, in a “neutral” tax world, as a first cut, that

Equation [3] would become:

At a 30 percent tax rate, Equation [4] illustrates the fact that a taxpayer keeps 70 percent of her initial resources. By multiplying each side of Equation [3] by .7, the equality is maintained.A New Understanding of Tax_html_m5d690a02

The problem that Mill identified was that an income tax is not neutral, because it falls again on the yield to capital, or r(PV) in Equations [3] and [4]. An income tax looks like the right-hand side of the equation below:

The income tax is not neutral because two minus ts appear on the right hand side of this equation. The left-hand side of this relation, that imposes a single tax on the FV of Equation [3], is no longer equal to the right-hand side as it had been under the “neutral” tax system posited in Equation [4]. What is actually left by the income tax — the right-hand side of Equation [5] — is less than this amount. The “=” sign of Equation [4] must now become a “>”sign. This is what Table 1 had shown, using the canonical Ant-Grasshopper example: Income taxes hurt savers compared to non savers.A New Understanding of Tax_html_105f7fec

C. Two Forms of Consumption Tax

The same equations just set out also illustrate the broad equivalence of the two basic forms of consumption taxation. Consider again Equation [4]:A New Understanding of Tax_html_47bae72d

This equation had set out the “neutral,” or one tax, condition: in order to maintain the equivalence of present and future values for a given increment of wealth, a single tax ought to be levied on the flow, however long the underlying wealth persists in the taxpayer’s hands. Now it does not matter, under the commutative principle of multiplication (which holds that ab = ba), where, or, better put, when, one levies the consumption tax’s single tax. That is:

The middle form of consumption taxation in Equation [6], where the minus t is levied up front, is the prepaid or yield-exempt model.[34] It is, in essence, a wage tax, like social security. The single tax is levied when dollars are first earned — the (1 – t) is applied to the PV — and never again. One does not pay a “second” social security tax on dividends and interest; the yield to capital is exempt. The recently added “Roth” IRAs work this way, and contemporary proposals from the Bush Administration would move tax policy even more decisively in this direction[35]A New Understanding of Tax_html_m2756ec91

The second form of consumption tax, where the minus t is levied on the back-end, is the postpaid, qualified account, or cash-flow model. This is how traditional IRAs and qualified pension plans are taxed under the so-called income tax. More simply, it is like a sales tax. You do not pay taxes when money is first earned: the (1 – t) lies in wait to apply to a bigger nominal sum later on down the road. Under the current income tax, you get a deduction(or non inclusion) for contributions to an IRA or a pension plan (or for the employer’s contribution thereto). You pay the single tax when the money is withdrawn, in the case of a pension plan, or actually spent, in the case of a literal sales tax.

The dramatic insight is that the two taxes are — or can be — the same, as in the simple Ant-Grasshopper example summarized in Table

1. Equation [6], relying only on the commutative principle of multiplication, shows this fact more formally.

D. Two Conditions of Equivalence

Equation [6], and thus the equivalence of the prepaid and postpaid consumption taxes — of wage and sales taxes — holds under just two seemingly innocuous conditions, constant tax rates and constant rates of return.

1. Constant Tax Rates

The tax rate, t, must be the same in the two possible periods of taxation — the period of first labor market earning, and the period of subsequent (in the case of any savings) consumption. To help make this clearer, Equation [7] simply restates Equation [6], showing the equivalence of the prepaid and postpaid models under the traditional view, with subscripts on the two t terms:

This form makes more transparent the mathematical fact, which is typically assumed, that t1 must be equal to t2 in order for the general equivalence of prepaid and postpaid consumption taxes to hold. In the Ant-Grasshopper example, the same 50 percent tax must apply at the start of Year 1 as at the end of Year 2. In the traditional view of tax, explored here and in Part III, these analytics morph into a norm that the tax rate should be the same.[36] In the new understanding of tax, the analytics open up the possibilities of and hopes for deliberately variable progressive rates.A New Understanding of Tax_html_e446d32

2. Constant Rates of Return

Just as the t in Equation [6] must be constant, so must the r. This second condition, a more technical one than the first, is that there not be “windfall” or“infra marginal” returns to capital, disproportionate to the net amount of capital invested — that the rates of return do not change between the second and third terms in Equations [6] and [7].[37]

It may, at first, seem intuitive that a prepaid consumption tax does not capture a windfall or lucky return in the capital markets at all, and hence a simpler statement of this second condition — that postpaid consumption taxes get at windfalls, while prepaid ones do not — is all that is needed.[38] But under a prepaid consumption tax model, there is less wealth in the taxpayer’s hands to invest in the first place. If the windfall returns shrink proportionate to the reduced private capital stock occasioned by the tax, there is no technical difference between the two models, hence the added nuance. Macroeconomic or micro- level individual behavioral changes can alter the equivalence as well.[39]

A simple numeric example again helps to illustrate these technical points. Suppose that there are some investments that will yield staggering(extraordinary) returns — say that they will double one’s money in a year, a 100 percent rate of return. Under a prepaid consumption tax model, recall that Ant will earn $200, pay $100 in taxes right away, and have $100 to invest. With the 100 percent rate of return available, this can grow to $200 in a single year. Under the postpaid consumption tax model, Ant will have the full $200 to invest initially and pay tax later. The question raised by this second condition is simply this: Can Ant’s $200 grow to $400? If so — this is a case where the windfall return possibilities expand with the private capital stock —the postpaid tax will collect its 50 percent on withdrawal, leaving her with $200, just as under the prepaid model with the supra normal 100 percent return.Or, instead, will Ant’s “first” $100 of savings double, to $200, and her “second” $100 of savings return the “normal” 10 percent, growing to $110, leaving her with $310 total? This is the case where the opportunities for windfall returns either go to the public sector, or are in any event invariant to the net amount of private capital invested: there was just one lucky opportunity to be had, for $100, whether Ant had $100 or $200 to invest. If that is the case,the postpaid tax will collect $155, leaving her with a like amount. If this latter case occurs then the postpaid consumption tax — but not the prepaid one— will have captured at least some of the high or “windfall” returns from the capital markets; Ant will have more value to consume in the prepaid world.

E. The Treatment of Debt

How the two forms of the consumption tax and the income tax treat savings is widely noted and reflected in traditional tax policy doctrine, now set out in basic tax textbooks.[40] There is far less discussion and hence less understanding of the proper analytic treatment of debt. This is unfortunate, as a practical matter, because debt is of enormous consequence both in everyday life and in understanding the appeal of different tax systems. The failure to get the tax treatment of debt down right led to an analytic mistake in the design of the Nunn-Domenici USA Tax, a progressive postpaid consumption tax that almost became American law.[41] The misunderstanding is also unfortunate, for the proper analytic understanding of debt is simple enough if one merely considers debt as a form of negative savings, or dissavings.

An income tax ignores debt under the Haig-Simons definition of income in Equation [1]. There is no genuine accession to wealth — no change in one’s net worth — when one borrows. The proceeds of debt will be put to one of the two basic and mutually exclusive uses of income, or some combination thereof— the money will be spent (consumed) or not (saved). In any event, the consumption, savings, or combined consumption and savings is precisely offset by the dissavings that the debt itself represents, a subtraction of Savings on the right- hand side of Equation [1]. Borrowing is a “wash,” as tax lawyers say.

Consistent with the ignoring of the initial incurring of debt, there is no general deduction for the repayment of the principal of debt: material resources are diminished by the payment, but savings or net wealth is increased by the elimination of the liability, resulting in another wash.[42]

A prepaid consumption or wage tax systematically ignores debt. This is because it only falls on labor earnings. Prepaid consumption taxes ignore all savings, negative savings included. There is no deduction for the repayment of principal or interest. One’s credit history is irrelevant to the social security or payroll tax authorities.

A postpaid consumption tax, in contrast, includes debt as a taxable inflow. Recall Equation [2]:

Consumption = Income – Savings. [2]

A postpaid consumption tax allows a general, unlimited deduction for positive savings. Borrowing is negative savings. Subtracting a negative means adding it, so debt comes into the postpaid consumption tax base in the first instance. Debt that is used to finance present period savings, however, will come out as a wash: an inclusion qua negative savings, an exclusion qua positive savings. Debt that is used to finance consumption, on the other hand,will trigger tax in the year of consumption: only the negative savings will appear on the right-hand side. In a later period, repayments of principal and interest are fully deductible from the consumption tax base. These repayments do represent positive savings.[43]

This sounds odd and unfamiliar, but it need not. Consider a routine sales tax, the most common form of a postpaid consumption tax. Grasshopper pays sales tax when he purchases an item, even if he is using borrowed funds to do so, as by putting the purchase on his credit card. Later when Gras shop per pays off his credit card balance, including any interest that he may have accumulated by then, he does not pay another round of sales taxes on the payment. So it would work under a broad-based, comprehensive postpaid consumption tax.

It may seem as if a postpaid consumption tax is to be disfavored on this score, but we shall see later that this is not so.[44]


The traditional view of tax opposes income to consumption taxation. A better understanding of tax shows that, under progressive rates, three distinct forms emerge: income, prepaid consumption, and postpaid consumption, each with unique positive and normative properties. This Part has two related goals. One, it canvasses some of the intellectual history of tax, to better understand where the traditional view came from and why certain misunderstandings persist. Two, it begins translating the new, better understanding of the analytic facts of tax into a normative argument structure; it helps lay the foundations for moving from an is to an ought, setting the stage for the new understanding of tax.

A. Means and Ends

A proper normative argument structure for tax — or any other practical political matter — ought to begin with a clear statement of the goals to be pursued, setting the ends, at least provisionally, first.[45]

We can note at the start that the form of tax, per se, is not plausibly such an end: few ordinary persons have strong preferences for income versusconsumption versus any other particular type of tax, apart from the effects of such taxes. It is these effects, of course, that matter.

On reflection, the principal end of broad-based, comprehensive tax systems is to finance the provision of public goods, the central activity of the moderndemocratic state, including, possibly, the distribution or redistribution of income itself, in a fair and efficient manner.[46] Fairness and efficiency are two broad, compelling ends for tax. For the most part, this Article sets aside efficiency concerns;[47] the new understanding of tax is based on the idea thatthere are three distinct types of comprehensive tax systems, with different claims to fairness most specifically because of how they affect capital as wellas labor market returns.

On further reflection, fairness is central to tax and not just, or primarily, because of a welfarist argument that efficiency should be the principal norm oflegal rules, while fairness should be left to the tax and transfer system.[48] Rather the reason to have a tax system, especially an individuated taxsystem, is to finance the needs of the state in a fair and just manner. A printing press — or any of a number of far simpler taxing systems than what wehave today — could raise the finances needed for public goods. In moving to individuated tax systems such as the broad-based income tax or any of itsusual competitors, society must desire individuated justice.

On still further reflection, this individuated sense of justice must stem from a desire for some differentiation or progression in the allocation of taxburdens; from some sense that the better able or more fortunate should pay more than the less able or less fortunate[49] “Genuinely progressive taxationis necessarily personal taxation,” as Vickrey began his classic 1947 Agenda for Progressive Taxation.[50] We can add that the converse is alsocompelling: Personal taxation ought to be progressive, or at least somehow individuated, based on ability to pay or benefits received or some suchprinciple. In this regard it is worth noting that no major policy proposal in the United States at least has been for a genuinely flat tax — all so-called flattaxes feature “zero brackets,” or other accommodations for family size, and so on.[51]

Indeed, a persuasive case can be made out under both liberal egalitarian political theories, such as those of John Rawls, and utilitarian or welfaristconceptions of justice that, at least given fair and efficient markets, the tax system is the best or even the only place to redistribute material resources(or, perhaps better put, to set the fair initial distribution of such resources).[52]

Thus all roads lead to some individuation in tax, which means some progression.[53] This is a compelling end for tax. But questions follow: On what grounds should we determine each individual’s fair share of the tax burden? In the classic language of tax policy, we look to levy taxes on individualsbased on the benefits they receive from the state, their ability to pay, or both[54] We can, with Adam Smith, elide the two principles and finesse thesemantics. But in any event, the new understanding of tax turns on the insight that this question of what to tax is vitally connected to the question ofwhen to tax. Having accepted progressivity as an end, we should ask when, in an individual’s flow of funds, is it fair and appropriate to levy progressivetax rates? In other words, when should we make the social judgments necessary to and inherent in a system of individuated progressive taxation?

In short, progressivity in tax burdens is an end, whereas any particular tax system for achieving progressivity is a means. Our commitment to the incometax is not foundational. It depends on the tax as being the best means to the ends we hold. We ought to reverse the intellectual process, to ask what taxis the best means to the end of fairness and justice.

B. The Traditional Logic of Tax

The political and intellectual history of tax have both influenced and, in turn, been influenced by, the way we have come to think about tax policy. Thisbidirectionality in reasoning helps to explain how the traditional view of tax arose and why it persists.[55] This section takes a look at the usual way ofthinking about tax, in a historical context.

Who? What? When? How much? are the questions that lie at the foundation of all practical tax systems. Each must be answered sooner or later, actively or by default, to get a tax system in place. How we answer these questions — and, further, in what order we answer them matters a great deal. The newunderstanding of tax changes the order of the questions.

It is logical enough to begin with the what question: the appropriate tax base. Whether we use ability to pay, benefits received, or both, we want to knowon what basis to levy our social judgment. Hence, much of the intellectual history of tax has been consumed with asking just this question.[56] This hasmeant, when it comes to broad- based, comprehensive tax systems, the celebrated income-versus- consumption debate at the core of the traditionalunderstanding of tax. There are important roots of this debate in the writings of Hobbes and Smith, both of whom came down on the side of consumptiontaxes, for rather different reasons.[57] Then came Mill and his analytic critique of the income tax as a double tax on savings, and the seeminglyconcomitant argument for a proportionate consumption tax. This argument has been enormously influential within the domain of political theory proper:Rawls has accepted the argument for consumption taxation (indeed, proportionate consumption taxation), at least in ideal theory, citing to NicholasKaldor,[58] and the “ultra liberal” thinker Roberto Unger has also recently endorsed consumption taxation as well.[59]

Practical politics, however, have come down decisively on the other side of the great divide. Having experimented with income taxation in the nineteenthcentury, America made a firm commitment by ratifying the Sixteenth Amendment in 1913 and implementing a statute within months, all motivated, atleast in large part, by a progressive desire to get at the fruits of capital.[60] Policymakers at the time rejected a wide range of consumption taxalternatives, in part because of the fact that consumption typically forms a higher percent of disposable income for the lower- and middle-income classesthan it does for the upper-income class — in other words, because the rich save more.[61] This led to a “base argument” for income taxation,[62] whichpredominated early on in the public political thinking about tax, and lingers to this day. The income base seems to be a means to the ends of tax justice.

The how much question has been a distant second — in terms of quantities of ink expended — to the what question, although much important recentwork has been done on point. The reasons for the historical neglect are not hard to come by: significantly high tax rates are a distinctly modern creature,not present until the twentieth century and not widespread until the latter half of that century. Smith and Mill discussed taxes in the range of 5 to 10percent.[63] The initial “progressive” income tax of 1913 had featured a top marginal rate, including a surcharge, of 7 percent, and it had applied to farless than 5 percent of all adult Americans.[64] It was thus the very existence of an income tax — supplemented by a corporate income tax and, later, in1916, by an estate tax — with its deliberate inclusion of dividends and interest, that furthered the progressive cause, providing the means to the end.

Things changed.

World War I radically altered the rate schedule, ratcheting it up, and World War II transformed the breadth of the tax’s application, expanding itenormously once the practical expedient of wage withholding was discovered.[65] The top marginal rate bracket under the income tax rose to above 90percent during World War II, and stayed at 90 percent throughout the 1950s, until John F. Kennedy cut it to 70 percent in 1963. These high tax rates nowadded to the base as means to the ends of justice in tax. But, meantime, the dramatic expansions in scale and scope triggered the perceived need forsome previously scarce thought, reflection, and justification: Why did we have such steep progressivity in tax rates?

Walter Blum and Harry Kalven, writing in full view of extremely high nominal rates, set the tone for postwar scholarship by sounding a skeptical note,sketching out the “uneasy case” for progressivity.[66]

Later, the case was made to seem far less uneasy by the economic analysis of optimum income taxation most famously made out by the Nobel LaureateJames Mirrlees, and subsequently brought into a wide tax scholarly readership by Joseph Bankman and Thomas Griffith — the latter pair writing afterRonald Reagan, America’s second great income-tax-cutting President, had slashed the top marginal rate all the way down to 28 percent.[67] Mirrlees,Bankman and Griffith, and the wider welfarist or utilitarian turn in law-and-economics theory lent a strong hand to the arguments for progressivity in tax.Given any form of diminishing marginal utility of wealth, social welfare could improve, under specified conditions, by taking proportionately more fromthose who have proportionately more material resources.[68] Further, the theory of optimal income tax gave prescriptive advice for how to effectuateprogressivity in tax, without relying excessively — and perhaps counterproductively — on steep marginal tax rates.[69] Such rates are only a means to theend of redistribution.[70] The optimal income tax movement attempted to reground analysis of the tax rate structure in the compelling framework of ends,equity and efficiency.

What is most important at this stage of the story is that the rate questions historically followed the base ones. Because high rates and a broadened basearose in the shadows of the actual income tax, which itself had followed from a simple conception of the income-versus- consumption debate, thetraditional view of tax infused the understanding of the effects of tax rates. Since it was by now assumed that a consumption tax base was moreinherently regressive than an income tax base — the base argument — a “rate argument” seemed to follow naturally enough.[71] If consumption taxesare regressive, a progressive consumption tax must be doubly so. More sophisticated scholars fell into a subtler trap. If the reason for a consumption taxwas to exempt the yield to capital, as the traditional conception of the income-versus-consumption debate would have it be, then the rate structure of anyconsumption tax was constrained. And so a rate argument joined with the base argument to favor an income tax in the service of progressivity or liberalegalitarianism.

The what and how much questions, asked in that order, have dominated discussions of tax policy, inside and outside the academy. The relative neglect ofthe who question has been unfortunate, for deep issues of justice lie buried in both the seemingly arcane questions of attribution, that is, of theappropriate taxable unit, and of the equally arcane questions of incidence, that is, of who really, ultimately, bears the burden of various alternative taxes.[72] If the central aim of tax as an instrument of social justice is to get citizens to share in the burdens of their society in proportion to something — their ability to pay, their benefits received, or some combination thereof — it matters critically who is in fact bearing the burden of any particular tax.

This then leaves the when question. It is hardly the case that matters of time and tax have been understudied.[73] But the questions of time have beenframed by the seemingly prior and foundational what, or tax base, question. There have been two large and persistent themes.

First, principles of timing have been used to help inform the fundamental tax base debate, that is, to illustrate the difference between income andconsumption taxes. Under the traditional view, timing principles have been used to show the equivalence of prepaid and postpaid consumption taxes inpresent value terms, and the differences between an income and any consumption tax.[74] There are only differences over time, after all — savings,which is analytically identical to nonconsumption, only exists in what an economist would call a “two period model.”[75] The initial mapping between anincome tax as a double tax on savings, on the one hand, and both forms of consumption tax as involving no effective taxation of the yield to savings, onthe other, was made out in simple, partial-equilibrium models. Since then, more sophisticated financial analysis has suggested that some but not all ofthe yield to capital is taxed under a postpaid, but not a prepaid, consumption tax — the “supranormal” or “inframarginal” returns, in some specifications,the return to risk, in others.[76]

Second, principles of timing have been brought into play in the context of what is wrong with the “income” tax: how its failure to currently tax all of the yield to capital leaves it short of its animating ideal, and how to cure this defect.[77] Tax policy scholars have analyzed how and when to tax capitalappreciation — or “ordinary” appreciation masquerading as “capital” appreciation — so as to effectuate a practicable income tax. Some scholars, forexample, have considered a form of “taxation on realization,” or “retrospective capital gains,” to make up for the deferral of taxes created by an income-with-realization-requirement tax;[78] others have explored questions of “original issue discount” and similar mechanisms for disguising the ordinary return to savings as capital appreciation.[79] All these technical questions have been framed by the income-versus- consumption debate: they arise out ofan attempt to ensure that the “income” tax is, in fact, an income tax.

These timing matters are important questions, to be sure. The tax- policy literature has generated valuable insights into matters of tax- policy design byasking them. But they are not the central questions of the fair timing of tax. A different question waits to be asked, one that promises new and pressinglypractical insights into matters of tax- policy design. Asking it lies at the core of the new understanding of tax. The new timing question sounds in acommonsensical morality, and follows from the first commitment of the tax system, to having at least moderately progressive rates:

When, in a taxpayer’s flow of funds, is it fair and appropriate to levy progressive taxes?

This is an altogether different question from traditional ones of timing, and the answers it leads to — the ways it leads us to think about tax — arefundamentally different as well. The new understanding of tax follows a different logic than the traditional view. It begins with a commitment toprogressivity and moves out to questions of timing. I explore this later. But first let us dwell a bit longer in the intellectual history of tax, to betterunderstand where we are, and how we got here.

C. The Modern Income-Versus-Consumption Debate

The contemporary origins of the income versus consumption tax debate, which has raged for centuries, lie in the works of two Harvard law professors,William Andrews and Alvin Warren, beginning in the 1970s. This debate repays a close and careful visit.

1. The Case for Consumption

The Haig-Simons definition (I = C + S), and its manipulation to show the essential structure of a consumption tax (C = I – S), was central to two importantarticles by Andrews, each published in the

Harvard Law Review in the early 1970s. In the first, published in 1972, Andrews used the relationship to suggest that while source neutrality, or the ideathat the type of inflow should not matter to judgments about tax, was a compelling norm, use neutrality was far less obviously so.[80] Features of the“income” tax, such as deductions for extraordinary medical expenses[81] or charitable contributions,[82] could be understood as appropriate normative refinements of the right-hand side of the Haig-Simons identity. In other words, not all “consumption” ought to count equally, at least in accordance with well-settled practices in tax. This is an important insight, and one that should be extended to differentiating between the uses of savings as well as theuses of consumption:[83] that is a principal aim of this Article and the new understanding of tax.

Andrews’s second article, published in 1974, profoundly changed the course of tax scholarship and policy.[84] Again looking to the right- hand side of theHaig-Simons definition, Andrews generalized an important real-world observation: what we call an “income tax” does a very poor job of getting at savingsor, in Simons’ words, “the change in value of the store of property rights between the beginning and end of the period in question.”[85] Andrews arguedthat we ought to systematically give up the attempt to tax the yield to capital, subtracting savings from income to generate a postpaid consumption tax,on the model of Equation [2], above.

Andrews’s article rekindled the income versus consumption debate, which had its roots in Hobbes, Smith, and Mill. Andrews drew especially on NicholasKaldor’s important and more recent work on consumption or expenditure taxation.86 In the event, Andrews’s article opened a floodgate forreconsideration of the case for adopting a consumption tax. Blueprints for Basic Tax Reform, an influential Treasury Department study, largely authoredby the public finance economist David Bradford (who later collaborated with Andrews), sketched out two routes for tax: perfecting the nominal incometax, and adopting a progressive postpaid consumption tax, a la Andrews’s 1974 article.[87] By the mid-1990s, the latter idea had ripened into a full- scale legislative proposal, the Nunn-Domenici USA (for “unlimited savings allowance”) Tax, which made it to the House floor in 1995.[88]

For all its power and influence, however, the reformulated Haig- Simons definition of “consumption” taxation has led to an analytic confusion. It is truethat a postpaid consumption tax does not tax the act of savings, or the use of available resources to save. But a progressive postpaid consumption taxcan, and — this Article argues ought to, under the appropriate circumstances, tax the yield to capital as the source of present consumption. It is all amatter of the fair timing of tax. This was an insight that Andrews himself made, in passing, in his 1975 reply to Alvin Warren’s critique of his 1974 article.[89] But by then, perhaps, it was too late. As with the Haig- Simons definition, the analytics had morphed into a norm: an is had become an ought.[90]


Andrews, like Mill in the prior century, had grounded the case for consumption taxation on the principled basis that the yield to capital should not betaxed. He had chosen a postpaid as opposed to a prepaid tax model partly on the grounds of administrative concerns: Blueprints for Basic Tax Reform,like Andrews, was content to change over to a prepaid consumption tax model when it was more convenient to do so.[91] As Andrews put his “mostsophisticated argument” for consumption taxation in his 1974 article:

[T]he lesser burden of a deferred tax is more appropriate because it ultimately imposes a more uniform burden on consumption, whenever it may occur,than does an accretion-type tax. . . . Neutrality with respect to consumption is important not only because it promotes efficiency in the allocation ofincome, but because it keeps the tax from bearing more heavily on one person than another on account of differences in need or taste for particular goodsor services, now or in the future.[92]

There is no denying the sophistication of this argument, or of Andrews’s elegant formulation of it. Ultimately, it is its rightness — its claims to beingfoundational to the argument for consumption taxation — that is in question.[93] Under the new understanding of tax, Andrews’s most sophisticatedargument becomes, quite simply, the wrong reason (the principled nontaxation of the yield to capital) for the right tax (the postpaid consumption tax);advancing this argument has had a harmful influence on the development of tax policy.

2. The Income Empire Strikes Back

There is also no denying Mill’s facts of the matter. An income tax falls twice on wealth that is saved; a consumption tax falls once, as the equations set out above have shown. But there is, of course, much room to argue about the normative consequences of this analytic fact: Is Mill’s second tax a good ora bad thing?

Alvin Warren answered Andrews’s 1974 article arguing for a postpaid consumption tax in a tremendously influential fashion. Warren’s first response wasa brief comment, in 1975, later expanded in a 1980 article.[94] A major part of Warren’s effort was to turn Mill on his head. Yes, an income tax imposes asecond tax on savings, Warren conceded, but that was a good thing: the yield to capital was an additional increment to wealth that differentiated itsrecipients from those who did not get it. Andrews had made a “horizontal equity” argument in defense of the postpaid consumption tax, arguing that the“most sophisticated” argument for a consumption tax was to preserve the pretax equality of savers and spenders.[95] This argument was to get Andrews— and the case for consumption taxation generally — in significant trouble. Warren rightly pointed out that its logic led to a case for flat, or nearly flat,rates.[96] For under progressive or variable tax rates, as a descriptive, analytic matter, the equivalence of the prepaid and postpaid consumption taxmodels can be destroyed, and the yield to capital can bear some tax.

Warren responded to Andrews by primarily making a vertical equity argument to counter Andrews’s horizontal equity (“most sophisticated”) argument.Warren also importantly shifted the analysis from the ex ante equality of present and deferred consumers (spenders and savers, like Ant andGrasshopper) to ex post outcomes.[97] The saver has more than the spender in the second time period, after all; it is thus fair and appropriate to tax hermore. This was an argument whose roots could be found in the writings of prominent public finance economists.[98] More important, it resonated withpopular sentiment and with the very reason for the income tax in the first place. Only wealthy persons have the capital to generate any significant yield atall. The vast masses of people living from paycheck to paycheck are hard pressed to understand an argument of ex ante equality suggesting that this yieldshould escape tax altogether when it comes to their distant, and rich, fellow citizens. Ordinary citizens are even less likely to understand or acceptarguments that the stream of value had already been taxed (as Mill would have it) or that the lingering psychic benefits of present consumption — the memory of things past — were not being taxed, so they had no real complaint vis- à-vis the savers even if the yield to capital was tax-exempt.[99] Insiding with popular morality and common sense, Warren was invoking what the new understanding of tax calls the yield-to-capital norm.

Meanwhile, Andrews’s argument for horizontal equity haunted the consumption tax crowd, although Andrews tried, tentatively, to back off from it in his1975 reply to Warren’s critique.[100] Warren’s argument for vertical equity was more powerful than Andrews’s horizontal equity defense of consumptiontaxation, suggesting that attitudes towards progressivity and the redistributive force of tax drive conceptions of “fairness” more than the always trickysemantic or rhetorical comparisons of putative equals.[101] The new understanding of tax involves putting the commitment to progressivity front andcenter: the central end of any broad-based tax is to effect some redistribution of material resources. While the case for a postpaid consumption tax hasan element of horizontal equity within it, as seen by the Ant-

Grasshopper example, as we shall see, even that element of horizontal equity is better understood as specifying the appropriate basis of comparison forthe more fundamental vertical equity judgments.

3. Why It Matters

In the intellectual back-and-forth over the income-versus- consumption debate, something important had been lost. Andrews had begun his 1974 articlewith a critique of the current “income” tax as not getting at the yield to capital at all: most of the article is concerned with a careful, critical analysis ofthe status quo in tax, with the claims for the “fairness” of a postpaid consumption tax more or less tacked on at the end. Warren had counterpunchedwith an attack on Andrews’s “most sophisticated argument” — an ideal argument for a consumption tax based on the principled nontaxation of the yieldto capital. This left open the intriguing possibility that Andrews was right, but for the wrong reason — he was actually right for Warren’s reason. Inpractice, a consumption tax, of the right sort, is the best real-world tax precisely because it does, and the actual income tax does not, get at the yield tocapital. Part V, below, extends Andrews’s critique of the so-called income tax to illustrate how the tax has become a specifically prepaid consumptionone. In theory, the ideal income tax “double taxes” all savings, whereas a postpaid consumption tax burdens some but not all savings, and in just theright cases —where capital and its yield are elevating lifestyles (a vertical equity norm), and not where capital and its yield are compensating for arbitrarily uneven labor market earnings (a horizontal equity norm). A consumption tax of the right sort best upholds the principles of source neutrality andvertical equity, all while making a better use of the ordinary moral intuitions about horizontal equities in comprehensive tax system design.

By resting the case for consumption tax on the preservation of the pretax equality of saver and spender —a horizontal equity argument Mill and Andrewswere inclining the tax system towards flat rates. In order to preserve this pretax equality, a postpaid consumption tax must work like a yield-exempt orprepaid one: t1 must equal t2 in Equation [7], above. The new understanding of tax turns on what happens when t1 does not equal t2, by design. At acrucial minimum, the argument structure for tax changes. Prepaid and postpaid consumption taxes are no longer automatically equivalent. Only theprepaid model features yield exemption by design. Postpaid consumption taxes sometimes burden the yield to capital, at other times do not. The case forchoosing a progressive postpaid consumption tax must therefore rest on arguments different from Mill’s “double tax” point or Andrews’s “mostsophisticated argument,” or, for that matter, arguments about the appropriate levels of individual or aggregate social savings. Indeed, they do.

The result of the intellectual history of tax has been, from a public policy point of view, unfortunate. Both canonical forms of consumption tax have beenlinked, viewed as broad equivalents, and tethered to both flat tax rates and the principled argument for the total nontaxation of the yield to capital. Thecase for consumption taxation has suffered on the altar of our prior commitment to progressivity. In the traditional view, the progressive income tax stands alone against the barbarian, nonredistributive flat consumption taxes at the gates, and doubly so: both because the income tax featuresprogressive rates, whereas there is a (wrongheaded) tendency to pair flat rates with consumption taxes (the rate argument), and because consumptiontaxes are assumed to exempt all or most of the yield to capital on purpose (the base argument). This has put liberals and progressives in the intellectuallyand politically untenable position of defending a highly flawed, highly unpopular status quo in tax, against any and all structural reform. Yet, ironically,once we accept progressivity in the rate structure as the first commitment of a comprehensive tax system, the very equivalence of yield-exempt andpostpaid consumption taxes no longer holds. Our eyes can open: the case for consumption taxation need not be about the importance of capital in thesmall or large at all.

A final and related point: In the grip of both the income-versus- consumption debate and Andrews’s (and many others’) horizontal equity argument forconsumption taxation, the analysis of the yield to savings has been source driven. The literature at least implicitly looks to the left side of the Haig-Simons equation, Equation [1], and asks from whence a particular return to savings came. Was the return to capital merely compensation for inflation, thereal riskless rate of return, compensation for risk, a windfall, or yet something else? These are questions and classifications based on the nature of theinput. The new understanding of tax firmly shifts the analysis — as Andrews generally had begun to do, in both his 1972 and 1974 articles — to the uses,or right-hand, side of the Haig-Simons identity. A postpaid consumption tax consistently finesses questions of where, exactly, the funds for privatepreclusive use or (equivalently) consumption come from: it is source neutral in this important sense. What matters — and all that matters — is how thereturns are used, or what level of lifestyle they finance.[102] The focus is on outputs.

D. Two Political Takes

Theory and intellectual history matter. Today’s political world follows the academy’s lead on the understanding of tax. Crudely, most tax politics havecome down to a battle of liberals versus conservatives, with the vast moderate middle holding the all-important swing vote. Liberals support a progressiveincome tax. They are very much concerned with the base, or what, and the rate, or how much, parts of tax policy design, following the logic of tax set outabove. A good deal of liberal energy has been exerted arguing for an income base, as well as for other taxes on wealth and capital — such as a separatewealth transfer or gift and estate tax; a corporate income tax; and, sometimes, a direct tax on wealth[103] — in order to get at capital or its yield. Liberalsof various stripes have also advocated progressive rates, to further advance the cause of redistribution.

Conservatives, meanwhile, have taken to arguing for flat consumption taxes.[104 ] Flat consumption taxes of various types are, indeed, broadly equivalentin their economic effects: all work to exempt from taxes all or most of the yield to capital under plausible assumptions. The choice between wage taxes,sales taxes, value-added taxes, and flat “income” taxes that exempt all capital gains, interest, and dividends comes down to, in good faith, matters ofadministration and, in less good faith, whatever the public will buy.[105]

An important practical fact of the matter is that conservatives — after scoring important victories in the 1980s, under Ronald Reagan, to bring progressivemarginal rates down — rather decisively lost the battle to go all the way to a flat-rate system, in both politics and the academy.106 While severalcandidates for the Republican presidential nomination, most prominently Steve Forbes and Jack Kemp, have championed the idea, none have been able totranslate its initial popularity into any enduring appeal. Indeed, Kemp had to back off from the idea when he became a vice-presidential candidate underBob Dole, who, like George W. Bush, was to advocate an across-the- board rate cut on income taxes that would lessen, but significantly not eliminate,progressivity in the tax. Later, when then President George W. Bush created a bipartisan panel to study tax reform and present a report of policy optionsto the Secretary of the Treasury, he included among several charges that the panel proffer only plans that offered to tax in “an appropriately progressivemanner.”[107] Meanwhile, inside the academy, critics of “flat” have scored decisive intellectual victories, virtually unopposed by reasoned argument on the other side.[108 ] The idea of progressivity in tax burdens would appear to be here to stay.

Still, this popular center may not hold. Incremental reform within the so-called income tax, by moving the tax system towards a prepaid consumption taxmodel, has also been flattening tax rates, and tying the hands of future generations that might want to restore more meaningful rate progression.[109]

How can this be — that progressivity is desired and disappearing at one and the same time? The answer to the apparent paradox lies in the choice of taxbase. Although the base and rate structures are logically, analytically distinct matters,[110 ] they are, of course, politically and economically connected.This is so, not simply in the sense that Stanley Surrey was fond of pointing out, namely, that any shrinkage to the tax base, ceteris paribus, has to lead toan increase in tax rates.[111]

On a deeper, more fundamental level — at the stage of initial tax system design — the nature of the tax base shapes and constrains the practical politicalpossibilities for progression in the rate structure. Taxes on wages are especially constrained because high tax rates, especially high marginal tax rates,deter the socially important and morally unobjectionable activity of working. In the new understanding of tax — contrary to the traditional opposition ofincome and consumption taxes — income and prepaid consumption taxes stand on one side of a divide, as taxes on inflows, which means, principally, taxing labor market earnings.[112] Postpaid consumption taxes stand on the other side of the divide, as taxes on outflows. It is far easier, and better, inboth theory and in practice, to predicate progressivity on outflows rather than on inflows. High marginal tax rates on spending deter only high-endspending, but this pattern of disincentives can be good for a liberal society.[113] Today, the principal challenge to progressivity comes not from themovement away from the income tax which, as we shall see, has been too long in coming to question seriously now, even if one wanted to — but ratherfrom the movement to the wrong kind of consumption tax base. Conservatives have shifted their attention to this critical battlefield, and are diligentlyworking to create a prepaid — and, not coincidentally, a relatively flat — consumption tax.

Liberals, for their part, have failed to think through the ramifications of their victory on the how much front. They continue to fight for an income tax andits traditional adjutants, the gift and estate, and corporate income taxes. In all this, liberals have been ill-served by the traditional understanding of tax. Itturns out that there is more than one way to skin the capitalist cat. In theory, given progressive rates, an income tax, per se, is no longer needed to get atthe yield to capital. Further, in practice, the actual income tax is not even good at doing the very thing that liberals insist on retaining it to do — namely,getting at the yield to capital — and it is highly unlikely ever to improve in that regard. There are deep, structural reasons for this failure, sounding notjust, or even primarily, in practical or administrative concerns — though these are profound — but far more so in normative reasons. To wit, most liberalsdo not want to perfect the income tax, for they do not want to get at the yield to capital in all instances: tax-favored savings plans have been as much, ifnot more, a feature of Democratic, rather than Republican, tax policy for many decades.[114] Advocates of redistributive taxes must wake up and realizethat their end is in jeopardy on account of their poor choice of means: they are fighting, and losing, the wrong war.

E. Three Neutralities

The three forms of taxation — income, prepaid and postpaid consumption taxes — do not map up as traditional tax theory would have them do underprogressive tax rates. Each tax is unique. Each tax corresponds with a particular instantiation of a “neutrality” norm, and it is worth considering thesenorms. First, however, we need to ask why we should care about neutrality at all.

1. Why Even Care About Neutrality?

Neutrality — of the right sort — is an attractive feature of tax-law design. Neutrality is an important element of fairness to political philosophers such asRawls, even though all thoughtful theorists are now aware that social institutions inevitably have disparate impacts on differing conceptions of the good.[115] Rawls reconciled this apparent dilemma by insisting, with others, on “justificatory neutrality” — the idea that social institutions must be justified byappeal to reasons not sounding in the advancement of any particular comprehensive doctrine.[116] Neutrality, in such a sense, is a constitutive elementof the fairness and legitimacy of state action.

Tax policy typically invokes neutrality in a specifically economic sense. Economic efficiency is obtained when tax systems are neutral relative to ahypothetical no-tax world.[117] This means that taxes do not distort the relative prices that emerge from such a no-tax state; it is those prices thatoperate to make for a competitive general equilibrium achieving first-best, Pareto-optimal, aggregate social welfare.[118] As long as any tax equallyimpacts all pretax prices, there is no relative change in prices, and hence no distortion in the allocation of resources, which is the exclusive concern ofeconomic efficiency.

An attempt to obtain neutrality in this sense is suggested by Andrews’s “most sophisticated” argument for consumption taxation, for the preservation ofthe pretax equality of savers and spenders. A consumption tax of any form — under the critical assumptions that the tax rate, t, and the rate of return, r,remain constant — preserves the pretax equality of future and present values, and hence is “neutral” in regard to the decision to save or spend. Theincome tax double taxes savings and thus hurts savers vis-à-vis spenders, both within the income tax regime and relative to a hypothetical no-tax world.

This is true so far as it goes. But there are serious challenges in moving from the is generated from these analytic facts to any compelling ought. Onesuch challenge derives from the simple economic fact that all real-world taxes have distorting effects.[119]

Avoiding a distortion to the saving-spending decision runs the risk of skewing the work-leisure tradeoff, for example, as Warren and others pointed out inresponse to Andrews. Any move from an ideal income tax to an ideal consumption tax would require raising tax rates to keep revenues constant, on account of the principled omission of an element of the tax base, the yield to capital, increasing the tax’s distortions.[120] Tax, because of its incentiveeffects and the limited information of government policymakers — not to mention administrative concerns[121] — is in a deeply “second-best” situation. There is simply no a priori way to say that welfare would improve, ceteris paribus, by moving from an ideal income tax to a consumption tax.

What to do? The general problem of maximizing social welfare or economic efficiency in tax is best solved by the highly intricate, sometimescounterintuitive, optimal tax literature, begun by Frank Ramsey in 1927 and importantly extended to income taxation by the Nobel Laureate JamesMirrlees in 1971.[122] This literature — and this literature alone — points the way towards a thoroughly welfarist conception of tax. Under such aconception, the question of the appropriate timing of tax — as of the appropriate tax base, the appropriate rate structure, and so on — is a technical onefor the experts. There is no a priori reason to favor the neutrality of any one tax over the neutrality of another, on economic grounds.

But adding to the difficulties with Mill’s and Andrews’s particular “neutral” argument for a consumption tax, and complicating the economics-based firstobjection, neutrality, as a construct of fairness, is a different matter from the narrowly economic welfarist perspective. There are two large reasons forthis. First, judgments of fairness need not take the pretax status quo as normatively appropriate, although the standard economics or welfarist account,with its Paretian constraint, typically (though not universally or necessarily) does.[123]

Second, and more important, the “optimal” welfare-maximizing tax answer may clash with ordinary moral intuitions and reflective normativecommitments. A quick example helps to illustrate this latter point. The core insight of the Ramsey optimal tax literature is the “inverse elasticity” rule.The government should tax goods in inverse proportion to their price-elasticities. The economic intuition for the rule is straightforward: The demand for goods that are inelastically desired is less distorted by a tax, and hence pretax prices are less affected by that tax.[124] In terms of “neutrality,” Ramseytaxation aims for equal and minimal distortion in the pretax, competitive general- equilibrium allocation of resources. Applying the Ramsey rule to thecase of income or labor taxes, as Mirrlees did in 1971, the principle becomes that we should tax inelastic suppliers of labor more than elastic ones. This isone among several reasons to consider more tax breaks for working married women, who tend to be more elastic suppliers of paid-market labor, thantheir husbands.[125] But such is a case where the precepts of fairness and efficiency happen to converge (making it all the more puzzling that real-worldtax policy has gone in the opposite direction).[126] Convergence will not always be obtained so felicitously, however, so that we cannot avoid a morefinely tuned moral reasoning in tax — we cannot turn the tax system over to a computer responding to elasticity data alone.[127] The theory of optimalincome tax suggests, for example, isolating persons with especially high work ethics, such as recent immigrants or, perhaps, members of certain culturalgroups placing a high value on work. Ordinary moral intuition — supported by liberal and social-contractarian political theory — should revile the thought.

The analysis shows that “neutrality” is not itself a trump, but rather a claim to be investigated empirically, and a call, but not necessarily a decisive call,on our reflective normative judgments. With these thoughts as background, another large and disturbing feature of the landscape emerges: allcomprehensive tax systems have a claim to “neutrality” of some sort. Any consistently applied tax system is neutral in regards to its intended base. A taxon apples, after all, would (or should) tax all apples. A tax that fell only on MacIntosh or Golden Delicious apples would violate this neutrality norm — unless it could be recast as a normatively appropriate tax on MacIntosh or Golden Delicious apples alone, and so on. We cannot avoid considering theneutrality of each of the three principal taxes under consideration.

2. Three Taxes, Three Neutralities

The neutrality of an ideal income tax is familiar: It falls on all inflows, whatever the source. Broadly speaking, the sources of present or futureconsumption (consumption plus savings) are the returns to labor or capital, whether one’s own or another’s. Thus, gifts are certainly “income” in a Haig-Simons sense: they are resources available for consumption or savings.[128] Add in windfalls, or manna — found value — and the ideal income tax baseis more or less complete.

Any resources available for a taxpayer’s personal use, whether they are presently consumed or saved, are taxed at the moment of inflow. Labor and capital market returns, and beneficent transfers, are the three primary sources of wealth. An ideal income tax would attach to all three.

This is a general norm of source neutrality. But, it is also — a point far less noted in the traditional tax-policy literature — one of use neutrality. Sincesources equal uses (Equation [1a]), taxing all sources means taxing all uses. While Mill and Andrews each point out that an ideal income tax is notneutral relative to savers and spenders, that observation arises only in a dynamic, or two-period, model. An income tax is use neutral in a static, or one-period model: It simply does not matter, in the Haig-Simons definition, what one does with her available resources, any more than it matters from whencethese resources came — you need not tell the government what you do with your income under an ideal income tax.[129] But as Andrews pointed out inhis 1972 article, it is far from clear that we ought to have use neutrality in taxation: medical expenditures and charitable contributions may not strike us,for example, in reflective equilibrium, as the kind of uses we ought to be taxing.[130] So, too, not all uses of capital transactions are created equal. Whilethe income tax is use neutral in a one-period setting, it is not neutral in a multiperiod one: Savers are “double taxed,” whereas present spenders need notpay taxes again on any lingering psychic yield from their pleasures past.[131]

Prepaid consumption or wage taxes apply to all of one’s own labor earnings, period. The yield to savings is never taxed, in the spirit of Mill’s anti-double-tax argument. Nor are other people’s capital, windfalls, or manna, taxed: All value must trace back to someone’s labor earnings, at some point in time,when (and only when) it was taxed. A prepaid consumption tax puts pressure on sorting out the labor-capital (as well as the labor-beneficent) distinction,which can get tricky in hard cases. But it, too, is neutral, in theory, relative to its intended base: All and only labor earnings get taxed.

A prepaid consumption tax is not, therefore, source neutral; it ignores all sources other than own labor market earnings. But a prepaid consumption tax iseven more use neutral than an income tax because it is dynamically as well as statically use neutral, thus avoiding Mill’s and Andrews’s criticism of the income tax. It simply and consistently never matters what one does with her resources under a prepaid consumption tax, whether within a one- or a multi-period model. Even under variable and progressive effective or marginal tax rates, a prepaid consumption tax is “neutral” as between savers andspenders — Andrews’s most sophisticated argument again — because of its consistent yield exemption. It preserves the pretax equality of present anddeferred consumers, ex ante to the actual distribution of capital market returns for savers.

Progressive rates do, however, change things dramatically. Under progressive rates, neither the prepaid consumption nor the income tax is neutral as tothe time path of labor market earnings, at least absent some averaging provision.[132] Taxpayers who earn their wages — or, under the income tax,receive any inflow — in relatively small, concentrated bunches will be hurt by progressive tax rates, vis-à-vis lower but steadier earners.[133] Artists,athletes, doctors, lawyers, and others with skills of limited temporal duration or high human capital requirements, and people who are dependent onwhimsical consumer demand or other markets, will suffer on account of the interrelation between their patterns of labor market realizations andprogressive marginal rates.[134] Most generally, any gap between inflows and outflows in constant real terms will increase one’s average annualeffective tax rate. This becomes a central theme in the new understanding of tax.

Finally, postpaid consumption taxes are neutral, too, and in a morally significant regard: They are neutral relative to the source of funds for financingpresent consumption. Since all that matters is the use — the fact of spending, or of “private preclusive use” as Andrews called it — postpaid consumptiontaxes are not use neutral, statically or dynamically, under progressive rates. They are not statically use neutral because savings are not taxed at all in the period of savings. They are not dynamically use neutral once we have relaxed the assumption of constant tax rates, by design. Some acts of savings will result in higher tax burdens than if they had not been engaged in; others will lower the burden of taxation. But in giving up use neutrality, postpaidconsumption taxes find genuine source neutrality. Whether consumption is funded by labor or capital market returns, or by beneficent transfers, it istaxed at the same rates as all other consumption at the same level.[135]

Postpaid consumption taxes, in contrast to the two other comprehensive taxes, are indeed neutral as to the time path of labor (or capital) marketearnings. It does not matter when a taxpayer earns or receives her lifetime resources; it matters only when she spends them. Thus, the person who earnsa high salary over a short period of time — like the well-educated but highly worked lawyer — is not burdened vis-à-vis the slow but steady earner, givenequal lifetime aggregate earnings and the use of capital market transactions to balance out the books.

In sum, an ideal income tax is both source and use neutral, although the use neutrality wanes in a dynamic setting, leading to Mill’s critique. A prepaidconsumption tax is not source neutral, as it ignores all but one’s own labor earnings — it ignores all capital market earnings and beneficent transfers —but it is use neutral, both statically and dynamically. A postpaid consumption tax is not use neutral, because it differentiates between savings andconsumption, but it is source neutral because it includes all sources of financing present consumption: labor, capital, and beneficence. Adding progressiverates into the mix adds an important dimension to the neutrality analysis. Progressive income taxes are not neutral as to the time path of inflows(earnings) or outflows (consumption); the former on account of the interaction between progressive rates and the base, the latter because of the doubletaxation of savings needed to effect certain patterns of consumption flows. Progressive prepaid consumption taxes are neutral relative to the time path ofoutflows (consumption) but not inflows (earnings). Progressive postpaid consumption taxes reverse this dynamic neutrality: they are neutral as to thetime path of earnings but not of consumption. It does not matter under a progressive postpaid tax when or how one earns or receives her wealth; whatmatters — and all that matters — is when and how she spends it.


The critical step in attaining a new understanding of tax is putting progressivity in the rate structure first, as the foundational commitment of thecomprehensive individual tax system, the primary means to achieve the end of a fair distribution of social resources. Things change once we presumeprogressivity in tax — once we no longer assume that the tax rate will be the same at the moments of first earning and of subsequent use. No longer area prepaid and postpaid consumption tax equivalent, even given constant rates of return and the relatively simple behavioral assumptions of thetraditional view. A tax designer now faces three choices of income, prepaid, and postpaid consumption taxes, each with fundamentally differentproperties.

Under this new understanding, at least part of the “best, most sophisticated argument” for a consumption tax of the right sort is that it is a far better, andfar more consistent, tax, on the yield to capital, under just the conditions in which it is fair and appropriate to tax such yield, than any other broad-basedtax, certainly in practice and almost as certainly in theory. An ideal income tax double taxes all savings, whatever their use. A prepaid consumption tax never taxes savings, whatever their use. A consistent, progressive postpaid consumption tax — a progressive sales or spending tax, in short — burdenscapital when savings and investments are used to enhance lifestyles (one’s own or another’s); but it does not burden capital when savings andinvestments are used to smooth out lifestyles (one’s own or another’s). A close, reflective reading of our tax practices reveals that this is what the actualtax system has been trying to do, but under the ill-fitting guise of maintaining an income tax: The nonideal income tax is at best a mishmash in regards tothe taxation of capital and its yield.[136] Theory and practice happily converge under a consistent, progressive postpaid consumption tax.[137]

This argument structure stands the traditional view on its head: It argues for a consumption tax for the very reason that the traditional view clings to anincome tax — to get at the yield to capital. The argument proceeds on both first-best grounds, namely that an ideal consumption tax is preferable to anideal income tax, as a matter of fairness — specifically in terms of its fairness at getting at the yield to capital — and on pragmatic or second-bestgrounds, namely that the best obtainable real-world tax system is a consumption not an income- based one, again specifically insofar as the taxation of the yield to capital is concerned.

This Part sets out the analytics of the new understanding of tax, anticipating, at the same time, the normative argument for a consistent progressivepostpaid consumption tax.

A. Two Norms

Critical reflection reveals two seemingly conflicting norms about the taxation of savings. In some cases, we desire to get at the yield to capital, contraMill, because we view such yield as the domain of the socially fortunate. Those with more capital have more ability to pay, and more benefits receivedfrom the state, than those without capital. In other cases, pace Mill, we do not want to doubly tax savings, because savings is a normal, even laudable,activity in the course of an ordinary life, and it seems unfair to penalize savers but not consumers, Ants but not Grasshoppers. These two norms,introduced above as the yield to capital and ordinary-savings norms, respectively, are in tension — fatal tension — under an income tax, which iscommitted to double taxing all savings. Neither is met under a prepaid consumption tax, which ignores all savings. But the two norms come into perfectharmony under a progressive postpaid consumption tax, which can be understood precisely as implementing them simultaneously. This is not the only, oreven necessarily the best, reason to favor such a tax, but it furthers the main point at hand: a commitment to progressivity in tax changes the traditionalanalysis of tax policy, especially in regard to the taxation of capital, and most advocates of an income tax should instead prefer a suitably designedconsumption tax for the very reasons leading them presently to think otherwise.

1. A Note on Reflective Equilibrium

This is an argument, and an argument structure, that appeals to our enlightened common sense, one that can result in a reflective equilibrium, in Rawls’shelpful epistemic term.[138] Such an equilibrium occurs when we have gone back and forth between relatively abstract political and moral theorizing, on the one hand, and paying close attention to our actual practices and ordinary moral intuitions, on the other; theory is checked by practice, and vice versa.This style of thinking looks to our actual practices for source material to interpret the way to a better — fairer — set of rules.[139] It is a mode of analysisfamiliar to lawyers and law students reasoning in the domains of common and constitutional law — where practitioners of the method read cases to try todiscern principles within them that they then endeavor to render consistent from a theoretical point of view — but curiously absent from our thinking about tax.[140] Yet precisely the same style of analysis can open up promising avenues for reform obscured by more conventional approaches. Considerthe following abstract and admittedly stylized account of where we are in tax, and how we got here.

Theory, at first, suggested some form of redistributive taxation to help effect social justice while financing important public goods — including possiblythe redistribution of income itself. This is a plausible, compelling end for tax. But a commitment to progressive or redistributive taxation is not nearly specific enough. Society still must answer each of the inevitable questions of tax: what, when, whom, how, and how much. Theory suggested an incometax as the best vehicle for redistribution, precisely because such a tax reaches the yield to capital, which is nearly the exclusive domain of the sociallyfortunate. Theory had read Mill;[141] the base argument was born. At an early historical moment where theory dominated — there was after all a paucityof practice at the time — the United States adopted an income tax. It was a limited tax, with modest and modestly progressive rates on the economicallyprivileged few.

Practice grew up in the shadows of this prior theory. But over time, these practices — nearly one hundred years of them by now — began to show anunease with the very idea of an income tax, especially as both tax rates and the breadth of the tax’s application increased far beyond their initial bounds.As the tax grew from its humble roots, compromises and deviations piled on each other, generating over time a badly flawed tax, with multiple holes in itscommitment to taxing the yield to capital. Unreflectively, as is its way, practice tried to patch up these holes, as by adding on corporate income andwealth transfer taxes to the income tax as “backstops” to its inherent desire to tax the yield to capital. The system attempted to close some of thewidening loopholes to clamp down on certain attempts to avoid its theoretical commitment to taxing the yield to capital, such as through complex rulesregarding “original issue discount” and so on,[142] while at the same time widening the holes in other cases, as through provisions for tax-favoredsavings accounts.[143]

Confronted with practical incoherence and conflict, we return to theory. Theory sees that something has gone badly awry in the progressive income tax —that is why we are where we are, reflecting over what to do next. Some take this as an occasion to argue against progressivity itself. Theory will soon seethat this is a mistake. For one thing, rather little of the practical morass of tax is directly traceable to the decision to have progressive tax rates.[144]More important, our normative commitment to at least moderate progressivity in tax burdens remains as solid as ever: indeed, a large part of thedisillusionment with tax relates to the sense that the rich are, in fact, not paying their fair share, and that the burdens of tax fall all too heavily on themiddle, laboring classes.[145] Progressivity is an end, ill- served by the means of the present tax system; we have not changed our ends. Further, thissense of unease with the status quo, however inchoate it is, is right in its factual predicates, and directly related to deep structural features of the so-called income tax — this is a lesson that theory can learn from a detailed consideration of our practical tax system, as considered further below.[146]Clinging to a commitment to progressivity is not a scholarly fiat: political attempts to cash in on disdain for the progressive income tax with a flat tax ofsome sort have not, in fact, resonated with the people.[147]

If progressivity is to remain, theory next considers whether something is wrong with the “income” part of the progressive income tax. Here, indeed, thingshave gone amuck, and the practical mess relates almost entirely to the erratic treatment of savings or accumulation, a point that Andrews had seen andmade forcefully nearly three decades ago — theory reads law review articles.[148] We are not, in fact, taxing all savings equally. Worse, the practicalcompromises we have made are theoretically incoherent, leading to the sorry state of affairs in which we fail to tax consumption financed out of the yieldto capital, and cannot even predictably induce more savings, on an individual or an aggregate social level, when we try.[149]

And so theory asks an obvious question: Should we be taxing the yield to capital? This is the question at the core of the income-versus- consumptiondebate, which has been needlessly, and unfortunately, all-or-nothing. Theory sees that a prepaid consumption tax, namely, a wage tax, can never get atthe yield to capital, within or between generations. This bothers theory; it seems to violate a core reason to want progressive individuated taxes in thefirst place. But theory also sees Mill’s point, and the practical resistance against a willy-nilly double taxation of all savings. Theory sees much principle inthe income tax’s consumption tax provisions, such as for retirement savings, and so becomes disenchanted with the extremes in the debate. Should we betaxing all yield to capital in the same manner? Is it the case that all savings are created equal? Are we equally normatively committed to double taxing —or altogether exempting — all forms of savings, as the stark income-versus-consumption tax debate would have it? If not, is a principled middle groundpractically obtainable?

2. The Norms of Capital

Asking just these questions brings theory to a critical epiphany. It leads abstract theory to understand what practice has been trying inchoately andimperfectly to express for scores of years by now. We do, in fact, want to burden some but not all savings. Further, on reflection, we see that our bestnormative judgments and ordinary moral intuitions flow naturally to the uses and not to the sources of such savings.150 It is not, that is, that ourreflective judgments counsel for taxing those savings that come from stocks versus bonds versus real estate and so on differently. Here, I put aside thefar lesser in magnitude, and more technical or economic, question of whether or not, in some special instances, because of market failures or for someother reason, we actively want a tax-based policy of inducing capital to flow to certain uses or areas, such as “empowerment zones.”[151] These aretechnical questions best left to technical experts. Theory is, in contrast, crafting the broad contours of a socially just comprehensive tax system; we aregetting the individuation of tax down right, in the spirit of Vickrey. Of course, tax can do other things, such as correct for market failures here and there.But the task of the major comprehensive individual tax system as a central component of a just social structure is wider and deeper than ad hoccorrections for market failures.

Back to the broader strokes of comprehensive tax policy: It strikes our ordinary moral intuitions that some uses of savings — paradigmatically, forretirement, but also for medical and educational needs, and so on — are appropriate on an individual and, perhaps, a social level, and, if anything, oughtto be encouraged, certainly not double taxed. Other uses of savings — as to enable grander lifestyles, in this or later generations — strike us as notdeserving of our sympathies in the same regard. How can theory reconcile these seemingly opposing intuitions? To further advance its practical project,theory needs a better, more specific, understanding in regard to the competing ideas about savings manifest in today’s tax system. On critical reflection,the two distinct norms anticipated above emerge. Note that these are norms about the taxation of the activity of savings, that is, about the flow of fundsgoing into and out of a taxpayer’s household, as befits Mill’s focus on such flows and Andrews’s focus on uses. Different norms might apply to the stockof capital, that is, to the very possession of wealth, or to how and where the value is invested. I shall revisit these concerns later.[152]

One norm is that capital and its yield, as a general matter, ought to bear some tax; those fortunate enough to be able to live off interest, dividends,capital gains, and so forth ought not be further privileged by way of exemption from the public-regarding burdens of tax. This is the yield-to-capital norm.Indeed, if anything, there is an urge to tax the yield to capital more than the yield-to-labor. The general intuition behind the yield-to-capital norm isreflected in the very choice of an income tax, as we have seen, and in the periodic attempts to plug up certain “loopholes” in the actual income tax’scommitment to taxing the yield to capital. This intuition is also shown in the misguided, if understandable (given the traditional view of tax), categoricalresistance to any comprehensive conversion to a consumption base. The yield-to-capital norm is further manifest in the insistence on maintaining separate gift and estate, and corporate income taxes: an insistence that may well also be misguided, on the better view of tax’s possibilities. The moreparticularized intuition that the yield to financial capital ought to bear, if anything, a higher burden than labor earnings, or the yield to human capital,reflects an ordinary moral intuition that such financial yields come more easily, without the psychic disutility of physical work. These attitudes werewidespread at the time of the adoption of the modern income tax, and they sensibly fit with the choice of that tax.[153] We can understand the yield-to-capital norm as a vertical equity one: it reflects an intuition that the yield to capital is a privilege of the economically fortunate.

A second norm, seemingly inconsistent with the first, is also evident in our practices of tax. This is the ordinary-savings norm, which rests on an intuitionthat some savings are different. Broadly, these are the savings that take place — or ought to — in the ordinary course of an ordinary life. Savings for one’sown retirement, for one’s children’s education, for medical and other emergencies, fit into this norm. There is a strong and widely held intuition that suchsavings should not be subjected to Mill’s double tax, whether or not proponents of the norm are aware of the canonical mappings of traditional tax policy.Such savings should be encouraged, if anything, and certainly not discouraged. To reconcile the ordinary-savings norm with the yield-to-capital norm, intheory, we can understand ordinary- savings as moving the yield to human capital — that is, labor earnings, wages — evenly through time. The ordinarymoral intuition to burden the yield to financial capital more than the yield to human capital, as the latter involves psychic disutility to work (and so on),does not extend so compellingly to labor earnings that are simply saved at a normal rate of return for some later day. This distinction will become clearerin the next section, with a practical analytic vocabulary regarding the uses of capital transactions before us.

In any event, the ordinary-savings norm is, of course, reflected in the many provisions of the law that favor (or do not disfavor) such savings: pensionplans such as 401(k) plans, IRAs of various types, medical and education savings accounts. These elements began in the 1940s.[154] A large and veryimportant trend of the 1990s was the expansion of such prosavings provisions. (The fact that some such provisions are structured along a prepaid model,as in the “Roth” IRAs, while others continue to come in a postpaid fashion, as with “traditional” IRAs, is yet another sign of the analytic muddle of tax.[155]

This move towards prepaid and away from postpaid consumption taxation has also characterized the contemporary conservative assault on progressivityin tax.) In any event, in the traditional normative language of tax policy, we can see this second norm as a horizontal equity one. “Ordinary” savers are notthe privileged elite. Rather, they are regular workers choosing to do a perfectly sensible — indeed, admirable — thing with some of their earnings: savethem for a later, perhaps rainy, day. Here, the familiar pair-wise comparisons carry normative force: Why should the thrifty Ant be taxed more heavily thanthe spendthrift Grasshopper, when both have the same resources as of a critical moment in time, and when Ant is actually doing what a reasonablesociety should want her to do at that time?

There is another and important sense in which this ordinary- savings norm reflects a horizontal equity perspective. It is that the vertical equity judgmentsmade by the basic rate structure — and the choice of an income tax, with its yield-to-capital norm — ought not fall on individuals only temporarilyelevated into the higher “ability to pay” or high tax-rate regions because of morally arbitrary patterns of labor market earnings. In order to make sure thatwe are taxing equals equally under the progressive rate structure — in order to best (most fairly) determine who are indeed “equals” — we need a widertime frame than the arbitrarily chosen twelve calendar month one of practical tax administration.[156]

The yield-to-capital norm was present at the dawn of the income tax: It was a large part of the reason for choosing such a tax. The ordinary-savings normfavoring — or, perhaps better put, opposed to disfavoring — certain classes of savings, in contrast, became apparent much later, after income tax rateshad risen and the tax’s breadth had expanded to reach the majority of adult Americans.[157] It was then that the horizontal equity issues becameproblematic; it was then that the call to escape Mill’s curse became more clarion. But herein seemingly lay a rub: The ordinary-savings norm isinconsistent with the choice of an income tax, made to further the yield-to-capital norm. As a practical matter, the coexistence of the two norms aboutcapital and its yield under a nominal income tax has generated a highly flawed status quo. As an analytic matter, it has left us in the grip of incoherence.The particular center we have chosen cannot hold.

Now, theory has a sharpened practical question to ponder: Is it possible to design a tax system that gets at some, but not all, of the yield to capital, in justthe way we want it to? That does, consistently and logically, what our imperfect real-world tax system attempts to do inconsistently and illogically? Thatis, a tax system that implements the yield to capital and ordinary-savings norms concurrently?

Surprisingly — especially to those in the grip of the traditional view — the seemingly inconsistent popular attitudes towards savings can be renderedperfectly coherent and consistent under a properly designed tax system. Those forms of savings that ordinary moral intuitions favor are precisely thosethat smooth out life-cycle consumption: that move wealth from high-earning periods into lower- earning ones, such as retirement, or into those of greaterurgency or objective need, such as times of increased education or medical expenses.[158] At the same time, the urge to tax some of the yield to capitalplausibly relates to material resources used to finance higher standards of living, namely, greater discretionary expenditures, within or between individuallifetimes. How can we relatively favor the one form of savings, which smoothes out labor earnings, while not favoring the other, which enhanceslifestyles? It turns out that a progressive postpaid consumption tax does exactly this. It is the mechanism of progressivity under the tax that does the bulkof the normatively desired work.

B. Two Uses of Capital

The analysis of the prior section suggests an analytic distinction not presently drawn in the tax policy literature. Capital transactions — borrowing, saving, and investing — can in fact be put to two broad (and analytically exclusive) uses within a taxpayer’s lifetime. One is to smooth out one’s labor earnings, which are earned over a limited period of years, into a steady consumption pattern over one’s entire life. This smoothing perspective solves a certainpersonal financial equation: it sums up an individual’s earnings in constant dollar terms, and then divides this total by the years in one’s life. The result ofthis exercise is to generate the same level of consumption, in real dollar terms, for each year of life; it balances out an individual’s books, so to speak, asif her life were self-contained and devoid of any windfalls, gifts, and the like. Smoothing effectuates the ordinary-savings norm.

The other use of capital transactions is, in short, to do anything other than smooth out earnings. Capital transactions can shift consumption patterns: tomake one better (or worse) off than she could be on the basis of labor market earnings alone, for certain periods of her life or throughout her entire life.Consumption shifting corresponds to the yield-to-capital norm. A simple graphical example helps to see these points.

1. An Untypical Picture of a Typical Life

Figure 1 shows, in stylized and financial terms, how many of us live. The solid line shows labor earnings, while the dotted line shows spending orconsumption. Simply to get an easily tractable example, Figure 1 reflects a world with no inflation, which solves the problem of translating fluctuatingnominal dollars into constant real ones.[159] There are also no taxes — yet — in the story.


The hypothetical taxpayer in the figure lives for 80 years. She works for 40 of those years, from age 20 to age 60, but, of course, she consumes for all 80years. Assume that she has no benefactors, such as parents, and no beneficiaries of her largesse, such as children; she acts as a self-contained financialunit, balancing her books of inflows and outflows within her lifetime alone. Later I shall relax this assumption, with a corresponding expansion ingenerality of the normative points.

In any event, during her labor market earnings years, the taxpayer makes a constant $60,000; throughout her life, she spends $30,000 annually. In such afashion she can balance the books, with her $2.4 million of lifetime earnings and spending.

2. Smoothing Transactions

The stylized picture of Figure 2 adds onto Figure 1 to show one very important use of capital: to smooth out consumption patterns over a lifetime. Thehypothetical taxpayer effectuates this smoothing by capital transactions. She borrows $30,000 a year for the first quarter, or 20 years, of her life, at 0percent interest.160 For the second quarter, the first 20 years of her working life, from age 20 to 40, she pays off this debt at the rate of $30,000 a year,living on her remaining $30,000 annually. For the third quarter, the final twenty years of her working life, from age 40 to 60, she sets aside $30,000 a yearfor her retirement, once again, in the simplifying assumptions of the story, at no nominal interest, and spends the remaining $30,000. When she retires atage 60, she draws down her retirement savings to finance continued consumption during her last quarter of life, once again at the rate of $30,000 a year.


A New Understanding of Tax_html_28a7ff5b

In this stylized example, we see that both “normal” borrowing and savings transactions — those that carry a normal rate of interest, principally (and in the simplified example, exclusively) compensating for inflation — help the taxpayer to smooth her consumption pattern. Borrowing shifts labor earningsforward in time, so that one can consume before she earns; savings shift them back, so that one can continue to consume after she ceases to earn. In Figure 2, with no inflation, the taxpayer will simply borrow $30,000 a year for the first 20 years of her life, pay this debt off over the next 20 years, save$30,000 for the next 20 years, and draw this down for the final 20 years.

In a simple setting with perfect knowledge, no transaction costs — and no other humans in the picture — the smoothing of Figure 2 can be achieved bywell-functioning financial capital markets. Of course, the world is not so perfect. In its imperfection, smoothing does not occur so precisely. In practice,families often function as annuities, insurance, and other capital markets.[161] By social norm or otherwise, our parents pay for our consumption in ouryouth; we may or may not pay them back in later years, but in any event, we are expected to pay for the consumption of our children in their early years.Families also provide important mortality insurance should grandparents outlive their finances, and so on. In an “overlapping generations” model, asillustrated in Figure 3, the smoothing of consumption shown in Figure 2 occurs between generations.[162]

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This Figure adds a second generation to the smoothing transactions of Figure 2. The darkened arrows indicate transfers across generational lines, fromparents to children, or vice versa. The story

behind Figure 3 is a common one, where parents help their children in their youth, and then these same children help their parents — paying them back,in essence — in their old age. Another familiar story of intergenerational annuities markets is where parents continually help their children, so the supportreceived from one’s parents is turned over to the third generation, as it were, in an infinitely overlapping generations model. The idea here is to sketchout rough possibilities; note that these intergenerational transfers can be smoothing or shifting.

Smoothing is simply an analytic possibility that almost all wage earners engage in to some extent: one has to smooth, somehow, if a limited period oflabor market earnings is to support a full lifetime of consumption, unless one is a significant beneficiary of some sort (more on this, which affects theyield-to-capital norm, anon). What is morally significant to theory is that smoothing strikes our ordinary moral intuitions — as reflected, in fact, in thepractices of the actual income tax — as a perfectly normal and appropriate thing to do. Smoothing effects the ordinary-savings norm. A reasonablepolitical and moral theory can certainly accept this norm revealed from practice, bringing about a reflective equilibrium; Mill and Rawls seem to havedone so, for example. Smoothing balances out the morally arbitrary ups-and- downs of labor markets.[163] Adding progressivity into the mix — as thefirst, foundational commitment of the comprehensive tax system’s claim to justice — makes this critically important. Income and prepaid consumption(wage) taxes fall on the unsmoothed lines of Figures 1-3; postpaid consumption (spending) taxes fall on the smoothed lines. Under progressive marginalor effective rates, taxpayers pay more tax based on the particular pattern of their earnings profile under prepaid consumption or income taxes, but notunder a postpaid consumption tax, when they engage in ordinary smoothing activities.

It is for these reasons that many scholars have long advocated taking a “lifetime” perspective on the imposition of tax burdens. This is an idea advancedby Vickrey, through a very clever proposal for the lifetime averaging of tax burdens, and picked up in recent years by those, such as David Bradford andDaniel Shaviro, discussing “endowment” taxes.[164] The smoothed perspective looks to this lifetime average: What is significant is the $2.4 million oflifetime consumption spread over 80 years, not the particular — and generally morally arbitrary — pattern of earning it. Any tax on inflows, such as aprepaid consumption or an income tax, that does not somehow allow for smoothing is penalizing those whose human capital gets realized in short periodsand in bunches — artists, athletes, doctors, and lawyers, say — vis-à-vis more regular, steady lifetime earners. This point was anticipated, in traditionalhorizontal equity terms, by Andrews, and developed by William Klein.[165] Indeed, Mill’s double-tax critique is most compelling when a taxpayer is simplytrying to break even within her lifetime, and so too with Andrews’s “most sophisticated” argument for consumption tax.

By moving to a lifetime perspective, allowing smoothing to lower tax burdens reflects as much a “vertical” as a “horizontal” equity norm. If we base a taxon outflows, thereby allowing people to smooth, and assume (only for now) no net transfers in or out of the taxpayer’s combined, total pool of resourcesavailable for her own personal lifetime consumption, then a taxpayer can solve a personal tax minimization problem by perfect smoothing. Note thatrough or imperfect smoothing comes out much the same way, on account of the width of the progressive marginal rate brackets: there is no need fortaxpayers to be precise actuaries.166 Taxes are then set — equals are then measured — on the basis of this smoothed consumption line, reflecting asustainable standard of living across a lifetime. Rather than a single year, or a short period of years, of high earnings elevating one into higher taxbrackets, it is this smoothed, sustainable pattern of consumption that sets one’s level of taxation. Then those who, after smoothing their labor earnings,are able to live a more costly lifestyle, are taxed more than those who are not: these are, necessarily, people who have enhanced their consumption bycapital market returns or beneficent transfers. “Equals” are measured by their lifestyles; lifestyles are financed by labor, capital, and beneficent transfers,and the consistent postpaid consumption tax does not mark the distinctions among sources.

The smoothed perspective as a measure of taxable ability is appealing to ordinary moral intuitions and in reflective equilibrium: it happens to map upperfectly with a postpaid consumption tax, but the argument is not a matter of semantic definitions. It is not, that is, the case that a postpaid consumption tax is independently desired for some reason and therefore that smoothing becomes the appropriate normative baseline against which todiscuss increasing or lowering tax burdens. It is, rather, that smoothing strikes us as an appropriate normative baseline, because it does not take intoaccount the morally arbitrary pattern of labor market earnings on a year-to-year basis, but rather rests its decisions about taxability on a sustainablelifetime pattern of consumption. A postpaid consumption tax implements this norm.

3. Shifting or Enhancing (Diminishing) Transactions

A second use of capital and its yield, already anticipated, is to change one’s average level of lifetime consumption: to enhance or increase one’s lifestyleby spending out of “surplus” capital funds, or to diminish it by being a net saver throughout one’s life or by transferring wealth to others — personal orinstitutional (e.g. charitable) beneficiaries. Shifting is the complement to smoothing. Smoothing takes the taxpayer’s average labor market earnings inconstant real dollar terms as its baseline. Shifting moves this baseline up or down.

In moving from a description of capital transactions to a normative position, a norm of self-sufficiency emerges: Capital transactions that are “simply”and “normally” translating uneven (by time) labor market earnings into even, smooth cash flows should not bear the sting of Mill’s double tax or, indeed,any positive tax burden at all. In the simple smoothed profile, there is no “luck” in the capital markets, no largesse from or to any other individual.Smoothing is what an ordinary person can do, with the fruits of her own labor, and access to normal, well-functioning capital markets with little or no risk.But capital transactions can change things, too. One can do better or worse than the smoothed profile, by being the beneficiary of good luck or someoneelse’s largesse, or by being the recipient of bad luck or a net benefactor to others.

Figure 4 presents a simple picture to illustrate this. Figure 4 adds onto Figure 3’s intergenerational example the possibility of taxpayers, within or acrossgenerations, living on more or less than what their average annual labor market earnings in constant dollar terms would allow. Beginning at age 30 ineach generation, the Figure shows “enhanced” consumption, where a taxpayer is living at $40,000 a year, more than her average annual labor marketearnings, in constant dollar terms, and a “diminished” consumption pattern, where the taxpayer is living at $20,000 a year, below her average annuallabor market earnings. The intergenerational setting helps to illustrate that there are several sources of this enhanced or diminished consumption profile.Good fortune in the capital markets — supranormal returns, in the language of recent tax policy analysis[167] — is one. Intergenerational transfers canalso either elevate or diminish consumption patterns, and altruism — transfers to charities — can diminish them.[168] Diminished consumption mightresult from a simple mistake, a failure to “die broke” out of an excess of caution, a failure of annuities markets, or a combination of all three factors.[169]It could also result from bad luck in the capital markets: from a failure to earn even normal returns on savings, or excessive payments for the use ofcapital early in life.


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A compelling case can be made that the enhanced lifestyle profile is “vertically” above the smoothed one: anyone who has received additional resourcesto consume, one way or another, is in fact more “able to pay” than someone who has not. Indeed, this is an animating norm of an ideal income tax, alogical concomitant of Henry Simons’s (and many others’) “source neutrality” norm. It is more arguable that the “diminished consumption” profilerepresents a lower rung on the vertical equity, or “ability to pay,” ladder; an ideal income tax generally treats people on the basis of their potential toconsume[170] or, somewhat equivalently, treats savings, gifts, bequests, and even many capital market losses as instances of consumption. But notethat, under a consistent, progressive postpaid consumption tax, the diminution in private consumption must be permanent, across generations, to result ina lesser tax burden. In lying in wait for ultimate private preclusive use, the progressive postpaid tax holds out the possibility — by design — of anincreased tax burden on certain patterns of intergenerational transfer.[171]

Now it is time to ask a pressing question: Why should the norms of capital apply inter, as well as intragenerationally? This is a point that distinguishes aconsistent progressive postpaid consumption tax from a progressive income tax with averaging, as discussed below. Once more, second-best concernsloom large: policing and taxing intergenerational transfers is hard. But still as a matter of first-best theory, and with the various pictures to help us, we can see that intergenerational transfers, like intragenerational savings, also differ in their intended and ultimate uses. Much intergenerational transferssmooth across generations, making for within-family annuity markets. Such transfers can save on certain transaction costs compared to third partymechanisms, and there is no compelling reason to burden them with a double or even triple tax, on transfer. Other transfers simply bring children up to alifestyle level closer to their parents, arguably maximizing utility.172 Yet other transfers create dynasties, allowing generations to live off the yield tocapital, without labor. The current system, with a wealth transfer tax rife with exceptions, once again reflects two norms, one allowing, the other seeking to tax, these transfers,[173] but implements them erratically, at best. A consistent progressive postpaid consumption tax perfectly implements bothnorms, at the same time, and across as well as within generations.

Back to the reasons for diminished consumption at the parental, or putative donor’s level: The parent who self-sacrifices to enable her child to live anenhanced lifestyle is not solving an intergenerational tax minimization problem; she is like the intragenerational taxpayer who fails to smooth. Herfamily’s total tax burden will go up, in constant dollar terms, on account of her financial behavior. The progressive postpaid consumption tax — consistentwith its focus on uses, or the right-hand side of the Haig-Simons identity — differentiates among the reasons for diminished lifestyles. Those who havehad bad luck in the capital markets, or who are benefactors of qualified institutional charities, say, will see their and their family’s tax burdens go down;those who are building private dynasties will see their familial tax burdens increase. While an ideal income tax would also adversely affect privatedynasty creation, it is worth noting that neither the actual income tax, where we are, nor a prepaid consumption tax, where we are heading, would.[174]

C. Progressivity

The key insight of the new understanding of tax is that, in devising a just and practicable comprehensive tax system, the commitment to progressivity inindividuated tax burdens ought to come first and be foundational. It is not sufficient to meet this commitment through the choice of base, alone. We donot have and have never had an income tax, and largely for the reason that we do not want one — we do not want the double taxation of all savings.Within the tax system, progressive rates have become the primary engine of effecting fairness.175 The next question is to what should we apply theserates: a question that can be restated in the temporal terms used above, namely as asking when, in a taxpayer’s flow of funds, it is fair and appropriate tolevy progressive taxes. Under progressive rates, the traditional view of the mapping between income and consumption taxes, and between types ofconsumption taxes, is wrong. Each tax has very different properties. These properties can be understood as affecting capital smoothing and shiftingtransactions differently: as, that is, differentially implementing the yield to capital and ordinary- savings norms. The principal mechanism forimplementing progressivity in the income tax — for meeting the vertical equity norm — is its system of progressive marginal rates. Such progressivemarginal rates work like a ladder. As one ascends into the higher-rate brackets or rungs of the ladder, she does not lose the benefit of the lower-ratebrackets or rungs. Consider the very basic marginal tax rate schedule set out in Table 2. The first $10,000 of income (or whatever is being taxed in thebase) generates no tax. The next $20,000 — the dollars that take one from $10,000 to $30,000 of total income — are taxed at a 15 percent marginal rate.Thus by the time a taxpayer has made $30,000, she has paid $3,000 (not $4,500) in tax: 0 on her first $10,000, and $3,000, or 15 percent, on her next$20,000. Once one exceeds $30,000, the next dollar is taxed at 30 percent. So a taxpayer making $30,001 is taxed $3000.30 (not $9000.30); the $3,000paid on her first $30,000, as calculated above, plus $.30 on her last, or marginal, dollar.

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Marginal tax rates are important for their marginal incentive effects.[176] Social justice, however, is more concerned about average or (equivalently)effective tax rates: ensuring that the more able to pay, in fact, pay a higher percentage of their wealth in taxes than the less able to pay. Average taxrates are simply the total tax paid divided by the total income (or alternative base). In our running example, using Table 2, the taxpayer who has made$30,000 and paid $3,000 in tax — while she stands on the brink of entering the 30 percent marginal rate bracket — is paying 10 percent taxes on average.(It is a common mistake to confuse average and marginal tax rates; this explains the emphasis on “not” numbers in the parentheses in the prior paragraph). While progressive marginal rates necessarily lead to progressive average tax burdens, the converse does not hold: we can achieveprogressivity in effective burdens with a combination of lump sum grants and declining marginal tax rates, a key insight of Mirrlees and the optimalincome tax literature.[177]


Figure 5 translates the simplified marginal rate schedule of Table 2 into effective tax rates. Having a progressive tax system means that such a figure,plotting income (or any alternative tax base) along the X-axis against effective tax rates on the Y-axis, will show a constant increase. That is, higher levelsof income, or labor wages, or consumption — respectively in each of the three taxes we are considering — will be taxed higher, on average,asymptotically approaching the highest marginal tax rate.[178]


The central argument of this Article can be seen by superimposing Figures 1-4 onto Figure 5, as Figure 6 does. I do not mean to suggest that tax rateswould or could be the same under the three tax systems. It can be hard, for macroeconomic reasons, to compare rates across different taxes.[179] Ratesmight differ under an income, prepaid, or postpaid consumption tax in order to raise the same amount of revenue; this depends on the breadth of thebase, and so on, and is a complicated empirical project. Further, and very importantly, as a normative matter, the nature of the case for progressionchanges with the nature of the tax base; this is another central insight of the new understanding of tax obscured by the traditional view. Once again, wecan think differently about taxing uses than sources. But fortunately it is not necessary to make the rates comparable — to “score” a revenue neutralresult — in order to see the main points. Figure 6 simply illustrates how capital smoothing and shifting transactions are taxed within each tax system,against a backdrop of not engaging in them.

A prepaid consumption tax taxes along the solid labor wage line and ignores all variations. Under the tax rates of Table 2, this means that the taxpayer inthe running example will pay $12,000 per year for the 40 years in which she works, a 20 percent average rate over her lifetime ($480,000 out of $2.4million).180 Such a tax ignores all shifting, upwards or downwards, and smoothing. The “spikier” the inflows line

— the greater the variance in the realization of labor market returns

— the higher the lifetime tax. Any enhancements due to success in the capital markets or someone else’s beneficence get ignored.

An ideal income tax would also tax on the basis of this labor market earnings line, and would add a further tax — Mill’s second — for any positive returnsto the savings needed to effect a constant lifestyle going forward.[181] In general, a progressive income tax burdens both shifting and smoothing capitaltransactions. Compare a taxpayer under an income tax who in fact earns and spends $30,000 a year, with one who earns $60,000 over 40 years andspreads it across 80. The latter, smoothing taxpayer is hit hard by progressive rates: she pays $480,000, just as under the prepaid consumption taxexample of the prior paragraph, a 20 percent effective rate. The naturally-smoothed taxpayer in contrast pays $240,000 in lifetime taxes — $3,000 a yearfor 80 years; her labor market earnings generate a 10 percent effective tax rate. The smoother is also hurt by the double taxation of savings needed toeffect her backward smoothing: any positive interest here will bear Mill’s double tax. She is also harmed by the tax treatment of debt in effectuating herforward or anticipatory smoothing, given the limitation on the deductibility of interest.[182] And, of course, any enhancements above her labor marketearnings will be taxed, while diminutions may or may not be relevant.

A postpaid consumption tax, in contrast, applies to the actual consumption line. The perfect smoother, living at $30,000 a year, would pay $3,000 a year,a 10 percent rate across her entire life ($240,000 out of $2.4 million), just like the naturally smoothed taxpayer. The enhanced consumption profile would pay more: under progressive tax rates, a postpaid consumption tax does get at the yield to capital, as well as beneficent transfers, when these are usedto upward shift. The diminished consumer would pay less. But if the diminished consumption was due to the transfer of resources to another taxpayer, thetax will lie in wait, to fall on this heir’s enhanced consumption.

We can cash these observations out with some simple, paradigmatic examples. Imagine three putative taxpayers: Steady Earner, who earns $50,000annually for all relevant periods; Lumpy Earner, who earns $100,000 annually for half of the relevant period, borrowing and saving, as in the exampleabove, to consume $50,000 annually throughout the period; and Trust Fund Baby, who lives off $50,000 of investments returns from an ancestral trust.[183] An ideal progressive income tax falls hardest on Lumpy Earner, treating Trust Fund Baby and Steady Earner alike. A progressive prepaid consumptionor wage tax falls hardest on Lumpy Earner and altogether ignores Trust Fund Baby.[184] (The actual income tax we have treats Trust Fund Baby quitewell, too, as Part V illustrates). A progressive postpaid consumption tax treats all three taxpayers alike.

In sum, an income tax double taxes both shifting and smoothing capital transactions; a prepaid consumption tax ignores both; and a postpaidconsumption tax accommodates smoothing but differentiates between upward (which lead to higher taxes) and downward (which lead to lower taxes)shifting transactions. By ignoring smoothing, progressive income and prepaid taxes make the time path of earnings economically significant. Byaccommodating smoothing, a postpaid consumption tax does not.

D. Debt, Again

Debt, or borrowing, is critical to smoothing, and also to the distinctions among the three types of ideal taxes.[185] Positive savings allow an individual todefer the enjoyment of labor-market earnings, to push them backward in time. Borrowing, as negative savings, serves a symmetric function: it allows oneto shift forward her labor market earnings, to consume before earning, as Figure 2 and subsequent figures had shown. An income tax is inconsistent in itstreatment of debt and savings, because it “double taxes” the latter but not the former, although the technical analysis depends on the deductibility ofinterest.[186] Both prepaid and postpaid consumption taxes are consistent: the former ignores all savings, and the latter deducts all savings. This leadsunder a postpaid consumption tax to the inclusion of debt as a taxable inflow (as negative savings) and a deduction for all repayments of principal andinterest.

All this takes on significance when progressive rates are in play. By ignoring both the initial incurring of debt and its subsequent repayment, the prepaidconsumption and income taxes each penalize those whose uneven pattern of labor-market earnings require them to borrow in their youth to finance theirlifestyles. An important class of taxpayers in this situation is, of course, students. The postpaid consumption tax solves this problem by including debt asa taxable inflow and allowing a systematic deduction for all repayments of principal and interest; it allows a taxpayer to smooth forward in time, just asretirement savings provisions under the so-called income tax allow her to smooth backward.

Students often recoil at the notion that the proceeds of their borrowing will be included in their tax base, as would be the case under a consistentpostpaid consumption tax. But such an inclusion, logically followed by a deduction in the year of repayment, in fact effectuates the ordinary-savings normgoing forward; it is traditional IRA or qualified-pension-plan treatment in reverse. Given progressive rates, the difference is significant. In the runningexample, the student borrower will pay a 10 percent effective tax on her loans under a postpaid tax, while she would pay 20 percent under an income or aprepaid consumption tax model to generate the after-tax dollars to pay off those loans. In practice, today, law students must earn twice their student-loanbalances in order to pay off their debts, because they must also pay Uncle Sam out of the earnings — first.

Within the new understanding of tax, borrowing, or negative savings, has an important symmetry with positive savings. Both typically effectuate theordinary-savings norm. Just as savings allow the wage earner to shift some of her labor earnings backward in time, to finance her retirement, soborrowing allows her to shift her labor market earnings forward in time, to finance her youth and education.[187] Progressive income and prepaidconsumption taxes burden these shifts — they disfavor smoothing transactions — because the tax falls, and hence the appropriate level of progressivityis set, at the moment of labor market earnings, which is arbitrary and uneven. Income taxes further burden smoothing transactions by the double taxationof savings used to effect them. A postpaid consumption tax, in contrast, accommodates smoothing because the moment of ultimate private use is themoment when decisions about rate progression are set. On the other hand, savings that finance enhanced lifestyles or debt that enables taxpayers to live“beyond their means” are disfavored by the ordinary operation of the tax: the former phenomenon effecting the yield-to-capital norm, the latter creating a“paternalistic push” to even out lifestyles within the structure of a progressive postpaid tax, and to use debt wisely.

E. Vickrey’s Cumulative Lifetime Averaging, Compared

A consistent postpaid consumption tax is not the only means of effectuating smoothing or averaging to avoid the problem of the uneven time-path oflabor market (and other) earnings. Vickrey proposed a mechanism of smoothing by accounting conventions, a “cumulative lifetime averaging” techniquethat helped to put tax burdens on what Vickrey took to be a normatively appropriate lifetime basis.[188] Blueprints for Basic Tax Reform also containedsome discussion of the idea,[189] and the Internal Revenue Code contained limited income averaging provisions for a number of years.[190] DespiteVickrey’s frequent protestations to the contrary, the idea is complicated in practice. It entails choosing a certain period for smoothing, adding upcumulative income (or consumption) within the period, subtracting previously taxed income (or consumption) and then applying a rate structure, whichcould lead to negative taxes (refunds) as well as positive taxes (payments) in the immediate period of the return, depending on how this period fit withthe average. Human events such as marriage, divorce, and death were subjects of some concern, and so on. A consistent progressive postpaidconsumption tax without cumulative smoothing is far easier to implement.

Let us set aside, however, these practical or second-best concerns for a moment. For present purposes, imagine that Vickrey’s proposal could beimplemented seamlessly, by summing up lifetime income, dividing by the years of the taxpayer’s life, and basing a payment (annual or lump sum) on theaverage annual income level. So stated, there are two issues at the level of first-best, or ideal, theory to differentiate the proposal I am pressing, for aconsistent, progressive postpaid consumption tax, from Vickrey’s proposal for cumulative averaging — though we importantly share the end of effectingmeaningful progression in the allocation of tax burdens, and hence have much more in common than sets us apart.

To see the two issues, note that Vickrey’s plan is set in the context of an income tax, where the problem of uneven labor earnings is made more acute byarbitrary patterns of financial capital realizations as well. Taxing earnings consistently throughout a lifetime, however, effectuates a smoothing, bydesign, such that an income tax with cumulative averaging begins to resemble a consistent postpaid consumption tax. The simplest way to see this point is that if a taxpayer balances her books within her lifetime — neither leaving nor receiving any net beneficent transfer — then lifetime income equalslifetime consumption (consider the Haig-Simons definition, Equation [1], across a lifetime, with no net savings, so that income = consumption). So there isno net difference, in the aggregate amounts taxed, between a Vickrey-income tax and a postpaid consumption tax for those who do not save beyond theirlifetimes. This background points out the two theoretical differences between Vickrey’s cumulative averaged income tax and a consistent postpaidconsumption tax.

First, those who do engage in intergenerational wealth transmissions — those whose available resources exceed their consumption within their ownlifetimes — will see their taxes, that is, the taxes paid within their generation, go down under a postpaid consumption tax compared to Vickrey’s tax.Once again, it is not, however, the case that total taxes, across generations, will go down by the transmission under the postpaid model; this depends onwhether the intergenerational shift is upwards or downwards, as noted above. The multigenerational comparison between Vickrey’s income averagingand a postpaid consumption tax also depends on the rate structure of each. The choice — still in first-best theory — turns on what we think ofintergenerational smoothing activities. Here reasonable minds can differ. In theory, one could certainly argue that an incentive to transfer wealth acrossgenerations in a smoothing fashion — or, equivalently, the absence of an incentive to consume excessively in the present generation — is a good thing.

This is so for several reasons. One, intergenerational smoothing implements a familial annuities market that need not be disfavored over third-partymechanisms (consider Figure 3, with its overlapping generations). Transfers from grandparents to parents and parents to children stand in lieu of eachgeneration’s annuitizing for itself, forward and backward within its own lifetime. Two, transfers to otherwise lesser-consuming individuals are, in astraightforward application of utilitarian theory, welfare-enhancing. Nor are these inducements somehow illiberal — after all, an incentive for the firstgeneration to consume everything and die broke is problematic, too. If the intergenerational transfers turn out to allow for greater consumption at thesecond and lower generations, the mechanism of progressivity under the postpaid consumption tax will burden them. A consistent progressive income taxwith Vickrey averaging, in contrast, will double-tax the transfers — in the first generation at a high level because of the potential to consume, in thesecond generation as a source of use. A single tax, set at a level individuated by the user, seems preferable. Once again, a consistent progressive postpaid consumption tax, applied across generations, implements both the ordinary-savings and yield-to-capital norms, simultaneously, by design. Thesenorms are as compelling between as within generations.

Whereas this first difference turns on our thoughts about intergenerational savings, the second difference between a consistent postpaid consumptiontax and Vickrey’s cumulatively averaged income tax relates to the taxation of consumption itself, within a generation. A move to a consistent postpaidconsumption tax avoids the problem of having the morally arbitrary pattern of inflows dictate the level of progressivity. But it only does so if the taxpayeractually does smooth his consumption. If Lumpy Earner makes and spends

$100,000 a year, he foregoes the benefits of smoothing under a postpaid consumption tax. Vickrey might well ask here why the actual pattern ofconsumption should matter, as opposed to an average lifetime measure that would reflect the vertical equities of the wider view without thehappenstance of uneven earnings or spending patterns.[191] In other words, even if Vickrey or a disciple should concede the first point, that consumptionand not income is the right thing to cumulatively average, why should we not do the averaging within a consumption tax design? Why, that is, should thegovernment differentiate between someone who spends an even $30,000 every year and someone who alternates years of $40,000 in spending withyears of $20,000 in spending? The Vickrey lifetime averaging mechanism, applied to a consistent consumption tax base, would alleviate this problem.

Now as with the first point, reasonable minds can certainly differ. There is nothing in the new understanding of tax that would or should reject acumulatively averaged consumption tax out of hand. Far from it: This is a serious idea, and an attractive means to a meaningful progressivity in tax, wherethe new understanding of tax aims. Once again, however, I suspect that the practical answers are decisive: Cumulative averaging is too complex, and itsbenefits over a nonaveraged postpaid consumption tax are too minor, to mandate it. But we can also once again proffer several arguments suggestingthat an averaging mechanism is not needed, and that the relatively simple, unadjusted, progressive postpaid consumption tax model, applied across andwithin generations is, indeed, an attractive ideal.

First, it is important to note that a taxpayer’s smoothing need not be precise to effectuate lifetime tax minimization, on account of the marginal ratebracket mechanism. The very width of the rate brackets, and the slope of their graduation, can be set to mitigate the effect. Consider again the marginalrate structure set out in Table 2. A considerable part of the virtue of a consistent postpaid consumption tax is that there can continue to be rate bracketsat higher levels of consumption because the disincentive effects do not fall on work effort per se.[192] Suppose, for example, that there was a 40%bracket extending from $100,000 to $200,000. A taxpayer who spent $120,000 in one year and $180,000 in the next would bear no burden on account ofnot consuming an even $150,000 in each year.[193]

Second, capital market mechanisms can rather easily and effectively deal with many consumption-smoothing problems, such as consumer durables, anissue that haunted Andrews and Blueprints.[194]

The problem is that a taxpayer who makes a large purchase in one year, say of a house or a car, will show a certain “lumpiness” in her consumption,which might indeed trigger higher taxes under a consistently progressive postpaid consumption tax. But capital transactions, such as leasing or buyingover time, can fairly readily solve these problems — in a manner that is not always possible with self-help labor market averaging.[195] Rather thanspending $20,000 on a car in a single year, for example, a five-year payment plan will effectuate a $4,000 annual charge. And housing, which is a complexitem to tax under any broad-based tax, because of its mixture of consumption and savings elements, can be handled in several different ways to avoid thespecifically lumpy consumption problem.[196]

Third, once the modifications suggested by the first two points (wide rate brackets, gradual progressivity, and capital market transactions) areunderstood, a strong argument exists that the pattern of household consumption is not morally arbitrary. Determining the appropriate spending level isimportantly a matter of choice, and one that affects the wider body politic.[197]

Fourth, and related, there are paternalistic reasons to try to get individuals actually to smooth their consumption — certainly a good deal of currentAmerican socio-economic policies are designed with this goal in mind, not the least being the forced retirement savings effected by the social securitysystem.[198] Vickrey, as a classical economist, was drawn to the neutrality of the income-averaging scheme; it does not matter whether a taxpayer doessmooth because all taxpayers with equal lifetime material resources, measured in constant dollar terms, pay the same lifetime tax, irrespective of howthey choose to spend their wealth. On the other hand, ordinary moral intuitions may question this proposition. It is prudent and good to live within one’smeans, to borrow sensibly in youth and to save responsibly in middle age.

Once again, to be clear and fair, these various arguments against Vickrey’s very clever cumulative lifetime averaging proposal, at least when set in thecontext of a consumption tax (that is, after the first point, on the income-versus-consumption difference, is set aside) may be more a matter of making a virtue out of a near-necessity, for Vickrey’s proposal is complicated, and would make annual tax reporting more burdensome and counterintuitive, while aconsistent postpaid consumption tax is comparatively straightforward. Still, a compelling case can be made that what the progressive postpaidconsumption tax does simply, by design, is also the right thing to do. We should celebrate the fortuity.


We now leave the comfortable towers of ideal theory, and descend into the devilish details of practice. The key insight of Andrews’s 1974 article was thatthe income tax was badly deficient when it came to getting at the savings component of the right-hand side of the Haig- Simons definition of income,

Income = Consumption + Savings. [1][199]

Andrews argued for a more consistent treatment of savings, in the form of its systematic exclusion, on essentially second-best grounds: even if we shouldtax all savings, as a matter of ideal theory, the fact that we do so only erratically, as a practical matter, suggests that we abandon the attempt in thename of consistency and fairness. Andrews ran into trouble when he tried to superimpose a possible first-best justification for the logically concomitantshift to a consumption tax.[200]

But there was no denying the facts of the matter: the so-called income tax was erratic in getting at savings, at best. Under the traditional understandingof tax, any failure to get at savings results in a consumption tax. Thus scholars and commentators, beginning with Andrews himself, began calling theexisting tax a “hybrid” one, a mix of income and consumption tax elements.[201]

The new understanding of tax shows that the conflation of prepaid and postpaid consumption tax models in the traditional view has limited theunderstanding of the status quo. Once we have come to understand that prepaid and postpaid consumption taxes are not equivalent under progressivetax rates, we want to know, specifically, what kind of consumption tax we have and should have, in whole or in part. The new understanding opens thedoor to a more nuanced critique of the present tax.

Much of tax policy since the 1970s, and especially in the last few years, has involved a steady drift towards a specifically prepaid consumption tax. Taxfalls fully on labor earnings as they come into households, but any subsequent taxation on accumulated financial capital or its yield is easily avoided.Taxes on the yield to capital have become voluntary in important ways. This is a fact, and one we ought to be confronting far more forcefully in ourpractical as well as normative tax policy.[202] Over time, the real fault line in practical income tax policy has become to preserve the tax as an effectivewage tax, while making sure that the gaps on the capital side — holes that the system seemingly lacks the will, the way, or both, to fill up — do not spillover to engulf the labor side. The Tax Reform Act of 1986, considered at some length below, is the grand example of this phenomenon. We are slowly,seemingly inexorably, drifting towards a prepaid consumption or wage tax. We will wake up soon with a flat tax, seemingly against our very own wishes.[203]

The traditional view of tax continues to argue for an “income” tax as if we have had, have now, or ever will have one, in opposition to the movementtowards a prepaid consumption tax. But the real choice — the only choice — is what kind of consumption tax to have. This Part aims to drive this pointhome, loud and clear. It canvasses what is wrong with the actual income tax as a practical matter. There are both structural and seemingly ad hocdeviations from the income tax’s commitment to taxing savings. Ironically, it is the ad hoc deviations that point the way towards a better future for tax;the structural gaps, nightmares of tax past, haunt its present. We start with these deficiencies.

A. Structural Gaps

The problems with the “income” tax begin — and, to some considerable extent, end — with Eisner v. Macomber,[204] a 1920 decision of the UnitedStates Supreme Court that dealt with the timing of taxation, although the Court itself and the parties before it were slow to see the true stakes involved.[205]

Mrs. Macomber, a shareholder in Standard Oil, had received a “stock on stock” dividend. To simplify the actual math of the matter, assume that this wasa one-for-one stock “split.” In other words, Mrs. Macomber, who one day held 100 shares of stock, found herself owning 200 shares the next day. Sinceevery other shareholder received the same split, the occasion was not itself an accession to wealth. The number of outstanding shares of stock hadsimply doubled across the board and — minor frictions aside — the value of each share of stock, necessarily, fell by half. If each of Mrs. Macomber’s 100 shares had been worth $10 each before the split, she would have had 200 shares worth $5 each after it. Mrs. Macomber’s total value of Standard Oilstock holdings would be $1,000 before and after the paper transaction.

The much-watched case made it all the way to the Supreme Court. It was clear that the government was having a hard time articulating its reasoning forimposing a tax on the unlucky Mrs. Macomber, and the case actually went through two hearings before the Court.[206]

Finally, the government got to the crux of the matter. Conceding that the actual stock dividend was not an accession to wealth, and that it was not the“new” shares of stock, per se, that it was attempting to tax, the government argued instead that the “income” had come from the antecedent rise in valueof Mrs. Macomber’s shareholdings, which the government could have taxed whenever it chose to; the moment of the stock on stock dividend was merelya “convenient” time to do so. This argument sounds in Haig-Simons income. The words Simons actually used to describe the savings component ofincome were, after all, “the change in value of the store of property rights between the beginning and end of the period in question.”[207] Suppose Mrs.Macomber had purchased the stock some years ago for $200. It was now worth $1,000. Mrs. Macomber had “income” of $800 in the Haig-Simons sense— at some time — because of the “change in value of the store of her property rights.”

Unfortunately for the government, by the time it got around to making its argument, the Justices rejected all of its claims by a five-to- four count. Mrs.Macomber would have no taxable income until and unless she “realized” the gain in her stock, as by selling it. The “realization requirement” announcedin Macomber is simple enough to understand. Its logic is compelling, even: Why should taxpayers pay a tax without a transaction generating the cashwith which to pay it? Why not wait until a sale or other disposition to get at the gain?[208] The answers given to these rhetorical questions in the contextof an income tax — that it was indeed alright to wait and see, and pay later — are devastating. The time value of money suggests that a tax paid later isbetter, to a taxpayer, than the same tax paid sooner.[209] Worse yet, the confluence of the realization requirement with two other structural features ofthe income tax combine to make any tax on the yield to capital, however and whenever used, voluntary. Macomber marked the end of the income tax, stillin its first decade of existence; as Andrews later put the matter, the realization requirement was “the Achilles’ heel” of the income tax.[210 ] Recall that,with Achilles himself, the seemingly minor flaw proved fatal.

1. Tax Planning 101

The realization requirement has a simple, intuitive appeal: indeed, a postpaid consumption tax operates much along a realization model, deferring thetime of tax until capital is converted into cash for consumption.[211] The problem is that the realization doctrine given birth by Macomber did not springinto existence under a postpaid consumption tax. It was engrafted onto a theoretical income tax. This is a fatal flaw.

Recall the income tax’s principled nontaxation of debt. Combined with Macomber’s realization requirement, this means that one can borrow — directly orindirectly using appreciated assets like Mrs. Macomber’s stock as collateral — and consume, tax-free. Consumption financed by debt backed by capitalassets falls out of the tax base for an income-with-realization tax. Far from simply missing an element of savings, or the yield to capital, the actualincome tax fails to reach the personal spending of the propertied classes. In such a case, there can in fact be no savings: if the borrowing to consumeprecisely offsets the rise in value of the assets — as it will in the numeric example set out below — there is no net accretion to wealth. There is simplyconsumption without taxation. The perverse result derives from the conjunction of two timing rules under the flawed income tax: first, the “wait untilrealization” doctrine of Macomber, and, second, the “wait until debt is repaid” doctrine inherent in the Haig-Simons definition of income. By usingunrealized assets to help obtain debt financing now,[212] the savvy taxpayer gets to have her cake and eat it, tax-free, too.

Eventually, it would seem, things must work out and the books become balanced: the debt must be repaid, with nondeductible or after-tax dollars from fresh labor-market earnings or realized capital transactions, and a tax will be paid. Later is better than sooner, so the taxpayer has still gained anadvantage from holding and borrowing, but at least a tax will get paid eventually. Yet “later” may never come when we add a third doctrinal feature of thestatus quo, not unrelated to the Macomber story: the “stepped-up basis” for assets acquired on death.[213] This statutory doctrine provides that assetsacquired from a decedent shall have a taxable “basis” equal to the fair market value of the property on date of death.[214] This means that an heir, whoacquires the property itself tax-free,[215] can also sell it the next day, tax-free.[216]

The stepped-up basis rule structurally follows from the realization requirement. Macomber alone gave taxpayers an incentive to acquire the kind of assetsthat rise in value without producing taxable cash, in the form of interests and dividends: Such disfavored assets walk head- on into Mill’s second tax,whereas the realization requirement gives a way to defer the government’s second bite at the apple for non-cash- generating property. The realizationrequirement destroys the source neutrality of an ideal income tax. Assets that go up in value via price appreciation alone, such as growth stocks, land, art,and so on, have an advantage over simple bonds and bank accounts that produce readily observable cash flows to their holders.[217] In the wake ofMacomber, the rich and well advised could be expected to acquire capital assets; the financial markets could be expected to generate such assets. Theydid. Further, Macomber gave wealthy taxpayers an incentive to hold onto their “winners,” even as they could sell their “losers.”[218] The ability to borrowtax-free meant that holding onto appreciated assets need not entail any personal sacrifice in consumptive lifestyle. And so it came to pass, predictablyenough, that the economy became full of assets with “built-in gain;” that is, assets that had a tax “basis” equal to their initial cost, but a fair marketvalue far in excess of this historic figure. Just like Mrs. Macomber’s stock, in the numbers given above, had a basis of $200 and a fair market value of$1,000.

This built-in gain had to be preserved in the case of gifts among the living, or any taxation on capital assets would be trivially avoided. Mrs. Macombercould simply give her stock to her husband or child, who could sell it, tax-free, and perhaps later gift the cash back to her. Hence the law instituted a“carryover” basis regime for gifts, preserving the donor’s basis in the donee’s hands.[219] But what of assets passed on after death? Heirs complainedthat it was unfair to saddle them with the inherent tax liability; it was also a practical nightmare to figure out the deceased’s basis in the assets. The taxsystem compromised by putting in place a separate gift and estate tax to get at the net wealth of the truly rich decedents, and allowing everyone toacquire assets from a decedent with a basis equal to their then fair market value — the stepped-up basis rule.[220]

As with the realization requirement, the stepped-up basis rule — for those who can understand it at all — makes a certain sense, in isolation. Yet whenput together with the realization requirement and the nontaxation of debt, one has all that she needs to understand “Tax Planning 101.” This is simple taxplanning doctrine that tax students can learn on the first day of a course in basic federal income taxation

— doctrine that underscores how easy it is for those with stocks of financial capital to avoid all federal taxation.[221] Tax Planning 101 is elegantlysimple:

• Buy,

• Borrow,

• Die.

That is it. By buying capital assets that appreciate without producing taxable dividends; selling one’s losers and holding one’s winners; borrowing tofinance present consumption; and continuing the game straight on to death, the rich and well advised can avoid all federal taxes. Tax Planning 101, asjust set out, avoids income tax to the spender and to her heirs. It avoids the increasingly important social security or payroll tax system, as discussed inthe next Part below, for its wealthy practitioners by the simple expedient of their never actually working. Tax Planning 101 avoids the estate tax becausethat is a net tax levied on assets minus liabilities held at death — but if Tax Planning 101 is taken to its limits, there is no net estate. Tax Planning 101means no taxes, notwithstanding a comfortable lifestyle for those with the assets in hand to play it.

2. An Example

To illustrate Tax Planning 101, consider the curious case of Artful Dodger.[222] Imagine that Dodger somehow has $1,000,000 after taxes. How he got itdoes not really matter, although it is worth noting that he could have gotten it tax-free from his parents.[223] With this stock of cash, Dodger buys assets.Not just any assets, but the kinds of assets that rise in value without producing taxable cash dividends: growth stocks, say, or land, art, sports franchiseseven. Dodger sells any assets that go down in value, taking tax losses when he can, carrying them forward when he cannot.[224]

Suppose that the general return on investments is 10 percent. Dodger’s $1,000,000, prudently invested, rises in value to $1,100,000 after one year. Hepays no tax on this “mere appreciation” under Macomber. This might appear to be all fine and good, because Dodger is continuing to save, and so should not be taxed under the logic of a consumption tax, and can await taxation under the logic of an income- with-realization-tax. The trouble is, Dodger neednot be saving at all. He could be consuming away.

Dodger borrows $100,000. He pays no tax on this because borrowing is not income under the Haig-Simons definition. Dodger can spend away, living aswell as a wage earner making $200,000, but subject to a 50 percent combined federal, state, and local income and payroll tax burden. At the end of Year1, Dodger’s net worth is $1,000,000: his $1,100,000 portfolio minus his $100,000 principal debt balance.

Dodger must pay interest on his debt. But he also has his assets, which he has maintained by borrowing.[225] So, in Year 2, the $1,100,000 portfolio goesup by another 10 percent, or $110,000, to a net of $1,210,000. Dodger promptly borrows this $110,000. He uses $10,000 to pay off the interest on his Year1 debt, and $100,000 to consume. At the end of the year, his net wealth is $1,000,000: a portfolio of

$1,210,000 minus $210,000 in debt.

As long as his portfolio rises by the same amount as the interest on his debt, Dodger never pays tax, always has $100,000 of consumption, and alwaysmaintains his $1,000,000 net wealth. If he can borrow less principal than the rise in his portfolio — live at a $50,000 level, say, or, in the case of BillGates, a few billion — and if the appreciation in his portfolio exceeds the interest rate on his debt over time, he keeps getting richer. If he needs todiversify his portfolio, not to worry: clever tax lawyers and accountants have devised ways to do just that, such as by various “mixing bowl” transactions,tax-free.[226] Too much risk? Not to worry: various financial instruments, such as “cuffs” and “collars” come to the rescue.[227] Much simpler devices,such as universal life insurance policies, can do the trick as well.[228]

Neither Dodger nor his estate, in this example, will ever pay any gift or estate tax. When Dodger dies, his heirs will inherit his assets income-tax free.[229] They can sell them off for no gain because of the stepped-up basis rule.[230] Then they can pay off Dodger’s debts and keep whatever cash is leftover. As long as Dodger has borrowed enough to bring his net estate below $1,500,000 or so — actually, below $3.5 million under current law, in 2009, orinfinity, in 2010[231] — no estate tax will be due.

This is all, of course, nice work — if you can get it. One can indeed get it — if she has wealth to start — under today’s tax laws featuring a nominalincome tax.

3. The Practical Facts of the Matter

How many rich Americans take Tax Planning 101 to its limits, avoiding all taxes, is an empirical question that is rather hard to answer. The very rich arerelatively few, and their ways are more or less a secret.[232] Certainly, plenty do follow Tax Planning 101, in some form; the advice is readily available.[233] It is also apparent, from the facts that some estates pay estate taxes and that some among the living do indeed pay some capital gains taxes, thatnot all who could take the game to its limits do so. Quantifying the narrow bottom-line consequences is elusive. But these very questions (i.e., how manypeople avoid capital taxes?) form the analytic basis for a consequentialist defense of maintaining the status quo with its porous income tax.[234] If fewindividuals actually take Tax Planning 101 to or near its limits, perhaps things are not so bad after all, contra to Andrews’s and other critics’ diredescriptions of the way things are.

Yet things in tax today are bad, and for several reasons notwithstanding the intractability of the empirical questions over Tax Planning 101’s actualbreadth. First, there can be no doubt — certainly none of the critics calling for more empirical analysis or pressing the consequentialist objection raise anydoubts— about the analytic facts of the matter, that is, about the legal steps in Tax Planning 101’s buy/borrow/die advice. This is basic tax. Yet the mereexistence of this legal structure raises troubling questions of both equity and efficiency. If some but not all who have capital take advantage of TaxPlanning

101, in whole or in part, what does this tell us about the fairness of the tax system? The essence of the claim that tax for those with capital is voluntary isnot that no one with capital pays taxes — people do voluntary things, even voluntarily pay taxes — it is rather that no one with capital has to do so.[235]There are perfectly legitimate ways for people with property to avoid paying any federal taxes. This is not so

— it is dramatically not so — for people earning labor wages, as we shall see. A system of tax that marks radical distinctions between the sources ofpresent consumption, and that turns further on wealthy taxpayers’ varying degrees of tax aversion and access to information

— not even terribly sophisticated information, for the basics of buy/borrow/die are indeed fairly basic — is at best a highly suspect system.

Second, and central to the analysis to follow in this subsection, the mere analytic facts of Tax Planning 101 — and not the breadth of their actualincidence — constrain important matters of practical tax design. In the language of economics, features such as low tax rates on realization are“endogenous” to an income-with-realization regime. There is simply no very good way, under an “income” tax with the realization requirement as nowconstrued, to heavily burden capital: If taxpayers are not flocking to advisers to avoid a 15 percent capital gains tax, might they not do so at a 40, or 50percent level? Evidence that some taxpayers pay some capital gains taxes at the favorable rates that persist today does not contradict the fact that theseare, indeed, favorable capital gains rates.[236] The present structure of tax haunts the possibilities for tax’s better future.

Third, the discussion might be effete, lacking in practical urgency, if the present regime, with its income-plus-estate taxes, embodied the only meaningfulpromise of getting at capital and its yield at all. The most strident critics of any form of consumption tax insist on the yield- to-capital norm, though theydo not use this language.[237] To such critics, getting some tax on some capital is better than getting no tax on any capital, which is what they take aconsumption tax to offer. But this false dichotomy follows only from the flawed traditional view of tax. Once we understand that a progressive postpaidconsumption tax gets at some of the yield to capital, and in just the cases in which it is most compelling to do so — and also as we come to see that thestructure of a postpaid consumption tax changes the nature of the arguments over the rate structure, allowing for more, not less, progression in them —we are no longer left clinging to a porous income tax as the sole hope for reaching capital and its yield. On ideal terms, an income tax overshoots its markby double-taxing all capital come what may; in nonideal terms, an income tax fails minimal standards of fairness and rationality by taxing the yield tocapital only among those most willing to pay it, or unwilling or unable to plan around it. A better way exists.

The balance of this subsection traces out a few of the analytic elements of the present income tax regime that have followed in the structural wake ofMacomber.

a. Capital gains preferences. The leading example of a provision in current law that follows from Macomber — a practical concession to the fact that wehave an income-with-realization tax — is the preferential rate for capital gains.[238] This is the tax rate that gets imposed when and if a taxpayer sells orotherwise disposes of her long-held, capital assets.[239] This rate has long been set at a fraction of the “ordinary” tax rates that fall on labor and theregular yield to capital in the form of interest and dividends. It is now capped at a maximum 15 percent, having been reduced from 20 percent in 2003 taxlegislation.[240]

Of all the arguments mustered in favor of a capital gains preference, the only truly compelling one is brute necessity in the face of Tax Planning 101: Whowould ever sell an asset and incur a 90 percent, or 70 percent, or even 40 percent tax when she could borrow against it and spend away, tax-free?[241]The realization requirement generates a so-called lock-in effect, set in motion by Macomber: a wedge between an owner’s willingness to sell a givenasset and a buyer’s willingness to pay for it, all on account of the built-in tax liability. Suppose, for example, that Mrs. Macomber had a personalsubjective valuation in her stock of $800; a third party buyer would willingly pay her $1,000. This is a deal that wealth (and welfare) maximizing suggestsought to happen. But if, on sale, Mrs. Macomber would have to pay $400 in taxes, her personal gain from the exchange would be only $600, less than hersubjective valuation. Since Mrs. Macomber quite rationally cares only about her after-tax return, the deal does not transpire. At high enough tax rates,there are many deals that do not take place. The resulting lock-in effect threatens to shut down the economy: assets will not trade and, therefore, will notgo to their highest and best use and users. This problem, in simple terms, is a function of the timing of tax: by making sales and exchanges trigger tax, anincome-with-realization requirement deters sales and exchanges. This is not the case under a consistent postpaid consumption tax: sales or exchanges ofany investment asset followed by reinvestment of the proceeds in other assets do not trigger tax — think of making adjustments inside an IRA or 401(k)plan. All that triggers a tax under a postpaid consumption tax is the decision to spend resources on private preclusive use.

Under an income-with-realization tax, some preference for capital gains is needed to lubricate the wheels of commerce, to keep the game going. All thatis left is to haggle over the price, as the saying goes, and the political system is indeed constantly flirting with lowering the rates further. By deferringMill’s “second” tax, Macomber moves the system toward a prepaid consumption tax; by lowering the magnitude of the ultimate second tax hit, capitalgains preferences — which follow from Macomber and the lock-in effect that a realization requirement generates — take us further in that direction. Ofcourse, holding assets until death in the manner of Tax Planning 101’s buy/borrow/die strategy is the limiting case: Here, the second tax, like Beckett’sGodot, never comes.[242]

Capital gain preferences are a microcosm of what is wrong with the status quo. We have seen, with Vickrey, that the principal reason to have acomprehensive individual tax system is to make individuated judgments of the appropriate progressivity of effective tax burdens. But the low rate oncapital gains, dictated by the flaws of an income- with-realization tax, is a crude and across-the-board affair — it is not individuated at all. A capital gainspreference is also source driven, a distinction based on the type of asset held and sold. It does not matter how one uses the proceeds — to smooth or toenhance, for oneself or another. Progressivity suffers, and individuation suffers, on the altar of the practical constraints of analytic tax system design.

b. Corporate dividend preferences. The 2003 tax act — one of several leading exhibits in making out the case that practical tax policy is moving towards aflat wage tax — not only lowered the capital gains rate to 15 percent, as discussed above, but it also extended this rate to corporate dividends, which hadtraditionally been taxed at ordinary income levels.243 The lowered or nontaxation of corporate dividends is an intricate economic matter that turned outto be an intricate political one as well. For present purposes, two themes are important.

One, this development plausibly follows from the structure of an income-with-realization tax. Just as Macomber generated a lock-in effect at the level ofindividual asset owners — generating a disincentive for them ever to sell their holdings — so too did it generate a lock-in effect, dubbed a “retainedearnings trap,” at the corporate level. Focusing solely on the individual tax consequences, a wealthy investor like Dodger would understandably lookaskance at a corporation paying him large cash dividends, taxable at ordinary rates that hit 90 percent and higher in the twentieth century. Better for thecorporation to keep the cash itself and reinvest, so that the value of Dodger’s shares would grow tax-free, like Mrs. Macomber’s, until and unless hedecided to trigger a realization event by a sale, at which time the tax would fall due at the much lower individual capital gains rates. The retained-earnings trap gave American corporations a good reason to hoard cash; at one point recently, Microsoft had $56 billion in cash on hand.[244] One way toget corporations to disgorge their cash holdings making companies smaller in the process — is to lower or eliminate the tax on corporate dividends at theindividual investor level.[245]

Two, the corporate dividend tax rate reduction is yet another step towards a relatively flat prepaid consumption tax. Tax Planning 101 points the way forthose with capital to avoid paying any further federal tax whatsoever.[246] But for those with stocks of capital unwilling or unable to take this advice, lifecontinues to get better, tax-wise, in any event. Virtually all subsequent taxes on capital are being eliminated or reduced. And as with the capital gainspreference, an argument for the normative propriety of a corporate dividend preference is not an individuated argument at all: anyone who ownscorporate stocks will see her dividends taxed at 15 percent, however wealthy she is, and for whatever use she puts the cash.[247]

c. Other consumption-tax elements. Preference for those capital gains actually realized and corporate dividends received are just two tips of a large iceberg. As Andrews was well aware, consumption tax elements abound in the so-called income tax. But what has not been generally noticed, on accountof the continued hegemony of the traditional view of tax, which has equated all forms of consumption tax, is how much of the current income tax is in facta specifically prepaid consumption or wage tax model. Consider a few more doctrinal matters.

In cash-value life insurance, a taxpayer overpays for the pure actuarial or “term” component of insurance. The insurance company then invests theexcess, on her account. The taxpayer pays no tax, basically because of Macomber, on the “inside build up” of appreciation, even if the insurance companybuys assets such as bonds that would produce ordinary income in her hands. When she dies and her heirs get the proceeds, these are income tax-free tothem,[248] and with rather trivial planning, the policy’s value will not count in her estate for federal tax purposes.[249] As with most instances of clevertax planning, this device does not work only for the altruistic or intergenerationally minded; taxpayers are free to borrow against the cash value of theirpolicy, tax-free. In such a case, when the insured dies, the insurance company first pays itself off, and her heirs — if she has taken this game to its limit— get nothing.[250] This is simply a one- stop shopping way to play Tax Planning 101, buy/borrow/die. It is also prepaid consumption tax treatment: thetaxpayer pays taxes on her wages, uses them to pay insurance premia, and never again pays tax.

For a good many Americans, their most significant asset is a house. Although home mortgage interest is deductible, principal payments are not. Theeconomics of home ownership work under a prepaid consumption tax model. One buys the asset with after-tax funds, but does not pay tax on its yield —the very important opportunity cost benefit of not having to pay rent. Further, when a married couple sells their house, they get to take away up to$500,000 of gain, tax-free.[251]

That will cover most homeowners, of course; for those with larger shares of appreciation, there might be a 15 percent capital gains tax on the excess ofgain over $500,000. The saga of the taxability of home sales under the income tax, like so much of tax today, owes much to Macomber. The realizationrequirement means that capital appreciation in personal residences gets ignored as it accrues, awaiting an ultimate sale or disposition. But here too thereis a lock-in effect, deterring families from “trading up” to get larger homes, or moving to a different area for job-related or other reasons. To deal withthese problems, the law employed a “rollover” provision for many years, allowing the built-in tax gain to follow the family’s real estate moves.[252]

But then the elderly had a problem: Once the kids had left the nest, and they wanted a smaller home or to relocate to a less expensive area, they faced anexploding tax time bomb. So Congress dealt with their problem, excluding gain when taxpayers older than 55 sold a residence.[253] Perhaps mercifully,President Clinton swept away many of the subtleties, allowing the $500,000 per couple exemption discussed above. Each step in the story made somesense. But, sweeping all details aside, what we are left with is an important asset fully taxed for most taxpayers on the prepaid consumption tax model:houses are bought with after-tax dollars, and their yield is never again taxed.

Retirement savings are a final and very important example of consumption-tax treatment. I shall discuss them below, as an ad hoc deviation from anincome tax. For these provisions follow not so much from the structure of an income-plus-realization tax, as from conscious decisions to deviate fromeither an income or an income-plus- realization ideal. It is noteworthy, however, that there has been a trend in the retirement savings area, which beganon the postpaid consumption tax model, towards the prepaid one. Together with the basic tax planning of buy/borrow/die, lower tax rates on capitalrealizations and corporate dividends, cash-value life insurance, and the taxation of home-ownership, the new developments in retirement savings help to move tax towards a world in which citizens will pay taxes on their wages, under a compressed rate structure, and never again. This is the world of prepaidconsumption, or wage, taxation.

B. Ad Hoc Deviations

This section discusses a variety of more conscious, deliberate prosavings provisions, such as pension plans and IRAs, that have been features of theincome tax since the 1940s.[254] Unlike the structural elements just canvassed, which followed from the income-plus- realization tax in the wake ofMacomber, these prosavings mechanisms have resulted from a deliberate rejection of the income- tax model. Policymakers wanted to encourage savingsand wanted to avoid Mill’s double tax. They added statutes to achieve this effect.

Significant technical problems follow from engrafting prosavings provisions onto an income tax, however, on account of the analytic inconsistency.Because one can borrow tax-free under an income tax, there is no logical assurance that savings will, in fact, increase with any nominal prosavingsprovision within such a tax: a taxpayer can open up an IRA with $2,000, using one hand, and borrow $2,000 on a credit card, using the other. The evidenceis mixed in terms of the empirical questions of how much various retirement and other savings provisions actually increase savings.[255] But the claimthat the center we have chosen cannot hold is once again not a narrowly empirical one; it is not based on aggregate macroeconomic statistics and ourvarying, imperfect understanding of them.[256] The critique is based instead on the analytic structure of tax, and what this says about tax’s fairness,efficiency, complexity, and possible reform. It is simply a difficult and scattershot affair to try to encourage and reward savings within a tax system ideallydesigned to double tax savings.

Still, the mere presence and persistence of the ad hoc deviations from an income tax, however ineffective, underscore the appeal of the ordinary-savingsnorm. The structural gaps followed, more or less from brute necessity, after Macomber. The ad hoc deviations, in contrast, have been repeatedly chosen,consciously and deliberately, by tax policy makers. This makes their implicit norms all the more compelling.

1. Retirement Savings

Retirement savings — which, with home equity, are the major assets for most Americans who have any assets at all (and many Americans do not)[257] —are taxed primarily on the postpaid consumption tax model; a taxpayer gets a deduction when she puts money into a tax-favored account, and she paystax when she withdraws funds. A growing trend in tax is to allow an option for taxpayers to choose a retirement savings plan structured under the prepaidconsumption tax model, such as the Roth IRA, instead of the traditional postpaid approach. Under these variations, there is no tax deduction up-front, andthere is no back-ended tax on withdrawal: this is an equivalent matter, assuming constant tax rates, as Ant and Grasshopper helped us to see.

The proliferation of retirement savings provisions resulting from the addition of a prepaid track to the longstanding postpaid one is another side effect ofthe influence of the traditional view, equating prepaid and postpaid consumption taxes, and it has added considerable complexity and confusion to tax. Itis also not irrelevant that Congress gets its one tax today under the prepaid, Roth-style account model, and thus it has a short-term incentive undercontemporary budgeting rules to prefer this approach.[258] Prepaid consumption tax savings plans also avoid the arbitrage problem noted above: there isno reason to borrow funds with one hand in order to “save” with the other, since there is no immediate tax benefit to savings.[259] There is also noreason to borrow in lieu of making withdrawals from a qualified account (or in lieu of realizing gains), as Artful Dodger might do,[260] because there is notax on withdrawal, aside from penalties for early withdrawal in some cases. And yet moving towards a prepaid consumption tax model has a cost, oneobscured by the traditional view but recognized by the new understanding of tax. This model does not allow for smoothing. Recall Figures 1-3, above,representing the typical pattern of earnings and spending in a taxpayer’s life. The single tax under the prepaid model falls due at the time of labor marketearnings, typically in a worker’s peak income — and hence most highly taxable — years. Because there is no way to escape the burden of wage taxation,prepaid consumption tax savings plans are in tension with highly sloping marginal tax rates, whereas a postpaid consumption tax gives taxpayers amechanism for avoiding the burden of higher rates — save, do not spend. It is not therefore surprising that the contemporary conservative tax reformmovement has been moving towards prepaid consumption tax savings plans — as a step on the path towards flat taxes.

The general tax treatment of retirement savings, under traditional IRAs and pension plans such as 401(k)s, reflects the appeal of the ordinary-savingsnorm and the appeal of favoring (or not disfavoring) capital-smoothing transactions. The original idea was to take some otherwise taxable income out of aworker’s high-earning, middle-aged years and move it backward to the time of retirement: backward smoothing, in the manner of Figure 2. As notedabove, these structures lack coherence under an income tax. When a taxpayer borrows and also opens an IRA, there is no net saving, just a tidy tax deduction. This is yet another instance where we can now understand that the true problem with the status quo, which seems as if it lies in theinconsistent treatment of savings — where Andrews had seen its “worst inequity and distortion” — actually relates to the inconsistent treatment ofconsumption. The taxpayer who both borrows and opens a deductible IRA is able to consume today, without any savings, and pay tax tomorrow; so toowith the taxpayer who borrows in lieu of withdrawing from her tax-favored account. In both cases, there is a deferral and a possible lowering of theultimate tax rate, but no savings.[261]

2. More and More

There have been two important recent developments in the field of ad hoc, prosavings deviations from the income tax. First, these accounts haveextended beyond retirement uses. There are now medical and educational savings accounts,[262] and the Bush Administration has proposed furthersavings accounts unlimited as to their use.[263] Second, the accounts are more and more likely to be structured on the prepaid consumption tax model.

Consider, for two important examples of both trends, the Coverdell Educational Savings Accounts (ESAs), formerly known as the Education IRAs, and theSection 529 Qualified Tuition Plans (QTPs).[264] The former works along an IRA model, but one of the Roth or prepaid variety. An ESA can be set up for each “qualified beneficiary,” or child, and persons can contribute up to $2,000 per year per account. There is, of course, the usual array of mind-bogglingprovisions, such as ceilings for those who make too much income, and rules for coordination with other proeducation features, such as the “Hope” or (notequivalently) “Lifetime Learning” credits.[265] QTPs are more complicated still: they must be maintained by a state or a “qualified educationalinstitution,” and their coordination provisions are intricate. Still, at the end of the day, QTPs have more generous contribution limits than ESAs. QTPs, too,work along the prepaid consumption tax model: taxpayers can put in large sums of money with after-tax dollars and rest assured that the investment yield will not be subject to any second tax on withdrawal, provided that the formidable terms and conditions of the statutory grant are met.[266]

An interim bottom line is that the model of allowing savings to escape double taxation, begun in the 1940s for retirement savings, has continued to grow and develop under the so-called income tax, by conscious government policy. The theme now extends beyond retirement savings to medical- andeducational-related savings. And there has been a dramatic shift, barely noticed by those working under the traditional view of tax, towards having thesingle tax fall at the time of initial labor market earnings, not the time of ultimate use.

C. Tax Shelters and the Noble Failure of TRA 86

Both the deep structural gaps and the increasingly ad hoc, pro- savings provisions move the income tax towards a consumption tax, as Andrews andothers have long pointed out. Further, in a distinction made salient by the new understanding of tax, the law is increasingly moving towards a specificallyprepaid consumption, or wage, tax. All “second” taxes on the yield to capital are voluntary under Tax Planning 101; those that do fall are deferred andcome due at low marginal capital gains rates — rates whose very existence owes to the presence of the structural gaps themselves. More and more adhoc savings provisions add to the trend, especially as they are created more and more frequently on the prepaid consumption tax model.

The other side of the coin in tax is what has been happening with labor market returns, or wages. The income tax per se makes no attempt to reachbeneficent market returns,[267] and we have just considered its seriously porous commitment to taxing capital market returns. If the taxation of wageswere porous, too, there would be nothing left to tax. But it is not porous: Even as the so-called income tax system has weakened in its taxation of capitalmarket returns, it has strengthened its commitment to taxing wages. Ad hoc savings provisions along the prepaid model do exactly this: by denying anycurrent deduction, they ensure that wages are taxed, and taxed now; by not taxing withdrawals, they assure that the yield to capital is never taxed. Onthe other hand, nothing in Tax Planning 101 is relevant to citizens who must live off the yield to their human capital, that is, off of their labor marketwages, often paycheck to paycheck. Indeed, for many who are building up such human capital by borrowing and schooling themselves — law students,say — a depressing reality lies in wait. These unlucky wage-earners-to-be will have to pay off their student loans with after-tax dollars drawn from theirhigh bracket years ahead. Their chosen path through life makes them income bunchers, who must rely on capital transactions to smooth consumption —which neither an ideal income tax nor a prepaid consumption tax accommodates their doing. The actual income tax, meanwhile, accommodatessmoothing only erratically, allowing backward smoothing to some extent, at a price of the complexity of the retirement and other ad hoc savingsprovisions, but not forward or anticipatory smoothing via debt at all. And as the actual income tax moves ever closer to a prepaid consumption or wagetax, even this accommodation for backward smoothing is at risk.

Much of the history of tax planning in the United States has been concerned with the situation of high wage earners and their search for “tax shelters.”The general strategy of a tax shelter (at least before 1986)[268] is to get some of the benefits that the propertied classes have long enjoyed under thebasic structure of an income-with-realization tax as a wage earner: to hide or “shelter” one’s wages from the tax collector. The propertied classes do notneed shelters, by and large, because the realization requirement, and the simple steps in Tax Planning 101 that follow from it, serve to keep their materialresources away from the tax collector perfectly, effectively, and legally.[269] It is those with large labor market gains who need help. Prior to the epochalTax Reform Act of 1986 (“TRA 86”),[270] sheltering for such wage earners had become almost as easy as avoiding taxes for property owners: it wassimple enough to play the game with other people’s money, or, indeed, with no money at all. The gaps in tax opened up on the capital side had leakedover to the labor-market side, threatening the entire system as a revenue- raising vehicle. But slowly, systematically, as marginal tax rates have comedown (a top rate of 70 percent when Ronald Reagan took office in 1981 has now been cut in half[271]), and as the structural and ad hoc opportunities toavoid “second” taxes on the yield to capital have expanded, the means for sheltering wage income have dried up. This continues the central theme of thepractical critique of the status quo: the so-called income tax system has morphed into an effective wage, or prepaid consumption, tax. To understand thispoint fully, consider the shelter game, then and now.

1. Some Quick and Dirty Examples

Let us reflect on the way things were, prior to the 1986 Act, in order to understand where we are and where we are heading. Simply to make the point,take four fairly basic tricks of the ancient trade of tax sheltering, here given evocative names and hypothetical taxpayers to illustrate.

The interest dodge: Susie, who has no capital, is about to earn $100,000 a year as an associate in a large law firm. She borrows $1,000,000 at 10 percentinterest. With an unlimited interest deduction,[272] she offsets her $100,000 salary completely on her tax return. With her $1,000,000 in cash, she playsTax Planning 101, just like the Artful Dodger. Susie buys capital-appreciating assets, such as growth stocks, and borrows against the appreciation to getcash to consume. She has no net wealth, because her liability offsets her assets. She consumes $100,000. She pays no income tax.

The simple straddle: Joe is in the same boat as Susie: about to make $100,000 a year as a lawyer, with no cash in his pocket. He borrows $200,000 on amargin account, and buys perfectly offsetting stock positions — in essence, he puts $100,000 on each side of a “heads or tails” coin flip. (He can do thiswith a put and a call option on the same commodity, or by going long and short on the same stock.) One position is guaranteed to double in value; the other to become worthless. Joe sells and then writes off the worthless one, claiming a $100,000 loss that, with unlimited loss offsets,[273] wipes out thetax liability on his salary from the law firm on his tax return. Joe holds his $200,000 winner, which precisely offsets his loan balance. Like Susie, Joe hasno net wealth. Also, like Susie, he pays no income tax on his

$100,000 salary. He, too, can consume away, tax-free.

The classic shelter: Sara is graduating from medical school, and is about to start earning $100,000 with no assets in hand. She buys an old hotel in Arizonafor $3,000,000, giving the owner a nonrecourse note for virtually the whole amount (no money down!).[274] Sara leases the hotel back to its owner,setting the rent she is owed on the hotel equal to the interest she owes on the note, which has a balloon payment due and payable in 30 years.Meantime, with a 30 year depreciation schedule, Sara gets $100,000 in ordinary income deductions each year.[275] Sara, too, like Susie and Joe, has nonet assets; the liability offsets the gross value of her holdings. Like her friends, she also pays no tax on her $100,000 salary. She will worry about whathappens much later, in Year 31.[276] For now, she consumes away, tax-free.

The kiddie shift: Tom is about to become a doctor, too, earning $100,000. He has four young children. Tom decides to buy a small office building, perhapsusing debt financing, which would generate a nice tax deduction[277] to sweeten his basic plan, and then gifts fractional shares of the building to hischildren. Tom then pays each of his offspring rent. The rent is a business deduction for Tom,[278] bringing his taxable income down, and just so happensto fall in each of his children’s “zero bracket.” Tom and kin pay no tax on the transferred amounts, which Tom directs his children to use for their basicfood and clothing — indeed, he can do this himself, as their natural guardian.[279]

More elaborate examples of the ancient sheltering art could be put forward, but these four simple tax-planning strategies serve to illustrate the pointperfectly well. All were alive and flourishing, in one form or another, for long periods in American tax law. The interest dodge, the classic shelter, and thekiddie shift were pretty much in full flower coming into the 1986 Act; either of the first two alone was sufficient, taken to its limits, to make the entireincome tax voluntary, even for those without their own financial capital stakes to play Tax Planning 101.

2. What TRA 1986 Did, and Did Not, Do

The traditional view of tax sees the choice of broad-based systems as one of income versus consumption. Andrews’s important articles from the 1970shad opened up an attractive avenue for tax reform, in the form of a progressive postpaid consumption tax. The influential Blueprints for Basic Tax Reformhad traced out the two perceived forks in the road, perfecting the income tax or moving towards a consistent consumption tax.[280] TRA 86 ostensiblytook the income-tax path.[281] This epochal legislation’s general strategy was to widen the income tax base, by eliminating scores of exemptions,exclusions, and deductions, in order to bring tax rates down. In particular, TRA 86 shut down all the shelters mentioned above, with the exception of thosealready shut down.[282]

There is thus no longer a general deduction for personal interest, and investment interest is subject to a “netting” rule:[283] the interest dodge is dead.Susie can still borrow money, but she cannot use the interest to offset her salary for tax purposes. Pure straddles had already been attacked, and thecapital loss offset rules generally limit the usefulness of Joe’s simple straddle idea.[284] The sweeping passive activity loss rules of section 469effectively shut down the classic shelter in most of its incarnations.[285] Susie can still run a rundown hotel, but she cannot use the tax losses generatedthereby to subtract from her salary as a doctor on her tax forms. The “kiddie tax” killed Tom’s clever idea, again in most instances, by putting children inthe same marginal tax bracket as their parents for unearned income[286]

Tom can still give his office to his children and pay them rent, but he will find them paying the same tax he otherwise would. In sum, TRA 86 wassystematic in curtailing tax shelters, thereby stopping the bleeding in tax and enabling lower tax rates on a broader tax base. But — and herein lies therub — the watershed TRA 86 did nothing about Tax Planning 101 or any of its three simple steps. TRA

86 did not touch the realization requirement of Macomber, although Congress clearly has the power to do so.[287] TRA 86 did not make debt taxable, or adeemed realization event for people with appreciated assets. TRA 86 did not alter or repeal the stepped-up basis rule for assets acquired on death. It istrue that TRA 86 repealed the capital gains preference, which resulted in an interim rise in its rate. Capital gains had for a significant time been set at 40percent of the ordinary income tax rate; thus, the top capital gains rate was 28 percent when Reagan took office with a 70 percent top ordinary ratebracket. When Reagan oversaw his first major tax-cutting bill, the Economic Recovery Tax Act (ERTA) of 1981, the ordinary rate fell to 50 percent. Thecapital gains rate fell in step, to 20 percent. TRA 86, which instituted a marginal rate bracket of 28 percent on the highest incomes,[288]eliminated anyfurther and specific capital gains rate preference, thus, in essence, restoring the pre-ERTA rate of 28 percent on capital gains. Interestingly, this created anatural experiment to see if capital transactions were elastic to the tax rate; there was, indeed, a spike in sales under the outgoing 20 percent regime.But recall that the capital gains rate, as argued above, is a reaction to the very existence of Tax Planning 101. Since TRA 86 left Tax Planning 101unchecked, its elimination of the capital gains preference was fragile from the start. A preferential rate soon enough reappeared, with the elder GeorgeBush maintaining the top rate at 28 percent when ordinary income tax rates went up; Bill Clinton reducing it first to 20 percent, then later to 18 percent;and the younger Bush bringing it down to its current 15 percent. As this saga of capital gains preferences played itself out, the simple advice ofbuy/borrow/die lived on.

What TRA 86 — one of the most sweeping acts of tax legislation ever passed, and the subject of laudatory volumes from the popular press[289] did wassimple. It shored up the status of the “income” tax as a prepaid consumption or wage tax. Shelters for wage earners were shut down or drasticallycurtailed. Yet people with capital could still buy, borrow, and die to their hearts’ content; tax remained voluntary for those with financial capital.


Tax policy typically suffers from blinders when it comes to taxes other than the income tax.[290] The personal federal income tax is, indeed, the largestAmerican tax. At least for the time being, the income tax also features relatively high marginal tax rates and rewards at least some sophisticatedplanning, even after the TRA 86 put a lot of tax shelters out of business.[291] The income tax’s size and malleability warrant its status as a relative staplein American law school classrooms. Yet, large as it is, the federal income tax accounts for less than one-half of all federal government revenues, and lessthan one- third of all taxes in America, state, local, and federal combined.[292]

Other taxes must be factored in to any general theory about fairness in tax today.

The new understanding of tax helps us to see the larger context of tax today. For while certain taxes — most importantly the corporate income and giftand estate taxes — are meant to correct for holes in the income tax’s commitment to taxing capital, they do not effectively do so. When we widen thelens of our inquiry to consider the state of tax generally in the United States, a surprise awaits: the principal theme advanced in the last Part onlydeepens. The American tax system, writ large, is moving, seemingly inexorably, towards a consumption tax — and specifically, under the newunderstanding of tax, towards a prepaid consumption tax — at relatively flat rates. What capital taxes remain are erratic in their operation, unprincipledin their conception, and — not unrelatedly — fragile in their vitality.

This Part explains these comments, beginning with the critically important payroll tax system.

A. Payroll Taxes

No normative analysis of tax today should ignore the payroll tax system. To begin with, the combined social security and Medicare system is indeed a tax:not only are the exactions from wages mandatory (the classic hallmark of a tax), but they are also untethered from any precise benefit or payback system— social security has long been on a “pay as you go” basis.[293] This means that the benefits system of social security, which indeed has some elementsof progressivity in it, can be separated from the contribution or tax part of the system.[294]

The payroll tax is also big. The employee pays 7.65 percent of her pretax wages: 6.2 percent for social security, up to a ceiling presently set at $90,000,plus 1.45 percent for Medicare, with no ceiling.295 The employer pays a matching share, but the real incidence is all on the employee: this is anemployee-specific cost, one that a rational employer must factor into account when considering whether to hire, and how much to pay, an employee.Consider, for example, an employee earning $10,000. She must pay $765 out of her wages in payroll taxes, and her employer must pay a like amount. Thismeans both that her employer considers her labor to be worth $10,765, and that $1,530 has gone to the government on account of her paid work.[296]

The full amount of $1,530 — the total tax, including the employer’s share — could go to the employee if Uncle Sam released his hold on it.[297] (The self-employed see this all much more directly, as they must themselves pay 15.3 percent of their wages up to $90,000, and are allowed an income-taxdeduction only for one-half of the total payroll taxes they pay.) The net result is a flat, 15.3 percent tax on labor earnings, starting with the first dollarearned, and extending upwards to $90,000, after which the social security tax ceases and the payroll tax rate drops down to the 2.9 percent (two times1.45 percent) of Medicare alone.

Table 3 puts together the payroll tax rate structure with that of the basic income tax, using 2003 rate brackets after tax reform.[298] Such tables are difficult to construct with any precision, on account of the considerable complexity within the income tax: varying “zero brackets” based on whether ataxpayer itemizes or not[299] and how many personal exemptions she has;[300] inframarginal rate changes brought on by the earned-income tax creditand its phaseout;[301] the loss of personal exemptions;[302] the alternative minimum tax;[303] and so forth. The table nonetheless gives the basic ratestructure facing a single individual taking the standard deduction.[304] It ignores the important EITC available for low-income taxpayers,[305] and sounderstates the degree of progression in the total tax system, although the EITC also adds a burden onto lower middle class taxpayers.[306]

Still, it gives a basic sense of the matter, while helping to illustrate why the EITC is so important. Most importantly, Table 3 shows how big the payroll taxsystem is, relative to the income tax.

A New Understanding of Tax_html_m791da0e

An individual taxpayer begins to pay 15.3 percent in payroll taxes right away on her first dollar of wages, with no accommodation for family size, medicalneeds, or anything else. Thus, over the range from $0 to $90,000, a taxpayer’s average or effective payroll tax rate — as well as her marginal one — is15.3 percent. In contrast, a single person under the income tax would have to earn over $53,000 before her average income tax rate was as high as 15.3percent.[307] Given that the average annual pay in 2000 was slightly over $35,000 per worker,[308] it should not be surprising to learn that between 70and 80 percent (or higher) of families with positive taxes pay more in payroll taxes than in income taxes.[309] Yet the payroll tax, alone among majorfederal taxes — the personal and corporate income and gift and estate taxes has never been cut.[310]

In any event, it is the aggregate of payroll and income taxes that matters to a rational taxpayer. Table 3 shows the rather compressed rate structure underthe payroll plus income taxes combined. It starts at 15.3 percent, quickly hits 30 percent, peaks at $76,800 at 43.3 percent, and then declinesprecipitously at $90,000, although it never falls below 30 percent or rises above 40 percent. Anyone who earns between $15,000 and infinity in wagespays federal taxes in this narrow band, between 30.3 and 43.3 percent, with the top endpoint at 37.9 percent.

Most important for the new understanding of tax, the social security or payroll tax is a canonical instance of a prepaid consumption tax. Its single levy isapplied up-front as money is earned in labor markets, and never again: no social security “contribution” is asked of returns in the capital or beneficentmarkets. Combined with the understanding that the nominal income tax is largely now a prepaid consumption or wage tax — the theme of the prior Part— this gives a dark spin to Table 3: the United States is evolving a steep wage tax, one that falls especially hard on the middle classes, at compressedrates.

B. Death — to the Rescue?

The payroll tax makes no effort to collect any tax on the yield to capital or from beneficent transfers. The income tax also ignores beneficent transfers tothe transferee, and, although it is intended to fall on the yield to capital, the actual income-plus-realization tax is erratic at best in living up to itstheoretical commitment. In large part for this reason, defenders of the idea that capital ought to bear some positive tax burden — that is, supporters ofwhat the new understanding of tax refers to as the yield-to-capital norm — have long advocated other, supplemental taxes to “backstop” the income tax,specifically in regard to the yield to capital.[311] Chief among these addenda has been the gift and estate tax.

There has been much debate of late about the estate tax, whose supporters seem to be losing: EGTRRA, the 2001 tax act, gradually weakens the tax, thenaltogether repeals it for the single year 2010, then brings it back in full force.[312] Congress has repeatedly considered extending the repeal, to make theelimination of the tax permanent.[313]

There is no need to rehash here the basic arguments over repeal, reform, or status quo. The main practical, descriptive point, for the new understandingof tax, is simply that the estate tax has been a very porous backstop to the income tax, indeed. The main theoretical, prescriptive point to see is that a giftand estate tax is not needed to backstop a consistent, progressive postpaid consumption tax in the first place.

Although, as with capital taxes under the income tax, decedents’ estates do pay some tax, the yield is consistently small.[314] Tax Planning 101,discussed above, provides a roadmap for readily avoiding the estate tax, by dying with net assets under its generous exemption level: spending it all anddying broke being the limiting case. This is morally problematic, because it is far from obvious that the spending of the rich is to be encouraged, or is anyless harmful than their passing on of wealth — and shortly we shall see that Tax Planning 101 can be used to pass on wealth, as well, if the wealthyperson so desires.

The use of Tax Planning 101 to avoid all federal taxes — the estate tax in particular by dying broke, or nearly so — shows once more that the deepproblem with the status quo is not, as Andrews put it in 1974, with its inconsistent treatment of savings or accumulation. Rather it is with the use ofcapital transactions to finance consumption, tax-free. This allows a restatement of a central theme in the new understanding of tax: All capital is not thesame, from the perspective of the quest for individuated justice in tax. What matters, morally, is the use that individuals make of their capital, not thesource of the yield to capital. Andrews saw the “worst inequity, distortion, and complexity” in the income tax’s treatment of accumulation, or savings. Notseeing — or not wanting to see, under the influence of Mill — any way to split the difference, to make distinctions among the uses of capital (as he hadmade among the uses of consumption in his 1972 article), Andrews recommended going all the way, to the total nontaxation of capital. Under the newunderstanding of tax, a surprising insight arises. What is problematic about the status quo — what is its “worst inequity” — is not the treatment ofaccumulation or savings, in and of itself; it is, rather, the inconsistent treatment of consumption, the other term on the right-hand side of the Haig-Simonsidentity. Through its structural problems, beginning — but not ending — with its inconsistent taxation of accumulation, the income-plus-realization taxallows the consumption of the wealthy to escape taxation altogether. The estate tax is not at all a “backstop” to this problem — of consumption financed by capital — because its mere existence encourages it. A potential taxpayer who has amassed or acquired significant portions of capital need not pay anyfurther tax, whatsoever, within her lifetime, no matter what her lifestyle. This is problematic.

Still, one might support the estate tax within the context of a basic consumption tax — even a prepaid consumption tax — model, as ensuring that a taxgets levied at least once per generation.[315] (Another, different way to support an estate tax under a consumption tax model is as a corrective to thelarge accumulations of “private” capital that a consumption tax allows, and even encourages; Andrews followed this rationale,[316] and I shall addressthis argument later.) The idea is that wealth coming into an individual’s possession — via labor market earnings or beneficent transfers — should betaxed once, and then all second taxes at the individual’s level should be avoided, in the spirit of Mill. If such a system were to work, the pressure on thechoice of prepaid versus postpaid consumption tax would lessen, because the greatest problems of socio-economic inequity tend to take place, as bothRawls and Robert Nozick, in their different ways, noticed, with a problem of iteration over time.[317] The more generations go by without the corrective ofa tax, the more the unfairness compounds. But so long as each generation is taxed once — the estate tax serving as a proxy for an accessions tax, making sure that a tax is paid before the receipt of beneficent transfers — the problem of iteration is held in check. If the gift and estate tax worked as planned, itwould put labor market and beneficent market returns on the same footing — taxed once each generation of beneficial users — with only capital marketearnings free of taxation, the latter in accordance with Mill’s principle.

The practical problem with this happy possibility is that the gift and estate tax does not work as planned. Even without further weakening — which seemsall but certain to happen[318] — the estate tax is simply not a very effective mechanism for levying a tax on second or subsequent generations. It has toomany holes, and of such a sort, as to make it inherently defective for the task. Consider the following two gaps.

One is the basic exemption amount, or so-called unified credit, now set at $1.5 million per person on death and $1 million for inter vivos gifts. A marriedcouple, with proper planning, has $3 million — scheduled to rise to $7 million by 2009 and to infinity, at least briefly, in 2010 — to pass on death,altogether tax-free. The $1 million amount can be given by any person, at any time, to any other person, without triggering a gift or estate tax.[319]Standard, sophisticated estate planning allows a basic leveraging of the value, as by placing assets in a family limited partnership form.[320] Wealthyparents with two children can transfer up to $2 million of prediscounted property to each child, altogether tax-free, and the children — or their financialadvisers — can play the Tax Planning 101 game to their heart’s content. If the wealth is transferred when the parents are 50 years old, and invested at an 8 percent rate of return, it will grow to being worth over $20 million per child by the time the parents reach 80.

In addition to this unified credit or exemption amount, there is a second hole, the “annual exclusion amount,” presently set at $11,000.[321] This is a per-donor, per-donee, per-year amount that can be given altogether tax-free. Once again, standard, sophisticated estate planning allows the values to bedoubled, with two parents, and perhaps quadrupled, with fractional share discounts. Two parents can give each of their children $30,000 or more worth ofvalue each year altogether apart from the exemption amount, just discussed, and also not including qualified medical and tuition expenses[322] — tax-free. A pattern of such annual giving, begun at birth, can easily result in each child having $8 million, tax-free, at her fortieth birthday — a good stake forplaying the Artful Dodger’s game.[323] Skillful use of perfectly legitimate estate-tax planning advice can get tens or even hundreds of millions of dollarsout of one’s estate, tax-free. So much for the once-per-generation norm.

These problems with the estate tax follow from its structure; it is a back-ended wealth tax, typically imposed when someone dies, on the wealth she hasleft over on her deathbed. But death is a difficult time to tax. Given the incentives generated by the tax’s high marginal rate structure, wealthy patronscan and do plan ahead to avoid it, making it the original “voluntary tax.”[324] Tax Planning 101 combines with Estate Planning 101 — give early, often,and in trust[325] — to eviscerate the tax. It is a mistake to think that Tax Planning 101 need be practiced by narrowly selfish individuals. While dyingbroke is the simplest and surest way to avoid the estate tax, the borrowing in buy/borrow/die can be used to transfer wealth down to the next generation,as well. In such a case, there is no tax at all in the second (or later) generation(s). The problems of iteration can become severe. A dramatic illustration of the stakes and problems has been the recent trend, initiated by estate-planning practitioners, to have states repeal the hallowed Rule againstPerpetuities, so as to allow wealthy benefactors to set up “dynastic” — that is, potentially infinitely lived — trusts.[326]

As it has been argued in the past, it still may be argued that an estate tax, with all of its holes, is better than nothing. This is parallel to theconsequentialist objection to income tax reform, considered above: the income tax may be rather ineffective at getting at capital, but at least it tries, andso we ought to retain it in the name of fairness. The support for the estate tax similarly follows from the implicit acceptance of the yield-to-capital norm:any taxes that get at capital are better than nothing. Within the traditional view, a consumption tax is the “nothing” in this choice set because it does notget at the yield to capital at all, and so advocates of the yield-to-capital norm cling to whatever is left of the income and estate taxes.

Fortunately, we do not have to face the choice of an ineffective estate tax or nothing. The new understanding of tax changes things. When we get the fairtiming of tax down right, we see that there is a better way — and a better time — to tax than either the moment of initial earnings or the time of ultimatedeath.

C. Corporate Taxes Too

The corporate income tax, like the gift and estate tax, has been defended as an important “backstop” to the personal income tax.[327]

The argument is that the corporate income tax gets at wealth that is left in the corporation — a tendency aggravated by Macomber — and so cuts againstthe deferral of the realization requirement. The desire to have a backstop to the basic income tax reflects the normative commitment to taxing capital andits yield, and an understanding that the actual income tax falls far short of implementing this goal. Yet, even less so than the gift and estate tax, thecorporate income tax is not a satisfactory backstop to the income tax.

To start with, like the gift and estate tax, the corporate income tax is porous and avoidable.[328] But there is a much deeper problem with the corporateincome tax. It is the problem of incidence — of who, really, ultimately bears the burden of the tax. Corporations are legal fictions; only real people payreal taxes. Thus the dollars remitted to the government on account of corporate taxes must come out of someone’s pockets, somewhere along the line.There is a great deal of uncertainty on this matter among sophisticated public finance economists. There are two broad candidates for ultimate payors,and each is problematic in terms of the fairness of tax. Some models suggest that some or all of the real burden of the corporate tax falls on wages orconsumption, adding to — not counterbalancing — the general bias of the status quo, towards a prepaid consumption tax.[329]

The corporate tax becomes a wage tax in drag. Other models suggest that some or all of the corporate tax falls on capital. This burden on capital cannotbe specific, however, as in a naive partial equilibrium model; it cannot be the case that the particular owners of particular corporations see the corporateincome tax come out of their pockets. Capital is capital, and it seeks a competitive rate of return. Thus, pricing or capitalization effects equilibrate themarkets after the corporate tax falls, so that all capital bears a competitive after-tax rate of return. In other words, the incidence of the corporate incometax, to the extent it falls on capital at all, must be felt rather generally in all accessible capital markets.[330]

In this very generality lies a problem. Those who see the corporate income tax as an important “backstop” to the income tax see it as an important tax oncapital. Yet the new understanding of tax has shown us that we do not want to tax all capital, all the time. This leads to a particular critique of thecorporate tax: to the extent it falls on capital at all, it is not an individuated tax — it fails Vickrey’s (and our) test for progression. The burden on capital makes it just as hard to engage in the kind of ordinary-savings or smoothing transactions that ordinary moral intuitions favor, as well as in the kind ofelevating, shifting transactions that these intuitions want to reach — it does not split the ordinary-savings and yield-to-capital norms. The corporateincome tax also does not make any differentiation based on the level of the beneficial owner’s income, consumption, or wealth; it is a crude one- size-fitsall tax, a flat tax in essence, like the current capital gains or corporate dividend tax.

If corporate taxes are to be justified, it must turn on the political economy, or the psychological political economy, of hidden taxes,[331] and not on theprincipled taxation of capital. Corporate taxes are simply far too crude a mechanism to effect individuated fairness in getting at the yield to capital oranything else.

D. State and Local Taxes

Roughly one-third of all taxes in America are collected at the state and local levels.[332] These, too, ought to play a role in any general theory about thefairness of tax.

The three largest state and local taxes are sales (36 percent of total), property (29 percent) and income (27 percent) taxes.[333]

At first glance, sales taxes are paradigmatic of the postpaid consumption tax. But here is a place where the traditional view of tax still holds. Becausestate and local sales taxes are flat taxes, they are indeed equivalent to wage, or yield-exempt, taxes under the traditional view, as Ant and Grasshopperhelped us to see. The reason to care about the new understanding of tax is to preserve and, indeed, strengthen the tax system’s commitment toprogressivity in effective tax burdens. State and local sales taxes more or less moot the point.

The remaining state and local taxes do not offer much of an antidote to what is happening on the federal side. State and local income taxes tend tosimply, and by rote, track the federal income tax, and thus contain all of the holes in the commitment to taxing savings we have been exploring. Thisleaves state and local property taxes, which do indeed effect some degree of progressivity, being based on the assessed value (or initial purchase price)[334] of real or personal property. But real property taxes, by far the major part of property taxes, tend to finance local public goods,[335] and often get“capitalized” into the values of homes. Without even factoring in the income tax deductibility of these payments, the equities of state and local propertytaxes are rather crude, at best.

E. Summing Up: A Voluntary Tax

Add together the so-called income tax, considered in the last Part, and the panoply of taxes considered in this Part, and this is what we have in America inthe early years of the twenty-first century: a highly burdensome wage tax at compressed tax rates. The major tax is the federal personal income tax, butthis is increasingly equivalent to a prepaid consumption or wage tax, at historically and relatively (since World War I) flat rates. The payroll tax is by farthe second biggest tax in the landscape, and it does not even pretend to be anything other than a rather flat, even regressive wage tax. State and localtaxes scarcely even try to posit a counter trend, and indeed tend to rely on flat sales taxes that feature yield exemption. The two federal taxes that aim atcapital — the gift and estate and corporate income taxes — are scattershot affairs at best, small in their magnitude, fairly easily avoided, and in anyevent crude in their ultimate equities.

In sum: taxes on beneficent transfers scarcely exist. Taxes on capital are easily avoided and virtually voluntary. Taxes on wages are high and inescapable.This is where we have come, guided by the traditional understanding of tax. Where to, next?


Traditional tax policy endlessly debates between the income and consumption taxes, mistakenly equating both forms of consumption taxes, which it seesas exempting the yield to capital — or, sometimes, falling arbitrarily on it — by design and on principle. Under the traditional view, the only hope tosatisfy both an ideological and an ordinary moral intuition to tax the yield to capital is to cling to an income tax. While one can blame special interestpolitics or other ills for the failure of the current tax system to address its many gaps, another culprit lies close at hand, like Poe’s purloined letter: theory, and most importantly, the traditional view of tax itself.

When we take a closer look at the analytic muddle of tax, we understand that we do not have, have never had, and will never have a pure income tax,largely for the reason that we do not want one. What we have is a mishmash of income and consumption tax elements.

The traditional view of tax would have us be forever doomed to some such uneasy compromise. For we are, it would seem, of two minds when it comes to the taxation of savings. With one mind, we want to tax the yield to capital, and hence we cling to the forms of income, corporate income, and gift andestate taxes. But with the other mind, we do not want to tax savings, and hence we riddle the so- called income tax with exclusions and deductions, andlack the will to strengthen the structural flaws applying to the taxation of the yield to capital.

The new understanding of tax liberates our minds from the grip of theoretical incoherence that dooms the present practice of tax. Normative reflectionfirst identifies and then reconciles the ordinary- savings and yield-to-capital norms. It turns out, mirabile dictu, that the people are of one, not two, minds— with two norms, not one — when it comes to the taxation of capital and its yield. It seems fair and appropriate to burden capital transactions whenthese facilitate or enable a better lifestyle, reflecting a greater “ability to pay” or more “benefits received” from the social compact. But it does not seemfair and appropriate to burden capital transactions when they are used simply and sensibly to move around in time uneven labor market earnings. Theseare ordinary moral intuitions that theory can easily accept, in a Rawlsian reflective equilibrium. The new understanding of tax shows us, analytically, thata consistent progressive postpaid consumption tax implements these two norms by design, simply, and at the same time.

All that remains, though it has been anticipated, is a normative argument, that this is should become an ought, and the clearing up of some final looseends. Those are the aims of this final Part.

A. A Better, If Less Sophisticated, Argument

Andrews’s “best, most sophisticated argument” for a consumption tax tracked Mill’s earlier observation about double taxation, which in turn had roots asfar back as Hobbes.[336] Andrews’s was primarily a horizontal equity argument, about preserving the pretax equality between present and deferredconsumption, between spenders and savers, Ant and Grasshopper. Mill had elegantly made the point at a time when taxes were few and rates were low.

A century and a half after Mill, things have changed. We have a better understanding of capital markets. More importantly, tax has expanded greatly inscope, and high tax rates — certainly compared to any Mill himself contemplated — are here to stay. These changes ought to lead to a rethinking of thegrounds for consumption tax. Under progressive marginal rates, a postpaid consumption tax does not feature yield exemption by design. Nor does such atax operate randomly. Capital market transactions that elevate lifestyles bear a higher burden of tax; those that smooth or diminish lifestyles lower theburden. This pattern of effect on the yield to capital is not a reason to abandon postpaid consumption taxation or progressive rates. Far from it: on thebetter understanding of tax, it gives a reason to support each. It is the argument structure for a consumption tax, of the right sort, that needs repair. Aprogressive postpaid consumption tax need not preserve the pretax equality of savers and spenders, and need not increase savings or the aggregatecapital stock at all. The tax needs a better if less sophisticated argument to justify it. Fortunately, this lies at hand, in common sense and ordinary moralintuition.

The answer lies not far from asking the right question: the question of the fair timing of tax. Under the new understanding of tax, the great divide isbetween taxes on inflows and taxes on outflows. The income and the prepaid consumption taxes stand together on one side of this divide, opposed by thepostpaid consumption tax. Prepaid consumption and income taxes each make their decisions about the fair burden of tax at the time of inflow into ahousehold; the difference is that an income tax includes capital market yields (as well as, possibly, beneficent transfers[337]), whereas the prepaidconsumption tax includes labor market earnings alone. But as Figures 1-6 illustrated, and common sense confirms, the pattern of inflows is, from a moralpoint of view, arbitrary. Predicating progressivity on inflows means that one’s effective tax burden turns on matters of luck and whim vis- à-vis the timingof inflows. This affects choices of life plans — it discriminates based on patterns of study, work, and leisure, having little or nothing to do with commandover material resources, ability to pay, or benefits received. At the same time, the income tax constrains the progressivity in the design of the tax system, the very thing an individuated tax system ought to be facilitating. Progressive wage taxes can only be avoided by not working, which imposes a cost to thewider society without apparent benefit.[338] There is no way out.

A consistent progressive postpaid consumption tax, in contrast, makes its decisions about the appropriate degree of progressivity at the right — fair —time.[339] It falls on outflows, or spending. Such a tax favors (or does not disfavor) capital smoothing transactions, but imposes a tax — in the form of thehigher effective progressive rates on lifestyle enhancing or capital upward shifting transactions. There is luck in what happens in capital markets — asthere is luck, too, in labor market earnings and beneficence[340] — but, importantly, this is luck that relates to the very reasons for deciding on theappropriate burden of taxation, luck that goes to command over material resources, ability to pay, and benefits received. It is not the morally insignificantluck over the timing of the receipt of material resources; it is the morally significant luck that goes to the extent of one’s total control over such materialresources.

A consistent postpaid consumption tax is source neutral in an appealing sense; it falls equally on labor market, capital market, and beneficent transfers,provided that they are used to elevate a taxpayer’s lifestyle. It does not matter what, exactly, supports an individual’s standard of living. All that mattersis that something did. Hence, the animating norm of the tax is solidly a vertical equity one, looking to a consistent, meaningful, observable, andcomparable measure of interpersonal well being. Among many other practical virtues, the tax can finesse questions of the precise source of wealth orincome — whether it was derived from labor, capital, or beneficence. This is a significant improvement on the status quo, in both theory and practice. Within lifetimes, much effort today goes into dressing up labor earnings in capital clothing, such as through the use of stock options. A consistentpostpaid consumption tax does not mark the distinction. Across lifetimes, wealth can be transferred either by financial and physical capital, or by humancapital — the children of the wealthy tend to get better (more expensive) educations, better networks, more job connections, and so forth.[341] Thecurrent regime, imposing a porous income-plus-estate tax, scarcely hits at intergenerational transfers of financial capital, although it does capture humancapital ones, by wage taxation at the child’s level. The postpaid consumption tax once again does not mark the distinctions. Financially privileged livesare taxed, on account of the privilege, however financed.[342] The practical virtues coincide with a moral, theoretical appeal.

At the same time, a consistent progressive postpaid consumption tax implements the other norm of capital, the ordinary-savings one. Capital transactionsthat smooth lifestyles, within or between generations, lower the aggregate burden of taxation.

For the most part, taxpayers do smooth. But a consistent, progressive postpaid consumption tax as I have described it (that is, without a mechanism suchas Vickrey’s cumulative lifetime averaging to modify or define it)[343] determines its level of progressivity on the basis of taxpayer’s actual consumptionpatterns, whether taxpayers have smoothed or not. Just as such a tax system allows taxpayers to lower the burden of taxation by smoothing, it penalizesthem, at the margin, for not smoothing. What is morally compelling about one’s spending level, in general, and, in particular, about average annual labormarket earnings in constant dollar terms? A consistent, progressive postpaid consumption tax makes its decisions of the appropriate level of taxation onthe basis of the former, and allows capital transactions that effectuate the smoothing to the latter to lower the burden of taxes. Why?

First, spending, as already suggested, reflects a fair and objectively observable measure of a taxpayer’s standard of living, command over materialresources, ability to pay, and benefits received. Spending turns on importantly voluntary, autonomous decisions, as Adam Smith suggested, rather thanthe impersonal, external factors that affect the timing of inflows.[344]

Second, and related, capital transactions that smooth uneven labor market earnings do not reflect greater ability to pay, benefits received, or commandover resources. They are simply the means by which one finances her lifestyle through time, dealing with the particular patterns of human and financialcapital realizations. Using a smoothed consumption line as an analytic baseline allows us to see two effects of a consistently progressive postpaidconsumption tax in its interaction with capital market transactions. First, taxpayers who fail to perfectly smooth consumption can pay a price for theiruneven spending profile; this was the “paternalistic push” of the system, noted above[345] (though, again, it can be eliminated through cumulativeaveraging within the postpaid consumption tax system). But, second, and much more important, taxpayers who can do better, in material terms, than theiraverage annual labor market earnings will see the value that enables them to do so — whether from capital market or beneficent transactions — taxed ata higher rate. If the combined present value of one’s lifetime annual consumption exceeds that of one’s aggregate lifetime earnings, something hashappened to allow the taxpayer to elevate herself in material consumption terms. The smoothed consumption line accepts the best lights reading of Mill’sargument against “double” taxation, and Andrews’s case for preservation of the pretax equality of savers and spenders, while at the very same timeconceding the most powerful criticism of these positions made by Warren and others, namely that those who receive a return to capital are better off, interms of their command over material resources, than those who do not. If capital has made one richer, viewed in a wide lens of time, the yield-to-capitalnorm (and vertical equity generally) demands that we tax the yield; if capital transactions have merely moved resources around in time, the ordinary-savings norm (and horizontal equity generally) demands that we not burden its yield. The smoothed consumption line, as a baseline for choosing the levelof progressivity imposed, is a principle imperfectly reflected in our present practices, most importantly in regard to retirement savings.

The bottom line, normatively, is what strikes us all as fair.[346] A prepaid consumption tax — like the current “income” tax — makes its judgments on theappropriate level to tax on the basis of labor earnings alone. It would ignore all the sources of enhanced lifestyle from capital markets or beneficenttransfers and penalize those with temporally uneven labor market earnings. A progressive postpaid consumption tax makes its decisions about theappropriate level of taxation on the basis of outflows. This means that capital transactions that smooth out uneven labor market earnings will lower theburden of taxation; both capital market and beneficent transactions that finance greater lifestyles than one’s own earnings would allow raise the burden.[946.]

The best, most sophisticated argument for a consumption tax of the right sort — a progressive postpaid consumption tax — is that this tax makes itsjudgments about the appropriate level of taxation at the right time, allowing for a fairer, more enduring degree of progression in tax burdens in boththeory and in practice, and differentiating between savings and investment activities that simply move around labor earnings in time and those thatfacilitate greater levels of consumption, alone among major comprehensive tax options. This is not as neat and elegant an argument as Andrews’s “most sophisticated” one. It does not pivot on any simple, handy turn of phrase. But it is a better argument. It connects the fairness of the tax base question —income versus

consumption, of both forms — to the issue of progressivity by means of the fair timing of tax. It thus not only reconciles the two appealing norms aboutthe taxation of savings the ordinary-savings and yield-to-capital norms — but it also allows for a better, fairer, more meaningful and enduringprogressivity in tax burdens. This is true both internal to the tax system or base in question, and external to them. Internally, a consistent, progressivepostpaid consumption tax tethers its decisions on the appropriate level of taxation to the objective, observable, meaningful variable of personal spending.Externally — as a matter of tax system design — a postpaid consumption tax importantly allows for more progressivity in tax burdens.[347]

B. Transitions, Implementation, and Objections

This Article has mainly been concerned to advance the new understanding of tax. I have addressed many of the practical issues of transitions to andimplementation of a progressive postpaid consumption tax elsewhere, as well as noted the most frequent objections to the practical proposal.[348] Thissection simply quickly canvasses some important themes, in the interest of at least noting them.

1. Implementation

As Andrews set out perfectly well in his 1974 and subsequent articles, a postpaid consumption tax is not difficult to implement. In particular, a consistentpostpaid consumption tax does not entail adding up all the particular items of consumption. Rather it rests on the simple elegance of the Haig-Simonsdefinition of Income, Equation [1] above. If Income equals Consumption plus Savings (I = C+ S), then Consumption equals Income minus Savings (C = I – S).All that is needed to implement a consistent progressive postpaid consumption tax is to systematically subtract savings from “income,” measured just aswe do today. This means, of course, adding in dissavings — including debt, to which we turn in a moment.

There are hard cases, of course, of defining “consumption,” but most of these already exist under the income tax (which after all includes consumption inits base, as well, as the Haig-Simons definition shows). The simplest way to get from the current system to a consistent postpaid consumption tax model is to repeal all limits on traditional IRA plans, and include debt as taxable “income.” Then one could repeal preferential rates for capital gains and allrules for the “basis” of investment assets.

2. The Role of Other Taxes

One considerable practical advantage of a consistent, progressive postpaid consumption tax is that it at least lessens the need for both gift and estateand corporate income taxes. These taxes have been perhaps best justified as being important “backstops” to the actual income tax’s flawed instantiationof the income ideal. Both taxes reflect a desire to get at some capital; the gift and estate tax might also reflect a norm to tax at least extraordinary, largeamounts of beneficence. Under the traditional view of tax, the gift and estate tax in particular is often thought to be important in any movement towardsa consumption ideal. This is either because a consumption tax enables second and later generations to live off the fruits of a prior generation’s capital,altogether untaxed, or because a consumption tax facilitates the building up of large stocks of private capital, as Andrews maintained.

Under the new understanding of tax, things change. A consistent, progressive postpaid consumption tax does fall on the yield to capital, under the rightcircumstances, and at a compelling time. Such a tax is also individuated, meeting Vickrey’s test. Second and later generations are taxed at the moment ofexpenditures, and the tax burden on the family will have increased if these descendants are in fact consuming at a higher level than their ancestors.Arguably, this incentive to redistribute wealth within extended families is a welfare- improving one.[349] In any event — and this is important — aconsistent postpaid consumption tax would impose a far greater, far more systematic and principled burden on inherited wealth than what obtains today,under the flawed income-plus-estate tax regime. As things now stand, under the effective prepaid consumption tax model, both present and futuregenerations living off the yield to capital need pay no tax. Relatedly, I shall consider below the theoretical issues involved with large stocks of privatecapital, which a postpaid consumption tax might be thought to make more likely and prevalent.[350] But it is again worth pointing out, however, both thatsuch large stores of capital can and do easily arise today, under the essentially “voluntary” tax on capital imposed by the income tax, and that stocks ofprivate capital might well decrease under a conversion to a consistent postpaid consumption tax, because under it — unlike the status quo —consumption financed by capital will bear a positive burden of tax.

A compelling case can be made, then, to replace the current income, corporate income, and gift and estate taxes with a consistent postpaid progressive consumption tax — and all to get at the yield to capital in a better, fairer, more individuated and progressive way. Such a tax consistently taxes people,including heirs, when they spend, not when they work or save. Aside from consistency, this principle comports with ordinary moral intuitions aboutfairness in tax. Still, justice might be thought to require some additional tax on inherited wealth, as a freestanding matter,[351] either at the level of thetransferor or in the hands of the transferee. It is worth noting, as a practical matter, that the latter might be effected by allowing earned-incomeallowances under the postpaid consumption tax, in effect isolating out those who live solely off of financial capital for higher tax burdens.[352]

This adds complexity to the simpler proposal for a consistent, progressive postpaid consumption tax, and is perhaps inconsistent with its best spirit, but itcan be done. Similarly, untethered from the idea that an estate tax is somehow needed to “save” the income tax, with its realization requirement and all, a wealth or wealth transfer tax, with broader bases and a much reduced rate structure, can isolate out some of the perceived harms of transferred wealthwithout the steep distortions of the status quo.

Still, much of the normative attraction of the new understanding of tax rests on its more compelling instantiation of a source-neutrality norm. Persons withhigh salaries are benefited in many ways, by the natural lottery of their talents, education, connections, luck, and so on. A consistent, progressivepostpaid consumption tax does not differentiate between and among sources of good fortune — own or other’s labor market earnings, own or other’scapital market yields. All that matters is how one lives in material terms. That is a fairly simple and compelling norm to implement.

3. The New Achilles Heel

To Andrews, and within the traditional view of tax, the realization requirement of Macomber was the Achilles heel of the income tax. And so it is, from theperspective of an ideal income tax. The realization requirement is the first and most important step in converting the so-called income tax into a wagetax. But from the vantage point of a consistent, postpaid consumption tax, the realization requirement gets it right: there is no need to tax until and unlesssavings or investments are cashed out and consumed on private preclusive use.

Under the new understanding of tax, however, a new Achilles heel arises: the tax treatment of debt.[353] It is the “borrow” part of Tax Planning 101’sbuy/borrow/die that is problematic. This is the step that allows consumption to escape tax-free.

The point is especially important because it is so poorly understood. Thus the USA Tax, the practical variant of a postpaid consumption tax that receivedserious legislative consideration in the mid 1990s, tragically neglected to include debt in its base.[354]

Theoretically, the treatment of debt is essential to the fair timing of tax and to providing symmetry to the taxation of capital market transactions byallowing forward as well as backward smoothing, in the manner of Figure 2. Practically, any postpaid consumption tax that does not include debt in itsbase is doomed to failure, on account of the ease of the arbitrage to avoid it.

Hence it is imperative that any real-world postpaid consumption tax tackle the issue of debt. This is the single biggest practical challenge facing the tax.Other perceived obstacles, such as the problem of “pre-enactment basis,” consumer durables, housing, and so on tend to be overstated.[355] The propertreatment of debt is essential to getting tax right.

4. Capital as Power

This section picks up an important and long-bracketed issue. The capital norms central to the new understanding of tax are norms about cash flow — theyare about how to account for and tax the yield to capital as it comes into and out of a household or a taxpayer’s control. But capital has anotherdimension as well: its mere presence and the power and pleasure that this presence brings.[356] What should the tax system do about the stock ofwealth? It was this concern that led Andrews to recommend adding on a gift and estate tax to a consistent postpaid consumption tax, out of worries thatprivate accumulation would grow unbearably great under a consistent consumption tax.[357]

There are compelling reasons, of both a nonideal and an ideal nature, why this concern against a consistent progressive postpaid consumption tax ismisplaced, and that in fact such a tax can adequately meet all of society’s reasonable concerns over the private capital stock.[358] But it is also importantto see that these are, indeed, logically distinct arguments. A tax on, or regulation of, private stocks of capital, at some quanta or in some cases, canaccompany any comprehensive tax plan — income, or prepaid or postpaid consumption. This is an argument worth having out, but it need not derail thelarger debate over comprehensive tax system design.[359]

The practical arguments begin with the fact that the present income tax is not working well, at all, to monitor the situation of private stocks of wealth.The new understanding of tax gives a precise reason to understand why this is so: the current system is largely a prepaid consumption or wage tax thatmakes little serious attempt to fall on capital or its yield. It is therefore a mistake to consider that private stocks of capital will necessarily increase underany conversion to a consistent, progressive postpaid consumption tax. Such a tax will have two large and important base-broadening features. First, therewill no longer be any need for special capital gains rates, or lower rates on corporate dividends and the like. Wealth that is consumed will all be taxed under a uniform rate schedule, just as now obtains, for example, for withdrawals from traditional IRAs and 401(k) plans. Second, consumption that isfinanced by debt backed by capital will now bear a tax. I have no ready way of quantifying the magnitude of this effect, but I suspect it to be large.[360]Finally, the rate structure can also increase in its slope under a consistent postpaid consumption tax. One of the animating goals of getting the fair timingof tax down right is to increase the level of progressivity in the tax system, reversing a seemingly irreversible trend under the status quo, witnessed over ahalf century of tax policy changes. Spending can be taxed in a more steeply sloped fashion than can wages.

These practical advantages of a postpaid consumption tax over the status quo add to the practical difficulties with any separate wealth tax, one thatwould apply to stocks of capital alone. Such taxes encourage consumption, of course, which seems inconsistent with the spirit of a consumption tax, butthe new understanding of tax helps to show that things are not so simple. A consistent, progressive postpaid consumption tax is a tax on capital inimportant cases, after all. But taxes on static sources of wealth are problematic, difficult, and costly. Postpaid taxes on cash flows are far simpler toimplement.

None of these practical, nonideal concerns would carry much weight, however, if theory suggested a large and persistent problem with private stocks ofcapital. As I have suggested, this is not a concern that ought either to favor the status quo, or to prevent a conversion to a more principled andprogressive postpaid consumption tax. Further, 103. even in the domain of theory, there are reasons to believe that the concern over capital as power ismistaken. A consistent, postpaid consumption tax already chills the use of “private” capital to fund private preclusive use at any point in the future,through its tax rate mechanism: the future tax operates as a present lien against potential consumption. Tax rates can — and I believe should — increaseunder the more principled tax system design. The further use of private capital to achieve private benefit can be affected far more by the regulation ofprivate capital than by its taxation. A consistent postpaid consumption tax provides a mechanism to regulate wealth. As I have written elsewhere, apostpaid consumption tax importantly redefines property rights: it changes what it means for wealth to be one’s own.[361]

Society has a stake in the private savings accounts, and is justified in regulating them, just as it does now with IRAs and pension plans. Simply forbiddingmonies in tax-favored accounts from being used to finance personal political pursuits, for example, would go a long way farther than the current tax system and farther than the current regulation of campaign financing — toward curtailing the power of private capital to influence politics.

In short, the problems of private capital as private power, far from posing objections to a consistent, progressive postpaid consumption tax, seem to offera powerful set of reasons for such a tax.

5. Transitions

Finally, it is often thought or written that transition concerns loom large in adopting any form of a consistent consumption tax. While any large-scale taxreform does indeed pose difficult problems of implementation and transition, the new understanding of tax helps to show that there are ways in whichthis usual and customary objection is overstated, or at least misstated. Practically, all that need be done is to repeal the limits on traditional IRAs and include debt as income. Taxing debt poses challenges, to be sure, but the rest does not; the move to a consistent postpaid consumption tax is mainly asimplifying one. Still, scholars fret that moving from a system that directly taxes capital — in theory — to one that does not will create problems. Theconcern is usually put in the terms of the traditional view of tax, that is, as if we were moving from an income ideal to a consumption one. In such a case,it appears as if “old” capital would suffer a fatal blow, whereas “new” capital would be blessed.[362]

But in fact, as the new understanding of tax shows, we do not have an income ideal. A good deal of capital has not yet been taxed under the existinghybrid. Further, as noted above and below, it is wrong to simply assume that any conversion to a consistent consumption tax would mean an increase inrates. A move to a consistent postpaid consumption tax would entail two major base-broadening features: the elimination of preferential rates for capitalgains and other sources of capital income, such as dividends, and the inclusion of debt-financed consumption. These would be balanced against the moresystematic deduction for savings, bearing in mind that much savings already escape tax.

On another hand, the new understanding of tax points to a new set of transition issues. Whereas moving from an income tax ideal to a prepaidconsumption model is simple enough — one gets there by repealing all second taxes on capital, as current policy seems bent on doing — and thetransition from an income ideal to a postpaid consumption one has at least been well-studied, the new understanding argues for the replacement of aprepaid with a postpaid consumption tax model. While actual law has allowed conversions of IRAs in the other direction — from traditional to “Roth”style[363] — the converse can be tricky. The attendant problems warrant study.

C. Common Errors About Income and Consumption Taxes

We have come a long way, using many words, covering the intellectual history of tax, the status quo, tax theory and practice in the income and othertaxes, and more. Now it is time to be brief, to list some lessons and final thoughts. Before concluding, this section simply lists and comments on somecommon mistakes in the popular understanding of tax systems based on the traditional understanding of tax that have been impeding better, more fruitfuldiscussion about tax reform. The new understanding of tax helps to set things straight.

1. We Have an Income Tax

As the growing cognitive psychological literature shows us abundantly well, labels matter.364 The major comprehensive tax system in America is officially termed the “income” tax, and virtually all political discourse about it takes it as such. Yet the tax system we have is far closer to a consumptiontax because of its many omissions of taxing capital and its yield. More specifically, under the new understanding of tax, we are moving ever closer to aprepaid consumption or wage tax. Second taxes have become voluntary.

2. The Principal Choice in Comprehensive Tax Policy Is Between an Income and a Consumption Tax

A central goal of the new understanding of tax has been to show that the classic income-versus-consumption debate is moot. We do not have, have neverhad, and will never have an income tax. The real choice is and ought to be over what form of consumption tax to have. Here the stakes are large anddramatic.

3. Consumption Taxes Are Flat Taxes

This is a confusion present in certain popular political discourses, one that conservative politicians have used to their advantage. Further, it relates backto Mill and an important theme in the tax policy literature. If the reason for supporting a consumption tax is to preserve the pretax equality betweensavers and spenders — to effect yield exemption — then there is indeed something compelling about a flat-rate structure. That is why a large element ofthe new understanding of tax lies in establishing the idea that this horizontal equity argument is not the right reason for a consumption tax.

4. All Consumption Taxes Are Created Equal

All flat consumption taxes are indeed largely equal, except for the important points about infra-marginal returns to capital. But progressive consumptiontaxes vary greatly. A prepaid consumption or wage tax, even at progressive rates, features yield-exemption, by design; a postpaid consumption tax mostdecisively does not.

5. Consumption Taxes Do Not Reach the Yield to Capital

The dominant analytic point of the new understanding of tax is that, under progressive rates, a postpaid consumption tax reaches the yield to capitalwhen such yield is the source of enhanced lifestyles, but not otherwise.

6. The Best Argument for a Consumption Tax Is One of Horizontal Equity

Here is where we can blame Mill, again, and take objection to Andrews’s “most sophisticated” argument. Indeed and ironically, a very good reason forconsumption taxes, of the right sort, is that they fall on the yield to capital under just the circumstances in which ordinary moral intuitions suggest thatthis is the right thing to do. But there are other good reasons for a consumption tax, of the right sort, most importantly including that a consistentpostpaid consumption tax opens the door to deeper, more-lasting progressivity in the allocation of tax burdens.

7. The Case for Consumption Taxation Is One About the Importance of Capital, on the Individual or Aggregate Level

Here is where we perhaps can blame Hobbes, and his “foundational” argument for consumption taxation based on the common pool of capital.365Depending on the rate structure, there can be more, less, or the same amount of capital under a consumption as under an income tax. Indeed, in partbecause a consistent postpaid consumption tax facilitates more progressivity — a steeper slope in the rate structure — than we now have, it is possible that tax rates could decrease on the lower income classes while increasing on the upper ones. In such a case we might get less savings among the poorand more savings among the rich, which can be a compelling normative endpoint, especially given a basically just society that provides basic needs andgoods to all its citizens.366

8. Rates Would Have to Increase Under a Transition to a Consumption Tax

The standard income-versus-consumption debate assumes that rates would have to increase under any conversion to a consumption tax, at constantrevenue needs, because the consumption tax fails to reach an element of the income tax’s base, namely savings. In fact, we do not have an income tax. Inmoving from the status quo — the flawed income-with-realization tax — to a consistent, postpaid consumption tax, there would be two large basebroadening features. First, we could repeal the special rate preferences for capital gains and corporate dividends.367 Second, we would have amechanism for picking up debt, and thus would add debt-financed consumption to the base. These two provisions could well offset the greater allowanceof deductions for savings, especially as so little savings is taxed today.

9. The Gift and Estate and Corporate Income Taxes Are Important Backstops to the Individual Income Tax

The traditional view of tax sets an income tax against all forms of consumption taxes. Most tax policy scholars and makers through the years have favored the former, for they ascribe to the yield-to-capital norm. But the status quo individual income tax disappoints, for it fails to get at the yield tocapital in many, and many of the most important, cases. Thus, the gift and estate and corporate income taxes are desired as “backstops” to the incometax, as some way of getting at the yield to capital. But in practice these taxes are porous in their application, and unfair in their incidence. Under the newunderstanding of tax, we can see that a consistent, progressive postpaid consumption tax does get at the yield to capital, in the right cases, in aprincipled and individuated manner. Thus, under it, and putting aside the analytically separable question of the problems of capital-as-power, these twoadditional taxes are not needed.

10. Adopting a Consumption Tax Would Be a Radical Change

If one believes that the great fault line in tax policy is between an income and a consumption tax, and that we have the former, then a change to aconsumption tax seems radical. But it is not. We do not have an income tax, and the only real question is what kind of consumption tax to have. Adoptinga consistent, postpaid consumption tax would entail only two major steps: (1) institute an unlimited deduction for savings, along the lines of traditionalIRA plans; and (2) include debt as a taxable input. At the same time, we could repeal: (1) all preferences for capital gains, corporate dividends, and thelike; (2) all rules relating to “basis” (as assets would have no basis, not having been taxed); (3) the corporate income tax; and (4) the gift and estate tax.While there are important transitional concerns, such as those over “pre-enactment basis,” these tend to be overstated.

D. Tax Matters

Why does the new understanding of tax matter? Because tax matters. Tax represents the last battle line for any meaningful redistribution of materialresources from the better able to the least well off.[368] The traditional view of tax gives us an impoverished choice set, between a wildly unpopularincome-plus-estate-plus-corporate- income tax regime that is scarcely doing any real work in the cause of liberal egalitarian justice, and a flatconsumption tax of some sort or another that cannot possibly do any such work. The new understanding of tax is essential to getting us out of thismorass.

The traditional view of tax pits income against consumption taxes, with income taxes, alone, on the side of liberal egalitarian justice and fairness in tax.Under its dim lights, liberals continue to cling to and argue for a porous income plus corporate income plus gift and estate tax regime, all unpopular andineffective choices. Meanwhile, conservative forces opposed to redistribution have begun to see the light of the new understanding. They are arguing, notjust for a consumption tax, but for a particular form of consumption tax: a prepaid one. To them, victory seems close at hand. With President Bush’sreelection, prepaid consumption proponents have been speaking openly of their mounting piecemeal victories and the ever- closer horizon of theirpromised land. The highly influential Grover Norquist, for example, notes of the four tax cuts in Bush’s first term that “[p]eople looked at those andthought they were just catch as catch can. But every one of those tax cuts moved us toward a single- rate tax system that taxes income just onetime.”[369 ] Stephen Moore, president of the powerful Club for Growth, foresees not “a big grandiose plan, but rather incremental steps.” Moore regardsthe flat tax as the “Garden of Eden . . . [that requires] that every change we make with tax policy is moving us in that direction.”[370] The newunderstanding of tax would have helped to predict the ultimate effects of this gradual shift.[371] Now that we stand on the brink of getting a flat wagetax, ordinary people are beginning to size up, comprehensively, where we are.[372]

What they see is not bright. These are dark times for the great progressive spirit in America. We have, perhaps wisely, rooted out many vestiges of inefficient and haphazard redistribution from our general socio-economic laws and regulations, persuaded in part by a welfarist economic argument thatsuch redistribution is best left to the tax system.[373] But when we look at that tax system, whose very design once served as a shining light ofprogressive liberalism, we see a steady retreat towards something very different from where we started. More darkly still, we seem ill-served by ourintellectual armament to halt the retreat. Most people pay little or no attention to the frightening details of tax, deterred and dismayed by its dizzyingcomplexity. Those who do know, and care, are trapped in the traditional income-versus- consumption debate. Progressives fight to maintain whatevervestiges of an income tax we have, and defend its adjutants, the corporate and gift and estate taxes, as the last best hope for justice in tax and, byextension, in society at large. Yet these very choices are giving comfort to the enemies of redistribution, for the income, corporate, and gift and estatetaxes are wildly unpopular — and, ironically, wildly ineffective to boot. The tax system is drifting, seemingly inexorably, towards a flat wage tax. All hope for effecting redistribution from rich to poor may soon be lost. Amidst the darkness, dramatic change seems beyond the pale; the very tinkering that hasgotten us into the state of tax we are in seems to be the only procedure for going forward. “People treat a plan as realistic when it approximates whatalready exists and as utopian when it departs from current arrangements. Only proposals that are hardly worth fighting for — reformist tinkering — seempracticable.”[374]

But perhaps it is darkest before the dawn. By rethinking first principles in the analytics of tax, we can come to a new understanding. An income tax is notneeded to advance the progressive cause, and in fact its very structure impedes it. Yet all consumption taxes are not created equal. While a prepaidconsumption or wage tax does indeed let capital off the social hook altogether, a consistently progressive, postpaid consumption tax gets matters justright, by design. It comports with compelling ordinary moral intuitions about the taxation of capital and its yield, allowing people to lower the burden oftaxation by ordinary-savings, but falling on the yield to capital when it facilitates a better, richer lifestyle. Such a tax, alone among feasible alternatives,allows for a structure in which a deep and meaningful progressivity in the allocation of tax burdens can flourish. It is not where we are headed now, but itcould yet be where we end up — if we get our understanding of tax down right.

[*] Robert C. Packard Trustee Chair in Law and Political Science, University of Southern California Law School; Visiting Professor of Law and Economics,California Institute of Technology. B.A. (Philosophy and Classics) 1980, Yale; J.D. 1985, Harvard; M.A. (Economics) 1994, University of Southern California.— Ed. Earlier versions of this Article were given as the Hugh J. and Frank Tamisiea Lecture at the University of Iowa School of Law, and at workshops atNew York University School of Law, Southern California Law & Philosophy Reading Group, University of Southern California Law School, Southern CaliforniaTax Policy Group, University of Michigan Law School, and Washington University School of Law. I thank all the participants at these occasions. I alsothank, in particular, Scott Altman, Ellen Aprill, Alan Auerbach, Reuven Avi-Yonah, Steven Bank, Pat Cain, Eric Claeys, Bill Gale, Jim Hines, Doug Kahn, LouisKaplow, Bill Klein, Dan Klerman, Kyle Logue, Andrei Marmor, Herb Morris, Steve Munzer, Bob Pollak, Katie Pratt, Don Regan, Jonathan Schwartz, DanielShaviro, Seanna Shiffrin, Reed Shuldiner, Joel Slemrod, Kirk Stark, Nancy Staudt, Jeff Strnad, Eric Talley, David Weisbach, Peter Wiedenbeck, and LarryZelenak for helpful comments and conversations. Tom Griffith deserves extra thanks for his detailed commentary on an early version. I also thank myresearch assistants Greg Barchie, Alex Baskin, Joan Huh, Mayer Nazarian, Keith Padien, and Christina Yang, and the always-superb University of SouthernCalifornia law librarians for all their assistance. Finally, I owe at least an extra word for the late David Bradford, who gave me characteristically smart,provocative, and helpful comments on this work. David’s grace and intellect, sorely needed in tax, will be deeply missed. Thank you, David.

[1.] JOHN STUART MILL, 5 PRINCIPLES OF POLITICAL ECONOMY, ch. II, § 4, at 179-80 (Jonathan Riley ed., Oxford University Press 1998) (1848).

[2.] See EDWARD J. MCCAFFERY, FAIR NOT FLAT, at 1 (2002) [hereinafter MCCAFFERY, FAIR NOT FLAT] (“[O]ur tax system is a disgrace . . . . complicated,inefficient, and unfair.”); Greg M. Shaw & Stephanie L. Reinhart, The Polls — Trends: Devolution and Confidence in Government, 65 PUB. OPINION Q. 369,382 (2001) (poll results from 1999 showing that a plurality chose the “federal income tax” as the “worst tax, that is, the least fair”).

[3.] MILL, supra note 1.

[4.] For some among several good sources of the political history, see SHELDON D. POLLACK, THE FAILURE OF U.S. TAX POLICY 45-53 (1996); ROBERTSTANLEY, DIMENSIONS OF LAW IN THE SERVICE OF ORDER: ORIGINS OF THE FEDERAL INCOME TAX (1993); and Steven A. Bank, The ProgressiveConsumption Tax Revisited, 101 MICH. L. REV. 2238 (2003) (reviewing EDWARD J. MCCAFFERY, FAIR NOT FLAT: HOW TO MAKE THE TAX SYSTEM BETTERAND SIMPLER (2002)). See also KEVIN PHILLIPS, WEALTH AND DEMOCRACY (2002). Another and somewhat related reason to go with an individual incometax was the failure to think through the possibilities of a progressive consumption tax; this failure of imagination was understandable, given the relativelylow dollar stakes involved, and the lack of both theory and real-world experience pertaining to large comprehensive tax systems. See STEVEN WEISMAN,THE GREAT TAX WARS (2002); Erik M. Jensen, The Taxing Power, the Sixteenth Amendment, and the Meaning of “Incomes,” 33 ARIZ. ST. L.J.

1057 (2001).

[5.] See Pollock v. Farmer’s Loan & Trust Co., 157 U.S. 429 (1895), modified by 158 U.S.

601 (1895).

[6.] See, e.g., MICHAEL J. GRAETZ, THE DECLINE (AND FALL?) OF THE INCOME TAX (1997); LIAM MURPHY & THOMAS NAGEL, THE MYTH OF OWNERSHIP:TAXES AND JUSTICE (2002); Anne L. Alstott, The Uneasy Liberal Case Against Income and Wealth Transfer Taxation: A Response to Professor McCaffery,51 TAX L. REV. 363 (1996); Michael J. Graetz, 100 Million Unnecessary Returns: A Fresh Start for the U.S. Tax System, 112 YALE L.J. 261 (2002); see alsoBILL BRADLEY, THE FAIR TAX (1984).

[7.] See, e.g., Noel B. Cunningham, The Taxation of Capital Income and the Choice of Tax Base, 52 TAX L. REV. 17, 17 (1996) (“Both bases includeconsumption; the difference is that an income tax also includes changes in wealth, or savings. Whether or not it is appropriate or desirable to tax savingshas been at the core of the debate.”); Barbara H. Fried, Fairness and the Consumption Tax, 44 STAN. L. REV. 961, 961 (1992) (“Under a plausible set ofassumptions, the two forms of consumption tax — a tax on consumption only and a tax on wages only — impose an equivalent tax burden in presentvalue terms.”). David A. Weisbach & Joseph Bankman, The Superiority of a Consumption Tax Over an Income Tax (draft on file with author) (“The onlydifference between an income tax and a consumption tax and hence the only issue governing the choice between the two tax systems is the taxation ofthe riskless return to savings.”). A particularly clear statement of the traditional view comes from the recent philosophical tract by Liam Murphy andThomas Nagel: “This equivalence allows us to say, furthermore, that any consumption tax scheme, in taxing not accretions to wealth as such, but ratheronly consumption, exempts from taxation normal returns to investment.” MURPHY & NAGEL, supra note 6, at 101; see also JOEL SLEMROD & JON BAKIJA,TAXING OURSELVES 231-34 (2d ed. 2000). Of course, most of these fine scholars note the assumption of flat, constant, or proportionate rates. See, e.g.,Fried, supra note 7, at 961 n.2. A way to understand the present Article is that it takes seriously the idea of nonconstant tax rates, and attempts to build anormative theory around them, taking the tax rates themselves as the prior, foundational commitment of tax. This proposed rearrangement in the politicalepistemology of tax is a central theme of this Article.

[8.] See, e.g., William D. Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 87 HARV. L. REV. 1113 (1974) [hereinafter Andrews, PersonalIncome Tax]; see also DAVID F. BRADFORD ET AL., U.S. DEP’T OF THE TREASURY, BLUEPRINTS FOR BASIC TAX REFORM (2d ed. 1984); Fried, supra note 7,at 963; Mark Kelman, Time Preference and Tax Equity, 35 STAN. L. REV. 649 (1983).

[9.] See, e.g., Joel B. Slemrod & William G. Gale, Overview, in RETHINKING ESTATE AND GIFT TAXATION 1, 30-32 (William G. Gale et al. eds., 2001); C.EUGENE STEUERLE, CONTEMPORARY U.S. TAX POLICY 10 (2004). For deep critiques of the horizontal equity norm, see Thomas D. Griffith, Should “TaxNorms” Be Abandoned? Rethinking Tax Policy Analysis and the Taxation of Personal Injury Recoveries, 1993 WIS. L. REV. 1115, 1155 (“Horizontal equityis, perhaps, the most widespread norm underlying traditional tax policy analysis. It is also the least helpful. [It] cannot provide the answer to [any] . . .important tax policy question.”); and Louis Kaplow, Horizontal Equity: Measures in Search of Principle, 42

NAT’L TAX J. 139 (1989).

[10.] See, e.g., Bank, supra note 4 at 2256-58.

[11.] At least the “traditional view” as referred to within the mainstream of legal academic discourse, and in the law school classroom. The economicsprofession has typically had a more sophisticated, nuanced perspective. See, e.g., William M. Gentry & R. Glenn Hubbard, Distributional Implications ofIntroducing a Broad-Based Consumption Tax, 11 TAX POL’Y & ECON. 1 (1997) [hereinafter Gentry & Hubbard, Distributional Implications]; Louis Kaplow,Human Capital Under an Ideal Income Tax, 80 VA. L. REV. 1477 (1994); Louis Kaplow, Taxation and Risk Taking: A General Equilibrium Perspective, 47NAT’L TAX J. 789 (1994) [hereinafter Kaplow, Taxation and Risk Taking]. Even the economics literature, however, refers to the prevalence of the standardview, see, e.g., Gentry & Hubbard, supra, at 5 n. 4 (referring back to Mill), and also typically suffers some limitations in its analysis and recommendationson account of the continued prevalence of this view.

[12.] A word on terminology is in order. What matters for most purposes for claims of justice is progressive average or (equivalently) effective tax rates,wherein taxes as a percent of total income (or consumption, or wealth, or whatever the base might be), rise in that base. See A. B. ATKINSON, PUBLICECONOMICS IN ACTION: THE BASIC INCOME/FLAT TAX PROPOSAL (1995); Joseph Bankman & Thomas Griffith, Is the Debate Between an Income Tax and a Consumption Tax a Debate About Risk? Does it Matter?, 47 TAX L. REV. 377 (1992) [hereinafter Bankman & Griffith, Debate]; Joseph Bankman &Thomas Griffith, Social Welfare and the Rate Structure: A New Look at Progressive Taxation, 75 CAL. L. REV. 1905 (1987) [hereinafter Bankman & Griffith,Social Welfare]; Marcus Berliant & Paul Rothstein, Possibility, Impossibility, and History in the Origins of the Marriage Tax, 56 NAT’L TAX J. 303 (2003);James A. Mirrlees, An Exploration in the Theory of Optimum Income Taxation, 38 REV. ECON. STUD. 175 (1971); MCCAFFERY, FAIR NOT FLAT, supra note2, at 78-87. The United States tax system relies, and has always relied, on progressive marginal tax rates. This is one but not the only means toprogressive average taxation; a better way, per the optimal tax tradition, is to rely on relatively flat, even declining marginal tax rates, coupled with a“demogrant” or lump-sum transfer to effect progression. See Bankman & Griffith, Social Welfare, supra at 1967; Mirrlees, supra; Joel Slemrod, OptimalTax and Optimal Tax Systems, 4 J. ECON. PERSP. 157 (1990). For the most part, this Article, following traditional tax policy discussions, shall conflateprogressive marginal and effective taxation; later it shall comment on how the new understanding of tax ought to change the analysis of progressivity,too.

[13.] Alvin C. Warren, Jr., Fairness and a Consumption-Type or Cash Flow Personal

Income Tax, 88 HARV. L. REV. 931, 933-36 (1975).

[14.] William A. Klein, Timing in Personal Taxation, 6 J. LEGAL STUD. 461, 461 n.2 (1977) (“The choice between income and expenditure can be regardedas a timing question because an expenditure base can be thought of as income minus a deduction for savings, and a deduction for savings can in turn beregarded as a deferral of tax on the income set aside as savings. . . . The choice [of income or consumption taxation] can also, and for some purposesmore usefully, be thought of as a zero tax rate on the income from invested savings.” (citations omitted)).

[15.] An especially good statement of the qualification in the traditional view comes from Anne Alstott, in her response to some of my earlier work. SeeAlstott, supra note 6. Alstott first sets out the traditional view, stating:

The defining characteristic of a consumption tax is that it removes from the tax base income that is saved or invested (for example, in financialinstruments like stocks or bonds or in real investments like plant or equipment). A consumption tax, by definition, taxes only income spent on current,personal consumption (for example, on cars, food and travel). By deferring tax on saved income until the money is spent, a proportional consumption taxessentially exempts the earnings on investment from taxation. A progressive consumption tax of the kind Professor McCaffery advocates would offersignificant tax benefits to savers while penalizing those with high levels of consumption spending.

Id. at 364-65 (footnote omitted). Professor Alstott adds a footnote explaining (in more detail than typical of the literature) the relevance of rates:

A proportional consumption tax exempts from tax the income from savings. . . . This familiar “yield exemption” result holds only if tax rates are constant,however, and under a progressive consumption tax, the exclusion may save tax at a rate that is higher or lower than the subsequent tax rate paid onconsumption. . . . In general, the tax rate on investment income will be positive where the saver faces a lower marginal tax rate than the consumer,negative where the saver faces a higher marginal tax rate than the consumer and zero where the two marginal rates are equal.

Id. at 365 n.11. For a related point, see Slemrod, supra note 12, at 159. See also Eric Rakowski, Can Wealth Taxes Be Justified?, 53 TAX L. REV. 263, 349-50 (2000).

Professor Alstott wrote these thoroughly correct analytic words on the occasion of a symposium on some of my earlier articles, after considering my ownreply to criticisms, part of which follows:

Professor Alstott likes income taxes because they capture the yield to savings. But so does a back-ended progressive consumption tax. The equivalence ofthe yield-exempt and the cash- flow consumption tax models depends on constant marginal rates; as I point out in my articles, this fact has led many toadvocate flat-rate consumption taxes. But a progressive cash flow or (equivalently) back-ended consumption tax consciously hits at wealth that is spentas it is spent, whether it is taken out of earnings or capital. There is no reason, dictated by political liberal theory alone, to link flat rates withconsumption taxes. A progressive consumption-without-estate tax is not a consumption tax in the sense that a consumption tax never taxes the yield tocapital. But I do not necessarily care about that, because no part of my analysis turned on prior definitions.

Edward J. McCaffery, Being the Best We Can Be (A Reply to My Critics), 51 TAX L. REV. 615, 630-31 (1996) (footnotes omitted) [hereinafter McCaffery,Being the Best]. The present Article grew out of my continued thinking about the relevance of variable and progressive rates to the income-versus-consumption debate. Not only did I notice the continued iteration of the view that consumption taxes do not reach the yield to capital in the popularpolitical culture and in tax policymaking circles, but I also came to see that my own earlier work was incomplete in that I had not developed a suitablygeneral theory of how, precisely, varying rates affected the choice of tax base, and of the normative basis for the argument. In time, I came to see that the reason for the repetition of the traditional view was having the wrong argument structure supporting a consistent consumption tax, a themethroughout this Article. Working on these issues over several years led to the present Article.

[16.] See, e.g., Alstott, supra note 6, at 386-87; William D. Andrews, Fairness and the Personal Income Tax: A Reply to Professor Warren, 88 HARV. L. REV.947, 954 (1975) [hereinafter, Andrews, Reply to Professor Warren]; Warren, supra note 13, at 940-51.

[17.] See, e.g., Edward J. McCaffery & Jon Baron, Framing and Taxation: Normative Evaluation of Tax Policies Involving Household Composition, 25 J.ECON. PSYCHOL. 679 (2003) (discussing, inter alia, experimental results showing a “neutrality bias”); see also Michael Livingston, Risky Business:Economics, Culture and the Taxation of High-Risk Activities, 48 TAX. L. REV. 163, 229 (1993) (criticizing naive neutrality norms in tax policy scholarship).

[18.] For a good example, see Warren, supra note 13, at 934-41 (responding to Andrews, Personal Income Tax, supra note 8). Warren saw clearly that“[t]he only relevant difference between a consumption-type personal income tax and a wage tax is thus the disparity that arises when tax rates are notconstant.” But he went on to argue, on account of Andrews’s “most sophisticated” argument for consumption taxation, that this fact argued againstprogressive rates.

[19.] See Edward J. McCaffery, Three Views of Tax, 18 CAN. J.L. & JURISPRUDENCE 153 (2005) [hereinafter McCaffery, Three Views].

[20.] This is what I have attempted to do in Fair Not Flat. See MCCAFFERY, FAIR NOT

FLAT, supra note 2.

[21.] There are, of course, compelling moral and political theoretic arguments for progressivity. See HARVEY ROSEN, PUBLIC FINANCE (6th ed. 2002);Andrews, Reply to Professor Warren, supra note 16; Bankman & Griffith, Social Welfare, supra note 12; Fried, supra note 7; STEUERLE, supra note 9. I alsolargely accept the argument of Louis Kaplow and Steven Shavell, tracking the two welfare theorems, that the general legal system should be evaluatedvis-à-vis the goal of welfare maximization or allocative efficiency, leaving the tax system to redistribute wealth. See LOUIS KAPLOW & STEVEN SHAVELL,FAIRNESS VERSUS WELFARE (2002). But this sensible bifurcation of normative labors puts more pressure on getting progressivity in tax down right. SeeEdward J. McCaffery & Jonathan Baron, The Political Psychology of Redistribution, UCLA L. REV. (forthcoming Aug. 2005); see also, Jonathan Baron &Edward J. McCaffery, Masking Redistribution (or Its Absence), in BEHAVIORAL PUBLIC FINANCE (Edward J. McCaffery & Joel Slemrod, eds., forthcoming2005). In fact, most Americans support the notion of progressivity and oppose a flat tax. See Will Lester, Poll: Americans Say Taxes Too Complicated,Associated Press, Apr. 12, 2005, available at http://staging.hosted.ap.org/dynamic/stories/T/TAXES_AP_IPSOS_ POLL?SITE=AP&SECTION=HOME&TEMPLATE=DEFAULT&CTIME=2005-04-11-

14-49-05 (noting that 57 percent of respondents to AP poll oppose a flat tax regime, while only 40 percent support it).

[22.] See infra Part II.C.

[23.] This is before bringing transaction costs into the story, which push the income tax to an income-with-realization tax, and generate other types of“hybrid” taxes. Edward J. McCaffery, Tax Policy Under a Hybrid Income-Consumption Tax, 70 TEX. L. REV. 1145 (1992) [hereinafter McCaffery, Hybrid]. Seediscussion in Parts V and VI, infra. Part of the argument of this Article is that unprincipled “hybrids” can lead to perverse, counter- productive results; thecurrent hybrid income-consumption tax, for an important example, ends up being a prepaid consumption or wage tax. See infra Part V. A consistentprogressive postpaid consumption tax, in contrast, is mixed in its effects on capital on the individual level, as I argue throughout, but is not a “hybrid.”

[24.] This is not to say that the subject does not matter indirectly, of course; the savings and consumption behavior of the wealthy affect the wholesociety. See Edward J. McCaffery, Must We Have the Right to Waste?, in NEW ESSAYS ON THE LEGAL AND PHILOSOPHICAL UNDERSTANDING OFPROPERTY 76 (Stephen R. Munzer ed., 2001) [hereinafter McCaffery, The Right to Waste?].

[25.] See infra Part II.B (explaining the Haig-Simons definition of income).

[26.] The real purchasing power at the start of the two periods is equal to 110.25/(1+r)2 = 110.25/1.21= 91.

[27.] See infra Part II.D for further discussion of these assumptions.

[28.] Like many elements in the traditional view, Andrews was among the first best spokespersons for this idea. See Andrews, Personal Income Tax, supranote 8, at 1114-19; see also BRADFORD ET AL., supra note 8, at 10; SLEMROD & BAKIJA, supra note 7, at 221-22.

[29.] The definition is named after Henry C. Simons and Robert Haig who, along with several others, derived it independently. Robert Murray Haig, TheConcept of Income — Economic and Legal Aspects, in THE FEDERAL INCOME TAX 1, 7 (Robert Murray Haig ed., 1921); HENRY C. SIMONS, PERSONALINCOME TAXATION: THE DEFINITION OF INCOME AS A PROBLEM OF FISCAL POLICY 50 (photo reprint 1980) (1938) (“Income may be defined as thealgebraic sum of the market value of rights exercised in consumption plus the change in value of the store of property rights between the beginning andend of the period in question.”).

[30.] See David A. Hartman, The End of Income Taxes, CHRONICLES, May 2003, at 42; Laurence Seidman, A Better Way to Tax, PUB. INT., Winter 1994, at65; Al Ehrbar, Consumption Tax, in THE CONCISE ENCYCLOPEDIA OF ECONOMICS, at http://www.econlib.org/library/Enc/ConsumptionTax.html (lastvisited Jan. 14, 2005) (“A consumption tax — also known as an expenditures tax, consumed-income tax, or cash-flow tax — is a tax on what people spendinstead of what they earn.”).

[31.] I.R.C. § 408 (traditional IRAs) (2004); § 401 (qualified pension plans) (2004). In a qualified pension plan that works on the “defined benefit” model,the employer’s contribution to the employee’s plan never enters into the employee’s income in the first place. This is equivalent, of course, to includingthe value in income and then allowing a deduction for savings.

[32.] In these examples, for simplicity, the text uses a single flat-rate tax. But nothing of any consequence changes if one imagines instead a vector oftaxes, as befits the step function approach to tax rates found in today’s income tax. See infra Part IV.C.

[33.] Don Fullerton & Yolanda Kodrzycki Henderson, The Impact of Fundamental Tax Reform on the Allocation of Resources, in THE EFFECTS OF TAXATIONON CAPITAL ACCUMULATION 401 (Martin Feldstein ed. 1987); Don Fullerton & Diane Lim Rogers, Neglected Effects on the Uses Side: Even a Uniform TaxWould Change Relative Goods Prices, 87 AM. ECON. REV. 120 (1997).

[34.] See BRADFORD ET. AL., supra note 8, at 31-33.

[35.] I.R.C. § 408A (2004) (Roth IRA); see also John Cassidy, Tax Code, NEW YORKER, Sept. 6, 2004, at 70 (discussing contemporary proposals from BushAdministration).

[36.] Warren pointed out that this should be so if Andrews’s “most sophisticated” reason for preferring consumption taxation were to hold sway. SeeWarren, supra note 13, at 944-45. Andrews, in his 1975 response to Warren, protested this point a bit, but eventually the nuance was lost on theliterature. See Andrews, Reply to Professor Warren, supra note 16, at 955.

[37.] See Michael J. Graetz, Expenditure Tax Design, in WHAT SHOULD BE TAXED: INCOME OR EXPENDITURE? 161, 172-75, 238 (Joseph A. Pechman ed.,1980); McCaffery, Hybrid, supra note 23, at 1151 n.24; Jeff Strnad, Periodicity and Accretion Taxation: Norms and Implementation, 99 YALE L.J. 1817(1990) [hereinafter Strnad, Periodicity and Accretion Taxation]; Jeff Strnad, Taxation of Income from Capital: A Theoretical Reappraisal, 37 STAN. L. REV.1023, 1056-61, 1087-88 (1985).

[38.] Cf. STEUERLE, supra note 9, at 241 n.4.

[39.] See Bankman & Griffith, Debate, supra note 12, at 385-86; Louis Kaplow, Taxation and Risk Taking, supra note 11; David Weisbach, The(Non)Taxation of Risk, 58 TAX L. REV. (forthcoming 2004); David M. Schizer, Scaling Up and the Taxation of Risky Investments: Derivatives and the Search for Practical Applications (Northwestern School of Law, Law & Economics Colloquium Series, Oct. 15, 2003), at http://www.law.northwestern.edu/colloquium/law_economics/Schizer.pdf (last visited Jan. 14, 2004); Lawrence Zelenak, Taxing (or Not) The Returns to Risk-Bearing (Dec.17, 2003) (draft on file with author); Weisbach & Bankman, supra note 7. This literature points out that, with an ideal income tax with full loss offsets, theonly difference between an income tax and a postpaid consumption tax is that the former includes, whereas the latter does not, the real, riskless rate ofreturn. Once again, this analysis holds tax rates constant in its models. The current income tax has limited capital loss offsets. I.R.C. § 1211 (2004). Forfurther discussion see infra Part V.C.1.


[41.] See LAURENCE SEIDMAN, THE USA TAX (1997). See generally USA Tax Act of

1995, S. 722, 104th Cong. (1995).

[42.] The deductibility of interest is a separate and more complicated matter. A case can be made for deducting all interest under an income tax, becauseinterest payments reflect neither present period consumption nor savings, but rather the compensation for consuming or saving in some other timeperiod. See Alan J. Auerbach, Should Interest Deductions Be Limited?, in UNEASY COMPROMISE 195 (Henry J. Aaron et al. eds., 1988). This was indeedgenerally the law prior to the Tax Reform Act of 1986. I.R.C. § 163 (1982) (amended 1986); but cf. I.R.C. § 265 (2004) (limitation on interest deduction ondebt used to acquire tax- exempt income). But because the “income” tax is not really an income tax — it looks more like a prepaid consumption tax (seeinfra Part V) — an unlimited interest deduction could literally obliterate the tax. Hence, the current law in regard to the deductibility of interest, as inmany other areas, is rife with uneasy compromises. See I.R.C. §§ 163(a) (general rule), 163(d) (limitation of deduction of investment-related interest),163(h) (limitation on deduction of personal interest) (2004).

[43.] I suspect that much of the misunderstanding of the tax treatment of debt follows from a failure to understand that zero is simply a number, merelyone point on the spectrum of possible wealth. Moving from a negative net wealth to zero, or from a deeply negative position to a less deeply negativeone, is an accession to wealth. So if a taxpayer is $5,000 in debt, and she pays off $1,000 of this, she has “saved” by increasing her net worth fromnegative $5,000 to negative $4,000. This is not analytically different from saving $1,000 to increase one’s bank account from $4,000 to $5,000. But itseems a fairly durable feature of most of our thinking about financial matters that strange things happen to our understanding around zero. See DanielKahneman & Amos Tversky, Prospect Theory: An Analysis of Decision Under Risk, 47 ECONOMETRICA 263 (1979); Edward J. McCaffery, Cognitive Theoryand Tax, 41 UCLA L. REV. 1861 (1994) [hereinafter McCaffery, Cognitive Theory and Tax].

[44.] See infra Part IV.D.

[45.] See Louis Kaplow, A Framework for Assessing Gift and Estate Taxation, in

RETHINKING GIFT AND ESTATE TAXATION 164 (James R. Hines Jr. & Joel Slemrod eds., 2001). I write “provisionally” because subsequent analysis mightreveal that the ends are not obtainable, or stand in some tension with one another, and so must be reconsidered.

[46.] See RICHARD A. MUSGRAVE, THE THEORY OF PUBLIC FINANCE (1959); Lester C. Thurow, The Income Distribution as a Pure Public Good, 85 Q.J.ECON. 327 (1971); STEUERLE, supra note 9.

[47.] But see, e.g., analysis of optimal consumption tax theory in note 347 infra.

[48.] This is the argument of Louis Kaplow and Steven Shavell, first pressed in Why the Legal System Is Less Efficient Than the Income Tax inRedistributing Income, 23 J. LEGAL STUD. 667 (1994), see also KAPLOW & SHAVELL, supra note 21. For partial critiques of the Kaplow-Shavell position,see Chris William Sanchirico, Deconstructing the New Efficiency Rationale, 86 CORNELL L. REV. 1003 (2001); Kyle Logue & Ronen Avraham, RedistributingOptimally: Of Tax Rules — Legal Rules, and Insurance, 56 TAX L. REV. 157 (2003).

[49.] Under a flat percent tax, taxpayers with higher incomes pay more in absolute dollars, leading to a certain confusion in the understanding ofprogressivity. See Edward J. McCaffery & Jonathan Baron, The Humpty Dumpty Blues: Disaggregation Bias in the Evaluation of Tax Systems, 91ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 230 (2003) [hereinafter McCaffery & Baron, Humpty Dumpty Blues] (discussing the “metriceffect”). The new understanding of tax aims for a progressive percent tax, that is, progressivity in effective tax rates.

[50.] WILLIAM VICKREY, AGENDA FOR PROGRESSIVE TAXATION 3 (1947). It is simply not compelling, normatively, as a matter of first-best theory, toimpose progressive taxes on entities, where the ultimate incidence of the tax burden is apt to be uncertain, at best, and quite possibly regressive relativeto individuals, at worst. See infra Part VI.C. But cf. Reuven S. Avi-Yonah, Corporations, Society, and the State: A Defense of the Corporate Tax, 90 VA. L.REV. 1193 (2004) (arguing that corporate income tax is important as a check on managerial power).

[51.] MCCAFFERY, FAIR NOT FLAT, supra note 2, at 51-53. Note also that progressivity can come from the expenditure side of fiscal policy. See Richard M.Bird & Eric M. Zolt, Redistribution via Taxation: The Limited Role of Personal Income Tax in Developing Countries, UCLA L. REV. (forthcoming Aug. 2005);Edward J. McCaffery & Jonathan Baron, The Political Psychology of Redistribution, UCLA L. REV. (forthcoming Aug. 2005).

[52.] See JOHN RAWLS, A THEORY OF JUSTICE 278 (1971); Kaplow & Shavell, supra note 48; KAPLOW & SHAVELL, supra note 21. For a good statement ofthe argument that the tax system is actually helping to set an appropriate initial normative baseline for ownership or command over material resources,see MURPHY & NAGEL, supra note 6.

[53.] STEUERLE, supra note 9, at 11, writes that “[A]ny general attack on the progressivity principle, in my view, is almost tantamount to an attack onnatural law theory.”

[54.] Adam Smith famously combined the two, reasoning that those who have more ability to pay are, on that account, more benefited by the veryexistence of the state: “The subjects of every state ought to contribute towards the support of government, as nearly as possible, in proportion to theirrespective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.” ADAM SMITH, AN INQUIRY INTOTHE NATURE AND CAUSES OF THE WEALTH OF NATIONS 777 (Edwin Cannan ed., The Modern Library 1937) (1776). The first clause points to “ability topay.” The second clause conflates this with the benefits-received view, by implying that the revenue enjoyed “under the protection of the state” isprecisely the measure of one’s ability to pay. One has the ability to pay, in other words, precisely because one benefits from the very existence andstructure of society, a point that echoes Amartya Sen’s argument that all “individual” wealth is in fact a joint product of self and society. See AMARTYAKUMNAR SEN, ON ETHICS & ECONOMICS 28 (1987); see also AMARTYA SEN, INEQUALITY REEXAMINED (1992); STEUERLE, supra note 9, at 14, 31 n.11(discussing SMITH, supra, at 777).

However we come out on the semantics, note that both “ability to pay” and “benefits received” are, in traditional tax policy terms, largely vertical equitynorms: those with more ability, and/or those who benefit more from the state, ought to pay more. MUSGRAVE, supra note 46; MURPHY & NAGEL, supranote 6.

[55.] For a general discussion of bidirectionality in legal reasoning, see Dan Simon, A Third View of the Black Box: Cognitive Coherence in Legal Decision Making, 71 U. CHI. L. REV. 511 (2004).


[57.] See THOMAS HOBBES, LEVIATHAN 386-87 (C. B. MacPherson ed., Pelican Books 1968) (1651). [T]he equality of imposition, consisteth rather in theequality of that which is consumed than of the riches of the persons that consume the same. For what reason is there that he which laboureth much, andsparing the fruits of his labour, consumeth little, should be more charged than he that living idlely, getteth little, and spendeth all he gets, seeing the onehath no more protection from the commonwealth than the other? But when the impositions are laid upon those things which men consume, every manpayeth equally for what he useth, nor is the commonwealth defrauded by the luxurious waste of private men. Id. Fried, supra note 7, at 962; Warren, supranote 13, at 933-34. SMITH, supra note 54, at 778.

Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it. . . . Taxes upon suchconsumable goods as are articles of luxury, are all finally paid by the consumer, and generally in a manner that is very convenient for him. He pays themlittle by little, as he has occasion to buy the goods. As he is at liberty too, either to buy, or not to buy, as he pleases, it must be his own fault if he eversuffers any considerable inconveniency from such taxes.


[58.] RAWLS, supra note 52, at 278, noting the common pool argument. Rawls was quick to add that, in practice, “even steeply progressive income taxes”may be the right answer, and here he joined with his fellow practical political liberals. Id. at 279. See also NICHOLAS KALDOR, AN EXPENDITURE TAX(1955); Kaldor begins his volume with the quotation from HOBBES, in note 57, supra. See also Mill, supra note 1.


[60.] See Jensen, supra note 4, at 1093-131. Of course, these arguments against a consumption tax are based on the traditional view of tax.

[61.] See POLLACK, supra note 4; STANLEY, supra note 4; Bank, supra note 4; Jensen, supra note 4; Slemrod, supra note 12. The equivalence of theformulations follows from the Haig-Simons “definition,” or identity, discussed below, that holds, in short, that Income = Consumption + Savings. See infraPart II.B. The variable Savings is, in other words, nonconsumption; if a person consumes more, she saves less, if a person saves more, she consumes less,all as a percent of income, or available resources. See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 14-15.

[62.] See McCaffery, Three Views, supra note 19.

[63.] SMITH, supra note 54, at 777, 782; Mill, supra note 1, at 171-73.


[65.] BROWNLEE, supra note 64; POLLACK, supra note 4; Carolyn C. Jones, Class Tax to Mass Tax: The Role of Propaganda in the Expansion of the IncomeTax During World War II, 37 BUFF. L. REV. 685, 686, 697 (1988/89).

[66.] Walter J. Blum & Harry Kalven, Jr., The Uneasy Case for Progressive Taxation, 19

U. CHI. L. REV. 417 (1952).

[67.] See Mirrlees, supra note 12; Bankman & Griffith, Social Welfare, supra note 12; see also Marjorie E. Kornhauser, The Rhetoric of the Anti-ProgressiveIncome Tax Movement: A Typical Male Reaction, 86 MICH. L. REV. 465 (1987). See also VICKREY, supra note 50. Mirrlees and Vickrey won the 1996 NobelPrize in Economic Sciences in large part for their work on tax. See Press Release, The Royal Swedish Academy of Sciences, The Sveriges Riksbank (Bank ofSweden) Prize in Economic Sciences in Memory of Alfred Nobel for 1996 (Oct. 8, 1996) at http:www.se/economics/laureates/1996/press.html (noting theircontributions to optimal taxation theory).

[68.] KAPLOW & SHAVELL, supra note 21; Bankman & Griffith, Social Welfare, supra

note 12.

[69.] See Bankman & Griffith, Social Welfare, supra note 12; Berliant & Rothstein, supra note 12; Mirrlees, supra note 12. The important distinctionbetween marginal and average, or (equivalently) effective, tax rates shall factor into the new understanding of tax. A flat percent tax combined with alump sum tax effectuates progressivity in average, or effective, tax rates. See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 79-85, for a simpleillustration.

[70.] See Mirrlees, supra note 12. Part of Mirrlees’s brilliance was to show convincingly how progressivity in effective rates could be obtained withoutprogressivity in marginal ones.

[71.] See McCaffery, Three Views, supra note 19.

[72.] EDWARD J. MCCAFFERY, TAXING WOMEN (1997) [hereinafter MCCAFFERY, TAXING WOMEN]; Grace Blumberg, Sexism in the Code: A ComparativeStudy of Income Taxation of Working Wives and Mothers, 21 BUFF. L. REV. 49 (1972); Edward J. McCaffery, Equality, of the Right Sort, 6 UCLA WOMEN’SL.J. 289 (1996).

[73.] See, e.g., Daniel I. Halperin, Interest in Disguise: Taxing the “Time Value of Money”,

95 YALE L.J. 506 (1986); David J. Shakow, Taxation Without Realization: A Proposal for Accrual Taxation, 134 U. PA. L. REV. 1111 (1986); David Slawson,Taxing as Ordinary Income the Appreciation of Publicly Held Stock, 76 YALE L.J. 623 (1967). See generally Cunningham, supra note 7; Mary Louise Fellows,A Comprehensive Attack on Tax Deferral, 88 MICH L. REV. 722 (1990); Kelman, supra note 8; Klein, supra note 14; Reed Shuldiner, A General Approach tothe Taxation of Financial Instruments, 71 TEX. L. REV. 243 (1992); Strnad, Periodicity and Accretion Taxation, supra note 37.

[74.] See supra note 7 and accompanying text.

[75.] See Strnad, Taxing Convertible Debt, 56 SMU L. REV. 399, 448 (2003); see also Jeff

Strnad, Periodicity and Accretion Taxation, supra note 37.

[76.] Much recent tax policy literature has been breaking down the analytics of the return to capital and exploring the related empirical andmacroeconomic issues. Scholars have analyzed the different components of the yield to capital — compensation for risk or inflation, inframarginal returns,the pure riskless rate of return — with the income-versus- consumption debate in mind, showing how different tax systems, with and without certaintechnical features (such as full loss offsets under an income tax), affect each component. See sources cited in note 39, supra.

This is all interesting and important work. A central message of this descriptive, analytic traditional literature is that a postpaid consumption tax, evenwith constant tax rates, most likely captures some or all of the supranormal returns to capital, whereas a prepaid consumption tax, by design, capturesnone of it. The traditional view has often left it at that; with Andrews’s “most sophisticated” argument haunting the consumption tax, the facts of thematter might even suggest a prepaid consumption tax from this analysis. Within the new understanding of tax, in contrast, where the commitment to progressivity comes first, the possibility that even a constant-rate postpaid consumption tax gets at some of the extraordinary returns to capital offers yetanother reason to prefer the postpaid model over the prepaid, yield-exempt one. The analytics normatively suggest a prepaid model only if (1) the reasonfor adopting a consumption tax is to preserve the pretax equality of present and deferred consumers (Mill’s insight and Andrews’s most sophisticatedargument, again), and (2) the proper moment for deciding on that equality is ex ante to the distribution of returns from the capital market. If these twoconditions held, it would be “wrong” — nonneutral — to burden any of the windfall return with a “second” tax. But both prongs are normatively dubious atbest. The horizontal equities of Ant and Grasshopper are not the best reasons for adopting a consumption tax, and an ex post perspective more befits asocial concern with individuated justice, given the moral arbitrariness of varying returns to capital, and, within the new understanding of tax, the wisdomof waiting until ultimate private preclusive use to make judgments about the yield to capital. This latter point, which echoes a strong theme of Warren’s— namely, that tax policy should take an ex post perspective — is, in essence, the yield-to-capital norm. Warren, supra note 13; see also Gentry &Hubbard, Distributional Implications, supra note 11; William M. Gentry & R. Glenn Hubbard, Fundamental Tax Reform and Corporate Financial Policy, 12TAX POL’Y & ECON. 191, 196-97 (1998) (citing U.S. DEP’T OF THE TREASURY, INTEGRATION OF THE INDIVIDUAL AND CORPORATE TAX SYSTEMS (1992));Barbara H. Fried, Ex Ante/Ex Post, 13 J. CONTEMP. LEGAL ISSUES 123


[77.] See Fellows, supra note 73; Halperin, supra note 73; Shakow, supra note 73; David Shakow & Reed Shuldiner, A Comprehensive Wealth Tax, 53 TAXL. REV. 499 (2000); Jeff Strnad, Periodicity and Accretion Taxation, supra note 37. See generally Deborah H. Schenk, A Positive Account of the RealizationRule, 57 TAX L. REV. 355 (2004); Deborah H. Schenk, An Efficiency Approach to Reforming a Realization-Based Tax, 57 TAX L. REV. 503 (2004); David M.Hasen, A Realization-based Approach to the Taxation of Financial Instruments, 57 TAX L. REV. 397 (2004).

[78.] See, e.g., Alan J. Auerbach, Retrospective Capital Gains Taxation, 81 AM. ECON. REV. 167 (1991); Alan J. Auerbach, Commentary, 48 TAX L. REV. 529(1993); Fellows, supra note 73; Shakow, supra note 73; Shakow & Shuldiner, supra note

[77] Strnad, Periodicity and Accretion Taxation, supra note 37.

[79.] See, e.g., Halperin, supra note 73.

[80.] See William D. Andrews, Personal Deductions in an Ideal Income Tax, 86 HARV. L. REV. 309, 331-37 (1972) [hereinafter, Andrews, PersonalDeductions].

[81.] I.R.C. § 213 (2004).

[82.] I.R.C. § 170 (2004).

[83.] See MCCAFFERY, FAIR NOT FLAT, supra note 2; McCaffery, Hybrid, supra note 23, at 1175-218.

[84.] See Andrews, Personal Income Tax, supra note 8.

[85.] SIMONS, supra note 29, at 50.


[87.] BRADFORD, ET AL., supra note 8.

[88.] USA Tax Act of 1995, S. 722, 104th Cong. (1995); see SEIDMAN, supra note 41; David Wessel, Nunn-Domenici ‘USA Tax’ Puts Levy on Consumption toEncourage Saving, WALL ST. J., Apr. 26, 1995, at A2; see also David Wessel, Another Round: Talk of Tax Reform is Gaining Momentum, But Plans VaryWidely, WALL ST. J., Jan. 31, 1995, at A1.

[89.] Andrews, Reply to Professor Warren, supra note 16, at 949; see Warren, supra note 13, for the critique, and Andrews, Personal Income Tax, supranote 8, for the original 1975 article.

[90.] See DAVID HUME, A TREATISE ON HUMAN NATURE 469-70 (L.A. Selby-Bigge ed., 2d ed. 1978) (1739) (presenting Hume’s famous dictum that anought cannot be derived from an is); Liam B. Murphy, Liberty, Equality, Well Being: Rakowski on Wealth Transfer Taxation, 51 TAX L. REV. 473, 473-74 &n.4 (1996) (arguing that popular opposition of the estate tax does note necessarily mean it should be replaced); Eric Rakowski, Transferring

Wealth Liberally, 51 TAX L. REV. 419, 421-22 (1996) (same, invoking Hume).

[91.] BRADFORD, ET AL., supra note 8. Andrews protests considerably that a postpaid or cash-flow consumption tax is not equivalent to a prepaidconsumption or wage tax, especially under variable rates — the insight behind the new understanding of tax. See Andrews, Reply to Professor Warren,supra note 16, at 953-55. But the point was not systematically developed by Andrews, by Bradford in Blueprints for Basic Tax Reform, or by later writers inthe tradition.

[92.] Andrews, Personal Income Tax, supra note 8, at 1167-68.

[93.] Actually, in its final clause, this quotation suggests the argument advanced by Vickrey, and this Article: Tax should not fall more heavily on anyperson on account of the morally arbitrary time path of her earnings pattern. See VICKREY, supra note 50. But under a progressive postpaid consumptiontax, tax does fall more heavily on taxpayers with higher tastes for goods and services; that is the very thing being taxed, and progressively.

[94.] Warren, supra note 13; Alvin Warren, Would a Consumption Tax Be Fairer Than an Income Tax?, 89 YALE L.J. 1081 (1980).

[95.] See supra text accompanying note 92. On horizontal equity, see generally MURPHY & NAGEL, supra note 6, at 37-39; MUSGRAVE, supra note 46;STEUERLE, supra note 9, at 10; for criticism, see Louis Kaplow, A Note on Horizontal Equity, 1 FLA. TAX REV. 191 (1992); Kaplow, supra note 9; Griffith,supra note 9.

[96.] Warren, supra note 13, at 944-45.

[97.] See Warren, supra note 13, at 941-44. For a discussion of ex ante versus ex post perspectives, see KAPLOW & SHAVELL, supra note 21, at 28-30;Fried, Ex Ante/Ex Post, supra note 76.


[99.] See Kelman, supra note 8, at 659; Warren, supra note 13, at 936; Warren, supra

Note 94, at 1100.

[100.] See Andrews, Reply to Professor Warren, supra note 16, at 953-56.

[101.] See Griffith, supra note 9; Kaplow, supra note 9; Kaplow, supra note 95.

[102.] For example, a taxpayer who engages in high-risk investments might indeed receive some high or supramarginal returns, but this same taxpayer islikely to lose on other investments so that, on balance, he or she will not “beat the market.” See BURTON G. MALKIEL, A RANDOM WALK DOWN WALLSTREET (rev. ed. 1999) (relaying a popular account of the “efficient market hypothesis”). A tax system designed somehow to isolate supramarginal returnsfaces a practical problem. To be fair, it ought to allow loss deductions as well. But loss deductions under an income-with-realization tax are problematic.See infra Part V. especially V.C. Even an ideal income tax, without the realization requirement and with some kind of inflation adjustment to isolate outhigh investment returns, faces a temporal problem under progressive rates: What if the supranormal high and low returns occur in different taxableperiods? These problems are all solvable, of course, in theory (see, for example, former law I.R.C. §§ 1301-05 (repealed 1986) (on income averaging);William Vickrey, Tax Simplification Through Cumulative Averaging, 34 LAW & CONTEMP. PROBS. 736 (1969); discussion in Part IV.E, infra), but at theprice of considerable real-world complexity. Meanwhile, a postpaid consumption tax gets this all right, as a matter of design. Since the tax only falls onactual expenditures, and since such expenditures, across a lifetime, can only be financed by net capital market returns (as well as labor market returnsand

beneficent transfers), the net yield to capital as used to finance consumption will be taxed.

[103.] See, e.g., BRUCE ACKERMAN & ANNE ALSTOTT, THE STAKEHOLDER SOCIETY (1999); Mark L. Ascher, Curtailing Inherited Wealth, 89 MICH. L. REV.69 (1990); Joseph Bankman, Commentary: What Can We Say About a Wealth Tax?, 53 TAX L. REV. 477 (2000); Michael J. Graetz, To Praise the Estate Tax,Not to Bury It, 93 YALE L.J. 259 (1983); Rakowski, supra note 15; Daniel N. Shaviro, Commentary: Inequality, Wealth, and Endowment, 53 TAX L. REV. 397(2000).

[104.] See, e.g., ROBERT E. HALL & ALVIN RABUSHKA, THE FLAT TAX (2d ed. 1995); Robert E. Hall & Alvin Rabushka, Putting the Flat Tax into Action, inFAIRNESS AND EFFICIENCY IN THE FLAT TAX 3 (1996). Grover Norquist, President of Americans for Tax Reform, and Stephen Moore, President of the Clubfor Growth, notably, have spearheaded the current conservative efforts. See, e.g., Stephen Moore, Editorial, How Much Tax Would You Like to Pay?, WALLST. J., Jan. 27, 2005, at A12.

[105.] See, e.g., SLEMROD & BAKIJA, supra note 7, at 14-15; David A. Weisbach, Ironing

Out the Flat Tax, 52 STAN. L. REV. 599, 599 (2000).

[106.] See Edward J. McCaffery, The Missing Links in Tax Reform, 2 CHAP. L. REV. 233 (1999); Weisbach, supra note 105; Lawrence Zelenak, The Selling ofthe Flat Tax: The Dubious Link Between Rate and Base, 2 CHAP. L. REV. 197 (1999); Clay Chandler, Taking a Democratic Cue, GOP Rivals Declare ‘ClassWar’ on Forbes, WASH. POST, Feb. 2, 1996, at A12; John Harwood, Forbes Plans to Drop Out of GOP Presidential Race, WALL ST. J., Mar. 14, 1996, at A20;Jacob M. Schlesinger, Party Favors: Why Tax Reform Won’t Top the Agenda of the Next President, WALL ST. J., Oct. 26, 2000, at A1; Lester, supra note 21(poll results indicating popular opposition to flat tax).

[107.] At least one of the plans had to include an income tax base. Exec. Order No. 13369, 70 Fed. Reg. 2323 (Jan. 7, 2005).

[108.] See, e.g., Barbara H. Fried, The Puzzling Case for Proportionate Taxation, 2 CHAP. L. REV. 157 (1999); The State of Federal Income TaxationSymposium: Rates, Progressivity, and Budget Processes, 45 B.C. L. REV. 989 (2004).

[109.] See Grover Norquist, Step-By-Step Tax Reform, WASH. POST, June 9, 2003, at A21; Bruce Bartlett, Bush’s High Five, NAT’L REV. ONLINE, Feb. 10,2003, available at http://www.nationalreview.com/nrof.bartlett/bartlett021003.asp (“By Bush’s second term, it is possible that we will have made enoughincremental progress toward a flat rate consumption tax that we may finally see fundamental tax reform fully enacted into law. If so, it will be atestament to a very clever, yet bold strategy that was initially invisible. . . .”).

[110.] Zelenak, supra note 39; MCCAFFERY, FAIR NOT FLAT, supra note 2, at 11.

[111.] See STANLEY S. SURREY, PATHWAYS TO TAX REFORM (1973); STANLEY S. SURREY & PAUL R. MCDANIEL, TAX EXPENDITURES (1985); Stanley S.Surrey, Federal Income Tax Reform: The Varied Approaches Necessary to Replace Tax Expenditures with Direct Governmental Assistance, 84 HARV. L.REV. 352 (1970); Stanley S. Surrey, Tax Incentives as a Device for Implementing Government Policy: A Comparison with Direct Government Expenditures,83 HARV. L. REV. 705 (1970); see also Boris I. Bittker, Comprehensive Income Taxation: A Response, 81 HARV. L. REV. 1032 (1968); Boris I. Bittker, A“Comprehensive Tax Base” as a Goal of Income Tax Reform, 80 HARV. L. REV.

925 (1967).

[112.] A prepaid consumption tax only taxes labor earnings, by design. An ideal income tax is designed to tax the yield to capital as well, but, in practice,it reaches capital income to a far lesser extent than it does labor market earnings. The failure of the so-called income tax to reach much of the yield tocapital effectively makes it a wage tax.

[113.] See ROBERT H. FRANK, LUXURY FEVER 232-35 (1999); McCaffery, The Right to Waste?, supra note 24; at 87-91 see also infra note 347 (discussingoptimum consumption tax theory).

[114.] See Jonathan Weisman, Democrats Put Tax Proposals in Context of Systematic Change, WASH. POST, Jan. 12, 2004, at A5; Rob Wells, Bush TaxPanel’s Breaux Seeks Income-Consumption Hybrid, WALL ST. J., Feb. 17, 2005, at A2 (discussing the support of John Breaux, Vice-Chairman of PresidentBush’s Advisory Panel on Tax Reform and former Democratic Senator from Louisiana, for a hybrid-based tax).

[115.] See John Rawls, The Priority of Right and Ideas of the Good, 17 PHIL. & PUB. AFF.

251, 262 (1988); see also Thomas C. Grey, Holmes and Legal Pragmatism, 41 STAN. L. REV. 787 (1989); Kelman, supra note 8; Richard Rorty, The Banalityof Pragmatism and the Poetry of Justice, 63 S. CAL. L. REV. 1811 (1990); Richard Rorty, Pragmatism and Law: A Response to David Luban, 18 CARDOZO L.REV. 75 (1996).

[116.] See Rawls, supra note 115; see also RONALD DWORKIN, FREEDOM’S LAW 38 (1996); CHARLES E. LARMORE, PATTERNS OF MORAL COMPLEXITY40-68 (1987); Bruce A. Ackerman, What is Neutral About Neutrality?, 93 ETHICS 372 (1983).

[117.] See FULLERTON & HENDERSON, supra note 33; FULLERTON & ROGERS, supra note 33.

[118.] This was proven many years ago by the seminal work of Kenneth Arrow and Gerald Debreau. Kenneth Arrow & Gerard Debreu, Existence of aCompetitive Equilibrium for a Competitive Economy, 22 ECONOMETRICA 205 (1954).

[119.] Slemrod, supra note 12, at 157, 159.

[120.] This, however, is not to say that a move from the actual income tax to a consistent consumption tax would work this way; the current tax is not anideal income tax or anything too close to it. Adopting a consistent postpaid consumption tax would have very important base-broadening features,including the inclusion of debt-financed consumption, and the elimination of preferential capital gains rates and the “stepped-up” basis for assetstransferred on death. Tax rates might well decrease in any conversion to a consistent postpaid consumption tax.

[121.] Slemrod, supra note 12.

[122.] F.P. Ramsey, A Contribution to the Theory of Taxation, 37 ECON. J. 47 (1927); Mirrlees, supra note 12. See also VICKREY, supra note 50.

[123.] This is a central theme of THE MYTH OF OWNERSHIP. MURPHY & NAGEL, supranote 6, at 31-37.

[124.] MCCAFFERY, TAXING WOMEN, supra note 72, at 170-73.

[125.] Id. at 175-82.

[126.] Id. at 183-84.

[127.] See Slemrod, supra note 12, at 159-62.

[128.] The income tax has never included gifts in gross income, though. See I.R.C. § 102 (2004). See also Douglas Kahn & Jeffrey H. Kahn, “Gifts, Gafts,and Gefts” — The Income Tax Definition and Treatment of Private and Charitable “Gifts” and a Principled Policy Justification for the Exclusion of Gifts from Income, 78 NOTRE DAME L. REV. 441 (2003); Carolyn C. Jones, Treatment of Gratuitous Transfers: Unraveling the Case for a Consumption Tax, 29 ST.LOUIS L.J. 1155 (1985); Marjorie E. Kornhauser, The Constitutional Meaning of Income and the Income Taxation of Gifts, 25 CONN. L. REV. 1, 102 (1992).

[129.] Of course, you would need to tell the government how much of your gross receipts was spent on generating income, so that you would be taxed onyour net income (the movement from I.R.C. § 61 (gross income) to § 62 (adjusted gross income) (2004), in sum), and therein many difficult issues of mixedbusiness-personal expenses, timing, and so on would remain. But once we had gotten to this net figure, the resources available to you to save orconsume, the government would be indifferent to your particular mixture of savings and consumption activities under a pure income tax.

[130.] Andrews, Personal Deductions, supra note 80; see also I.R.C. § 213 (2004) (extraordinary medical expenses); id. § 170 (charitable contributions).

[131.] Kelman, supra note 8.

[132.] See prior law I.R.C. §§ 1301-05 (1982) (repealed 1986); see infra Part IV.E for a discussion of averaging.

[133.] Klein, supra note 14, at 463.

[134.] Id. at 470-79. See also BRADFORD ET AL., supra note 8, at 44; VICKREY, supra note 50, at 165-68.

[135.] See Andrews, Reply to Professor Warren, supra note 16, at 949-50.

[136.] See infra Part V.

[137.] This answers the question of whether the critique of the income tax and the argument for a progressive postpaid consumption tax throughout thisArticle is ideal, or first-best, as opposed to nonideal, or second-best, a confusion rampant in tax policy. My answer is both. The argument is that theproblems with the actual income tax flow, in large part, from the failure of ordinary moral intuitions to support the income ideal; many of the inequitiesand distortions noted in Andrews, Personal Income Tax, supra note 8, followed from an unwillingness to tax all savings. By keeping to the form of anincome tax while attempting to implement both the ordinary-savings and yield-to-capital norms, we created an incoherent nonideal system. A progressivepostpaid consumption tax, on the other hand, implements the first-best ideals of the ordinary-savings and yield-to-capital norms, and so its nonideal, real-world instantiation will not be in conflict with its animating ideal. It is true, as some commentators have pointed out, that we may continue to wantdeviations from the taxation of all consumption under a postpaid consumption tax; there will continue to be arguments for medical expense andcharitable contribution deductions, and so on. But recall that these arguments also apply to an income tax, which aims to tax all consumption and all savings. See e.g., BRADFORD ET AL., supra note 8; MCCAFFERY, FAIR NOT FLAT, supra note 2, at 130-38, 148-50. There is no change, ceteris paribus, inthe analysis of consumption terms. The progressive postpaid consumption tax simply puts the taxation of capital or savings on a more principled footing,implementing the yield to capital and ordinary-savings norms, and does so by design. Both the first-best and second-best arguments for such a resolutionare


[138.] RAWLS, supra note 52, at 19-21, 48-51. Actually, Rawls credits Nelson Goodman with the development of the term and concept. Id. at 20 n.7 (citingNELSON GOODMAN, FACT, FICTION AND FORECAST 65-68 (1955)).

[139.] See generally RONALD DWORKIN, LAW’S EMPIRE (1986); Gregory C. Keating, Rawlsian Fairness and Regime Choice in the Law of Accidents, 72FORDHAM L. REV. 1857 (2004); Edward J. McCaffery, Tax’s Empire, 85 GEO. L.J. 71 (1996) [hereinafter, McCaffery, Tax’s Empire].

[140.] I am here following a methodology I have laid out elsewhere, one that consciously draws on a model of normative constitutional and common lawargument. See McCaffery, Tax’s Empire, supra note 139.

[141.] See MILL, supra note 1. For an overview of the history of the desire for progressivity in tax, see Jensen, supra note 4; Bank, supra note 4.

[142.] See, e.g., I.R.C. §§ 1271-1275 (2004) (o.i.d. rules); see also Halperin, supra note 73.

[143.] See, e.g., I.R.C. §§ 401 (qualified pension plans), 408 (traditional IRAs), 408A (Roth IRAs) (2004); see infra Part V.B for an analysis of the currentsystem’s ad hoc deviations.

[144.] Bankman and Griffith make this point well. See Bankman & Griffith, Debate, supra note 12; Bankman & Griffith, Social Welfare, supra note 12.

[145.] In a 2003 CNN/Gallup/USA Today poll, 63 percent of respondents thought the rich pay too little in taxes, while only 7 and 12 percent, respectively,thought middle- and lower- income taxpayers pay too little. KARLYN H. BOWMAN, AMERICAN ENTERPRISE INSTITUTE, PUBLIC OPINION ON TAXES 18(2004), http://www.aei.org/publication16838 (last visited Jan. 14, 2004); see also GRAETZ, supra note 6, at 10-13; SLEMROD & BAKIJA, supra note 7, at 5;Graetz, supra note 6, at 282-83.

[146.] See infra Part V.

[147.] See supra notes 106-110 and accompanying text.

[148.] See Andrews, Personal Income Tax, supra note 8, at 1128-29.

[149.] The reason is that it is possible to save on the one hand and borrow on the other, resulting in a deduction with no net savings, or to move existingsavings into tax-favored accounts, thereby obtaining a similar bottom-line result. See Edmund L. Andrews, Savings: Lots of Talk, but Few Dollars, N.Y.TIMES, Mar. 13, 2005, at § 3, p.6; Elizabeth Bell, Adam Carasso, and C. Eugene Steuerle, Retirement Saving Incentives and Personal Saving, 105 TAXNOTES 1689 (2004) (reporting that tax breaks for retirement programs cost $112 billion in 2004, according to the Office of Management and Budget;personal savings, for all purposes, totaled $100.8 billion).

[150.] See McCaffery, Hybrid, supra note 23, at 1148 (arguing for a hybrid income- consumption tax “because of the different values we place on thedifferent types of savings”).

[151.] Empowerment zones are regulated by I.R.C. §§ 1391-1397D (2004). Of course, such regulations have complicated and sometimes counterproductiveeffects. See Jeffrey S. Lehman, Updating Urban Policy, in CONFRONTING POVERTY 226, 228-30 (Sheldon H. Danziger et al. eds., 1994); Jeffrey S. Lehman& Timothy M. Smeeding, Neighborhood Effects and Federal Policy, in 1 NEIGHBORHOOD POVERTY: CONTEXT AND CONSEQUENCES FOR CHILDREN, 251,259-62 (Jeanne Brooks-Gunn et al. eds., 1997).

[152.] See infra Part VII.B.4.

[153.] See generally, e.g., Bank, supra note 4; Jensen, supra note 4.

[154.] See infra note 254 and accompanying text.

[155.] See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 50.

[156.] See generally DAVID F. BRADFORD, UNTANGLING THE INCOME TAX (1986); BRADFORD ET AL., supra note 8; VICKREY, supra note 50; DanielShaviro, Endowment and Inequality, in TAX JUSTICE 123 (Joseph J. Thorndike & Dennis J. Ventry, Jr. eds., 2002).

[157.] See Jones, supra note 65.

[158.] For a philosophical discussion of urgency and objective needs, see T.M. Scanlon, Preference and Urgency, 72 J. PHIL. 655, 660-61 (1975).

[159.] The assumption does not materially affect the analysis. Inflation can be generally accounted for by indexing the rate brackets, which is howprogressivity will be achieved: Fully indexed, the system maintains a constant effective tax rate on constant real value dollars, as the no-inflationassumption also effects. Further, under a progressive postpaid consumption tax, the full deductibility of principal and interest washes out the time valueeffects at least at the normal rate of interest.

[160.] This is, of course, a simplifying assumption, but it does not affect the analysis. Recall the 0 percent inflation in the story; at a positive rate ofinflation, the wages would be higher to reflect the inflation in the principal of the debt. Consider also that many loans are intrafamily transfers, as I shalldiscuss below. Any real interest, in fact, reduces the amount of lifetime consumption (below the posited $2.4 million in the example), but then any realpositive rate of return on the savings in the third and fourth quarters of the taxpayer’s life increases it.

[161.] Laurence J. Kotlikoff, Intergenerational Transfers and Savings, J. ECON. PERSP., Spring 1988, at 41, reprinted in WHAT DETERMINES SAVINGS? 68(Laurence J. Kotlikoff ed., 1989); Laurence J. Kotlikoff & Avia Spivak, The Family as an Incomplete Annuities Market, 89 J. POL. ECON. 372 (1981), reprintedin WHAT DETERMINES SAVINGS? 88 (Laurence J. Kotlikoff ed., 1989); Laurence J. Kotlikoff & Lawrence H. Summers, The Role of IntergenerationalTransfers in Aggregate Capital Accumulation, 89 J. POL. ECON. 706 (1981), reprinted in WHAT DETERMINES SAVINGS? 43 (Laurence J. Kotlikoff ed., 1989).

[162.] Robert J. Barro, Are Government Bonds Net Wealth?, 82 J. POL. ECON. 1095, 1116 (1974); Kotlikoff, supra note 161; Kotlikoff & Summers, supranote 161.

[163.] BRADFORD, supra note 156; BRADFORD ET AL., supra note 8; VICKREY, supra note 50. Of course, the position that these ups and downs are indeedmorally arbitrary requires argument, which this Article does not provide in any length or depth. Suffice it to say that it is hard to imagine a compellingmoral argument that a putative taxpayer should pay more taxes strictly on account of her uneven pattern of labor market earnings vis-à-vis an equal butsteadier earner, yet a system of progressive average rates has precisely this effect under a prepaid consumption or income tax. The practical prevalenceof the ordinary- savings norm — the widespread allowances under the “income” tax for backward smoothing further testifies to the moral insignificanceof particular patterns of labor market realizations.

[164.] See BRADFORD, supra note 156; Shaviro, supra note 156. Note that these ideas are predicated on individual levels; a somewhat parallelmacroeconomic idea can be found in Laurence Kotlikoff’s and others’ writings on “generational” accounting. See supra note 161.

[165.] See Andrews, Personal Income Tax, supra note 8, at 1170; Andrews, Reply to Professor Warren, supra note 16, at 957-58; Klein, supra note 14;Edward J. McCaffery, The Uneasy Case for Wealth Transfer Taxation, 104 YALE L.J. 283, 350-51 (1994) [hereinafter McCaffery, Uneasy Case].

[166.] See infra note 193 and accompanying text.

[167.] See generally Bankman & Griffith, Debate, supra note 12; Alvin C. Warren, Jr.,

How Much Capital Income Taxes Under an Income Tax Is Exempt Under a Cash Flow Tax?, 52 TAX L. REV. 1 (1996).

[168.] All this depends, of course, on supporting the semantic claim that such personal or institutional (charitable) giving is not “consumption;” a positionthat the present income tax law takes, at least relative to charitable giving. See Andrews, Personal Deductions, supra note 80, at 346.

[169.] STEPHEN M. POLLAN & MARK LEVINE, DIE BROKE (1997); see also Kotlikoff & Spivak, supra note 161, at 372-73.

[170.] See Warren, supra note 13, at 934.

[171.] In this way, the progressive postpaid consumption tax acts as an accessions tax, falling on heirs. See McCaffery, Being the Best, supra note 15, at631. Of course, this might not address all of the concerns of advocates of wealth transfer taxation, because the postpaid consumption tax can facilitategreater stores or stocks of private wealth. I discuss this issue infra Part VII.B.4.

[172.] See Louis Kaplow, A Note on Subsidizing Gifts, 58 J. PUB. ECON. 469 (1995).

[173.] See infra Part VI.B (criticizing current wealth transfer tax system).

[174.] See infra Part V for a critique of the current “income” tax.

[175.] Another idea for effecting justice in social systems is to abandon progressivity in tax, per se, and to obtain redistribution via transfers orexpenditures. See Bird & Zolt, supra note 51 (commenting on this strategy for the developing world).

[176.] MCCAFFERY, FAIR NOT FLAT, supra note 2, at 78-81; Bankman & Griffith, Social

Welfare, supra note 12.

[177.] See, e.g., Mirrlees, supra note 12; Berliant & Rothstein, supra note 12.

[178.] That is, as x (income) approaches infinity, a taxpayer gets closer to paying the highest marginal rate, here 30%, on average.

[179.] Rates might also change over time on account of the greater efficiency of a new tax, a point David Bradford impressed on me. See David F.Bradford, Transition to and Tax Rate Flexibility in a Cash-Flow Type Tax, in 12 TAX POLICY AND THE ECONOMY 151-72 (James Poterba, ed., 1998). Thiscomplicates but does not fundamentally alter the analysis.

[180.] Once more, she pays 0 on her first $10,000; $3,000, or 15%, on her next $20,000;

and $9,000, or 30% on her “last” $30,000.

[181.] This second tax is not reflected in the picture because of the simplifying assumption of a 0% rate of return.

[182.] See I.R.C. § 163(a), (d), (h) (2004).

[183.] $50,000 represents a 5% annual yield on a $1,000,000 corpus, a sum easily transferred tax-free under today’s wealth transfer system. See infra PartVI.B.

[184.] Some one might have once paid some tax on Trust Fund Baby’s fortune, of course, but not necessarily. See Boris I. Bittker, Tax Shelters and TaxCapitalization or Does the Early Bird Get a Free Lunch?, 28 NAT’L TAX J. 416 (1975), reprinted in COLLECTED LEGAL ESSAYS 547 (1989) (a charming tale ofbenefiting from the income tax’s incentives . . . before the tax was even enacted).

[185.] See Adam Hime, Note, Getting Schooled by the Hybrid-based Tax: Equity and Efficiency in the Federal Tax Treatment of Debt-financed Post-Secondary Educational Expenditures, 77 S. CAL. L. REV. 871, 889-91 (2004).

[186.] See generally Auerbach, supra note 42.

[187.] Note that intergenerational smoothing allows family annuities markets to effect this result.

[188.] See Vickrey, supra note 102.

[189.] See BRADFORD ET AL., supra note 8, at 74-75. I thank David Bradford and Jim Hines for a discussion of this and related points.

[190.] I.R.C. §§ 1301-05 (1982) (repealed 1986). For a discussion of how these (complex) provisions operated, see BORIS I. BITTKER, FEDERAL TAXATIONOF INCOME, ESTATES AND GIFTS (1981) ¶ 111.3.13, pp. 111-70 to 111-75.

[191.] I thank Jim Hines and David Weisbach for their persistence in pressing these points on me.

[192.] See FRANK, supra note 113, at 228-31; Edward J. McCaffery, The Tyranny of Money, 98 MICH. L. REV. 2126, 2129-30 (2000) [hereinafter McCaffery,Tyranny] (reviewing FRANK, supra note 113). This point also relates back to the first argument against Vickrey’s position, specifically his use of an incometax base as default. A well-designed tax system, I am arguing, should allow an “escape valve” for excessive lifetime earnings — it should allow andperhaps even encourage the wealthy to continue to work and save, hoping that they not spend their “surplus” funds on themselves. A tax system thattaxes spent and unspent resources does not do this; it disincentivizes work effort by those who have already funded their own generation’s needs andwants.

[193.] Even a taxpayer who slightly straddles the line will not pay a grave price, on account of the slope of the marginal rate brackets. For example, ataxpayer who consumes $230,000 one year (in the 50% bracket, say), and $170,000 the next, would pay an extra $3,000 (10% of $30,000), or 1.5% ofincome, for the imprecision. If the brackets increased in 5% intervals, the “problem” would be even smaller. I thank Reed Shuldiner for the example.

[194.] See Andrews, Personal Income Tax, supra note 8, at 1150, 1155-57; BRADFORD ET AL., supra note 8, at 81, 108-09, 117.

[195.] See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 134-36. Reed Shuldiner has pressed me on this need for advice. But, of course, taxpayers todayneed much advice on shifting labor and capital market returns around in time. Consumption smoothing, in contrast, seems more natural and largely withina taxpayer’s control. See SMITH, supra note 54, at 778.

[196.] See BRADFORD ET AL., supra note 8, at 78 (ignoring the imputed income of home- ownership “for the sake of simplification”); MCCAFFERY, FAIRNOT FLAT, supra note 2.

[197.] McCaffery, The Right to Waste?, supra note 24; McCaffery, Uneasy Case, supra note 165; Smith, supra note 54, at 778. It is curious that some argueagainst this moralism, while advocating, explicitly or implicitly, for progressive income tax rates. It is difficult to see why the harm from unequal earningsis greater than the harm from unequal spending, especially when a tax system can constrain what can be done with the earnings. The problem of theaccumulated capital itself is, of course, a different matter, which I have addressed elsewhere and note again below, infra Part VII.B.4. See McCaffery,Being the Best, supra note 15; Edward J. McCaffery, The Political Liberal Case Against the Estate Tax, 23 PHIL. & PUB. AFF. 281 (1994) [hereinafterMcCaffery, Political Liberal Case]; but see Rakowski, supra note 15; Deborah Geier, Incremental Versus Fundamental Tax Reform and the Top OnePercent, 56 SMU L. REV. 99 (2003).

[198.] Deborah M. Weiss, Paternalistic Pension Policy: Psychological Evidence and

Economic Theory, 58 U. CHI. L. REV. 1275 (1991).

[199.] Professor Andrews wrote:

[T]he ultimate policy choice to be made is between achievable ends, not abstract ideals. Most of my prior article [Andrews, Personal Income Tax, supranote 8] was designed to show that the most intractable difficulties in the existing income tax arise from the virtual impossibility of achieving asatisfactory reflection of real accumulation in a practical income tax base, and that these difficulties could be readily avoided by pursuing the goal ofconsumption instead of accretion.

See Andrews, Reply to Professor Warren, supra note 16, at 947.

[200.] See Andrews, Personal Income Tax, supra note 8, at 1167-68.

[201.] The phrase was first used in Andrews, Personal Income Tax, supra note 8, at 1117. See also Auerbach, supra note 42; McCaffery, Hybrid, supra note23.

[202.] See Edward J. McCaffery, A Voluntary Tax? Revisited, Proceedings, 93rd Annual Conference of the National Tax Association, 2000, 268 (2001)[hereinafter McCaffery, A Voluntary Tax?]; see also ROBERT T. KIYOSAKI & SHARON L. LECHTER, RICH DAD, POOR DAD (1997).

[203.] Norquist, president of Americans for Tax Reform, notes that piecemeal tax measures are bringing us ever closer to a flat tax. See Norquist, supranote 109.

[204.] 252 U.S. 189 (1920).

[205.] For additional detail, see Majorie E. Kornhauser, The Story of Macomber: The Continuing Legacy of Realization, in TAX STORIES 53 (Paul L. Caroned., 2003).

[206.] Macomber was first argued before the Court on April 16, 1919, restored to docket for reargument May 19, 1919, and reargued October 17 and 20,1919. The decision was handed down March 8, 1920.

[207] See SIMONS, supra note 29, at 50.

[208.] See I.R.C. § 1001(a) (2004).

[213.] See I.R.C. § 1014 (2004).

[214.] See id. For a definition of “basis,” see MCCAFFERY, FAIR NOT FLAT, supra note 2, at 30 (“Basis means, in essence, after-tax dollars.”). I prefer thisdefinition to the often-used definition of “cost” in part because of the stepped-up basis rule.

[215.] I.R.C. § 102 (2004).

[216.] The stepped-up basis under I.R.C. § 1014 (2004) means that the gain calculated under I.R.C. § 1001 (2004) will be zero.

[217.] See KIYOSAKI & LECHTER, supra note 202. The holders of appreciating assets that do not produce cash flows can simply borrow against theincrease in value of such assets, thereby gaining access to cash without the tax liability of assets that generate realized proceeds.

[218.] The tax benefits of this strategy are subject to capital loss offset rules, discussed infra Part V.B.2.

[219.] I.R.C. § 1015 (2004); see also Taft v. Bowers, 278 U.S. 470 (1929) (upholding carryover basis for gifts).

[220.] See I.R.C. § 1014 (2004). Joseph Dodge and Jay Soled have suggested that taxpayers may not even be waiting until death to avoid gain legally.Instead they seem to be inflating the basis of assets sold during life, knowingly or unknowingly cheating on their taxes. See Joseph M. Dodge & Jay A.Soled, Inflated Basis and the Quarter-Trillion Dollar Revenue Question, 106 TAX NOTES 453 (2005).

[221.] See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 32-33.

[222.] This example is borrowed from id. at 33-34.

[223.] See I.R.C. § 102 (2004). Of course, his parents would have, at one time, paid tax on the initial labor market earnings, see Warren, supra note 13, at934-41, unless they happen to have received these before the initial imposition of the tax. See Bittker, supra note 184.

[224.] I.R.C. § 1211 (2004).

[225.] Suppose, for example, that Dodger has $1 million worth of assets. He can sell the assets, pay the tax now, and spend what is left, say $600,000with a 40% effective tax. Or Dodger can instead borrow against the asset and consume tax-free. If he borrows $600,000 at a 5% interest rate, he alsoretains the asset, worth $1 million and appreciating at its own rate. He can buy a “collar” or enter a “stop loss” order should his assets ever fall in value,which would leave him in the same financial position as he would have been in with an initial sale. But if the assets do not fall in value, he wins. The netcost of borrowing is i – r, where i is the interest on the debt and r the return on the asset. If r exceeds i, as it typically would, Dodger makes real value onthe strategy. He has his cake and is eating it, too, tax-free.

[226.] For a discussion and explanation of mixing bowl transactions, see Louis S. Freeman et al., The Partnership Union: Opportunities for Joint Venturesand Divestitures, in TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 117-22 (2004).

[227.] See, e.g., James Bicksler & Andrew H. Chen, An Economic Analysis of Interest Rate Swaps, 41 J. FIN. 645, 652 (1986); Phyllis Plitch, Esoteric Tacticfor Investors Grows Popular, WALL ST. J., May 27, 1997, at B105B (describing the use of collars).

[228.] See, e.g., Farhad Aghdami, Income, Gift, and Estate Tax Planning with Life Insurance, ALI-ABA’s Direct-to-Desktop CLE Course Forms, athttp://d2d.ali- aba.org/_files/thumbs/rtf/ CK025-05AghdamiLifeIns_thumb.pdf (last visited Feb. 1, 2005).

[229.] I.R.C. § 102 (2004).

[230.] I.R.C. § 1014 (2004).

[231.] Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, § 521, 115 Stat. 71 (2001).

[232.] See Douglas Holtz-Eakin, The Uneasy Empirical Case for Abolishing the Estate Tax, 51 TAX L. REV. 495, 509-11 (1996) (discussing the difficulty ingleaning the motives and techniques of wealth transfers).

[233.] The advice can be found readily enough, for example, in such bestsellers as KIYOSAKI & LECHTER, supra note 202; POLLAN & LEVINE, supra note169; see also MCCAFFERY, FAIR NOT FLAT, supra note 2 (describing and referring to numerous popular tax planning books). Evidence from sophisticatedeconometrics that we collect little if any revenue from capital taxes also suggests the point. See Roger Gordon et al., Do We Now Collect Any Revenuefrom Taxing Capital Income? 89 J. PUB. ECON. 981 (2004).

[234.] See Geier, supra note 197.

[235.] See McCaffery, A Voluntary Tax?, supra note 202; Gordon et al., supra note 233.

[236.] And see Dodge & Soled, supra note 220, for a suggestion that taxpayers are dramatically under-stating their true capital gains.

[237.] See, e.g., MURPHY & NAGEL, supra note 6; SLEMROD & BAKIJA, supra note 7, at 10-13; Alstott, supra note 6; Deborah A. Geier, supra note 197;Rakowski, supra note 15.

[238.] I.R.C. § 1(h) (2004).

[239.] See I.R.C. §§ 1221 (2004), 1222 (2002) for a definition of capital assets.

[240.] Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. No. 108-27, § 301,

117 Stat. 758 (2003).

[241.] Other common arguments for a capital gains preference are simply not convincing. For example, there is an argument that much of the gain fromthe sale of an asset reflects compensation for inflation. This argument, made before general rate-bracket indexing, lacked a strong claim to fairness, because much of the return to human capital, too, compensated for changes in the inflation or monetary rate. After rate-bracket indexing became fullyeffective, the capital gains argument lacked much force. Further, indexing of an asset’s basis for inflation is a far better reaction to the “problem” ofinflationary gain than a crude discount to all assets held a year or more. Another argument is that capital gains can result in “bunching,” or the temporaryelevation of a taxpayer into a higher-rate bracket. In fact, the evidence on bunching of capital realizations is slim; and capital market transactions, such asinstallment sales, (see I.R.C. § 453 (2004)) can deal with the problem, as could a more targeted averaging mechanism in the tax laws. And again, it isunclear why there should be solicitude for the taxpayers with financial capital who suffer this problem, when there is no adjustment for those with humancapital who also fall victim to bunching. This Article is an attempt to make the smoothing phenomenon general, and to be indifferent to thefinancial/human capital source of the problem. All that said, however, the lock-in effect is a compelling argument for a capital gains preference. SeeEdward J. McCaffery, Capital Gains: What’s the Point, and Are We Missing It?, 43 TAX NOTES 223 (1989).

[242.] Dodge & Soled, supra note 220, suggest taxpayers aren’t waiting for Godot, either: They are taking matters into their own hands, overstating basisand thereby understating gain. I.R.C. § 1001(a) (2004).

[243.] Jobs and Growth Tax Relief Reconciliation Act § 302; see also, STEUERLE, supra

note 9, at 224-25.

[244.] Brier Dudley, Microsoft’s $75 Billion Plan: Share Wealth with Investors, SEATTLE TIMES, July 21, 2004, at A1; Gary Rivlin, Microsoft to Pay SpecialDividend to Stockholders, N.Y. TIMES, July 21, 2004, at A1; see also Jonathan Fuerbringer, Companies With Cash Hoards Don’t Necessarily Pay It Out, N.Y.TIMES, July 22, 2004, at C7.

[245.] The incentive appears to have worked. See CHRIS EDWARDS, REPLACING THE SCANDAL-PLAGUED CORPORATE INCOME TAX WITH A CASH-FLOWTAX 23 (Cato Inst., Policy Analysis No. 484, 2003), at http://www.cato.org/pubs/pas/pa-484es.html (Aug.14, 2003).

[246.] See supra Part V.A.1.

[247.] Del Jones, CEOs, Heirs to Stock Fortunes Win Big with Cut, USA TODAY, Jan. 9,

2003, at 3B (noting that each of the five Walton heirs would save $197 million annually in taxes if dividends were tax-free).

[248.] I.R.C. § 101 (2004).

[249.] See generally I.R.C. § 2042 (2004).

[250.] Cf. Knetsch v. United States, 364 U.S. 361, 364-66 (1960) (describing a scenario in which borrowing against a life insurance policy would have left a“relative pittance”). Although Knetsch lost his case, much sophisticated planning with life insurance persists to this day.

[251.] I.R.C. § 121 (2004).

[252.]I.R.C. § 1034 (1988) (repealed 1997).

[253.] I.R.C. § 121 (1988) (repealed 1997).

[254.] The Revenue Act of 1942, Pub. L. No. 77-753, 56 Stat. 798 (codified as amended in scattered sections of 26 U.S.C.) first made employer pensioncontributions tax deductible. IRAs were introduced in 1974 in the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. No. 93-406, § 202, §§Stat. 829, 958-66 (codified as amended at 26 U.S.C. §§ 219, 408 (2000)). See generally Steven F. Venti & David A. Wise, Government Policy and PersonalRetirement Saving, 6 TAX POL’Y & ECON. 1, 37-38 (1992) (data suggests IRA program induces “substantial new saving”).

[255.] See Bell, Carasso & Steuerle, supra note 149 (reporting that tax incentives for retirement programs in 2004 cost the government $112 billion in2004, while all personal savings were $100.8 billion that year); but see generally, Venti & Wise, supra note 254, at 25 (suggesting IRA programs do inducenew saving).

[256.] Our understanding is imperfect in large part because the problems are intractably hard. There are problems of joint causation and a great deal ofnoise in the economic statistics.

[257.] U.S. DEP’T OF COMMERCE, STATISTICAL ABSTRACT OF THE UNITED STATES: 2003, at 469, 742 (123d ed. 2003). Nearly half of all American familiesdo not have a retirement plan while about a third of all American families do not own a primary residence.

[258.] See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 50; Elizabeth Garrett, Accounting for the Federal Budget and Its Reform, 41 HARV. J. ON LEGIS.187, 192-93 (2004).

[259.] On the other hand, one can easily shift existing taxable savings into a prepaid account, eliminating capital taxes without new savings. See RogerGordon et al., Toward a Consumption Tax, and Beyond, 94 AMER. ECON. REV. 161 (2004).

260. See supra Part V.A.2.

[261.] It is worth noting, however, that the taxpayer who plays this game, using traditional IRAs or pension plans, cannot escape tax altogether, as can thetaxpayer with financial capital who plays Tax Planning 101: some tax must be paid on the withdrawal of funds from the IRA or qualified pension account,even if the taxpayer dies before the withdrawal. I.R.C. § 691 (2004) (income in respect of decedent). This is yet another example of the system’s fargreater solicitude for taxing wages than the yield to capital.

[262.] See INTERNAL REVENUE SERV., PUB. NO. 969, HEALTH SAVINGS ACCOUNTS AND OTHER TAX-FAVORED HEALTH PLANS (2004), athttp://www.irs.gov/publications/p969/ (last visited April 5, 2005); INTERNAL REVENUE SERV., PUB. NO. 970, TAX BENEFITS FOR EDUCATION (2004), athttp://www.irs.gov/pub/irs-pdf/p970.pdf (last visited April 5, 2005) [hereinafter TAX BENEFITS FOR EDUCATION].

[263.] See Daniel Altman, Taxes and Consequences: The Second Term Begins, N.Y. TIMES, Nov. 7, 2004, § 3, at 4 (discussing inter alia BushAdministration proposals for lifetime savings and universal retirement accounts).

[264.] I.R.C. § 529 (2004).

[265.] See I.R.C. § 530 (2004); TAX BENEFITS FOR EDUCATION, supra note 262, at 9-24, 40-49.

[266.] See I.R.C. § 529 (2004); TAX BENEFITS FOR EDUCATION, supra note 262, at 50-53. The terms and conditions may include making the withdrawalsbefore 2010, when the law is presently set to expire.

[267.] See I.R.C. § 102 (2004).

[268.] In the 1990s, a new generation of “corporate tax shelters” arose to offset corporate income taxes, but also to shelter the large capital gainsoccasioned by the boom time 1990s. In the latter case, the corporate form exploited a gap in the coverage of I.R.C. § 469 (2004). See Symposium,Business Purpose, Economic Substance, and Corporate Tax Shelters, 54 SMU L. REV. 3 (2001).


[270.] Tax Reform Act of 1996, Pub. L. No. 99-5511, 100 Stat. 7085 (codified as amended in scattered setions of 26 U.S.C.).

[271.] In 1981, the highest rate was reduced from 70 percent to 50 percent. Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172 (1981).Under the Jobs and Growth Tax Relief Reconciliation Act, the top rate was cut to 35 percent.

[272.] Prior law I.R.C. § 163 (1982) (amended 1986).

[273.] The present law does not contain such unlimited loss offsets. See I.R.C. § 1211 (first added in 1954, amended to current assets in 1986) (2004)(capital loss offset rule).

[274.] Facts based on Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976), which did not work. But see Comm’r v. Tufts, 461 U.S. 300 (1983)(illustrating a simple case that did work).

[275.] See I.R.C. §§ 167, 168 (2004).

[276.] Under Tufts, she will have capital gains of $3,000,000 — a small price to pay for $3,000,000 worth of tax-free ordinary income for 30 years. And, inany event, she can always find another shelter, holding them until she dies, thereby playing Tax Planning 101. See supra Part V.A.1.

[277.] See I.R.C. § 163 (2004); supra note 272 and accompanying text. Under an unlimited interest deduction, as generally obtained prior to 1986, even aloan to finance a gift would generate deductible interest. But see I.R.C. § 265 (2004).

[278.] See I.R.C. § 162 (2004).

[279.] See, e.g., Brooke v. United States, 468 F.2d 1155 (1972).

[280.] See BRADFORD ET AL., supra note 8. Note that these are exactly the options that the Bush Administration, early in its second term, seems to beconsidering again, this time with a prepaid consumption tax model ascendant. See Altman, supra note 263.

[281.] See BRADLEY, supra note 6.

[282.] There had already been anti-straddle legislation, I.R.C. § 1092 (added in 1981) and the “at risk” rules limited some shelter games. I.R.C. § 465(added in 1976).

[283.] See I.R.C. § 163 (2004), especially 163(d).

[284.] See I.R.C. §§ 1211 (first added in 1954, amended to current limits in 1986), 1092(c)- (f) (introduced in 1981, 2002) (anti-straddle provisions).

[285.] I.R.C. § 469 (2004).

[286.] I.R.C. § 1(g) (unearned income of minor children, a/k/a “kiddie tax”).

[287.] See CHIRELSTEIN, supra note 56, at 73 (explaining that Macomber’s realization requirement not constitutional, merely an administrative rule); seealso I.R.C. §§ 1271-1274 (2002) (o.i.d. provisions) (instances of Congress’s imposing tax without realization).

[288.] See I.R.C. § 1 (1986); see also McCaffery, Cognitive Theory and Tax, supra note 43, at 1898 (discussing TRA 86’s rate “bubble”).


[290.] This is beginning to change. See Deborah A. Geier, Integrating the Tax Burdens of the Federal Income and Payroll Taxes on Labor Income, 22 VA.TAX REV. 1 (2002) [hereinafter Geier, Integrating the Tax Burdens]; Andrew Mitrusi & James Poterba, The Distribution of Payroll and Income Tax Burdens,1979-99, 53 NAT’L TAX J. 765, 765 (2000); Deborah A. Geier, The Payroll Tax Liabilities of Low- and Middle-Income Taxpayers, 106 TAX NOTES 711 (2005)[hereinafter Geier, Payroll Tax Liabilities].

[291.] See Calvin H. Johnson, A Thermometer for the Tax System: The Overall Health of the Tax System as Measured by Implicit Tax, 56 SMU L. REV. 13,45-50 (2003); Michael L. Schler, Ten More Truths About Tax Shelters: The Problem, Possible Solutions, and a Reply to Professor Weisbach, 55 TAX L. REV.325, 388 (2002).

[292.] In 2002, federal personal income taxes raised just over $858 billion, or 46.3 percent of total federal receipts of $1.853 trillion, and 30 percent oftotal government receipts of $2.847 trillion. See OFFICE OF MGMT. & BUDGET, EXECUTIVE OFFICE OF THE PRESIDENT, HISTORICAL TABLES: BUDGET OFTHE UNITED STATES GOVERNMENT, FISCAL YEAR 2004, at 29-30, 293 (2003).

[293.] See Geier, Integrating the Tax Burdens, supra note 290; Geier, Payroll Tax

Liabilities, supra note 290; Edward J. McCaffery, The Burdens of Benefits, 44 VILL. L. REV. 445, 453-58 (1999) [hereinafter McCaffery, Burdens]. Althoughpayroll taxes have some relationship to benefits — as do income taxes, of course, in some way — I analyze them here solely in regards to their taxburden, on wages.

[294.] The system is not unequivocally progressive. See MCCAFFERY, TAXING WOMEN, supra note 72, at 89-105; DANIEL SHAVIRO, MAKING SENSE OFSOCIAL SECURITY REFORM 19-22 (2000).

[295.] See SOC. SEC. ADMIN., PUB. NO. 05-10024, UNDERSTANDING THE BENEFITS 8 (2004), at http://www.ssa.gov/pubs/10003.html (last visited Mar. 7,2005). The ceiling is $90,000 in 2005.

[296.] Since the employee never sees the employer’s share in her pay stub, it is in some ways more accurate to “gross up” her salary, and see that shehas paid $1530 out of $10,765, a 14.2 percent rate. See, e.g., DANIEL N. SHAVIRO, EMPLOYMENT POLICIES INST., EFFECTIVE MARGINAL TAX RATES ONLOW-INCOME HOUSEHOLDS, at http://epionline.org/studies/shaviro_02-1999.pdf (Feb. 1999). On the other hand, the $10,000 without any deduction forher share of payroll taxes paid — is what the employee must report to the IRS for income tax purposes, so the 15.3 percent figure used in constructingTable 3, below, is also accurate. On reported wages of $10,000, $1530 goes to the government. Table 3 thus does reflect the taxes paid on reportedwages, although it does not precisely track take home pay: this is set at 1 minus the tax rate net of the employer’s share of the payroll tax (so a taxpayermaking $30,000, say, faces a marginal rate of 22.65 percent and gets to take home 77.35 percent of her next dollar in reported wages, considering thepayroll and income taxes alone).

[297.] It is a mistake to think that simple supply and demand analysis affects this result. The employer is facing the full tax in his wage decisions; the taxworks like a simple downward shift in the demand curve, as a per unit tax. The lower after-tax wage obtained by workers may indeed affect aggregatelabor supply, but this does not change the fact that existing workers are paying the full burden of the tax.

[298.] Up-to-date tax rate tables can be found at http://www.irs.gov.

[299.] I.R.C. § 68 (2004).

[300.] I.R.C. § 152 (2004).

[301.] I.R.C. § 32 (2004).

[302.] I.R.C. § 68(c) (2004).

[303.] I.R.C. § 57 (2004).

[304.] It uses $5000 for the standard deduction and $3000 for the personal exemption, creating an effective “zero bracket” of $8000.

[305.] For general discussion of the EITC, see Anne L. Alstott, The Earned Income Tax Credit and the Limitations of Tax-Based Welfare Reform, 108 HARV.L. REV. 533 (1995); McCaffery, Burdens, supra note 293, at 486-91.

[306.] See MCCAFFERY, TAXING WOMEN, supra note 72, at 145-48 (discussing EITC


[307.] The solution to the problem of $0 + .10($15,000 – 8,000) + .15($36,400 – 15,000) +.25(x – 36,400) = .153x, where x is the income, and equals$53,505.

[308.] U.S. DEP’T OF COMMERCE, STATISTICAL ABSTRACT OF THE UNITED STATES: 2004-2005, at 410 (124th ed. 2005).

[309.] See Mitrusi & Poterba, supra note 290, at 772-74 (the authors find just over 70 percent, but refer to CBO data indicating 80 percent).

[310.] McCaffery & Baron, Humpty Dumpty Blues, supra note 49, at 231.

[311.] Most prominently, see Andrews, Personal Income Tax, supra note 8, at 1177-88; see also, Henry J. Aaron & Harvey Galper, A Tax on Consumption,Gifts, and Bequests and Other Strategies for Reform, in OPTIONS FOR TAX REFORM 106, 111-12 (Joseph A. Pechman, ed., 1984); Karen C. Burke &Grayson M.P. McCouch, Death Without Taxes?, 20 VA. TAX REV. 499, 503-04 (2001); Harry L. Gutman, Reforming Federal Wealth Transfer Taxation AfterERTA, 69 VA. L. REV. 1183, 1191 (1983) (“With a seriously eroded income tax base, a transfer tax . . . serves as a ‘backstop’ to the income tax by taxingthe wealth that taxpayers accumulate through tax-preferred income sources.”).

[312.] Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, §

501, 115 Stat. 69 (2001).

[313.] See Edward J. McCaffery and Linda Cohen, Shakedown at Gucci Gulch: The New Logic of Collective Action (draft on file with author) [hereinafterMcCaffery & Cohen, Gucci Gulch]; Edward J. McCaffery, A Look into the Future of Estate Tax Reform, 105 TAX NOTES 997 (2004).

[314.] In 2004, the estate and gift taxes yielded only $25 billion, just over 1% of federal revenues. Office of Mgmt. & Budget, Historical Tables, Budget ofthe United States, Government, Fiscal Year 2006 [hereinafter Historical Tables], at 43-44 tbl. 2.5, available at http://whitehouse.gov/ (last visited Apr. 3,2005). GEORGE COOPER, A VOLUNTARY TAX?: NEW PERSPECTIVES ON SOPHISTICATED ESTATE TAX AVOIDANCE (1979); McCaffery, A Voluntary Tax?,supra note 202; Martin Sullivan, For Richest Americans, Two-Thirds of Wealth Escapes Estate Tax, 87 TAX NOTES 328 (2003).

[315.] See Aaron & Galper, supra note 311.

[316.] See, e.g., Andrews, Personal Income Tax, supra note 8.


[318.] It seems highly unlikely that the exemption level, which is set to reach $3.5 million per person in 2009, will return to its pre-EGTRRA levels. Not onlyhas the exemption level never been lowered in the history of the tax, but all current Senators, except for Russell Fiengold (D-WI), are on record assupporting at least a heightened exemption level. See McCaffery & Cohen, Gucci Gulch, supra note 313.

[319.] EGTRRA keeps the gift tax exemption level at $1 million per person, so the higher numbers in later years refer only to the estate tax, as things nowstand.

[320.] Sullivan, supra note 314, at 332. But see Estate of Strangi v. Comm’r, 85 T.C.M. (CCH) 1331 (2003) (casting family limited partnership technique intosome question).

[321.] I.R.C. § 2503 (2004).

[322.] Id.; MCCAFFERY, FAIR NOT FLAT, supra note 2, at 68-74; INTERNAL REVENUE SERV., PUB. NO. 950, INTRODUCTION TO ESTATE AND GIFT TAXES 4-5(2004), at http://www.irs.gov/publications/p950/index.html (last revised Sept. 2004).

[323.] At a 5% annuity rate, this sum can generate $400,000, tax-free, every year, for life.

[324.] See COOPER, supra note 314; McCaffery, A Voluntary Tax?, supra note 202.

[325.] See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 68-73 (discussing “Estate

Planning 101” and other techniques for avoiding or minimizing estate taxes).

[326.] See, e.g., Jesse Dukeminier & James E. Krier, The Rise of the Perpetual Trust, 50

UCLA L. REV. 1303 (2003); Stewart E. Sterk, Jurisdictional Competition to Abolish the Rule Against Perpetuities: R.I.P. for the R.A.P., 24 CARDOZO L. REV.2097 (2003).

[327.] See, e.g., Kim Brooks, Learning to Live with an Imperfect Tax: A Defence of the Corporate Tax, 36 U.B.C.L. REV. 621, 672 n.51 (2003); but cf. RogerH. Gordon & Jeffrey K. Mackie-Mason, “Why Is There Corporate Taxation in a Small Open Economy? The Role of Transfer Pricing and Income Shifting,” inTHE EFFECTS OF TAXATION ON MULTINATIONAL CORPORATIONS, 67 at 88 (Martin Feldstein, James R. Hines, Jr., & R. Glenn Hubbard, eds., 1995)(corporate tax is a backstop to tax on labor, not capital, income).

[328.] The avoidance is partly due to the prevalence of corporate tax shelters. See generally, Mark P. Gergen, The Common Knowledge of Tax Abuse, 54SMU L. REV. 131 (2001); George K. Yin, Getting Serious About Corporate Tax Shelters: Taking a Lesson from History, 54 SMU L. Rev. 209 (2001); LawrenceZelenak, Codifying Anti-Avoidance Doctrines and Controlling Corporate Tax Shelters, 54 SMU L. REV. 177 (2001). But the overall yield from the tax hasdropped fairly steadily over many decades, from a high of 7.2% of GDP in 1945, to 4.2% as late as 1967, to 1.6% in 2004. See HISTORICAL TABLES, supranote 314, 33-34 tbl.2.3.

[329.] Arnold Harberger, an early advocate of the view that some or all of the burden is borne by capital, now feels it is mostly borne by labor. See ArnoldC. Harberger, The Incidence of the Corporation Income Tax, 70 J. POL. ECON. 215 (1962) (the seminal piece); Arnold C. Harberger, Monetary and FiscalPolicy for Equitable Economic Growth, in INCOME DISTRIBUTION AND HIGH-QUALITY GROWTH 203 (Vito Tanzi & Ke-young Chu eds., 1998) [hereinafterHarberger, Monetary and Fiscal Policy]. See also Gordon & Mackie- Mason, supra note 327 (incidence on labor, given small open economy (as inCanada)).

[330.] See Harberger, Monetary and Fiscal Policy, supra note 329.

[331.] Jennifer Arlen & Deborah M. Weiss, A Political Theory of Corporate Taxation, 105 YALE L.J. 325 (1995); McCaffery, Cognitive Theory and Tax, supranote 43, at 1874-86.

[332.] In 1999, state and local governments collected approximately $816 billion in taxes, U.S. DEP’T OF COMMERCE, supra note 308, at 272, whereas thefederal government collected approximately $1.828 trillion. Id. at 308 tbl.454. Of the $2.644 trillion total, state and local taxes accounted for just over 30percent.

[333.] Id. at 272. The figures for income taxes seem to include corporate as well as individual taxes, and therefore overstate the effect of the latter.Compare id. at 272, with id. at 270.

[334.] This is the case, for example, in California, under Proposition 13. CAL. CONST. art. XIIIA, §§ 1-6.

[335.] Charles M. Tiebout, A Pure Theory of Local Expenditures, 64 J. POL. ECON. 416 (1956). For discussions of Tiebout, see Bruce W. Hamilton, AReview: Is the Property Tax a Benefit Tax?, in LOCAL PROVISION OF PUBLIC SERVICES: THE TIEBOUT MODEL AFTER TWENTY-FIVE YEARS 85, 90-92(George R. Zodrow ed., 1983); George R. Zodrow & Peter Mieszkowski, The Incidence of the Property Tax: The Benefit View Versus the New View, inLOCAL PROVISION OF PUBLIC SERVICES: THE TIEBOUT MODEL AFTER TWENTY-FIVE YEARS, supra, at 109.

[336.] See Andrews, Personal Income Tax, supra note 8; MILL, supra note 1, at 814; HOBBES, supra note 57, at 386-87; Fried, supra note 7.

[337.] Douglas A. Kahn & Jeffrey H. Kahn, “Gifts, Gafts, and Gefts” — The Income Tax Definition and Treatment of Private and Charitable “Gifts” and aPrincipled Policy Justification for the Exclusion of Gifts from Income, 78 NOTRE DAME L. REV. 441 (2003).

[338.] I have speculated elsewhere that a society that wished to reduce its citizens’ working hours might indeed welcome such an incentive. SeeMcCaffery, Being the Best, supra note 15, at 623. But this does not strike me as a compelling reading of contemporary American norms.

[339.] As I have put the matter in a different context: “Our current tax system taxes people when they work, when they save, when they marry, when theygive, and when they die. These are wrong choices, all. We should tax people when and only when they spend.” Edward J. McCaffery, Tax Reform to DieFor, WALL ST. J., Nov. 21, 2003, at A12.

[340.] See RAWLS, supra note 52, at 7, 326 (“natural lottery” distributes talents and abilities, while society’s “basic structure” determines income, socialstanding and the like).

[341.] See John H. Langbein, The Twentieth-Century Revolution in Family Wealth Transmission, 86 MICH. L. REV. 722 (1988) (explaining that wealthtransmission has changed from land to human capital in the 20th century).

[342.] In this regard, a consistent, progressive postpaid consumption tax operates as a better, more practical “privilege tax” than the specificallydesignated tax discussed by ACKERMAN & ALSTOTT, supra note 103.

[343.] See Vickrey, supra note 188.

[344.] SMITH, supra note 54, at 777-78, quoted in note 57, supra. I have discussed the voluntariness of spending in McCaffery, Cognitive Theory and Tax,supra note 43; McCaffery, A Voluntary Tax?, supra note 202; Edward J. McCaffery, Why People Play Lotteries and Why it Matters, 1994 WIS. L. REV. 71.

[345.] See supra Part IV.E.

[346.] See McCaffery, Being the Best, supra note 15; see also Warren, supra note 13, at

[347.] I have simply posited this point throughout. It follows from my intuition that deterring high-end spending is more reasonable than deterring high-wage labor earnings. To some extent, this is simply a moral argument. See McCaffery, The Right to Waste?, supra note 24, McCaffery, Uneasy Case,supra note 165. For the empirical consequences, under a consistent, progressive postpaid consumption tax, we need to rethink the analysis of optimal taxation. It is not optimal income tax that we should model, but optimal postpaid consumption taxes. Of course, for most Americans, living from pay check to paycheck, the two converge because income equals consumption for those who do not save. And in all cases, the social-welfare maximizer will still be concerned with the elasticity of labor, a productive input. But under a consistent postpaid consumption tax, the nature of this input ought to change. Highmarginal tax rates on high-end consumption need not deter labor efforts, as opposed to spending decisions. Such taxes will deter those who earn only to spend on themselves — such people will rationally backward induce, and stop working today — but they need not deter those building up wealth for other reasons, including intergenerational altruism (yet another reason not to engraft a wealth transfer tax onto a consistent postpaid consumption tax model,or to choose Vickrey’s cumulative lifetime income averaging over a cumulative lifetime consumption averaging or the simpler general tax outlined here).To the extent the behavioral response to progressive spending taxes is to save, this can be a public good. The questions are technical, empirical ones,beyond the scope of the present effort. But they hold out an intriguing possibility — the very spirit behind the project of ascertaining the fair timing of tax.If we get the form of tax right — its timing and its base — we can, at long last, get its redistributive functions down right. The embarrassments of today point us to hope for a better tomorrow. I thank Kirk Stark for pressing these thoughts on me.

[348.] See MCCAFFERY, FAIR NOT FLAT, supra note 2, at 117-60.

[349.] See Kaplow, supra note 172; see also McCaffery, Uneasy Case, supra note 165, at 319 (citing Joseph E. Stiglitz, Notes on Estate Taxes,Redistribution, and the Concept of Balanced Growth Path Incidence, 86 J. POL. ECON. S137, S146-49 (1978)).

[350.] Andrews thought so. See Andrews, Personal Income Tax, supra note 8, at 1118-19.

[351] Cf. RAWLS, supra note 52.

[352.] Cf. Andrews, Personal Income Tax, supra note 8; McCaffery, Uneasy Case, supra note 165.

[353.] Compare Calvin Johnson, What’s a Tax Shelter?, 68 TAX NOTES 879 (1995) (arguing that the prevalence of tax shelters arises out of the treatmentof debt), with Hime, supra note 185 (analyzing the problem with current tax law treatment of debt).

[354.] See SEIDMAN, supra note 88; McCaffery, Tyranny, supra note 192.

[355.] Pre enactment basis is “[t]he basis in an asset held prior to the start of a new tax system.” MCCAFFERY, FAIR NOT FLAT, supra note 2, at 164. For discussion of the pre enactment basis of assets in the move from the current “income” tax to a consumption tax, see Louis Kaplow, Recovery of Pre-Enactment Basis under a Consumption Tax: The USA Tax System, 68 TAX NOTES 1109 (1995).

[356.] See MURPHY & NAGEL, supra note 6, at 114 (“It should be obvious that wealth is an independent source of welfare, quite apart from the fact that some of it may be consumed later.”) I have long argued against the relevance of this fact to tax policy. See McCaffery, Uneasy Case, supra note 165;McCaffery, Political Liberal Case, supra note 197. More recently, Weisbach & Bankman, supra note 7, have made similar criticisms.

[357] See Andrews, Personal Income Tax, supra note 8, at 1169-70.

[358.] I first pressed these arguments in 1994. See McCaffery, Political Liberal Case, supra note 197; McCaffery, Uneasy Case, supra note 165. Iattempted to revise them again in 1996. See McCaffery, Being the Best, supra note 15. I now realize that this argument should not derail the case against comprehensive tax reform; a separate argument can be had out over wealth taxes, which can as easily accompany a so-called income as a postpaid (or,for that matter, prepaid) consumption tax.

[359.] Rakowski, supra note 15; Shakow & Shuldiner, supra note 77; Shaviro, supra note

[360.] I thank Bill Gale for related discussions.

[361.] See McCaffery, The Right to Waste?, supra note 24.

[362.] This leads to the problem of pre enactment basis, a concern which I feel is overstated. See Kaplow, supra note 355

[363.] I.R.C. § 408A(d)(3)(C) (2004).

[364.] See Edward J. McCaffery & Jonathan Baron, Heuristics and Biases in Thinking about Tax, in Proceedings of the 96th Annual Conference on Taxation,2002, 443 (2003).

[365.] Hobbes, supra note 57; Fried, supra note 7, at 962 (calling Hobbes’s argument foundational).

[366]. See RAWLS, supra note 52, at 90-95, 277.

[367.] Because a consistent postpaid consumption tax eliminates the need for the concept of “basis,” the base would also broaden by including gain now lost to the over-stated basis problem. See Dodge & Soled, supra note 220.

[368.] Or perhaps it does. There is also some hope for effecting redistribution through expenditure programs. See Bird & Zolt, supra 51; see also Baron &McCaffery, Masking Redistribution, supra note 21 (experimental results showing that ordinary subjects fail to compensate in tax system for decline in redistribution attendant on “privatization” of formerly publicly provided goods and sources).

[369.] Warren Vieth, U.S. Tax Code May Be Facing a Full Rewrite, L.A. TIMES, Nov. 7, 2004, at A27. I have been making this point for a while.

[370.] Id.

[371.] See Edward J. McCaffery, Ten Facts About Fundamental Tax Reform, 101 TAX NOTES 1463 (2003).

[372.] See, e.g., Primer: Consumption Tax, WASH. POST, Nov. 7, 2004, at F3 (the Washington Post’s basic explanation of the consumption tax). Taxscholars too are concerned. See, e.g., Martin M. McMahon, Jr., The Matthew Effect and Federal Taxation, 45 B.C. L. REV. 993, 998-1012 (2004) (presenting data showing that the extremely rich are getting richer); William G. Gale & Peter R. Orszag, An Economic Assessment of Tax Policy in the Bush Administration, 45 B.C. L. REV. 1157, 1220-31 (2004).

[373.] See KAPLOW & SHAVELL, supra note 21.



(forthcoming in MICHIGAN LAW REV. (2005))

USC Law and Economics and

Legal Studies Research Paper No. 05-11


Sponsored by the John M. Olin Foundation

University of Southern California Law School

Los Angeles, CA 90089-0071

This paper can be downloaded without charge from the Social Science Research Networkelectronic library at http://ssrn.com/abstract=705383



A. Loomings

B. The Road Ahead


A. An Example

B. The Income Tax

C. Two Forms of Consumption Tax

D. Two Conditions of Equivalence

1. Constant Tax Rates

2. Constant Rates of Return

E. The Treatment of Debt


A. Means and Ends

B. The Traditional Logic of Tax

C. The Modern Income-Versus-Consumption Debate

1. The Case for Consumption

2. The Income Empire Strikes Back

3. Why It Matters

D. Two Political Takes

E. Three Neutralities

1. Why Even Care About Neutrality?

2. Three Taxes, Three Neutralities


A. Two Norms

1. A Note on Reflective Equilibrium

2. The Norms of Capital

B. Two Uses of Capital

1. An Untypical Picture of a Typical Life

2. Smoothing Transactions

3. Shifting or Enhancing (Diminishing) Transactions

C. Progressivity

D. Debt, Again

E. Vickrey’s Cumulative Lifetime Averaging, Compared


A. Structural Gaps

1. Tax Planning 101

2. An Example

3. The Practical Facts of the Matter

B. Ad Hoc Deviations

1. Retirement Savings

2. More and More

C. Tax Shelters and the Noble Failure of TRA 86

1. Some Quick and Dirty Examples

2. What TRA 1986 Did, and Did Not, Do


A. Payroll Taxes

B. Death — to the Rescue?

C. Corporate Taxes Too

D. State and Local Taxes

E. Summing Up: A Voluntary Tax


A. A Better, If Less Sophisticated, Argument

B. Transitions, Implementation, and Objections

1. Implementation

2. The Role of Other Taxes

3. The New Achilles Heel

4. Capital as Power

5. Transitions

C. Common Errors About Income and Consumption Taxes

1. We Have an Income Tax

2. The Principal Choice in Comprehensive Tax Policy Is Between an Income and a Consumption Tax

3. Consumption Taxes Are Flat Taxes

4. All Consumption Taxes Are Created Equal

5. Consumption Taxes Do Not Reach the Yield to Capital

6. The Best Argument for a Consumption Tax Is One of Horizontal Equity

7. The Case for Consumption Taxation Is One About the Importance of Capital, on the Individual or Aggregate Level

8. Rates Would Have to Increase Under a Transition to a Consumption Tax

9. The Gift and Estate and Corporate Income Taxes Are Important Backstops to the Individual Income Tax

10. Adopting a Consumption Tax Would Be a Radical Change

D. Tax Matters

To tax the sum invested, and afterwards to tax also the proceeds of the investment, is to tax the same portion of the contributor’s means twice over. The principal and the interest cannot both together form part of his resources; they are the same portion twice counted; if he has the interest, it is because he abstains from using the principal; if he spends the principal, he does not receive the interest. Yet, because he can do either of the two, he is taxed as if he could do both, and could have the benefit of the saving and that of the spending, concurrently with one another.[1]

Robert C. Packard Trustee Chair in Law and Political Science, USC Gould School of Law, Los Angeles, USA