A better tax approach

Mankiw's prescription for fiscal reform:

1. Substantial cuts in spending. Ensure that the commission is as much about shrinking government as raising revenue. My personal favorite would be to raise the age of eligibility for Social Security and Medicare. Do it gradually but substantially. Then index it to life expectancy, as it should have been from the beginning.
2. Increased use of Pigovian taxes. Candidate Obama pledged 100 percent auctions under any cap-and-trade bill, but President Obama caved on this issue. He should renew his pledge as part of the fiscal fix. A simpler carbon tax is even better.
3. Use of consumption taxes rather than income taxes. A VAT is, as I have said, the best of a bunch of bad alternatives. Conservatives hate the VAT, more for political than economic reasons. They should be willing to swallow a VAT as long as they get enough other things from the deal.
4. Cuts in the top personal income and corporate tax rates. Make sure the VAT is big enough to fund reductions in the most distortionary taxes around. Put the top individual and corporate tax rate at, say, 25 percent.
5. Permanent elimination of the estate tax. It is gone right now, but most people I know are not quite ready to die. Conservatives hate the estate tax even more than they hate the idea of the VAT. If the elimination of the estate tax was coupled with the addition of the VAT, the entire deal might be more palatable to them.
   

Let us start with 1 and 4. If Republicans get 4 then they have no bargaining power for 1. Republicans have a choice here, and they will make the wrong choice, you can bet on that. Substantial spending cuts come when the progressive rates are more progressive, not less.

The VAT is a good idea, it allows us to reduce the revenue from income taxes. So take a lower total share of income taxes, but make them more progressive. As it is, the very wealthy get way more gain from government than the 2% share they pay. History shows that when the rich have progressive rates up to the Clinton level, then they began to take government responsibilities inside the firm, government deflates. Mankiw's prescription will have the opposite effect he envisions, a lower progressive tax allows the firm to rely on government to handle much of their labor overhead.

Remember Reagan cuts the progressive rate, government takes 23% of the economy, under Clinton progressive rates go up and government share goes down to 19%, then Bush takes us back again to big government. Mankiw the economist is asking for the economy to violate supply and demand.