The Kotlikoff tax and entitlements reform plan

The cover story in the latest New Republic is an article by the economist Laurence Kotlikoff and the author Niall Ferguson describing what they call the "New New Deal," ostensibly a plan the Democrats should advance in lieu of Bush's idiotic Social Security "reform" to show that they have constructive ideas to eliminate the fiscal gap. Early Democratic blogger responses, such as by Matthew Yglesias in tpmcafe.com and Kevin Drum in washingtonmonthly.com are not encouraging, to say the least. Apart from disliking the substance, they note that Kotlikoff and Ferguson would have to be quite mad to think the plan had possible political appeal for the Democrats at the current juncture. I myself would cut Kotlikoff and Ferguson a large break on this point, since they are trying to get the ideas out there rather than to make practical short-term political suggestions to the Democrats. So what about the substance of their plan as a longer-term objective?

A word of disclosure here: the only one of these individuals whom I know personally is Kotlikoff, with whom I am on friendly terms. I feel that if I have learned a fair amount from him, although I certainly have many disagreements with him. (For example, I see no basis for his definition of "inter-generational equity" as having all age cohorts pay the same lifetime net tax rates.) So I am predisposed to be at the least much less hostile, and all the more so because, despite my intense anti-Bush sentiments, I am certainly no conventional Democrat or even New Democrat and would be bipartisan or non-partisan if the Republicans were still sane, adult, and in favor of constitutional democracy.

Anyway, the Kotlikoff plan, as I will call it since he is evidently its main designer, has three components that I will comment on in turn:

1) REPLACE THE INCOME AND PAYROLL TAXES WITH A 33% RETAIL SALES TAX (RST) PLUS A REBATE. I'll start with the good news. The rebate is like a zero bracket but better. To illustrate, suppose we had an income or consumption tax with a $20,000 exemption and a 40% rate above that. Someone who earned or spent $20,000 would get an $8,000 benefit from the zero bracket, but someone who earned or spent zero would get no benefit, as she wouldn't have paid tax anyway. Kotlikoff gives everyone the $8,000 in effect (using my numbers). To put it another way, Kotlikoff has a demogrant instead of a zero bracket, which I would certainly say is better assuming proper integration with the welfare system (a subject I don't have space for here).

The bad news is that just about everyone with serious institutional knowledge realizes that the RST is a terrible idea administratively. A value-added tax (VAT) can be substantively equivalent, but leaves much more of a paper-matching and audit trail for compliance purposes. And existing RSTs at the state and local level have horribly pockmarked tax bases, leaving out lots of things and double-taxing others due to screw-ups with the business-level exemption. A really bad model to follow, I would say.

Also, as a business-level tax, the RST has no adjustment for personal or household circumstances, other than the amount spent on consumption. So we have the Graetz problem (from my earlier posts on Michael's idea) all over again, although at least the credit side is more spelled out.

2) PHASE OUT CURRENT SOCIAL SECURITY AND REPLACE IT WITH A COLLECTIVE "PERSONAL SEECURITY SYSTEM" - Everyone would pay what is in effect a 7.15% payroll tax up to the Social Security ceiling - so the payroll tax isn-t really repealed in full - and notionally deposit it in a personally owned "account." But the Social Security Administration would invest all the money, on everyone's behalf, in a market-weighted global index fund. So everyone would have the same portfolio and get the same rate of return (at least if they retired in the same year). Plus the government would guarantee no loss to contributors (i.e., a real return of no less than 0%).

Unlike the Bush plan, this one is fully funded - assuming Congress ignores the revenues because they are deemed to be in individual accounts - and it achieves risk-sharing among participants and economies of scale. I am liking it better as I think about it a bit more. Essentially it amounts to forcing everyone to save 7.15% of their first $90,000 of earnings and invest it prudently, assuming that Congress doesn't undo the saving by spending more and/or taxing less in the rest of the budget, which the ownership of the accounts is supposed to accomplish.

3) REPLACE MEDICARE AND MEDICAID WITH RISK-ADJUSTED VOUCHERS THAT GIVE EVERYONE THE SAME BASIC HEALTH INSURANCE COVERAGE FROM PRIVATE INSURERS - For example, you might get a $150,000 voucher if you are 75 and have colon cancer, as opposed to a $3,500 voucher if you are a healthy 30-year old single (their example). Again this raises issues I can't discuss in this already-long entry, but this is a serious idea. One question it raises is whether the government could get the pricing sufficiently well-adjusted and what would happen if it couldn't. A second is whether market forces, which the plan relies on after socializing health risk, work well enough in this particular consumer market. Medicine is a pretty bad market no matter what (consumers don't know much, those who do the diagnosis have an interest in selling more services, etc. - think of auto repair mechanics but with higher stakes). So market solutions may not work very well here, although one can be confident that non-market solutions won't work very well either.

Anyway, this is a serious plan apart from the retail sales tax. Why not make that a VAT, or better still an X-tax so there can be brackets, if desired, not limited to the better-than-zero-bracket aspect of having a demogrant?