President Bush gave former Sens. Connie Mack of Florida and John Breaux of Louisiana the unenviable task of trying to say something new and interesting about tax reform.
When it comes to designing a simple tax system that does the least damage to the economy, it would be difficult to find a better role model than Hong Kong. As The Economist wrote a few years ago, "The territory's tradition of simple and low taxes ... is widely seen as a main reason for its stunning rise to prosperity." Many advantages of the Hong Kong tax system have been widely emulated in Asia, yet remain poorly understood in this country. One such misunderstanding may have resulted in an unfortunate spat between two old friends, Steve Moore and Bruce Bartlett.
Moore proposes that individual taxpayers should be allowed to either pay taxes under the current rules, or instead forego deductions for mortgage interest and charitable deductions and pay 20 percent on that broader measure of income. "Bruce Bartlett attacked this plan as a gimmick," writes Moore. "But he fails to realize this is precisely how the Hong Kong tax system works. Hong Kong has a complicated system and a simple flat tax, and filers choose between the two."
Gimmick or not, Moore's "freedom to choose flat tax" is not remotely similar to the Hong Kong tax system, which is not complicated in any respect. I may have been partly at fault for that misunderstanding.
Steve Moore and Bruce Bartlett were advisers to Jack Kemp's tax reform commission in 1995, and I was research director. Asked by one commissioner about Hong Kong's "flat tax," I replied that the tax on salaries is not flat but steeply progressive. There are four marginal tax brackets of 2 percent, 8 percent, 14 percent and 20 percent. I would prefer a single tax rate, for reasons I explained last November in "The Case for One Tax Rate." But any tax with a top rate of 20 percent is hard to fault.
Unlike the United States, Hong Kong is not plagued with tax credits that create random spikes in marginal tax rates as the credits are phased out. But Hong Kong does allow charitable deductions up to 25 percent of salary income and a mortgage interest deduction up to about $13,000 (in U.S. dollars). Other deductions are allowed for adult education, care of elderly relatives and retirement savings plans.
Personal exemptions are so generous that most employees owe little or no tax on salaries. For those with high salaries, however, it is cheaper to forego personal exemptions (but not deductions) and pay a 16 percent "standard rate." Only the top 2 percent usually pay that standard rate, yet they account for nearly half of all revenue from the salaries tax.
Groping for an explanation of the standard rate a decade ago, I suggested it was something like an "alternative maximum tax" -- a phrase Moore has used to describe his own, very different tax proposal. But the standard rate is automatic, not a matter of choice. Taxpayers fill out a one-page online return declaring their salary and deductions, and the government sends them a bill.
The standard rate does not make Hong Kong's tax system simpler, but it does make it more efficient. Academic studies of optimal taxation have long concluded that marginal tax rates should be lowest at the highest levels of income. As Joseph Stiglitz wrote in 1987, "the marginal tax rate on the highest income (ability) individual should be zero." Hong Kong does not go quite that far, but the marginal rate is reduced from 20 to 16 at the highest incomes, while keeping their average tax high by eliminating personal exemptions.
As clever as this is, it is not the most interesting aspect of the Hong Kong tax system. What makes taxes in Hong Kong so uniquely simple and effective is that businesses pay all the taxes on income originating in business (profits), and employees pay all the taxes on salaries.
Hong Kong has no payroll tax for Social Security, no general sales or value-added tax, no tariffs on imports and no personal tax on income from financial assets. What Hong Kong has is called a "Dual Tax" -- progressive tax rates on labor income but a flat tax of 17.5 percent on corporate profits, 16 percent on property owners and unincorporated enterprises.
The low tax on profits brings in substantially more revenue than the tax on salaries, in marked contrast to the United States, which collects little from profits taxes that are nominally twice as high. Corporations in Hong Kong pay the profits tax before distributing dividends to shareholders, so there is no extra tax on dividends to be collected from individuals. Reinvested profits result in more business income to tax in the future, so there is no extra tax on capital gains to be collected from individuals.
Companies in Hong Kong deduct interest payments, however, so it would be theoretically appropriate to tax individuals on income they receive from local corporate bonds. This exemplifies the key tax principle of symmetry: Whatever is a deductible expense for those making any payment ought to be taxable income for those receiving that payment. But there would still be no need for individuals to report interest income, because a flat tax can easily be collected at the source, before the check goes out.
The United States could easily adopt something similar to the Hong Kong tax. It would require no wrenching changes, such as giving up interest deductibility for corporations or homeowners. Some tax rates would presumably have to be higher (the 2 percent rate is ridiculously low anyway), but not as much higher as you might think.
Hong Kong's taxes on salaries and profits amounted to about 7 percent of GDP last year, while combined U.S. corporate and individual taxes brought in only 8.6 percent of GDP. Since a larger percentage of American employees have higher salaries, a salary tax such as Hong Kong's would raise more money even without higher tax rates.
The Hong Kong tax system has one major advantage over even the most elegant theoretical alternatives. It has been tested for more than 50 years. It works.
Correction: Where my last column said, "Jobs have not been shrinking since 1979 because (of) labor-saving devices," the word "not" is not right. Before being shortened it read, "Jobs have not been shrinking because manufacturing was shrinking, but because (of) labor-saving devices ..."