Optimized Taxation: A Benefits Approach to National Tax Rates

National tax rates are set by politicians usually after consulting public finance experts or economists. Perhaps they should also turn to operations research (O.R.) experts who can bring a different, optimized perspective.

This article attempts to address national tax rates by proposing several adjustments to the national tax strategies and presents three models that calculate optimized tax rates to find, as best as possible, a match between expenditures and revenues. The models can be adjusted to match any political point of view regarding the amount of deficit planned or desired or any economic concept, such as dynamic scoring, or any philosophy regarding personal versus corporate tax rates.

The first model asks what income tax rates would be needed to have a reasonably balanced budget while (1) treating all income the same, (2) adding a national sales tax and (3) eliminating all corporate taxes. The second model incorporates those three changes and also uses a “Benefits Received” taxation approach by setting income tax rates to match the costs of government to those who most benefit from the government’s expenditures. The third model is a compromise between the two.

All three models use the same level of government expenditures. No attempt is made to suggest how much the government should spend. The models simply optimize the revenue side of the federal budget. Obviously, the tax rates could change with different levels of expenditures.

Before presenting the models, this article discusses a general, public policy approach to taxation and offers a justification for a new way of setting tax rates.

Taxation Strategy Behind the Basic Model

Although there is a rich academic literature on how to pay for the government’s services and products, there is little agreement on the matter [1]. The reality is that the government spends money and someone has to pay for it [2]. Currently, tax policy is done almost independently of expenditure policy. As a result, most people have no idea what their tax dollars pay for.

This article presents an optimization model with a new way of assigning specific tax amounts to those who benefit most from specific government expenditures. The basic assumptions and principles of the model include:

1. Income tax should be the primary source of revenue. Tax it progressively. Treat all income the same. Provide a “reward” for increases in income (alternate maximum tax).
2. Tax consumption: Add a national sales tax – a final sales tax, not a value-added tax (VAT) – with two levels: one for regular goods and a higher rate for luxury goods.
3. To encourage growth, eliminate (as much as possible) all corporate taxes.
4. Government services should be paid for by the primary beneficiaries.

The following will attempt to explain all four points in some detail.

First, tax all income the same. Current income is the clearest measure and most determinable of a person’s ability to pay taxes. Capital gains, carried interest and other forms of income should be taxed the same as earned income. Whereas this model proposes a progressive tax system, an alternative maximum tax can be added by basing one’s income tax on the smaller of the current year’s income or the previous year’s income, thereby giving taxpayers one year tax-free on their added earnings.

Second, add a national (final) sales tax (not a VAT) of, say, 1% for all nonessential or low-cost items and 2% on luxury items, primarily to be used for social safety net programs as is done, in principle, in Europe.

Third, eliminate corporate taxes, as best as possible. Corporations create jobs. Let the capitalist economy use its revenues to create jobs. (Note: Recent efforts have been made to get an international agreement to set a minimum tax of 15% on corporate profits.) Of course, safeguards would have to be added to prohibit corporations from paying for personal expenses and thereby avoiding income taxes.

Fourth, match tax rates to government expenditures based on who benefits. No one likes to pay taxes, but if people knew what direct benefits they receive from their taxes (as is true of other personal expenditures), they would, perhaps, better understand the taxes they pay. Although virtually everything the government does is to improve public safety or the business environment, few people understand where their money goes. The Benefits Approach is an attempt at such a tax policy.

Paying for Government Services: A Benefits Received Approach

To create a “benefits approach,” it is essential to first group all government expenditures into logical, cohesive categories. Later, this article will examine which income levels benefit most from those expenditures.

Categories of Government Expenditures

There are many ways federal spending can be divided into broad categories. Here is one categorization:

1. National defense: Most would agree this is a service that needs to be provided by the federal government.
2. Education: A free society needs an educated population. A thriving and growing economy needs an advanced, educated population.
3. Infrastructure: The U.S. economy depends on the movement of goods and people. Our competitive advantage in the world’s economy depends on our supply chain capabilities.
4. General administration: Law enforcement; food testing and protection; public health programs; nonmilitary research and development; environmental concerns; and legislative, judicial and rule-making functions all must be paid for.
5. Social insurance programs: The social safety net – Social Security, Medicare, food stamps, etc. Social Security and Medicare add up to nearly half the U.S. federal budget.
6. Debt service: Unfortunately, an increasing amount of the federal budget goes to cover the interest payments on the federal bonds issued over the last two decades.

Optimization Model Formulation I

Using pre-pandemic values for income, business activity and government expenditures (Table 1), an optimization model was created to minimize the budget deficit using the current progressive income tax system approach, but not yet implementing the Benefits Approach.

Corporate taxes are eliminated, but a national sales tax is added. All income is treated the same. It calculates progressive marginal income tax rates increasing at no more than 12% from income bracket to income bracket and caps the highest marginal rate at 50%.

Objective Function:

         Minimize: Total Expenditures minus Total Revenues

Decision Variables:

         Marginal Income Tax Rates

Constraints:

         Marginal Rate Income Bracket_(i) ≤ Marginal Rate Income Bracket_(i+1)

         Marginal Tax Rate Increase per Income Bracket ≤ 12%

         Top Marginal Rate ≤ 50%

         Nonnegativity of Decision Variables

Table 1 shows the taxable income tax brackets used (2021 brackets), number of households and total adjusted gross income (AGI) for consideration in the model.

Table 1: Taxable Income

Actual Government Expenditures and Revenue

The model used actual federal government expenditures in 2017, the last pre-pandemic year when this version of the model was first worked on. Table 2 lists both expenditures and tax revenue for the federal government in that year. Note: Details may not add to totals, owing to rounding.

In the model, Social Security, Medicare, other social insurance taxes and other receipts are all fixed at their 2017 levels and do not vary from optimization run to optimization run. The same is true of the proposed national sales tax, which, using a 1% rate for conventional items and a 2% rate for luxury items, was estimated to total $67.2 billion annually. The items that change to achieve an optimal solution are the income tax bracket rates. Those will be optimized to attempt to achieve the most balanced budget possible within an assortment of “benefits” and tax rate constraints.

Table 2: Expenditures and Receipts (in billions $USD)

Results of Model I

The optimization model creates marginal rates to minimize the budget deficit. Tables 3 and 4 show the revenues and rates from the optimized model.

Total Revenue

Total revenue was calculated by adding (1) the estimates of income taxes using the model’s optimized marginal rates, (2) the estimate of revenue from a national sales tax and (3) the 2017 actual receipts for Social Security, Medicare, etc. Table 3 displays the revenue expected from the income levels of 2017 and the marginal tax rates computed by the model along with the “plug” numbers for other receipts.

The model used a fixed tax rate for the consumption tax rates: 1% for general consumption and 2% for luxury item consumption. The model used 2017 consumption figures to calculate the expected revenue from the consumption tax (Table 4).

Table 3: Revenue from Model I                                      

The expenditures for 2017 were $4,025 billion. As such, this model created marginal rates that came within $52 billion of achieving a balance between revenues and expenditures. This indicates that it is possible, although not necessarily desirable, to have a balanced budget by eliminating corporate taxes while raising upper income tax brackets to essentially what they were when Ronald Reagan was president of the United States.

Income Tax Rates by Bracket

Marginal tax rates from running the Optimization Model I along with the approximate current rates and the results of Models II and III are displayed in Table 4.

Table 4: Comparison of Marginal and Total Rates

The marginal rates appear to jump substantially, but the total tax rates increase at a reasonably smooth pace. The model’s rates are lower than or the same as current rates for income levels below $500,000 and higher for income levels above that.

The Optimal Model Formulation II: The Benefits Approach

This version of the model uses the Benefits Approach, which creates a system in which people pay (as closely as possible) for the primary benefits they receive.

Consider dividing the population into three basic categories: high, medium and low income. For the purposes of testing the model, income level cutoff points were established at $20,000 and $500,000.

The case can be made that everyone benefits from all categories of expenditures, but some benefit more than others. Using the expenditure categories presented and the demarcation of the tax-paying population, the optimization model assigns expenditures to income categories as follows:

1. High income: National defense, education, infrastructure, some general administrative functions
2. Middle income: Social insurance, most general administrative functions
3. Low income: Social insurance, welfare

High income. The Benefits Approach proposes that the high-income category population should pay for all of national defense, infrastructure and education expenditures, as well as part of other expenditures including some general administrative costs, such as the U.S. Congress, courts, food and drug testing, law enforcement, etc. This category’s contribution to the safety net will be through the national sales tax, not through their income tax.

Middle income. Middle-income individuals should pay to cover their share of general administrative costs and pay as they do now for social insurance (Social Security and Medicare). Their contribution to the social safety net expenditures should be paid for out of the sales tax revenues.

Low income. This category will pay essentially no income taxes, similar to the current Federal Earned Income Tax Credit. The cutoff in the model to begin paying income taxes is set at $20,000. However, low-income individuals will still pay into Social Security and Medicare and will pay the national sales tax on consumables.

Consumption Tax

As previously stated, the model adds a consumption tax, one rate for general consumption and a higher rate for luxury items. The consumption tax could be used for social programs such as child care payments, guaranteed minimum income or food stamp programs.

Added Constraints

In the first model, the high-income tax rates produce revenues greater than the expenditures for the categories of defense, infrastructure and education. To limit the rates to match categorical expenditures, two additional constraints were added:

Sum of Taxes Collected per Each Income Category ≤ Sum of Expenditures Designated for Each Income Category

Sum of Taxes of Middle-Income Category ≥ 50% of General Government Expenditures

The results for an optimization run with those additional constraints are also displayed in Table 4. These rates are the same as those in Model I for income levels below $500,000 of taxable income but are actually lower for income levels above $500,000 when compared with not only the current rates but also the proposed rates in Model I. However, the drawback of this model is that the budget is not balanced. The deficit is projected to be $370 billion. As such, a third version of the model was attempted. This version used the Benefits Approach constraints but limited the deficit to $200 billion.

The Optimal Model Formulation III: Compromised Approach

As a “compromise” between the first two runs, a third run was made to limit the deficit to $200 billion, but not forcing the equality constraint for high-income rates. Table 4, as mentioned earlier, displays the rates from the third run.

Unsurprisingly, these rates are between the rates found in the first two runs and are conceivably politically doable. High-income taxpayers do pay more than the expenditure categories “assigned” to them (about 15% more). However, it could still be said that the general policy of allocating government expenditures to the different income categories is complied with in this run.

Conclusion and Political Discussion

What are the chances such an approach could be adopted? Consider the following:

First, for conservatives, the elimination of corporate taxes should be pleasing. The logic is that without taxes, businesses will be able to do what they are supposed to do: create jobs and earn profits. Although under this strategy high-income individuals pay more income taxes, they likely earn their income from being corporate owners and executives. They will likely make more than they would under the current tax policy.

For liberals, raising taxes on higher-income individuals is something they have argued for since Reagan was president. These rates may seem high, but they are far lower for high-income individuals than they were in times when the economy was booming.

On the other hand, liberals may not like the consumption tax and have referred to it as a regressive tax. However, in Europe, most social safety net expenditures are paid for by “regressive” value-added taxes.

Both sides might be in favor of the alternative maximum tax. Although it was not included in any calculations, it would come into play in a multiyear model.

This paper does not use the “dynamic scoring” techniques often used to justify tax cuts. The rates could be set to create a deficit, particularly in weak economic times, to provide the incentive projected from those models [3].

If this model is ever taken seriously, it would make sense to increase the rates over a multiyear period. Jumping from the current 37% maximum rate to 50% should probably be accomplished in a two- or three-step process so there is less “shock” to the economy. In addition, the corporate rate could be reduced to zero over the same time frame.

The approach is set so that, as expenditures change, the rates should change. For example, if Congress decides to spend more money on national defense during a period of economic stability, the rates for higher income brackets would go up to cover the added expense, but not increase within the other income brackets. The same would be true for other expenses and the tax brackets associated with those expenditures. This would allow the government to maintain a reasonably balanced financial situation over time.

Coda

This work is all based on 2017 income levels and government expenditures. The world has changed tremendously since then; however, the fundamental approach would not be different as new numbers are used.

This article does not advocate for any particular level of government expenditure or government programs. Nor does this article advocate for a truly balanced budget, but instead advocates for a more rational approach to taxation given a level of expenditures. Tax rates could be adjusted as expenditures change.

Also, as said, the optimization model does not take into account the effect of taxation on economic activity, in the way Keynesian methods do [4]. It would not be hard to build some feedback aspects into a more advanced version of the model to make an estimate of such effects.

Acknowledgment

Computing and research assistance was provided by Chang Du, a master’s student at the Center for Urban Progress at NYU Tandon School of Engineering. Initial work was done at Columbia University by Gregory Feldman, Javier Mata, David Mills, Derek Neal and Annie Perizzolo while students in Columbia’s Department of Industrial Engineering and Operations Research.

References

1. Harvey Rosen and Ted Gayer, 2014, “Public Finance,” New York: McGraw-Hill.
2. Milton Friedman, 1962, “Capitalism and Freedom,” Chicago: University of Chicago Press.
3. Stephanie Kelton, 2020, “The Deficit Myth: Modern Monetary Theory and the Birth of the Peoples Economy,” New York: Public Affairs.
4. John Maynard Keynes, 1965, “The General Theory of Employment, Interest, and Money,” San Diego, CA: Mariner Books.