How the Tax Code Should Account for Automation

Bill Gates, founder of software giant Microsoft, has suggested that robots be taxed, with the revenue generated used to educate and train the U.S. labor force. While Amazon’s Alexa has her own opinion (more on that in a moment), commentators harbor mixed emotions regarding Gates’ suggestion. And for good reason.

If the economy stays on its current trajectory and automation continues unabated, the labor market risks contracting.  Said differently, while every day the so-called Technology Era ushers in new jobs, on balance, more may be lost than gained.

The current U.S Internal Revenue Code (“Tax Code”) exacerbates matters. It imposes the heaviest tax burden on labor income, subjecting it to both income taxes and payroll taxes. On the other hand, business profits and investment income face only a moderate tax burden, because they are not subject to payroll taxes. Finally, capital gains face the lightest tax burden, subject either to preferential rates or to no tax at all.

In the past, these three different modes of taxation made sense. The income derived from labor was plentiful, easily identifiable, and readily replenished, making it a logical source of tax revenue.  At the same time, Congress has historically relied on lower tax rates on non-labor income to boost economic growth by encouraging taxpayers to engage in business and invest in capital assets.

Yet, in the 21st century, automation casts a dark shadow on retaining the status quo. In the never-ending quest to maximize profits, industries routinely seek to reduce costs, including those of labor, making the use of robots highly attractive.

Left unchecked, the trend away from labor utilization bodes poorly for the long-term sustainability of the income tax.  Due to the Tax Code’s anachronistic rate structure, if labor income diminishes, tax revenue will plummet and will not be correspondingly offset by equivalent increases in business profits, investment income, and capital gains.

In terms of formulating tax reform measures, Congress must recognize the interconnectedness between labor and technology. In the early 1900s (when Congress instituted the Tax Code), through personal sweat and toil, a farmer could hypothetically produce $1,000 worth of wheat in one growing season. Today, using advanced machinery, the very same farmer might instead produce $10,000 worth of wheat.  It is easy to see that $9,000 of the farmer’s profits would be attributable to technology (e.g., advanced harvesting machinery). In many other occupations, because labor and technology continue to converge, it is a futile exercise to distinguish between income derived from labor versus that from technology.

The conflation between labor and technology informs how Congress should modify the Tax Code. We have the following three specific reforms in mind.

First, Congress should avoid assigning different tax rates to different categories of income. Instead, all income should be subject to the same progressive tax rate structure. Instituting this reform would help stabilize the labor market, reduce wealth inequality, and solidify the tax base. In addition, taxpayers would no longer have an incentive to manipulate the kind of income they generate, attempting to transform their otherwise ordinary income into investment income or capital gains to save taxes.

Second, to promote capital investment, Congress lavishes the business community with all sorts of so-called tax expenditures. Tax expenditures are those deductions, credits, and exemptions in the Tax Code that are designed to achieve various social and economic goals. Familiar examples of tax expenditures that benefit businesses include bonus depreciation deductions, preferential tax treatment for qualified enterprise zone investments, and tax-free like-kind exchanges for real estate. These financial indulgences come at a steep price: They cost the U.S. Treasury billions of dollars annually and simultaneously make investments in the labor market less attractive. On the other hand, the cost of tax expenditures that promote labor, such as those that subsidize education, pales in comparison to those that promote capital. Accordingly, we recommend that Congress significantly reduce or eliminate many of the tax expenditures related to capital investment (e.g., bonus depreciation or the mortgage interest deduction) and direct more spending towards education and job-training.

Third, our country’s current funding mechanism for Social Security is antiquated. Payroll taxes are the primary mechanism through which Social Security achieves solvency. However, payroll taxes on both employees and employers also significantly detract from the financial attractiveness of labor force utilization. Congress should consider shedding this mode of funding and switching to a system, such as a universal basic income, where funding and payments are not tied to taxes on labor alone.

From a politician’s perspective, robots make an ideal candidate to be taxed. They still can’t vote, speak up at open-house forums, or demonstrate in street protests. But defining exactly what is a robot is elusive if not impossible. (Is the Mars Rover a robot? Is a hotel kiosk?). Instead of directly taxing robots, however, Congress can more fairly and equitably tax what robots produce, namely, business profits, investment income, and capital gains; and, by doing so, propel the Tax Code into the 21st century.

Back to Alexa. Asked if she should pay taxes, her response is, “Sorry…I don’t know that one.” Clearly, she is patiently waiting for Congress to supply a definitive answer.

This post comes to us from professors Jay A. Soled at Rutgers University and Kathleen DeLaney Thomas at the University of North Carolina School of Law. It is based on their recent article, “Automation and the Income Tax,” available here.