August 02, 2004

National Sales Tax: It's not all fuzzy kitties
Posted by Dale Franks

I would love to have the income tax abolished. And I love the idea even though I suspect that, in terms of the tax I pay, switching over to such a system would give me a right pranging. Getting the IRS out of the business of auditing individual citizens is a good thing. It is always a good thing to keep the government from nosing around in the lives of its citizens.

But it's a bit dishonest to expect that there aren't some serious issues that have to be addressed when you talk about a switchover to something like the Fair Tax, which is, as of now, the only fully fleshed-out proposal on the table.

Regressivity

A sales tax is regressive.

Now, I have to say at the outset that I'm not sure I care much about regressivity. When you distill out all the "compassion" rhetoric about progressive taxes, the argument basically boils down to a very simple proposition: "You have more money than I do. Gimme." The whole argument behind progressivity is that, since you can afford to pay more taxes, you should. That's not morality, that's expediency.

As a practical matter, however, a steep rise in the cost of living of around 22%, would signifigantly lower the living standards of many people.

As it stands now, the lowest income quintile actually receives a 5% increase in income from the current tax system, through various credits, like the EITC. In fact the "taxpayers" in the bottom 50% of earnings only pay 3.6% of all federal income tax revenues.

But, let's say you're a lower middle-class taxpayer that see's 10% of your income deducted through witholding. It doesn't do you any favors to eliminate that 10% withholding, then slap a 22% tax on everything that you buy. Without quibbling too much about specifics, that's effectively a 12% pay cut, all other things being equal.

Now, one might argue that the poor get just as much benefit out of the DoD, or interstate highways, so why shouldn't they have to pay for it? But, now the poor are paying their fair share with money that would otherwise go to frivolous things like food and clothing for their children.

So, to avoid sending poorer people deeper into poverty, we'd have to exempt classes of goods from the NST, like housing, non-prepared foods, and clothing. Or, we would have to have some sort of rebate program where people are regularly refunded some portion of the NST they pay.

OK, we can do that, but now we have to increase the NST rate to avoid losing revenue. So, now we've got, say, a 30% NST rate on taxable items.

Maybe that would be a good thing. People would actually begin to see how much of a bite the feds actually take out of the economy, and start pressuring for spending cuts, and wondering why it is the federal government needs 20% of our GDP every year.

Or, maybe they'd just form "corporations" and buy everything as "business expenses" and pay no sales tax at all. Then where'd we be?

I'm no fan of progressivity, but I'm no fan of having millions of children going to bed at night after a hearty evening meal of ramen and broth, either. Of course, my solution is to eliminate huge swathes of the federal government, so that the NST doesn't have to have such a high rate. I suspect, however, that in the real world, that won't happen. So the issue of progressivity has to be realistically addressed.

Tax Evasion

Sales taxes don't have a sterling reputation for compliance at rates much above 10%. Several countries have tried to implement high-rate sales taxes, only see rates of evasion so high, they've had to switch to a VAT, because the enforcement is so much easier.

When you take a 22% NST, and marry it to the state sales tax, you end up with a combined sales tax of 29.5 in California. Jack up the NST rate to 30% to answer regressivity concerns, and you're at 37.5%.

Now, the thing about sales taxes is that there's no cross-reporting on whether a sale is a B2B tax exempt sale, or a taxable sale for personal consumption. And, of course, there's no witholding either. So enforcement would seem to be problematic.

As soon as someone starts a "business" and gets an exemption certificate, they start using it to buy goods for personal use. It already happens in the states, where sales taxes hardly ever get much above 8%.

Some mechanism for enforcing compliance will have to be worked out. And I'm not sure how it would be done. No one has ever managed to create a high-rate sales tax with a reliable enforcement mechanism. Even with the income tax, and armed IRS goons, there's already about 15% rate of income tax evasion now. For non-withholding incomes, the rate of evasion approaches 50%.

The VAT, at least, has a pretty strong enforcement mechanism, with cross reporting built in, along with an economic incentive to businesses to accurately report their taxes. The NST, on the other hand, requires that a 3rd party, who has no vested interest or ability in ensuring you are paying the sales tax properly, collect it for the government.

I think that there's need to be cautious about assumptions concerning how realistic it would be to have 30% sales tax rates that also include a workable enforcement mechanism.

The Tax Base

Broadening the tax base would be a good thing. It's be more equitable, and efficient. But it's also easier said than done, because doing so would have ripple effects.

For instance, health insurance isn't taxed, now, but it would be under the NST. OK, now, a couple of million more people can;t afford health insurance, and they join the ranks of the uninsured. Right now, homeowners can deduct the interest on their mortgage from their income taxes. Well, under the NST, you can kiss that goodbye. Oh, and the house now costs 22% more, because of the NST. The real cost of home ownership, therefore, rises signifigantly. Fewer people can now afford homes.

So, let's say we exempt health insurance and housing from the NST. Fine, now we have to jack up the tax rate on the NST to make up for that revenue.

And, of course, once you start granting tax loopholes, where does it end? Why not exempt gasoline sales, since people need cars and trucks to go to work, to deliver packages, or to diliver produce to the grocery store? Once you start down the loophole path, there's no telling where you'll end up.

Conclusion

As you can see, there are a lot of issues that conversion from income taxes to a national sales tax would have to address.

On balance, I'm still for a national sales tax. Apart from the considerations I've already mentioned, such a tax would make the cost of government much more obvious to the citizenry. It's easy to call for more government services when you're told it can be paid for by taxing "the richest Americans" You can just keep asking for more government goodies, with the expectation that someone else will pay for it.

When it's your dollar that's on the line, you become real interested in how much this neat government stuff is gonna cost, and you get interested in cost control real sudden-like.

To my mind, this is one of the most powerful arguments for having a NST. The cost of government can no longer be hidden, and it affects the personal finances of the citizenry as a whole. Every citizen has a vested interest in keeping the cost of government low, because, if they don't, they have to shell out the money for it.

But, I don't have any illusions that it'll be an easy sell to an electorate that's used to having as much government as they want, while forcing someone else to pay for it.

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Comments

I would like to see a combination flat tax and NST whose combined percentage would equal what ever is necessary to generate our present tax revenues. This would allow us to collect taxes from the black market economy while not raising the prices on goods so much that it will restrict spending. It will continue to allow some tool of audit on those who will continue to try and cheat the system but still tremendously increase a persons take home pay. It remains non regressive with certain exemptions and allows for a fair tax collection from those who are rich and but decide to live like Silas Marner.

Posted by: Dman at August 2, 2004 11:47 PM

The usual case for the regressivity of a sales tax is that rich people save a larger fraction of their income than do not-rich people. This argument is incorrect when viewed from a dynamic perspective. Saving doesn't avoid the sales tax, it only delays it. In addition, savings earns interest, so the sales paid sometime in the future will be larger as a result. There are some technical arguments about whether or not the increase in the sales tax paid in the future offsets the delay in the payment, but, in principle, it could go either way and in any case the future payment of the sales largely vitiates the regressivity argument.

Thanks for your blog.

George

Posted by: George at August 2, 2004 11:50 PM

I would like to see a combination flat tax and NST whose combined percentage would equal what ever is necessary to generate our present tax revenues.

Actually, you really, really, don't want that. I guarantee you that if we go that route, we'll end up With European rates of taxation, with both high VAT rates and high personal income tax rates.

Posted by: Dale franks at August 3, 2004 12:15 AM

I have no answers to contribute, but I do want to chip in some valuable questions...

A real world factor to consider in looking at income, sales taxes or VATs is a number of existing treaties with other nations. Nations attempt to compete, and reciprocate, on tax structure, so as to maximize revenue for both.

The US now operates at a slight disadvantage to Europe in that our manufacturers pay "income" type taxes on sales exports. European manufacturers, on the other hand, who sell outside their domestic markets can claim a tax rebate on VAT paid for materials and their international customers pay for the end product with no, or reduced, VAT (a vestige of mercantilism toward the political goal of increasing exports.)

"Harmonization" of the US tax structure with European Union rules would level the playing field.
(It might "level" to a higher plateau, we have to be REALLY Careful!)


Posted by: Pouncer at August 3, 2004 08:58 AM

Concerning the NST (National Sales Tax), I believe that you are both sorely and severely uninformed as to some of the key aspects of the Fair Tax Act, HR 25.

First point you've missed is the concept of monthly _pre_bates which would go out to everyone (since everyone would be, by definition, a tax payer -- finally!) at the first of the month to cover the amount of taxes -- whatever the percentage would be -- based on the then-published poverty level. By definition, the absolute poorest among us would pay _zero_ percent of taxes. Everyone else would be able to buy essentials, pretty much, without paying taxation, thereby introducing progressivity into the system (then again, in my personal view, I think everyone should pay for government with zero subsidies on that, period).

Secondly, according to HR 25, the sales tax would be taxing only _new_ goods and the like. The idea for this is, "once you've taxed something, it shouldn't be taxed again." I think this is a phenomenal idea per se!

Thirdly, you seem to fail to see what would happen once all direct taxation was removed from the equation of personal, business or other production. In theory (because it hasn't be tried yet, to my knowledge), the cost of goods sold would go down relatively proportionally to the point that whatever the percentage of taxation turns out to be, one could very well be in a "break-even" scenario: it would cost no more today to get that good/service than it did before; it's a matter of how the costs are managed. Further, I believe in the greatness of capitalism and the free-market system, and believe that supply/demand would dictate that prices might actually become more competitive in this type of environment.

These three points are crucial in understanding a national sales tax as per HR 25. As you may know, we have to remember that this is not about getting away with no taxes, this is about what we, as a country want to have taxed: productivity or consumption.

Remember also that the United States has the world's second highest corporate income tax, from what I understand. It therefore cannot be a wonder that our ability to manufacture goods is severely diminished based on this variable alone.

Finally, I believe everyone should remember that an income tax is a tax on income, _not_ wealth -- hence why many a politician has no problems in raising taxes because many of these folks already have trust funds!

Let's devolve the IRS to where it's either eliminated or parceled out to the States (again, see HR 25 for more info on this), thereby making sure the federal government has limited powers of intrusion on we the People.

Enjoy,

-Phil

Posted by: Phil at August 3, 2004 09:41 AM

Phil. Very well written. Very passionate. I wasn't adressing HR25, however. I was talking about sales taxes in general. I merely mentioned HR25 because it's the only one on the table right now. I didn't address any criticisms at it, however.

Posted by: Dale Franks at August 3, 2004 11:28 AM

As an exporter in Taiwan, I get to rebate all my VAT taxes.

VAT makes people pay tax when they consume and not when they save. That's good, right? Especially for America, where savings are abominal. Yes, it might hurt at first.

Exempt food, and you help the poor a lot, making it pretty progressive.

Posted by: cobacoba98@yahoo.com at August 3, 2004 11:33 AM

Oh, yes, and I also import.

There I pay a VAT of 5% on everything coming in....

Posted by: coba at August 3, 2004 11:36 AM

There already is a market on under-the-table payments made to workers in order to avoid things like 1099s, withholding taxes, income taxes, verification of citizenship status, etc.

I'm wondering what the impact of a NST or VAT like tax will be. Will more people turn to bartering? How much business is driven off the books in order to avoid paying taxes? (I realize these are rhetorical questions, but didn't see them addressed in your post)

Posted by: Chrees at August 3, 2004 01:37 PM

"The real price of housing goes up". Actually the real cost of owning home becomes more evident and so the price of housing goes down. Have you ever heard someone say "Well we paid more for the house but we can write off the mortgage interest so it's ok"? I hear this idiocy often. As a seller, you know that your buyer is willing to pay you more because the other taxpayers are subsidizing the bill. By eliminating the mort interest deduction, the seller can no longer ask as high a price. Imagine what would happen to say the price of diamonds if the IRS suddenly granted a 2000 tax credit on the purchase of a diamond. Ding, ding you get full credit if you answer "well the price will go up 2000".

The people who would be nervous about dropping the mort int deduction are the ones who bought right up to the edge, although they might recoup enough in eliminated taxes to make up for it. Of course the mortgage holders would be nervous because suddenly the value of the asset underlying the mortgage has dropped.

Posted by: Paul at August 3, 2004 06:43 PM

Sorry I forgot to mention in the previous post: If one of the goals of a NST is to make the cost of fed gov apparent, a partial step would be to eliminate withholding and make everyone pay quarterly. Imagine the uproar when people have to sit down and write that check every three months!
Paul

Posted by: Paul at August 3, 2004 06:45 PM

With a national sales tax pushers, pimps, and prostitutes would be paying into the system and waitresses wouldn't feel like lawbreakers for not reporting the actual tip amount.

Another thing, the fairtax people you link to above indicate that the tax would apply only to new items. Anything sold as used would be tax free. Used cars, used clothes, used books. The poor (or cheap) could always shop used and not pay taxes at all under that system. Hopefully the wealthy will still want their shiney new toys or the entire system breaks down though.

Posted by: ruprecht at August 5, 2004 08:04 AM

It seems that people are saying that mortgage payments would go up by 20% or whatever the tax rate is at the time.

It seems to me though that the tax would be, or at least should be, on the price of the property when it was purchased. This amount would then be included in the amount of the loan and amortized over the period of the loan just like car loans that already are subject to sales tax.

Without working through the numbers, my guess is that one would be paying less this way than under the current system of mortgage interest being a deduction only.

Posted by: Connie at August 5, 2004 01:07 PM

OK, why not just issue a tax card to everyone, based off of their yearly income. Poor people get a tax exempt status, rich people get a 30% tax rate (er, something like that).

That would make the "Progressive" left happy, eliminate an income tax and help me not break above a certian income bracket!

(yea, I'm being sarcastic)

Posted by: useless at August 5, 2004 04:45 PM