Friday, April 16, 2010

National Sales Tax is No Panacea

Imagine America without an income tax; it’s easy if you try. No more payroll tax; no more tax brackets; no more audits too. What you earn is what you get whether it comes from wages, net profits, or investment income and April 15 means nothing to us anymore.

Sounds like Utopia and that is what the national sales tax proponents want you to believe. Presidential candidate Mike Huckebee supports a national sales tax to replace the Federal Income Tax. So do the Americans for Fair Taxation. Even Republican rising star and candidate for the US Senate in Florida, Marco Rubio, endorses it. They all envision a much more simple, and in their view, a more fair tax structure. They believe it would eliminate the need for the Internal Revenue Service, stimulate the economy, and even resolve our illegal immigration problems.

There is an old saying, “If it sounds too good to be true, then it probably is.”

The national sales tax proponents estimate it would require a 23% sales tax rate to generate enough revenue to replace the Federal Income Tax. But, here in lies the first problem with the national sales tax proposal. You have heard of hidden costs, right? Well, here is a whopper for you. If I asked how much tax you would pay on a $100 purchase with a 23% sales tax, most everyone would say $23. But, that is not the kind of math the national sales tax proponents use. They say, you would pay $30 in tax and $30 divided by $130 equals a 23% tax rate. Talk about smoke and mirrors. Every state in the country that has a sales tax divides the tax collected by the price of the good or service to calculate the excise tax rate. $30 divided by $100 equals a 30% tax rate.

Let’s address the fairness issue. I do not believe it is the government’s responsibility to redistribute income to make things more “equal.” However, there is a certain sense of fairness that suggests that those who have higher income can better afford to pay higher taxes. That is this core principle behind America’s progressive income tax structure wherein those with higher income levels may find themselves paying a higher percentage tax rate. Indeed, America’s income tax structure is so progressive that in 2007, the top 10% of income earners paid 71% of the income tax collected. But, it is also common knowledge among economists that sales taxes are the most regressive form of taxation. The reason is that people with lower income levels spend a much higher proportion of their income on sales taxable goods and services. While it is true that wealthy people buy more expensive products, in the end, they spend a much lower percentage of their income on sales taxable items. Wealthier people save a much higher percentage of their income and investments and savings are not sales taxable items.

A national sales tax may mean the end of the Internal Revenue Service, but can anybody really be gullible enough to believe that there will not have to be something like a Bureau of National Sale Tax to develop a reporting system, account for the sales tax revenues, and enforce the collection from consumers and payment to the Federal government of a national sales tax. And, if you think people use the barter system to avoid income tax now, just wait until they can save 30% on the cost of a car by trading straight across. I do not believe anybody has really studied or measured the amount of barter trade that occurs in America today, but we all know it happens every day. People all over the country are providing goods and services in exchange for other goods and services they need and thus avoiding income tax and Social Security and Medicare taxes. A 30% sales tax will drive even more of our economy underground, and to deter barter trade, the Federal government would have to create an onerous and invasive tax bureau that would make the IRS look like a pussy cat.

The national sales tax proponents argue that by eliminating payroll taxes, consumer’s pay checks would increase and thus they would spend more and stimulate the economy. What the proponents fail to consider is that any tax diverts money from the private sector to the government sector. If a national sales tax collects the same amount of revenue for the Federal government as the income tax does now, then the amount of money diverted from the private sector remains the same. A national sales tax that effectively replaces the income tax cannot stimulate the economy because it does not result in any more money being available for private sector economic activity. Moreover, what happens to the housing market when mortgage interest paid is no longer deductible for income tax purposes? What happens to car sales or large appliance sales when their costs effectively increase by 30%? How many fewer dinners will your family buy at restaurants when the cost of a meal goes up 30%?

I fail to see how a national sales tax would resolve our illegal immigration problems. People who are in this country illegally are even less likely to conform to our laws and regulations. They already have well developed systems of barter trade and underground activities to avoid detection. It would be easy to adjust such a system to help them avoid a national sales tax as well. And, the incentive for citizens and legal residents to pay cash for services provided by illegal immigrants would go up because the services these immigrants provide would be sales taxable services under a national sales tax.

Historically, economists and tax policy wonks have always maintained that the most fair and stable way to fund government operations is through a system that includes a mix of property taxes, sales taxes, and income taxes. All of us would like a more simple and fair tax system. The Internal Revenue Code is the largest piece of legislation in this country. Even, the IRS cannot answer every question about the income tax. Certainly, current Treasury Secretary, Timothy Geithner, and other government officials have had their problems figuring out their income taxes.

Ronald Reagan proposed income tax reform in the late 1980’s. He wanted a simple and much lower flat rate tax for all taxpayers. To keep it revenue neutral, increase equity, and insure everyone pays some taxes, Reagan’s tax reform would have eliminated all tax deductions. At its surface, this sounds like a good idea. But the facts are that Congress has used the tax code over the years to create incentives for certain activities such as home ownership, charitable contributions, saving for retirement, investment capital for business, and even historic preservation. While the wisdom and need of those incentives could be questioned, the reality is that billions upon billions of dollars have been invested on the basis of the current rules of the game. Many people would argue that changing those rules in the middle of the game is grossly unfair and would cause economic havoc.

When it comes to tax policy and tax reform, a couple of principles come to mind. Be careful what you ask for and Caveat Emptor (buyer beware). Although I hate to say it, maybe in the case of the income tax versus a national sales tax the old adage is true, “Better is the devil you know than the devil you don’t know.”

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