Last week I described four incidental burdens that arise from income taxes:
- They conflict with key elements of the Bill of Rights
- Calculating the correct amount of tax costs many taxpayers significant amounts of money and/or time
- The rates, coupled with the large number of collection points, create incentive for tax evasion
- The underground economy is entirely untaxed (at a federal level)
In order to alleviate those burdens, several people have proposed forms of consumption taxes, ranging from value-added taxes (VATs) to national sales taxes. One of these proposals is called “FairTax.” The notion of “fair taxation,” as I mentioned two weeks ago, is a matter of perspective. Nonetheless, as currently proposed, FairTax has some degree of progressivity.
The fundamental principles of the proposal are as follows:
- Taxes are levied at the point of purchase for services and new goods only. Used goods may be sold ad infinitum tax-free.
- Taxes are “prebated.” That is, an amount of money is given to every taxpayer each month to provide a mechanism of progressivity, effectively making a portion of purchases tax-free.
- Taxes are presented as part of the final sale price, which makes the tax rate appear to be lower. For example, a purchase price of $100 includes $23 in tax. This is fiscally equivalent to a sales price of $77 with a 30% sales tax, though it would be presented as a 23% tax, since tax represents 23% of the final price. This can lead to confusion about the tax rate.
There are some really good aspects to this approach:
- It encourages saving, which in the long run reduces poverty among the elderly.
- Self-reporting is unnecessary for the majority of taxpayers, which eliminates much of the damage to civil rights.
- It is somewhat progressive, at least as far as spending is concerned. The degree of progressivity there is dependent on how much money is prebated, and how that amount is determined.
- It taxes much of today’s underground economy, because even those who make money under the table will buy legitimate goods and services, and pay taxes on them.
- Since used goods are untaxed, it encourages reuse, which is environmentally beneficial.
- It’s short and simple, which makes inadvertent noncompliance less likely.
There are several downsides to this model, too:
- Placing the entire tax burden at the point of sale to the final consumer, the tax rate is high enough to encourage tax evasion. In this case, there would likely be an increase in under-the-table commerce, particularly in services, which are harder to trace.
- Americans’ spending outside the US isn’t subject to the tax. This may be offset by foreigners’ spending within the US, depending on which is greater at any given time. In terms of nominal dollars in taxes levied, a weak dollar would be advantageous here, while a strong dollar would result in less tax revenue.
- Encouraging saving, while fiscally advantageous in the long run for most of the economy, slows the economy in the short run by reducing commerce. This downside is similar to that of government not running deficits. It hurts the economy in the short run, with the benefits of avoiding a cost to be paid in the future.
- The tax is progressive only as far as spending is concerned. Since higher-income earners save a larger percentage of their income, the ultimate tax from an income perspective is regressive. It’s even more regressive when looking from a net worth perspective.
So the “FairTax” as a replacement for the current income tax is trading one set of taxation issues for another. It’s hard for me to say that it’s better or worse than the existing model; it’s just different.
Much of the progressivity of the model depends on the amount of prebating, and the method by which that amount is determined. Some additional progressivity could be added by charging different tax rates for different items, perhaps based on the price of the specific item relative to the median price for items of that class. This approach, while improving progressivity, comes at a cost of significant complexity, and thus higher implementation costs and greater likelihood of tax evasion (either intentional or inadvertent).
The impact to the economy of shifting from an income model to a consumption model can be reduced by transitioning over time. Doing so would be particularly innocuous if it occurs during an economic upswing. In essence, it would be a close cousin to Keynes’s countercyclical model of reducing government spending during economic booms, and one would expect it to have a similar effect.
Over time in this series, I’ll put other proposals under a similar microscope. One thing should be clear by now: all tax models have unintended consequences. In essence, we have an engineering problem. Like all engineering problems, the goal is to maximize the benefits and minimize the costs (financial and otherwise). But the “ideal” solution is only ideal for some. If you only get to apply a single solution, it will inherently be not ideal for a large segment of the population.
I’m outlining all of this so that we can discuss the bigger picture of the costs and benefits of each of these models. As I go through these various models, we can all draw upon the full spectrum of existing and proposed models of taxation.
For now, I’d like to leave you with one question. What is the order of importance to you of the following:
- Civil rights
- Progressivity of tax
- Avoidance of tax evasion
- Short-term impact on the economy
- Long-term impact on the economy
…and why? The answers to these questions largely determine which tax model you’ll prefer.
- Progressive at What Cost? (538refugees.wordpress.com)
- Deficit Puzzle: Where’s the Fair Tax? (economix.blogs.nytimes.com)
- Fair and Balanced (538refugees.wordpress.com)
- Value Added Taxes Around the World (turbotax.intuit.com)
- National debt: The ugly facts (money.cnn.com)
- As new Congress convenes, focus is on cost cutting (ajc.com)
- What’s the Deal with Consumption Taxing? (turbotax.intuit.com)