Wednesday, February 24, 2010

A Fresh Look at Federal Taxation?

A few years ago an interesting, but improbable idea for tax reform was discussed during the presidential primaries. It has been labeled the “fair tax,” and proposes replacing all existing federal taxes with a single federal sales tax on all final goods and services. It also includes several related tax policies. Its proponents cite many benefits of this tax system, including:

  • Making taxation more transparent. With a single uniform tax, Americans will have a clearer idea of what they spend on taxes, and how the effective tax rate is changing over time. This should result in greater government accountability.
  • Reducing public and private tax administration and collection costs. The Government Accountability Office estimates that Americans spend between $200 and $300 billion each year complying with the federal tax system. That is between two and five percent of GDP! Relying only on a sales tax could reduce these costs substantially, considering that transactions increasingly occur at large retailers with automated payment systems.
  • Allowing collection from all American consumers. The fair tax would collect from all consumers in the country, regardless of nationality, citizenship, or country of residence.
  • Incentivizing “societally beneficial” spending behaviors. The fair tax would influence the spending decisions of the wealthy Americans. The fair tax will be a disincentive to spending money on “additional” consumer goods at the margin of benefit. Conversely, they will choose to invest in job creating companies, finance research and development, and donate more to charities and non-profits—all of which improve others’ standard of living.
  • Increasing the global competitiveness of companies operating in the United States. The elimination of all corporate taxes will encourage companies to keep their most important functions domestic. It will also encourage foreign companies to move production to the United States. The United States currently has one of the highest corporate tax rates in the world.
  • Making it easier to save. Currently, the American private savings rate is an abysmally low 4.6 percent, and was negative only a few years ago. The fair-tax will help Americans prepare more quickly for retirement and unexpected expenses. Additionally, increases in savings will lessen the strain on our already stressed social welfare system.

The fair tax need not be regressive

After learning more about the fair tax, many of my initial objections to it disappeared. Critics of the fair tax incorrectly label it as regressive, suggesting that it taxes those with lower incomes at a higher rate than those with higher incomes. In reality, the fair tax incorporates a “prebate.” Every taxpayer will receive a monthly rebate equal to the amount of sales tax that they will pay on purchases below the poverty level. The result is that those living below the poverty level will pay no net taxes. Additionally, the fair tax would eliminate the regressive FICA payroll tax that is currently paid by low-income Americans.

Many current sales taxes often excludes categories of products like food for home consumption and prescription drugs to give the appearance of “progressivism.” However, economists have found that the wealthy often spend a great deal more on unprepared foods and medical care (i.e., they are normal goods), and the positive intentions of these exemptions are often lost. Exemptions are not a particularly effective way to make the sales tax less regressive, and the practice results in market distortions that favor certain industries over others (benefits for food producers, pharmaceutical companies, etc.). The fair tax would eliminate these types of distortions.

Reliance on a sales tax will not increase instances of tax dishonesty

Few people realize the magnitude of uncollected taxes today. The IRS estimates the current tax gap (the amount that goes uncollected) to be nearly $300 billion per year. There is also not a strong likelihood of increased “underground” sales. Retail businesses will collect the tax at the point of sale, like they already do effectively in 45 states.

With the simplified system, the federal government will free up many resources to pursue tax crime and investigate fraud.

Implementation of the fair tax is not unfeasible

Adopting the fair tax will necessitate a constitutional amendment, requiring the approval of 37 states. It would include a repeal of the sixteenth amendment, which authorized the income tax.

Researchers estimate that sales tax will need to be around 23 percent to maintain current revenue levels. However, this is difficult to confirm due to difficulties in modeling.

Revenue stability is a concern with a sales tax. However, consumption is typically a more stable source of income than revenue, which is the current income tax base. Additionally, the fair tax is only currently being proposed at the federal level, meaning that a balanced budget is not required.

It is difficult to say how politically feasible the fair tax is. The mere mention of changes to the existing tax structure brings about strong emotion-laden responses. However, the plan should be carefully evaluated. Objections must move beyond “this isn’t how it’s been done before” for the study of public policy and administration to be useful.


1 comment:

  1. Sean, the fair tax is a very interesting topic. I have the major concerns:

    First, how reliable is the estimation of 23% rate for the national sales tax to be "revenue neutral"?

    It seems that the rate was estimated based on a projected base that includes all sales, which is three times larger than the current sales tax base. That is, if it were estimated with the current tax base, the rate would indeed be 69%!

    Moreover, I am not sure whether price elasticity has been fully considered in the estimation. Even if we can include all sales in the tax base, such a high rate would have significantly reduced the size of tax based due to price elasticity or evasion.

    The second concern is about vertical competition of tax base. If the federal government levies a high national sales tax, it will create difficulty for states to generate further revenue from sales tax.

    A possible outcome is that states will over time shift to a high reliance on state income taxes. The outcome would be a income-sales tax swap, which I am not sure is desirable, because it may be more efficient, both economically and operationally, for the national government to levy the income tax.

    rather than the current available sales base.