FAIR TAX, FLAT TAX, OR VALUE-ADDED TAX?

by Richard "Chip" Peterson, PhD, April,2010

    Many people have advocated that our country adopt a "fair tax." Such a tax would be a flat rate tax levied upon consumption expenditures (the value of the amount of resources and goods that an individual uses up each year) rather than on incomes (which equals the value of goods and services that each individual produces each year). Clearly, such a tax would be less likely to discourage (potentially beneficial) income producing activities and more likely to discourage (potentially wasteful) consumption activities in the economy as a whole. In addition, such a tax would not tax savings and investment and thereby would allow the economy as a whole to accumulate more capital goods more easily and, consequently, grow faster than would otherwise be the case. 

    The arguments for a consumption based tax like the "fair tax" in lieu of an income tax are strong but are less appealing in a practical sense. It is highly unlikely that a fair tax could be adopted in lieu of an income tax. Only if the 16th amendment were to be repealed so no income tax was allowed could the government be trusted to not impose both taxes simultaneously. Thus, the adoption of a "fair tax" would likely lead to an increase in overall taxation at the federal level. Furthermore, since the required rate on a flat rate fair tax that was supposed to replace the income tax would have to be quite high-- at least 20% to 30%--strong arguments would be made that it should only be leveled on the consumption of nonessential goods, and should not be levied on essential goods like food, medicine, or maybe even housing expenditures. However, the more items that were to be exempted from the tax, the higher the tax rate would have to be on remaining items. Flat tax rates would almost certainly have to exceed 30%, and possibly 40% on taxed items if there were no income tax and the Federal government continued to fund a high level of national defense and other activities to which the population has become accustomed. Thus, I oppose the "Flat Tax" on practical grounds since I think it would be levied in addition to and not instead of an income tax.

    If the 16th amendment cannot be repealed on practical grounds, a flat rate income tax at the Federal level is preferable to the current income tax system in my opinion. The present tax system has relatively high marginal tax rates--especially for the more productive members of the society who earn the highest incomes. It also has many exclusions. Neither feature is desirable. 

    High marginal income tax rates discourage productive activity since the producer gets to keep less of what he or she produces. Thus, he or she has a greater incentive to not do any extra work of a taxable nature and to seek ways to increase his or her welfare in other ways (people can work less and take more leisure, or take less risk and earn lower returns while worrying less, or stay at home and produce goods or services  that will not be taxed because they are not traded in formal markets). 

    High marginal income tax rates also provide greater incentives for producers to lobby their politicians to obtain various tax loopholes. The value of each loophole obtained is greater when the tax savings per dollar of extra loophole obtained are greater. This process has two major distorting effects. First, it makes people tend to pay off politicians to obtain favorable tax treatment for their income or activities. Not only does this lead to graft and corruption, but also, it tends to make politicians favor tax systems with high marginal tax rates so they can reap even greater payoffs (often called "donations"). Second, high marginal tax rates coupled with tax favors for favored activities will tend to bias production efforts away from areas where marginal tax rates remain high and toward areas where tax exclusions are substantial. As a result, resources and productive activity in the economy as a whole will be less productively employed than would otherwise be the case and overall economic efficiency and the productivity of the economy as a whole will suffer.

    Because of the problems caused by high marginal tax rates and politically granted exclusions, I favor a flat income tax. A low marginal income tax rate will be less likely to cause politicians to be corrupted (as the gains from obtaining tax favors will be less) and low rates  will be less likely to cause people to choose leisure over work, discourage risk-taking, or cause people to divert their productive efforts to areas where they are relatively less productive solely to avoid extra taxation). While an income tax would be  levied on gains resulting from savings and investments, its discouraging effects on savings and investment would be less the lower the rate of taxation. In addition, if the "double taxation" of savings returns (first when the income is earned before it is saved, and second when earnings are received on the savings) is deemed to be discouraging investment, capital formation, and productivity in the economy, adjustments could be made (such as by allowing people to exclude savings out of income from the initial tax--as is presently done to some extent with IRAs). Overall, because a low rate income tax --which is feasible if all present loopholes and deductions are closed, the flat rate could probably be 20%-- has less distorting effects on people's decisions to work, save, invest, and corrupt politicians, I favor a flat rate income tax over the present tax system. As a side benefit, a flat rate tax would be simple to assess so most people could easily do their own taxes (thereby saving personal hassles and expenses paid to tax-preparers) and the IRS could shrink substantially--thereby easing the burdens and hassles it frequently imposes on present taxpayers. 

    Unfortunately, in its greed to obtain more tax revenues from the public, and contributions for politicians, the Federal government is unlikely to adopt a flat rate income tax. Instead it is planning to raise marginal tax rates and also has been planning to impose a value-added tax (VAT). A value-added tax is something like a national sales tax with a flat rate, but it also has characteristics that make it somewhat similar to an income tax. I fear that it may be sold like a flat-rate national sales tax at the same time as the income tax is retained. A value added tax levies a flat rate, such as 20%, on the goods that someone sells. However, while the purchaser of the goods pays the whole 20%, the seller can deduct the tax from the cost of the goods that he purchased before they are sold. Thus, if the seller paid $120 for goods he or she sold for $200, with a 20% rate he would owe tax of $40 on the overall sale but could receive a credit of $24 on for the cost of goods sold--so his net VAT tax due would be $16--which also equals 20% of the $80 additional value he added to the goods when he sold them . In order to receive the credit for the cost of goods sold, the seller would have to record the name of the person or industry from whom he purchased the goods and have a proof of purchase available. In this way, his suppliers would be on the books of the tax authorities as having sold goods for $120, and would be liable for $24 in taxes on that sale. Consequently, the tax authorities could check the sales statements of the suppliers and ascertain whether they  had properly reported all their sales and had paid all their taxes (the other $24 in taxes due on the final sale in our example).  This dual reporting nature of the VAT could simplify tax enforcement. 

    The VAT tax is widely used by European countries--as well as by Canada. In addition to its self-reinforcing reporting nature, it can provide advantages for countries that pursue a mercantilist trade policy. Such a country can encourage exports by rebating taxes on exported goods. People who make many purchases while traveling in Europe can often file forms documenting their purchases when they depart the country (as at the airport) and receive the VAT tax portion of their purchase price back--often saving up to 15% or 20% of the initial purchase price. This policy is designed to stimulate exports. A similar application of the Vat can be used to discourage imports. The full Vat can be levied upon the value of imported goods. Thus, if goods cost $100 at the point of import, a 15% or 20% additional tax may be levied upon them. We see this often when we send gifts to our daughter, son-in-law and grandchildren in Canada, since Canada levies a 15% VAT on all goods coming into the country in amounts greater than $50. Thus, it often is cheaper for us to order gifts from Canadian sources than to send them across the border. That is one intent of the VAT, to discourage imports and encourage domestic sales, when it is levied upon imports.

    I understand that some Democratic Congressional leaders are already discussing a national VAT tax. It would probably have a low rate to start--5% or possibly less--just to get people to agree to it. However, its rate would probably rise substantially over time. People who advocate a "fair" tax might agree to the VAT thinking that it would be like a consumption tax and would keep marginal income tax rates from rising. However, it is more likely it would be a way that the Democrats could raise taxes on the middle class and others while keeping their promise to not raise income tax rates on lower income people. They still could, and probably would continue their ideologically driven policy of  raising income tax rates substantially on upper income people. They also would probably continue their attempts to raise capital gains taxes, taxes on dividends and other taxes that would squash savings incentives and returns on private investments. Thus, while a VAT might have some attractive features, it would be desirable only if it were adopted in lieu of income taxes and other savings, investment,  and productivity discouraging taxes. 

Email Chip with any questions., Chippete@aol.com

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