Fundamental tax reform is back in the news. Although the flat tax certainly has not disappeared from view, the newest plan to attract attention is a national retail sales tax. Reps. Dan Schaefer (R-Colo.) and Billy Tauzin (R-La.) have proposed a 15 percent sales tax to replace the existing income tax system (the federal personal and corporate income taxes and the estate tax). A group called Americans for Fair Taxation would replace those taxes and the payroll tax with a 23 percent sales tax. Ways and Means Chairman Bill Archer (R-Tex.) has indicated general support for sales taxes but is keeping his options open.
At first glance, a sales tax sounds simple, familiar and easy; after all, 45 states already operate such taxes. It is fantasy, however, to think that a sales tax could ever replace the federal tax system.
The first issue is truth-in-packaging. If a good costs $100 and the customer pays $30 in taxes on top of that, most people would call that a 30 percent sales tax. Not sales tax advocates. To them, it’s a 23 percent tax because the tax payment ($30) is 23 percent of the price plus the tax ($130). Thus, the 15 percent and 23 percent proposals above would really be 17 percent and 30 percent sales taxes. And that’s only the start of the problem.
If all consumption that could plausibly be taxed were included, a 17 percent sales tax (calculated the standard way) would be needed to replace revenues from the individual, corporate and estate taxes and a 29 percent rate to replace the payroll tax, too.
But no sales tax will cover all consumption. A tax on all consumption would wallop the poor. Even sales tax advocates propose subsidies to help offset the regressivity of the tax. The subsidy proposed by Americans for Fair Taxation would allow rebates for households’ consumption up to the poverty line. This would raise the required rate significantly, to 27 to 45 percent.
In addition, for reasons of politics, social policy and tax administration, a federal sales tax would likely exempt certain types of consumption that are difficult or undesirable to tax. States commonly exempt food, health, housing, education, government purchases and most services; many states tax less than half of all consumption. A very conservative estimate is that a federal sales tax would exempt 10 percent of consumption, which would raise the required rate to 30 to 50 percent.
That’s not the end of the story, though. States could no longer piggyback on the federal income tax. This would most likely lead the states to drop their income taxes and conform with the national sales tax. Add in the revenue raised by already existing state sales taxes, and the combined federal-state sales tax rate would need to rise to at least 40 percent to replace the income tax system and 60 percent to replace the payroll tax, too.
All of this assumes that taxes are perfectly enforced. But about 15 percent of income goes unreported under the income tax: 5 percent when taxes are both withheld and reported to government by third-parties, compared with 54 percent without withholding or reporting. Since the sales tax would have no withholding or cross-reporting, evasion could be much higher than 15 percent.
Evasion would raise the required rate further and thus create more incentives to evade, a vicious cycle that would ultimately make a high-rate sales tax unworkable in the United States, just as it has in other countries. European countries with variants of sales taxes have found that the tax becomes unadministrable even at rates as low as 10 to 12 percent. Virtually every country worldwide that attempted to raise significant revenue via sales taxes has eventually shifted to a value-added tax for administrative reasons.
Enforcement problems arise because all responsibility for tax remittance falls on the retailer, who may find it easy to underreport sales. Also, it may be easy for individuals to use their business IDs to make personal purchases tax-free.
Why would a federal sales tax fail when state sales taxes appear so successful? State taxes can meet revenue requirements at rates between 3 and 7 percent and so do not face the evasion problems that a federal tax would.
In fairness, some sales tax plans would add government purchases to the tax base. This could reduce the required tax rate, but would not change the basic conclusion about enforcement. Nor is it obvious that including all government purchases is either desired or feasible. Proponents also claim the sales tax would boost saving and growth, but this is overstated. Almost all net personal saving occurs via tax-preferred saving plans such as 401(k)s. These accounts are already taxed as they would be under a sales tax, so a sales tax would provide no new incentives here. And if interest rates fell, as advocates claim, the rate of return on these accounts would fall as well.
Estimates show that a sales tax would cut taxes by more than $75,000 for each household in the top one percent of the income distribution, while raising taxes on low- and middle-income households, even if there were a rebate for taxes on consumption up to the poverty line. And a recent study indicated that, unless health insurance were exempted, the number of uninsured people would rise by between 6 million and 14 million.
Surely, the tax system needs repair, and serious discussion of realistic consumption and income tax reforms should proceed. But sales tax advocates are presenting feel-good fantasies, not serious alternatives. Although psychologists believe that fantasy is both normal and healthy in certain circumstances, it is not usually considered a sound basis for public policy.