16 Aug 2004 mmangino   » (Observer)

I saw a link to a website called FairTax on a slashdot post recently. I went to the site and looked, and what they are requesting is an abolishment of the US progressive income tax and a replacement 23% increase in sales tax. This sounds like a bad idea.

There are several interesting details, such as the fact the every person gets a rebate of the tax paid on spending up to the poverty level. The other interesting detail is that tax is only charged on new goods. There are claims that this proposal would be revenue neutral to the government, however I don't know whether or not I agree.

I see several major flaws with this proposal:

  1. A 23% tax on new goods that doesn't apply to used goods would likely significantly increase the desirability of used goods, leading to a decrease in the purchase of new goods. (This would also decrease revenues to the governemtnt)
  2. All of their analysis of the impacts are based upon the assumption that costs to consumers would be reduced on all goods and services by 23% which they claim is the cost of the corporate income tax which is being eliminated. My experience in these situations is that the corporation would be more likely to just increase their profit. They also include a reduction in interest rates of 23%. I find this absurd, as interest rates haven't changed in the past as corporate tax rates have changed.
  3. They claim that a smoother revenue stream would result, as when times are bad people are still spending which leads to level taxation. While this is true, I question the desirability of it. The federal government has very strong borrowing power and is in a much better position to winter a reduction in revenue that the average working person. The current tax on income has as a side effect that you pay more when times are good and you can afford it. When times are bad, you pay nothing. Losing this feature makes it more difficult for people when times are bad.
  4. Finally, for better or for worse, the US tax code serves as more then a revenue generator, it is also a method of social engineering. The government currently uses tax breaks as an incentive to induce desired behavior, such as home ownership and job creation. This ability is lost with the fair tax plan.

Another plan I have read calls for the replacement of our current income tax with a VAT similar to that of the EU. In many ways, our current tax system is similar to a VAT. In VAT (value added tax), you pay tax on all purchases. You also collect tax on all items you sell. For example, if I buy two parts for $0.50 and combine them into a product I sell for $2.00, I would pay a tax of $0.20 on my purchases (assuming a 20% tax rate) and collect a tax of $0.40 on the sale of goods which I would then remit to the government. This much is identical to a sales tax. The difference in VAT is that I can actually deduct the $0.20 I paid as tax on goods from the amount I pay the government. I only pay tax on the value I add to the good.

In the US, we have a corporate income tax. Corporate income tax is determined based upon an accounting of the company. The basics are that you take Revenue (the $2.00 in the example above) and subtract out expenses (the $1.00 above plus whatever overhead and personnel expenses I have) to come up with a number called earnings, or profit. You then pay a tax on this amount. It should be noted that if you discard the cost of labor, this amount would be identical to a VAT.

There is no question that the tax code is horribly complicated and poorly specified. While we could certainly deal with simplification to the code, I worry that the drastic measures suggested would lead to unintended consequences. I would rather streamline the tax code over time by removing the years and years of special allowances and benefits that have been added over time.

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