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Caveat Emptor

Thursday, June 1, 1995
"Any sales tax will inevitably become a complex, pervasive, multi-rate value-added tax."
-- Dick Armey

One of the most refreshing feelings in the new Washington is the growing sense that our current tax system is not long for this world.

Only days after the November election, Congressman Bill Archer, the chairman of the House tax-writing committee, boldly declared his desire to "tear out the income tax by its roots." House Speaker Newt Gingrich and Senate Majority Leader Bob Dole have since formed a commission to consider entirely new alternatives. Presidential candidates Phil Gramm, Richard Lugar, and Arlen Specter want to scrap the system. A half dozen congressional panels are holding hearings on the subject. Even Congressman Richard Gephardt, the House Democratic leader, has floated a major rewrite (albeit without details).

The question is no longer whether America will get rid of its burdensome tax system; the question is, what new system should we replace it with? It is a question that will likely dominate our politics through the next election.


There are three main contenders: One is a plan advanced by Senators Sam Nunn and Pete Domenici. They were among the earliest to call attention to the most economically lunatic feature of the current tax code -- the highly destructive double taxation of savings -- and develop a way to fix it. Called the "USA Tax," their proposal, while fairly complicated, defers taxation on income that is saved, while taxing income that is used for consumption. It is a sincere and innovative effort to encourage the savings necessary for continued economic growth.

The second contender, which I strongly favor, is the flat tax. Designed to make the tax system as neutral and simple as possible, the flat tax would sweep away all loopholes, deductions, and exemptions, and replace them with a single generous personal allowance. All other income would be taxed at one low rate of 17 percent. As the plan's authors, economists Robert E. Hall and Alvin Rabushka, have pointed out, a flat tax would allow Americans to figure their taxes on a form the size of a postcard. The use of the tax code by would-be social engineers would end. Like the USA Tax, the flat tax would also end the double taxation of saving.

While support for the flat tax is soaring -- almost 60 percent of Americans appear to favor a version of it, if polls are to be believed -- the Nunn-Domenici plan may have been overtaken by events. Conceived at a time when it appeared to many that the redistributionist Democratic Party would control Congress indefinitely, the plan contains sharply progressive tax rates that would kick in at surprisingly low income levels. It addresses the disincentive to save quite well, but it may make the other problems in the code, high rates and complexity, even worse than the current system. With the new politics in Washington and across the country, superior alternatives are now clearly within political reach.

Then there's choice number three: the national sales tax. This is a sweeping plan to wipe away the current system and replace it with an unprecedented federal tax on retail purchases. Although it's not as widely discussed as the flat tax, it has substantial support among many far- thinking conservatives, including Archer and Lugar. Indeed, there are few conservative hearts that could not be at least a little warmed by its central promise to end the income tax altogether.

This last choice demands serious examination at the moment. Although well-intentioned, the sales-tax option has several serious flaws. Before getting into that, though, we must remember that supporters of all these plans are allies in a fight to end America's single greatest impediment to achieving its possibilities: the IRS code, circa 1995.

Any American tax system should meet three basic criteria. It should be fair, simple, and pro-growth. The current system fails miserably on all three counts.

Is it simple? Not by a long shot. In 1990, American workers and businesses spent 5.4 billion hours preparing their taxes for the government. That's more time than it takes to build every car, truck, and van manufactured in the United States each year. After seven decades of amendments, revisions, exemptions, loopholes, and extensions, the code has become an incoherent mess. The IRS now sends out eight billion pages of forms and instructions each year. Laid end to end, they would stretch 28 times around the circumference of the earth.

Is it fair? Hardly. The tax system is as much an exercise in social engineering as it is a way of raising government revenue efficiently. Through its exemptions and loopholes, the government tries to guide the economic decisions of free Americans in the misguided belief that the government knows best. Among other things, the code tells us that it is better to invest in a municipal sewer system than the next Microsoft, that buying rather than renting a home is a better choice for everyone everywhere, that purchasing air compressors is better than buying computer software. Government has neither the competence nor the right to make those decisions for us. The pretense that "government knows best" is an insult to our citizens.

Is it pro-growth? As written, the tax code actually punishes savings and investment, by placing double or even triple tax burdens on capital. This lowers wages, destroys jobs, and depresses the living standards of all Americans. At the same time, it burdens American workers with punishingly high tax rates and overall tax burdens. With state and local taxes and other federal taxes, Americans now pay more in taxes than they spend on food, clothing, and shelter combined.

All who have worked to end this system, no matter what plan they currently favor, should be welcomed as members of the tax-reform movement.

Now for a closer look at option number three. What follows is my assessment of the major arguments advanced in favor of the national sales tax:

A sales tax is not an income tax. The case for a sales tax begins with one highly appealing applause line. It will allow us, supporters argue, to eliminate the income tax altogether, possibly even repealing the 16th Amendment, which authorized it and made Big Government possible in the first place.

Even if that goal were politically feasible -- and I don't think it is -- the exchange would come at a high price. We would give up the income tax for a more intrusive and pervasive tax system.

The reason is simple. If the government sets out to collect a new tax at the cash register, it will soon have no choice but to extend that tax beyond the retailer to every level of production, as it desperately tries to stop inevitable and massive tax evasion. Any sales tax will become a complex, pervasive, multi-rate, value-added tax. We will soon be living under a VAT -- possibly the most insidious tax scheme ever devised.

Sales-tax backers often oppose a VAT. But that's what they'll get. To generate sufficient revenue by taxing goods only at the retail level, the government would need to impose a sales tax of at least 20 percent, which means that consumers would suddenly find that everything they buy appears to be 20 percent more expensive. But people will not pay such a high tax. They will either find ways to label their consumer goods tax-exempt wholesale items, they will purchase goods in a cash black market, or they will evade it some other way. A sales tax, in other words, will be immediately undermined by a silent tax revolt, and the government -- following the pattern of European countries -- will respond by imposing a VAT.

A VAT is assessed at each stage of production and is much easier to collect and enforce for a host of reasons. You can hear the bureaucratic lament in a 1993 report by the Organization for Economic Cooperation and Development, which noted: "Governments have gone on record as saying that an RST [retail sales tax] of more than 10 percent to 12 percent is too fragile to tax evasion possibilities, and it is probably not entirely accidental that in OECD counties, VAT rates are nearly always above 12 percent and that, except in Canada and Iceland, RST rates have always been well below 12 percent."

These unhappy governments were speaking from sad experience. In 1967, 21 developed countries had retail, wholesale, manufacturer, or multi-stage sales taxes. Today, 20 out of 21 of these sales taxes have become value-added taxes. Every developed country except Australia that has had a sales tax now has a VAT. (Even Canada and Iceland, mentioned as exceptions when the OECD report was written, have since replaced their retail-tax-only systems with VATs.)

Whether or not the sales tax evolves into a VAT, the government would become intimately involved in almost every economic transaction between consenting adults. The simplest exchange, from a vegetable farmer selling his produce to the corner grocer selling a loaf of bread, would be under the shadow of a government tax collector taking his cut. In fact, every businessperson in America would become a tax collector for the government.

"But businesses already collect taxes for the government," sales-tax supporters counter. There's a big difference. Today, businesses collect a relatively small share of the income tax, since three quarters of the income in the economy is labor income, paid by individuals. But under a sales tax, there is no direct tax on individuals, so businesses will be responsible for collecting several times what they collect today. That means IRS scrutiny of American businesses could be expected to rise proportionately. Since the 10-12 million businesses in America have fewer rights under law than individuals, we can expect IRS abuses to rise exponentially as well.

It would be an administrative mess. A national sales tax may well exempt many basic necessities from tax --beginning with food and clothing. This would lead to bitter disputes over the difference between food and candy, between real clothes and costume accessories. Congress and the courts would likely find themselves debating the nutritional value of Twinkies, the body coverage of sportswear, and much else, just as state governments do today, but on a larger scale.

Worse, the federal sales tax and the dozens of different state sales taxes -- aside from having different tax rates -- would likely exempt different items. That means a small businessperson would need to look up the correct state sales-tax rate, apply the federal rate, subtract the state tax rate from items exempted only by the state, or subtract only the federal rate from items federal-only exempted. Then he would need to do separate calculations for each of the states in which he does business. (And he would need to catch any mistakes before the tax enforcer appears.)

The likely consequence would be a slowdown in business activity -- and a loss of jobs and drop in wages for millions of American workers.

We could eliminate the IRS. Ignoring or dismissing this inevitable tendency for a sales tax to become an all-pervasive VAT -- with a huge accompanying bureaucracy -- some sales-tax advocates nevertheless argue that the sales tax would allow us to eliminate the IRS altogether.

The argument is presented with an interesting federalist twist. The states, they say, could collect the new federal sales tax through their existing sales-tax systems. The federal government, then, could do without its own revenue collection agency. We could bring about the ultimate devolution of federal authority.

One immediate problem, however, is that five states do not have a sales tax and would not take kindly to enforcing one for Washington. Even those that do would consider the costs of collecting a huge federal sales tax (the main source of federal revenue) an unbearable federal mandate.

The enforcement costs for current sales taxes, currently about 5 percent, are manageable. However, if you add a 20 percent federal sales tax on top of that, the compliance problems grow exponentially. It makes little sense for a state government to pay the enforcement costs for a 25 percent tax when it only gets one fifth of the revenue. Many states would simply eliminate their sales taxes.

But the point is purely academic. For reasons dating back to the unhappy years of the Articles of Confederation, the federal government will never rely on state governments for its prime source of revenue. It will not happen.

In truth, a sales tax would not eliminate any federal agency. It will actually allow a huge increase in the size of the federal government by allowing politicians to raise taxes with relative impunity. Why? Because sales taxes are hidden from the taxpayers, concealed in the price of the goods they buy.

Try this experiment. Stand outside a grocery store and ask shoppers as they leave how much they just paid in sales tax. You'll find that virtually no one knows. Can you guess how much you paid in sales tax last month, or last year? The problem is, if people don't appreciate how much they pay in taxes, it is a lot easier for politicians to raise them.

Individuals would no longer need to file tax forms with the government. Since people would pay their taxes whenever they purchase an item, some sales-tax advocates argue, the government will never need to know a taxpayer's name. There would be no filing of any tax papers at all by an individual.

That's not quite right. Under almost any sales-tax plan, individuals would still file with the government -- but for entirely different reasons than they do today.

It's almost certain that one way or another, any federal sales tax would need to exempt certain basic necessities in order to make it progressive. One way to do this, as I've mentioned above, would be to order retailers not to charge tax on food and clothing and whatever else the government selects.

But exempting a handful of items isn't enough. Absent a generous rebate, most Americans would face a stiff tax increase under a sales tax. That's why most sales-tax proposals provide for a rebate. The truth is, the overwhelming majority of Americans would still need to file with the IRS to claim their rebate (or else face a substantial tax increase).

Some have suggested the IRS could simply send out checks to every American by Social Security number, obviating the need for taxpayers to file with the IRS. This is a fantasy. It wouldn't be long before there were more Social Security numbers than citizens. Whether or not Americans file directly with the IRS, the potential for fraud is staggering. Even under the current Earned Income Tax Credit program, fraud levels are as high as 30 to 40 percent. How much fraud would there be if the federal government were cutting thousand-dollar checks to every American?

Of even greater concern is the political dynamic that would develop once we couple a hidden sales tax with a highly visible tax rebate. Americans would be quietly nickel-and-dimed to death by a sales tax they may hardly notice, but every year a very noticeable and generous check would arrive from Washington like manna from heaven. Government, and even the tax bureaucracy, might become highly popular after all. And in my judgment, if there could be anything worse then people hating the IRS, it would be for people to love the IRS.

A sales tax will tax the underground economy. The notion here is that a sales tax will more effectively tax illicit trade in both legal and illegal goods and services than any income tax. If true, this would bring in tens of billions of dollars in revenue to the government as we collect revenue from people who are currently outside the system.

The neighborhood drug dealer almost always serves as the illustration. Since the drug dealer declines to file a 1040 form, the argument runs, maybe we could at least recoup some of his income through a sales tax. The government may have no record that he exists, but when he uses his blood money to buy a sports car, the government will collect tax from him.

That sounds compelling at first, but if we think it through, it doesn't hold together. Look at it this way: Both systems will equally fail to tax the drug trade for the simple reason that the drug dealer will not play along in either one. If there's an income tax in place, he won't report his income. If there's a sales tax in place, he won't collect tax from his customers. Either way, the government loses exactly the same amount of money.

Consider the following example. Suppose there is a drug dealer who makes $50,000 in sales to his customers every year and then turns around and spends it. Under an income tax system, we wish to tax the income of the dealer and his customers, while under a sales tax we wish to tax all of their purchases.

Under the income tax, we tax the income of the drug consumers (assuming they are law-abiding citizens besides their drug use), but we can't tax the income of the drug dealer. Thus we lose $50,000 from the tax base. Under the sales tax, we tax the purchases of the drug dealer, but we don't tax the purchases of the drug consumers. Loss to the tax base: $50,000.

It has to be the case that neither system taxes the value of the drug trade because the amount people spend on drugs must equal the income of the drug dealer. And since the drug dealer will not report sales or income tax, neither system will capture the value of the drug trade.

The same would hold true for the underground economy in legal goods and services as well -- which, of course, is much larger. The proverbial plumber who doesn't report his house-call income today would not report it for sales-tax purposes either. At best, it will be a wash.

Actually, economic reasoning aside, the whole "underground economy" argument for a sales tax is flawed. It's obvious that if we try to impose a national sales tax of 20 percent or more on the public, the underground economy will explode. The "contraband" involved, though, will not be just crack cocaine, but virtually any sort of consumer good. That's exactly what happened in Canada when the government imposed its goods-and-services tax. The tax raised much less than projected. Coincidentally, the Canadian Treasury soon noticed a dramatic increase in the amount of real currency flowing through the economy. Why were Canadians suddenly using so much cash? Guess.

A sales tax will reduce the trade deficit. Supporters say that a sales tax will increase U.S. competitiveness by taxing imports and not taxing exports. As tax-policy people put it, a sales tax is "border adjustable." Since exports aren't sold in the U.S., they would escape a domestic sales tax; since foreign imports are sold here, they will get hit. This way, American firms receive a significant tax advantage over foreign firms, and that will favorably alter our trade balance.

There are very few economists who hold this view, however. An immutable law of economics holds that trade surpluses and deficits are linked to the amount a nation lends or borrows. When savings are low, the trade deficit must be high, but if we substituted a tax on imports for some other tax, it will not affect the amount Americans save. That means the trade deficit not only will stay the same, it must stay the same, as a basic principle of economics.

Economists might explain it this way (simplifying, of course): If there is more investment occurring in our economy than can be financed by our savings, then foreign investors must be accounting for the difference. In effect, they are taking the money we pay them for their cars and VCRs and using it to buy our stocks and bonds, thus supplying the investment capital that we don't supply ourselves. This difference is the "trade deficit."

The only way to change the trade deficit, then, is to change our savings rate. If we increase our savings relative to our domestic investment, we will have less need for foreign cash. The trade deficit will then drop, as we spend relatively less money buying foreign goods and relatively more investing at home.

But anything we do to tax incoming foreign goods -- including slapping them with a sales tax -- will have no effect on the amount of money Americans are putting into domestic stocks and bonds or even their own bank accounts. There is simply no relationship between them.

What will happen instead is this: Our exports will increase at first because of the new tax advantage. But since our savings will remain the same, the dollar will be artificially strengthened. This will make our exports more expensive, and the original balance of trade will be gradually restored -- along with the original trade deficit. The policy will be self-defeating.

Even if a border adjustment were to work as its proponents claim, it would still be a bad idea. It would make the goods Americans buy -- whether produced here in America or abroad -- more expensive, while foreigners could purchase American-made goods more cheaply. It's hard to see how Americans benefit from paying higher prices than foreigners do to purchase American products.

Adam Smith makes a relevant point in The Wealth of Nations. Smith reminds us, "Consumption is the sole end and purpose of all production; and the interest of the producer bought to be attended to, only so far as it may be necessary for promoting that of the consumer."

In a border-adjustable system, however, to borrow from Smith again, "the interest of the consumer is almost constantly sacrificed to that of the producer; and it seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce."


All of the above assumes, of course, that we really could replace the income-tax system with a national sales tax. But could we? The roots of the income tax go back to the 16th Amendment, passed in 1916 to authorize the government to levy a tax on individual incomes. In my view, repealing the amendment and ending the income tax for good is, politically, not in the cards. Conservatives in Congress have tried for years to pass a balanced-budget amendment without success. I believe we will eventually succeed, but in the midst of that grueling fight, I believe the notion of getting 290 members of the House, 67 members of the Senate, and three quarters of the states to repeal the 16th Amendment is a dream.

And that is perhaps the best argument against the sales tax. If we try to exchange an income tax for a sales tax, we could easily end up with both. It would be a tragic irony if conservatives who favor a smaller government unwittingly provide the liberals with a comprehensive new taxing authority without eliminating the old one.


We must not lose sight of the commendable motives behind the sales tax. Its supporters want a tax code that does not interfere with economic decisionmaking, minimizes the paperwork burdens on the taxpayers, limits the size of the federal government, avoids excessive taxes on savings and investment, and is straightforward and fair.

For all the above reasons, however, the sales tax is not likely to achieve those goals. The flat tax, however, will do so. By placing a single tax rate on all income, it will not distort economic decisions. Citizens will be free to spend and invest their money as they see fit without taking tax considerations into account. The paperwork burden, for most taxpayers, will be reduced to filling out a postcard-sized tax return. Americans will get an honest bill and know how much their government costs them. Savings and investment income will be taxed, but only once. The punitive double taxation of savings in the current code will be gone. The flat tax meets the tax-reform criteria -- it is simple, fair, and pro-growth.

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