Tax me now, AND tax me later

One of the tax reform ideas that has apparently gained a following is the national sales tax.  (Some are also calling it the Fair Tax, but I'm not so sure "fair" is an accurate description, so I'll keep calling it the national sales tax.) 

It's reasonably easy to find lists and discussions of the pros and cons; Wikipedia is a decent starting place, but here's a short summary of what you'll usually see.  (Hint: it's missing my big objection, which I'll explain later): 

Possible advantages of a national sales tax:
• No federal taxes are deducted from your paycheck;
• No savings are taxed;
• Consumption is taxed when you spend the money;
• The 23% sales tax rate makes the cost of government very visible;
• No more IRS.
• A "prebate" makes it progressive.

Possible disadvantages of a national sales tax:
• It might prove difficult to collect, esp. in states with no sales tax today;
• It could be easy to evade;
• It might reduce retail sales;
• It might not be progressive enough to satisfy some;
• Future politicians might reinstate the income tax;
• It could increase the size of the underground economy.

Those points by themselves are enough for a lengthy debate, but did you notice what's missing from the list?  It punishes savers—specifically, those who have already been saving.  That's a show-stopper for me; if you've been a disciplined saver, it should be a show-stopper for you as well. 

In a nutshell, here's what happens: Under today's system, many people choose not to spend all of their net take-home pay.  For example, if you have a savings account at your bank, or a Roth IRA, you are one of those savers who paid federal tax on your income, then took a piece of what was left and put it into a savings account.  But now, if a national sales tax suddenly replaces the income and payroll taxes, those "after-tax" dollars you thought you saved would all of a sudden become pretax dollars.  They'd be taxed a second time, as soon as you spent them.  Double taxation of your principal is what it would amount to. 

To illustrate...

Before the national sales tax:

After the national sales tax:

I went to the "Fair Tax" website and searched up and down for any provision that would fix (or mitigate) this problem, but had no luck.  If you know of anything I missed, please let me know.  For now, I have to conclude that the so-called Fair Tax is unfair to those of us who long ago formed the supposedly good habit of saving a little extra all along the way.

Proponents of the so-called Fair Tax should not assume I'll give their proposal much support until I know how they propose to fix the problem of double-taxation-of-principal.  Until then, a short way to describe what I think of it would be "tax-me-now AND tax-me-later." 

Comments

[Aaron]

Implement a new currency at the same time as the tax, where each Old US dollar would be converted to 1.23 New US dollars.

(See also the Euro)

[jp]

Steve,

I, too, have amassed a sizable post-tax nest egg and I fully understand your point. However, I'm willing to 'take one for the team' because the benefits of the consumption tax on our economy far outweigh the impact to me.

Eliminating the need for tax attorneys, IRAs, estate plans, variable annuities, etc. would be a huge benefit.

[jp]

Steve,

I, too, have amassed a sizable post-tax nest egg and I fully understand your point. However, I'm willing to 'take one for the team' because the benefits of the consumption tax on our economy far outweigh the impact to me.

Eliminating the need for tax attorneys, IRAs, estate plans, variable annuities, etc. would be a huge benefit.

[Jim]

Steve,

I believe that you are correct in that the FairTax proposal doesn't make a specific fix to the problem you've stated (double taxation of past savings). However, some of the supporting analyses of the fair tax say that prices would fall and/or wages would increase (since payroll taxes and corporate income tax would be scrapped). Also, you forgot to show the payroll taxes in your first diagram, the ones that employers pay that most economists agree lower your paycheck before you even see it.

Frankly, I'm a little surprised that you gave such a cursory treatment of the FairTax proposal. I understand the impact personally of double taxation, but I thought you'd at least give a little analysis in terms of its impacts on growth, its progressivity, and how it addresses the other issues that were mentioned for the other proposals.

You might also want to note that the 23% rate is a "tax inclusive" rate, i.e. stated like an income tax. At the register, it would be a "tax exclusive" rate of 30%, stated like a sales tax.

[Bob]

I'm opposed to this though I never considered Steve's objection....a very strong one, indeed.

My objection is that this is too radical from a psychological perspective. It's conceptually complex for most people. Yes, that's right. It may be touted as simple but the change is too dramatic.

I like a form of flat tax. Simpler
to grasp and easier to implement.

[Jim]

Steve,

1) I forgot to add that you did not include arrows in your diagrams to show how the gains and interest on your savings are taxed in each case. I know that you don't like to show too much information in one picture, but that seems quite relevant to discussing double taxation of savings.

2) There was also no discussion from the view of tax code simplification and the effect on compliance costs for business and individuals. I seem to remember that that was the key idea for this line of posts.

[Don Lloyd]

Steve,

Off the top of my head, this would only be a significant net problem if you had no traditional IRAs, appreciated stocks or gold, or other assets which would become tax-free, to blend in on new purchases.

That said, it is important to note that changes in prices will offset part (not all) of the tax.

Also, Aaron's idea to bring in a new dollar with the tax likely has merit.

Regards, Don

[James Dhimmi]

Great post Steve! I never thought of that post-tax savings problem before. Next week, do one of these advantage/disatvantage thingies about the Flat tax, then mix them all together for a more comprehensive tax reform advantage/disatvantage thingie.

[Ironman]

Last summer, Greg Mankiw ran the numbers on his blog comparing the effective outcome of an income vs a consumption tax:

http://tinyurl.com/yponev

From which I constructed the following tool to do the related math:

http://tinyurl.com/yo6ldl

While the current tax code provides an incentive in the form of tax-deferred savings, that's really a second-best solution (increased time and hassle costs, special accounting, etc.) for getting at what you really want (increased tax-free savings). Here's how Mankiw put it:

"... a consumption tax taxes current and future consumption at the same rate, whereas an income tax in effect taxes future consumption at a higher rate than current consumption.

"The bottom line: Both consumption taxes and income taxes discourage work, but income taxes discourage saving as well. "

[Jim]

Bob,

I'm not sure how someone can be smart enough to fill out a 1040 but lack the smarts to figure out a sales tax. Also, under the FairTax proposal, retailers would be the ones calculating and submitting the tax returns, so the burden of the thinking wouldn't be on most consumers.

James Dhimmi,

Steve already did a posts on flat tax systems. Look in the July 2007 archive for one on the single rate flat tax and one on a dual-rate system.

[Bob]

Jim:

Where did I state anything about the fair tax and intelligence? I stated that it was a complex concept from a psychological perspective - it is a radical change.

Reading the comments here I'm more convinced than ever that explaining this to the general public would be a stretch.

A flat tax, on the other hand, is a very simple concept and the postcard sized form should be relatively easy to explain.

BTW, I don't buy for one second that, by making the 23% tax transparent, it will change the federal governments spending behavior. These people are beyond redemption.

[workindev]

It doesn't seem like it would be too hard to figure out what your basis is on those post-tax accounts, and issue tax credits towards the new consumption tax to make up for some or all of the double taxation.

[Bob]

"It doesn't seem like it would be too hard to figure out what your basis is on those post-tax accounts, and issue tax credits towards the new cosumption tax to make up for some or all of the double taxation."

See, this is what I mean. Not to dump on workindev but please don't tell me this simplifies things.

[JBL]

1. William Gale over at http://www.taxpolicycenter.org/ has done a lovely little analysis that in order to remain revenue-neutral, the sales tax rate would have to be at least 31 percent, and probably higher. The 23 percent figure uses several unrealistic and mutually contradictory assumptions.

2. I have seen another study, can't offhand remember where, that indicates that almost all of the "boost" from a national sales tax (to future savings or wages or whatever) would come from this one-time double taxation of existing capital.

3. The main problem with the current tax code is its monstrous complexity. It doesn't matter what the basic rate structure is if almost nobody ends up paying the basic rate. An income tax is theoretically no more complex than a sales tax, and is in some ways simpler. We have complicated it by adding thousands of special deductions and credits. The argument that a sales tax would be simpler assumes that there would be no similar tinkering with the sales tax - no exemptions for homes, school supplies, certain food items, "economic development zones", nothing. That's not a realistic assumption.

4. Traditionally, the National government in the US uses income taxes, State and Local governments have different combinations of income, property and sales taxes. One of the difficulties in establishing effective democracies in the developing world is that decentralized government effectively requires smaller political subdivisions to have their own sources of revenue, independent of the National administration. The US would not encounter many of the difficulties faced by the developing world, but there is considerable difference among the states in their approach. Replacing the National income tax with a National sales tax would conceivably complicate the issue. It would certainly decrease the options available, since the states would only be able to tweak sales and property taxes, instead of all three, unless a state wanted to implement its own income tax separate from the Federal government, which would counteract the reduction in paperwork at the Federal level.

[workindev]

"See, this is what I mean. Not to dump on workindev but please don't tell me this simplifies things."

It really isn't complex. It would be a one-time credit assessment on your current after-tax cash balances. It would be no harder than it is to calculate capital gains today, and it would be a one time event.

Don't get me wrong - I'm not exclusively in favor of a consumption based tax. I'm in favor of any taxation method that makes it more efficient and more fair to everybody who pays, so that we can pay the least amount of taxes while still funding the growth-promoting services that the Government provides. I think that both the "fair tax", and a flat tax fit this bill.

[Yevgeny]

The problem that Steve raises with existing savings and the "fair tax" would make it a non-starter for me.

Another problem is that the implementation of the "fair tax" is that it has the potential to cause tremendous economic dislocations. In the months leading up to the introduction of the "fair tax" people would be stock piling goods to avoid the coming 20+% price increase. Then after it is implemented people would strongly resist buying anything for as long as possible. This would cause a massive boom followed by a subsequent bust.

A true flat tax is a better alternative. By this I mean one rate with no deductions for anything. I would also tax government benefits after a one time adjustment to offset the initial flat tax rate. If people want to pay more tax they can vote for it but there would be no more increasing taxes for the other guy.

[Bob]

I'm with JBL and Yevgeny on this. I'm not so sure we can really define fair to everyone's satisfaction but we can get close and for heaven's sake, simplify the darn thing.

Hhhhm. Oxymoron coming. Government simplicity.

[Adam]

Maybe I missed discussion of this, but the Fair Tax also does away with taxes on capital gains. So the "double-tax" that Steve talks about would at least be partially offset by the fact that capital gains distributions will no longer be taxed like they would in the current system, no?

[Aaron]

I would also suggest any tax reform move the date of tax season to around one week or so of national and state elections. I would guess that would bring a lot more "economic" thinking to our voting public.

[Aaron]

I have another question: would such a tax help exporters? In most countries that use VAT, those are rebated for anything exported (while imports have to pay VAT upon sale)

For the effect of boom/bust, I am sure we can see similar taxes implemented in other countries and what happened. Was it the GST tax in Canada that also caused uproar? I can't remember.

[Ian]

Naysayers railing against the FairTax become, ipso facto, defenders of the an INCOME TAX system. Prof. Larry Kotlikoff believes that the current tax system IS bringing the country to nothing less than an "economic meltdown (*)" by virtue of the invisibility of actual taxes paid. If Americans do not understand the true cost of their government, they're unlikely to hold Congress accountable - thus the enabling mechanism to continued profligate spending.

Even with the foregoing notwithstanding, do FairTax naysayers really believe:

• Workers love having their pay confiscated, hourly, through gov't withholding and don't mind getting their money back by involuntary servitude - to the tune of 50 hours/year (on average) - preparing an annual tax return?

• That certifying the number of persons in your family (annually, and, ancillarily, upon change in household) is an abrogation of our freedom - more intrusive and complex than filing a tax return every year subject to threats and intimidation by theIRS.

• It's better to have theIRS fishing through citizens' income transactions (complete with audits, interest, penalties, and threats against individuals, families, businesses as well as confiscation of their homes, property, and bank accounts) rather than - Gawd forbid - issuing a gov't check to an individual (while pretending that Social Security payments disbursement logistics really can't work for "prebates")?

• That an monthly advance tax rebate is the same thing as "being on the dole" ? (Only lobbyists, special interests, and business deserve "handouts" ? - the politician gets a payoff from a lobbyist, the lobbyist gets a payoff from its client, and the citizen gets higher taxes and/or prices that pay for it all.)

• "Hidden taxes" in higher prices are fine because they're not "taxes," per se? (Hey, forget that families are really paying business's costs for complying with a business income tax code - staff, consultants, submittals, etc.)

• It's far better to have a gargantuan tax collection "service" in Washington, than to have 50 decentralized, smaller, leaner state collection agencies collecting taxes from fewer sources?

• That the work by notable economists (paid tens of millions of $'s by Americans for Fair Taxation) doesn't carry weight because it was paid for by private funds instead of some gov't / quasi-gov't enterprise?

• That FairTax's backing by many economists (**) doesn't carry any weight because (the Brookings') Wm Gale's testimony before the President's Commission on Tax Reform is - somehow - above all that?!

(NOTE: The Commission/Gale made up their own "consumption tax" requirements, as if that constituted a legitimate rebuke of the FairTax plan. Dr. Kotlikoff has requested - but never received - Gale's technical "modus operandi" which would definitively explain just how Gale's conclusions can be reconciled with Kotlikoff's well-documented technical work (***).

(*) http://snipurl.com/meltdowninprogress (If what Prof. Kotlikoff is saying is true, timely replacement of the income tax with the FairTax consumption tax MUST HAPPEN SOON.)

(**) http://snipurl.com/econsopenletter (Lists every tax that FairTax will eliminate, together with the power they represent to pol's and lobbyists.)

(***) http://snipurl.com/taxpanelrebutted (No fair equating the Tax Panel's idea of a consumption tax with the FairTax plan.)

It would appear that we have NO CHOICE but to ACT: http://snipr.com/scrapthecode

[Steve]

Jim, and all:

Fair points you brought up; the national sales tax will supposedly simplify the system, according to its proponents, and that would be a big benefit. It could be debated until we're all blue in the face, but there are only two ways to find out for sure -- one is the way it's always done, the other is the way I wish it could be done.

(Method 1)
All or nothing. Debate until the best debaters win, then (if that's the NST side), change the entire nation over to the NST -- and find out subsequently all of the effects, good and bad, small and large, that nobody could think of during the debate. That, by the way, is what always happens whenever a new idea is tried in the real world. With luck, the discovered good news would neutralize the discovered bad news; without enough luck, the bad news would burden several generations. (The GI Bill was one of our lucky guesses; some of the Great Society laws were the other kind.)

(Method 2)
Test markets. Try it in a small way, in maybe two or three states who'd like to volunteer (one with a sales tax collection structure already in place, one without). Set up the laws so that if certain expectations are not met after x years, the test would automatically expire. That kind of small, real-world experiment would reveal most or all of the good news and bad news nobody could think of during the debate. This would take some creative thinking by constitutional lawyers, given that the feds would temporarily not be treating all 50 states "equally" -- but the Louisiana Purchase was unconstitutional, and we did that one anyway, so I have confidence that the right minds could think up a way to make the test-market approach seem sufficiently constitutional.

Method 1 is how Capitol Hill does everything, and it's how we get stuck with near-permanent bad laws. Method 2 is widely used by the private sector to limit the losses from seemingly good ideas that can't cut it in the real world, and also to identify the few gems among a large group of seemingly good ideas.

Maybe I'm dreaming, but wouldn't it be nice if we could test-market things like the NST and national health care -- to see if they live up to the politicians' promises *before* the laws become impossible to back away from?

[Bob]

Steve becomes the voice of reason again with a very rational suggestion...one that is proven in the private sector.

I had to chuckle, though, at Ian's view that somehow we can hold Congress accountable. Exactly how we do that when these jackals are the very people that write the law is beyond me.

[mysticaltyger]

Good point. I can only hope you added your argument against the national sales tax to the wikipedia article!!!!

[rg]

I am living in France where we already have a national sales tax (VAT) of 19.6%. This is on top of national and local taxes and on top of national social security and on top of taxes on property (house).

If you guys can pull off 23% and no other tax I would say chapeau.

Btw the average family of four is not worse off in France than in the US.

rg

[John F. Opie]

Hi -

Uh, I can't believe that no one has mentioned that a national sales tax or VAT is regressive, i.e. those with lower incomes pay higher tax rates that those with higher incomes.

What people are missing is that consumption is only a part of expenditures. Those with high incomes use proportionately less of their income for consumption at any given time, while those with small or limited incomes use virtually all of their income for consumption purposes.

Sorry, but the only thing a VAT does is to reduce the quality of life for people with low incomes. I saw that one proposal pointed to a 31% VAT to be income neutral: that means that a $10 item now costs $13.10, or that a $100 item now costs $131. Maybe you and I could shrug at that, but go talk to someone living on a fixed income and tell them that you're going to raise all of their prices by 31% and see how they react. They'll either have to do without, or buy goods that are substandard because they can't afford any different.

They're not earning enough as is to actually pay income taxes, but now y'all want to tax them to give yourselves a tax break?

Now that's just vile.

Now a flat tax, that's a different story. But that's not what we're talking about here, is it?

Oh, and I dare say that this sort of turns a lot of federalist sentiment on its head: while state and local taxes may seem to be small, I can't imagine that you'll find the consensus to get states to drop their rights to tax for the promise that the Feds will fairly divide up the pot. If you think that can happen, then you really, really need to review how the Federal government and state governments actually do the dividing up of some of the revenues: you'll see that no one is happy with it.

Further, and this is really a stupid result, you're taking away flexibility of local and state governments to implement their own economic development policies. If you think that the Feds are better at such stuff than local governments, then I really want what you're smoking: if it wasn't for tax breaks and similar incentives, communities couldn't compete for business startups and relocations nearly as effectively as they do.

The best thing that ANY country can do is to get RID of VAT: it's regressive and punitive for low-income consumers, and makes it harder for them to save and then invest to get out of poverty...

And before anyone jumps, I live in Germany with a 19% VAT and have a number of friends on very limited incomes. They hate VAT with a passion, and don't understand why they have to pay 19% of what little money they have so that it can be squandered by the German government.

[John F. Opie]

Oh, and exactly how is a "prebate" going to work? Does a low-income person get a special credit card to pay with, permanently marking them as low-income consumers? Show me how it is supposed to work: I cannot see how it does...

...and having people buy things and then apply for rebates means delays in money transfer, making low-income consumers dependent on how efficient the government would be on getting them their "rebates". You really think that the government can be efficient in such a thing? Not to mention how ripe this is for abuse: if you want to buy something and the VAT is 20%, then find some poor guy and give him 10% for him to buy it, you save 10%. Don't think that this isn't gonna be a problem???

[Mike H]

John, I'm not a proponent of a sales tax, but I thought I'd clear up that problem for you. The prebate would work by giving every person in the country the same amount of money every month or so and that is supposed to take care of the taxes up to the poverty line (not that the poverty line is a good indication of poverty in my opinion, it should probably be increased by at least 50% to be more realistic)

[John F. Opie]

@Mike H -

Ok, but basically that means you are simply giving out a base income to everyone, meaning that you are also giving it to Bill Gates.

That means for low-income level folks, you are giving them money to take it away from them later; for high-income folks you are giving them money that you don't take away from them.

All you are doing is move the axis from 0 to whatever level the income is determined to be, without changing, however, the fundamentally regressive nature of the tax. You can hide it by giving low-income people money to avoid them really noticing how much it hurts them, but hey, here's a more radical idea: don't tax them at all, like they aren't taxed right now (income tax).

Makes a lot more sense to me, and you avoid giving bureaucrats and politicians control over how people spend their money (which you do by differentiating consumer goods types, varying the tax appropriately: hence you can lower tax on "good" things like food and medication, and raise them on "bad" things like gasoline, single malt scotches and bags of trans-fat potato chips.

Of course, once you give politicians that sort of power, then they will start to play with it: imagine a government where they decide that red meat is bad for you and tuna fish shouldn't be sold because of the dolphins killed. The sales tax on these could be changed to 50% in order to discourage their purchase, punishing those who have a different opinion.

And don't think things like that don't happen...

[Ken]

I'd only support the national sales tax if the appeal of the 16th amendment is tied to it.

In fact, forget the sales tax, just repeal the 16th.

[Geoff]

It's a wonder some of the misconceptions folks have about a consumption tax. Removing all the embedded taxes from prices because of corporate tax, extra gas tax, compliance tax, etc would immediately lower prices to help off-set the sales tax. The prebate allows us to argue "effective tax rates" which mean people living at incomes where they basically consume all their income will have effective tax rates of zero while the wealthy will have effective tax rates essentially that of the consumption tax rate. I liked the comment about "taking one for the team" as far as double-taxing savings because people like me who are just starting out would benefit immensely from a consumption tax and the likely economic outcomes. We would produce 10 fold more than what you "lose" by paying a consumption tax on your savings. Plus, nobody will pay any taxes ever again on their savings. It will encourage people to save and produce rather than spend and consume. Also, I understand the concern about the Feds possibly reinstating an income tax in the future (especially with Democrats at the helm) but you must understand that for HR 25 to be signed into law, the entire country would have to vote out those representatives who aren't friendly to consumption tax and replace them with FairTaxers. A tax revolution of that magnitude would most certainly culminate in the repeal of the 16th amendment. Finally, the concern about the compliance costs of switching to such a system are completely unfounded. There are many many many more income tax payers than businesses that would be collecting the consumption tax, and if you read HR 25, it calls for a piece of the tax percentage to be reimbursed to the businesses who collect the tax to cover compliance costs. As far as the government's issuing of prebates, many welfare recipients already receive their entitlements via a check card, which seems to be the most modern and easy way to distribute earned money. The government would simply send out a questionairre to heads of household asking for the SSNs of all dependents and then issue a debit card to the head of household, and then debit it the appropriate amount monthly. Seems much easier than having to comply with a tyrannical IRS with W2s and such forms.