Taxes & Spending

Tax Reform: Say It Is So, Mr. President

“It’s an interesting idea,” George W. Bush said last month of a federal sales tax proposal to replace the income tax system that annually confounds American taxpayers. Aides downplayed that “interesting idea” within 24 hours of Bush’s initially favorable comment. The reason? A misinformed tirade against the rumored sales tax proposal by John Kerry.

A federal sales tax would entirely replace the federal income tax, thus ending the Internal Revenue Service, audits, paycheck withholdings, and the drudgery of filing tax returns. Under a sales tax, workers receive all of the money they earn. Since funds are untaxed until spent, a sales tax does not discourage savings.

Kerry’s accusations, along with pleas from special interest groups intent on preserving their place of privilege in the world of tax write-offs, left a large paper trail of attacks on the idea of a federal sales tax over the last few weeks. The majority of these attacks cannot withstand the scrutiny of common sense, much less economic theory:

Fiction No. 1: A national sales tax would produce the “largest tax increase on the middle class in American history.”

The facts: Economic models indicate that current government spending levels would require a federal sales tax ranging from 17-23% (depending largely on whether Social Security taxes are collected through the sales tax or continue as a paycheck withholding). These figures vary little from the 21.4% overall effective federal tax rate for 2005. All federal sales tax proposals under consideration include a universal rebate, similar to the safeguard offered by the existing standard deduction. Most proposals set the rebate at, or above, the current poverty level. For a family of four, this means that no federal sales taxes will apply on the first $18,850 spent. Additionally, the abolition of the Internal Revenue Service (IRS) would lower federal spending by over $10.67-billion per year. This translates into an average yearly savings of $104 for each American taxpayer.

Fiction No. 2: Small businesses will be hurt most by a national sales tax.

The facts: Since a sales tax means businesses would no longer file income tax returns, estimates project the total cost of business compliance with a national sales tax at less than $5 billion per year. This is a distinct advantage, since projected tax compliance burdens on private firms run at least $100 billion annually under the current system. (Some analysts place the total at two or three times that amount.) This means that small business owners could reduce prices to become more competitive while expanding their own margins. Small businesses would be the first to benefit from customers with extra money in their pockets thanks to decreased tax burdens.

Fiction No. 3: Collecting a sales tax will place a stifling burden on retail sales businesses.

The facts: Administering a national sales tax would be no different from administering a state sales tax, a feat already performed by retail stores in 45 states and the District of Columbia. Mercifully, a federal sales tax ends the onerous task of preparing and filing taxes–a chore that robs Americans of at least 6.7 billion hours each year.

Fiction No. 4: Sales taxes on services are easy to elude and difficult to administer.

The facts: In addition to an income tax of up to 35%, self-employed service providers face a 15.3% payroll tax. Thus, due to its lower burden, a sales tax drastically reduces the incentive for such an individual to evade taxes. More importantly, even individuals participating in underground and black-market economic activities–people who formerly skirted their tax obligations–will bear their share of the tax burden by purchasing goods and services.

Fiction No. 5: A national sales tax will substantially increase the price of goods and services.

The facts: Currently, the prices of all goods and services offered by legitimate taxpaying businesses in the United States reflect the costs of the businesses’ tax liabilities, as well as the costs of tax compliance. Under a sales tax system, the tax rate will be lower at each step of production, and the compliance cost is virtually eliminated. This means the final price for consumers, even including the federal sales tax, will increase little, if at all, from current prices.

Over Labor Day weekend, comments from the Bush Administration that the White House is looking into a flat rate income tax came as a hopeful sign. However, until Bush and his aides embrace–rather than merely contemplate–a specific plan, there is no assurance that a meaningful debate over tax reform will take place this election.

Given the possible benefits of a federal sales tax, or even a flat tax, President Bush should stand in firm support of the idea. Considering a sales tax demonstrates that the administration recognizes the current income tax system is broken and desperately needs a comprehensive fix. The President should reconsider his quick dismissal of this “interesting idea.”


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