National Sales Tax: Why it shouldn't get a hearing

George Yin, currently at the University of Virginia but very recently staff to the Joint Committee on Taxation, presented the Dunwody Lecture at the University of Florida College of Law on March 24, 2006 on the question "Is the Tax System Beyond Reform?"  The lecture dealt with two questions 1) can a national sales tax substitute for the income, estate, payroll and corporate taxes? and 2) what obstacles to finding a suitable tax reform for our present system are presented in Congress?   I want to share with you the gist of his comments on the first issue--a national sales tax system.

This blog has often argued against a tax reform that would substitute a consumption tax for our current income and estate taxes.  Although consumption taxation could theoretically be made as progressive (or more) than the current system, I suspect that it would not and that the net result of a change would be that part of the tax burden currently borne by the upper 20% would be shifted to the middle class.

Yin's discussion of the problems with a national sales tax are worth bearing in mind as this perennial tax reform topic comes up again in Congress in the guise of H.R. 25, an ambitious bill introduced by John Linder (R. Ga.) to replace all of our current federal taxes with a national sales tax.  As Yin notes, Bush, and other national leaders have spoken in favor of the idea, and a 2005 book (deceptively called "FairTax") by Neal Boortz and John Linder hit the best seller list.  So the idea is around and continues to garner support in spite of its deep flaws.

What are those flaws described by Yin?  Try the following.

• Categorization problems.   The FairTax bill would tax only business-to-household transactions, and would not tax household-to-household transactions (such as sales of used goods between households) or business-to-business transactions.  That means that there will be significant opportunities for evasion by disguising a business-to-household transaction as one of the other types of transaction.  Given the difficulty we currently face in separating business and personal, even with a long-developed set of rules, one would expect this aspect of the system to result in significant tax evasion.
• Creation of a huge, new entitlement program and corresponding bureaucracy.  A national sales tax would be inordinately regressive, so the proposal provides for an entitlement of a rebate of the amount of tax that would have been paid on poverty level spending for the taxpayer family involved.  This means the creation of the largest entitlement program ever initiated in this country (about $600 billion annually), one that is based again on characterization of members of a household, a topic that is subject to considerable tax-evasive manipulation.  In addition, a national registry of eligible families would be created  that would have to be updated for every change (birth, death, adoption, divorce, marriage) to permit a new poverty spending level to be determined.  Privacy  issues and problems connected with administrability of a large new bureaucracy would abound.
• Farreaching shifts in the allocation of the tax burden.  Since all business-to-household transactions would be taxed, there would be a considerable shift in the way costs are apportioned among taxpayers.  All purchases and services provided by businesses  would be subject to taxation.  For example, a home purchase would be taxed, the insurance on the home would be subject to tax, the mortgage transacction would be subject to tax, each of the legal, accounting, real estate and other services in connection with it would be taxed.  Financial service payments (depositing money without interest is essentially payment of a fee through foregone interest) would be subject to tax.  These costs, especially on particular transactions like house purchases, could become prohibitive for lower-income Americans and difficult for middle income taxpayers. 
• Inconsistent treatment of state, local and federal government.  Government services and goods (state, local and federal) would be taxed, else there would be a distortive shift from private to government services.  Fees for park entrances, for example, would be increased by an additional amount at the national sales rate.  But each family would also need to be taxed on the government services of national defense, police and fire protection, clean water, Center for Disease Control, Food and Drug Administration protection, highways, road safety and other government services from which families benefit.  How calculate that?  It would be difficult, so the FairTax proposes that government itself would pay a tax on everything it provides (including compensation of employees).  But, as Yin notes, the FairTax book pulls a fast one here.  It treats the tax the government pays as a way to reduce the overall national sales tax rate, but forgets that it will need to increase the revenues to the government to provide enough money to pay the tax.  Shame on Boorst and Linder.
• Noncompliance.  In the current system, there are about 150 million taxpaying households and businesses.  With a fairly high proportion of honest taxpayers, a few noncompliant taxpayers do not destroy the tax collection system.  In a national retail sales tax system, there would be only 10 million retail businesses (plus governments) responsible for paying all the taxes.  These are today the least compliant of all taxpayers.  That does not bode well for the ability of the system to collect taxes due.  Yin calls that a "concentrated pressure point for evasion."
• Unfair distribution of the tax burden.   The overall effect of a national sales tax would be to ease the tax burden on the super-rich, and increase the tax burden on middle-income taxpayers.  And without an income tax, Yin points out, the government might well not even have the data needed to determine who is in the middle class, even if it decided to increase the cash grant to help alleviate that burden (if it could figure out how to get the cash with which to do so).
• Exorbitant rate requirement.  Perhaps the most telling defect of the national sales tax proposal is the misinformation about what rate would be necessary for a revenue neutral system.  The FairTax book estimates a rate of 34%.  But the FairTax proposal assumes revenue neutrality with future tax changes that haven't yet been made (making Bush's 2001-2005 tax cuts permanent), thus reducing the amount of revenues needed.  Second, the FairTax book counts governmental taxation payments inconsistently to reduce the needed rate of national sales taxes (see above).  Third, the FairTax book assumes no noncompliance, even though it is estimated that noncompliance is especially high for the retail sector that the proposal relies on to collect taxes (see above). After Yin considers all of these factors and more, he cites the President's Advisory Panel on Tax Reform's estimates that the rate for the FairTax proposal would have to be more than 100 percent to be revenue neutral!  So on a $200 lawnmower purchase, the tax might be $225 or more, in addition to the purchase price.

The impact of such a national sales tax system on lower-income Americans and senior citizens living on fixed incomes would likely be catastrophic.  Let's hope that the 50 sponsors of Linder's bill come to their senses before this proposal gains momentum.