Tuesday, February 21, 2012

Snared by the "Fair Tax"

There is a deceptive tax reform plan that is becoming increasingly popular among American conservatives and quasi-libertarians. It goes under the propaganda term “The Fair Tax.” The term “fair tax” is a snare to trap the economically unsophisticated public into believing that sales taxes are better than all other taxes, including a tax on land value.

The proposal is to replace all current federal taxes with a national sales tax. Each family would receive a “prebate” money amount that would offset a portion of the tax, to make it less regressive, less burdensome on the poor.

The stated purpose of the shift to a national sales tax is to promote more savings and investment. Indeed, an income tax penalizes savings by taxing income from interest and dividends. By reducing the yield of savings, an income tax reduces the compound growth of the savings, making people poorer when they retire. However, the current U.S. income tax shelters savings yields in IRAs (individual retirement accounts), employee savings plans such as 401k and 403b, and self-employment savings sheltered accounts. Thus much of savings can already grow free of taxes, and a Roth IRA or similar plan also does not tax the funds when they are withdrawn. Moreover, there are generous tax savings such as accelerated depreciation available to enterprises that invest in capital goods.

While a tax on income penalizes savings, a tax on purchases penalizes borrowing. If one buys a car for $20,000 and needs to borrow the funds for the purchase, a $10,000 sales tax forces the buyer to borrow $10,000 more, and then pay interest on that extra $10,000. Since for the whole economy, borrowing equals savings, and the economy depends heavily on credit, there is no good economic reason to favor savings over borrowing. Indeed, what benefits investment and consumption is borrowing; savings that just sits there does nobody any good. other than a temporary parking place for money.

Contrary to the claim that taxing consumption stimulates enterprise, a national sales tax would shut down many small firms and perhaps also some big ones. This due to what professor Mason Gaffney calls the “quantum leap effect.” Businesses that sell to the global economy cannot raise their prices to pass on the tax to customers, so the tax eats into their profit, and if they were making only a normal profit or less, they will no longer be profitable, and shut down. A national sales tax, on top of state sales taxes, will create a quantum leap downward of land uses, shifting land use to enterprises that can pass on the tax, but which generate less output and employment.

Without a federal income tax, the U.S. states that have income taxes would most likely also switch to a sales tax, since state tax systems piggy-back on the federal tax. The stated “Fair Tax” rate would be 23 percent, and if the state sales tax rate is, say, 17 percent, the combined tax rate would be 40 percent. But that does not take into account the massive tax evasion that would occur. There is already substantial tax evasion for state sales taxes, especially on mail order goods. The higher the sales tax rate, the greater the tax evasion. Rather than a 40 percent combined rate, it might be around 50 percent to make up for the evaded tax and the even greater evasion caused by the increase in taxes to make up for evasion.

Another problem with the snare tax is that business-to-business sales would be exempt from taxation. That opens up a wide avenue for tax avoidance. Start a business and make your purchases for business purposes, and you have no tax burden. If you buy a car, for example, it would be for your business as a writer. With no income tax, you can make up income by paying your friend to write blogs while he pays you. Have lunch with your friend, and the meal is a business expense. If the government considered this tax evasion, it would respond with even more severe tax enforcement, requiring receipts for all purchases, and audits on inventory and personal property.

Taxes on both production and consumption have what economists call a “deadweight loss” or “excess burden.” A sales tax has as much excess burden as a sales tax. Moreover, a national sales tax would subsidize land values as much as an income tax. The desired public goods provided by government make locations more attractive and productive, raising the land rent and land value. When the taxes are paid by others, landowners receive a rent and site value subsidy.

The advocates of a national sales tax claim that it is the best tax, both more efficient and more equitable than all others. But they have no argument as to why a sales tax is better than a land value tax. A sales tax interferes with free trade, while a land-value tax does not impose any cost on trade. The snare tax advocates have a good point in saying that replacing the current multiple taxes with just one national tax would reduces tax costs, but a single tax on land value would do so even more. In rejecting a land-value tax, the snare tax advocates are not just violating free trade, but promoting subsidies to land value, whether deliberately or inadvertently.

The economic analysis of the snare taxers is faulty. The snarists claim that since income taxes raise prices by the amount of the tax, their replacement by sales taxes would leave prices unchanged. But much of the burden of taxing wages is on labor as well as on consumers. To the extent that wage taxes reduce wages, the taxes do not get passed on to buyers. Some of the burden of income taxes is also on landowners. To the extent that taxes are at the expense of rent by reducing land rent, it does not get shifted to consumers. Income taxes raise the prices of goods by less than the tax amount, so a sales tax that is directly on buyers could well substantially increase prices.

The funny thing about sales taxes is that probably most of the tax revenue is paid from land rent or at the expense of land rent. On the consumer side, landowners buy stuff out of the income they get from rent. On the production side, much of the “producer surplus” is land rent, so what is paid as a sales tax consists of funds that otherwise would have been paid as rent. But by taking the rent indirectly, via a sales tax, the government imposes a high excess burden, whereas if the same rent were collected directly, by a tax on land value, there would be no deadweight loss. The unnecessary deadweight loss has to be included as a cost of the snare tax, but the economically ignorant are snared into thinking that a sales tax is the best tax, because they have not learned how to analyze economic reality.

Another problem with the snare tax is that it is not easy to distinguish investment goods and “consumer” goods. Suppose you want to put in a new roof on your house. Economically, this is an investment. But if you are not set up as a business, the roof will be subject to a huge sale tax as a “consumer” good. The tax will end up stifling investment. If you do set up a business because you sell alfalfa sprouts you grow in your house, you will be audited and put in prison for tax evasion.

Economically, all goods are capital goods and are investments until they are consumed, and by taxing some goods and not others, the snare tax will be complex, evaded, and require police-state enforcement. Moreover, since services will be included in the sales tax, there will be a large temptation to pay the barber only $5 and give a $15 tip, as the tip will not be a taxable payment but a gift, unless the tax auditor says otherwise and levies to both a big fine.

Finally, there is a big transition problem with the snare tax, as those who are retired have paid high income taxes all their working lives, and now that they are consuming their savings, they will be subjected to high consumption taxes. As a practical matter, the snare tax is politically difficult if not impossible to implement because of the opposition by retired seniors.

Mason Gaffney has shown that historically, candidates and officials who have promoted sales taxes have committed political suicide. But sometimes instead of regicide, the country adopting high consumption taxes committed economic suicide, as did for example old Russia prior to World War I or France before its revolution.

We now have quasi-libertarians being snared by the national sales tax. Their sales-tax candidates may well attract the snare-tax crowd, but in the end, the snare tax will end up crushing the libertarian movement, as most folks have the right economic instinct to suspect that very high sales taxes cannot do them any good.