August 30, 2014

Is a National Sales Tax Really Fair?

Fair Tax

A progressive income tax threatens our liberty and prosperity. It punishes the productive by taxing them the highest amounts, reduces employment by increasing the cost of employees and reveals our personal finances and thus invades our privacy.

A popular suggestion is to eliminate the income tax and replace it with a national sales tax, called the fair tax. The idea is that everyone pays their fair share based on what they spend rather than what they earn. Taxing consumption rather than productivity would encourage saving and investment, in turn stimulating production and economic growth.

The national sales tax would fall between 23% and 30%. It could replace the income tax and the 6.2% employee portion of the Social Security tax.

If the income tax was eliminated, the Internal Revenue Service, as well as thousands of pages of the tax code, would be obsolete. You would not be required to report your personal financial information to the government, which would both protect your privacy and reduce falsification on tax returns.

Critics suggest that a national sales tax is regressive, favoring the rich. This criticism depends on how you measure rich, that is, what you use as a denominator. If you measure dollars spent per dollars of income, the tax is regressive. The poor spend a greater percentage of their income. Advocates try to address this issue by providing a prebate of taxes up to the poverty level.

But income is only one measure of rich. It measures your productivity and the value of your yearly labor. Advocates of the fair tax suggest this should not be the deciding factor of how you ought to be taxed.

Another measure of rich would be those who have a higher standard of living. Those who live rich would have to pay tax on whatever portion of their assets they choose to spend. For wealthy individuals who are spending amassed fortunes, the change would be much more progressive. Wealthy individuals may have little income and yet have a very high standard of living.

These are three very different measures of rich: accumulated wealth, annual production and consumer lifestyle. A flat sales tax is exactly in proportion to this third factor, a lavish consumer lifestyle. If you use dollars spent as your measure of rich, the tax is fair and exactly proportional so those who spend more pay more.

Claims of “fair” or even “regressive” or “progressive” depend very much on what is used as the denominator. You can argue that your lifestyle spending–lavish or frugal–is at least a measure of how rich you live. And it is easy to make the case that how rich you live should determine how much you should be taxed.

Taxing income decreases productivity. Taxing consumption will similarly decrease spending. Less demand for consumer goods will reduce prices and also consumer debt. Families will be encouraged to have capital to save and invest as the tax burdens are removed on investments.

Deferred consumption, money not spent, is the textbook definition of capital. And because a sales tax is a consumption tax, more people will defer consumption and have capital to invest instead. Money invested earns more money. Increased savings and investing help create a healthy country with better economic growth.

One benefit of eliminating a progressive income tax is that it can accidentally tax people it doesn’t intend to burden. Many economic incidents can artificially inflate your income for a single year, pushing you into the highest tax bracket. For example, selling a house in California is the easiest way to be part of the top 1% and get hit with tremendous taxes. With a sales tax, one year of extraordinary spending would at least be taxed at a flat rather than a progressive rate. Every dollar spent would be treated the same for tax purposes.

Tax evasion would still be a problem. Currently unreported income in the United States is estimated to be about $2 trillion. This is distinct from illegal economic activity. Moving the tax from an income tax to a sales tax may or may not change this dynamic. Contractors may be just as tempted to offer discounts if you pay in cash and promise to keep quiet about it.

Similarly, Internet sales and goods from overseas would need to have a sales tax applied. Otherwise online orders from foreign countries could be another method of dodging the tax. A foreign sales tax acts the same as an import tariff.

Tariffs were the main source of federal revenue from the founding of the United States until the passage of the Sixteenth Amendment providing for an income tax in 1913. The Constitution gave Congress the power to collect duties, imposts and excise taxes but prohibits taxes between the states. Proponents of the fair tax suggest repealing the Sixteenth Amendment and replacing it with a sales tax provision.

Although a sales tax would be better than an income tax, we might easily make do with just the constitutional provision for import tariffs if the government functioned with a smaller budget.

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About David John Marotta

David John Marotta+ is the Founder and President of Marotta Wealth Management, Inc. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)

Comments

  1. Luis says:

    America needs to collect more than just tariffs to fund DoD and protect our nation’s security from terrorists and others who hate us and want to end our world dominance. We’d be vulnerable to embargos set against us as a simple way of causing us harm. We can’t be dependent on foreign economies to keep ours raised. God help the Euro zone help us. No thank you!

  2. Doug says:

    Wouldn’t a decrease in consumer spending also hurt the economy? Businesses also grow when people want or have the ability to buy what they produce (not just from initial or subsequent capital being raised). If the tax code encourages people to hoard their money, rather than spend it on goods & services, wouldn’t this become a double edged sword?

    Maybe I’m missing something – help me out here.

    Love your articles as always, David.

    -Doug

  3. Dale Seng says:

    I like the idea of a tax that doesn’t provide an incentive against being productive, but much more importantly, I don’t like the idea of paying twice!

    What about the people who have already “deferred consumption”? They have paid the tax on the income already. If the country were to switch horses, then those who are entering retirement would have to pay again when they spend it? Since retirees vote, and this is a huge pocketbook issue with them, I doubt this idea will go very far. And as someone who has deferred consumption, I certainly hope it doesn’t! Or maybe they could write a few pages of tax code to get a rebate for “old savers”?

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