By Charles E. Price and Leonard G. Weld
Considering the Economics Instead of the Politics
Whenever a politician or economist says that the federal income tax system needs a major overhaul, people listen with hope and enthusiasm. The reality, of course, is that no system will be perfect, implementing any change will take time and money, and the current system is firmly entrenched. But times are changing. The current federal income tax system looks more out of date every year, and some alternatives look preferable to the current state of affairs.
A major contender is the national retail sales tax, which could level an increasingly uneven playing field for taxpayers; downsize the IRS by using parts of existing retail sales tax systems; and, with the right exceptions to the "one tax rate for everyone," keep the tax system from becoming regressive.
There is a growing sentiment among lawmakers and political leaders for federal tax reform. The stated objectives of tax reform include encouraging taxpayer savings, increasing fairness, implementing simplicity, promoting neutrality, and downsizing the IRS. Perhaps the most difficult objective to achieve is fairness. Past attempts at fairness have led to special treatment and exemptions for certain groups and increased the complexity of the federal system.
A number of tax systems have been proposed to reduce complexity and increase fairness. One such system, a national retail sales tax (NRST), would apply a one-size-fits-all tax rate to retail purchases of goods and services. What could be fairer and easier to administer?
Progressive, Regressive, or Neutral
The current federal tax system is a progressive rate system that applies higher tax rates as taxable income rises. To the majority of taxpayers, this system seems fair: The more you earn, the higher your tax rate. A major criticism of the NRST is that application of the same rate to each taxpayer creates a proportionately heavier tax burden on low-income taxpayers because they spend a greater percentage of their income on necessities than those at higher income levels. Many economists consider this regressivity (a relatively greater tax burden as income diminishes) to be an insurmountable flaw of both the NRST and a flat tax. But there are possible solutions--and many ways of viewing the problem.
The current federal income tax system is overloaded with provisions that influence taxpayer behavior. For instance, homeowners can deduct their mortgage interest payments and property taxes but renters receive no comparable benefit. Deductibility of charitable contributions encourages philanthropy. Corporations can provide their employees with benefits that are tax deductible for the employer--benefits not available to sole proprietors.
Moreover, certain kinds of behavior are rewarded by various tax credits:
* Alcohol fuel credit
* Low-income housing credit
* Enhanced oil recovery credit
* Indian employment credit
* Orphan drug-testing credit.
These deductions and credits compound to create a tax system that is far from neutral, meaning a tax that does not favor certain transactions, entities, or industries. An NRST would be neutral in all of these areas.
Making the NRST Work in Theory
Some economists suggest that the federal government could piggyback an NRST on the state sales tax systems. However, because only 45 states have a retail sales tax, the federal government would have to underwrite a tax administration system in the other five states or administer an NRST itself. Either system would eliminate compliance costs for the taxpayer/consumer because individuals would not file tax returns.
The government would send tax forms to registered businesses, which would then remit their tax payments on a weekly, monthly, or annual basis, depending on sales volume. Therefore, providers of retail goods and services would bear a greater compliance cost burden than wholesalers and manufacturers. Still, remitting taxes this way would require less aggregate effort than filing 1040s and the associated schedules.
A federal agency would need to police, administer, and collect the NRST. This would include issuing rulings, procedures, and other formal announcements. Most commentators agree that administration and collection costs for an NRST would be less than the current federal income tax system, and the size of the IRS could be greatly reduced.
Employee benefit administrators and pension plan representatives fear that tax reform would eliminate the tax-favored status of those plans. These groups point out that businesses would have less incentive to offer these benefits if the tax deduction disappeared. Would employers convert amounts being paid to qualified plans into higher salaries? In any event, without tax-deductible, qualified retirement plans, employees would be responsible for providing for their own retirement and benefits, with the freedom to make their own investment and benefit decisions. There would be no tax on investment earnings and no withdrawal restrictions. Employees would be able to change jobs more easily because there would be no portability issues. Not a bad result all around. The disadvantage is that some employees would neither plan for retirement nor purchase adequate health insurance.
Another advantage of an NRST is that consumers are familiar with paying a retail sales tax and it does not engender the same hostility as the income tax.
In replacing the federal income tax with an NRST, capital gains, dividends, interest, rent, and wages would have no federal income tax consequences. Tax would be incurred only upon the purchase of a product or taxable service--hence the NRST's classification as a consumption tax. An individual who saves rather than spends pays less tax. The NRST applies only to final sales by businesses to consumers.
The Tax Base Issue
The current retail sales tax has almost as many versions as there are states. States may or may not apply sales taxes to food, medicine, clothes, automobiles, video rentals, and dozens of other categories. Most states exempt products subject to an excise tax. Therefore, although gasoline, tobacco products, and alcoholic beverages are not currently subject to sales tax, these items might be taxed under an NRST system.
A major question is whether to tax services. The thought of paying sales tax on food, prescription drugs, rent, utilities, health care, tuition, car repairs, movie tickets, funeral services, haircuts, and taxi rides might enrage some people. But when the tax base is narrowed, the rate must increase for the NRST to be a revenue-neutral replacement for the federal income tax.
The Tax Rate Issue
NRST supporters maintain that a rate of about 18% would allow for the repeal of the federal income tax. The Office of Management and Budget says that in fiscal year 1997 the federal government collected revenues of $1,579 billion. Using the 1997 fourth quarter estimate of annual personal consumption expenditures ($5,593 billion), a tax rate of 28.2% would have been necessary ($1,579 / $5,593) in order to provide the same amount of revenue. This is close to the 27.7% rate that the Joint Economic Committee (JEC) presented in a document based on 1993 data that reviewed the consequences of replacing all federal taxes with an NRST. The JEC document explained that the Department of Commerce personal consumption expenditures amount imputes a rental value to a taxpayer for living in a residence that the taxpayer owns. Deducting that value from the tax base raises the required tax rate to 32%.
Because individual and corporate income taxes account for only approximately 53% of federal budget receipts, perhaps a rate of 18% is feasible if payroll taxes, estate and gift taxes, all other government excise taxes, and borrowing remain the same (See the Exhibit).
Would People Save More?
Savings are critical to long-term economic growth: Domestic savings and foreign investment capital provide the funds businesses use for capital expansion.
Personal savings as a percentage of gross domestic product (GDP) declined from an average of 5.8% in the 1970s to 5.0% in the '80s, and to 2.7% in the '90s. In the first quarter of 1999--a period of great prosperity--personal savings reached a low of 0.5% of GDP. The last time the personal savings rate was negative was 1933, during the Great Depression.
Economists make two fundamental observations about income taxes and personal savings:
* Income decomposes into two elements: consumption and savings. Therefore, all income taxes reduce the amount available for savings.
* The more an individual saves, the greater the lifetime tax burden.
On the other hand, a consumption tax only taxes money spent for goods and services. Savings are not taxed and neither is the return on those savings, which increases the return on investment. The popularity and explosive growth of 401(k) plans indicates that taxpayers might save more and spend less under a consumption tax system. Tax-free saving may prove an even more powerful incentive than tax-deferred saving.
Economists do not agree whether a consumption tax such as the NRST would encourage savings. The increased rate of return might encourage individuals to save more, but for "target" savers (those saving a specific amount for retirement, college tuition, or a new car) the higher return would merely reduce the income needed to reach their target.
The Regressivity Issue
As noted earlier, many economists view consumption taxes as placing an unfair burden on low-income households. Applying the consumption tax to food and medicine would reinforce this perception. To be politically viable, a consumption tax may have to go beyond mitigating regressivity to the point of being as progressive as the current federal income tax system.
The federal government could reduce the regressivity of a consumption tax by--
* providing tax exemptions or low tax rates for low-income households. Under an NRST system, this would mean issuing some kind of tax-exempt or low-rate certificates to qualifying households, similar to the way businesses and nonprofit entities are allowed to purchase goods without paying sales tax.
* providing tax exemptions or reductions for products deemed necessities (e.g., food and medicine). Unfortunately, research shows that exempting food and medicine does little to alleviate regressivity, especially when lost revenue is recouped through a higher tax rate on other items. Economic research is inconclusive regarding the regressive effect of taxing services.
* increasing the availability of transfer payments to low-income households. These payments can take the form of payroll tax credits (assuming those taxes are still in place), monthly or quarterly refundable credits, additional food stamps, or an increase in other low-income assistance programs now provided by the government.
There is also the position that a consumption tax may not be regressive. Some economists maintain that when a country fully considers redistributing wealth through government programs, a consumption tax is less regressive than on first impression. The argument is that an accurate picture of regressivity must include government distributions as well as government collections. A full analysis would include payments made through government programs, including Social Security, Medicare and Medicaid, food stamps, and the refundable earned income credit. Taking these programs into account, low-income households may be less disadvantaged than they seem.
Regressivity might also be examined relative to lifetime wealth accumulation. An individual with significant wealth might have relatively low annual income resulting from lifestyle choices such as switching careers, returning to school, retiring, or rearing children. Such households may have accumulated considerable wealth before the low-income years. Because obtaining accurate data is difficult, economic analyses do not distinguish between wealthy low-income households and poor low-income households.
An NRST that does not tax business-purchased inputs provides no avoidance incentive for manufacturers. Businesses would need to register in order to receive exemption certificates for business purchases. Detecting individuals attempting to register as businesses in order to receive personal goods in the guise of business inputs would require a compliance program. Also, under an NRST, retailers might be tempted to retain tax collections for business or personal use. States with sales/use taxes have had to deal with both of these issues.
Under an NRST system, the retail tax evader would have a greater incentive to underreport gross sales: Because an NRST is based on gross sales rather than income, the would-be evader would reap a greater reward. This problem would probably be more prevalent among small service companies than large retailers.
To avoid economic distortions, business inputs must be purchased tax-free. If taxes were collected on business inputs, the purchase price of the end product would include all the prior taxes, which would then be taxed again at the final sale, creating a problem of tax "cascading," resulting in artificially higher prices for goods that use more inputs. Cascading would also encourage companies to integrate vertically as a means of avoiding input taxes, giving large companies an economic advantage over small companies.
An NRST system must have a reporting system for business inputs purchased that would support audit activities. As noted earlier, this requirement is essential to ensure that business inputs are not converted to personal use. Beyond requiring retailers to ask that the purchaser present a certificate, little help can be expected with enforcement. One alternative is to require businesses to pay the sales tax on high-price purchases and then submit the invoice for a sales tax rebate. This alternative, however, would increase administrative costs.
The transition from an income tax to an NRST is problematic. What should be done about after-tax dollars that have been saved? With no special provision for after-tax savings, those savings would be taxed again when spent. Senior citizens would be affected the most because they have the most savings and consume a large percentage of their income.
Also, companies with net operating loss (NOL) carryforwards and other offsets would need a transition period to take advantage of those earned tax breaks. However, with no business income tax or tax on business purchases, companies in these situations would need special accommodation.
Finally, an NRST would affect state income tax systems. Many states rely heavily on federal tax rules, definitions, and forms. States would need to determine the cost-effectiveness of expanding their state systems and continuing to collect income taxes or abandoning the state income tax in favor of expanded sales taxes. *
Charles E. Price, PhD, CPA, is the Charles M. Taylor Professor of Taxation at the School of Accountancy at Auburn University.
Leonard G. Weld, PhD, is chair of the Department of Accounting and Finance and E.H. Sherman Professor of Accounting at the Sorrell College of Business at Troy State University, Troy, Ala.
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