Taxing Times

Squabbling between flat taxers and sales taxers could allow the Internal Revenue Code to escape unscathed.

Daniel J. Mitchell from the August/September 1997 issue

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* Is it realistic to believe that a sales tax would pull in revenue from the underground economy, as supporters often assert? Neither the flat tax nor the sales tax is likely to have much of an impact on the underground economy, for the simple reason that lawbreakers do not want the government to know what they are doing. A prostitute is not going to pay a flat tax on her income, and she is not going to collect a sales tax on her services. Sales tax advocates make a big deal about how she would pay a sales tax when she buys her leopard-print hot pants. But that's much like saying that her customers would pay a flat tax on the income they use to obtain her services. There is an equal amount of leakage in both tax systems.

* If the sales tax becomes a value-added tax, which taxes the "value added" to a product or service at each stage of the production process (with the result that the final effect on the retail price would be the same), would supporters of the sales tax back away? Because it is much simpler to administer and much less susceptible to evasion, lawmakers would be tempted to impose a VAT rather than a national sales tax. Free market supporters traditionally have been skeptical of a VAT, viewing it as a hidden tax that would become a money machine for politicians. Lawmakers could mitigate that problem by requiring that the VAT appear separately on bills and receipts (much like the sales tax) rather than be included in the list price of a product. Nations as diverse as Japan, New Zealand, Canada, and Mexico have taken this route. Sales tax proponents need to be clear about what conditions, if any, would have to be satisfied before they would support a VAT.

* Is it an overstatement to argue that the sales tax would eliminate the IRS? Just as it is wrong to claim that a sales tax (or, for that matter, a flat tax) would collect large amounts of money from the underground economy, it is silly to think that any tax system could exist without a tax collection agency. Yes, a sales tax would allow a huge reduction in the size of the IRS (as would the flat tax), but it is an exaggeration to
assert that the government will somehow seize more than $1.5 trillion from the economy without revenue agents snooping around. And it's misleading to claim that the IRS would be abolished simply by giving it a new name or shifting tax collection to the state level.

* To prevent giving government a big
competitive advantage over the private sector, sales tax supporters would impose a payroll tax, paid by the employer, on government wages. Barring a reduction in the gross pay of government workers, this would boost government spending. With both parties worshiping at the shrine of budget balance, how would this spending increase be financed? Many believe that all prices will rise by a certain amount following the adoption of the sales tax, so it is only logical to expect the cost of government to rise by a similar amount. Others believe the elimination of imbedded income taxes will cause prices (excluding the sales tax) to fall and that this price reduction would include falling wages for government workers. Despite the merits of these arguments, opponents would label the increased spending a budget buster. The alternative--cutting the pay of government workers--might create even greater political obstacles.

* Current sales tax proposals include a universal rebate to protect the poor, but how likely is it that the public would support a plan that has the government send checks to Bill Gates and Donald Trump? And if lawmakers decide that some people should not get the rebates, wouldn't the government need income calculations to determine eligibility? Sales tax supporters will argue, as have I, that the rebate is a sound proposal and that it serves the same purpose as the flat tax's family allowance. In the rough-and-tumble world of politics, however, this could be a very hard position to defend. If this battle cannot be won, the government will maintain the authority to monitor peoples' incomes, thus undercutting one of the strongest reasons for adopting a sales tax. And such a program could be highly susceptible to fraud. The closest analogy we have in current law is the Earned Income Tax Credit, which the government admits has an error or fraud rate exceeding 25 percent.

If enacted as its supporters envision, a national sales tax would yield spectacular benefits for the American economy. Like the flat tax, it would increase after-tax incomes, stimulate job creation, boost savings, safeguard civil liberties, and reduce political corruption. The key question, however, is whether the sales tax can overcome the political obstacles outlined. The flat tax, of course, faces political obstacles as well. The home mortgage and charitable contribution deductions have been thorny issues. Defenders of the status quo also have scored points by falsely claiming that dividend and interest income would be tax-free in a flat tax world, and they have had some success making the same argument about capital gains. There are other politically sensitive issues that haven't yet been exploited by opponents of the flat tax, such as the elimination of the tax preference for employer-provided health care.

On the other hand, the flat tax has been battle-tested. Not only has it been widely condemned by the left, it also was attacked by much of the Republican establishment during the 1996 presidential primaries. These attacks chipped away at the flat tax's popularity, but it still generates 40 percent to 65 percent support in polls (depending on how the question is worded). The sales tax, by contrast, attracts only about 30 percent support--a figure that might well erode during a negative campaign.

In the short term, proponents of the flat tax and sales tax should spend less time attacking each other and more time mounting a unified assault on the current system. Then, as we get closer to 2001, both sides should honestly assess the political landscape and unify behind the reform with the greatest chance of passing. The main objective, at least for those of us who believe in equal treatment under the law and who want a tax system that does not penalize productive behavior, is that one or the other of these good plans replaces what we have now.