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

Imagine, if you will, a damsel in distress.

She has been captured by an evil ogre, who is dragging her into a dark forest for unspeakable purposes. Riding to her rescue are two gallant knights, each possessing strength, virtue, and courage. But both knights are so anxious to be the hero that they fight each other for the privilege of defending the lady's honor. They are so consumed by this contest that the ogre is able to sneak off with the damsel, giving our story an unhappy ending.

Unfortunately, the same thing may happen with tax reform. Economists have long argued that America's multiple-rate, loophole-ridden tax code penalizes productive behavior. The good news is that most Americans, including a surprisingly large number of politicians in Washington, agree that the current system stinks. The bad news is that advocates of change are divided between proponents of a flat tax and proponents of a national sales tax. (For an outline of the debate, see "Rewriting the Code," July 1995.) And just as the squabbling between the knights allowed the ogre to escape, any disunity among the tax reformers will strengthen the ability of special interest groups to defend the status quo.

Since congressional Republicans haven't decided upon a unified strategy for replacing the current Internal Revenue Code, flat tax and sales tax advocates will spend the next couple of years vying for the hearts and minds of Americans who want genuine reform. The flat tax advocates include House Majority Leader Dick Armey (R-Tex.), likely GOP presidential contender Steve Forbes, Citizens for a Sound Economy, and Grover Norquist's Americans for Tax Reform, while the Cato Institute and Citizens for an Alternative Tax System back a retail sales tax. Armey has introduced a bill that would replace the current income tax with a 17 percent flat tax. A proposal backed by Deputy Majority Whip Billy Tauzin (R-La.) and Rep. Dan Schaefer (R-Colo.) would replace the income tax with a 17 percent retail sales tax.

What makes this split particularly frustrating is that the flat tax and sales tax are virtually identical. Both would junk the current system. Both would restore fairness by taxing at one low rate. Both would eliminate all forms of double taxation, and both would wipe out special preferences. The only real difference between the two would be the collection point: The flat tax imposes one low tax rate on income when it is earned, and the sales tax imposes one low tax rate on income when it is spent.

In the long run, the biggest winner in the debate between the flat tax and the sales tax may turn out to be the current system. There is an obvious solution: Either sales tax fans have to rally behind the flat tax, or flat tax partisans must shift their allegiance to the sales tax. That transition should happen in the next year or two so that both sides are united and fully prepared for the tax reform battle after the next presidential election. The question, of course, is which side should give in. As a flat tax advocate, I clearly have some biases. Nonetheless, I have defended the sales tax in speeches, in the press, and in congressional testimony. I am perfectly willing to abandon the flat tax if there is compelling evidence that the sales tax is a more politically realistic way of achieving our goals.

But to convince me that the sales tax is better than the flat tax, supporters of the sales tax need to answer some questions. Their inability to answer these questions may suggest that they, rather than advocates of the flat tax, need to change horses.

* Since no political jurisdiction in the world has ever successfully replaced an income tax with a sales tax, why should we believe the United States is different? I see no plausible scenario in which a sales tax could receive 51 votes in the Senate, 218 votes in the House, and a presidential signature. The sales tax also has not fared well in public opinion polls. Perhaps major advertising and promotional campaigns could change the political dynamics, but an honest assessment of the potential impact of such an effort also has to consider the possible effectiveness of a negative campaign by defenders of the status quo.

* Advocates of the sales tax rightly insist that it be accompanied by complete, irreversible abolition of the income tax, which would require repeal of the 16th Amendment. Would it be possible to obtain the required two-thirds vote in both houses of Congress and ratification from 38 state legislatures? Even amendments that garner 80 percent or more in polls, such as a balanced budget amendment, have a hard time getting two-thirds majorities in Congress, to say nothing of the obstacles an amendment would face getting three-fourths of the states to ratify. Failure to permanently kill the income tax would create the risk that we would be stuck with both an income tax and a sales tax.

* Would repeal of the income tax entail elimination of payroll taxes? The only sales tax proposal that has actually been turned into legislation is the Tauzin-Schaefer bill, which does not repeal the Social Security and Medicare payroll taxes. While these taxes are not as economically harmful as the personal income tax (largely because they are a version of the flat tax, imposing one rate on a proper definition of income), there's always the risk that politicians would gradually alter the payroll tax so that it degenerates into something that more closely resembles the current progressive income tax.

* Trying to eliminate payroll taxes would bring Social Security into the tax reform debate. Would it be possible to simultaneously reform the tax code and make a major change in Social Security? Americans for Fair Taxation has proposed using the sales tax to replace both the income tax and the payroll taxes. Yet any attempt to eliminate the payroll taxes would require supporters to grab the "third rail" of American politics with two hands. Opponents will exploit the opportunity to instill fear in senior citizens as they attempt to kill any legislation.

* If the income tax is eliminated, how will the government determine eligibility for means-tested programs? Presumably, neither flat tax nor sales tax advocates are sympathetic to coercive income redistribution, but it would be very difficult to simultaneously reform the tax code and eliminate all of these programs. As with Social Security, it would be a shame if prospects for tax reform were dragged down because of a tangential issue. Sales tax supporters should therefore develop an easily understood, politically realistic alternative for determining eligibility.

* Many Americans flinch at the thought of paying a sales tax on such big-ticket items as cars. Has there been any polling to determine an effective response to demagoguery on this issue? Clearly, if your take-home pay increases by 17 percent because the income tax is repealed, a 17 percent sales tax could not possibly leave you worse off. Yet opponents can be expected to capitalize on the sticker-shock effect, and an intensive educational effort would be needed to counter them.

* Speaking of demagoguery, what is the most politically astute way to answer those who would exempt from the sales tax services such as leukemia treatments for poor children or products such as wheelchairs for muscular dystrophy sufferers? Sales taxes throughout the United States and value-added taxes around the world are riddled with loopholes. Opponents will try to kill the sales tax by exploiting these sensitive issues. And special interest groups, representing certain industries or consumers, will work hard to carve out exemptions. Sales tax advocates need to acknowledge that granting tax-free status to any group of products or services will put upward pressure on the tax rate, which will create additional incentives to seek out more loopholes, putting even more pressure on the rate, and so on.

* While items such as food and medicine are considered worthy of exemptions, there are many which could receive hostile treatment. Is there any strategy for avoiding discriminatory tax treatment of tobacco, caviar, liquor, and other politically incorrect products? Like the flat tax, the sales tax is based on the principle of getting the government out of the business of using the tax code to direct economic decisions. But certain products and services will draw fire from those who like imposing their values on the rest of society. Any campaign to adopt a sales tax needs an effective strategy to prevent the bill from becoming a Swiss-cheese-like amalgamation of special preferences and penalties.

* 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.