01.07.08
Implications of a “Fair” Tax?
A few years ago, Steve Forbes ran for president on a “flat tax” platform, promising a greatly simplified income tax schedule with a 17% tax assessed on all earned income (with an initial exemption). Mike Huckabee is pushing an even more radical reform, replacing not only the income tax but also the payroll taxes for Social Security and Medicare with a 30% national sales tax on all new goods and services. The government would then rebate an amount equal to the tax on a poverty-level income, greatly reducing the burden on lower-income households.
There is no such thing as a free lunch. If this tax is to support our current level of spending, it must withdraw the same amount of money from the economy. Who might win under this proposal? What economic choices might be affected?
- Imported goods and services would be taxed, eliminating one of the major economic incentives for outsourcing (the avoidance of paying US taxes).
- Those who have been saving in Roth IRAs would be penalized. They paid income tax on that money up front in the expectation that it would be tax free when withdrawn for retirement. Existing savings in taxable accounts would be similarly reduced in value. If this idea catches on, spend your money quick!
- The distinction between tax-deferred accounts (e.g. 401k plans) and conventional investment accounts would disappear. Since taxation would be on consumption, all savings would be tax-deferred. In theory this should stimulate savings, however the elimination of tax-deferred accounts would also eliminate the penalties triggered by an early withdrawal of those funds. It could become very tempting for people to “borrow” against their retirement savings, just as many borrowed against their home equity in recent years.
- FICA taxes are effectively regressive, taxing wage income (up to a limit) but not investment income. The tax burden on low-income workers would likely be reduced under this proposal. At the other end of the scale, the wealthiest individuals generally spend only a small portion of their income. Thus their tax burden would also be reduced, with the remainder growing tax-deferred until it is ultimately spent. This suggests to me that “middle America” would likely bear the brunt of the costs of this plan.
Am I missing any major implications?
Michael Rawdon said,
January 7, 2008 at 5:44 pm
If the mortgage interest deduction is eliminated, then people who own homes for which they are currently paying mortgages would be penalized. I think it likely that a large number (possibly even a majority) of those people would be forced to sell or be foreclosed, since they rely on that deduction to afford their mortgage payments.
I’m not sure how 401(k) contributions would be affected. Contributions to such accounts are currently not taxed at the time of contribution, which is one of the motivations for people to use them. This could lead to less long-term retirement investing, at least through that mechanism. But I’m not clear enough on all the details to make a good guess here.
Would real estate transactions be taxed under Huckabee’s plan, I wonder?
There are some interesting questions about enforcement of a national sales tax, too. Would consumers be required to file a return every year with a list of everything they purchased? Would retailers/wholesalers/other sellers be required to do the same for everything they sold? Who would track all this? If it’s not tracked, wouldn’t people just dodge paying the tax left and right? And wouldn’t a national sales tax be a huge motivation for the growth of black markets across the country? How much risk (in terms of dealing with a black market) would people be willing to bear to buy items (especially expensive items like electronics or appliances or cars) without paying a 30% tax on the items?
Valentine said,
January 7, 2008 at 11:59 pm
Under the current system, your income is taxed and you pay your mortgage (and other loans) out of what remains. Some portion of those payments are tax deductible, however you still pay FICA taxes on that amount. Under this proposal, not only mortgage payments but ALL interest payments would be tax free. I believe this would have the effect of making existing mortgages more affordable, not less affordable.
Purchases of new homes would be taxed, though the sale of existing homes would not. This has the potential to discourage new construction while increasing the nominal value of existing homes. If anything, this would be a boon to those owning homes before the transition.
The tax would presumably be collected from retailers and service businesses. There would necessarily be enforcement, with revenue officers on the lookout for businesses offering “tax free” services. Alternatively some might cheat the system by collecting tax from their customers but failing to remit them to the government — of course this is possible for self-employed individuals under the current system as well. Is it easier to track consumption or employment? There are probably fewer businesses selling goods and services than there are people employed.
The most likely dodge would be to buy goods overseas and have them shipped to the US. Enforcement of the tax on imports would require a beefed up Customs authority.