n the eyes of many Americans, more vulnerable to economic down- Iour income tax system is overly turns; it slows economic growth. : complex, basically unfair and—in short—fatally flawed. At least half The Consumption Tax Is the Time the citizens surveyed in recent public opinion polls would support The principal alternative to an radical reform. income tax is a consumption tax. Right for a They have a point. Although Consumption taxes encourage length is not necessarily synonymous saving and investment by deferring New Approach? with complexity, the U.S. income taxes on income until that income tax code now has more than 700 is spent. They make moot a host of times as many words as the U.S. complex issues concerning depre- Constitution. Furthermore, the costs ciation schedules and the timing of of complying with the individual capital gains. Furthermore, a house- income tax code are high and rising hold’s wealth and well-being are “The sum the average (Chart 1). Estimates of the compli- more directly tied to its consump- ance costs associated with the tion spending than to its income. firm pays to keep track corporate income tax are even Three alternative versions of the of tax-related higher, ranging from about 50 consumption tax have been proposed. percent to more than 100 percent Two of the proposals can be de- information may of the revenue collected. In other scribed as direct taxes on consumer words, the sum the average firm purchases—the national sales tax exceed what it pays to keep track of tax-related and the . The third proposal, pays in taxes.” information may exceed what it known as the unlimited savings allow- pays in taxes. ance (USA) tax, exploits the principle The complexity of the tax code that income must either be saved or feeds public suspicion that the tax consumed by taxing the difference system is unfair. Many taxpayers between income and savings. would agree with Nobel Prize win- Although equivalent in spirit, the ning economists Milton Friedman proposals differ in important details. and James Buchanan that much of Before discussing the likely economic the system’s complexity results consequences of replacing the in- from politicians’ trading tax prefer- come tax with a consumption tax, it ences for campaign contributions. may therefore be helpful to review Economists’ training leads them the distinguishing characteristics of to focus more on the tax system’s the alternative plans. inefficiencies than its complexity and unfairness (though the three Chart 1 The Rising Cost of problems are closely related). Here Complying with U.S. Tax Codes too, the U.S. income tax code falls short. A striking example of ineffi- Costs as a percentage of revenue ciency in the income tax code is its 10 9.6 9 unequal treatment of income from 8 7 different sources. Under current law, 7 wage and interest income is taxed 6 only once—at the individual level. 5 Meanwhile, profits are taxed twice— 4

first at the corporate level then 3 2.4 2 again at the individual level. For 1.2 profits that are distributed as divi- 1 dends, the top combined marginal 0 50 yrs. ago 25 yrs. ago 10 yrs. ago Two yrs. ago tax rate can exceed 65 percent. NOTE: Compliance costs include the resources that the This heavy taxation of dividends and expends in enforcing the tax laws as well as the costs that taxpayers incur in capital gains discourages saving filling out tax forms. and entrepreneurship; it encourages SOURCES: Joel B. Slemrod, as quoted in Business Week, January 9, 1995, and James L. Payne, firms to use debt finance rather Costly Returns, (Lanham, Md.: Institute of than equity finance, making them Contemporary Studies Press, 1993).

5 The National Sales Tax. Represen- write checks to the government for tative Bill Archer (R-Texas) and the taxes due on the wage compo- Senator Richard Lugar (R-Indiana) nent of value added. In effect, the argue that consumption spending flat tax treats each worker as an should be taxed directly. A national independent contractor. This differ- sales tax on retail purchases would ence in the treatment of wages has be one such strategy. An equivalent two important benefits. First, taxes measure would be to impose a tax wouldn’t be hidden, as they are at each stage of production on the under a standard VAT. Second, the difference between sales revenue flat tax approach would allow a and payments made to other busi- certain amount of each individual’s nesses for materials, equipment and wages to be exempted from taxa- “Once enacted, any of supplies. Such a sales tax is called a tion ($13,000 for singles, $26,000 these three proposals value-added tax, or VAT. Most sales for couples, plus $5,300 per depen- tax proposals would exempt food dent under the Armey proposal), would likely have and medicine to reduce the burden making it easy to limit the tax of taxation on the poor. All other burden on the poor. a positive effect on goods and services would be taxed. On the negative side, flat tax saving and investment.” Economists estimate that the sales opponents claim that people with- tax rate would have to be at least out labor income would pay no 21 percent to raise as much rev- tax. The statement is only superfi- enue as the current income tax. cially true: nonwage income would An attractive feature of a national be taxed before it is distributed, at sales tax is that even those with the same rate as wage income. illegal sources of income would Representative Armey proposes pay taxes with every purchase. In that the initial tax rate be 20 per- the same vein, a sales tax is anony- cent. Most economists think the mous: no one need know how much rate would need to be closer to 23 money the taxpayer makes or where percent to replace the revenue from it comes from. Another advantage the current income tax. is that the sales tax concept is The USA Tax. Senators Sam Nunn familiar and easy to understand. (D-Georgia), Pete V. Domenici The proposal does have draw- (R-New Mexico) and Bob Kerrey backs, however. A 21-percent sales (D-Nebraska) propose a consump- tax levied at the retail level would tion tax disguised as an income tax. invite widespread under-the-counter The key difference between the cur- sales. The VAT approach would rent income tax and their USA tax reduce the incentive to cheat by is that under the USA plan net new taking many small bites instead of saving would be fully deductible one large one. However, the costs of from income for tax purposes. complying with a VAT would be Households would continue to re- extremely burdensome to small port wage, dividend, interest and businesses. Moreover, because taxes capital gains income on their tax would be hidden in the prices con- returns. They would continue to sumers pay rather than transparent deduct home mortgage interest and as with the sales tax, a VAT could charitable contributions. A modest be an invitation to tax increases. deduction for higher education ex- The Flat Tax. Representative penses would be introduced. The Richard Armey (R-Texas) proposes value of fringe benefits such as em- a modified VAT known as the flat ployer-provided health insurance tax. Under a VAT, firms pay tax on would be included in household their sales less the sum of their pur- taxable income for the first time. chases from other businesses. The Tax rates on personal income would flat tax would work in exactly the be graduated—rising from 19 per- same way, except each firm’s cent to 40 percent—while the cor- employees would be paid with pre- porate income tax would be scrapped tax dollars, and employees would and replaced with an 11-percent

6 VAT. Tax rates would be higher and real output, relative to their than under the other reform propo- level under an income tax. sals, partly because the USA tax In the near term—described in would retain more deductions than the left-hand column of Table 1— the other proposals and partly be- greater investment can be achieved cause Social Security benefits, in only at the expense of consumption. effect, would be financed from gen- So, in the years immediately follow- eral revenue under the USA plan. ing tax reform, consumption would Of the three reform proposals, be lower than it would have been the USA tax is the only one that under the current system. uses the tax code to stimulate On a cautionary note, the pros- investment in education as well as pect of tax reform may have a per- in plant and equipment. It is also verse effect on the economy in the “While there’s room the only reform proposal that prereform period. Knowing that for disagreement incorporates Social Security taxes. investment would soon be receiv- On the minus side, the USA tax ing more favorable tax treatment, on exactly which would do little to simplify the tax people would be likely to spend code. It would continue the current more on consumption and defer options package is subsidy to home ownership and investment in the months before right, there can be actually would increase the incen- the new tax law takes effect. tive for home ownership by not The Effects on Interest Rates. The little doubt that the counting new home equity loans real yield on short-term bonds as taxable dissaving. Additionally, moves opposite from the capital consumption tax is households would be able to accu- stock, all else being constant. Since an idea whose time mulate up to $35,000 in nonmort- the capital stock would gradually gage debt without tax liability. Con- increase under a consumption tax, has come.” sequently, the USA tax would pro- relative to its level under an income vide less overall stimulus to saving tax, the real yields on short-term and investment than the other tax corporate and Treasury debt would reform proposals reviewed here. gradually decline after tax reform, eventually stabilizing at about Likely Effects of Switching three-fourths their current levels. To a Consumption Tax The time path of short-term mu- nicipal bond yields would be quite Once enacted, any of these three different. Municipal bonds currently proposals would likely have a posi- have an advantage relative to corpo- tive effect on saving and investment, rate and Treasury bonds because for two reasons. First, because they they are tax-exempt. Under either a are consumption taxes, each pro- national sales tax or the Armey flat posal defers the taxation of income tax, this advantage would disappear: until the income is spent. Second, all bonds would be treated the same. each proposal eliminates the current After the implementation of tax re- system’s punitive taxation of divi- form, the yield on municipal bonds dends and capital gains. As shown would jump upward to match the in the right-hand column of Table yield on other bonds. Thereafter, 1, increased saving and investment the yields on all short-term bonds will eventually pay off in a higher would move in tandem. capital stock, higher real wages and greater consumption. Laurence Kotlikoff of Boston University has Table 1 Likely Effects of the Switch estimated that switching to a con- To a Consumption Tax sumption tax would boost the nation’s stock of plant and equip- Near term Long term ment by nearly 27 percent after 20 Investment + + years. A 27-percent increase in the Capital stock 0 + capital stock would mean nearly Wages and benefits 0 + 10-percent increases in real wages Consumption – +

7 Chart 2 diately following reform—some Treasury–Municipal Percentage Yield Gaps: Behaving as Predicted people would suffer net losses. Risky new businesses in high- Percent growth, capital-intensive industries 40 would be clear winners from tax One-year gap Federal Reserve Bank of Dallas 35 reform. These firms would benefit 30 from the more favorable treatment Robert D. McTeer, Jr. 25 of equity finance and the increased President and Chief Executive Officer

20 flow of savings provided by a con- Tony J. Salvaggio sumption tax. Holders of existing First Vice President and Chief Operating Officer 15 30-year gap municipal bonds would be short- Harvey Rosenblum 10 term losers under the national sales Senior Vice President and Director of Research 5 Kemp Commission tax or Armey flat tax because these W. Michael Cox formed Vice President and Economic Advisor 0 plans remove current tax prefer- J F M A M J J A S O N D J F M A M J J A S O N D Stephen P. A. Brown 1994 1995 ences for municipal bonds. (The Assistant Vice President and Senior Economist SOURCES: Board of Governors of the Federal Reserve USA tax plan would remove the tax System, Bloomberg and authors’ calculations. Research Officers preference for new municipal bonds John Duca but retain it for existing bonds.) Robert W. Gilmer The current return on a 30-year People who live in high-tax areas— William C. Gruben Evan F. Koenig bond is an average of the one-year like New England and the Great returns expected over the next 30 Lakes region—are also hurt by tax Economists Kenneth M. Emery years. Therefore, if people think reform in the short run because they David M. Gould that either a national sales tax or lose their ability to deduct state and Joseph H. Haslag the Armey flat tax is coming, a local income and property taxes. D’Ann M. Petersen Keith R. Phillips gradual closing of the gap between Similarly, homeowners would likely Stephen D. Prowse long-term Treasury and long-term find that the fall in long-term inter- Fiona D. Sigalla municipal bond yields should est rates caused by tax reform Lori L. Taylor Lucinda Vargas already be apparent. There should would not, at first, fully offset the Mark A. Wynne be no corresponding closure of the elimination of the mortgage interest Mine K. Yücel gap between short-term Treasury and property tax deductions. Carlos E. Zarazaga and short-term municipal bond Research Associates yields until reform is imminent. Professor Nathan S. Balke, Southern Methodist Conclusion University; Professor Thomas B. Fomby, Southern The behavior of municipal bond Methodist University; Professor Kathy J. Hayes, yields relative to Treasury bond The choice between the current Southern Methodist University; Professor Gregory W. yields suggests that traders began U.S. income tax and a consumption Huffman, Southern Methodist University; Professor Finn E. Kydland, Carnegie Mellon University; taking the possibility of compre- tax is like the choice a family makes Professor Roy J. Ruffin, University of Houston; hensive tax reform seriously follow- when deciding whether to trade in Executive Editor ing the appointment of its 5-year-old car for a new model Harvey Rosenblum (R-New York) to chair a reform in its first year of production. The Editors commision (Chart 2). At the long new model has no track record. Its W. Michael Cox • Mine K. Yücel end of the maturity spectrum, handling might take some getting Managing Editor recent months have seen the per- used to, and buying it would mean Rhonda Harris centage gap between 30-year pulling together a down payment. Copy Editor Treasury bond yields and 30-year On the other hand, it has an engine Monica Reeves municipal bond yields cut in half, that is more powerful, more effi- Graphic Design from 20 percent to 10 percent. cient, and easier to repair and main- Gene Autry • Laura J. Bell • Ellah K. Piña However, no change in tax regime tain. The performance of the older is expected until after the 1996 vehicle has been slowly deteriorat- elections: no shrinkage of the yield ing, and the car needs more and The Southwest Economy is published six times gap is yet apparent for bonds that annually by the Federal Reserve Bank of Dallas. The views more repair. While there’s room expressed are those of the authors and should not be mature before November 1996. for disagreement on exactly which attributed to the Federal Reserve Bank of Dallas or the The Politics of Tax Reform: Winners options package is right, there can Federal Reserve System. and Losers. The vast majority of Articles may be reprinted on the condition that the be little doubt that the consumption source is credited and a copy is provided to the Research people would gain from the switch tax is an idea whose time has come. Department of the Federal Reserve Bank of Dallas. to a consumption tax. But the gains The Southwest Economy is available free of would not be distributed evenly, charge by writing the Public Affairs Department, Federal —Evan F. Koenig Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX and—especially in the years imme- Lori L. Taylor 75265-5906, or by telephoning (214) 922-5257.

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