n the eyes of many Americans, more vulnerable to economic down- Iour income tax system is overly turns; it slows economic growth. Tax Reform: 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 flat tax. 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 Internal Revenue Service 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.