Flat tax, sales tax or VAT?

IS RADICAL CHANGE FOR THE FEDERAL SYSTEM REALLY ON THE HORIZON? MAYBE - AND IF SO THE POTENTIAL IMPLICATIONS FOR STATE FISCAL SYSTEMS ARE ENORMOUS.

In the new political environment in Washington, many ideas previously viewed as pipe dreams are being taken seriously as blueprints for policy action. In no area is this truer than in tax policy, where some of the most sweeping changes ever contemplated are now getting more than passing attention. The sponsors of such proposals come from both parties, and in many cases hold key leadership positions. A recent article in Fortune magazine declares, "Right now we are witnessing . . . the beginning of the end of the American income tax system." (June 12, 1995)

Is the political climate ripe for radical change? Consider this: The chairman of the Ways and Means Committee speaks of "pulling up the income tax system by its very roots" by repealing the 16th Amendment to the U.S. Constitution. The House majority leader would like to end income tax withholding. A prominent U.S. senator and presidential candidate proposes to abolish that most hated federal agency, the IRS. Alice Rivlin, President Clinton's budget director, is a relatively recent convert to the idea of shifting to consumption taxation.

Senate Majority Leader (and presidential aspirant) Robert Dole has joined House Speaker Newt Gingrich in appointing a commission to be headed by former Congressman and Housing Secretary Jack Kemp to assess the various proposals.

What's driving these radical tax reform proposals? Analyst Stephen Moore of the Cato Institute makes the case succinctly: "First, the U.S. tax system reduces economic growth through punitive tax rates on savings and investment. Second, the needless complexity of the tax code imposes large costs on American businesses and workers." Though both these premises may be subject to dispute, they are reflected in most of the proposals, nearly all of which have as basic goals the promotion of savings by shifting taxation to consumption and simplification of the current tax system.

Some proposals are based on the idea of radically simplifying the federal income tax, "flattening" the rate structure and eliminating deductions, while others would replace the income tax with some sort of consumption tax.

THE 4 PROPOSALS

Major proposals have been put forward by members of Congress; several have already been introduced, but others have yet to be drafted as, legislative language. There are four basic approaches: the "FLAT" TAX, the CONSUMPTION-BASED INCOME TAX, the VALUE-ADDED TAX or "VAT" and the NATIONAL SALES TAX.

1 FLAT TAX IDEAS

The flat tax approach is aimed principally at simplifying the current federal income tax. Since its inception, the federal income tax has been a "progressive" tax, using a graduated rate structure so that the marginal rate of taxation increases with income - the more you earn, the greater the percentage of your income you pay in tax. Over time, exemptions proliferated, and the actual base of the tax has become quite complicated.

In its purest form, a flat tax would be an income tax levied at one rate on all income. In practice, all proposals have some "zero bracket," a threshold level of income below which no tax is owed. Beyond this base level, one marginal rate applies.

The most prominent proposal of this kind now in Congress comes from House Majority Leader Richard Armey of Texas, who originally introduced a flat tax bill in 1994. A similar bill has been introduced by Pennsylvania Senator Arlen Specter, a presidential candidate. Individual wage income would be taxed at a rate of 20 percent with a basic standard deduction ranging from $12,350 to $24,700 depending on filing status, and generous treatment of savings and investment. The proposal would repeal the withholding from wages of income taxes. Mortgage interest and charitable contributions would not be deductible under the Armey plan, though the Specter bill retains these popular deductions. Both plans would end the deductibility of state and local taxes, and of interest on state and local government bonds. The federal corporate income tax would be replaced with a type of VAT.

A Democratic alternative is Congressman Richard Gephardt's "10 percent" tax proposal. With this modified flat tax, the House minority leader returns to the themes of the "FAIR" tax bill he promoted 10 years ago with New Jersey Senator Bill Bradley. (That bill, along with the Kemp-Roth proposal, led to the 1986 Tax Reform Act that reduced rates, simplified the rate structure and eliminated many exemptions. In the end, this reform did not achieve the radical simplification early advocates had sought.) Under this plan, most individuals would face a marginal rate of just 10 percent, but high rates would be retained for high incomes. Gephardt's proposal is an attempt at radical simplification while maintaining the progressivity of the current system. Unlike the other proposals, it does not seek to reduce the tax burden on savings and investment.

ARGUMENTS PRO

Proponents argue that reducing the marginal rate of taxation will increase the incentive for investment, which in turn will lead to greater growth in the economy and benefit everyone. Since the wealthy have the money to invest, taxing it away from them at high rates reduces investment. It also reduces work incentives for higher income taxpayers.

Even more important, the elaborate system of deductions and exemptions in the current system distorts economic decision making. The flat tax would be economically neutral, which would promote efficiency and growth.

Congressman Armey sees simplification as perhaps the greatest advantage of his proposal. With one tax rate for all income, and no targeted tax breaks, "taxpayers will be able to pay their taxes on a simple, 10-line form the size of a postcard." There are also economic benefits to simplification. The current system requires enormous expenditures on accounting, bookkeeping and tax preparation, which essentially waste economic resources. A tax with a highly simplified rate structure and few exemptions would ease compliance.

Armey sees an advantage of the flat tax over, say, a VAT in terms of "visibility" of the tax. Whereas a VAT is hidden in the price of goods, with a flat tax people would know how much they are paying for government. Armey would enhance this feature by repealing withholding, requiring everyone to make a monthly tax payment along with their other bills.

ARGUMENTS CON

Opponents of the flat tax argue that, for all of its flaws, the current income tax is somewhat progressive, and therefore fair. The problem with a flat rate tax is that as income decreases the portion of income devoted to necessities increases. Therefore, a tax applied at the same percentage rate to people with vastly different incomes would be more burdensome on the poor. (This is the traditional case for a graduated tax.) Furthermore, many of the countries that are outperforming the United States in terms of investment and growth actually have higher marginal tax rates.

As for the goal of simplification, opponents say that flat tax advocates are aiming at the wrong problem. The Byzantine complexity of the current federal income tax system is attributable not to the progressive rate structure, but to the many exemptions - loopholes - that have been added over the years, the bulk of which benefit wealthy individuals and businesses. It is possible to have a flat tax with just as many exemptions as the present federal code. It would be equally possible to construct a very simple graduated tax, that would be highly progressive, but have few loopholes. Thus, if simplification is the goal, why not eliminate the exemptions, but leave the graduated rate structure? This last argument could be the point of departure for Congressman Gephardt's "10 percent" tax proposal.

ISSUES FOR THE STATES

In order to have a low flat rate, many deductions now in the code have to be eliminated, especially large ones such as state and local taxes and the tax advantages on state and municipal bonds.

The Armey/Specter approach taxes only individual wage income, not interest, dividends and capital gains. States that wish to maintain their comprehensive income taxes would face a problem without those federal data, which presumably would no longer exist.

On the business side, Armey/Specter could have some benefit to states because they could easily couple the proposed VAT, which is similar to Michigan's Single Business Tax, easing state administration and perhaps providing a broader base than current state corporate taxes.

2 CONSUMPTION-BASED INCOME TAX IDEAS

Although it has the most intimidating name, a consumption-based income tax is in certain ways the simplest. It is an attempt to establish consumption rather than income as the basis of taxation without radically changing the current system of administration. In principle, the rate structure need not change, filing requirements could remain the same and the IRS would not be abolished. Essentially, the current income tax could be moved to a consumption base by exempting savings and investments. Thus, any income saved would not be taxed. (The returns from savings and investments are taxable, under this plan, unless they are plowed back into savings again.)

The one entry in this category so far is a proposal put forward by Georgia Senator Sam Nunn and Senate Budget Committee Chairman Pete Domenici of New Mexico, which they call the Unlimited Savings Allowance or "USA" plan. Individuals would be taxed on income from wages, interest and dividends minus additions to savings made during the year. The tax would be broad based and graduated with three brackets. For businesses, the Nunn-Domenici plan would replace the current corporate income tax with a type of VAT.

ARGUMENTS PRO

If the goal is to stimulate savings and investment by shifting the burden of taxation onto consumption, this approach would require the least radical change in the current federal tax system. It keeps a graduated rate structure and the current system of administration and withholding. Perhaps because it is the least radical, the USA plan seems to have generated the least interest so far. It is true that it would do little to simplify the current system - indeed it might add to the complexity. But it would appear to be the easiest way to move the United States to a consumption tax basis. So its legislative prospects may improve if that becomes the principal goal and more radical proposals lose favor as they come under public scrutiny.

ARGUMENTS CON

USA may be a plan without a constituency. Conservative advocates of tax reform say that Nunn-Domenici just doesn't go far enough. It doesn't reduce marginal tax rates, and it doesn't simplify anything. Consumption tax opponents dislike it for the usual reason: It reduces progressivity.

ISSUES FOR THE STATES

A consumption-based income tax like the USA plan could pose a problem for state policymakers. In theory, states could opt not to conform to the new federal tax code. In practice, legislatures may find it difficult to retain their existing, income-based tax codes, both for administrative and political reasons. If states do conform to the federal tax, a real incentive will be created for individuals to save while working - and receive a tax deduction - and then upon retirement move to a state with a lower income tax or no income tax, thus escaping taxation by the state that gave them the deduction.

On the business side, Nunn-Domenici appears to provide the same benefit to states as the Armey/Specter flat tax, should they wish to piggyback. It might have an additional advantage, though. Dan Bucks, executive director of the Multi-state Tax Commission, points out that the bill could solve transfer pricing problems caused by multinational corporations shifting income to overseas subsidiaries, hence avoiding taxation.

3 VAT IDEAS

The tax of choice in most other industrialized countries, the value-added tax is similar to a sales tax in that it is a tax on consumption, at a single percentage rate applied to goods and sometimes services. Whereas a sales tax is levied only at retail, that is, on the final sale of a commodity, the VAT is levied incrementally, at each stage of production through to final sale. The rate is applied to the difference between the sale price and the cost of inputs.

Texas Congressman Bill Archer, chair of the House Ways and Means Committee, is a VAT proponent as is Florida Congressman Sam Gibbons, ranking Democrat on the tax-writing panel. South Carolina Senator Ernest Hollings, ranking member on the Commerce Committee, has long supported a VAT.

ARGUMENTS PRO

The main argument for replacing the income tax with a VAT is that savings would be free from taxation, boosting investment. The tax is inherently broad-based, thus spreading the burden of taxation and allowing it to be levied at a lower rate than some other taxes might. Moreover, by including services, it would broaden the tax base.

ARGUMENTS CON

Like sales taxes, the VAT is criticized from the left as highly regressive. Compared to a sales tax, it may be even more difficult to exempt certain commodities such as food. A major criticism of VAT from the right is that it is a "hidden tax," one that is not seen by the ultimate taxpayer, i.e., the consumer - because it becomes a cost of business concealed in the final price of the good. For this reason, it can become a cash cow for the government.

Introducing a VAT in the United States would require a whole new system of collection and administration. (The Treasury Department once estimated that a new bureaucracy of 30,000 employees would be needed.) Administrative costs could be high.

ISSUES FOR THE STATES

The VAT is essentially a sales tax, and so a national VAT would encroach on the states' most important tax base.

A federal retreat from income taxation could open up new revenue possibilities for states. However, states currently depend on IRS data for enforcement, so changes will have to be made in the way states administer their income taxes.

4 NATIONAL SALES TAX IDEAS

Conceptually, a national sales tax is the most straightforward proposal: The federal government would simply adopt the tax that 45 states have been relying on for years: a point-of-sales tax levied at retail at a fixed percentage rate. The general sales tax generates more revenue than any other state tax.

The leading advocate for a national sales tax is Indiana Senator Richard Lugar, who would replace the entire federal income tax system. Though he has not yet introduced it as legislation, Lugar has made the proposal a centerpiece of his campaign for president. Under his plan, the Internal Revenue Service would be abolished, and states would be responsible for administration of the tax.

ARGUMENTS PRO

Like the other proposals it would shift the burden of taxation away from savings and investment and eliminate the high marginal tax rates on incomes. It would allow the federal government to take advantage of the relative popularity (or minimal unpopularity) of the sales tax. Since it is added at retail, the sales tax is not hidden like a VAT.

ARGUMENTS CON

A national sales tax would be subject to the same criticism that state sales taxes, and other consumption taxes, have received - namely, that it is inherently regressive. The rate necessary to replace the revenue currently generated by the federal income tax could generate major sticker-shock for taxpayers - 17 percent or more, depending on the breadth of the base. As with the VAT, it would require an entirely new tax administration system, built from scratch.

ISSUES FOR THE STATES

A national sales tax presents many of the same issues as a VAT. More than any of the other proposals, it would represent a direct encroachment on the most important source of state tax revenue. State and local sales taxes currently range from 4.5 percent to almost 10 percent. If a national sales tax is adopted with a rate of, say, 17 percent the combined state/local/federal rate would be as high as 27 percent in some places and would average well over 20 percent in the 45 states with sales taxes. Can a rate this high be sustained? Would states be effectively precluded from ever raising the sales tax again? Would states be forced to adopt a federal base, either by preemption or just through the inevitable pressure to conform?

On the other hand, there might be some advantages to states from a federalization of the consumption tax base (e.g., a solution to the Bellas Hess problem). Lugar would include services, so piggybacking could give states access to a broader base than their current taxes, making it possible [TABULAR DATA OMITTED] to lower rates.

The Lugar plan would apparently include a very large mandate, requiring states to administer and collect the federal tax. However, they would be compensated for the associated costs, so it would not be an unfunded mandate.

QUESTIONS FOR THE STATES

It should be clear that a major federal tax restructuring will raise many questions for states.

In truth, there is no way to radically restructure the federal tax code that won't affect states in some way. Almost any substantial federal change will wreak havoc on state policy, at least in the short run. The 1986 reform was mild compared to these proposals, and it required substantial legislative action in almost every state. To the extent that the federal government moves to sales-based taxes, it encroaches on the states' most important revenue source. The more the feds tinker with the income tax, the more turmoil they create for the administration of state income taxes. State income taxes are dependent upon the federal tax, and a radical departure from that tax could make state administration difficult.

This does not mean that such change would necessarily be bad for states. If the proponents are right and tax reform leads to a significant improvement in economic performance, individual state economies will grow, providing all kinds of benefits including higher state revenue collections.

Also, almost any major federal tax reform is likely to spur consideration of state tax reform. Following the 1986 federal reform almost every state re-examined its tax code. As that experience showed, this can be most discomfiting, but may well be a useful exercise that can result in efficiencies.

If the federal government does radically restructure the income tax, states will be forced to consider whether and to what degree to conform to the new federal code. Some might choose to "de-couple," joining the handful of states that are currently independent of federal Form 1040. Others may choose to "piggyback" more closely on the new federal tax than the old.

If Washington moves directly into the consumption tax base with a VAT or sales tax, states face a more difficult question. They could move away from consumption taxation and into the vacuum left by the feds in the income tax arena. They could try to maintain their existing sales taxes and compete for the base. Or they could seek a deal with Washington that lets them share in the revenue of the national tax or more closely integrates federal and state taxation.

This latter approach has been widely suggested. Most of the advocates for a federal sales tax or VAT, from Senator Lugar to Alice Rivlin, have at least raised the possibility of some kind of sharing arrangement as compensation for the encroachment on the traditional state revenue base. The lure of this approach is that a national tax could be more comprehensive than any state could accomplish on its own. A raft of border problems, from mail-order sales to transfer pricing, could be resolved instantly, with both the federal government and the states benefiting.

The drawback to this approach is the potential loss of state fiscal autonomy. Major revenue decisions affecting the states would now be made in Congress. State legislators will want to consider whether the potential revenue gain is worth such a sacrifice. As the tax commission's Dan Bucks likes to say, "The power to tax is the core of state sovereignty."

In any case, if states hope to have any influence on the nature of the coming tax reform debate, which may begin in 1996 and be joined in earnest after the next presidential election, they need to gear up now. As the issue begins to move through Congress, each state should be prepared to model the effects of different proposals on its own tax system, consider the costs and benefits, and communicate them quickly to Washington. The last time around (in 1985-86) many states were taken by surprise at the changes, and intergovernmental considerations took a back seat. This time there is plenty of warning, and states need to start preparing now to weigh in.

RELATED ARTICLE: VAT VS. SALES TAX

Although they are administered differently, there is a certain equivalence between a VAT and a general sales tax.

Take a loaf of bread (in a somewhat simplified world). Inadequate that there are three businesses involved in bringing the bread to market: A) a farmer, who grows the grain, and then sells it to B) a baker, who makes it into bread, and then sells it to C) a grocer, who packages the bread and sells it to the consumer. Here's a comparison of a value-added tax and a sales tax, each levied at 10 percent.

FIRM        PRICE   VALUE-ADDED   TAX PAID     TAXES PAID
                                  WITH VAT   WITH SALES TAX

A) Farmer    .20         .20        .02             .0
B) Baker     .70         .50        .05             .0
C) Grocer   1.00         .30        .03            .10
TOTALS:                 1.00        .10            .10

The total value-added ($1) is also the final product price (the "retail" price, charged by the grocer). Thus, a sales tax, which is levied only on a final sale, would yield exactly the same revenue (10 cents in the illustration) as a VAT of the same rate, levied at each stage of production.

Christopher Zimmerman is NCSL's chief economist in the Washington, D.C., office.