The national sales tax: avoiding the zero-sum scenario.

Editor's Note: As part of The Tax Executive's continuing effort to keep its readers informed of emerging tax policy issues, the journal is pleased to publish the following article by Senator Richard Lugar on a proposed national sales tax. This article complements Paul McDaniel's piece in the November-December 1995 issue, which highlighted the issues involved in taxing consumption only. As the debate on fundamental tax reform moves forward, The Tax Executive will publish descriptions and critiques of various alternatives to the current system.

Stagnant wages caused by a low-growth economy are a primary reason for our national discontent. With the recent release of the report by the National Commission on Economic Growth and Tax Reform -- the Kemp Commission -- there is a growing body of evidence that our income tax system is; a major impediment to economic prosperity. I agree with the report's conclusion that the current income tax code should be scrapped in its entirety. The report fails to recommend, however, the bold steps that are required to generate strong economic growth: The income tax must be eliminated and replaced with a broadbased consumption tax.

Significant increases in income elude most Americans, denying them the kind of hope for a prosperous future that stimulates investment, risk-taking, and entre reneurial energy. The Labor Department recently reported that wages are growing at their slowest level since the department began tracking the data in 1981. And even more disconcerting, from March 1994 to March 1995, the average real wage of Americans actually decreased 2 percent. We must decisively change our economic system.

Replacing the income tax with a national retail sales tax will dramatically boost savings and investment, which will in turn increase wages and create jobs. Economist Dale Jorgensen of Harvard University has concluded that if a consumption tax like the national sales tax had replaced the current system in 1986, the United States would have experienced $1 trillion in additional economic growth. Under this scenario, income levels could be as much as 20 percent higher, providing the typical American family with $4,000 to $6,000 of additional income annually.

With this sort of dynamic growth, Congress could better address many of the fiscal problems we face -- declining standards of living, balancing the budget, and preserving the long-term financial stability of Medicare and Social Security. Unfortunately, the present level of economic growth dims any hope of solving these predicaments. In a low-growth economy, there are far too few resources for all competing interests. The economy becomes a zero-sum game in which no one gains unless it comes at the expense of another.

This zero-sum scenario is exemplified by the continuing budget negotiations between Republican Congressional leaders and President Clinton. One of the major issues of contention has been whether the economy would grow at 2.5 percent, the President's position, or at a more conservative 2.3 percent, as Republicans contend. This argument, however, is misguided. Neither one of these rates of growth will make a difference. If we do not aim higher, for the first time in the modern era, our children and grandchildren may find themselves economically worse off than our generation.

Our economy has not always been mired by low growth. As economist Milton Friedman points out, prior to the early 1970s, annual economic growth hovered at a rate close to 4 percent. This level of growth had been sustained for almost 90 years, excluding the depression years. Since the early 1970s, however, the growth rate has slowed to around 2.4 percent. And in the first half of 1995, the U.S. economy grew at an anemic annual rate of just 1.6 percent. To make matters worse, it is now the goal of the Federal Reserve to cap economic growth at 2.5 percent.

Vigorous economic growth would obliterate the zero-sum scenario. An example is our Social Security system, which is expected to run out of funds in the year 2029. These findings are based on the economic assumption that the United States' economy will grow at a level below 2 percent. But let's assume that our economy expands at 3 percent or above, a figure well within our historical average. The Social Security system would remain financially solvent well into the next century.

Unfortunately, our economy is weighed down by an income tax system that discourages growth by taxing savings and investment at least twice. Savings are vital because they supply the capital for buying a new machine, developing a new product or service, or employing an extra worker. As a nation, the United States saves less than any of our major trading partners. The Japanese save at a rate nine times greater than Americans, and the Germans save five times more than we do. Few realize that before World War II -- before the income tax system reached its present form -- Americans saved a larger portion of their earnings than the Japanese.

The National Sales Tax Proposal

I propose to liberate the American economy by eliminating the personal and corporate income taxes, as well as capital gains taxes and the estate and gift taxes, and replacing them with a 17-percent state-administered consumption tax on retail goods and services.

It is important to note that I favor most tax reform ideas, including flat tax proposals, over the current income tax system, which is highly intrusive and taxes investment and savings twice. After studying alternative consumption tax plans, however, I have concluded that a state-administered national sales tax is the best alternative.

Encourage Savings

Critically important, the national sales tax would stimulate our economy by encouraging savings. The bottom line is that as a nation, we do not save enough. A national sales tax would reverse this trend by taxing consumption directly while leaving savings and investment untouched. Economist Laurence Kotlikoff of Boston University estimates that our savings rate would more than triple in the first year of a broad-based consumption tax. A recent Money Magazine survey backs these conclusions, finding that 56 percent of individuals polled would begin to save more if a national sales tax were implemented. A national sales tax is a powerful catalyst -- one that will lead to greater jobs and opportunities for all Americans.

Simple

The national sales tax is easy to understand. Currently, more than 97 percent of our population pays a sales tax on a daily basis. With the adoption of a national sales tax, compliance costs would drop dramatically. Americans currently spend $200 billion annually complying with the federal income tax. These compliance efforts -- keeping records, filling out forms, and hiring accountants and lawyers -- are economically wasteful, creating no real wealth in our society. The Tax Foundation equates this situation to General Motors dumping every vehicle it sells annually into the ocean. The Foundation estimates that replacing the income tax system with a national sales tax would reduce compliance costs by up to 96 percent. Most taxpayers would never again have to file a return or fear an audit. Although I applaud the efforts of flat tax advocates to simplify tax forms, nothing can be more simple than no forms at all.

Fair

Another appealing feature of the national sales tax is its fairness. Everyone pays the tax, including wealthy individuals, criminals, and illegal aliens. The national sales tax would tax the underground economy. When criminals and illegal aliens consume the proceeds of their activities, they will pay a tax. Foreign tourists will pay the tax. Tax systems, like the flat tax, that rely on voluntary income reporting will never collect most of this revenue.

The fairness test must likewise consider those with limited means to pay taxes -- senior citizens, the unemployed, and those with low paying jobs. One strategy for addressing this problem would exempt a threshold level of goods and services consumed by each American from the federal sales tax. Each citizen who has a Social Security number would receive this exemption, similar to the plans of flat tax advocates, to fight regressivity. Another strategy is to exempt items such as housing, food, or medicine. I am committed to designing a tax system that does not fall disproportionately on the less fortunate.

A Check on the Federal Government

A state-administered national sales tax would provide an important check on the federal government. Allowing the states to administer the sales tax would eliminate the need for a centralized Internal Revenue Service. The Framers of our Constitution created our federalist system in order to limit the concentration of power in one governing authority. They understood that centralized power increased the risk of governmental tyranny. Prior to the adoption of the Sixteenth Amendment in 1913, it was unconstitutional for the federal government to circumvent the states and directly collect income taxes from its citizens. The Sixteenth Amendment gave the federal government the means to expand and centralize its powers.

The abusive practices of the Internal Revenue Service are often cited as the logical outcome of the Sixteenth Amendment. As the size of the federal government grew in the latter half of this century, the authority of the IRS necessarily expanded as well. In 1929, the IRS collected approximately one-third of all government receipts in the United States. Today, the IRS collects over two-thirds of our nation's tax receipts. Twice as big as the CIA and five times the size of the FBI, the IRS collects and controls more information than any other federal agency. Many Americans have had their right to privacy wrongfully violated by an IRS audit. In 1992, the IRS caught 368 of its employees looking through taxpayer files without authorization. And the intrusiveness may increase as revenue shortfalls encourage the agency to squeeze tax dollars out of the system.

Allowing states to collect the national sales tax would restore the federalist balance that the Framers intended. Instead of the federal government collecting taxes and redistributing the revenue to the states, states would collect the national sales tax, retaining their portion for administration and state-run programs, and remitting the remainder to the federal government. This process would provide the states with greater leverage in negotiating with the federal government and prove to be an effective check on the federal taxing authority.

Administratively Feasible and Cost Effective

The states would be effective administrators of the national sales tax, bringing 60 years of sales tax experience to the table. Ernest Dronenberg, a member of California's Board of Equalization and a leading expert in the field, has recently conducted an extensive study on the effectiveness of a state-administered national sales tax. In this report, Mr. Dronenberg argues that not only would states be able to administer the federal tax, but also a national sales tax would prove to be cost effective for state revenue agencies. Because 45 states already have the sales tax apparatus in place, he concludes that the cost-savings of replacing the income tax with a state-administered national sales tax would be significant, reducing the tax administration costs by as much as 98 percent. He estimates that a state-administered national sales tax could be levied for less than $1 billion, compared with the $8 billion required to administer the current income tax system. These savings could provide a powerful revenue incentive for states collecting the national sales tax.

Transparent

The national sales tax is the most transparent of the tax reform proposals. A federal tax that is evident to everyone would bolster efforts in Congress to cut federal spending. If average Americans are paying the tax every day, they will make certain that Congress spends funds wisely. On the other hand, a flat tax would constantly be subject to tinkering by the Congress, similar to the current tax code. It may start flat, but many would seek to amend the tax code to promote special interests or social agendas. The national sales tax would be much more difficult to amend because of its transparency, relegating deductions and loopholes to the past.

Encourages Exports

Finally, a national sales tax would bolster exports. Most of our trading partners have tax systems that are border adjustable. They are able to strip out their tax when exporting goods. The income tax, and for that matter the flat tax, are not border adjustable. American goods that are sent overseas are taxed twice: once by the corporate income tax that is passed on to the price of goods and once by the destination country's tax. The national sales tax would not be levied on our exports, leveling the playing field with our trading partners.

Conclusion

We must jettison the current income tax system that has stifled our growth and prosperity. If we do not dynamically change our tax system, I fear that the politics of envy will increasingly fractionalize our society. Our country has always been grounded on the premise that there is opportunity for all who are willing to work for it. I firmly believe a national sales tax would revitalize our economy, generating a tide of economic benefits that will raise the well-being of every American simultaneously. High wage jobs would be created, standards of living would increase, and poverty would drop. Let's give this kind of hope and future to all Americans.

RELATED ARTICLE: TEI Treaty Survey Shows Strong Interest in Latin America 

TEI recently submitted comments to International Tax Counsel Joseph H. Guttentag providing the results of a poll of members of TEI's Executive and International Tax Committees concerning which treaties should be given priority by the Treasury Department. The December 15, 1995, letter updates comments that were submitted in May. (The comments are reprinted in the July-August 1995 issue of The Tax Executive.

In its comments, the Institute noted that its members' "interest in Latin America appears to be on the rise." Three of the top four countries that responding members identified as ones that should receive the highest priority from Treasury in negotiating new or revised treaties are in Latin America. "Brazil remains the number one pick, with Chile and Venezuela coming in second an fourth, respectively," the Institute said.

In addition, responding members expressed strong interest in the negotiation of new treaties with Singapore and Japan. South Africa and Switzerland continue to receive the strongest endorsements among treaties that have been identified by Treasury as being on its priority' list, although TEI noted that interest in the South Africa treaty has waned since the last survey.

TEI's comments were prepared under the aegis of its International Tax Committee, whose chair is Philip J. Bergquist of Apple Computer, Inc.

RICHARD G. LUGAR is the senior United States Senator from the State of Indiana. He previously served as Mayor of Indianapolis and is currently a candidate for the Republication Presidential nomination.