The tax reform revolution: "the four approaches to tax reform--flat, USA, national sales, and value-added--all are variations on the same theme. All would shift the base of Federal taxation from income to consumption while simplifying the process of complying with tax law.".
Tax reforms come in many shapes and varieties. Two main motivating factors for reform are present: to increase economic growth by encouraging savings and investment and to simplify the burdens of tax preparation.
Shifting the tax base to consumption. The most basic change in the nation's revenue structure would be to introduce a new form of Federal tax, one levied on consumption instead of income. For years, economists have debated the respective merits of income and consumption as the basis for taxation. The U.S. uses consumption taxation to a far lesser degree than most other developed Western nations.
In recent years, the traditional preference for income-based taxation has eroded. A poll of macroeconomists at 15 universities reported that 63% favored "a fundamental reform of the American tax system towards a consumption tax," with 37% opposed. Tax experts have devised--and criticized--a variety of specific consumption-based taxes. No consensus, however, has been reached on the details. It is likely that two interrelated clusters of issues--the general desirability of a tax on consumption and the specific form that it should take--will receive increased public attention in the years ahead.
Many analysts believe that taxing people on the portion of society's output that they consume is fairer than taxing them on what they contribute by working and investing. In the 19th century, economist John Stuart Mill made this point in advocating the exemption of savings as part of a "just" income tax system. In the 1940s, American economist Irving Fisher argued that the income tax involved double taxation of savings and distorted the choice of individuals in favor of consumption. Thus, not only is the income tax unjust, it encourages consumption and leisure at the expense of thrift and enterprise.
The Treasury proposed a "spendings tax" in 1942 as a temporary wartime measure to curb inflation. The proposal quickly was rejected by Congress. A major argument against the expenditure tax--then and now--is that the exemption of savings would favor the rich since they are better able to save large portions of their income. Some believe this would lead to greater concentrations of wealth in the hands of a few. Proponents of an expenditure tax respond that it can be made as steeply progressive as desired. Moreover, the trend in income taxation since 1980 has been away from progressivity and toward a flatter, more proportional revenue structure.
Another objection to the consumption base is that it would favor the miser over the spendthrift, even when both have similar spending power or ability to pay. The response offered to this argument is that consumption uses up the resources available to the nation, while saving adds to these resources. Moreover, the fundamental way for an individual to minimize consumption tax liabilities is to consume less: the incentives to work, save, and invest are unimpaired. By contrast, the basic way to minimize the income tax is to earn less, which dampens incentives to work, save, and invest--with deleterious effects on economic growth and living standards.
In practice, much of the impact of shifting to a consumption tax base would depend on how the tax was structured. The two major categories of alternatives are expenditure (or income) taxes levied on the portion of income not saved (which conceptually is the same as consumption) and sales or value-added taxes collected on individual purchases. In essence, the first category is composed of top-down taxes, whereas the latter consists of the bottom-up variety. In theory, the base of the two types of taxes is the same--the value of goods and services purchased--and the yields could be very similar. Each of the revised tax systems could be revenue neutral, raising as much revenue as the current income tax.
In the top-down category, the two major alternatives are the flat tax and the savings-exempt income tax, the latter often referred to as the USA tax (for Unlimited Savings Allowance).
The Flat Tax. The key feature of the flat tax is that one rate would be levied on all income above a generous family deduction. In effect, the flat tax would be a form of consumption tax because the returns on saving and investment would not be taxed. The tax would be paid only on wages, salaries, and retirement income. Interest, dividends, and capital gains would be exempt for individual taxpayers based on the justification that adequate taxes had been levied at the business level. Thus, double taxation would be avoided. No deductions, however, would be allowed for interest payments, charitable contributions, or state and local taxes.
The flat tax would be much simpler than the current income tax. A key reason is the absence of "transition" rules. For example, with the substitution of a flat tax for the current income tax, the holders of municipal bonds (on which the interest is exempt from Federal income tax) would experience a substantial reduction in the market value of their portfolios. That is likely because investors buy these low-yielding "munis" for their unique tax-exempt feature--but all interest would be tax-exempt for individuals under the flat tax. Thus, the loss of this special characteristic would reduce the value of municipal bonds substantially.
Unlike the other variations of consumption taxation, the flat tax on business covers all domestic operations, including sales and exports. Likewise, all purchases (including capital equipment) are deducted from taxable revenue, including imports.
The Savings-Exempt Income Tax. The proposed USA tax (or consumed income tax, as technicians often refer to the concept) would be collected much as income taxes are now. The annual taxpayer return would continue to comprise the heart of the collection system, and a rate table accompanying the return could ensure as progressive a tax structure as Congress desires. However, one major change would be instituted. The portion of income that is saved would be exempt from taxation--until it is spent.
The difficult bookkeeping requirement to tally all consumption outlays can be finessed quite simply. Based on the notion that income equals consumption plus savings, consumption readily can be estimated, indirectly but accurately, merely by deducting savings from income.
A companion shift to the adoption of a top-down consumption tax would be the conversion of the corporate income tax to a cash-flow tax on business. A major change--and one that would encourage investment--would be to expense, or write off, all capital investments, such as purchases of production equipment and factories in the year in which they are acquired. At present, these outlays are deductible on the income tax over the useful life of the asset, which is a period of several years or even decades.
In many ways, such a business version of the consumption tax would be simpler than the existing corporate tax. For example, by focusing on cash flows, it would avoid the complicated transfer pricing arrangements under which domestic subsidiaries of foreign corporations minimize their U.S. tax payments.
Although these changes may sound quite technical, a top-down consumption tax would be a move toward simplification. In effect, the major substantive change for the individual taxpayer would be to convert the complicated Individual Retirement Accounts (IRAs) to an unrestricted savings mechanism. The individual taxpayer would decide how much to save and in what form and over what time period. Taxation based on income is by its nature more complicated than extracting revenues from consumption. Income taxation is inherently complex for many reasons. Complicated timing rules are necessary, such as depreciation allowances, capitalization of expenses, and inventory accounting. Inflation distorts the tax base by eroding the value of depreciation allowances and overstating the real value of capital gains. Being based instead on cash flow, taxation of consumption automatically avoids these difficulties.
In the case of the USA tax, transition rules are provided to avoid taxing consumption that is paid out of income previously taxed. Such a short-term complication--like some others contained in the proposed tax--are designed to maintain fairness among different categories of taxpayers. Although consumption-based taxation is designed to replace rather than supplement the existing income tax, it could increase Federal revenues over a period of time. This would come about from the higher rate of economic growth that could result from the encouragement given to savings and thus to investment. Bottom-up types of sales and value-added tax likely would generate similar effects.
An expenditure or consumption tax, as explained above, can be calculated via a top-down approach, building on the records that already are available to provide the data needed for enforcement of existing corporate and personal income taxes. In contrast, sales and value-added taxes (VAT) represent a very different way of collecting a general tax on consumption.
National Sales Tax. On the surface, a national retail sales tax seems like a very simple device for collecting revenues in place of the complicated income tax structure. However, because consumption tends to be a smaller share of income as we go up the income scale, many supporters of the sales tax recognize the need to soften the regressive impact on the poor. The required modifications inevitably introduce complications. The most widely used approach, at the state level, is to exempt categories of purchases on which the poor spend a larger proportion of their income than other citizens, such as food, housing, and medicine. Another proposal is to provide each taxpayer with a "smart card" (similar to a credit card), with credit for sales taxes based on family size. Yet another alternative is to give every taxpayer an automatic standard refund, also based on family size.
A national sales tax levied at the retail level may present special problems for small businesses. Unlike larger companies, which buy from wholesalers or directly from manufacturers, smaller enterprises often make their purchases from the same retailers as do consumers and, therefore, would have to pay the retail sales tax. Situations such as this led France and other Western European nations to move from relatively simple sales taxes to the more sophisticated but complicated VAT.
Because any sales tax (including VAT) is included in the price of purchases, it registers in all of the price indexes and, hence, exerts an inflationary force on the economy. The counter-argument is that this is a one-time effect only, occurring when the tax is enacted or increased and that the inflationary impact could be offset by appropriate changes in monetary policy (albeit at times with an adverse effect on the levels of production and employment). A study of 35 countries that introduced a VAT revealed that in only six did the new tax contribute to a faster rate of inflation.
Opponents also charge that either a national sales tax or VAT would invade the traditional area of sales taxation, that of state and local governments (46 states impose a sales tax). However, most states have come to rely on income taxes, despite heavy use of the same tax base by the Federal government.
Turning to administrative aspects, Federal imposition of a sales or value-added tax would require establishing a new tax-collection system by the government and new record keeping on the part of taxpayers. However, much of the current tax-collection system could be eliminated (except for the collection of payroll taxes for Social Security and Medicare).
Value-Added Tax. The VAT is, in effect, a comprehensive sales tax that avoids the double counting otherwise inevitable when the same item moves from manufacturer to wholesaler to retailer. In total, a VAT should be equivalent in yield to a single-stage sales tax levied at the retail level. Essentially, a firm's value added is the difference between its sales and its purchases from other firms. Value added also can be estimated by adding labor and capital inputs supplied by the firm itself--represented by wages and salaries, rent and interest payments, and profit. Although the top-down consumption tax notion remains a theoretical concept, the bottom-up VAT now is an existing tax in many countries.
Proponents of the VAT contend that it is economically neutral because, ideally, it is levied at a uniform rate on all items of consumption (unless exceptions are made to soften its regressive nature). The VAT does not distort choices among products or methods of production. Thus, shifting to a more capital-intensive and perhaps more profitable method of production does not affect the tax burden. Nor is the allocation of resources across product, market, and industry lines impacted. In these regards, the VAT is superior to the existing array of selective excise taxes.
Advocates of the value-added tax also point out that, in contrast to an income tax, there is no penalty for efficiency and no subsidy for waste. Moreover, the VAT is neutral between incorporated and unincorporated businesses and, theoretically, even between public and private enterprises. By focusing on consumption, it avoids a double-tax burden on the returns from capital. This tax starts off with no exclusions or exemptions and thus, at least initially, provides a broader and fairer tax base, one that the underground economy will have more difficulty evading.
Another argument in favor of U.S. adoption of a value-added tax is that so many other nations have implemented this form of revenue gathering. It fits in better than other taxes with the growing international character of production. The VAT has become one of the revenue workhorses of the world. It is a key component of the tax system in more than 120 countries, raising about one-fourth of the world's tax revenue. Virtually every important country in Europe imposes this tax, and it has spread throughout the Third World. France has used value-added taxation since 1948, and other members of the European Union have done so since the late 1960s or early 1970s. Canada adopted a seven percent VAT in 1991.
Unlike the situation in the U.S., though, the adoption of a tax on value added was true reform in those countries. That is, value-added taxes typically replaced an extremely inefficient form of consumption tax that already was in place: a cascading sales or turnover revenue system. Those latter taxes apply to the total amount of a firm's sales rather than only to its value added. Thus, sales taxes would be paid over the production process. Cascade-type taxes favor integrated firms (which legally can avoid one or more stages of the tax), but they severely discriminate against independent companies that operate at only one phase of the production process.
An added, widely cited reason for adopting a VAT is the anticipated foreign trade benefits. Unlike an income tax, a sales-based tax can be imposed on goods entering the country and rebated on items leaving--supposedly encouraging exports and discouraging imports. Thus, a VAT would seem to help reduce this nation's large trade deficit. However. many economists believe that fluctuations in exchange rates largely would offset these initial effects and result in little change in the balance of trade.
Opposition to VAT
Opponents of a value-added tax offer an extensive list of shortcomings. They contend that a VAT, as in the case of any consumption-based revenue source, is inherently regressive: Those least able to pay face the highest rates. That regressivity can be softened by exempting food and medicine or by offering refunds to low-income taxpayers, but such variations make the collection of the tax more complicated. They also provide opportunity for people in the underground economy to avoid paying taxes.
A variety of approaches have been suggested for collecting the new tax. The simplest is the credit method. Under this approach, the tax is computed initially on a company's total sales, and the firm is given credit for the VAT paid by its suppliers. To a substantial degree, the VAT would be self-enforced. Each company would have a powerful incentive to ensure that its suppliers paid their full share of the tax, because any underpayment would have to be made up by the next firm in the chain of production and distribution.
In practice, the collection of the VAT may not be as simple as outlined here. That would be the case if certain transactions were exempted (such as food) and if nonprofit institutions and government enterprises were treated differently from business firms. Exemptions are no minor matter in terms of the administrative complexity they generate. In France, a long and extensive debate occurred over whether or not Head & Shoulders antidandruff shampoo was a tax-exempt medicine or a cosmetic subject to the full VAT. (The product is taxable.) Food eaten at a location away from the business at which it was purchased may be tax-exempt. What happens if a McDonald's sets up tables outside of the restaurant?
The four approaches to tax reform analyzed in this article--flat, USA, national sales, and value-added--all are variations on the same theme. All would shift the base of Federal taxation from income to consumption while simplifying the process of complying with tax law. Proponents of consumption taxation believe that, from a macroeconomic viewpoint, each of the four alternatives, by expanding the pool of savings, would increase the rate of capital investment in the economy and thus enhance the prospects for economic growth. In turn, faster economic growth would raise employment opportunities and living standards while increasing the flow of revenues into the Treasury.
It may not be too surprising that many business leaders advocate a general shift to consumption as the primary tax base, and quite a few endorse one (or more) of the specific approaches to making that fundamental change. Nevertheless, consumption taxes have their critics, especially those concerned about the "distributional" effects. Each of the four approaches would alter the distribution of the Federal tax burden by income classes. As noted earlier, the bottom-up sales taxes and VAT reforms would require substantial modifications in order to avoid the regressive results that many fear. Also, the allocation of the business tax burden across industries would be different under each of the alternatives. As a general proposition, capital-intensive firms catering to industrial markets tend to favor consumption taxes. Labor-intensive companies, and especially those serving consumer markets, are far less enthusiastic, and many are quite hostile to the entire approach.
It typically takes several years for Congress to consider and enact a comprehensive tax reform. In the process, numerous changes usually are made in the original proposals on which it holds hearings. Some tax analysts believe that some combination of the four approaches to consumption taxation is likely to emerge--in the form of a tax that is flatter than the current income tax (but not flat), defers taxation on much savings (but not all), and is somewhat simpler than the status quo (but still filled with all sorts of complexities).
Several warnings are appropriate to those who would embark on fundamental reform of the Federal revenue system: None of the proposals is as simple as the proponents claim; each has substantial advantages and disadvantages; and all should be structured to raise the same amount of revenue as the tax system they replace. (That is the way professional analysts with no axe to grind compare the various reform proposals.)
Murray Weidenbaum, Economics Editor of USA Today, is Mallinckrodt Distinguished University Professor and honorary chairman of the Weidenbaum Center on the Economy, Government, and Public Policy, Washington University, St. Louis, Mo.
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|Title Annotation:||National Affairs|
|Author:||Weidenbaum, Murray L.|
|Publication:||USA Today (Magazine)|
|Date:||Jan 1, 2005|
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