All Commentary
Wednesday, November 1, 2006

Sales, Flat, or Spherical, Tax Reform Isn’t the Answer

Lately there has been a flurry of interest in tax reform, typically aimed at making compliance less onerous, removing the incentive for special-interest lobbying, and reducing the size and intrusiveness of the tax-collection agency. While few people will reject those ends, that does not imply that the attempt to achieve them is the optimal use of the inevitably limited time and energy that citizens choose to devote to political activities. Of particular relevance to readers of this magazine is whether friends of liberty ought to focus on such reforms to forward the cause of freedom.

There are also schemes circulating for supplementing the current income tax with, for example, a sales tax or VAT (value-added tax), but such plans are unlikely to gain much support from libertarians, given that they pose the obvious danger of providing the government with an additional way to collect revenue. Since they threaten to merely increase the overall tax burden on society without offering, from a libertarian point of view, any compensating benefits, I will not address them in this article.

However, suggestions for replacing the income tax with a sales tax, or simplifying it by taxing everyone at a single rate and eliminating all deductions (a “flat” tax) have caught the fancy of some libertarians. The main attractions of these ideas are that substituting a sales tax or flat tax for the current income tax appears to ease the burden of tax compliance. A sales tax in particular does not seem to penalize savings and investment the way an income tax does, and the promoters of such policy changes contend that their new system of taxation will produce results closer to those that would come about on the unhampered market than does the existing apparatus.

One popular proposal along such lines has recently been described in The Fair Tax Book, coauthored by talk-show host Neal Boortz and Georgia congressman John Linder. Because of its prominence, I will use it as a paradigm for all plans of its kind. I believe that the problems it contains are endemic to other similar schemes; so my case against Boortz and Linder also applies more generally.

The authors under discussion present their alternative to our present system as a virtual cornucopia pouring forth blessings on the American people. Implementing their idea, they contend, will do away with the oft-reviled IRS, reduce the effort devoted to complying with the tax code to almost nil, greatly lift the living standards of the poorest Americans, reverse the trend of U.S. firms relocating overseas, and provide a tremendous boost to the nation’s economy. Clearly, if these promises are realistic, everyone should enthusiastically support their plan. However, a clear-sighted analysis of the proposal reveals that the case for predicting these benefits is constructed on a foundation riddled with wishful thinking and flawed logic.

For example, Boortz and Linder argue that their tax system will greatly boost the purchasing power of most Americans’ incomes, since it eliminates the portion of the cost of every good that currently stems from the seller’s tax burden. However, their argument relies on a ludicrous assumption as to where the incidence of present taxation actually falls: On the one hand, they claim that eliminating the income tax will reduce the price of what you buy roughly 20 or 30 percent because producers all pass the tax they pay on to you through higher prices. On the other hand, they also point out all the money you’ll save by no longer paying your own income tax. Apparently, unlike those involved in making everything you buy, you can’t just pass on that tax to others. It seems the incidence of the income tax falls entirely on one special segment of American society: the readers of The Fair Tax! The authors are guilty of counting the savings their readers will see from ending the income tax twice, once in the price of the things they buy and again in their own paychecks. In reality, getting rid of any tax will result in some combination of lower prices and higher incomes, the proportion depending on the particular circumstances of each case. But the total of the two effects will only sum to the gross reduction in taxation, and certainly not to double that figure!

Another supposed advantage of the Fair Tax is that, unlike the present situation where taxes are withheld from every paycheck, obscuring the share of one’s income that the government takes, the Fair Tax will be clearly visible, listed on every sales receipt. However, given that it would be a ubiquitous aspect of all one’s shopping, it is hard to see why its presence won’t fade from view just as readily as the income tax has through withholding. After all, workers today get a “receipt” with every paycheck that plainly shows how much of their salary went straight to Uncle Sam, but that has not solved the problem.

IRS Unnecessary?

Another curious claim on the part of the authors is that the Fair Tax will make the IRS unnecessary. Apparently, people will simply pay this sales tax with no need for an enforcement agency. No one will ever claim that what are really retail sales are wholesale, and no one will ever hide cash transactions from the government—all because we’ve changed how we collect a tax burden that remains just as large as it is today.

To illustrate the lack of realism on display, I’ll offer just one example of how the Fair Tax could be avoided (with a little imaginative effort the reader will probably be able to come up with many others): the tax is imposed only on final sales, meaning those to consumers, and not on purchases made by producers along the way to that end point. So let’s say some executive is tired of paying 23 percent extra—that’s the sales tax rate our authors envision—on everything he buys. The way around the tax is to have the firm pay for as much of his consumption as possible, by devising some way to portray buying the items as important business expenses rather than personal purchases.

Boortz and Linder will no doubt respond that such a practice will be illegal, but that’s not the point. To catch people at such a game requires an investigative body on the lookout for its taking place—the players are not going to turn themselves in, nor will those uninvolved easily spot the activity and report the participants to the authorities. Even with today’s comparatively low sales taxes imposed by state and local governments, it is common for small-business owners to offer a customer a discount for paying in cash, thereby splitting the savings from tax avoidance between the two parties. The Fair Tax rate, three or four times higher than its present counterparts, will promise a proportionally larger reward for successfully dodging it. Fair Tax advocates may not call the agency tasked with enforcing compliance with the new law the IRS, but they will surely require such an agency if they plan to maintain government revenue at anywhere near its current level, which is a crucial element in their sales pitch.

Moving Offshore

The contention that this kind of tax reform will stem the tide of American businesses relocating overseas relies on firms taking into account the tax impact of corporate decisions. If moving headquarters to some tax haven, such as Bermuda or the Cayman Islands , can significantly lower the firm’s tax costs, then the move is likely to get serious consideration. It is true, therefore, that eliminating corporate taxation, as Boortz and Linder propose to do, will be an attractive change in the eyes of multinational companies. However, executives do not consider only corporate taxes in deciding where to locate. The taxes they and their employees will personally have to pay, as well as the amount the local tax system adds to the cost of the products purchased within the country, are also relevant factors. Therefore, the best bet for a nation wishing to retain existing businesses and attract new ones is to have a low total tax burden, rather than to eliminate one form of taxation while seeking to completely offset the lost revenue by introducing a new method of collection.

To be fair to our authors, I will note that they also suggest their support for reducing the overall tax take, but they have decided to separate that issue from their tax proposal and focus on the latter, since they believe it would prove highly beneficial even without any tax cuts. This, I suggest, is a major error.

There is a subtle matter of economic theory, expounded by the great Austrian economist Ludwig von Mises, that is worth examining here since it has great bearing on the topic at hand. In his crowning work, Human Action, Mises points out that the actual burden of any tax is determined by the market process rather than by the taxing authority. The deep import of Mises’s contention can easily be overlooked because it seems at first glance to merely reiterate a standard lesson contained in introductory economics courses. It is commonplace for beginning students to encounter a demonstration of how the portion of a tax on, say, alcohol, that is paid by the buyer versus the portion borne by the seller is quite independent of the government’s decision as to which party is legally obligated to pay the tax. If, for example, there were only one supplier of alcohol, while drinkers’ demand for booze dropped very little in response to increased liquor prices, then the consumers would wind up bearing most of the burden of any new tax, even if officials assign the seller the responsibility for remitting it. Indeed, Boortz and Linder sometimes seem to grasp this idea, although they ignore it in contending, as I noted, that all the cost of the present income tax is passed on through higher prices.

But Mises’s insight goes well beyond the typical analysis. The mainstream textbooks analyze the market for the taxed good as if it were entirely self-contained, isolated from the rest of the economy. But in the real world the supply and demand for any good is deeply intertwined with the markets for all alternative goods and services that might be produced or consumed. That means that although legislators might be seeking to tax the alcohol industry, in reality it could turn out to be, say, truck drivers who are hardest hit, if liquor companies shift toward shipping by rail in response to their new cost. Or perhaps soft-drink manufacturers will be the group most affected, if consumers decide to forgo a few sodas a week to maintain their previous level of alcohol consumption at the now higher price.

One crucial ramification of understanding that the market determines the true incidence of a tax is that the particulars of how a government collects its revenues are of decidedly secondary importance. Of course, it is possible to design tax schemes so Byzantine that trying to comply with them is even more onerous than paying the taxes themselves. But in general the market process will distribute the true incidence of a nation’s tax system according to the cumulative dictates of individuals’ supply-and-demand decisions, thwarting policymakers’ dreams of directing the burden by top-down planning.

Another fundamental error common to tax-reform schemes like the Fair Tax is that their proponents evaluate the attractiveness of their favored plan in an ideal world where powerful and wealthy special interests won’t greatly influence its realization. They then compare that fantasy scenario with the messy reality of the tax code we have today. But any method of taxation that attempts to divert as much of the output of society’s productive activities into the coffers of the state as does the current one will inevitably prompt intense efforts by a multitude of parties to tailor the actual details of the system to their liking. I see no reason to imagine that their lobbying would not complicate any “reformed” tax code until it is as convoluted as what we have today. The only reform that is likely to avoid that fate is a dramatic reduction in the total tax take, thereby greatly decreasing the potential payoff of successfully tilting the system in one’s favor.

I don’t mean to rule out the possibility that one or another tax reform might represent a genuine improvement over the present situation. But the key question is whether such proposals deserve any significant portion of the necessarily limited attention that libertarians can devote to policy issues. A small reduction in the penalties currently imposed for drug crimes would no doubt be a step forward, but I suggest that focusing on such a goal would be a distraction from the real libertarian aim of repealing all laws violating individuals’ freedom to decide on their own what to eat, drink, and smoke.

Similarly, while the hope of achieving any large decrease in the level of taxation may appear remote today, that hope will only recede further into the distance if we dissipate our energy in marginal battles that, even if won, would leave the core of the problem untouched.

Those who desire to relieve the crippling effect that today’s massive states have on their citizens ought to focus on reducing the share of private wealth that governments are able to claim as their due. To instead concentrate on tinkering with the means by which that claim is effected is like a doctor treating a person for athlete’s foot even while the patient is suffering a heart attack.

  • Gene Callahan is a writer and economist who teaches at the State University of New York at Purchase.