Saturday, November 19, 2011

Notes on the Consumption Tax

GOP Presidential candidate Herman Cain has stirred up debate by proposing sweeping reform of the tax code. Under his 9-9-9 plan, there would be a 9% flat federal income tax, a 9% flat federal corporate tax, and a 9% federal sales tax instead of the current system. He has been, predictably, attacked from both sides of the political spectrum. The left have criticized the flat income tax and the sales tax as regressive. But, even the right have attacked him for creating a new revenue stream for the federal government in the form of a consumption tax, even though his plan calls for income taxes and corporate taxes to be much lower than current rates (although many pay less because of deductions and exemptions that would not exist in Mr. Cain's plan, the lowest marginal income tax rate currently is 10%).

However, there is a long tradition of support for a consumption tax in conservative politics. In 1994 Rep. Bill Archer (R-TX), then chair of the House Ways and Means committee began advocating for a national retail sales tax to replace the federal income tax. In 1996, Representatives Dan Schaefer (R-CO) and Billy Tauzin (R-LA) introduced legislation proposing such a tax. John Linder (R-GA) introduced the Fair Tax Act (H.R. 2525) calling for a 23% national sales tax to replace the federal income tax. Linder popularized the act in a 2005 book co-authored by conservative radio talk show host Neal Boortz entitled The Fair Tax Book. Governor Mike Huckabee (R-AK) made the Fair Tax the centerpiece of his 2008 campaign for the Republican nomination for President. Granted, these proposals all sought to replace the federal income tax completely and not add a consumption tax to an income tax, albeit at a lower income tax rate.

Although the size and scope of government should probably be much smaller than it currently is, there is a legitimate role for government (see previous post).

Since government, as Jefferson put it, is a necessary evil, it needs to have revenue to accomplish those tasks. There is no other way for government to obtain revenue other than taxation. Therefore, there will always be taxes and the notion that we can live in a nation without taxes is the the right's version of the what Milton Friedman called the great myth of government - that everyone can live at everyone else's expense. Although the size and scope of government should probably be much smaller than it currently is, there is still going to be a need for some government and therefore a need for some taxation.

If there has to be taxation, there are many reasons to prefer a consumption tax. First of all, it is less coercive than an income tax as you can always choose to do without or not to buy the goods and service being taxed (granted you don't have that choice if it is being levied on food...), or at least to limit your tax liability by limiting your consumption. You have no such recourse for an income tax. A consumption tax you pay only when you choose to spend, and you have chosen to spend money anyway - it simply raises the price of the good or service you have chosen to purchase. An income tax takes your money before you even see it and does so even if you are trying to save your earnings. The second reason to favour a consumption tax is related: when you tax something you get less of it. We tax savings in this country and thus the savings rate is abysmal. As a consequence, our central bank creates credit out of thin air to encourage economic growth because there is no pool of saved capital for banks to lend. This creates economic bubbles and further discourages savings because they do so through an artificially low interest rate. As a consequence many Americans are overleveraged and our economic growth is never sustainable (furthermore the lack of savings has everyone turning to government for their retirement, which further compounds the problem). If we taxed consumption we would encourage savings and have growth that actually stems from real accumulated capital... Thirdly, the consumption tax is economically neutral. It is applied across the board, equally and to everyone and is therefore less hampering to economic growth. It does not discourage job creation by taxing job creators at a higher rate. Fourth, it is a more efficient tax. At a lower rate it can collect more revenue because it is much harder to avoid or defraud and it collects tax from a lot of people who currently don't pay taxes. Furthermore it collects this tax in a way that is fair and behaviour neutral rather than taxing one group more or less than another depending on their willingness to jump through certain behavioural hoops (like buying a house or putting in green light bulbs...). Fifthly it, it is a tax that favours American manufacturing. As it is levied on imports and taken off on exports, it makes imported goods less competitive on the domestic market and our exports more competitive overseas.

Progressives argue that a consumption tax is regressive and will put the pinch on working class families by making their food, clothing, and shelter more expensive. This is largely a straw man however because no one is talking about adding a consumption tax to the current income tax. If the consumption tax either replaces the income tax or allows for a lower income tax, the burden isn't necessarily higher. It is, however, more transparent. The cost of goods and services wouldn't necessarily be higher if a consumption tax either replaced or allowed for lower income and corporate taxes. You don't notice that the fact that you as a consumer have to pay your share of the corporate tax on everything you buy as it gets added into the cost of production. You would be very aware of paying the consumption tax, but it would replace a lot of invisible taxation. Although it is preferable to tax all things at the same rate, for the reasons given above, there are ways to minimize its regressivity, such as a prebate for lower income families or exempting grocery items from the tax (as the state of Maryland does with its sales tax).

Keynesians (and, scandalously, some Republican candidates for President) oppose the sales tax because it discourages spending. This presumes that all spending is good and all economic growth is a result of spending. That view of economics has landed us where we are today, a debtor nation with almost no savings rate. Prolific spending can produce impressive economic growth - a boom, but that will be followed by a bust because it is not sustainable. On the other hand, if more saving was encouraged the accumulation of capital would be the market force that drives interest rates down and encourage lending out of capital that already exists rather than lending out of artificially created capital. As the interest rate came down from the encouragement of savings, people would start saving less, which would then force interest rates up again to encourage savings again. The market could set the interest rate, rather than a central bank making up how large the money supply would be - and by inflating the currency to encourage "growth" making us all poorer. That would be the path to sustainable economic growth, rather than Keynesian boom and bust.

Furthermore, experience doesn't bare out the canard that consumption taxes hamper economic growth. First and foremost, people are still going to consume and their consumption habits aren't going to change that much (particularly since the net effect on cost might not be that much once the invisible taxes are removed). Secondly, the tax is applied equally across all sectors of the economy, so the net effect on economic activity is zero - it doesn't favour one type of economic behaviour over another (other than favouring saving, which in the long run is probably a good thing) and it doesn't distort economic activity. Contrast that with the current federal income tax and corporate tax structure which actually discourages savings, investment, and hiring and ask your self which is more detrimental to economic growth (not to even get into the distortions in the market place created by all the different loopholes, exemptions, and deductions). Texas has only a consumption tax and a rather high one (if memory serves, 8.25%), but has had incredible economic growth and is one of the few states whose economy is still growing in this recession. Canada enjoyed unprecedented economic growth in the the 1990's and 2000's after initiating a federal sales tax - if the consumption tax is so detrimental to the economy, why wasn't Canada left behind when the rest of the world was booming? The combination of the more efficient consumption tax and massive cuts in government spending allowed Canada to get its debt under control (Canadian debt was 80% of GDP in the early 90's, which is where U.S. debt is now), limit inflation, and eventually even cut income tax rates. As a consequence, Canada has fared much better in the current recession, hasn't needed to bail out a single bank (although they did help bail out Chrysler and GM) and the Canadian dollar went from being equal to about 70 cents USD to being essentially equal to the U.S. dollar. Most Canadians (certainly all of my relatives in Canada) hate the tax because it is visible and the Conservative government that passed it was decimated in the next election, but it is really hard to argue that it hasn't served Canada well.

Although it would be preferable to replace the federal income tax with a consumption tax, the Canadian experience suggests that simply having a consumption tax and lower income tax and corporate tax rates would be much better than the current system.

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