A Stitch in Haste

The Urban Institute has released a major study analyzing the math behind the leading proposal to replace the federal income tax with a national sales tax, H.R. 25 (a/k/a the Fair Tax Act of 2005). Link to the study here (PDF – 23 pages); link to the legislation here.

The sponsors of the House bill have suggested that, as structured, their tax paradigm would be revenue-neutral to the federal government at a 23% sales tax rate.

To which the Urban Institute's response is: Bullsh*t!

According to UI, even under the most optimistic assumptions, the correct number would be closer to 44%. Or, stated differently, a 23% national sales tax would fall $7 trillion short over the next decade under H.R. 25.

But those optimistic assumptions are also hopelessly unrealistic. UI demonstrates, via comprehensive models, the various fallacies and errors (and one might dare say flat-out lies) behind the 23% number. Some highlights:

--The 23% number is "tax inclusive," which is how people think of income taxes but not sales taxes. The actual sales tax as normal people measure it is really 30%:

Suppose a good costs $100, before taxes, and there is an additional $30 sales tax placed on top of that price. The tax-exclusive sales tax rate is the ratio of the tax to the pretax price (that is, the tax payment is excluded from the denominator). In this example, it would be 30 percent (30/100). The tax-exclusive rate corresponds to the "mark-up at the cash register." In contrast, the tax inclusive tax rate is the ratio of the tax payment to the entire cost of the good, including both the pretax price and the tax payment itself; in this example, it would be about 23 percent (30/130).

So right off the bat, before any scrutiny of any of the underlying assumptions, we're really talking about a 30% sales tax, not 23%. But it gets worse.

--The 23% number assumes absolutely zero tax avoidance (legal) or tax evasion (illegal). That's nonsense and we all know it. In fact, evasion may be far easier under a sales tax than under the income tax (e.g., you could easily have an ongoing agreement with your barber, nanny, mechanic, or whomever to keep the haircuts, daycare, tune-ups or whatever "off the books"). UI notes that the current federal income tax evasion rate is estimated at 17% of aggregate taxable income; if the evasion rate were comparable for a national sales tax, then the revenue-neutral tax rate would escalate dramatically (more on that below).

--Under H.R. 25, state & local government purchases would be subject to the national sales tax. Of course, the (narrow) holding of McCulloch v. Maryland, 17 U.S. 316 (1819), concerned the other direction (i.e., states cannot try to tax the federal government), but UI also suggests that any attempt by the federal government to impose a sales tax on state governments might be constitutionally suspect. Not my area of expertise. (And anyway, let's assume it is constitutional to tax the states and their subdivisions. Where will the states, counties, cities and school districts get the money to pay this new federal sales tax? From you and me, of course. Damned if you and damned if you don't.) UI estimates that if state and local government purchases were exempt from the national sales tax, the revenue-neutral tax-exclusive rate would, ceteris paribus, rise from 30% to 36%.

--H.R. 25 taxes financial services. For example, the national sales tax would apply to your mortgage interest payment, or at least that part in excess of the going rate on Treasuries:

Thus, for example, a taxpayer with a mortgage at a 7 percent rate would have 4/7 of the mortgage interest payment subject to tax if the Treasury rate were 3 percent even though the home purchase itself was already subject to tax.

While we're on the subject: Under H.R. 25, if you buy a newly-constructed home, then you pay sales tax on it, but if you buy an existing home, then you don't pay the tax. Try to explain how that's fair or how it won't have a huge impact on the economically vital housing market.

--Under H.R. 25, each household (defined how?) would receive a rebate, called a "demogrant," designed to exempt purchases equivalent to the poverty level. Two observations: First, still think there wouldn't be an Internal Revenue Service to manage (and audit) these "demogrants"? Second, think the liberals, socialists and Rawlsians wouldn't eventually call for means testing the demogrant such that the "rich" (defined how?) won't get it?

All-in, UI estimates that, under various scenarios about evasion, exemptions (e.g., for food purchases) and excluding state and local government purchases, the revenue-neutral sales tax rate under H.R 25 could actually be anywhere from 53% to 82%. Either that, or keep the national sales tax lower and explode the deficit.

And finally, I'll repeat my own warning: Any proposal to move from a federal income tax to a national sales tax must, absolutely must, include a constitutional amendment repealing the Sixteenth Amendment. Otherwise, we will simply go from an income tax today to a sales tax tomorrow to both the day after tomorrow.

Libertarians would be better off simply advocating lower taxes (and spending) rather than persisting in this deck-chair-rearranging debate about which tax is "better." The only better tax is a lower tax.