A Stitch in Haste

A newcomer (probie?) on my blogroll, Economics with a Face, quoted, without much comment, a Bloomberg report on tax simplification and calls for replacing the federal income tax with a national sales tax (sorry, the link provided in the blog is not working):

Under either a flat tax or sales tax, the poor would be given an exemption "that recognizes the right of a family to provide for itself before it provides for the government," said Pete Sepp, vice president for communication at the National Taxpayers Union, a non-partisan advocacy group in Washington.

I found this statement utterly bewildering. How exactly do you give the poor, or anyone else, an exemption from a sales tax?

You exempt products from a sales tax, not people. Is the point that “basic necessities” (i.e., what poor people spend their money on) will be exempt? If so, then you can’t simultaneously argue fairness for the poor and simplicity, since a sales tax peppered with exemptions meant to ease the tax burden on the poor will not be simple, it will be very complicated.

Look at any state that has less than a ubiquitous, prophylactic sales tax, and you find a complex web of lists, exemptions, schedules, etc., often the result of politics and lobbying more than common sense. For example, in my home state of New York: lemonade is exempt but root beer isn't, basketball shoes are exempt but bowling shoes aren't, frozen fried chicken is exempt but prepared fried chicken isn't.

Very difficult, and very political, decisions would have to be made were a federal sales tax to be implemented. Will pharmaceuticals be taxed? College textbooks? College tuition? Home purchases? Rent? Utilities? Orthodontics? Haircuts? Museum admissions? Funerals? And so on, and so on, and so on...

Not a road I’d like to see the federal government go down, given its track record with the Internal Revenue Code (currently at 2.8 million words and growing).

For Discussion: I'm always afraid to say "Open Thread," because if no one posts, then that imposes negative externalities on my ego, but I invite readers to contribute sales tax conundums from their home states -- examples of closely-related items where one is subject to sales tax and the other not.

POST SCRIPT: Let the record reflect that I have nothing whatsoever against the National Taxpayer Union. They seem to talk libertarian enough. I think the spokesman just flubbed in this particular instance.

UPDATE: Peter at Economics with a Face posts a thoughtful update addressing my concerns. I certainly have no problem with people engaging in the academic thought experiment of replacing the federal income tax with a sales tax, using efficiency and/or equity as the evaluating criteria. But let's call a duck a duck -- in the real world any proposal for a federal sales tax must be loudly and unequivocally opposed for the simple reason that

income tax today + sales tax tomorrow = both taxes next week

Or have I become just too cynical in my [not that] old age?

Related Post:
Denny's For Breakfast

(Cross-linked at Outside the Beltway.)

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.

This is what one chamber of Congress does to the tax code when it's in a hurry:

--Lets taxpayers with incomes of $65,000 or less ($130,000 for couples filing a joint return) deduct $4,000 for higher education costs. The deduction is $2,000 for those earning up to $80,000 (or $160,000 with joint returns). The cost is $3.3 billion over two years.

--Extends through 2007 a research and development tax credit that offers a 20 percent credit for new activities. The cost is $16.3 billion over five years.

--Extends through 2007 the welfare-to-work tax credit under which employers can get a maximum credit of $3,500 for the first year of employing a person who has received public welfare.

--Extends through 2007 the deduction of up to $250 for teachers who personally buy classroom supplies. The two-year cost is $379 million.

--Extends through 2007 the option of taxpayers from states without income taxes to deduct state and local sales taxes. The seven affected states are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. The cost is $5.5 billion over two years.

Can you imagine what they do when they're able to take their time about it?

Now, after we get through the obligatory libertarian harumphing, consider the alternative: a national sales tax.

Does anyone honestly believe it would be any different?

Some advocates of replacing the federal income tax with a national sales or consumption tax insist that these tax preferences and loopholes would vanish if we switched to a consumption. Why?

Does anybody honestly believe that Congress will impose a national sales tax on baby formula? Or food in general, for that matter? Or rent? Or a trip to the emergency room?

Now imagine the sales taxes that Congress would pass: Buy an American car instead of Japanese — get a sales tax break. Buy a desktop computer (a middle-class device) — get a tax break. But Blackberries — a vanity of corporate executives? Tax them. Coach airfare? Tax free. First Class? Tax it. Whole Foods tax-free; KFC taxed.

And so on.

Remember always: these are politicians we're talking about. It is preposterous to presume that they will behave any differently under one tax regime than they will under the other.

And it's not only preposterous but also flat-out dangerous to think that we can go from a federal income tax today to a federal sales tax tomorrow without going to both taxes the day after tomorrow. Are you willing to take that chance?

The problem is not primarily how we tax, it's how much we tax. And how politicians are allowed to manipulate whatever tax system we happen to have.

Lower taxes generally, and the loopholes will take care of themselves.

One of the reasons I dismiss calls for replacing the federal income tax with a federal sales tax is because such proposals are founded on several false premises. See my previous post.

Among the most glaring of these faulty assumptions is that the Politics of Pull and the Politics of the Warm Fuzzy Feeling wouldn't permeate a federal sales tax the exact same way they infect state sales taxes.

Who seriously believes that federal politicians and bureaucrats would, for example, allow diapers to be taxed? Or college tuition? Or an appendectomy? Or the interest on your mortgage (your bank "sold you" financial services, so -- I am not making this up -- the sales price, which is the interest you pay the bank, would get "sales taxed" as well, at least under one proposal).

In New York State, soda (even diet soda) is taxed but iced tea isn't. Frozen chicken is not taxed but heated chicken is. Basketball shoes are not taxed but golf shoes are. And so on.

So the IRS would not "disappear" under a federal sales tax -- it would continue to do exactly what it does today: issue regulations and interpretations. Much like state finance departments do when implementing and enforcing their sales taxes.

One example: the brainiacs in Tennessee:

Laundering or dry cleaning of tangible personal property is a taxable service in Tennessee. Thus, charges for bathing animals are subject to sales tax while charges for grooming are not taxable.

Are you getting all this down?

Persons providing animal grooming services who have been making a single charge that includes both the bathing and grooming of an animal have two options:

--Separately itemize the charge for bathing from grooming and apply sales tax to the charge for the bathing portion of the invoice, or

--Continue to make a single charge for both bathing and grooming, and apply tax to the total charge on the invoice.

Don't worry -- there's only 39 more pages of such minutiae that the Tennessee government expects people -- not accountants, not business owners, but everybody -- to know and abide by.

I'm sure that Congress and the IRS would do a far better job with a federal sales tax. Just look at their exemplary track record with the Internal Revenue Code -- all 16,485 pages of it.

It's quite simple really: Take care of tax rates, and tax simplification will take care of itself.

(Via Tax Policy Blog.)

A bit of a spat between Rudy Giuliani and Mike Huckabee:

Republican presidential hopeful Rudy Giuliani criticized the "fair tax" plan that has been touted by rival candidate Mike Huckabee on Monday, saying it could hurt home buyers.

The former New York City mayor cited the struggling U.S. housing market as a reason to avoid the plan, which would eliminate all taxes on income and investments in favor of a hefty federal sales tax.
...
"This would not be a good time — I don't know if there would ever be a good time to do this — to advocate ending the home mortgage deduction. The home mortgage deduction is considered by many critical to the ability of people to buy a home and keep their home."

Huckabee supports the national sales tax plan, pompously labeled by its proponents as the "Fair Tax." The Tax Foundation, a group that I generally consider an ally, screeches against Giuliani here.

I blogged about the mortgage interest deduction previously. The precis: It's an unwarranted, politically based, warm fuzzy feeling deduction that should never have been introduced in the first place. But now that it has been around for decades, it would be fundamentally unfair to repeal it (what the law calls "detrimental reliance").

The far more ironic observation regarding this kerfuffle is that no one — not Huckabee, not Giuliani and not even the Tax Foundation — seems willing to observe, or perhaps even to know about, a pesky fact:

Under a national sales tax, not only would mortgage interest no longer be deductible, but it would itself be subject to the sales tax. Mortgage interest would convert from a tax advantage to a tax burden.

What part of "a tax on all goods and services" is unclear? Well, when you take out a mortgage — or any loan, for that matter — the bank is "selling" you a service (i.e., financing). The price you pay for that service is the interest. So that gets taxed, no different than buying a Happy Meal, or diapers, or a college education, or an emergency appendectomy. Everything gets taxed. Everything.

And that tax on the mortgage interest would, of course, be on top of the tax levied on the price of the home itself (the property is the "good" while the financing is the "service" — but both get taxed).

The other dubious aspects of the "Fair Tax" — such as the flat-out lie about it being 23% ("0.3/1.3=0.23" is a 30% tax, not a 23% tax) and about how the actual tax rate would have to be as high as 82% to be revenue-neutral — are already noted here.

As for mortgage interest, debates about whether the deduction was wise or equitable ex ante are all well and good, but relative to the "Fair Tax," two wrongs can hardly be described as a right.

Bottom line: Take care of tax rates, and tax fairness will take care of itself.

Does this sentence make any sense to you?

"Dogs have feathers, because birds have feathers and dogs would therefore have feathers if they were birds."

No?

Then how much sense does this sentence make? (WSJ - $)

The FairTax rate is 23% on retail sales when calculated "inclusively," as are income tax rates.

But just as a dog is not a bird, a sales tax is not an income tax. So to say that a sales tax rate can legitimately be presented by the same metric as an income tax rate is as ridiculous as saying that "dogs have feathers -- assuming that dogs are birds."

It is as simple as it is unarguable: the FairTax proposal is a 30% national sales tax:

"0.30 / 1.30 = 0.23"
is a 30% sales tax, not a 23% sales tax. All else is willful deceit...

...as is the 30% itself, incidentally.

Mike Huckabee (R-Jesusland), leading huckster of the "FairTax" proposal, during his Super Tuesday speech:

I really do look forward to nailing the "going out of business" sign on the front door of the IRS.

To which I replied at another blog:

If the "FairTax" would abolish the IRS, then who is going to calculate and distribute its "prebate" provision?

Since the "FairTax" exempts some nebulous entity called "tuition," who other than the IRS is going to promulgate rules and regulations deciding what is and is not "tuition"?

Since the "FairTax" considers mortgage interest above the risk-free rate to be a "service" subject to the tax, who other than the IRS is going to determine exactly what that risk-free rate is over what periods and how it is to be applied?

Since the "FairTax" applies to sales of new homes but not to existing homes, who other than the IRS is going to set the rules for deciding what does and does constitute "new" or "existing"?

I could go on, but you get the idea.

They lie about their proposal being a 23% tax and not 30%. They lie about how the reality-based rate would have to be at least 44% and possibly as high as 82%. And they lie about abolishing the IRS.

It's quite simple really: Keep tax rates low for all, and "fairness" will inevitably follow.