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FLAT TAX & SALES TAX.

Examines pros & cons of fairness & effectiveness of two consumption-based reforms to correct deficiences & injustices in tax system.

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PROS AND CONS OF FLAT TAXES AND SALES TAXES

This research paper examines the potential advantages and disadvantages from a public policy standpoint of various types of consumption-based taxes which have been proposed to remedy the deficiencies of the current federal tax system. A flat tax, rigorously applied, would be far superior to the present system because it would be simpler, fairer, a more efficient way of collecting public revenues and consistent with optimizing economic growth. However, it would benefit disproportionately higher income individual taxpayers, certain property owners and business generally and impose crushing burdens on lower income and many middle income taxpayers who depend on personal services income for maintaining their way of life and who consume most of

For solong as people have their income invested for everyone's benefit,including their own, they do not have to pay tax on that income."[1 ] In one version of the flat tax contained in a bill sponsored by Rep.Richard Armey (R. There are many more middle class than higher income personaltaxpayers and a higher percentage of middle class registered voters votethan do lower income taxpayers. Conclusion On balance, the arguments in favor of some type of consumption tax,most likely a modified flat tax, would appear to outweigh itsdisadvantages. Rev. 114 & 1148. 1995) USA Today, at p. R. There would beproblems in valuing and accounting for fringe benefits and for items ofimputed income. 722, 1 4th Cong., 1st Sess., 147 Cong. 36-37.----------------------- [1] M. 13, 1996) Economist, p. Under the USA Tax the proceeds would be taxable when theyare received and the premiums are deductible.[12] Since it taxes a person on his consumption, the flat tax would yieldthe highest tax savings to higher income taxpayers because they currentlyare subject to higher rates (up to 39.6 percent on taxable income over$256,5 ) and because they are currently taxed at various rates on theirincome and gains from savings and investments. Pollack, The flatliners (Sept. 198-199. [5] Id. Rev. 1282-1328.J. Mayer, T. Growth industries which make heavy capital investments in researchand development and capital equipment would come off best. D. 15.William D. 32. McNamee, Death to the IRS (July 31, 1995) Business Week, pp. Schnepper, The tax mess who is to blame? Its proponents claim that it would be easier to collect than a flattax, but Armey disputes that assertion, pointing out it could be evadedrelatively easier by behind the counter deals involving retailers andpurchasers. [23] Schenck, supra, 1322.----------------------- 14 However, it would benefit disproportionatelyhigher income individual taxpayers, certain property owners and businessgenerally and impose crushing burdens on lower income and many middleincome taxpayers who depend on personal services income for maintainingtheir way of life and who consume most of their income. Andrews argues that "a consumption-based tax, one whose burdens are apportioned to current consumptionexpenditures rather than to total accretion" would be fairer.[8] Rabushka &Hall argue that the current tax system discriminates against savings andproductive investments and that a flat tax "would shift billions of dollarsfrom investments that reduce taxes to those that produce goods andservices," thereby raising tax revenues and living standards.[9] Likely Effects of a Flat Tax Under a 'pure' flat tax, all income from wages, salaries and otherforms of personal service income, such as consulting fees and fringebenefits would be taxed but income from savings and investment would not.Gains from the sale of investment assets would be taxable when they wereconsumed --i.e. A flat tax would be easier tocollect, especially if it were withheld at the source as proposed by theArmey-Shelby bill, than under the present complex reporting and withholdingsystem. 1996), pp. Joseph Cayer eds.,American Public Policy (5th ed. S 5664(1995). [3] Robert E. 84. The richest 2 percent of the population in 1992 received44.6 percent of aggregate family income, as compared with 41.4 percent in1967 and the poorest 4 percent saw their share of that income decline from17.6 percent to 14.9 percent over the same period.[19] This growinginequality of income does not concern consumption tax enthusiasts, who seesavings and investment as the driving force of the economy, while othereconomists profess concern about the social effects of this trend and itseventual depressing effect on the level of aggregate demand. A pure flat tax would greatly simplify and reduce the cost of taxpreparation, compliance and enforcement. [15] S. A flat tax, rigorously applied, would befar superior to the present system because it would be simpler, fairer, amore efficient way of collecting public revenues and consistent withoptimizing economic growth. He argues that a straight flat tax would be much easier toenforce and collect than a sales tax and that "a flat tax can eliminate upto 94 percent of the current costs of compliance."[21] The Europeans have used VAT taxes for decades. Finally, many argue that the present system is unfair. 13, 1996) Economist, p. 13, 1996) Economist, p. Rev. 1317. Deficiencies of the Current Tax System During the last several years, a great many Americans have expresseddissatisfaction with the current income tax system. It has, however, been estimated that retention ofthis deduction would cost the Treasury $6 billion a year. [1 ] Paul E. Without some exemptions anddeductions, a flat tax would have an especially regressive impact on lowerincome taxpayers who save and invest little and consume a higher percentageof their income, out of necessity. 722, 1 4th Cong., 1st Sess., 147 Cong. Rec. . 18, 1995) New York Times,page D 15.M. Ga.), as follows: "Everyone has a stake, a large one, . Most state and local governments depend to a large extent on revenuesfrom their sales and other excise taxes. (Sept. Carr & N. . The home buildingindustry might be adversely affected by the elimination of this deduction;but Steve Forbes argues that home buyers would benefit from an overalllowering of interest rates which would result from exempting interest fromtaxation. 5 - 61.Robert E. Cochran, Lawrence C. Bradford, Untangling the Income Tax (1996).Clarke E. 32.america's tax revolution (Jan. 18-22.Alan Schenck, The Plethora of Consumption Tax Proposals: Putting theValue Added Tax, Flat Tax, Retails Sales Tax and USA Tax inPerspective (Fall 1996) 33 San Diego L. 36; and McNamee, supra, p. [6] J. 1995), pp. The impact of a flat tax on businesses would vary according to theirtype. . 5& 19. 5 . Cochran, Lawrence C. When they take their income out ofsavings and reduce the national stock, they pay tax on that income. Mayer, T. Such a tax has been proposed by Senator Richard Lugar andothers. R. Hall & Alvin Rabushka, supra, p. A VAT tax is morecomprehensive than a retail sales tax in that it catches a broader range oftransactions at wholesale and distribution levels, and since all businessesare responsible for compliance it might reduce the opportunities for taxevasion which are present at retail outlets. Thetwo leading types of sales taxes, a value-added tax (VAT) and a retailsales tax, would tax consumption transactions rather than income at thesource. G. 18, 1995) New Republic, pp. PROS AND CONS OF FLAT TAXES AND SALES TAXES This research paper examines the potential advantages anddisadvantages from a public policy standpoint of various types ofconsumption-based taxes which have been proposed to remedy the deficienciesof the current federal tax system. Equity investments would no longer suffer a taxdisadvantage vis-a-vis debt instruments, the interest on which is nowdeductible. VAT is imposed at alllevels of distribution and imposes an excise tax at the value added toproducts at each level. Rec. 2 6 , 1 4th Cong.,1st Sess., 141 Cong. The Economist recognized that these effects would cause someshort-term discomfort, but "by shutting off the tap for everybody at once,most taxpayers would gain far more in simplicity and economic efficiency[as well as in equality of tax treatment] - than they would lose."[2 ] After the 1986 Tax Reform Act eliminated many personal deductions,Congress voted in tax increases, a process which was repeated underPresident Bill Clinton in 1993, in order to reduce the budget deficit. 18, 1995) New Republic, p.19. 11, 1996) New YorkTimes, page D 15. The ultimate burden of VAT taxes are passed on toconsumers in much the same way as are sales taxes. not reinvested. 1995).Jack Kemp, Lower taxes, higher revenues (Sept. [14] David F. S5664 (1995). All taxpayers would be taxed, regardless of their source ofpersonal or business income, at the same rate. Proposed variantsof the flat tax would ease its regressive features; however, they might notproduce the necessary revenues at the tax rates currently proposed andmight also lead to further complexity and inequities in the tax code. The philosophical rationalefor this distinction was summarized by tax lawyers Paul O'Neill & RobertLutz, the principal draftsmen of a pending bill in Congress, the USA Tax,which was sponsored by Senator Peter Dominici (R. 1995) USA Today, pp. N. [18] Armey, supra, p. 2 6 , 1 4th Cong., 1stSess., 141 Cong. (Sept. 1994) USA Today,p. Pollack, The flatliners (Sept. G. Donald, Burdensome taxes (April 11, 1994) Barron's, pp. This suggests that it may be politicallynecessary to allow home mortgage interest to be deducted in order to securepassage of a flat tax. 1996).T. E 1461 (1995).Internal Revenue Code (1997).USA Tax Act of 1995, S. Seemingly as easy or easier to collect as a flat tax, a nationalVAT or retail sales tax would have even more regressive effects than a flattax, diminish state tax revenues and offer opportunities for tax avoidance. TABLE OF AUTHORITIES Statutes and BillsFreedom and Fairness Restoration Act of 1995, H. Andrews argues that if "the primary,intended, real effect of any general-revenue raising tax is to . 1994) USA Today, pp. R. All non-business deductions woulddisappear. Thesame risk would be present after a flat tax was adopted, namely, thatCongress would simply raise the flat tax rate. Rec. 84-85.Paul E. [2 ] America's tax revolution (Jan. Donald, Burdensome taxes (April 11, 1994) Barron's, p. The Armey-Shelby bill and the USA Tax incorporate as their tax onbusiness (BT) a modified VAT, including a deduction for wages and otheremployee costs. [16] Jack Kemp, Lower taxes, higher revenues (Feb. [11] Dick Armey, The flat income tax (Nov. [8] Andrews, supra, 1116. 22- 23.David F. Under the USA Tax System, when people earn income save part of it and add to the national stock of savings, they get a tax deduction. Lutz, Unlimited Savings Allowance (USA)Tax System (March 13, 1995), 66 Tax Notes 1482-1574.S. 15. If it is desirable for public policy reasons to subsidize aparticular cause or activity, a better way to do so, in the view of taxprogressives, would be by direct subsidies which would be voted onseparately and openly rather than through the current insidious processthrough which special interests lobby for tax preferences. Other SourcesA better way to pay (Jan. R. 13, 1996) Economist, p. Rev. 1113-1188.Dick Armey, The flat income tax (Nov. Similar policy arguments can be raised in favor of retaining thededuction for charitable contributions, the retention of tax-free intereston municipal bonds and other worthy causes. [12] O' Neill & Lutz, supra, 15 7. E 1461 (1995). [13] Andrew, supra, 1165-1166. 23. 85. If it is deemedthat the wealthy are benefiting too much from a flat tax, a direct taxcould be imposed on wealth (as opposed to high incomes), as is the case inabout a dozen European countries. Andrews, A Consumption-Type or Cash Flow Personal IncomeTax (April 1974) 87 Harvard L. Hall & Alvin Rabushka, The Flat Tax (2d ed. Should an individual be allowed a deduction for the cost ofpremiums paid on life insurance? .curtail [private] consumption, then it is presumptively fair and efficientto distribute the burden of tax proportionately or progressively inrelation to levels of consumption."[13] Bradford says that such a tax wouldviolate the principle of vertical equity or the concept that "those withbetter circumstances should bear more of the tax burden."[14] Most proposals in current circulation would allow thresholdexemptions and deductions for lower income taxpayers. 152. Tex.) and Senator John Shelby (R. [9] Robert E. [17] Id. The difficulty with allowingsuch deductions is that they are likely to lead an endless demand foradditional deductions (what about catastrophic medical expenses, forexample?) and thus vitiate the principal benefits of the flat tax itself. [22] Alan Schenck, The Plethora of Consumption Tax Proposals: Puttingthe Value Added Tax, Flat Tax, Retail Sales Tax and USA Tax in Perspective(Fall 1996) 33 San Diego L. Pros and Cons of Sales Taxes A retail sales tax would be imposed on all sales transactions at theretail level. Both retail sales and VATsince they are imposed at the point where funds are used for consumptionrather than at their source would capture some income which is unreportedand untaxed under the current system. Tax lawyer Alan Schenck says that"states with retail sales taxes may be opposed [to a national VAT] becausethey fear that it would more difficult for them to raise their sales taxrates."[23] All sales taxes, whether they are direct or indirect, hit the poormuch harder than more affluent taxpayers, for the reasons set forth above.One VAT proposal would give families with annual incomes of up to $3 , VAT rebates. . The Armey-Shelby billwould effectively shield the first $33, of taxable income of a family offour, Steve Forbes the first $36, . Hall & Alvin Rabushka, The Flat Tax (2d ed. McNamee, Death to the IRS (July 31, 1995) Business Week, p. [19] Clarke E. Another advantage of a flat tax is that it would eliminate the manyhidden special tax benefits accorded to many groups, especially the largecorporations. [2] A better way to pay (Jan. Carr & N. [21] Armey, supra, p. Some politicians such as Armey talk of filing tax returns on apostcard but the computation of the income and expenses of some individualsand almost all businesses would not be quite that simple. [4] T. in the national stock of savings. Mex.) and formerSenator Sam Nunn (D. O'Neill & Robert A. [7] William D. . They would gaina cash flow advantage from being allowed to expense those investments on acurrent basis, instead of having to amortize them over time, and they wouldbe more attractive to investors than slower growing or less capital-intensive businesses. Miss.) (the Armey-Shelby bill), the personal flat tax rate starts at 2 percent and would bephased down to 17 percent over three years.[11] The National Commission onEconomic Growth and Tax Reform headed by Jack Kemp proposed a 19 percentrate. Bradford, Untangling the Income Tax (1986) p. Schnepper, The tax mess who is to blame? A March, 1995Yankelovich poll for Time/CNN showed that among those surveyed, 8 percentsaid that the current system of tax exemptions and deductions favored therich, 34 percent favored making major changes to the Internal Revenue Codeand another 22 percent wanted to replace it entirely.[1] The failures ofthe current system were summarized by the Economist as follows: "It isriddled with exemptions for everything under the sun; it stifles investmentand entrepreneurship; and it is beastly to comply with."[2] Flat taxadvocates Robert Hall & Alvin Rabushka estimate that the annual costs ofdirect and indirect compliance and enforcement are in the hundreds ofbillion dollar range.[3] Financial writer Donald estimates that taxpayersspend 5.2 billion hours a year in tax compliance.[4] The Internal RevenueService (IRS) has become a notoriously inefficient federal agency,seemingly unable to cope with a rising amount of uncollected taxes, $156billion in 1994.[5] The IRS is perceived by many to have a 'bullymentality,' has become overly intrusive in the private lives of sometaxpayers and overbearing in its treatment of them.[6] On a more theoretical plane, tax lawyer William Andrews points outthat much of the complexity and inefficiency of the present system stemsfrom the difficulties involved in attempting to tax not only personalconsumption, but also the accumulation of wealth, "the hybrid character ofour treatment of accumulation," which he says is "hardly attainable inpractice."[7] Under the present system, a great deal of cost and effort isassociated with the attempt to measure that accumulation, some of which istaxed over time and other portions of which are never taxed, such as lifeinsurance proceeds and interest on municipal bonds, and other gains areonly partially taxed, such as capital gains, because of lower rates, taxnon-recognition and the stepped basis capital assets receive when thetaxpayer dies. The Treasury argues that proponents of a flattax are understating the rate of tax which will have to be imposed toreplace the current stream of revenues, which it maintains will have to beat least 25.8 percent.[15] Kemp argues that the tax revenues of the federalgovernment will increase under a flat tax, pointing to the 6 percentincrease after the tax cuts of the 192 s, the 16 percent increase after the1963 Kennedy tax cuts and an increase of 4 percent after the Reagan taxcuts.[16] Supply-siders in the 198 s overestimated the stimulative effectson the economy of tax cuts, but it remains an article of faith amongproponents of a flat tax, Kemp arguing that it could lead to a doubling ofthe rate of economic growth.[17] Armey asserts that savings and investmentwill increase, "resulting in an economic boom" which will increase theincome of the average family by $4,3 per annum by the year 2 2.[18] Assuming that a flat tax will stimulate the economy by encouragingsavings and investment, the question still remains as who will derive mostof the benefits. Such a deduction would appear to belogical if the proceeds are to be taxed. Rec. 85. Andrews, A Consumption-Type or Cash Flow Personal Income Tax(April 1974) 87 Harvard L. 22;Freedom and Fairness Restoration Act of 1995, H. O'Neill & Robert A. There is an on-going debate as to the effects of a flat tax on fiscalrevenues and on the economy. The solution offered by the Armey-Shelby bill is to exempt life insurance proceeds from income, estate andgift taxation, which is totally inconsistent with the theoretical rationalefor a flat tax. Lutz, Unlimited Savings Allowance(USA) Tax System (March 13, 1995) 66 Tax Notes 1482;USA Tax Act of 1995, S. However, imposition of a VAT is avery large undertaking, which the Europeans have never used as asubstitute, only as a supplement, to individual and business income taxes.The General Accounting Office estimates that the annual costs ofintroducing a national VAT would be in a range of $122 billion and $183billion.[22] One advantage of a retail sales tax is that the collectioncould be left to the states, largely removing the need for a large IRS. The basicargument is that income and gains associated with savings and investmentare subjected to double taxation at the corporate and the individual leveland that because of the patchwork of incentives, exemptions, deductions andother loopholes in the IRC, certain classes of taxpayers, especially thosewho save and invest, are discriminated against while others are favored,for example, investors in oil and gas drilling who can take advantage offast write off depletion allowances. To forestall such action,the Armey-Shelby bill would require that future tax rate increases beapproved by supermajorities of three fifths to two thirds. 22. It is not clearthat the home mortgage interest deduction affects home buying decisions.Canada and Australia, which do not allow it, have roughly the samepercentage of home ownership as does the United States. Joseph Cayereds., American Public Policy (5th ed. D.

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