Replacing the Federal Income Tax


Thank you Chairman Archer for the opportunity to testify duringthese three days of congressional hearings on radical overhaul ofthe U.S. tax code. I commend your leadership and courage forconvening these historic hearings.

A revolutionary change in our tax system is fundamental tore-energizing the American economy and restoring the Americandream. Although Congress may not be ready quite yet to enact a flattax or a national sales tax, let me assure you that the public is.Americans are entirely exasperated with the current incometax--they want a system that is simpler, fairer and morepro-growth. A recent article in Parade Magazine asked readerswhether they would favor a national sales tax over the currentincome tax. More than 50,000 responses have been received. They arerunning 50 to 1 in favor of abolishing the income tax. Even IRSagents are writing in saying we should scrap the income tax.

Let me state my overall conclusions from the start.

  1. The entire personal income tax, corporate income tax, capitalgains tax, and estate tax can and should be replaced with aneighteen percent national sales tax that protects the poor.Eventually, as we cut down on the size and scope of the federalgovernment and accrue the dynamic revenue feedback effects ofhyper-charged economic growth that would result from abolishing theincome tax, the sales tax rate could be lowered to well below 15percent.
  2. We ought to consider enacting the Armey flat tax plan as anintermediate step to abolishing the income tax completely. Althoughthere is much disagreement over the merits of a flat tax versus asales tax, what is most remarkable in this debate is not howdifferent these two plans are, but how similar they are. Forexample:
    • The Armey plan and the sales tax plan both vastly simplify thetax code.
    • The Armey plan and the sales tax plan both have a 17 to 20percent flat tax rate.
    • The Armey plan and the sales tax plan both eliminate alldeductions in the tax code. This means that both plans are fightinga common enemy: the army of special interest groups who have spentdecades carving out their special interest exemptions andloopholes.
    • The Armey plan and the sales tax plan both have virtually anidentical tax base: consumption. The economic impact is verysimilar and explosively positive.

Mr. Chairman, it is my view that you and Mr. Armey agree on farmore than you may think.

The only real dispute--and this is certainly an area of enormousconsequence--is whether we should collect the tax through apostcard income tax return or at the cash register. This is wherethe sales tax in my opinion is far superior in the longterm to theflat tax. I favor a national sales tax because I believe that theincome tax is incompatible with a free society. The IRS routinelyintrudes on our basic civil liberties and privacy rights--and it'sintrusions are getting worse all the time. I want an America whereit is no longer the government's business how much money you makeand what you do with it.

Still, it may make sense to enact the flat tax immediately andthe sales tax later--as Cato has advocated in our Handbook forCongress. Once we have established the principles of a low flatrate tax on consumption with no deductions--and all the specialinterest lobbies have been steamrollered--it is a logical next stepto scrap the income tax entirely. This may be a canyon that needsto be crossed in two leaps. The first leap should be the flat tax.The second the sales tax.

In earlier testimony the case against the income tax and for anational sales tax has been eloquently presented. I will thereforediscuss not the issue of whether a national sales tax, but how. Ialso want to debunk some of the common myths circulating about thealleged impracticalities of a national sales tax.

The Cato Institute has developed a national sales tax plan withthe following four features:

  • An 18 percent sales tax on all final use goods and services(this is not a retail sales tax) except housing and securities.Over time the rate would gradually decline to below 15percent.
  • Every American would receive an annual rebate on the tax paidon the first $5,000 of purchases. This would mean that for a familyof four, the first $20,000 of consumption during the year would betax free.
  • The states--45 of which already have an income tax--would beresponsible for collecting the national sales tax. (The federalgovernment would reimburse the states for the cost of collection.This would not constitute an unfunded mandate.) With the statescollecting the tax, the federal IRS police force would be largelydisbanded. With the infrastructure of the income tax systemdismantled, it would be very difficult for a new income tax to bereinvented.
  • A two-thirds supermajority requirement in both houses to raisethe sales tax or any other federal tax.

The national sales tax is the only plan that fixes all of thedefects of the current income tax system. Here is how:

  1. Because the sales tax exempts all savings and investment, thedouble taxation problem would be eliminated. Because the sales taxis a single flat rate, the disincentive effects from high marginalrates would be eliminated. That giant sucking sound you would behearing would be investment capital from across the globe sweepinginto the United States.
  2. By eliminating the income tax entirely, compliance costs--estimated at $200 billion a year--would be substantiallyreduced.
  3. The sales tax would virtually eliminate the Internal RevenueService. The sales tax is the only plan that solves theintrusiveness of the current system.
  4. A sales tax would be paid by consumers every time theypurchased a good or service at the cash register. Because the taxwould appear on the receipt, the sales tax would be highly visibleto taxpayers. All purchases--from an 89 cents grape slurpee atseven-11 to a $20,000 Ford Bronco--would be taxed. Taxpayers wouldbe constantly reminded of what a hefty price we pay for governmentin America today.

A common question that I am asked about this plan is: Do thenumbers really add up for the sales tax to raise as much revenue asthe income tax does? To answer that question, in 1993 the CatoInstitute commissioned a study by economist Lawrence Kotlikoff ofBoston University to examine the economic impact of replacingfederal income taxes with a national sales tax--roughly asdescribed above. The purpose of the Kotlikoff study was todetermine a) What would be the impact of the sales tax on economicvariables such as savings, wages, and output? and b) What is thenecessary sales tax rate to completely replace on a revenue neutralbasis the federal personal income, corporate income, and estatetax?

Kotlikoff discovered that to completely replace federal incometaxes would require an initial sales tax rate of 17.4 percent.After five years the rate could be reduced to 15.4 percent, andafter ten years the rate could be lowered to 13.9 percent. Thereason the rate can be lowered is that the study finds a verypositive economic feedback from the tax change. Specifically, theKotlikoff study finds that after ten years, a national sales taxwould:

  1. More than double the national savings rate.
  2. Increase the capital stock by 8 percent above the levelattained under the current tax system.
  3. Raise income and output by 6 percent more than would beachieved under the current tax system. That would increase nationaloutput by almost $400 billion per year.
  4. Lift the real wage rate by 3 percent.
  5. Reduce interest rates by 50 to 100 basis points.

Kotlikoff concludes the Cato study by issuing the followingendorsement for a sales tax: "A shift to a national sales tax hasthe potential for dramatically improving incentives to save. Thedistortion to save is so great under our current system of incometaxation, that it appears we could switch to consumptiontaxation...and end up with much higher rates of saving and capitalaccumulation and a higher level of per capita income."

What then, are the arguments against the national sales tax?Here are the most common objections, and the reasons theseobjections are exaggerated, or in some cases, just plain false.

Objection 1. The sales tax is regressive.

The rebate feature of the national sales tax makes this proposalnonregressive. Remember, a family of four would pay no tax on itsfirst $20,000 of purchases each year. This is the equivalent of azero bracket under the income tax. It is similar to the Armeypersonal deduction--though not as generous.

There are various ways of providing this rebate. Assuming thatthe sales tax were set at 18 percent, a family of four would beentitled to a rebate of $3,600 ($20,000 x 18 percent) for the year.The government could send a quarterly rebate check of $900 to everyfamily of four; a $450 check to every family of two; and so on.

Another possibility would be to provide every family with anannual "smart card" that would have a sales tax credit based onfamily size. A married couple with no kids would receive a $10,000credit on its card. Each time the couple made a purchase, the smartcard would deduct that amount until the card's $10,000 credit wasused up. After the first $10,000 of purchases, the family wouldbegin to pay the sales tax.

So it dead wrong to argue that a sales tax is inherentlyregressive.

Objection 2: A sales tax of 18 percent would entaillarge- scale evasion.

A national sales tax of 18 percent, when added to the existingstates sales taxes, would bring the total sales tax to between 20and 25 percent.

Critics are right when they argue that a sales tax this highwould encourage evasion. But compared to what? Evasion is already ahuge problem with the income tax. An estimated $150 billion ofincome tax goes uncollected each year--according to the IRS's owncalculations. Moreover, states report that the their sales taxesare generally easier to collect than their income taxes, becausethere are so fewer points of collection.

I believe that much of the evasion that goes on with our taxsystem is a result of the correctly perceived unfairness of thesystem. Once we move to a national sales tax that is perceived asfair, simple and just, compliance rates will climb substantially.This is also true of the Armey flat tax as well.

Objection 3: the sales tax may not be a replacement, butrather an add-on to the current income tax.

A very legitimate concern voiced by many conservatives is thedanger that America will end up with both a sales tax and an incometax. This has been the experience with the consumption tax VATs inEurope. For this reason, some critics argue that the sales tax isonly acceptable if the 16th Amendment to the Constitutionauthorizing a federal income tax were repealed. That wouldcertainly be highly desirable, but is not necessary. To protectagainst the reintroduction of the income tax, I would insist on asupermajority tax raising requirement.

Objection 4: The national sales tax has been a politicaland economic disaster in Europe and Canada.

VATs have had highly negative consequences in Europe. They havenot raised savings rates, they have not reduced income tax burdens,and they have been an engine of growth of government. For thesereasons, I strongly oppose a value-added tax. But no Europeannation has implemented a national sales tax as a completereplacement for the income tax. This is the critical differencebetween our proposal and what has occurred in Europe andCanada.

I believe that the national sales tax is the superior tax reformproposal on the table. Many of the reform ideas now in themix--including the Nunn-Domenici plan--will soon fall out of thepicture and the national debate will begin to revolve around justtwo proposals: the flat tax and the national sales tax. Mypreference is the sales tax, but either of these would be vastimprovements over the current system.

Stephen Moore

Committee on Ways and Means
United States House of Representatives