Replacing the Federal Income Tax

June 8, 1995 • Testimony

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

A revolutionary change in our tax system is fundamental to re‐​energizing the American economy and restoring the American dream. Although Congress may not be ready quite yet to enact a flat tax or a national sales tax, let me assure you that the public is. Americans are entirely exasperated with the current income tax–they want a system that is simpler, fairer and more pro‐​growth. A recent article in Parade Magazine asked readers whether they would favor a national sales tax over the current income tax. More than 50,000 responses have been received. They are running 50 to 1 in favor of abolishing the income tax. Even IRS agents 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, capital gains tax, and estate tax can and should be replaced with an eighteen percent national sales tax that protects the poor. Eventually, as we cut down on the size and scope of the federal government and accrue the dynamic revenue feedback effects of hyper‐​charged economic growth that would result from abolishing the income tax, the sales tax rate could be lowered to well below 15 percent.
  2. We ought to consider enacting the Armey flat tax plan as an intermediate step to abolishing the income tax completely. Although there is much disagreement over the merits of a flat tax versus a sales tax, what is most remarkable in this debate is not how different these two plans are, but how similar they are. For example:
    • The Armey plan and the sales tax plan both vastly simplify the tax code.
    • The Armey plan and the sales tax plan both have a 17 to 20 percent flat tax rate.
    • The Armey plan and the sales tax plan both eliminate all deductions in the tax code. This means that both plans are fighting a common enemy: the army of special interest groups who have spent decades carving out their special interest exemptions and loopholes.
    • The Armey plan and the sales tax plan both have virtually an identical tax base: consumption. The economic impact is very similar and explosively positive.

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

The only real dispute–and this is certainly an area of enormous consequence–is whether we should collect the tax through a postcard income tax return or at the cash register. This is where the sales tax in my opinion is far superior in the longterm to the flat tax. I favor a national sales tax because I believe that the income tax is incompatible with a free society. The IRS routinely intrudes on our basic civil liberties and privacy rights–and it’s intrusions are getting worse all the time. I want an America where it is no longer the government’s business how much money you make and what you do with it.

Still, it may make sense to enact the flat tax immediately and the sales tax later–as Cato has advocated in our Handbook for Congress. Once we have established the principles of a low flat rate tax on consumption with no deductions–and all the special interest lobbies have been steamrollered–it is a logical next step to scrap the income tax entirely. This may be a canyon that needs to 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 a national sales tax has been eloquently presented. I will therefore discuss not the issue of whether a national sales tax, but how. I also want to debunk some of the common myths circulating about the alleged impracticalities of a national sales tax.

The Cato Institute has developed a national sales tax plan with the 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 15 percent.
  • Every American would receive an annual rebate on the tax paid on the first $5,000 of purchases. This would mean that for a family of four, the first $20,000 of consumption during the year would be tax free.
  • The states–45 of which already have an income tax–would be responsible for collecting the national sales tax. (The federal government would reimburse the states for the cost of collection. This would not constitute an unfunded mandate.) With the states collecting the tax, the federal IRS police force would be largely disbanded. With the infrastructure of the income tax system dismantled, it would be very difficult for a new income tax to be reinvented.
  • A two‐​thirds supermajority requirement in both houses to raise the sales tax or any other federal tax.

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

  1. Because the sales tax exempts all savings and investment, the double taxation problem would be eliminated. Because the sales tax is a single flat rate, the disincentive effects from high marginal rates would be eliminated. That giant sucking sound you would be hearing would be investment capital from across the globe sweeping into the United States.
  2. By eliminating the income tax entirely, compliance costs‐ -estimated at $200 billion a year–would be substantially reduced.
  3. The sales tax would virtually eliminate the Internal Revenue Service. The sales tax is the only plan that solves the intrusiveness of the current system.
  4. A sales tax would be paid by consumers every time they purchased a good or service at the cash register. Because the tax would appear on the receipt, the sales tax would be highly visible to taxpayers. All purchases–from an 89 cents grape slurpee at seven‐​11 to a $20,000 Ford Bronco–would be taxed. Taxpayers would be constantly reminded of what a hefty price we pay for government in America today.

A common question that I am asked about this plan is: Do the numbers really add up for the sales tax to raise as much revenue as the income tax does? To answer that question, in 1993 the Cato Institute commissioned a study by economist Lawrence Kotlikoff of Boston University to examine the economic impact of replacing federal income taxes with a national sales tax–roughly as described above. The purpose of the Kotlikoff study was to determine a) What would be the impact of the sales tax on economic variables such as savings, wages, and output? and b) What is the necessary sales tax rate to completely replace on a revenue neutral basis the federal personal income, corporate income, and estate tax?

Kotlikoff discovered that to completely replace federal income taxes would require an initial sales tax rate of 17.4 percent. After five years the rate could be reduced to 15.4 percent, and after ten years the rate could be lowered to 13.9 percent. The reason the rate can be lowered is that the study finds a very positive economic feedback from the tax change. Specifically, the Kotlikoff study finds that after ten years, a national sales tax would:

  1. More than double the national savings rate.
  2. Increase the capital stock by 8 percent above the level attained under the current tax system.
  3. Raise income and output by 6 percent more than would be achieved under the current tax system. That would increase national output 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 following endorsement for a sales tax: “A shift to a national sales tax has the potential for dramatically improving incentives to save. The distortion to save is so great under our current system of income taxation, that it appears we could switch to consumption taxation…and end up with much higher rates of saving and capital accumulation 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 these objections 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 proposal nonregressive. Remember, a family of four would pay no tax on its first $20,000 of purchases each year. This is the equivalent of a zero bracket under the income tax. It is similar to the Armey personal deduction–though not as generous.

There are various ways of providing this rebate. Assuming that the sales tax were set at 18 percent, a family of four would be entitled 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 every family of four; a $450 check to every family of two; and so on.

Another possibility would be to provide every family with an annual “smart card” that would have a sales tax credit based on family size. A married couple with no kids would receive a $10,000 credit on its card. Each time the couple made a purchase, the smart card would deduct that amount until the card’s $10,000 credit was used up. After the first $10,000 of purchases, the family would begin to pay the sales tax.

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

Objection 2: A sales tax of 18 percent would entail large‐ scale evasion.

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

Critics are right when they argue that a sales tax this high would encourage evasion. But compared to what? Evasion is already a huge problem with the income tax. An estimated $150 billion of income tax goes uncollected each year–according to the IRS’s own calculations. Moreover, states report that the their sales taxes are generally easier to collect than their income taxes, because there are so fewer points of collection.

I believe that much of the evasion that goes on with our tax system is a result of the correctly perceived unfairness of the system. Once we move to a national sales tax that is perceived as fair, 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, but rather an add‐​on to the current income tax.

A very legitimate concern voiced by many conservatives is the danger that America will end up with both a sales tax and an income tax. This has been the experience with the consumption tax VATs in Europe. For this reason, some critics argue that the sales tax is only acceptable if the 16th Amendment to the Constitution authorizing a federal income tax were repealed. That would certainly be highly desirable, but is not necessary. To protect against the reintroduction of the income tax, I would insist on a supermajority tax raising requirement.

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

VATs have had highly negative consequences in Europe. They have not raised savings rates, they have not reduced income tax burdens, and they have been an engine of growth of government. For these reasons, I strongly oppose a value‐​added tax. But no European nation has implemented a national sales tax as a complete replacement for the income tax. This is the critical difference between our proposal and what has occurred in Europe and Canada.

I believe that the national sales tax is the superior tax reform proposal on the table. Many of the reform ideas now in the mix–including the Nunn‐​Domenici plan–will soon fall out of the picture and the national debate will begin to revolve around just two proposals: the flat tax and the national sales tax. My preference is the sales tax, but either of these would be vast improvements over the current system.

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