A Sales Tax or Value-Added Tax?
Understanding traditional types of stand-alone consumption taxes.
August 30, 2007
by Lester Snyder
This article has been excerpted from Lester Snyder’s book, Double Take: Unequal Taxation of Equals, (Vandeplas Publishing, 2007). Reprinted with permission.
The one consumption-type tax that we are most familiar with is the state sales
tax, which taxes retail sales of goods and (in some states) services,
and while collected by the seller, it is normally included in the price paid
by the retail consumer. It is in addition to all other state and local taxes,
and has a narrow tax base, in other words it does not tax all sales. For
example, it does not tax purchases of stocks, real estate, and other investments,
and it does not tax all services, such as legal and health, and has a sporadic
array of food exemptions. In most states it does not tax purchases of business
equipment and lottery tickets.
After his re-election in 2004, President George W. Bush stated that he intended to overhaul our tax law by scrapping the federal income tax and putting in its place a national sales tax or a tax on what we spend, rather than on what we earn. Some members of Congress and others have proposed various consumption-type taxes over the past several years, but this is the first time a president has put the power of his office behind the proposal of such a radical reform of our tax system. Why is it being advanced now, and what are some of the pros and cons of a consumption tax?
Replacing the income tax (in its entirety or only partially) with a national sales tax or one of the consumption taxes, such as the most “popular” (yet least understood) Flat Tax, raises a number of problems. These concerns range from potential effects on low-income people, who consume most of their income, to international trade, where the treatment of exports and imports would be coordinated with the Value-Added Tax and other World Trade Organization precepts. These questions require careful explanation, not as yet publicly disclosed by the administration or Congress. Let’s look at some of the key issues:
For example, if Ames Ford, Inc., an auto dealer, buys a car from the manufacturer at a base price of $20,000, Ames will pay the manufacturer an additional tax of $4,000 (assuming a 20 percent VAT rate) or a total of $24,000. The $4,000 represents the tax paid by the manufacturer on the purchase of its raw materials, which it passes on in its sale to the dealer, plus its profit (or value added). The dealer then sells the automobile to the consumer at $30,000, which includes a 20 percent VAT tax of $6,000, representing the value added (or mark-up) by the dealer. The dealer remits to the government the $6,000 less the $4,000 VAT it paid to the manufacturer. In the end, the tax is paid at each stage of production, with each one in the chain paying the tax on what it sells the product for, and taking a credit for what it paid for the materials it purchased. The government ends up with its 20 percent tax on the final purchase price, paid by the ultimate consumer. This procedure supposedly reduces the amount of tax avoidance, since the purchaser at each stage must have proof of the tax paid to the company that sold it the product.
By far the most contentious issue in adopting a national sales tax (or a VAT) in place of the income tax is the regressive feature of such a tax. Consumption as a percentage of annual income is greater for low-income families than for high-income households. Rich folks would be taxed only on a small percentage of their income or wealth. The sales tax becomes more difficult to administer when we introduce exemptions for food, clothing and shelter although some state sales taxes already do so. The bill introduced by Rep. John Linder would provide for cash payments to low-income individuals, and make the tax rate for others 23 percent of items purchased. Some economists calculate the rate needed to make up for the $1 trillion in lost income tax revenue at over 30 percent.
[Note that the Flat Tax proposed by Hall-Rabushka should not be confused with
the suggestions in this book to remove the progressive rate feature in the
current income tax law. The “Flat Tax” is a consumption tax
where the rate could be flat or progressive.]
Adopting a national sales tax by itself would not change the tax on business income. It is unlikely that Congress would repeal in their entirety the corporate tax and the income tax on other businesses. Legislation in the past few years has reduced taxes for many large and some small businesses, but only selectively. The American Jobs Creation Act of 2004 inadequately deals with imbalances in international trade. There is evidence that the Jobs Act, by allowing corporations to repatriate their foreign earnings back to the United States at a reduced tax cost in return for creating new jobs at home, in fact resulted in huge layoffs of employees. The corporate tax savings was gobbled up by management and investors.
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