Economics With A Face

Won’t a National Sales Tax Shift the Burden of Taxation to the Poor and Middle Class?

Looking at the most recent data from the IRS, this indeed could be a cause for concern.

As we can see the top 1% of income earners paid over a third of the total income taxes collected by the IRS. Conversely, the bottom half of the income scale pays a scant 3.5% of total income taxes. Any reforms to broaden the tax base would then seem to surely increase the burden on lower income individuals.[1]

One thing to remember though is that the income scale above does necessarily translate into a scale from rich to poor. To demonstrate this point, imagine a family where a husband and wife both work, earning $55,000 and $40,000 respectively. This would put their household in the top 10% of income earners, but it would not mean that they are wealthier than 90% of the country. In fact if they are putting a child through college, have a mortgage, a car payment, etc., finding dollars to spend at a country club would probably be impossible. Similarly, take a family where the head of the household is unemployed, but they sell their home for a one time capital gain of $150,000. While this would push them into the top 5% of income earners, the comfort of this cash windfall would most likely be short lived.

Conversely, consider a retired couple who owns their home outright, has very few expenses, and retires with a pension of $50,000 a year. While this would place them lower on the income scale than the families in the two examples above, who could seriously argue that they are poorer?

This is a key flaw in our current tax system that is partially addressed in the article authored by Baum. Each individual with a valid social security number would receive a check from the government, reimbursing them for their taxes paid on purchases up to the poverty level. Therefore the poor, as defined by the Census Bureau, would pay no taxes. For a family of four the poverty level is currently $18,810 a year. A family that made $100 over this level, and decided to spend that money on a new television would pay a total of $23 in taxes (an effective tax rate of 0.12%). A family that made $1,000,000 over the poverty level and decided to spend it all on a new yacht would need to pay $230,000 in taxes (an effective tax rate of 22.58%).

So while the truly poor would face a minimal tax rate, if any at all, what about the middle class? Here I must defer to calculations on the fairtax.org website. They compare various middle income families' tax returns under the proposed national sales tax and the current system. The results look very favorable and can be viewed here.

Now can I vouch for these calculations personally? While they look correct, there certainly could be something that I am missing. But taken at face value, at the bare minimum, they show promise. If we find there is a segment of the population that would be unjustly burdened under the plan, we could (and should) tweak the minimum refund level to address these concerns.

Of course, it would also take quite an effort to reform the current tax code but in my opinion the benefits would outweigh the costs. The question that follows is what are the benefits that make it worthwhile?

A flat national sales tax would have the enormous benefit of simplifying the tax code. It would eliminate both the wasteful spending of billions upon billions on tax compliance and a 45,622 page tax code that not even the most intelligent tax lawyers and accountants can understand. But what intrigues me most about such a tax it would shift taxation to consumption, rather than savings.

But if Consumption Drives the Economy, Won't a Sales Tax Kill Economic Growth?

It is an excellent question. For even if a national sales tax could be implemented without shifting the tax burden to the less fortunate, could it not have disastrous economic consequences? It’s said that consumption drives the economy, and thus taxing it would seem to surly hurt economic growth.

To take this viewpoint though is to ignore the important role that savings play in consumption. Let’s take the most obvious example: the housing market. Would it be possible for the average middle class family to buy a house if they had to do so out of their present income? Clearly the answer is no. Yet everyday people pay for expensive items such as houses, cars, large appliances, or college tuition that exceed their disposable income. How can this be? They can do so by relying on the savings of others to finance these purchases. Without savings, consumption of these expensive items would be severely limited, if not impossible.

Similarly, a majority of the country earns a living by selling their labor (i.e. they receive wages). The majority of these wages are then used to consume goods that are essential (such as food, shelter, medical, etc.) or for pleasure (i.e. entertainment, vacations, etc.). But wages would also be impossible without savings. Factories and businesses that employ so many of us could not be constructed without a source of funds. In addition, wages themselves could not be paid if the owners had not put money aside to pay them. Products take weeks, months, even years to produce before they are finally sold for a profit. But employees don’t need to wait until the product is sold to collect their wages, they are paid out of savings. Can you imagine how poorly the economy would function if everyone had to wait until the final product they helped to produce was sold in order to collect the money they had earned? Such an economy would fall apart.

This is not to demean those who earn wages compared to those who save in any way. Clearly, saving money wouldn’t do much good if there was nowhere to invest it. And more importantly, this classification ignores the fact that these groups are often one in the same. I’m simply pointing out that savings are key to any economy and to consumption, no matter the source of the funds.

For me it is always easiest to look at such a system in very simple terms. Imagine an economy that is represented by one farmer with one product: corn. The farmer can use the corn he possesses in one of two ways. He can eat the corn to feed himself or plant it to grow more corn for the future. Now obviously if the farmer were to eat his entire supply of corn he would have none to plant, and while content today, he would starve in the future. On the other hand, if the farmer were to plant his entire supply of corn, he would starve before he could reap the future benefits. Clearly, there is a trade-off. That which is planted (i.e. saved) needs to produce enough in the future to equal his current consumption. If the farmer plants enough so that the future yield is greater than his current consumption, not only will he be able to consume more in the future, he will be able to save more as well. By saving, his corn field will grow larger than it is today… and this is equivalent to economic growth.

Now our economy consists of much more than corn but the analogy is still valid. By saving instead of consuming we increase our capital stock. Our savings flow into the technologies, factories, and business of tomorrow and that allows us to both produce and consume more than we currently do. Wealth is created. Again, this is the definition of economic growth and savings is what spurs it.

To look at it another way it’s beneficial to everyone if someone who has earned a small fortune invests $500,000 in a new company that creates products and expands our economy. If instead they use this money to buy a new sports car they are spending their money not on something that will create wealth, but something that will be of use only to themselves and will be worth less and less as it is worn out. We're all better off if this rich individual saves his money, for it benefits us all.

And remember, if you want people to stop smoking, tax cigarettes and people will do less of it. On the flip side, if you want people to save, make savings tax-free and people will do more of it. That’s the essence of a national sales tax.

The Rich Will Live Tax Free

"...to me it is morally wrong to say that if you work for a living you should pay taxes, but if you are rich and live off of other peoples [sic] work you shouldn’t. "

This was the conclusion of a rant against my previous post on a national sales tax over at San Diego Politics by friend Patrick Finucane. I'm not sure that he realized it, but he actually makes a strong case for the sales tax he is trying to demonize.

Even ignoring the erroneous Marxian undertones, the statement is still absurd as proven by the discussion above. Missing from Pat’s analysis is the straightforward fact that the reason people save and invest their money now is so that they can spend and consume products in the future. If someone has saved $20,000 and they pull this money out of the bank to buy a new car, they will pay taxes, even if they are the richest person in the world.

If you’re worried about the wealthy not paying taxes you need look no further than our current system. A family with $10,000,000 in municipal securities (i.e. state and local bonds) pays absolutely no federal income taxes.[2] If these bonds yielded 5% this would mean an annual income of $500,000 without paying a dime in taxes. If you think this is an unrealistic assumption, think again. The Kerrys, who are worth hundreds of millions of dollars, had an effective tax rate of a little over 12% last year. This is lower than the average rate of a middle class family from the most recent IRS data. Their tax rate was so low largely because they were invested in tax free bonds. Even taking away municipal securities, wealthy individuals can afford tax attorneys that can help them redefine income, or stash it offshore. These are options not available to the poor and middle class.

Implying that the basis for a national sales tax is that the “rich” shouldn’t pay taxes is blatantly false. The basis is that when anyone invests and saves their money (something that helps the economy grow and thus helps us all) they should not be taxed. But everyone is taxed when they spend their money consuming what we could call luxury items.

In short, the rich in no way get off tax free.

In conclusion…

… I realize there needs to be a debate on this issue and I myself have many more questions. I do believe though that some of the initial fears are overblown. I’m looking forward to a vigorous discussion on this issue, as I think it’s clear that our current system of taxation is in dire need of repair. Undoubtedly, we could surely do better than our progressive income tax. Hopefully I’ve demonstrated that a national sales tax might be a viable replacement that would make us all better off.

[1] Keep in mind that while I am focusing on income taxes, the proposed Fair Tax would replace "the entire federal income and Social Security tax systems, including personal, gift, estate, capital gains, alternative minimum, Social Security/Medicare, self-employment, and corporate taxes."

[2] I understand that the tax free status means a lower yield but the point is that no taxes are being paid to the federal government.

Additional note: I owe much to the teachings of George Reisman and his book Capitalism for the discussion on savings and consumption.