Is a Federal Sales Tax Viable?

The nation should have a tax system that looks like someone designed it on purpose.

-William Simon

White House insiders have begun to speak publicly about European-style value added tax (VAT) to help get the deficit under control, Paul Volcker explaining that “[a VAT] is not as toxic as it once was.” At the same time, a number of conservatives, including former Arkansas governor Mike Huckabee and radio talk show host Neal Boortz, are promoting the FairTax, which was developed by a group called Americans for Fair Taxation and written into a bill sponsored by Georgia Congressman John Linder (R).

The VAT and the FairTax are both consumption, i.e., sales, taxes. Beyond that, though, they have little in common. The VAT is levied on top of all existing taxes whereas the FairTax is designed to replace the federal tax code – - including income taxes, Social Security and Medicare payroll taxes, capital gains and estate taxes – - and with it the entire IRS bureaucracy.

The VAT has been gaining favor throughout the world. Its attractiveness to governments is simple; a VAT is easily enforceable and broad-based, a gigantic money machine. To the Obama administration, trying to spend its way out of a recession and arguably out of capitalism itself, the VAT is ideal.

How does the VAT work? Whereas a traditional sales tax is paid directly by the consumer, a VAT is imposed on the value added at each stage of production and distribution. The VAT is assessed and collected from each supplier in the chain, which in turn collects it from the next supplier, and so on. Although the end user ultimately pays the VAT, the tax is buried in the price of the product or service. Since, unlike a traditional sales tax, the VAT isn’t obvious, consumers are likely to offer less resistance to tax hikes than they might if the tax were more visible. In most countries that have adopted VATs, the rate of taxation starts low but climbs substantially higher within a few years.

Sales taxes, including the VAT, are intrinsically regressive; lower income families must spend a higher proportion of their earnings whereas the wealthy often have funds leftover to save or invest after covering their expenses. But the FairTax is well, fairer. Every household receives a “prebate” or monthly check to cover the taxes on spending up to the poverty level. Those with the ability to save or invest large chunks of their incomes would shoulder proportionately less of the tax burden year to year, but they would have to pay taxes on that money when they or their heirs eventually spent it.

Additionally, no one could avoid the FairTax, at least not legally. Legislators couldn’t give tax breaks to special interest groups. Loopholes would disappear. And since everyone, even illegal aliens, buys goods and services, no one would be exempt from the tax.

Since the FairTax only taxes consumption, it incentivizes investment and entrepreneurship, which spur economic growth. The FairTax also encourages education by treating tuition and school-related expenses as investments rather than expenditures. Smart.

But as always, the devil is in the details; and the FairTax numbers don’t add up. First, the tax is 30% over the pre-tax price, not 23% as cited by FairTax proponents. Here’s the discrepancy: Say you buy a $10 movie ticket. Your tax will be 30% of the ticket price, or $3. How can they call it 23%? Well, $3 is 23% of $13. Income taxes are is often cited as a percentage of spending, but it’s a misleading way to calculate a sales tax.

Even with the prebate, the FairTax would strike many as unfair to the middle class. The rich will pay less, at least in the short term, than they do now and the middle class will pay more. If the FairTax were to stimulate growth, the middle class burden would decrease; but this would take several years under even the most optimistic scenario. 

Then there’s the matter of revenue. Although proponents insist the FairTax will raise as much revenue as all other federal taxes combined, leading economists have expressed doubts. If they’re correct, the FairTax might end up being more than 30% or else have to be supplemented by an income tax of some sort. The government’s out-of-control spending and skyrocketing deficit increases the likelihood of one or both of these options.

In addition, under the FairTax system, municipalities and states also pay taxes to the federal government on their purchases. States would have to raise property or sales taxes, increasing the total tax burden on their citizens.

Although there might be a solution, transitioning from our current system to an exclusively consumption-based tax would disadvantage senior citizens. Retirees, who have paid income taxes on their earnings throughout their careers, would be charged the FairTax on any products or services they bought with their savings, resulting in double taxation.

Enforcement would also be a challenge. With all taxes combined into one, there would be tremendous temptation to cheat on the FairTax. Even though the IRS would no longer be needed, it would take plenty of government employees to monitor and enforce FairTax compliance.

The VAT would add another layer of complexity to an onerous system and further burden an already over-taxed public. The FairTax is appealing in its simplicity and transparency, but as a workable tax, it’s only fair.

Amy H Laff