Exploring the Idea of Replacing Federal Taxes with a National Sales Tax

Exploring the Idea of Replacing Federal Taxes with a National Sales Tax

Exploring the Idea of Replacing Federal Taxes with a National Sales Tax

The idea of using a national retail sales tax to replace pretty much all of the federal tax structure–that is, instead of the federal individual income tax, corporate income tax, payroll tax, and estate and gift tax–has some elements of broad appeal.

There’s an old Greek legend of the “Gordian knot,” where whoever could untangle the knot would become a great conqueror. Alexander the Great reputedly just cut the Gordian knot with a sword. The modern tax code may be a Gordian knot for our own time, where untangling it is impossible but cutting through it can achieve the goal. As an individual or someone running a business, imagine never filling out a tax form again.

Thus, a Fair Tax proposal has been introduced in every Congress since 1999 to replace other federal taxes with a national sales tax. It’s not likely to pass, now or in the future, but the thought experiment is intriguing. For those of us who prefer to root around in the policy details rather than to make sweeping gestures with swords, what are the tradeoffs and issues here? William G. Gale and Kyle Pomerleau discuss “Deconstructing the Fair Tax” (Tax Notes Federal, March 27, 2023, p. 2169+).

How High Would the National Sales Tax Rate Need to Be?

Of course, the answer to this question depends in part on what is counted as “sales.” The Fair Tax takes a broad perspective here: for example, it includes pretty much all goods and services, including rent on housing, purchasing a newly built home, health care spending, and even interest payments and fees for credit cards and mortgage debt (which is viewed as a kind of “service” payment).

There’s also a bit of terminology here that needs exploring. Say that something costs $100, and there is a 30% tax added, so when you get to the cash register, you pay $130. Most people would think of that tax rate as 30%. But if you wanted to make the tax rate sound lower to people, you might instead calculate the tax rate as 30/130–that is, the tax divided by the total price after-tax, not the price before tax. That’s called the “tax-inclusive” rate, and your added 30% has suddenly changed to a 23% tax rate. The supporters of the Fair Tax promise a 23% tax-inclusive rate, which is the same a 30% tax-exclusive rate.

But Gale and Pomerleau point out that the 23% rate is likely to be a considerable understatement, as well. When they dig into the underlying calculations, they find, for example, that the authors of the Fair Tax are assuming that a positive rate of inflation will push up collections from the Fair Tax over time, but also that government spending will not experience any inflation rate at all. Obviously, this kind of assumption (and there are others like it) makes it easier for the 23% tax-inclusive rate to cover future spending.

What if inflation affects both taxes and government spending in the same way? Then Gale and Pomerleau calculate that to maintain current spending levels would require a tax-exclusive rate of 39% (which is a tax-inclusive rate of 28%.

But the Fair Tax supporters also assume that there would not be a black-market economy where these sales taxes are often evaded, understated, and avoided. If you build in an assumption that 17% of a national retail sales tax will be avoided or evaded–which matches the assumption of current levels of avoidance and evasion–then the necessary tax rate to maintain current spending levels would be a tax-exclusive rate of 51% (or a tax-inclusive rate of 34%).

If you think that future Congresses would be likely to rule that certain items should not be included in the national sales tax, then the tax rate on everything that remains included would need to be higher still. In short, the national sales tax doesn’t come cheaply. And remember that the national sales tax would be on top of any state and local sales taxes.

What About Progressivity and Taxing those with High Incomes?

An obvious concern with a national retail sales tax is that everyone pays the same tax rate, no matter their income. There’s a bit of a political challenge here for those who would like those with high incomes to pay more in taxes, but who tend to overstate their case by saying that those with high incomes currently pay little or nothing in the current tax system. If you believe that, then a national sale tax would raise taxes on the rich! But in fact, those with high incomes do in fact pay more in taxes (whether they should pay still more is a question I leave in abeyance here). Thus, a national sales tax by itself would raise taxes on those with lower incomes and reduce taxes on those with higher incomes.

To their credit, the supporters of the Fair Tax recognize this issue and offer a suggested fix, called a “family consumption allowance.” It works similarly to a universal basic income, but the idea is only to offset the national retail sales tax, not to provide enough to live on. Eevery household would get a monthly check from the government. The amount of the check would be determined by multiply the poverty-level income for that household times the tax-inclusive tax rate.

How much might this payment be? For a family of three, the US poverty line is $24,860 in 2023. Multiplied by 23%, and then divided into 12 monthly checks, this works out to $477 per month. Again, this is not intended to be enough to live on. The Fair Tax proposal doesn’t make any changes to existing programs to support the poor. It’s just intended to offset the national sales taxes paid on poverty-level income.

This part of the proposal would make the national retail sales tax less of a burden to the poor than to the non-poor. But it would not come close to making the overall federal tax rate as progressive as it currently is.

What About Interactions with Other Tax Issues?

A national retail sales tax would have unpredictable interactions with a number of other policies. For example, 42 states (and a number of cities) have income taxes. Under current law, these taxes can piggyback on the federal income tax, and make a few idiosyncratic changes. But if no federal income tax existed, a lot of people and companies would presumably get pretty grumpy about retaining the state and local income taxes. In addition, income taxes are used for a number of public policies. Getting rid of the income tax means getting rid of all tax deductions, including mortgage interest. It means getting risk of income tax breaks for, say, buying an electric vehicle.

Of course, the government could still provide subsidies in these areas. But instead of providing the subsidies in the form of tax breaks, which have the effect of spending but don’t look like spending, it might need to do so by actually cutting checks for such subsidies.

There are also a number of administrative issues in shifting to the collection of a national retail sales tax that I’ll skip over there, but they aren’t trivial.

There’s an old joke among economists about value-added taxes, which function as a sort of national sales tax. The joke goes: “America has not enacted a value-added tax because the Democrats fear that it’s not progressive and the Republicans fear that it would become a money machine for the government to raise taxes. However, America will enact a value-added tax as soon as the Republicans realize that it’s not progressive and the Democrats recognize that it can be a money machine for raising taxes.”

Transferring all of the US tax burden to a national retail tax seems an unwise idea, and an idea where the marketing of a 23% rate over promises what it can deliver. The proposal for a national sales tax is interesting, in part, because it potentially opens the door to some ideas that have had very little traction in national-level American politics, like a universal income payment and a national value-added tax.

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Timothy Taylor

Global Economy Expert

Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.

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