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Lester Snyder

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:

  • All consumption-type taxes have a common linchpin: savings and investments are exempt from taxation. A sales tax is an ideal mechanism to encourage people to save or invest since it reaches only retail purchases of tangible goods and services by the consumer. The same is true of a Value-Added Tax (VAT), a popular form of consumption tax, which is on top of an income tax in most developed countries. Under a VAT, unlike a retail sales tax, each business pays taxes on the difference between what it sells a product for and the cost to acquire or produce the product.

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.

  • Enter the Flat Tax proponents who make their consumption tax less burdensome by using remnants of the income tax to provide for a low-income allowance of $20,000-30,000 for each household, and applying a single rate of say 17 percent to wage-related income, after eliminating many deductions. Their proposal does have an element of progressivity at the low end of the income scale, but, while simpler than the current law, it does require the retention of much of the Internal Revenue Code to measure taxable income. Of course, there is no assurance that Congress would allow the tax rate to remain low or “flat” for long.

[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.]
 

  • Before we can determine a tax rate for any consumption tax we must decide what to tax and what not to tax, the so-called “tax base” issue. Just by way of example, should we tax health care services, buying a home, purchase of life insurance (is it investment or consumption?), lottery and gambling winnings (less losses?), investment in pension plans? And what about some big ticket items such as Internet transactions, intellectual property, telecommunications, transportation, and purchases made out of the country? Most of these items are still lingering in a cloud of uncertainty (and potential litigation) in the European Union and other VAT countries and are subject to inconsistent treatment even under our state sales taxes. Before we can estimate any rate of tax we must decide what is meant by the “retail sale of goods or services,” no small task in today’s changing economic climate. Adding any of these items to the tax base reduces the rate of sales tax. The proponents of these new regimes would remind us that many of these issues are still not satisfactorily answered under our current income tax laws.
  • Those opposed to a consumption-type tax point to its unfairness as being essentially a tax on “wages” or labor. While basically correct, how different is it in reality from our present federal income tax where, according to IRS statistics, over 80 percent of the tax is collected from wages and salaries? In fact, many experts conclude that a consumption-type tax (with appropriate low-income allowances) would end up imposing roughly the same tax liability on wage earners as they pay now. But many of the “unequal taxation of equals” issues illustrated in chapters 1-6 of this book would not be clearly resolved. Then why change the tax structure? One reason given by those who favor consumption taxes is that it would encourage more savings by getting you to purchase non-taxed items, such as stocks and bonds. A second reason is to change the way we tax businesses.

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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Lester B. Snyder, JD/LLM, is a professor at the University of San Diego School of Law. For 20 years, he was editor-in-chief of the Journal of Real Estate Taxation. He was the first professor-in-residence in the Tax Division of the U.S. Department of Justice. His new book, Double Take: Unequal Taxation of Equals, (Vandeplas Publishing, 2007) was published in June of this year and is available at Amazon.