Comment: What’s bonkers and what’s not in GOP’s ‘Fair Tax’ proposal

The plan to replace the income tax with a flat consumption tax makes sense, but not if it’s a sales tax.

By Karl Smith / Bloomberg Opinion

Among the many concessions Kevin McCarthy agreed to in order to become speaker of the House is one that would give the so-called Fair Tax Act a full hearing on Capitol Hill. To describe the bill as radical would be an understatement. Not only would it abolish the Internal Revenue Service, but it would also replace all existing federal taxes with a flat, nationwide 30 percent sales tax. That would be on top of existing state and local rates. Sure, the bill probably doesn’t have much chance of passing, but it has some merit and is a good starting point for a discussion about tax reform.

The bill’s handful of supporters — led by Rep. Buddy Carter, a Georgia Republican — hopes to spark a more general conversation about tax reform. Politically, most everyone outside the group of supporters calls it foolhardy. Legendary low-tax activist Grover Norquist described it as a gift to the Joe Biden administration. In policy terms, though, the underlying idea — a flat tax on consumption — is not as crazy as it sounds.

The fiscal challenges the U.S. faces over the next decade are stark. Both Democrats and mainstream Republicans should come to recognize that incorporating a flat tax on consumption into the federal tax system is one of the least painful — both in terms of the burden on working families and the economy as a whole — ways of meeting those challenges. The Center for a Responsible Federal Budget projects that the annual budget deficit could expand to as much as 10 percent of gross domestic product by 2032. In that scenario, which assumes the Fed remains committed to keeping interest rates high to fight inflation, interest payments alone would account for almost half the deficit.

The prospect of closing that gap through spending cuts alone is bleak. It would require an across-the-board reduction of roughly 25 percent. If, as is likely, defense and Social Security are shielded from any major reductions, the necessary cuts would rise to 50 percent. That 50 percent would apply to Medicare, Medicaid, the subsidies that cap Obamacare premiums and other programs widely regarded as essential.

The reality is that reining in the deficit without increases in revenue is unrealistic. The challenge is doing so without curbing economic growth. Research by former President Barack Obama’s Council of Economic Advisors shows that since World War II, increasing taxes by 1 percent of GDP would lead to a drop of 2 percent to 3 percent in economic output. Given the U.S.’s $31 trillion debt load, that type of slowdown would exacerbate the challenge in shrinking the deficit by raising interest payments as a percentage of GDP.

Economists have long known that flat consumption taxes are less damaging to economic growth than the current system. More recent research suggests that this advantage grows exponentially as tax rates rise. The reason the Fair Tax Act isn’t a realistic way of implementing a flat consumption tax is that, like any sales tax, it places the entire burden of tax collection on retailers. This can work as long as tax rates are low, but once they start to climb into the double digits, selling goods and services “off the books” at a discount becomes so profitable that honest retailers could find themselves run of business.

To solve this problem, most countries have turned to a value-added tax, or VAT. Like the sales tax, the VAT is a tax on consumption rather than income, but it’s collected at various steps throughout the supply-chain process based on how much each step adds to a product’s value rather than collected all at once at the end. Sweden pioneered its use in the 1960s to cover the rising cost of its expansive social welfare systems.

In the European Union, the average VAT rate is 21 percent. Unlike sales tax in the U.S., VAT rates are traditionally calculated inclusive of the tax itself. Had the authors of the Fair Tax Act structured their proposal as a VAT, the inclusively calculated rate would have been 23 percent. When you consider that E.U. countries levy both income and payroll taxes on top of the VAT, the Fair Tax Act, which would replace income and payroll taxes, seems like a bargain.

Yet the bill’s supporters deliberately decided to propose a sales tax despite its infeasibility because the VAT is associated with the high-tax countries of western Europe, potentially creating a public-relations nightmare and triggering severe backlash among constituents. But these countries turned to a VAT with the same goal that motivates Fair Tax Act proponents today: Raise a lot of revenue with minimum impact on job growth and investment. The difference is that European countries needed the revenue to cover higher spending, while Fair Tax Act proponents are looking to get rid of the IRS. In either case, the most efficient way to raise revenue while preserving economic growth is a flat tax on consumption.

Democrats have opposed flat taxes since Steve Forbes brought the idea into mainstream debate during his 1996 presidential campaign. The core of their objection is that more of the burden falls on middle- and lower-income households relative to a progressive tax. Taxing consumption, rather than income, exacerbates this effect because, in general, wealthier families are likely to save a larger portion of their paycheck. This opposition ignores the potential for flat taxes to generate the revenue necessary to fund progressive priorities without sacrificing growth. That’s precisely what pushed western European countries toward the VAT.

The closest thing the U.S. has to a flat tax on consumption is the Medicare payroll tax, which is paid by both employees and employers. (The Medicare Payroll tax is not paid on income that comes from profits, rents and interest payments. In the long run, that works out to be the same as taxing consumption because almost all savings are invested in one of those three areas.) In 2021, the tax raised a little over $400 billion, or about 20 percent of the $2 trillion brought in by federal income taxes. The combined rate, including employers and employees, of the Medicare payroll tax was only 2.9 percent. Individual income tax rate brackets, on the other hand, ranged from 10 percent to 37 percent.

The revenue-raising power of a flat tax is so strong that Emmanuel Saez, an economics professor with the University of California at Berkeley and one of the economists who popularized the wealth tax, backed a form of the flat tax as part of his ideal reform proposal in his critique of the U.S. tax system. Saez would tax personal income rather than consumption.

Mainstream Republicans have been more open to flat taxes, and they shouldn’t be scared away now by the radical proposals of Fair Tax supporters or the surprising support flat taxes receive from left-leaning economists. Indeed, given that Republican enthusiasm for outright cuts to entitlements have waned, the need for a flat tax is greater than it has been at any time since World War II. Even if Democrats insist on something closer to the Saez model, Republicans should eagerly support it.

The deficit is not going away, and the spending cuts needed to balance the budget are enormous while enthusiasm for such cuts is tepid at best. Accepting that revenues have to increase but demanding that we use the most economically efficient tax possible is the only way to prevent wildly inefficient taxes to be rushed through once a crisis strikes.

Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina.

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