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On Tuesday, the House Ways and Means Committee held a hearing to consider a national sales tax (often misleadingly called a “Fair Tax” by its proponents) and a value-added tax (VAT).
A national sales tax and a VAT are both consumption taxes and therefore both have the same regressive effect. Poor families have little choice but to spend all of their income on consumption while rich families tend to save most of their income. So a tax on consumption will naturally take a much larger share of income from poor and middle-income families than from rich families.
Proposals to implement a VAT take many forms and are usually discussed as a supplement to existing revenue sources. Proponents of a national sales tax, however, are usually describing a very specific proposal (and a specific bill that is reintroduced each year) misleadingly called a “Fair Tax.”
The so-called “Fair Tax” would replace the federal personal income tax, corporate income tax and estate and gift taxes with a 30 percent sales tax. (Proponents use a convoluted calculation to claim that it’s actually a 23 percent rate.) The tax would apply to all types of consumption, including those that would be difficult or impossible to tax in the real world (like rent, health care services, and, oddly, government spending.)
The proposal includes a rebate to all families that proponents claim mitigates the gross unfairness of the sales tax. The rebate would basically be a cash grant that would vary only by family size.
But as Citizens for Tax Justice and its research wing, the Institute on Taxation and Economic Policy (ITEP), have long explained, the national sales tax would be extremely regressive. ITEP’s classic report from 2004 illustrates that the poor and middle class would pay much more under a national sales tax (the so-called “Fair Tax”) in every state. (State-by-state figures are included in the report.)
Unfairness is not the only problem. Proponents of a national sales tax vastly understate what the sales tax rate would have to be in order to replace the revenue collected under the current federal tax system. As the ITEP report explains, sales-tax proponents’ convoluted claim that the national sales tax rate would be 23 percent instead of 30 percent is only the beginning of the distortions. To truly raise as much revenue as the current federal tax system, the theoretical rate would have to be between 45 and 53 percent. And because such a high rate would encourage cheating, the real rate would have to be higher still.
Sales-tax advocates sometimes try to make their plan look less regressive by focusing on the taxes people pay over their entire lifetimes. Professor Laurence Kotlikoff of Boston University used this technique during his testimony before the Ways and Means Committee to argue that the “Fair Tax” can be progressive! The non-partisan Congressional Research Service notes however that the use these sorts of “highly stylized life cycle models” is actually rather controversial.
Kotlikoff seems to be arguing that because everyone is going to use their income for consumption sooner or later, then a tax on consumption is not inherently any more regressive than a tax on income. A flat 30 percent tax applied to spending, he asserts, would have the same effect as a flat 23 percent tax applied to income over the course of someone’s life. Adding the rebate included in the Fair Tax proposal, Kotlikoff and other proponents claim, makes it progressive.
Here’s why this argument is all wrong. First, rich people don’t eventually use all of their income for consumption but leave a great deal of it to others after they die.
Second, a flat 23 percent tax on income would, of course, be more regressive than our current system, which taxes poor and middle-income people at rates below that and rich people at rates above that.
Third, the rebates included in the Fair Tax would not be enough to offset this regressive impact since the current income tax provides negative taxes for many low-income families.
Other advocates of a national sales tax have made even wilder arguments, like the claim that retail prices will somehow not rise even when the new national sales tax is included in the price, or the claim that the IRS would become unnecessary because states would voluntary collect the tax and remit it to the federal government. (This sounds a lot like the failed Articles of Confederacy, which were replaced by the U.S. Constitution in order to give the federal government the power to raise revenues on its own, rather than relying on voluntary contributions by the states.)
Many of the pro-sales-tax arguments were cogently refuted in testimony given by Bruce Bartlett, a former Reagan administration official. Bartlett has written a great deal about the Fair Tax and its history, starting with the original sales-tax proposal by the Church of Scientology.