Flawed Tax Proposals – Part 1

Presidential candidates are confused as to what constitutes a “consumption tax”, in their tax proposals.

A consumption tax is any tax that is ultimately paid by consumers of the product or service.  The most obvious such tax would be a sales tax applied at the point of sale; but that confuses collection time and place with tax payment by consumers.  Consumption taxes certainly include a VAT or a FairTax, collected from the business and embedded in the final price.  However, taxes collected much earlier in the process must also be included: income, payroll, unemployment, excise, and corporate taxes; and any of the above taxes paid by capital equipment, component, inventory, or service suppliers.  Stretching it, one might also include mandated costs to business, like employee healthcare, in the consumption tax category.

Therefore, any tax proposal that “gets rid of the income tax in order to move to a consumption tax” is based on flawed reasoning.  Consumers already pay the cost of the income tax embedded in the labor cost component of final price.

When any of the “embedded” tax rates are increased, even if presented as a “tax on the rich”; a significant percentage of the actual tax burden will be passed on to consumers through an increase in price.

The effect on price is critical in evaluating any tax proposal. For example if the core price without any taxes, which would include all costs plus a reasonable net profit, is $1.00, and the tax component of the final price is 25%; the final price will be $1.33.  However, if you raise the tax component to 50%, final price must be $2.00.  When taxes go up as a percentage of total price, prices go up geometrically.  This includes “phantom taxes” that linger.

A “phantom tax” is created when the tax disappears, but the legacy provision for tax on gross salaries does not.   Assume that John makes $100,000 in gross salary and pays 25% or $25,000 in taxes, and the organization he works for charges $100,000 for his services, making no profit.  Under the FairTax, tax on his gross income would be eliminated, effectively giving John a 33% raise, the “phantom tax” amount.  The FairTax must then be layered on top of John’s gross salary to cover the entity’s tax liability.  At the FairTax rate of 23%, the organization must charge $130,000 to break even.  Notice that the taxes collected at the lower 23% rate result in $30,000 of tax, higher than the $25,000 raised at the 25% rate on gross salary.  [In “FairTax, the Truth” on page 143 the FairTax originators note that they expect prices to go up by 24.8%.]

Since the FairTax eliminates taxes on income, but does not eliminate the “phantom tax”, it is fatally flawed.  The Cruz tax proposal also creates a partial “phantom tax” by dropping the income tax rate to 10%, while gross salaries are unchanged.  Both FairTax and Cruz plans heavily favor those with high effective tax rates, since those with high salaries get a huge bump in take-home pay, whereas someone with a minimal tax bill would see little take-home increase.

The Cruz plan also disallows salaries as a deduction, creating a tax-on-tax doubling of taxation.  VAT programs often have the same problem, which (depending on the new tax rate(s) on income) could be fully or partially corrected by allowing a credit for taxes paid on salaries .

Eliminating all taxes on wealth creating investment will accelerate growth, increasing the tax base.  Full reliance on a consumption tax for changes in our tax code is an economically sound approach, but legacy issues must be taken into consideration before making changes.  The negative effects of proposed changes will be highlighted by increases in prices to the consumer.

More on eliminating wealth taxes in “The Painless Tax”.

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