Just as there are myriad complications in as simple a concept as taxing “income,” there are just as many if you want to tax “sales” or “business profits.”
Herman Cain’s 9-9-9 plan may prove to be a flash in the pan, but it certainly has generated plenty of conversation about whether it’s feasible.
The idea of changing federal taxes to promote greater economic efficiency – and perhaps greater fairness – is one that isn’t going to go away. So it is useful to look at other taxes besides the federal personal income tax.
First, note that most advocates of tax “reform” argue we need to increase incentives to save and invest. This will, economic theory tells us, lead to faster growth of national output, total national income and employment. But increasing saving inherently involves reducing incentives to spend on current consumption. Making it more expensive to consume and more rewarding to save thus lies at the core of most proposals for change.
The simplest way to discourage spending is to increase the cost of goods and services by taxing them – hence calls for a national sales tax of some kind.
One must be careful here, however. Economists understand there are important differences between “sales taxes,” as imposed by a majority of U.S. states, and “value-added taxes” that are common in most other countries including Canada and Europe.
But the term “value-added tax” is still poorly understood by most people; it often is described as “a sort of national sales tax.” This causes enormous confusion.
Cain presents his as a sales tax, perhaps because the idea of a new value-added tax is anathema to many in his party. So let’s start with that. (Ironically, his “tax on business profits” is even closer to a classic VAT.)
Choosing what items should be subject to a sales tax is always a challenge. The more goods and services you tax, the more revenue you get for a given tax percentage. Narrow the range of taxable items, perhaps in the interest of “fairness,” and the higher the rate must be.
If you want to discourage consumption, then you should tax all services and goods that households buy. This seems to be what Cain is suggesting. But it would involve a far broader base than that of most existing state sales taxes. Many people are not used to paying sales tax on doctor visits, hospital bills, fees for attorneys or accountants, apartment rentals, water bills, YMCA memberships, home and car insurance, car towing or sewer line cleaning. Yet, all these would be taxed under a true broad-based sales tax aimed at discouraging consumption.
The fact that businesses also buy many of the same goods and services as households introduces complexity.
State sales taxes usually exempt physical raw materials that will undergo further transformation in businesses like manufacturing. But other items businesses buy, like office supplies, may be subject to the tax. This expense must get recovered in the price of the goods that eventually are sold. The higher the sales tax rate and the broader the range of items taxed, the more such taxes can add up, cascading into the costs of goods and services.
One can avoid this by exempting all purchases by businesses from the sales tax. But this can be an administrative headache, and it provides incentives for households to cheat by posing as businesses whenever possible.
Yes, this incentive may already exist in states that broadly exempt business purchases of goods and services. But if you add another 9 percent to the combined sales tax rate and extend that to more services, you increase incentives for evasion.
A value-added tax is designed to prevent both the cascading of sales taxes and cheating. With a VAT, tax is due on the “value-added” at each stage of producing some good or service. At each step, the seller of a product must pay tax on the value of the product minus the purchased inputs for that product, and the VAT already paid at earlier steps in the process. Properly structured, the VAT is incorporated once and only once in the final price of the product.
Governments like VATs, because if properly administered they are hard to cheat on. Thus they are crucial tools in countries with deep cultural histories of tax evasion, like Italy and Greece or across Latin America.
Economists like them because they are the least distorting of any tax. That is, they induce fewer incentives to use resources in wasteful ways than do income taxes or traditional sales taxes. This is a consensus view, regardless of economists’ political affiliations.
Most VATs don’t allow deducting labor costs when calculating “value-added.” If so, they thus act as a payroll tax on labor. Cain’s tax on business profits, at least as presented on his website, similarly does not allow for businesses to deduct labor costs in calculating taxable “profits.” If so, what he is proposing is largely a VAT by another name. Perhaps this is good, but then let’s call it that.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.