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Journal of Financial Planning - April 1996 "It is naive to think a national sales tax as a replacement for an income tax or the flat-tax scheme is going to change the dynamics of competing interests." Tax Reform Proposals Need Reformingby Peter Katt, CFP, LIC With the Republican takeover of Congress in 1994 and the Republican presidential primaries, attention has been focused on tax reform. Leading the way is the flat-tax idea initiated by House of Representatives Majority Leader Dick Armey in 1994 and more recently championed by Republican presidential candidate Steve Forbes. The other tax reform contender is a national consumption tax combined with the abolition of the income tax, promoted in Congress by Ways and Means Chairman Bill Archer and presidential candidate Senator Richard Lugar. I will examine these two tax reform ideas, using the following tax policy principles as a scorecard, then offer an alternative. I will not address contiguous issues such as a balanced budget and the size of government, which, in many ways, are more important than the tax reform issue. Tax Policy Principles
Consumption Tax There are two types of consumption taxes being discussed. One is a national sales tax levied as a percentage of the price of goods and services purchased by consumers. A national sales tax is very visible and consistent with a representation with taxation principle. However, as it is presently offered - it would replace income taxes entirely, probably requiring a rate of 15 to 20 percent - it probably won't produce broad bipartisan support for two reasons. First, many state and local governments derive most of their revenues via sales taxes. Competition from a national sales tax would not be welcome by state and local political interests. Second, unless very complicated lists of what is covered with threshold prices subject to a national sales tax are devised, the class warfare card will become trump. Reagan Democrats paying, say, a 17-percent national sales tax plus state and local sales taxes on food, clothing, and so on, while Steve Forbes and Ross Perot pay no tax on multi-million dollar annual incomes won't sell. If all necessities (food, clothing, housing, transportation, recreation) and lower-cost nonessential items are excluded (the fairness issue), what we might end up with is nothing more than a quasi-luxury tax which wouldn't generate enough revenue. Back to the income tax we would go. The other consumption tax being discussed is a value-added tax (VAT), which taxes goods and services at various stages of production and distribution (as value is added). A VAT would adhere to the principle of representation with taxation and might even be popular on a bipartisan basis, but the VAT is very invisible and indirect. An increase in the VAT tax would result in higher prices for products and services, making it difficult for citizens to know how much they pay in federal taxes. It is this obscurity that has the potential of making the VAT a public policy disaster because it gives our political elites a nearly hidden way to raise government revenues, thereby largely removing their accountability. Flat Tax The political selling point of the flat tax is its simplicity, which is Armey's primary argument. The public policy selling point, highlighted by Forbes, is his prediction of greater economic growth. Essentially, under a flat-tax system, everyone with income above specified personal exemptions will have the same marginal tax rate, although different effective tax rates. Flat-taxers split over whether unearned income is to be taxed, the taxation of capital gains, and whether to continue the popular home mortgage and charitable deductions. The flat-tax idea has tremendous political appeal in Republican primaries because it can be conveyed in a simple message without having to pay homage to the tax-fairness gods. Hold up a postcard with "17 percent" in bold lettering on it, declare that a rising tide lifts all boats, and you have your campaign - next stop the White House. The flat-tax concept has caused otherwise savvy pundits to simply swoon. I think they have forgotten that campaign rhetoric is a poor forecaster of actual policy implementation - otherwise, the middle class would be in the third year of its tax cut and the federal budget would be two years from balance. Thinking beyond the campaign rhetoric discloses that the flat-tax concept has serious political and public-policy flaws. The basis of these concerns is my perception that the political pressure points for the flat tax will be the personal exemptions and the flat-tax rate. Armey and Forbes have already started the personal exemptions bidding at $36,000 for a family of four. It is possible that, during the legislative debate over the flat tax, personal exemptions would become more generous in order to accommodate moderate Republicans and a few Democrats (most Democrats probably won't be associated with it, anyway). Later, during subsequent elections, it is likely that Democrats and the national media would continue playing the class warfare card, focusing on the injustice of Reagan Democrats having the same marginal tax rate as Steve Forbes. Under this pressure, personal exemptions could steadily climb. Concurrent with escalating personal exemptions, it is likely that the flat-tax rate also will rise. It doesn't take much to imagine enough legislative compromises, including some Democratic victories, that would result in a majority of voters being relieved of income tax obligations entirely via higher personal exemptions while the flat-tax rate on the few shouldering the income tax burden would be higher than the marginal rate is today. This Democratic "Trojan horse" might cause personal exemptions to rise to, say, $56,000, with a single flat-tax rate of, say, 41 percent in the no too-distant future. While a flat tax would be visible and direct, it wouldn't receive broad bipartisan support. Rather, in a breathtaking irony, partisan support would switch from Republicans to Democrats as Democrats came to realize how they could turn the flat tax against Republicans and use it as the ultimate progressive tax system by removing more and more citizens from the tax rolls via the personal exemptions, while raising the single rate on their favorite whipping group, the rich. Once Americans have fallen below the personal exemption threshold, it is unlikely they would return to the tax rolls anytime soon, setting up the situation of an increasing majority voting for higher exemptions, more government and a higher flat-tax rate on fewer taxpayers. Representation without taxation is a dreadful public policy resulting for getting the "s" out of tax rates. Linking Sales Tax with Progressive Tax It is possible to devise a tax plan that is visible, capable of attracting bipartisan support (unless the goal of partisan bickering is partisan bickering for its own sake), and better integrate the body politic by increasing representation with taxation. This could be done by essentially retaining the current income tax system, linked with a very low national sales tax of, say, two percent. This linkage would be done by constitutionally forbidding any exemptions to the goods and services covered by a national sales tax (everything would be included) and requiring that any future increases or decreases in either the income tax or national sales tax must be done in unison on a proportional basis. This would give us a greater sense of shared citizenship because every adult would have a stake not only in government spending decisions, but also in how government is funded, while still retaining a sense of fairness necessary to obtain bipartisan support. For example, if handling an international crisis by increasing the military budget were deemed a national priority causing tax rates to temporarily increase, say, 10 percent, the national sales tax would be raised to 2.2 percent, and the marginal income tax rates would be raised by a proportionate amount. Therefore, if there were marginal tax brackets of, say, 15percent, 20 percent, and 25 percent, they would be raised to 16.5 percent, 22 percent, and 27.5 percent, respectively. If, several years later, the perceived need for larger military budgets had ended, income tax rates and the national sales tax rate could return to previous levels. Or if discretionary budget costs had steadily been rising and such increased spending was consistent with a majority's desires, income tax rates and the national sales tax rate again would be raised proportionately, more or less permanently. Conversely, if less government was supported by the majority, lowering tax rates could be done, again proportionally. Combining a very low national sales tax with progressive income tax rates may seem unnecessarily complicated. However, as I thought about the ramifications of various approaches that only used linking income tax rates to create maximum participation at fair rates (thereby avoiding a national sales tax entirely), it became obvious that our political elites could defeat this goal by adjustments to taxable income (via personal exemptions) and reductions in the actual tax (via credits) unless stifling rules were applied to the minutiae of future tax policy debates. The Myth of Tax Simplicity Once of the strongest selling points for both the national sales tax as a replacement for the income tax and the flat tax is its simplicity. Two points about simplicity: First, creating an inherently flawed system because it is simple is nonsense. Second, the imperfect body of tax laws we now have is the natural product of many battles between competing interests, with the tax code a scorecard of their victories, losses and compromises over many years. While sound-bite harangues about our unholy tax system are appealing during political campaigns, every rule in the tax code is the natural result of the unorderly process a free society uses to govern itself. Within the context of this reality, the tax code is indeed logical. However, to an idealist or political opportunist, tax simplification can be a powerful myth that will become tomorrow's broken promise. It is naïve to think a national sales tax as a replacement for an income tax or the flat-tax scheme is going to change the dynamics of competing interests. Complicated tax laws will creep back over time because debates about tax laws are one of the primary ways of handling battles between groups and ideologies in a free society. Conclusion Linking a very low national sales tax with income tax rates is very visible and combines tax fairness with maximizing the number of citizens with a stake in paying for government. It would have a reasonable chance of creating a bipartisan consensus if Republicans will accept the constitutional legitimacy of progressive rates, Democrats accept the constitutional legitimacy of all Americans paying a very low national sales tax, and they both accept the constitutional legitimacy of keeping the proportionate relationship between them permanent. By constitutionally integrating the body politic in this way, the never-ending struggles in a free society to determine the legitimate roles of government and how to pay for government will be conducted in a far more rational way. It will deprive political harlots of their divide-and-conquer, class-envy strategy and keep them from spreading the naïve dreams of tax simplification. Marginal tax rate increases only on the rich, as some sort of punishment, and then promising the same tax rate for everyone as redemption would be a thing of the past. Americans at the highest marginal tax rate and Americans paying only very low national sales taxes both will have a stake in the most important question of government: what are we willing to pay for? These tax reform musings, hatched during a Michigan winter by a warm fire, may be as naïve as I have accused others of being in my attempt to resolve major philosophical tax issues via a grand political compromise while conceding the reality of ongoing battles for advantage within the tax code. The contemplative mood from my cozy abode is the antithesis of the frenzied and hyperactive environment of our political players. Unless they see something in it for themselves, our politicos aren't going to compromise on an issue just because it would result in the greater public good. Nevertheless, such political compromises someday may be more desirable as a way of avoiding personal disasters, like term limits. Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, April 1996.
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