Conservative “think tanks” continue to push the so-called “fair tax” plan — replacing the progressive federal income tax with a regressive national sales tax. Their argument is that the U.S. needs to tax work and investment (income) less and consumer spending more, to rebalance the economy. The fact that the tax burden would shift from the wealthy to the middle class and poor, in this view, is merely an unimportant (and undisclosed) side effect. Meanwhile, a Federal Deficit Reduction Commission may recommend a federal value added tax – a sales tax that is more difficult to cheat – in addition to the income tax. Former Fed Chairman Volker has suggested it. The reason is the United States is broke, and we are facing higher taxes and diminished public services as a result. On April 15 the U.S. Senate, dominated by members of Generation Greed who do not want to admit what they have done to their children and the country, passed a non-binding resolution objecting to the addition of a value added tax by an overwhelming margin.
As usual, there is an option that I would be in favor of that no one is likely to consider – enacting a regressive value added tax as a replacement for the even more regressive payroll tax. If a shift in the tax burden from work to spending were the goal, and the shift from the rich to the rest were not, Republicans and conservatives would be in favor. If restraining excess consumerism while raising revenue without hurting exports, which President Obama proposed to double, were the goal Democrats would be in favor. And yet I have not heard anyone make this proposal.
Let’s start with some definitions, so everyone can understand what we are talking about. The payroll tax, allegedly dedicated to Social Security and Medicare but spent on other things during the period from 1983 to 2008 when the former program was in surplus, falls on wage and self-employment income at a rate of 15 percent for poor and middle class – up to an income of just over $100,000 – and 2.6 percent above that income level. Which means that above an income of $100,000 per worker, the more you earn the lower your tax rate. That is a regressive tax – you pay a higher percentage of your income the less you earn.
In theory, half of the tax is paid by the employer and half by the employee, but in practice the employer share is shifted to the employee based on labor market conditions, via wages increases falling below inflation. The self-employed and freelancers pay the full 15 percent regardless. The Earned Income Tax Credit (EITC) is designed to offset the cost of the payroll tax for the poor, which means the payroll tax hits moderate and middle-income households hardest.
But only if they work, because retirement and investment income is entirely exempted from the tax. That’s the reason, as Warren Buffett says, all CEOs face a lower marginal tax rate (the tax on the last dollar of income they earn) than their secretaries. It is one of the reasons that senior citizens pay vastly lower federal taxes than working people even if they have the same income (or a higher income), as I show every year (most recently here).
Now in theory senior citizens did pay that payroll tax when they are working, and today’s young workers will get the benefit of not paying it when they retire. In practice most today’s retired paid much lower payroll tax rates earlier in their careers, before the big payroll tax rate increase in 1983 allegedly to “save Social Security.” In practice, that tax increase merely (and only partially) offset two rounds of cuts in the progressive income tax, once under Reagan and one under Bush. Among the beneficiaries of the cuts – wealthy seniors with lots of investment income.
From an administrative point of view, the payroll tax is collected by businesses from their employees. Only the self-employed have to worry about paying it themselves.
A value added tax also paid by businesses, like a sales tax. But whereas a straight sales tax is only collected at the point of retail sale – in one big hunk that makes tax fraud and the underground economy appealing – a little of the value added tax is take at each stage of production – from raw materials production, manufacture, wholesale distribution, and retailing. For each business, a value added tax is a tax on sales minus the cost of purchased materials and inputs, because materials and inputs were already taxed at the previous stage of production. In an accounting sense, a value added tax is in effect a tax not only on wages (all of them, not just those under $100,000) but also profits, interest and rent.
Just as the payroll tax is mostly shifted to workers in lower wages even though it is collected by their employers, however, a value added tax is in theory passed on to consumers in the form of higher prices. Therefore, if a payroll tax were to suddenly be replaced by a value added tax, in theory workers – particularly moderate and middle income workers — would see their take home pay rise, but everything they wanted to buy would cost more. Working and (to the extent that employers pay part of the payroll tax) hiring would become more attractive, but spending and (to the extent that businesses would absorb part of the value added tax) selling would become less attractive.
How would people react?
We shouldn’t overstate the effect of taxes, compared with culture, on people’s decisions. Nearly 30 years ago most forms of consumer interest payments (other than mortgages) ceased to be tax deductable, and for moderate, middle and upper middle income households most forms of saving and investment income became tax exempt, through provisions such as IRA, 401Ks, 529s, etc. Even for the wealthiest, the tax rate on capital gains and stock dividends was eventually cut to 15 percent, compared with a federal marginal tax rate of up to nearly 50 percent on wage and self-employment income based on the payroll and income taxes combined.
The theory was that savings and investment would be encouraged, and borrowing discouraged, by these benefits for the former and removal of benefits for the latter. But with an “I want for me now!” cultural tsunami happening at the same time, savings disappeared and borrowing soared, in both the tax favored mortgage category and in the form of credit card debt. The opposite of what those who proposed the shift in the tax burden predicted. To the point where the U.S. is nearly bankrupt after three decades of importing more than we export, and borrowing more than we save. So much for the “fair tax” idea that we have to provide even more favorable treatment for investment to encourage “savings and investment.”
Now the U.S spending binge has to reverse. We should be skeptical of the effect of taxes, but consider this. If a product or service is produced in the U.S., and either purchased here or exported, the payroll tax is applied to the workers who make it. That discourages production in the U.S., particularly by moderate and middle income workers since the tax is regressive, although it is unlikely this effect is anywhere near as significant as the difference in wage rates between countries. One can avoid the payroll tax by making something outside the U.S., even for a U.S. customer.
And the value added tax? Consumers pay that tax whether the good they purchase is made in the U.S. or made in China. At the same time, in countries with a value added tax in force (most of Europe), the VAT on exported products is typically rebated. So exports are not subject to the VAT the wage working to produce them is subject to the payroll tax. Tourists can in some cases get part of their VAT rebated. So replacing the payroll tax with a VAT would, in theory, not only encourage work and hiring and discourage consumer spending, but also encourage exports and discourage imports.
Now European countries tax both payroll and spending heavily, and not only have much more expensive goods and services but also higher unemployment. We are heading for a similar tax burden, but not as a result of health care reform, but as a result of debts left to us and unfunded benefits demanded by Generation Greed. The question is how to allocate the damage.
Moreover, no one would need to be taxed into poverty by a VAT. Just as the EITC offsets the payroll tax for the poorest, so a reversible income tax credit (refunded to you even if you owe no income tax) for all households could offset the VAT. Call it the LMITC (low and moderate income tax credit), giving back in cash some of what lower and moderate income households paid in higher prices as a result of the VAT.
So who would object to replacing the payroll tax with a VAT, which would presumably be higher as a result of our national debt? Generation Greed for one. It could argue that its members already paid the payroll tax when working, and forcing them to pay a VAT when retired would mean they had paid twice. In reality, those now “in or near retirement” in George W. Bush’s words, collectively have taken and will take much more out than they put in, leaving behind a diminished country and a big debt. The less greedy members of Generation Greed would probably appreciate the opportunity to alter their legacy, even if that meant facing higher prices and spending less, but they aren’t the majority within their own generation and they don’t make the most noise. And, of course, the Senate is comprised primarily of members of Generation Greed.
Instead, what we get in Congress is alternative proposals to “help” future generations by making them worse off, to pay for those who came before. (Just like public employee pensions at the state and local level). The Republicans oppose any restraint on entitlement spending for those “at or over 55” no matter how much needs to be borrowed. But in order to limit the tax burden for younger generations, they would only provide any old age benefits to those coming after if total federal spending – including all that interest – were lower than 19 percent of GDP. President Obama showed some willingness to try to restrain the increase in senior health care spending to provide something to someone else and some assurance Medicare would remain solvent, but Democrats in Congress watered down those portions of health care reform. Whereas Republicans propose to “help” younger generations by taking away their safety net old age benefits, therefore, Democrats propose to “help” younger generations by raising their taxes to “save Social Security.” The same rue that was used in 1983 when the regressive payroll tax was jacked up.
Perhaps that’s why replacing the regressive payroll tax with a regressive VAT, rather than just adding a VAT or using it to replace the progressive income tax, hasn’t been proposed. Except by me.