The Flat Tax and the FairTax Federal Consumption Tax — A Comparison

Both the Flat Tax and the Federal Consumption Tax Are Neutral Toward Savings and Investment

The flat tax and the consumption tax both remove the income tax bias against savings and investment. The flat tax accomplishes this result by expensing capital costs and exempting the return on savings. The consumption tax accomplishes this same result by only taxing final consumption sales. Each would result in higher levels of savings and investment, higher rates of capital formation, higher productivity, and higher real incomes.

Both the Flat Tax and the Consumption Tax Reduce Marginal Tax Rates Dramatically, Although a Consumption Tax Will Reduce Marginal Tax Rates More Than a Flat Tax

Flat tax supporters often emphasize, correctly, that marginal tax rates, rather than average or effective, are the most economically relevant tax rates. It is the marginal tax rate that affects an individual's decision about what to do.

A consumption tax can be viewed as imposing a zero marginal tax rate on labor and capital income, if the economic incidence of the tax is on consumers. Alternatively, one can view the incidence of the consumption tax on the factors of production (labor and capital). The comparison below is based on the view that the consumption tax is incident on the factors of production.

The flat tax bill would reduce the top marginal income tax rate to 17%. This rate, however, is not revenue neutral. The flat tax is revenue neutral at about a 21-22% rate, not taking into account the impact of the plan on economic growth. In the real world, the flat tax would cause economic growth that would increase the tax base, perhaps reducing the revenue neutral tax rate to 20% (within a few years). The flat tax would not affect the employer or employee Social Security or Medicare payroll tax. Those that have earnings below the Social Security wage base ($72,600 per worker in 1999) would, therefore, face a marginal tax rate of 32.3%. Taxpayers over the Social Security wage base would face a marginal tax rate of 19.9% on wage income and 17% on capital income. These figures are about 3-5% points higher in a revenue neutral flat tax.

Under a federal consumption tax, the poor would experience negative effective tax rates because of the universal rebate. They would pay no tax up to the poverty level. Middle-income and affluent taxpayers would pay 23% at the margin. It should be noted that since taxes have crept up over the past several years, the revenue neutral tax rate, without taking into account economic growth, is approaching 25%. Once the FairTax-induced economic growth is taken into account, 23% would probably raise as much revenue as the current system.

Thus, middle-income taxpayers would pay a much lower marginal tax rate under the consumption tax than under the flat tax. This is because the FairTax replaces payroll taxes as well as the income tax. Affluent taxpayers would pay comparable marginal tax rates under the consumption tax and the flat tax. These differences are summarized in the table below.

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Comparative Marginal Tax Rates

The FairTax generally has a more positive impact on marginal tax rates than does the flat tax.

Both the Flat Tax and the Federal Consumption Tax Promote Economic Growth, but the Consumption Tax Will Be More Pro-Growth

Since it will have a better impact on marginal tax rates and the arguably equivalent tax on capital investment, the consumption tax will have a more positive impact on economic growth. Moreover, because U.S. and foreign producers for overseas markets can produce goods and services tax free under a consumption tax, but not under a flat tax, the consumption tax will have a relatively more positive impact on economic activity in the U.S.

The Consumption Tax Does a Better Job of Eliminating Work Disincentives for the Poor

Since the Consumption Tax plan removes the payroll tax while the flat tax keeps the payroll tax (and repeals the earned income tax credit), the FairTax will make it easier for the working poor to climb out of the dependency trap. In contrast, the working poor will continue to pay the 15.3% payroll tax on their first dollar earned under the flat tax. Under the FairTax, payroll taxes are repealed and a rebate of the consumption tax on expenditures up to the poverty level is provided. Thus, the marginal tax rate the poor will face is zero, and therefore, lower under the consumption tax than under the flat tax.

The flat tax is biased against workers because only those earning wages pay the tax. Those that earn income from capital gains (such as those with personal wealth) can avoid paying their fair share of taxes. This makes it less palatable to the American public.

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A Flat Tax is Easy to Convert Back Into an Income Tax

Under the flat tax, the I.R.S. continues to exist. They will administer a system that is not structurally different from the income tax. All individuals and businesses will file tax returns.

With five simple changes, the flat tax can be converted into a graduated income tax. Step one is to depreciate rather than expense capital costs. Step two is to make interest expenses deductible and interest income taxable. Step three is to tax capital income (such as dividends and rent) and capital gains. Step four is not to allow inventory purchases to be deducted until the inventory is sold. A fifth step is to impose graduated rates, which would complete the transition back to a graduated income tax.

After a consumption tax is enacted, it will be virtually impossible to go back to an income tax. The I.R.S. will no longer exist because the states will, for the most part, be administering the tax system. The entire income tax apparatus will have disappeared, and the expertise in administering this present Byzantine system will be dispersed. People will have gotten used to not filing returns and will not want to go back to the old system. People will have gotten use to keeping what they earn and will not want to go back to withholding.

Although it is also quite possible to apply graduated rates under a flat tax, it is not possible to impose graduated tax rates on individuals or businesses under the FairTax because the consumption tax is an indirect tax imposed on goods and services.

A Consumption Tax Actually Gets Rid of the I.R.S.

In general, states would administer the federal consumption tax because they already have the expertise. States would not be required to administer the tax; however, in most cases, they would choose to do so. FI.R.S.t, they will be provided with a generous administration fee to administer the federal tax. Since 45 states already administer sales tax systems, the incremental costs of implementation of the FairTax will be low (particularly if the state conforms its tax base to the federal tax base). Second, for the fI.R.S.t time, states will be able to tax direct mail sales originating in their respective states under this integrated system. This will broaden the state's tax base and put all retailers on an equal footing. Third, states will know that if they do not administer the tax, the federal government will do so. Given that choice, they will want to do it themselves for reasons of control and professional pride.

The Flat Tax May Require Only a Postcard for Wage Earners, but the Consumption Tax Requires No Tax Return At All

Flat tax proponents are proud that their individual tax form will fit on a postcard. So, of course, could today's 1040 EZ. Under a consumption tax, individuals who are not in business for themselves will file no return. No return is preferable to a postcard.

Compliance Costs Will Be Lower Under a Consumption Tax Than Under a Flat Tax

A flat tax would simplify the tax code considerably. However many of the complexities of current tax law would remain. For example, tremendous pressure, would be placed on intercompany pricing rules since offshore income is exempt from tax. Manipulating the prices at which goods change hands between a U.S. company and its foreign affiliate could zero out the U.S. source income under a flat tax. Under a flat tax, the cost of employee benefits, interest, insurance, and other costs must be segregated since they are not deductible. The current complex pension system stays largely intact. Under a consumption tax, the question is simply how much did a firm sell to consumers.

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A Federal Consumption Tax Is Much Easier for the Public to Understand Than the Flat Tax

A federal consumption tax is something that is easily explained and understood by the public. Flat tax proponents have had difficulty explaining it to the American people, notwithstanding large budgets, Mr. Forbes's Presidential campaign, the efforts of Majority Leader Armey, the Heritage Foundation, Citizens for a Sound Economy, and others.

Perhaps the most obvious problem with explaining the flat tax is the issue of capital income. Again and again, it has been argued that the flat tax does not tax "coupon clippers." This argument is made in response to the allegation that rich people can live well and tax free on interest and dividends and pay no tax while the working stiff has to pay tax. Although this allegation is false because the tax on that income is effectively withheld at the business level, flat tax proponents have failed in their efforts to get their message across.

The Consumption Tax Is More Visible

Under the flat tax, much of the tax burden is hidden in the business tax. Will recipients of dividend and interest payments actually understand that a withholding tax has been imposed by denying a deduction to the business making the payment? Will recipients of employer-provided fringe benefits understand that a withholding tax has been imposed by denying the employer a deduction for the benefits? Will the non-deductibility of employer taxes be understood as tax increases? In all cases, it is highly doubtful. Thus, hundreds of billions of dollars in taxes are hidden under a flat tax.

There are those who believe that hiding taxes from the American people is a good thing, because if the people actually understood the true level of the tax burden, they wouldn't stand for it. The consumption tax, however, works on the principle that taxes should be visible and fairly convey the true cost of government. The consumption tax will by law be shown on every retail purchase sales receipt, and this provision will be mandatory.

The Consumption Tax Is Not a VAT and Will Not Turn Into One; the Flat Tax Is a VAT

Flat tax supporters who are also consumption tax opponents often argue that a consumption tax would turn into a value-added tax (VAT). VAT's are usually hidden taxes, collected at each stage of production.

The consumption tax is not a VAT since the consumption tax is collected at the retail level, and no tax is imposed on intermediate sales.

The flat tax is a VAT. None other than the father of the flat tax, Robert Hall of Stanford University (along with Alvin Rabushka), in his 1995 Ways and Means Committee testimony said, "The Hall-Rabushka flat tax is a value-added tax." Thus the flat taxers are effectively attacking their own proposal when they attack a VAT. Most, however, do not understand their own proposal well enough to understand this.

The flat tax is not an income tax because its tax base is not income. At the business level, value added by capital is taxed by the flat tax. At the personal level, labor value added is taxed. The business tax burden under the flat tax is much higher than under current law. Interest expense, most insurance expenses, taxes (including payroll taxes), rent, and other expenses are not deductible under the flat tax. The aim of the flat tax is not to measure net income, but value added.

The flat tax is identical to the USA Tax business tax, an acknowledged subtraction method VAT, except in two respects. First, the flat tax taxes exports and exempts imports from tax. This makes it an origination principle VAT instead of the usual destination principle VAT. The other difference is that business can deduct wages in the flat tax, but not in normal VAT's. The flat tax individual tax, however, is a wage tax. Thus, the flat tax taxes wages just like a normal VAT. However, because it taxes wages at the individual level, the flat tax taxes most government value-added, while normal VAT's do not.

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Tax Evasion Under Both Systems Will Be Comparable

Under a consumption tax, the number of persons that the tax administration authorities must focus on is reduced by 80% or more. Only businesses are in the tax system. Dramatically lower marginal tax rates — lower for most than the flat tax — will reduce the marginal benefit to cheat. If enforcement and associated penalties remain comparable, and the marginal benefit to cheating falls, evasion should decline. The overall legitimacy of the system will improve, and non-compliance generated by frustration or hostility will decline. Individuals who are not in business, and non-retail businesses will be unable to cheat on their taxes, since they will not be in the system.

Retailers would benefit equally from cheating under the flat tax and the consumption tax (assuming the rate were the same). Let's take a bar owner that pockets $1,000 per week and fails to report his sales either to the income tax, flat tax, or consumption tax authorities. In the world of either the income tax or the flat tax, that pocketed $1,000 will reduce the owner's gross revenues, and therefore, his profits by $1,000 per week. He will, of course, continue to report all of his expenses. He will retain the documentation for the wages he paid and the liquor he bought. The government will lose revenue equal to the tax rate times the $1,000 per week. In a consumption tax world, the government will loose revenue equal to the consumption tax rate times the $1,000 per week. In both cases, the loss to the government is the same.

The Transition Is Easier Under a Consumption Tax Than Under a Flat Tax

Under the flat tax, the tax liability of the business community increases dramatically, by hundreds of billions of dollars per year. All capital value added is taxed at the business level. Only wages are taxed at the individual level. About $5 trillion worth of future deductions (remaining basis), relating to inventory acquisitions, depreciation on capital investment made under the income tax, and so on, exist under the income tax. Since the return on these assets would be in the flat tax taxable base, failure to allow these deductions would amount to a confiscation of nearly one-fifth of existing wealth. The business community, large and small, will not let the flat tax pass without transition rules.

For example, under the Armey-Shelby flat tax if you bought a building for $1 million dollars the day before the bill went into effect and sold it for $1 million the day after the bill went into effect, you would have taxable income of $1 million (even though you have no profit) since the bill assumes that you have expensed the building. In the real world, the taxpayer's income tax basis in that building is going to have to be deductible. The revenue from this kind of expropriation is presently counted in flat tax revenue estimates.

Allowing these deductions, however, would increase the revenue neutral tax rate in the flat tax considerably. Alternatively, the transition could be funded by a complex series of taxes on various windfall gains accruing to certain businesses or taxpayers.

Under the consumption tax, corporations and other businesses and investors pay no tax on their income. Accordingly, it is doubtful that any transition "relief" is appropriate. The future income of their assets will be tax free. Transition rules are only appropriate with respect to inventory held on the date of the changeover, since those inventory costs would not have been deducted in the income tax and the sale of the inventory will be taxed. Rules need to be provided to ensure that the CPI used to index benefit payments includes the consumption tax to protect against any consumption tax induced price increases (although it is not clear there will be any, since repealed income and payroll taxes account for 20-25% of the price of goods and services, according to Harvard economics department Chairman Dale Jorgenson). That's about it. The transition is a much simpler problem under a consumption tax.