Is it Time to Switch to a Consumption Tax?

The first presidential debate covered a topic dear to my heart: tax relief to Middle America. Both sides agree that something must be done, but they differ on the best way to provide relief.

There is talk of streamlining the tax code and shifting things around to benefit the middle class. In the past there has also been talk of a flat tax and a fair tax but neither idea gained enough traction to get passed. Our tax situation is kind of like having your mother-in-law living in your house: you complain about it, but you’re never going to do anything about it.

The tax code has become so huge and complex that it’s intimidating for anyone to think about for an extended period of time, much less work to reform it.

Here’s my idea: Let’s completely eliminate the income tax and replace it with a true progressive tax – a consumption tax. It would mimic a national sales tax where goods and some services would be subject to taxation. The rates would be determined, but there are many benefits to having a consumption tax:

1. It would create a level playing field. The current income tax system is called a progressive tax system. But if many high-income earners pay a mere 15% and Middle America is paying 25%-35%, that doesn’t seem progressive.  A consumption tax, however, would be a true progressive tax if properly constructed. For example, groceries and other necessities may be exempt or taxable at a low rate. Larger-ticket items for those who can afford the finer things would be levied at a higher rate.
2. It would encourage savings. If you don’t spend, you don’t get taxed. The government loves using the tax code as a behavior modification tool. Decades ago, the IRA contribution became deductible because the government foresaw the death of the Social Security system and wanted to encourage folks to start saving for their futures outside that system. A consumption tax would carry on that built-in form of encouragement.
3. It would bring in more taxpayers. A consumption tax would widen the tax base by bringing the underground economy to the surface forcing everyone to pay taxes. We get upset at those who work under the table or who work in illegal industries and do not file income tax returns and pay their fair share, and this would prevent that. Approximately 15% of Americans comprise the The Tax Gap, which is currently estimated at $385 billion, if we bring these folks back into the fold, I imagine the budget deficit would narrow.
4. It would remove any loopholes. Romney talked about closing loopholes in last week’s debate, and that is a great idea, but when one loophole closes another one opens. It’s just a matter of working with a tax pro to create a new strategy based on the new set of rules in order to minimize one’s tax liability.

Every year rules change to make one group happy, disappointing yet another group that now has to restructure their holdings in order to stay ahead of the game.  If a tax were based on what people purchase rather than what people earn, there would be no need for loopholes.

1. Pay as you go becomes a benefit. I see quite a few entrepreneurs get into tax trouble because they cannot keep up with quarterly estimated tax payments. It’s so much easier to shell out $1 versus $1,000 on any given day. Imagine having no problem trying to raise funds to satisfy your tax liability. A large percentage of this population would avoid tax troubles and live within their means.
2. Audits would be a thing of the past. This will increase the privacy and freedoms that this country was founded upon. There may be business audits to ensure that all sales were correctly accounted for and all consumption taxes were collected and remitted, but at the individual level, there would be no reason for the IRS to come to you and demand to look at every item listed on your bank account statements.
3. It would foster economic growth. Everyone’s net pay would go up because there would no longer be a need for federal withholdings. Imagine all that extra income that can now be used to pay for goods and services. Sure, most of it is going back to the IRS in the form of consumption tax but it will hit the marketplace first.

As with any system of taxation there is always the potential for abuse. Levying a consumption tax in lieu of the income tax would give the responsibility to business owners to collect and turn over the taxes. That’s a lot of money to be entrusted to our nation’s companies.

Business owners already must collect income taxes from wages, sales taxes and excise taxes. Rather than collecting the income taxes from wages, they will be collecting consumption taxes from buyers, so it’s pretty much the same thing. However, because there will no longer be an income tax, any entity and individual who normally makes estimated tax payments rather than having withholding at the source, will now be paying a consumption tax and thus increasing the amounts that sellers of products and services will be required to gather and turn over to the government.

There’s a very good answer to this quandary: We could implement a merchant credit card machine that will direct received funds to the business owner’s bank account for the net purchase and to the US Treasury for the consumption tax liability. That way the business owner never has access to the funds and cannot abuse the position.

Another disadvantage is the loss of behavior modification tools. I wonder what would happen to charitable giving if people no longer receive a tax break for their contributions? Perhaps purchases in thrift stores run by nonprofits could be excluded from taxation. This will encourage purchasing from these stores which will expand their abilities to fulfill their program goals. This will also provide another needed exemption for the nation’s poor.

Another problem to consider under a consumption tax system is whether or not we will be driving sales away from American businesses. If you must pay a 20% consumption tax on a new vehicle, will you instead attempt to import one from another country? I suppose raising import duty taxes could prevent folks from taking this route. The wild card is online sales: To save on the consumption tax, American shoppers can turn to Amazon UK to get the latest book, rather than go to the local bookstore. These are issues that must be addressed.

Finally, will the levying of a consumption tax provide us with sufficient revenues? The government needs to bring in at least, actually more than it is now.

No system is perfect, but with this one, I think we’re getting warmer.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.