Replacing the Income Tax With a National Sales Tax

It’s a compelling idea, replacing the federal income tax with a national sales tax. The strongest case here is that the IRS has become too intrusive, too invasive and threatening, and it is immoral for the government to know so much about our personal income.

Moreover, the Obama Administration has pushed the IRS across the Rubicon, cementing its place as an enforcer of ad hoc policy that neurotically changes every day (more than one tax change a day, says the Taxpayer Advocate) instead of its historic role as a pure tax collector. Tax officials have warned as much, given the agency’s controversial history enforcing nonprofit law--a severe conflict of interest targeting conservative anti-tax nonprofits--and ever-changing health reform.

The taxpayer advocate, Nina Olson, has also cautioned that the U.S. “tax system should not be so complex as to create traps for the unwary,” that, though the 1986 tax reform law is a model, any subsequent attempts at simplification have fallen apart because “each tax break has a constituency, and constituencies that stand to lose benefits tend to organize quickly to protect their interests.” Meanwhile, costs of complying with individual and corporate income tax requirements amount to nearly $200 billion annually, Olson has said.

Another argument against the federal income tax is that taxing income decreases productivity and hurts job growth, as small business formation has been cut in half since 1978, while tax rates and complexity have steadily risen. Small businesses have been the driver of job growth in the U.S. Look to Venezuela, where President Nicolas Maduro is raising taxes by decree, where small businessmen tell me they face rates higher than 90%, and job growth has collapsed while inflation has soared, with food lines around the block. “We are giving up running our own businesses because why work when the government just takes what we do with extortionary rates?” says a local entrepreneur. Already, U.S. multinationals have pulled up stakes due to high U.S. taxes, whereas bringing that estimated $2 trillion offshore back home is the cheapest stimulus of all.

One argument for a national sales tax says that both the tax code and the IRS would be slimmed down. The IRS could be scaled back to a federal excise tax agency, similar to its mission to collect trust fund excise taxes like the gasoline tax.

Taxing consumption could potentially decrease spending, but the argument here is less demand for consumer goods could lower prices and also consumer debt. In addition, if people put off spending money they may instead increase their savings, which is capital to invest that could create economic growth. Although, given microscopic savings rates thanks to the Federal Reserve’s low rate policies, pay to save looks less appealing, after inflation, than the stock market’s returns, which might see an extra boost under a national sales tax.

One scenario has it that under a national sales tax individuals would not have to keep tax records or file income tax returns. Instead, businesses would see longer tax forms. More than 150 million Americans have to file a federal tax return, a state tax return, and even a local income tax return in dozens of cities or counties (see here:

Today, just five states—Alaska, Delaware, Montana, New Hampshire and Oregon—do not impose sales taxes, versus the other 45 states that do, the Tax Foundation said in its annual review of state and local sales tax rates. On top of their state sales tax, 38 states also collect local sales taxes.

The top five states with the highest sale state and local tax rates are Tennessee (9.45%), Arkansas (9.26%), Alabama (8.91%), Louisiana (8.91%) and Washington (8.89%). The state with the lowest state-local sales tax is Colorado (2.9%), the Tax Foundation says.

But one of the strongest arguments against the national sales tax is a lesson in futility, that bureaucrats simply can’t help themselves from larding more taxes on top of each other.

“The fact that 38 states allow local governments to levy sales taxes within their jurisdiction,” is a case in point, says Tax Foundation economist Scott Drenkard in a statement. Those local taxes, “when combined with the statewide rates, can result in substantially larger tax bites,” he says, adding, “while many factors influence business location and investment decisions, sales taxes are something within policymakers' control that can have immediate impacts.”

Already, the states are the experimental labs for cutting income taxes and replacing them with higher state sales taxes, as has been the case in Kansas and Missouri.  But it’s a difficult task.

“In 29 of the 39 states with both sales taxes and significant income taxes, current sales tax rates would have to more than double to replace revenue lost from repealing state income taxes,” says Tax Analysts Martin A. Sullivan. “To replace income taxes in the 45 states with substantial revenue from those taxes, only five could have revenue-neutral sales tax rates below 8%, and only 10 could be below 10%.” (see here:

Another case against a national sales tax is that it would hit the poor harder, would likely hit services and not just goods, and would raise issues of fairness (state and local governments would likely lobby for laws to make themselves exempt so as not to pay it).  Internet sales taxes, taxing prostitution, all would be on the table.

Also, national sales taxes have risen steadily in countries where they have been implemented. For example, the U.K.’s value-added tax (VAT) started at 10% in 1973, but has since doubled to 20%, and it hits practically everything, including Apple iTune sales ( Thirty countries in Europe have VATs, but just three, Canada, Japan, and Switzerland, have rates under 10%.

Tax policy pros also warn a national sales tax would require an equally intrusive tax man to collect it. Joel Slemrod, veteran tax expert at the University of Michigan, has also cautioned that a national sales tax would require an invasive tax collector as bad as the IRS. He dubs it NAUSEA-I, an acronym for "not administrable at usual standards of equity and intrusiveness."