Economics for Today 9th Edition by Irvin Tucker

Exercise 26

IS IT TIME TO TRASH THE 1040S?
Applicable Concepts: flat tax, national sales tax, and Value Added Tax (VAT)
Two controversial fundamental tax reform ideas are often hot news topics. One proposal is the flat tax discussed earlier in this chapter, and the other is a national sales tax. The flat tax would grant a personal exemption of say, $36,000, for a typical family and then tax income above this amount at 17 percent with no deductions. As stated by Senator John McCain as a presidential candidate, the argument for a flat tax is that it would allow people to file their tax returns on a postcard and reduce the number of tax cheats. McCain proposed that the flat tax be optional to the current tax system.
The flat-tax plan described earlier creates serious political problems by eliminating taxes on income from dividends, interest, capital gains, and inheritances. Also, eliminating deductions and credits would face strong opposition from the public. For example, eliminating the mortgage interest deduction and exemptions for health care and charity would be a difficult political battle. And there is the fairness question. People at the lower end of the current system of six progressive rates could face a tax increase while upper-income people would get the biggest tax break. The counterargument is that under the current tax system, many millionaires pay nothing because they shelter their income. Under a flat-tax scheme, they would lose deductions and credits.
A national retail sales tax is another tax reform proposal. In 2014, Mike Huckabee, Republican candidate for president, made this idea, called the Fair Tax, central to his campaign. A consumption tax could eliminate all federal income taxes entirely (personal, corporate, and Social Security) and tax only consumer purchases at a given percentage. Like the flat tax, loopholes would be eliminated, and tax collection would become so simple that the federal government could save billions of dollars by cutting or eliminating the IRS. Taxpayers could save because they would no longer need to hire tax preparers and lawyers to prepare their complicated 1040 tax returns. Also, the tax base would broaden because, while not everyone earns income, almost everyone makes purchases.
Critics of a national sales tax argue that retail businesses would have the added burden of being tax collectors for the federal government, and the IRS would still be required to ensure that taxes are collected on billions of sales transactions. Moreover, huge price increases from the national sales tax would lead to "black market" transactions. The counterargument is that this problem would be no worse than current income tax evasion, and a sales tax indirectly taxes participants in illegal markets when they spend their income in legal markets. Also, a sales tax is regressive because the poor spend a greater share of their income on food, housing, and other necessities. To offset this problem, sales tax advocates propose subsidy checks paid up to some level of income. Critics also point out that retired people who pay little or no federal income tax will not welcome paying a national sales tax.
There are also debates on using a value-added tax (VAT) that is popular in Europe and many other countries. VAT is a consumption tax levied at each stage of production. Suppose a vendor buys apples from a farmer to sell at a market. The vendor's VAT is based on a percentage of the difference (value added) between the cost the vendor paid and the sales price customers pay. Customers who buy the apples bear the VAT cost built in the price of the apples they purchase.
Assume the federal government replaces the federal income tax with a national sales tax on all consumption expenditures. Analyze the impact of this tax change on taxation efficiency and equity. Note that the federal government already collects a nationwide consumption tax through excise taxes on gasoline, liquor, and tobacco.