Nathan Lewis, Contributor
I write about monetary and tax policy for the 21st century.
For a number of years now, people have asked me whether I prefer a “flat tax” or a “fair tax.” Both are problematic.
The “flat tax” is typically conceived as a replacement for the existing personal income tax. This is fine, but it ignores the payroll tax, which is really just another form of income tax. So, it is only half of an income tax reform. In practice, quite a few countries have gone this route, beginning especially with Russia in 2001, and the results have been very good. These countries have generally replaced their income tax systems, but have kept what amounts to relatively high payroll taxes.
I would like to see a top-to-bottom income tax reform, which includes payroll taxes. Or, I should say, which does not include payroll taxes: I would like to see the payroll tax system eliminated entirely and integrated into a single income tax system. Neither Hong Kong nor Singapore, which are models of what can be achieved with a flat tax system (or nearly so in Singapore), have a payroll tax. The result is that taxation on the lowest incomes is very low, and the overall system has a high degree of progressivity despite modest top rates.
Hong Kong’s flat tax system, with no payroll or sales/VAT taxes, generates about 13% of GDP in revenue per year, with a top tax rate of 16%. This is quite good, and shows excellent efficiency and high compliance. However, 13% of GDP is still rather short of the 18.5% of GDP that the U.S. Federal tax system has generated over the past several decades. So, we would have to decide either to reduce spending considerably — which might be nice, but is a separate discussion — or generate more revenue somehow.
Now we come to the “Fair Tax,” a rather horrible name for a system which aims to generate all revenue from a single national VAT or sales tax. This would be equivalent to a 30% sales tax rate, as normally calculated (exclusive method).
There are a lot of positive things to be said about the Fair Tax, especially the elimination of the IRS and all of the intrusive bookkeeping involved with the income tax. By maximizing the taxation on consumption, we would be theoretically minimizing the taxation on investment, capital, and employment, with potentially excellent results.
The problems are that many states already have a sales tax (9.6% average rate in 2010), which means that the combined rate would either be 39.6% or that states would have to generate income by some other means. States also have income taxes, which presumably would be eliminated along with the federal income tax, thus generating another revenue issue.
We end up with a rather impressively high sales tax rate, which raises the question of tax evasion — the higher the rate, the greater the incentive for evasion — and also the problem of regressivity, putting the largest burdens on the lowest incomes.
I have argued in the past that conservatives should adopt the principle of progressivity as much as possible. The problem of “what to do with the poor” is as old as government itself. Instead of pretending the problem doesn’t exist, conservatives would do well to have their own, conservative-themed solution. Democrats promise government services and welfare, and we should recognize that that has had some success. So what should the conservative solution be? Even the most libertarian thinker can agree that, if you have no better solution – don’t take their money!
I conclude that the problem with the Fair Tax is much the same as the problem with the Flat Tax — by itself, it can’t generate enough revenue without becoming a caricature of the original principle.