The Best Fix for Our Tax System? Replace Income Taxes With Sales Taxes

It would mean simpler compliance, less cheating, and a lighter carbon footprint. It would even be an offshore-resistant job creator.

615 income tax alan cleaver flickr.jpg

Alan Cleaver_2000/Flickr

This week's Working it Out question was, "What one change would you make to our taxation system?" Readers' most frequent ideas were versions of "soak the rich." For example, "Eliminate tax breaks for the wealthy. We have been waiting for the 'trickle down' for almost ten years now and it hasn't happened." Or this: "Is investment really going to dry up if the capital gains rates are higher for the wealthy?"

Calls to soak the rich aren't surprising in light of the ubiquitous narratives attacking candidate Mitt Romney paying "only" $6.2 million in federal taxes over the last two years. A Google search on the term "Romney tax return" yielded 448,000 links that were posted in the last week alone! (In fairness, Republicans don't have a monopoly on mining tax loopholes. For example, John Kerry's wife, Theresa Heinz Kerry, has a net worth of $500,000,000, 10 times that of Romney, yet in the year Kerry ran for president (they filed "married, filing separately,") she paid a lower rate than Romney.)

Part of me is sympathetic to further taxing the rich. After all, the rich-poor gap is very wide. (Although in fairness, according to studies reported last week in the New York Times, the rich in the last two years are getting poorer and forecast to keep getting poorer.) In addition, no matter how smart, hard-working or innovative someone is, or how many jobs he or she creates, it seems cosmically unjust that some people have a mansion (or two), yacht (or two) and more money than they could spend in Methuselah's lifetime, while other people must eat ramen in hovels. Also making me sympathetic to squeezing fat cats is that the poor spend rather than save a larger percentage of their income, so by redistributing dollars to them, more money gets quickly pumped into the economy.

On the other hand, I am not immune to opposing arguments, for example, those made in The Economist, which points out that, as of 2006, the top 10% pay 45% of total taxation and that taking money from the rich to give to the poor punishes the innovators and job creators and rewards people who are not, and we'll get more of what we reward, less of what we punish. Plus, money left in the hands of the rich will create more jobs and more innovations--from disease cures to iPhone5--than if Robin-Hooded.

As a result, en toto, I am agnostic on the wisdom of redistributive "justice." Given that this week's Working it Out question was, "What one change would you make?" I'd be hard-pressed to join the readers' modal belief that it should be to further tax the rich. If, however, I could propose a second change, it might be to toughen the Alternative Minimum Tax to avoid the rich being such good miners of tax loopholes that they pay little or no tax.

The change in our tax system that I believe would most benefit America is to replace our federal, state, and local income tax with sales tax.

In 2004 testimony to the House Ways and Means Oversight subcommittee, University of Michigan professor Joel Siemrod estimated that Americans spend at least $135 billion annually on tax record-keeping and return preparation, In 2011, a Laffer Foundation study indicated that Siemrod was too conservative: We pay $431 billion, an extra 30 cents on top of every dollar we pay in taxes. We're all eager to find a way to get back even a few minutes in our day and a few extra dollars in our wallet. Imagine if all that money and the time we spend on tax record-keeping and preparing were returned to us.

Another problem with income tax is that underpayment is rife. The IRS reported that in 2006, the most recent data year available, Americans under-reported $450 billion, up by 1/3 from just five years earlier. An IRS report released just this week found that tens of thousands of federal employees, including in the White House, collectively underpaid billions of dollars. Alas, in our system, cheaters too often win.

In place of federal, state, and local income tax, I'd substitute a national sales tax with basic items exempted to ensure the poor pay relatively little, plus a luxury tax to ensure the rich pay their fair share. The luxury tax would not be set so high as to significantly grow the black market.

What constitutes "basic items?" I'd want to test whether exempting non-luxury food, clothing, and cars under $5,000 would result in low- and moderate-income people paying more or less tax than they now pay in income tax.

The sales-tax rate would be reduced by:

• including Internet sales as taxable, which would allow local businesses to compete on a level playing field

• legalizing and then taxing prostitution

• heavily taxing alcohol and tobacco, because consumption of both products impose heavy burdens on people, their families, and on the health care system

Because of those, I'm guessing (wildly) that the revenue-neutral federal sales tax rate could be around 10 percent plus an additional 4% state and local. Add to that the existing state and local sales taxes, and I'm guessing the total sales tax would end up at about 25%, of course, with basic items exempt.

Advantages of sales tax versus income tax:

-- Less time and money spent on tax record-keeping and income tax reporting. Unlike with the income tax, individuals would not have to keep tax records nor file income tax returns. Currently, 150 million Americans must file an often complicated federal tax return, a state tax return, and in hundreds of cities, counties, and school districts, a local income tax return. And retailers would have little additional work. I propose a unified sales tax form: each retailer would submit sales information on one form, one copy to the IRS, another to the state, another to any local taxing authority, just as our W-2 forms currently do. Of course, states and locales could, as currently, set their own tax rates.

-- Less cheating. Of course, just as with state sales tax, some people manage to avoid tax by buying in the black market, but much less money would likely be lost to cheating than the aforementioned $450 billion every year lost just to federal income tax underpayment. Some academics prefer a value-added tax (VAT) to a sales tax because it's even more fraud-resistant, but a VAT likely requires as much paperwork as an income tax. Also, a VAT taxes not just products but services, which, for reasons stated below, is undesirable.

-- Sales tax hits consumption instead of income. That means we'll consume less and thus decrease the national carbon footprint.

-- Consumer spending would likely be reallocated from taxable products to not-sales-taxed services: from new mom aide to homework helper to personal errand-doer/concierge to technology demystifier to elder companion. If we spend more on such services than, for example, yet another pair of shoes, our national quality of life should improve. And reallocating spending from products to services would create good, offshore-resistant jobs. While most jobs such as tutor or personal assistant would be part-time, two or three of them could comprise a reasonable living and a career that many people would consider more rewarding than manufacturing or distributing said shoes.

Of course, if consumption of products declines, some jobs will be lost in production, tax accounting, and other sectors. But just as most people wouldn't justify the tobacco industry because it creates jobs, that shouldn't justify retaining a high-consumption society or the need for so many accountants and auditors: currently, 1.3 million.

So if I were allowed to make one change in our taxation system, it would be to replace the income tax with sales tax. What do you think?