The Free Market
The Myth of the Replacement Tax
The Free Market 19, no. 6 (June 2001)
While some taxes are worse than others, there is no good tax. All taxes distort production, depress economic growth, and punish producers and consumers. It's also true that different kinds of taxes affect production and punish people in different ways.
You can even use taxes to manipulate social and economic outcomes. A tax on children will discourage large families; large deductions will make children more affordable and hence more numerous. In the same way, a tax on egg production will cause producers to shift out of that market and into others.
Contrary to the textbooks, no tax is neutral with respect to its effects on the market economy. A tax on consumption will draw down on the profits of the producers and push firms out of the industry. A tax on production will diminish the number of viable competitors and thereby cause prices for the good produced to be higher than it otherwise would be.
Many people are indifferent to taxes placed on goods that we ourselves don't produce or consume. That s why luxury taxes and inheritance taxes that affect only a small part of the population are ubiquitous, whereas there are many exceptions available for the consumption of food and drugs. Taxes on the production of things that don' t affect us personally are more politically viable than those that do.
All that said, a major myth plagues many people in the antitax movement. It is that one kind of tax can be replaced with another with net gains for society. The most pernicious form of this myth advocates the creation of a brand new tax (always said to be fairer and less complex) to displace a bad old tax (such as the income tax).
For example: for years, writers and groups have dreamed up plans to abolish the income tax. Of course this is a great idea. If we had the will, we could abolish it today. Imagine that no one filed a tax return at all this year, and all withholdings were refunded. The government would still have enough revenue from other sources to spend the whole of the budget from 1990, with some left over.
In other words, if we cut back the federal budget to a pre-Clinton level, we could abolish the income tax right now and never feel it. Was the level of spending in 1990 so insufferably low that we were somehow denied "essential public services"? Of course not, so why not get rid of the income tax? The reason: once the politicians have their hands on the money, and are used to spending $2 trillion instead of $1 trillion, it is quite difficult (but not impossible) to persuade them to relinquish the money.
That is why so many of the people and groups who want to scrap the income tax seek what they see as a politically viable solution. They want to replace the income tax with some other form of tax that would supposedly be more painless to pay. The favorite candidate here is the innocuously named national sales tax. We picture ourselves paying an extra few pennies on what we buy at the checkout counter and never again having to worry about income taxes.
In fact, the national sales tax would have to be 20 percent at the retail level in order to match the revenue generated by the income tax. If your computer cost $2000, you would pay an extra $400 to the government for the privilege of owning one. Sales would plummet in the official market, and a huge black market would emerge overnight.
The government response would be to initiate a vast crackdown on tax evaders, which means that no businessman in America could conduct a single sale without thorough reports to the revenue agents. As in Europe, they would have to crack skulls but because not everyone can be policed, enforcement would be even more politically corrupt than it is now.
The government would face immense political pressure to reduce the tax, and apply it not just to the retail level but to all levels of production, even when one business bought and sold to another. That would encourage vertical integration to reduce the costs. The antitrust police would be encouraged to crack down on integrations taking place for purposes of tax evasion. That would put the government in the full-time business of designing the structure of America's industries.
Another suggested replacement tax is the idea of moving away from Social Security taxes toward new "fees" for new "private retirement accounts." Again, there are problems with this replacement tax. How would existing beneficiaries get paid if current payers diverted their taxes? How long would the transition last? Such a system would invite the politicians in to prop up the stock markets that people invest in with money they had no choice but to pay.
The answer to these riddles is that opponents of any tax need to forget trying to dream up comfy alternative taxation schemes. Typically, the replacement tax being proposed creates even more problems than the present system.
The only right way to call for an end or a cut in a tax is to demand that it be replaced with nothing. That also means making the case for dramatic spending cuts as well.
That' s not a hard case to make. Let's eliminate all the new spending of the Clinton years and abolish the income tax. In my book, that would be a moderate step back to fiscal sanity. Then we can start hacking away at the payroll taxes that take an even larger bite from paychecks than income taxes. The rule: all taxes that are abolished should be replaced with nothing but the freedom to keep what is ours.
Cite This Article
Rockwell, Llewellyn H. "The Myth of the Replacement Tax." The Free Market 19, no. 6 (June 2001).