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The Tax Shift Racket

November 15, 2002

Every new president in memory has plotted a grand "tax reform," and the outlines of George W.'s are becoming ever more clear. The Washington Post reports that the administration—particular treasury secretary Paul O'Neill—is seriously considering a move away from the income tax toward a national consumption tax.

The purpose is not to yield lower taxes. On the contrary. One Treasury official quoted in the story complains that it is "inherently difficult to measure income…there are just too many ways to minimize it." Neither is anyone talking about eliminating the income tax altogether. The idea would be to gradually shift from one method to the other as the predominant means of scarfing up the people's property.

In other words, we may watch a repeat of an old Washington trick, called the tax shift. The tax shift is one of the great games of government. In the game, the government uses the prospect of lowering one tax in order to buy support for raising another. The proposal to move from an income tax to a consumption tax is a good example of the game.

The essential key to understanding the trick is to realize that the government wants money and is going to get it one way or another. Zig zagging from one method to another does not change the reality. But it can fool the gullible. And it can raise a lot of money from affected groups during the transition period.

One helpful way to understand this is to think of a robber who promises to stop coming through your front door if you promise to leave open the back door. So it is with the state that promises to stop taxing your income if you let it tax your consumption. The issue is not the method; it is the amount.

The case for the consumption over the income tax rests on these essential claims:

1. The consumption tax is at least voluntary. Actually, it is just as coercive as any tax. Under the income tax, if I earn income and don't pay the tax, I can be fined and jailed. Under the consumption tax , if I want to consume a tax item and don't pay the tax, I get fined and jailed.

It's true that I can choose not to consume that item. Similarly, under the income tax, I can choose not to earn income. Nothing is voluntary if I am not permitted to exempt myself. There is no such thing as a voluntary tax. If there were, it would be called something else. (The lottery isn't a tax; it is a government-run enterprise.)

2. The consumption tax doesn't tax production. Yes it does. Businesses don't set their own prices, which is why they cannot simply pass on the consumption tax to the consumer. If they could raise their prices without its affecting their profits, they would have already done so. Imposing a new tax on a business, ceteris paribus, the business will have to absorb the cost of that consumer tax into its own operations. In this way, the consumption tax is a tax on production, wages, research, investment, and every other aspect of economic life.

3. Consumption tax is easier to collect. Assuming this to be true, why is this necessarily a good thing? A tax that is hard to collect suggests that it less tempting to increase. What's more, a consumption tax might be easy to collect at 1%. But to replace the federal tax with a national consumption tax would require a tax of some 25%, while some estimates even put the replacement rate above 50%. Any tax on this level would throw markets into chaos, create an overnight black market in everything, and give a great excuse for massive despotism and mandatory record keeping.

4. The consumption tax doesn't tax savings. Generally this is true. But the government should not be in the business of prodding us into a particular pattern of saving and consumption. It should leave that up to us. Saving is great to the extent it reflects individual preferences. Consumption is great in the same way. But there is no way to know a priori what the right mix should be. And think of this: the degree to which the consumption tax discourages consumption is the same degree to which it does not raise revenue. How does the tax-hungry state deal with that paradox?

As an aside, note that income saved today will be taxed twice, once when income was taxed and once when consumption is taxed. This is grossly unfair. Also, the consumption tax diminishes the value of savings. The only point to saving is eventual consumption. The reduced purchasing power of the dollar after the tax is imposed is imputed to the value of money available for consumption, i.e. savings.

5. The consumption tax, whatever its problem, is at least not progressive. Far too much is made of the flat versus progressivity issue. Think of it this way. Would you rather pay a flat 40% tax, or finagle your way through a system with 20 different rates ranging from 1% to 39% (all else being equal)? If you knew that you would pay less under a progressive system, that is the one you would favor. This why the flat tax has never gone anywhere politically: it necessarily means raising some taxes while reducing others.

The champions of the consumption tax, particularly those who claim to support free markets, need to redirect their energies, away from the method of taxation to its level. They need to adopt the general principle that whatever the existing tax, it should be lower and lower. Going back to the robber analogy, the ideal system would be to have every door and window bolted down solidly.  

Let's not reform taxes. Let's eliminate them, starting with the income tax. That is not unrealistic. The income tax this year will yield $1 trillion for the federal government. Cutting that amount gives us a budget equal to the federal budget of 1987. Was the government intolerably small back then?

For more on all these issues discussed here, see the Frederick L. Maier Taxation Archive.

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