Analyzing the Concepts: Flat tax, national sales tax, and value added tax (VAT)
ID: 1212288 • Letter: A
Question
Analyzing the 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 in this course, and the other is a national sales tax. The flat tax is favored by former presidential candidate and publisher Steve Forbes. It would grant a personal exemption of about $36,000 for a typical family and then tax income above this amount at 17 percent with no deductions. As stated by recent presidential candidate John McCain, 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 would be optional to the current tax system. The flat-tax plan described above 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 2008, Mike Huckabee, Republican candidate for president, made this idea 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, say, 30 percent. 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 would save because they no longer need to hire accountants 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 in use 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 paid by the vendor and the sales price customers pay to purchase apples from the vendor. Customers who buy the apples bear the VAT cost built into the price of the apples they purchase. ANALYZE THE ISSUE Note that this assignment is worth more points than the other assignments, so it is very important that you complete it. For this assignment, you are required to write a short essay (1 – 3 pages). It is strongly recommended that you go beyond the textbook and consider some of the elements that we discussed in class. For example, what evidence can you point to with respect to the experiences of countries beyond the USA? Properly cite any outside sources that you use (APA style). It is expected that you will write at a level appropriate for undergraduate students of economics. “Bullet point answers” will not be considered sufficient. Refer to the “Critical Thinking” grading rubric posted to the Blackboard site, to understand how points will be awarded. The organization of your essay is up to you but at minimum, you must address the points below: Assume that 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.
Explanation / Answer
A Federal income tax is levied by the government of the U.S. on annual earnings of individuals, corporations, trust and other legal entities. It is applied on all forms of earnings. Whereas, national sales tax is a tax levied upon consumption expenditure. It is levied upon the consumers at the point of sale of goods & services. This tax is an extra cost added to the retail price of the products.
There is no agreement on how much saving would be encouraged by shifting of taxes as Americans have a low rate of savings. Replacing the federal income tax with a national sales tax might improve the productive use of economic resources. This change in tax will have a lighter burden of tax on the upper middle class and high class of individuals and households. At any level of income, individuals with high level of consumption face an increased level of tax burden. Moving to tax consumption from income tax might aim in economic growth as there may be slight reduction in the increase in savings.
Shifting to consumption tax disallows interest deductions for businesses and allows deductions in investment expenditure. Economic distortions are eliminated with a change in shift of taxation. There will be reductions in misallocations of economic resources.