Just as there are myriad complications in as simple a concept as taxing “income,” there are just as many if you want to tax “sales” or “business profits.”
Herman Cain's 9-9-9 plan may prove to be a flash in the pan, but it certainly has generated plenty of conversation.
The idea of changing federal taxes to promote greater economic efficiency is one that isn't going to go away. So it is useful to look at other taxes besides the federal personal income tax.
First, note that most advocates of tax “reform” argue we need to increase incentives to save and invest. This will, economic theory tells us, lead to faster growth of national output, total national income and employment. But increasing saving inherently involves reducing incentives to spend on current consumption. Making it more expensive to consume and more rewarding to save thus lies at the core of most proposals for change.
The simplest way to discourage spending is to increase the cost of goods and services by taxing them —hence calls for a national sales tax of some kind.
One must be careful here. Economists understand there are important differences between “sales taxes,” and “value-added taxes” .
The term “value-added tax” is still poorly understood by most people, in large part because the media often describe it as “a sort of national sales tax.”
Cain presents his as a sales tax, perhaps because the idea of a new value-added tax is anathema to many in his party.
Choosing what items should be subject to a sales tax is always a challenge. The more goods and services you tax, the more revenue you get for a given tax percentage. Narrow the range of taxable items and the higher the rate must be.
If you want to discourage consumption, then you should tax all services and goods that households buy. But it would involve a far broader base than that of most existing state sales taxes. Many people are not used to paying sales tax on doctor visits, apartment rentals, water bills, YMCA memberships, home and car insurance, and more. Yet, all these would be taxed under a true broad-based sales tax aimed at discouraging consumption.
The fact that businesses also buy many of the same goods and services as households introduces complexity.
State sales taxes usually exempt physical raw materials that will undergo further transformation in businesses like manufacturing. But other items businesses buy may be subject to the tax. This expense must get recovered in the price of the goods that eventually are sold. The higher the sales tax rate and the broader the range of items taxed, the more such taxes can add up, cascading into the costs of goods and services.
One can avoid this by exempting all purchases by businesses from the sales tax. But this can be an administrative headache, and it provides incentives for households to cheat by posing as businesses whenever possible.
This incentive may already exist in states that broadly exempt business purchases. But if you add another 9 percent to the combined sales tax rate and extend that to more services, you increase incentives for evasion.
A value-added tax is designed to prevent both the cascading of sales taxes and cheating. With a VAT, tax is due on the “value-added” at each stage of producing some good or service. The seller of a product must pay tax on the value of the product minus the purchased inputs for that product, and the VAT already paid at earlier steps in the process. Properly structured, the VAT is incorporated once and only once in the final price.
Governments like VATs because they are hard to cheat on.
Economists like them because they are the least distorting of any tax.
Most VATs don't allow deducting labor costs when calculating “value-added.” Cain's tax on business profits similarly does not allow for businesses to deduct labor costs in calculating taxable “profits.” If so, what he is proposing is largely a VAT by another name. Perhaps this is good, but then let's call it that.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
