Free Liberal

Coordinating towards higher values

Towards a Truly Progressive Tax System

By Carl Milsted

After many disappointments, it does look like the Republicans are up to something good: getting rid of the income tax. The idea of a 23% national sales tax, or “Fair Tax” as it is coined, is getting a lot of buzz in Republican and conservative circles. Unlike the old “Flat Tax” proposal, the Fair Tax truly gets rid of the hated income tax once and for all. See for details.

Alas, many Democratic Party politicians and are screaming bloody murder, claiming that a national sales tax would be a huge shift of the tax burden from the rich to the middle class. Even worse, these politicians are right! The Fair tax would be a huge tax cut for the rich. Wealthy families will be able to compound their investments indefinitely, tax deferred. Welcome to the new aristocracy.

So, should liberals oppose the Fair Tax? Should liberals become the defenders of the hated income tax? Or is it time for a counter-proposal?

First, let us admit that this plan has a lot of good things to be said for it—including things that are good from a liberal point of view.

  • The Fair Tax is collected from businesses only. No longer will the government be able to bypass the 5th Amendment by using the IRS. Civil libertarians have reason to rejoice.

  • Because it includes a rebate, the Fair Tax is actually a tax cut for the poor. While the poor do not pay income taxes, the working poor do pay considerable payroll taxes for Social Security and Medicare. Since the Fair tax replaces these taxes as well as the personal income tax. If you purchase the poverty level’s worth of consumer goods, you pay no tax. If you purchase less, your tax rebate will be higher than the taxes you pay. Eco-hippies take note!

  • The Fair Tax would be a huge boon for small business. Calculating income for tax purposes, and computing withholding from employee paychecks requires a great deal of overhead. A big corporation like Wal-Mart can devote specialists to the problem. A Mom and Pop operation has to divert Mom and Pop’s limited time to this effort. The Fair Tax would make it much easier for Mom and Pop businesses to compete against the big block stores.

  • The current tax system hits mainly American labor, which ends up subsidizing foreign imports and outsourcing. The Fair Tax would make American manufacturing more competitive, since the sales tax would apply to both U.S. and foreign consumer products equally.

  • The current system subsidizes the financial sector. It encourages low savings and high indebtedness through the mortgage deduction. It encourages workers to go to Wall St. with their retirement savings via their company’s pension and 401(k) plans. With the Fair Tax, homeowners could pay off their homes without tax penalty. Workers could put their savings into their own businesses tax free instead of have playing the market to get a tax break.

    These are mighty good benefits, and the above list is not complete. But do we have to give up on a progressive tax system in order to get the benefits of the Fair Tax?

    No, it is possible to have a liberal counter-proposal that is even better for the economy.

    Besides giving a big loophole for the rich, the Fair Tax would have enforcement problems. Combine a 23% national sales tax with a 7% state sales tax and you get a 30% sales tax. This provides a very visible motivation to do business under the table. We can expect many service businesses to quietly offer “cash discounts” in order to bypass this tax. While the income tax is much harder to calculate than a sales tax, it does offer the “benefit” of being self-enforcing. Each expense recorded by one business is a source of revenue for another business or employee. To minimize one’s taxes, one must report on others. This is not true for a national sales tax.

    So, if our counter-proposal had some other tax(es) to go along with a national sales tax, we could lower the rate and thus reduce the benefits of cheating, thereby cutting enforcement costs. But this benefit holds only if the supplemental taxes are at least as enforceable as a sales tax.

    Let us reconsider the income tax. Income obeys the following mathematical identity:

    Income = Consumption + Change in Wealth

    That is, you either spend or save what you make. The Fair Tax only taxes the first term on the right hand side of this equation. This is the reason why the Fair Tax would be a huge tax break for the wealthy: the wealthy have a great deal more wealth than the rest of us. On average, the wealthy consume a smaller fraction of their income, so a consumption-only tax system results in the rich paying a lower proportion of their income than the middle class.

    One way to fix this disparity would be to restore the capital gains tax. Make the capital gains tax the same as the sales tax and we get a flat tax system. (Actually, we get a progressive system once you figure in the rebate.) I do not like this idea because it requires a great deal of record keeping and individual tax filing to make it work. Further, it results in people “gaming the system” by holding onto investments longer than is optimal in order to defer paying capital gains taxes. This is bad for the economy.

    There is a simpler approach: instead of taxing the change in wealth, tax wealth itself. A flat rate set of wealth taxes would hit the rich harder than the poor and middle class. Such taxes could be fairly simple to assess and collect—at least compared with income taxes.

    Combine some wealth taxes with a lower rate national sales tax and you get a greatly simplified tax system that is more progressive than the system we have today.

    So what do I mean by wealth taxes? Is this a call for having everyone report their possession to federal government in order to be taxed? No! I would only tax wealth that the government knows about already.

    The classic wealth tax would be the real estate tax. This is how states and localities have been financed for centuries in this country. Property owners hate them because they are very visible. However, the assessment of property value requires very little work on the part of property owners compared to an income tax or even a sales tax. And note that there is no reason for the government to compile detailed records on individuals to collect this tax. Each county has records of who owns what property. Owners pay to each respective county. There is no need whatsoever to connect the county records together in order to determine how much a particular landowner owns. In theory, you could have numbered accounts owning land and the system would still work!

    But property taxes are only for the state level. What about the federal level? Well, there are several sorts of property that the federal government is mainly in charge of enforcing: broadcast licenses, patents and copyrights immediately come to mind. Right-of-ways for railroads, pipelines and aircraft are also enforced at the federal level. These could all be taxed at that level.

    My favorite idea for a federal wealth tax would be a value tax on corporations. Instead of taxing corporations based on their income—whatever that means—we tax corporations based on what they are worth on the open market. The value of any publicly traded corporation is easily accessed public knowledge: it is simply the market cap, the number of outstanding shares times the price of each share. We could compute the corporate tax of the entire Fortune 500 with a single computer hooked up to the Internet!

    Not only would this tax be easy to compute, it would encourage big corporations to divest themselves of excess subsidiaries, holdings and sideline businesses. We would likely go from merger-mania to breakup-madness.

    Combine these ideas with a national sales tax, and you will have a truly fair and simple tax system. But be forewarned: there will be much whining on the part of the truly rich.

    Dr. Carl S. Milsted, Jr. is a senior editor of the Free Liberal. He is the author of By day, Milsted is a physicist who writes software for national defense applications. He hopes to eventually move on to the more interesting and lucrative field of Mad Science.