A Thought On the Fair Tax Debate

Missouri will soon decide whether to replace its income tax with a revenue neutral sales tax. This proposal of course has attracted much debate, some rational, some strident. This post was inspired by two conversations: one with Lily Fortel of Grassroots Organizing, a group of political activists on the left, and Abhi Sivasailam, who co-wrote a policy analysis of the fair tax proposal with Dr. Joe Haslag.

My general principle of goverment is that we should treat most of our important government programs as if we were engineers designing and operating HVAC systems (by way of example). The difference of course, is that HVAC systems aren’t political.

So here’s the deal with how the taxonomy of taxes can be misleading. Sales taxes, by definition, are regressive taxes: they apportion liability regardless of income level. Graduated income taxes, by definition, are progressive: you can tax people by their income level.

But here’s the problem. These are definitions of taxes in a vacuum. In the real world parameters matter and allow us to make more nuanced judgments. A bad income tax is not necessarily superior to a good sales tax.

American conservatives dislike our income tax structure. It is costly to comply with, inefficient, and applies high marginal tax rates to our most productive citizens, stifling innovation and economic growth on the margin. These are legitimate concerns. Liberals, of course, are a far more varied group, but the general consensus is that sales taxes are too blunt an instrument of fiscal policy, since it is harder to exempt low-income people.

But I suggest that a re-evaluation of the costs are in order. Implicitly, complying with an income tax is extremely costly on every level. One must keep records, and receipts, and spend many hours doing tedious calculations and revisions or outsource it to a professional; the more successful one is the worse this problem becomes because you start having to deal with more complicated tax structures. The incentive to cheat on one’s taxes rises with income, and the richer you become the more tax shelters of some variety you can buy your way into. We spend inordinate amounts of money on monitoring and enforcement through revenue departments, who are unique amongst all government entities in the amount of scorn and derision flung upon them by virtually everyone of every political stripe.

Keep in mind this basic fact of our income tax system. Many people never file or sufficiently pay their taxes and get away scot-free because the IRS simply can’t monitor everyone.

The costs of complying with a sales tax are far simpler, since instead of dealing with individual citizens, you deal with the far smaller number of businesses, which are far more easily regulated. There are already straightforward and efficient mechanisms for enforcing and collecting point-of-sales taxes. Businesses face far great incentives to meaningfully comply, since sales taxes are usually tied to the status of their business license. Functionally, increasing a sales tax would at best only marginally increase the cost of collecting the tax. You don’t need much extra machinery to scale up or down.

There are other arguments relevant to this debate, but the point here is simple: we should consider the implicit costs of the economy-wide market distortions that exist relative to a world in which sales taxes replaces some or all of the tax revenue for governments.

Right? Because a world where there is an artificial market for tax professionals, for example, is  a world where talent that might find itself pursuing other more productive options is drawn into preparing income taxes for people. A world in which there is an artificial market for tax professionals who help you shelter your income from taxation is a world in which very smart people are incentivized on the margin  to pursue careers in wealth management and protection as opposed to wealth creation. There is a very clear tradeoff in the choices people make career-wise; it is a common theme that grossly oversized incomes in the financial sector drew some of the world’s greatest minds away from professions like teaching, medicine, the hard sciences, etc, over the past twenty years. In some sense the forgone benefits of the advancement in other fields due to the financial sector brain drain is incalculably great. Likewise, industries that exist to add nothing of value but to enforce and monitor a tax system that is comparatively less efficient are functional brain drains. Perhaps the incentives are lower, but they are systemic. Forgone economic growth is particularly hard to calculate, demonstrate, and weigh, but it is surely important.

In a nutshell, income taxes are vastly more expensive to enforce and monitor and generate large industries devoted to servicing income taxes and not doing other productive things. Sales taxes don’t have any of those liabilities. To extend the nod to engineering this fits the maxim that the best interface is the most idiotpoof because it’s the cheapest to maintain. I leave the implication up to the reader.

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2 thoughts on “A Thought On the Fair Tax Debate

  1. Just as a note – The IRS spent just 44 cents for each $100 it collected in 2005.

    While I may agree that by and large there are more productive uses of intellectual capital than financial engineering, I’m curious to know 2 things.

    1. Do you have any estimates available about the processing cost of a revenue neutral sales tax regime? i.e. Would the IRS spend only 40 cents? or 30? or 50? I know you’ve guessed that the smaller N-size of businesses means that they would realize some savings, I’m just curious to know how much.

    2. Do you really think that revenue collection inefficiency is a dead-weight loss of such priority it’s worth busting up a nearly 100 year-old established system? I imagine the transaction costs alone would in the medium term be daunting, and rather than shrink the market for tax professionals, just shift the market from individuals to corporations. Corporations don’t just pay on what they sell, they pay on what they own – or not pay on what they could justify not owning. We’d still need an elaborate system of record keeping, checking, statutory provisions, and enforcement to account for those revenues.

  2. Social comments and analytics for this post…

    This post was mentioned on Twitter by eapenthampy: blog post: a Thought on the Fair Tax Debate http://bit.ly/bI7wWA @asivasailam @sheelal90…

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