The recent IRS scandal might end up having unintended consequences — a national sales tax. A switch from taxing income to taxing consumption could mean the end of the IRS altogether. A sales tax would be simpler putting collections solely on the shoulders of the merchants. We would no longer need to spend hours figuring out what is income and how to reduce it for tax purposes. The amount of tax we pay each year would become a function of how much we choose to spend. Anyone who is unhappy with the way the federal government spends their tax dollars could spend less to curb the amount of their tax dollars being deposited to the government till.
Sound wonderful? There are some problems. For starters, analysts predict the sales tax rate would need to be 29.9% to completely replace the current income tax system. This may be different from rates proposed earlier this year. Language in a bill introduced this spring listed the rate at 23%. However, the bill stated the tax is calculated as 23% of the item’s total price, including the tax. Leave it to a politician to add a level of complexity. The actual rate comes to just under 30% when figured as an add-on percentage to the price of an item. When you purchase an item with a price tag of $100, a 29.9% sales tax would bring the total amount you pay to $129.90. 23% of $129.90 is $29.90 which is how the 23% proposed tax is to be calculated.
The good part of a national sales tax is that income tax, estate and gift, and FICA taxes would all be eliminated. There would no corporate income tax. All investment income including dividends and capital gains would be completely tax free. Pensions and IRA withdrawals would also be free of income taxes. The tax man would get his share when you tried to spend the money. In place of these taxes would be a federal sales tax levied on all goods and services.
A portion of the sales tax revenue would be transferred to the Social Security and Medicare trust funds to make up for the lost revenue from the FICA tax on wages. The bill proposed tax rebates to help offset the impact on lower income families. A rebate payment equal to 23% of the federal poverty level and then adjusted for household size.
Exemptions to the tax would be limited in order to make the tax revenue neutral. Borrowing an exemption from the state sales tax system, assets purchased for business use or for investment wouldn’t be taxed. Unfortunately sales of homes, food, prescription medications, and other necessities would be subject to the tax.
Proponents of a national sales tax say savings would be rewarded since only consumption is being taxed. Last year it took the average taxpayer 23 hours to fill out their 1040. It takes 7 hours to complete the 1040 EZ. Analysts estimate our country spends 6 billion hours and $163 billion to do their income taxes. Most of this time and money would be saved switching to a national sales tax. Our current income tax system is complex. There are six definitions of a child, more than a dozen educational credits and 16 different types of tax-favored savings plans. Small businesses pay $16 billion to help prepare their tax returns. Businesses with five or fewer workers pay $4,500 per employee on average to comply with the tax code. A national sales tax would eliminate this waste.
Critics point out several huge problems starting with the size of the tax rate. Some believe the 29.9% rate will not be sufficient to replace all the revenue generating in the current income tax system. Exemptions and transition rules are bound to creep into the bill in order to satisfy enough lawmakers to get it passed. Adding exemptions will further reduce revenue. Taxing home sales would be even more unpopular than trying to eliminate the current mortgage interest exemption. Lawmakers would be pressured to exempt necessities like food and medicine as many state sales tax systems already do.
The chances of a national sales tax fully replacing the income tax are slim. Tax reform may be coming but it will most likely take the form of broadening the tax base and lowering rates. However, to make any meaningful reduction in rates, some of the most popular deductions will need to be sacrificed. The big three are home mortgage interest, state & local taxes and retirement plan contributions. This is where the big savings are and without reducing one of them significantly or all three in some fashion, tax rates cannot move much lower from where they are currently.
- A national sales tax would need to be nearly 30% to replace the current income tax system.
- The average taxpayer spends 23 hours each year completing their return.
- The largest itemized deductions are mortgage interest, state & local taxes, and retirement plan contributions.