On April 18, Rep. Buddy Carter (R-GA) offered observations on the floor of the House in support of the Fair Tax Act of 2023, of which he is a sponsor. One of his arguments was that the FairTax would do a better job of taxing the underground economy than the income tax it is intended to replace.
His argument was as follows: many practitioners of clandestine or illegal activities do not report their income to the Internal Revenue Service (IRS) or pay income taxes on those activities despite the fact that they are legally required to do so. However, they consume many legal goods and services. Therefore, while an income tax does not lie on them, a consumption tax, such as the retail sales tax under the FairTax, would be successful.
Broadening the tax base in this way is laudable, both from the standpoint of equity and economic growth, but excise taxes won’t necessarily solve the problem.
The most obvious reason is that excise taxes create a different horizontal inequality: legal goods and services are taxed, while illegal ones are not. Presumably, if you’re the type of illegal activity that doesn’t file income taxes, you won’t file the FairTax with the proper authorities either.
But more subtly, Rep. Carter’s argument is based on assumptions about the incidence of taxes, or who bears the burden of the tax. In her argument, the FairTax comes out of the pockets of consumers, while the income tax comes out of the pockets of wage earners.
Although it is an intuitive reading of the names “consumption tax” and “income tax”, these technical terms refer more to the treatment of savings and investment, or cross-border trade, than to whether consumers or those who earn income bears the final burden.
Income and consumption overlap widely
Consider the simplest type of transaction in an economy: Alice creates something and sells it to Bob. In most systems, Alice is responsible for remitting the tax. With a 20 percent income tax, for example, she could sell an item for $1, withhold $0.20 in tax, and pocket $0.80 after tax. However, with a 25 percent sales tax, she could collect $0.80 and remit $0.20 sales tax. In either case, Bob pays $1 and Alice takes home $0.80. (If you’re curious why the rates are different, it’s a question of whether the value of the tax itself is included in the denominator when calculating the percentage; for income taxes, it’s included, while for most taxes on consumption, is included). excluded.)
Since these two scenarios are effectively identical, it would be extraordinarily strange if Alice kindly offered Bob more generous terms in one scenario than the other, just by virtue of the fact that the tax has a different name. Both taxes are worth 20 percent of the value of Alice’s work, measured by the final amount collected from Bob.
Expanding the example further generally results in identical accounting for income tax and excise tax. For example, imagine that Bob is not a final consumer, but a producer who uses Alice’s product as an intermediate good, improves it to double its value, and sells it to Charlie for $2. The taxable amount becomes 20 percent of the total value of Alice and Bob’s combined work, ultimately determined by the amount charged to Charlie.
With a 20 percent income tax, Alice could have $1 in income and $0.20 in taxes. Bob has $2 in revenue with $1 in cost of goods sold times $1 in revenue and $0.20 in tax. Everyone takes home $0.80 after taxes, and the government collects $0.40 in taxes.
Under a 25 percent excise tax, Alice could collect $0.80 and Bob could collect $1.60. The government would collect $0.40 in taxes and Charlie would still pay $2. (Some excise taxes are structured in such a way that Bob would pay the entire tax on behalf of the entire production chain, while others are structured in such a way that Alice and Bob share the responsibility.)
Again, everyone’s after-tax income is the same in both scenarios. Changing the name of the tax does not drastically change the burden between Alice and Charlie.
But the bases of the consumption and income tax do They have some important differences. The first is in the treatment of savings or investment. Individuals and businesses alike have many ways to save or invest, but generally speaking, an income tax falls partly on capital goods like factories or equipment as creation occurs, while a consumption tax only falls on returns on capital goods after they begin. producing final products. This is important to individuals and businesses because of the time value of money.
The second difference is in the treatment of trade. A consumption tax falls on imports but not on exports. An income tax falls on the income of exporters but does nothing on imports, which generate income for people in other countries. While this may seem to have significant implications for trade, in the long run exports allow imports (and vice versa), so the effects cancel out once trade has made a full “round trip”.
Distinctions between the income tax base and the consumption base are absolutely important for economic efficiency, but are limited in scope. distributive implications for how consumers and producers share the burden.
Holes in the Tax Base Matter for Distribution
Broad theoretical statements and stylized examples are one thing. The actual taxes that exist in the world are another. They are much messier and have all kinds of holes. For example, the US income tax excludes workers’ health care benefits entirely, even though an economist would call them income. And excise taxes in the US are often sales taxes, levied on goods but not most services. Value added taxes, used in many other countries, are sometimes broader but have their own exclusions.
Holes in the tax base are important for distribution and are regularly discussed. For example, in 2014, there was substantial debate in Washington, DC, about expanding the sales tax base to include some services, such as gym memberships. The result was strong institutional opposition from gyms and yoga studios. This is, at least, circumstantial evidence that producers believed that an excise tax on their products would hurt their pockets, a belief that expressly contradicts the assumption that consumers are the ones who pay excise taxes.
The distributional consequences are far from the only important property of fiscal policies. But if one is interested in the distributional consequences of consumption or income taxes as they are practiced in real life, the distinction between producer-side and consumer-side incidence is a bit misleading. Instead, the largest distributional consequences are determined by the economic activities that taxes, as implemented in practice, fail to capture.
In this sense, Rep. Carter’s instincts in trying to bring illegal activities into the tax base are good. Unfortunately, the FairTax probably does little to shift more of the tax burden onto people who engage in illegal activities. It’s true that they typically don’t pay income tax, giving them an unfair (and illegal) tax break. But it is unlikely that refer Fair taxes on their sales, which also gives them a useful tax advantage under Rep. Carter’s preferred system; in fact, the very tax break that gyms and yoga studios in Washington, DC, were so desperate to keep.
The fundamental problem in either system is that taxes are remitted when legal purchases of goods or services are made, but they are generally not illegal. The FairTax won’t fix that.