Understanding Taxes and The Economy
To understand the impact of taxes on the economy you first need to understand how the economy works. The vertical axis represents prices from high to low. The horizontal axis represents quantity or jobs from low to high. The demand curve, depicts the trade-off of goods. High priced goods in a normal economy would have low demand while low-price goods would be in high demand. The supply curve, has just the inverse relationship. Manufacturers would be willing to produce more goods at a higher price and less goods at a lower price. The intersect between demand curve and the supply curve represents the market price. The market price is the optimal price in which a consumer is willing to buy a product and a producer or manufacturer is willing to sell a product. The optimal market price can only be obtained in perfect competition. Because perfect competition doesn’t exist in the real world, consumers inevitably end up paying higher or sometimes lower prices than the optimal market price.
For example, imported goods which are generally taxed domestically via a sales tax or VAT tax are imported into the US market with virtually zero tax burden. This puts domestic manufacturers at a significant disadvantage when the nation funds its spending through an income tax. In the United States the disadvantage caused by a bad tax system, high wages and tough regulations has encouraged companies to manufacture any place but in the United States. To understand the difference between the VAT tax, income tax and the consumption tax, we will walk you through how each tax impacts the domestic marketplace.
Value Added Tax (VAT)
The Value Added Tax or VAT tax is utilized by every developed nation in the world with the exception of the United States. The VAT tax is utilized by South America, Europe and Asia. Yes, China, Mexico, Germany and Japan utilizes a VAT tax in one form or another. The VAT tax is a form of consumption taxation. A VAT tax places the tax burden ultimately on the end consumer but each step in the manufacturing process only pays tax on the value that they created. By charging the tax at every step of production, it eliminates leakage that can occur in a sales tax model. There is no need to know the purpose of the consumer in order to assess the tax since all sales are taxed.
VAT Tax Example
We are going to walk through a simple manufacturing process and explain how the VAT tax would be applied in each phase of production. Assuming manufacturing process begins with a Miner.
- When the miner sells his product he must charge tax to the manufacturer.
- The manufacturer then takes the raw material of the miner and adds value. When the manufacturer goes to sell its product to a distributor, it must charge tax on the total value of the good at that point and completion but may deduct the tax paid to the miner.
- The distributor then markets the product to the end consumer. When the distributor sells the finished product it must charge VAT tax on the entire finished goods but may deduct the tax charged by the manufacturer. This results in the distributor only paying tax on the value he added to the product.
- The end consumer ends up paying the total tax and is able to deduct nothing.
- Imported goods are assessed the same VAT tax as domestically produced goods. In essence, the VAT tax acts like an import tariff.
- If the product is exported, the VAT taxes is never collected. As a result, goods coming from countries that utilize a VAT tax are virtually untaxed and realize a significant advantage over the United States.
A VAT tax, in theory, is applied at each phase of production. To ensure that domestic production is not at a disadvantage, the VAT tax is also applied on imported goods. Finally, when the finished product is exported, any VAT tax is refunded. This deviation from the core taxing philosophy is allowed to protect domestic production and enhance international competition of domestic products.
Because the VAT taxes are so popular across the world, these carve-outs of applying VAT tax on imports, which are effectively an import tariff, and the refunding of VAT tax on exports, which are effectively a subsidy are accepted by the World Trade Organization (WTO).
The United States is the only nation in the developed world that predominantly funds its government through an income tax. Most of the developed world leverages a VAT tax, favoring a consumption-based tax instead of an income tax. Some nations, will use both a VAT tax and an income tax but only the United States relies on an income tax for the majority of its government funding.
If we understand that businesses do not pay taxes, just collects, the income tax has no advantage over any form of consumption taxation. All forms of taxation will increase the cost of goods. Whether the tax is added at the end of the transaction or whether it is embedded into the product cost like in the case of an income tax.
Income Tax Example
There are four inputs into production, capital, labor, land and entrepreneurialism. We tax all the inputs.
- Capital that represents rents, factories and machinery is taxed. Even though a company may seek sales tax exemption, the companies producing capital (rents, factories and machinery) are taxed both through their profits and the labor required to produce the goods. This tax gets embedded in the product cost of any producer.
- Labor is perhaps the most taxed input in our manufacturing process. The employer is taxed. The employee is taxed. They are taxed for the income they produce. They are taxed for the services they will consume such as Social Security and Medicare. All of these costs are paid by the business whether it be through direct taxation or increased wages. These taxes get embedded into the cost of producing goods and services.
- Land that represents raw materials is taxed in a similar way to capital. Even though the direct purchase of the raw material may be exempt from sales tax, the entire process of producing the raw materials and preparing them for manufacturing is taxed and thus gets embedded into higher product costs.
- Entrepreneurism, which is the skill set of applying capital, labor and land into a successful enterprise, is rewarded through profits. We all know that the income tax taxes profits.
The primary objective of the income tax is to fund the government. A secondary goal of the income tax is to redistribute wealth. Unfortunately, because the income tax increases the cost of business and embeds that cost deep into the product cost, it actually steals wealth from the less fortunate. It does this by increasing the cost of doing business domestically, which thus reduces employment opportunities, as well as increasing the overall cost of products that are being consumed, the hidden tax.
Income tax, in addition to failing in its redistributive purpose, is vastly inferior to the VAT tax or any consumption-based tax in positioning an economy to compete on the global stage.
Struggle Between the Income Tax and the World
We can thank the Republican Party for the brilliant concept of the income tax. They first introduced it in 1862 in order to fund the Civil War and then revisited it in 1909. President Taft in an address to the nation proposed a 2% income tax on businesses. The Republican party then drafted the 16th amendment to legalize the taxation of income. However, it was Woodrow Wilson, a Democrat, who was in office when the income tax was ratified in 1913. The income tax rate in 1913 was 7%, by 1917 Woodrow Wilson had increased the tax rate to 67% and the rate continued to climb under Democratic guidance until 1944 where it peaked at 94%. It was also the Democratic Congress that modified the income tax bill to increase the coverage from 7% of the US population paying income tax to 64%. Today, it is estimated that only 54.7% of Americans actually pay income tax, directly. This low participation, of course, throws into question the effectiveness and fairness of the income tax.
In the early adoption of the income tax, international trade was relatively minimal, making the income tax more of a domestic matter than a trade issue. After World War II, the world was in shambles. There was virtually no competition. China was devastated. Europe was in ruins. Japan had been defeated. Only the United States was spared the devastation of war. Because there was no competition, the income tax appeared to offer no real issues when it came to trade.
The latter part of the 20th century and into the 21st century, the United States lost a lot of its advantage as the world recovered. In a world devoid of major conflicts, competition has thrived. Things like containerization have shrunk the ocean, making the cost of labor and government policies more significant than distance to market.
In the United States, the concept of free trade has been championed. However, the world isn’t interested in free trade as much as it’s interested in fair trade. Both the income tax and the VAT tax increases the cost of a product. The difference between the two tax systems is that the income tax becomes embedded in the product cost and upon export remains embedded. Likewise, because tariffs have been villainized, there is no methodology to apply taxes to import goods in an income tax system.
With a VAT tax, on the other hand, when goods are exported all the tax that had been imposed in the production of the item is refunded to the seller. In essence, exports from VAT nations, the rest of the world, are coming to the US shores tax-free. Likewise, when the United States exports its product to a VAT nation, in addition to the embedded tax of the US government the nation will also apply its own VAT tax. This is effectively an import tariff, however, because we call it a VAT tax the WTO permits this treatment.
When it comes to trade, the United States has put itself in a most dubious position. It is no wonder that politicians cry foul when international companies receive rebates for their VAT tax and our imported products are assessed additional VAT tax. With the WTO supporting the VAT tax and demonizing import and export taxes, perhaps the income tax needs repealed and rendered to the annals of history.
A Better Tax
The United States needs to abandon the income tax and adopt some form of a consumption tax. A consumption tax will not only put us on equal footing with the rest of the nations of the world but also could encourage domestic growth and prosperity. Every American needs to realize even though they may not directly be paying income tax, they are paying it through increased product prices. Every time they buy a McDonald’s hamburger or gallon of milk or car they are paying income tax. Perhaps the most villainized component of the income tax is that it gets embedded into the products that we buy. Another side effect of the income tax is that because it increased the cost of doing business it also encourages business to be done elsewhere thus robbing many Americans of gainful employment.
The consumption tax that we will propose will not only eliminate both the corporate and individual income tax but also eliminate the need for Social Security and Medicare taxes. Americans need to come to the understanding that no one else is going to pay our tax but us. Part of the challenge with the income tax is that it gets hidden to most tax payers.
The consumption tax that will be recommended has a lot of components of the Fair Tax with some modifications. Today’s tax system accounts for about 23% of total sale prices on an imputed basis or 30% on traditional US sales tax rate. This of course only applies to domestically produced goods. Imported goods are virtually untaxed both from the originating country and from the United States.
The consumption tax that we recommend is 20%. We believe in a balanced tax system that would include not only a consumption tax but also import tariffs (small) and more use of enterprise entities by the federal government. Whether the taxes are collected in a manner similar to a VAT tax where each phase of production is taxed or we utilize a series of exemptions in a more traditional sales tax model the concept of taxing consumption is the same. The VAT tax offers some elegance in its simplicity as well as eliminates the possibility of leakage in the taxing process. However, leveraging a sales tax application allows the state more precision in its taxing methodology.
Components of a consumption tax would be:
- Tax Rebate: For all Americans, purchases up to the poverty rate would be rebated in a form of a payroll credit. The average American would receive a little more than $2,400 a year or $4,800 per family to offset taxes on necessities. The tax credit which would show up on each payroll check allows the consumption tax to be progressive in nature. In addition to not seeing an income tax being deducted from the payroll check, the average American would also see no Social Security tax and no Medicare tax. The elimination of the Social Security and Medicare tax for the average American worker would be an additional $3800 cash in the bank plus whatever the income tax withholding would have been. When compared to the traditional income tax, where impoverished Americans pay no tax however everything that they purchase has tax embedded in it therefore making the income tax inferior to a consumption tax particularly when considering the tax burden on lower income Americans.
- Tax-free Education: Human capital is the biggest asset of any nation. Therefore, all forms of education would be exempt from the consumption tax. However, in order to achieve the exemption qualifying organizations would need to achieve a 20% reduction in the rates being charged. Also, increases in tuition would be limited to the rate of inflation. Finally, to receive the exemption the applicant must be a US citizen. All other applicants would be subject to the standard consumption tax. By making education more affordable, ideally the need to incur student debt should decrease significantly.
- Tax-Free Sale of Existing Homes: A consumption tax is intended to target new items, therefore, the sale of an existing home would be exempt from the consumption tax. A reasonable exemption level would need to be set. Tax-free on a modest home is reasonable, tax-free on a mansion is not. We would recommend the exemption being about $1 million. However, representatives on the coast may suggest the limit being slightly higher. Also, new homes would be subject to the consumption tax. However, the construction industry today is taxed on everything they purchase and the income they make. The net impact should be virtually zero.
- Tax-Free Transfer of Used Personal Items: Again, a consumption tax is intended to target new items, therefore, selling a used car, used clothing, or used furniture would be exempt from the consumption tax. The flea markets of America need not to worry, there will be no taxes on their sales. Like an existing home sales there would need to be a reasonable limit set. Selling a used Ferrari still results in a tax transaction. Hundred thousand dollars would be a reasonable starting limit; however, your representatives may have a different level in mind.
- 401(K) Accounts and New Stock Issuance Would Be Tax-Free: Encouraging retirement savings and providing capital for business expansion are critical to a nation. The consumption tax and not tax either one of these activities. The transfer of wealth whether it be in stock or other forms would be subject to the consumption tax. To lessen the burden, the seller would be given the option to pay the consumption tax on only the increased value of the stock or business. There would be no credit for losses. Transferring financial assets, like stock outside the United States to be treated as a sale. However, transferring cash would be tax-free.
Tax Wealth, Not Productivity (Income): the consumption tax targets wealth not income. Therefore, there would be:
- No corporate income tax
- No Social Security tax
- No Medicare tax
- No personal income tax
- No tax on jobs
- No tax on exports
- No tax and saving
- No tax on investing
- No corporate income tax
- Domestic Products and Imported Products Would Be Taxed the Same: United States needs to stop shooting itself in the foot. We need to stop being our own worst enemy. The world has evolved from the days of import duties and have transformed into VAT tax. While economists may argue for free trade the world has opted for fair trade. Each nation except for the United States has chosen to impose the same tax on imported goods as it imposes on its own domestic companies. They have also decided not to tax its own exports but that the job was more important than the tax. A tax system that would equalize the tax and domestic goods with that of imports is long past due. The consumption tax achieves that goal.
Prospects of Meaningful Tax Reform
What are the prospects of the United States actually implementing meaningful tax reform? Unfortunately, I fear that chances for meaningful tax reform are pretty slim. Things will need to get worse before rational thoughts are possible.
If you look at the Democratic Party, they’re convinced that everything is going just dandy. After all, 45.3% of all Americans pay no income, large percentage of their constituency. To hear the Democrats at their convention the main problem is there is not enough free stuff and somebody else is not paying their fair share. This rhetoric has little hope of putting America in a true competitive position.
To be balanced, if we look at the Republican party, creators of the income tax, they appear to be equally enamored with their creation. Of course, negotiating better trade deals is hard to argue against. However, understanding the taxing systems and the inherent disadvantage America is placed in, goes way beyond good negotiating. The current Republican platform argues that if we just tweaked the income tax a little differently all the woes would be solved.
With the current position of both parties, it is unlikely that any meaningful tax reform particularly one that will benefit the United States both domestically and in international trade is anywhere on the horizon. Instead, it looks like the income tax will remain the tax of preference tweaked to enhance one party or the other’s social engineering. This, of course will fail. Hopefully, someone will have the foresight to put America first before we go bankrupt.