Question

Analyzing the Concepts:

Flat tax, national sales tax, and value added tax (VAT)

Two controversial fundamental tax reform ideas are often hot news topics. One proposal is the flat tax discussed in this course, andthe other is a national sales tax. The flat tax is favored by former presidential candidate and publisher Steve Forbes. It would granta personal exemption of about $36,000 for a typical family and then tax income above this amount at 17 percent with nodeductions. As stated by recent presidential candidate John McCain, the argument for a flat tax is that it would allow people to filetheir tax returns on a postcard and reduce the number of tax cheats. McCain proposed that the flat tax would be optional to thecurrent tax system.

The flat-tax plan described above creates serious political problems by eliminating taxes on income from dividends, interest, capital gains, and inheritances.

Also, eliminating deductions and credits would face strong opposition from the public. For example, eliminating the mortgage interest deduction and exemptions for health care and charity would be a difficult political battle. And there is the fairnessquestion. People at the lower end of the current system of six progressive rates could face a tax increase while upper-income people would get the biggest tax break. The counterargument is that under the current tax system many millionaires pay nothingbecause they shelter their income. Under a flat-tax scheme, they would lose deductions and credits.

A national retail sales tax is another tax reform proposal. In 2008, Mike Huckabee, Republican candidate for president, made this idea central to his campaign. A consumption tax could eliminate all federal income taxes entirely (personal, corporate, and Social Security) and tax only consumer purchases at a given percentage, say, 30 percent. Like the flat tax, loopholes would be eliminated, and tax collection would become so simple that the federal government could save billions of dollars by cutting or eliminating the IRS. Taxpayers would save because they no longer need to hire accountants and lawyers to prepare their complicated 1040 tax returns. Also, the tax base would broaden because, while not everyone earns income, almost everyone makes purchases.

Critics of a national sales tax argue that retail businesses would have the added burden of being tax collectors for the federal government, and the IRS would still be required to ensure that taxes are collected on billions of sales transactions. Moreover, huge price increases from the national sales tax would lead to "black market" transactions. The counterargument is that this problem would be no worse than current income tax evasion, and a sales tax indirectly taxes participants in illegal markets when they spend their income in legal markets. Also, asales tax is regressive because the poor spend a greater share of their income on food, housing, and other necessities. To offset thisproblem, sales tax advocates propose subsidy checks paid up to some level of income. Critics also point out that retired people who pay little or no federal income tax will not welcome paying a national sales tax.

There are also debates on using a Value-Added Tax (VAT) that is in use in Europe and many other countries. VAT is a consumption tax levied at each stage of production. Suppose a vendor buys apples from a farmer to sell at a market. The vendor’s VAT is based on a percentage of the difference (value added) between the cost paid by the vendor and the sales price customers pay to purchase apples from the vendor. Customers who buy the apples bear the VAT cost built into the price of the apples they purchase.

ANALYZE THE ISSUE

Note that this assignment is worth more points than the other assignments, so it is very important that you complete it.

For this assignment, you are required to write a short essay (1 – 3 pages). It is strongly recommended that you go beyond the textbook and consider some of the elements that we discussed in class. For example, what evidence can you point to with respect to the experiences of countries beyond the USA? Properly cite any outside sources that you use (APA style). It is expected that you will write at a level appropriate for undergraduate students of economics. “Bullet point answers” will not be considered sufficient. Refer to the “Critical Thinking” grading rubric posted to the Blackboard site, to understand how points will be awarded.

The organization of your essay is up to you but at minimum, you must address the points below:

Assume that the federal government replaces the federal income tax with a national sales tax on all consumption expenditures. Analyze the impact of this tax change on taxation efficiency and equity. Note that the federal government already collects a nationwide consumption tax through excise taxes ongasoline, liquor and tobacco.

Answer 1

Flat Tax

A flat tax system applies the same tax rate to every taxpayer regardless of income bracket. Generally, a flat tax applies the same tax rate to all taxpayers, with no deductions or exemptions allowed.As most flat tax systems or proposals do not tax income from dividends, distributions, capital gains, and other investments it may create issues for the political mandate.As per the issue mentioned flat tax of 17% would be applicable on ordinary income after a flat deduction of $36000 is made.This implies whether an income is earned from salary or wages or dividends or inheritances after a flat deduction, same tax is applicable on net income of individuals irrespective of tax bracket they are falling in.As most people with high income save most of the money with little consumption, such tax is regarded as skewed or biased towards those whose consumption is high.So it actually taxes consumption.

As a flat tax imposes the same tax percentage on all individuals regardless of income, many see it as a regressive tax. A regressive tax is on which taxes high-income earners at a lower percentage of their income and low-wage earners at a higher rate of their income. The tax is seen as regressive due to a more significant portion of the total funds available to the low-income earner going to the tax expenditure. While the upper-income payer still pays the same percentage, they have enough income to offset this tax load.

The other argument here could be that earlier taxes were anti-rich or by taxing individuals with higher income meant that putting higher effort or trading off more work with less leisure was deterred by taking them at higher rates.If wealthy are taxed at less, more and more people would be induced to work more ,put higher effort to earn more.This would bring efficiency and raise economic growth as well as tax revenue for the FED,. Supporters of a flat tax system propose that it gives taxpayers incentive to earn more because they are not penalized with a higher tax bracket.Also, flat tax systems make filing easier and individual would be able to file tax returns on postcard.Furthermore as the State has to incur administrative costs to uncover tax avoidance or tax evasion methods (often employed by high income earners) such a system would reduce tax cheats.If billionaires and millionaires who shelter their income are given deductions or credit then they would be motivated to pay taxes.In many countries in Europe as well as Russia this flat tax system has worked well in the favor of the country.

However it is noted by economists who favor tax equity over tax efficiency that it may be possible that a low wage earner incurs medical costs or a student incurs cost of loan paid for obtaining higher education which is greater than the deductions allowed.Therefore for such people even essential expenditure would be taxed.Such may not go down well with the public and may create animosity towards the FED for favoring rich.In other words, it may have serious equity related issues.If individuals have to pay taxes on obtaining better healthcare or education then it would deter them to consume these and eventually economic development would be affected.

National Retail Tax

In order to properly analyze such a large change to the tax system, these areas are analysed -

1. Impact on consumer spending and the economy
2. Advantaged and disadvantaged groups under a national sales tax
3. Feasibility of this reform

One of the largest effects to move to a national sales tax system would have is to change people's working and consumption behavior. People respond to incentives, and tax policies change the incentives people have to work and to consume.Many economists argue that when workers earn more, they'll also spend more. So a change to a national sales tax plan reduces the disincentives to work, and workers as a whole would likely end up working and earning more. Generally people do not like paying taxes if they don't have to. If there is a large sales tax such as 30% in this case on purchasing goods, people would spend less money on those goods.Furthermore, in order to lessen their tax burden they may resort to different methods,such as spending less and saving more, spending money outside of the United States, spending in a manner that evades taxes

From analysis point of view a change to a national sales tax is likely to influence the macroeconomic variables such as Production would likely rise as marginal income tax rates fall to zero, which induces people to work extra hours, Personal Disposable income would rise as people are not taxed on income and presumably may work extra hours.Consumer spending within the country may or may not rise, Saving and spending abroad would likely increase, which would cause a weakening of the home currency with respect to foreign currencies.The price of investment goods such as bonds may rise as people wish to save more, so interest rates would fall.The after-tax price of consumer goods would go up due to the new sales tax.

It is important to note, however, that not all consumers would be affected equally by these changes as changes in government policy never affects everybody equally and not all consumers would be affected equally by these changes. Next we explain in turn how this reform affects various groups -

1. Seniors lose as they do not not earn income at a steady rate during their lifetime.A switch to a national sales tax would, in effect, result in taxing much of that money twice. These individuals would have already paid a lifetime of income taxes and would now be living off of a mix of previously taxed and tax-deferred savings. Under a new national sales tax system, the previously taxed savings would essentially be subject to tax again when used for purchases. Unless special consideration is given to the current generation of seniors, they would end up paying a disproportionate share of taxes.
2. Generally under the current system, the working poor pay very little (if any) income tax. But everyone needs to consume to survive. The poor would get hit twice under such a scheme. While currently the poor pay very little tax, under the new system they would have to pay taxes on their consumption, so their total tax bill would rise dramatically. The poor also spend a larger proportion of their total income on consumption goods to survive, so they would ultimately pay a larger percentage of their income in taxes than wealthier individuals.
3. Under a national sales tax system, essential deductions would disappear with the elimination of the income tax. A sales tax, other than for purposes of the rebate, would not distinguish between families and individuals. T
4. The proposal is that it will make the IRS irrelevant, which would eliminate the need for jobs in these industries,
5. A consumption tax can be avoided by not consuming. So it makes sense that people who do not consume a lot will benefit from the plan.
6. People who can shop in other countries would gain as it may be possible that in other countries consumption is taxed at lesser rates.
7. National sales tax will only be charged on goods bought by individuals, not by firms. Owning a business would give an individual an advantage as goods could be purchased free of sales tax if they are claimed as business expenses.
8. As FED charges taxes on gasoline, tobacco and liqor which are demerit goods i.e. have negative externality on environment and health,so uniform national sales tax on such goods would actually raise their consumption.

Like the flat tax proposal before national sales tax system may address the issues of an overly complex system even though the implementation of this system would have several positive and  negative consequences for the economy.

VAT ( Value Added Tax)

VAT is a tax levied on most goods, products and services available for purchase. Everything individuals buy, as well as what companies selling domestically purchase, includes VAT in the price.VAT is actually tax rates charged on each production activity in a business.So If suppose in a manufacture of bread, there are number of activities from selling raw material to converting it to dough and baking and finally packaging and distributing.So a value is added at each stage of production activity and VAT is charged on each of this activity at varying rates.This allows for reducing cascading affect of taxes.

As per EU VAT system, cross-border trade between businesses in different Member States are currently exempt from VAT. This provides an easy loophole for unscrupulous companies to collect VAT and then vanish without remitting the money to the government.

As for the main objective of the new reform, it aims to charge VAT on sales made across borders, according to which the rate applicable in the country of destination will be charged. Hence VAT system is expected to ensure a robust, simpler and fraud resilient system, which will certainly increase trust and cooperation between tax administrations.Also, the new reform is expected to bring greater consistency in VAT rules. Traders selling cross-border will be able to make declarations and payments using a single online portal in their own language, with the same rules applied in their home country. Moreover, the new reform concerns simplification of invoicing rules for sellers trading across borders, which is likely to result in a reduction of costs for companies.

Though the purpose behind the reform is positive, there will be a major increase in the administrative work for companies, requiring major adaptations in business systems.Furthermore, although the new reform may seem progressive, the VAT fraud issue still presents another prominent problem its proceedings could be used for more sinister purposes.