Fair Tax, Flat Tax, or Value Added Tax?

Greg Mankiw provides here a nice summary for comparing the Fair Tax, a particular flat tax (Hall-Rabushka), and a value added tax (VAT).

Like professor Mankiw, if I were a benevolent dictator, I would replace the U.S. personal income tax, corporate income tax, payroll tax, and estate tax with a consumption tax --- a simple national retail sales tax (NRST). Mankiw prefers a VAT because he thinks a VAT reduces compliance problems compared to the Fair Tax.

I personally favor the Fair Tax because of its visibility, transparency, and efficiency. A VAT is out of sight, and therefore, out of mind --- pretty much like an income tax that's deducted by your employer before you ever get your paycheck.

Do you know how much federal income tax you paid last year? Most people have no idea. With the Fair Tax, you would see how much you pay in federal tax every time you made a purchase of a final good or service. You would also get your paycheck without a huge deduction for personal income tax and payroll taxes.

I think it's important that people understand how much federal taxes they are paying. The Fair Tax would accomplish that goal and would rid us of the ridiculous, unfair, despicable, abhorrent embarrassment called the United States Tax Code.

A good friend asked me to post in this blog a little bit of analysis about the NRST tax rate that would be necessary with and without the federal government being required to pay the NRST on its own purchases. The Fair Tax calls for the federal government to pay the NRST on its purchases. Some folks think that would be a problem. The analysis below shows it is not.

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Comparing the Required National Retail Sales Tax (NRST) Tax Rate for Budget Neutrality with and without Taxing Federal Government Spending.

Define the following economic variables:

C = Annual dollar value of households’ spending on final goods and services

T = Annual tax collections by the federal government

G = Annual dollar value of federal government spending on final goods and services

a = Percentage of annual household spending on goods and services subject to a national retail sales tax

b = Percentage of federal government spending on goods and services subject to a national retail sales tax (if federal government spending on final goods and services is subject to the NRST at all)

t = National retail sales tax rate

For simplicity, assume there is no federal budget deficit; then G=T, which says total federal government spending is equal to total federal government tax collections. This assumption has no effect on the analysis; it just makes the calculations less cluttered and easier to follow.

Assume also that all federal taxes are collected domestically, so we can ignore duties on imported goods and services. This assumption also has no effect on the analysis.

If federal government purchases are not subject to the NRST, then

T = (t)(a)(C), which implies that

t = T/(a)(C)

For example, using approximate numbers (dollars in trillions) taken from the 2003 National Income and Product Accounts for the United States, and from U.S. Department of Treasury reports, if federal government purchases are NOT subject to the NRST, then

t = T/(a)(C), where C=$9.267, a=90%, and T=G=$1.668 ,

t = 20.2 % tax exclusive =$1.668/(0.90)$9.267 =, which is a 16.67 % tax inclusive rate

Now, if a portion of federal government purchases of final goods and services are subject to the NRST, then tax collections will be

T = (t)(a)(C) + (t)(b)(G),

which says that tax collections come from households and from the federal government itself. But total tax collections can also be written

T = G + (t)(b)(G),

which shows that total tax collections must sum to the part that the federal government will spend on final goods and services (G) plus the part that the federal government will pay itself in taxes (t)(b)(G). Using algebra and the equations above we get

G + (t)(b)(G) = (t)(a)(C) + (t)(b)(G), which simplifies to

G = (t)(a)(C), or rearranging,

t = G/(a)(C).

For our example using 2003 data we get

t = $1.688/(.9)($9.267), or

t = 20.2 % tax exclusive =$1.668/(.9)$9.267 =, which is a 16.67 % tax inclusive rate

Conclusion: If the federal government also pays the NRST on a share of its purchases of final goods and services, the tax rate consumers pay for revenue neutrality stays the same. It does not rise or fall, regardless of whether the federal government pays or does not pay the NRST on its own purchases of final goods and services.

If the government pays itself taxes, this is really just moving dollars from one pocket to another pocket (i.e., robbing Peter to pay Peter) The NRST tax rate that consumers face must stay the same, since government cannot pay itself taxes without first collecting those taxes from households. That really shouldn’t surprise anyone, since households are the ONLY source of tax dollars available, provided we are not collecting taxes from the rest of the world

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Second Conclusion: Focusing attention on what NRST rate will be required for budget neutrality is something of a red herring. The household sector pays all the taxes that ever get paid---period, end of sentence, end of story. This is true whether the tax base is a portion of aggregate consumption or a portion of aggregate income, since households ultimately own all the real assets of businesses, and therefore own all the income generated by those real assets. Moreover, comparing the marginal tax rate paid currently on income to the marginal tax rate that would be paid on consumption under a NRST is also something of a red herring. Since the rates are applied to different tax bases, the rates are not directly comparable in any meaningful way. What does it matter if one or the other rate is higher or lower? What matters is how many dollars flow into the federal coffers.

Third Conclusion: Lower marginal tax rates are always more productive, regardless of whether the tax base is consumption or income. That’s because most dollars of federal taxes that are siphoned away from households in no way increase the nation’s stock of capital (real assets like technology, plant, equipment, and tools), which is the well-spring of growth in real gross domestic product. Growth in the nation’s stock of capital is in turn the well-spring of growth in the productivity of labor. Finally, growth in labor productivity is the source of growth in real wages of labor.

Fourth Conclusion: If we really want the fastest growth possible in real gross domestic product and labor productivity, we must reduce the share of gross domestic product spent annually by the federal government. But that’s another story.