Politics & Policy

Clearing the Confusion in Tax-Reform Discussion

Rubio campains in Easley, S.C., Feburary 14, 2016. (Alex Wong/getty)
The Rubio plan is structured to avoid double taxation of wages.

In the current presidential campaign, Republican candidates have proposed some important new tax-reform ideas. However, rather than providing clarity, recent discussions of tax policy have become muddled in confusion. This is especially true in the discussion of the value-added tax (VAT) that has been proposed by Senator Ted Cruz. (Senator Rand Paul proposed a similar measure.) Representatives of the Cruz campaign and the senator’s defenders have denied that their “business flat tax” is in fact a VAT, contrary to the analysis of all market-oriented think tanks and news organizations like the Wall Street Journal.

Now the left-leaning Tax Policy Center (TPC) has released its analysis of Senator Marco Rubio’s tax plan, and in press reports TPC director Len Burman has characterized the Rubio plan as “effectively a value-added tax.” This mischaracterization injects the supposedly “nonpartisan” TPC in the middle of an intra-party debate. And it’s wrong. Simply put: The Rubio plan does not include a VAT. The Rubio plan reforms the individual and corporate income-tax system to reduce taxes on work, savings, and investment, eliminate most deductions, and provide tax relief for families.

To sort this out, it’s helpful to recall what a VAT is. As the U.S. Chamber of Commerce notes:

A VAT is a tax imposed and collected on the value added at each stage in the production and distribution of a good or service. It is, in effect, levied on the difference between the sales and production inputs of a business.

In particular, this means that, unlike the corporate income tax, under a VAT, businesses are taxed on their wage bill. This is not a minor distinction, as it means that wages are taxed twice: at the business level by the VAT and then again at the individual level by the individual income tax. The Cruz business flat tax does not allow businesses to deduct wages, so it is a VAT. The Rubio corporate income tax allows wage deductions, so it is not a VAT.

RELATED: Smart Tax Reform Would Ignite Economic Growth

While the deductibility of wages may seem like a narrow accounting issue, it has a huge impact. The hidden double tax on wages vastly expands the tax base and raises effective marginal income-tax rates. For example, in touting his plan, Senator Cruz mentions only the 10 percent flat tax, never noting that when coupled with 16 percent VAT, this implies a marginal tax rate of over 24 percent. By contrast, marginal income-tax rates for middle-class families are a transparent 15 percent under the Rubio plan.

#share#In popular discussions, VATs like those in Europe are often referred to as sales taxes, because they are charged on each transaction. The Cruz VAT is administered differently, charging businesses periodically rather than on each transaction. This minor administrative distinction has led the Cruz campaign to claim, contrary to all other analyses, that their plan is not a VAT. However, Japan uses this method to collect its VAT, and the collection method has made no difference in impact. As in Europe, businesses in Japan have passed on the VAT to consumers through higher prices and to workers through lower wages. Also like Europe, Japan has raised its VAT over time, with another hike scheduled for next year, meaning that it will have doubled since 2013.

Every country that has instituted a VAT has increased it over time to fund a growing government.

More important than the terminology is the impact. Value-added taxes are hidden, indirect taxes that are collected by businesses but actually raised on consumption expenditures. VATs vastly expand the tax base, covering many activities, such as home sales, purchases by charities and non-profits, and employer-provided health care, that are not currently taxed. VATs hit seniors especially hard, as they effectively tax accumulated savings when it is spent. (Proponents of VATs often tout them as a way to raise revenue on an aging population.) Moreover, since lower-income households consume a larger share of their incomes, they bear a proportionately larger share of the VAT burden than richer households. Finally, because VATs are hidden and cover such a large tax base, they have provided an easy source of government revenue. Every country that has instituted a VAT has increased it over time to fund a growing government.

#related#Senator Rubio’s tax plan does not include a VAT, so it shares none of these drawbacks. To be sure, the Rubio plan reduces taxes on saving and investment, and so shifts the burden of taxation onto consumption. But while all VATs are consumption taxes, not all consumption taxes are VATs. Under the Rubio plan, wages are taxed only once, and in a completely transparent way, so workers will see the impact of the tax cut on their paycheck. Unlike a VAT, the Rubio plan does not create any new taxes, but instead simplifies the tax code. So, unlike a VAT, the Rubio plan would not require more IRS agents to administer and would not provide a ready source of revenue for future politicians to exploit. Further, under the Rubio plan, families with higher incomes face higher tax rates — 15 percent for low- and middle-income families, rising to 25 and 35 percent for higher incomes. This progressivity, coupled with the enhanced child credits, makes the Rubio plan better for low- and middle-income families than a VAT.

Thus it is clear that the TPC is mistaken to characterize the Rubio plan as a VAT. This is far from the first time that this allegedly “nonpartisan” institution has misrepresented a Republican tax proposal.

— Noah Williams is a professor of economics at the University of Wisconsin–Madison. He is an informal adviser to the Marco Rubio campaign.

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