Writing in the Wall Street Journal today, John Cochrane has it exactly right: the best strategy for conservative tax reformers to follow at this point is to move the system towards taxing consumption rather than total income (consumption + investment) but not by adding another tax-collection system to what we already have. Remember that the Flat Tax (in its original form), the Fair Tax, and the USA Tax (or inflow-outflow tax) are all consumption taxes. They all recognize that putting one layer of taxation on current consumption but multiple layers of taxation on future consumption — by taxing both investment principal and returns, as well as corporate income before it is distributed — is a huge economic distortion. It discourages capital formation, encourages debt over equity, and inevitably leads to special-interest pleading and accounting gimmicks.
The three tax models use different means to address the problem. The Flat Tax excludes capital gains, dividends, and other investment returns from the tax base. The Fair Tax collects revenue on all goods and services sold at retail, excluding business inputs as well as investment products. The USA Tax essentially makes tax-free IRAs unlimited, so all investment is taxed either at the front end or the back end but not both. While generally targeting the same tax base, these options have pros and cons. The Fair Tax, for example, is more likely to capture revenue from consumption associated with foreign visitors and black-market transactions while the others do a better job of capturing revenue from consumption that occurs online. The Fair Tax offers the prospect of eliminating large swaths of compliance costs, at least off the backs of households. The Flat Tax and USA Tax have the capability of being phased in over time — by reducing rates on particular investment returns or gradually increasing the deduction for deposits into savings accounts, for example. All three have practical and political obstacles, as well. I am skeptical that a national sales tax would ever apply to most professional services, which are represented by powerful lobbies and generally escape taxation at the state and local level. The other two systems would require the elimination of longstanding tax breaks with powerful constituencies of their own. Apply your best public-choice analysis here.
Whatever you think of these options, the very worst idea in my mind would be to layer a national sales tax of any kind on top of the current federal income tax. Want to know why so many European countries have managed to keep their marginal income tax rates lower than ours while still collecting far more revenue to fund far bigger government than we have? Because they levy value-added taxes (VATs), which are national sales taxes that don’t show up on a retail bill but are instead hidden from consumers in intermediate stages. It is probably true that, given a certain level of taxation, it would be better to do it through a combination of a VAT and income tax rather than through a progressive-rate income tax alone. There would be less economic distortion and more economic growth. But the existence of a VAT is very likely to increase that overall level of taxation, particularly over time, just as states with personal income taxes, corporate income taxes, and statewide sales taxes tend to have higher tax burdens than do states possessing just one or two of those options.
Both Ted Cruz and Rand Paul have a VAT-like mechanism as part of their tax-reform plans. Both are misguided, to say the least. Even if they were able to get their plans enacted intact in the short run, in the long run what we’d end up with is a new, costly federal sales tax plus a continuing, problematic income tax. In other words, we’d end up like much of Europe. Both senators have good ideas on many subjects of interest to conservatives, but not in this case.