How to axe the IRS: Switch to an elegant and fair value-added tax

Ever notice the filing deadline for the U.S. income tax – April 15 – is about as far away from Election Day as possible? If the annual ordeal punctuated on Oct. 15, the frustration and outrage taxpaying citizens feel would translate into a voter revolt and finally compel politicians to deliver a simpler and fairer system.

The personal and corporate taxes levy terribly high marginal rates, offer a myriad of special-interest credits and deductions, require expensive recordkeeping and impose complex auditing functions at the Internal Revenue Service that have proven susceptible to political abuse. Americans believe it favors the very wealthy and big businesses, who can afford high-dollar lobbyists and big campaign contributions. It does encourage businesses of all sizes to often make decisions based on tax considerations instead of sound economics.

Foreign governments rely more on value-added taxes, which approximate national sales taxes. In compliance with World Trade Organization rules, those are rebated on exports and applied to imports. Income taxes are not, placing U.S. businesses at a cost disadvantage.

The most comprehensive tax reform would be to replace the personal and corporate income taxes with a VAT.

The Treasury annually collects about $2 trillion through personal and corporate taxes. This could be replaced by an 11 percent national sales tax on all private purchases and payments – be they computer equipment, college tuition or lunch at the corner deli. Businesses and institutions would pay the taxes they collect less the taxes they pay on materials and equipment, rent and the like. This subtraction would avoid the double taxation on goods and services purchased and effectively create a VAT. It would end the headaches associated with valuing inventories, calculating depreciation on buildings and machines and much other work that cost billions in accounting and legal fees.

A VAT would favor no activity over another, and mostly end the problem of U.S. firms parking profits abroad to avoid U.S. taxes.

Ways and Means Chairman Kevin Brady proposes to do essentially this for the corporate income tax. His plan would eliminate credits and deductions and lower the maximum corporate rate from 35 percent to 20 percent, which would be refunded on exports and applied to imports. This plan faces a lot of undeserved opposition from retailers who say it would raise prices 20 percent on imported goods and make them less competitive, but that’s nonsense. First, it would be levied on the import value of the goods – that excludes any domestic logistics costs and wholesale and retail markups. Second, as all retailers would be paying the same tax on imports, Wal-Mart and Target would have the same costs as other brick-and-mortar and internet vendors.

Moreover, by removing the disincentive to manufacture in the United States created by foreign reliance on VATs, it would create new competition from new U.S. suppliers of toasters and cell phones–who would now be aided by more automated production process then when their manufacturing was relocated to China.

The Brady Plan still has two flaws. It would continue the myriad of filing headaches and inequities most ordinary Americans endure paying personal income taxes, and many businesses are limited liability corporations and pay through the personal income tax system. They would face even greater disadvantages by paying rates up to 39.6 percent and not enjoying rebates on exports. The logical option is to generalize Brady’s reforms to include the personal income tax as well. Junk it and impose a VAT of 11 percent on all economic activities.

Two problems would remain. A VAT would tax rich and poor consumers at the same rate. The elderly, who more or less live on savings, have already paid income taxes on those savings and would be taxed again. An effective response would be to raise the rate to 14 percent, and award each parent $4,000 for each child under 21 and to seniors 65 and older. Taking things a step further, the Social Security and Medicare taxes could be eliminated by raising the rate to 20 percent.

Temptations would abound to exclude or exempt all kinds of activities, but that would do more to appease big corporate contributors and the wealthy than to serve the public interest. That is the kind of thinking that gave us the current mess – and inequities, slow growth and mindless harassment from the IRS.

Elegant, egalitarian and efficient, a value-added tax without exemptions would permit the economy to grow faster and create more jobs.

Peter Morici is a professor at the University of Maryland’s Robert H. Smith School of Business. He served as chief economist of the U.S. International Trade Commission from 1993-1995. He tweets @pmorici1.

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