Retirement and Social Security Reform
Tax Reform Doesn't Have To Be Radical To
Investor's Business Daily
February 15, 2005
By Ernest S. Christian
President Bush's effort to fix the tax code
would be much easier if all aspiring tax reformers would drop
the academic argot about "consumption taxes" and
other cant that serves only to confuse and mislead.
Everyone should also get over the false idea that "fundamental"
tax reform must consist of either a national retail sales
tax or a flat tax that allows no deductions for home mortgage
interest, charitable giving or anything else. They should
also get over the corollary notion that measures the quality
of tax reform by the amount of trauma caused. The truth is
Take, for example, the president's goal of simplifying the
tax code. Without doubt, repealing the mortgage interest and
charitable deductions would cause much traumatic disruption.
But the simplification value of doing so would be essentially
nil. These traditional deductions are not complicated. In
addition, President Bush has pledged to preserve them.
Now, consider the goal of boosting economic growth by removing
double taxes on saving, investment and export trade. This
could be accomplished - as some suggest - by replacing the
entire federal income tax with a 35% national retail sales
tax - but why go to such an extreme?
Double taxation of investment can be eliminated much more
simply and directly under the current code - in the case of
business investment, by replacing depreciation with first-year
expensing and, in the case of personal saving, by using the
Roth IRA technique to exempt the yield on all aftertax savings.
There are several ways of eliminating the double taxation
of export income under either the current corporate income
tax or something quite similar. And just last year, in Resolution
705, the House of Representatives voted 423-1 in support of
Using a vocabulary borrowed from academic economists, tax
reformers have created the widespread impression that fixing
the tax code is a radical experiment that starts by replacing
the "income tax" with something called a "consumption
Defining The Term
Before jumping to conclusions, however, it helps to understand
the lingo. And guess what! In the academic argot adopted by
tax reformers, the "consumption tax" appellation
means good things.
For one thing, it means a tax that allows businesses to expense
the cost of capital equipment. It also means a tax that defers
tax on the amount of income that a person puts away in savings
or a tax that does not defer tax but, instead, exempts the
yield (e.g., interest) on previously taxed savings.
By this surprise definition, the Roth IRA is a "consumption
tax" to the extent that it exempts from further taxation
the yield on a limited amount of previously taxed income contributed
to the retirement account. And if tax reform were to exclude
from further taxation the yield on all previously taxed savings
(not just previously taxed retirement savings), then, poof,
the existing federal "income tax" would all of a
sudden become a "consumption tax."
"OK," most Americans would say, "I'm against
double-taxing saved income the same way I'm against double-taxing
consumed income. But why didn't you say what you meant to
start with? When you said 'consumption tax,' I thought you
were talking about some kind of retail sales tax."
Confusion - in this case, deliberate - has also obscured the
true nature of the much talked about "value-added tax."
In reality, a tax on value added is a fairly ordinary business
tax similar to our current corporate income tax combined with
a payroll tax imposed at the same rate.
In popular mythology, however, everyone thinks that a VAT
is automatically included in the price of consumer products
- despite demand elasticities and other factors that greatly
limit the ability of a business to stick customers with its
own tax costs.
The myth about the VAT always being passed on in the price
of products was created in the 1960s. The French had replaced
their old business gross receipts taxes with a new tax based
on a quantity (similar to net income) that was called "value
In an effort to gain a trade advantage, the French wanted
to subsidize exports by rebating the tax to each business
in proportion to its exports, but the tax treaty (now WTO)
prohibited rebates except in the case of a tax on the exported
product itself (the classic example being a tax on an exported
barrel of whiskey).
To get around this treaty prohibition, the French asked the
U.S. trade negotiators to join them in pretending that a tax
based on value added, unlike a tax based on net income, always
becomes part of the price of products and, therefore, that
a proportionate part of a business's value added tax payments
can be rebated to it when it makes an export sale.
To help the struggling French economy of the 1960s, and with
the hope of gaining other concessions they wanted (but didn't
get), U.S. negotiators agreed to the fiction.
The "VAT," as it came to be called, quickly spread
around the world. So did the myth which, by now, has been
repeated so often that most people actually believe it.
Even though they know better, many scholars have perpetuated
the myth in order to preserve the special status of exports
under the VAT. Other academics have added to the confusion
by referring to the VAT as a "consumption tax,"
not because they think it is a tax on consumers but, instead,
because it allows businesses to expense capital equipment.
Even some members of the U.S. Congress have joined the conspiracy
about the VAT, in the hope that the U.S. will sooner or later
convert the existing U.S. corporate tax on net income into
a tax on business value added, and thereby gain the ability
to exclude U.S. exports from tax in the same way that our
trade negotiators allowed other countries to do nearly 40
The current corporate income tax is already quite similar
to a business valueadded tax. The VAT allows a deduction for
first-year expensing of business capital equipment and, if
tax reform succeeds, so will the corporate income tax.
The two forms of tax are also the same in not allowing a deduction
for dividends paid to shareholders. They do, however, differ
in the treatment of interest. The corporate income tax allows
a deduction for interest paid, but the VAT does not: Both
interest and dividends are nondeductible. (Nondeductible dividend
and interest payments are, however, supposed be excluded from
the income of shareholders and creditors as illustrated in
a 1992 Treasury study.)
A U.S. business VAT would probably have a rate of only 8%
to 10% compared to the current corporate income tax rate of
35%. On the other hand, unlike the current corporate income
tax, a VAT-like corporate tax would allow no deduction for
wages paid to employees and, absent some adjustment, would
make labor more expensive for companies to hire. The most
obvious way to compensate companies for not being able to
deduct wages is to allow them a tax credit for the current
7.65% employerpaid OASDHI payroll tax on wages.
The federal income tax may or may not be replaced by a "consumption
tax" and the base of the corporate tax may or may not
be changed to "value added." But before any decisions
are made, it is important fully to understand the choices
in plain English.
Christian is a former Treasury tax official who is now
Director of the Center For Strategic Tax Reform in Washington,