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Grand Unified Theory of Indirect Taxes

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Published : April 18th, 2021
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I’ve said in the past that “tax technology” is actually quite new. Most of the familiar taxes that we have today — the retail sales tax, the VAT, the payroll tax — were actually invented in the 20th century. They did not exist before. Mostly, they work very well. Unfortunately, we are stuck with an old and inherently problematic tax, the Income Tax, which was (arguably) necessary at the time because governments needed to raise a lot of money for wartime, but they didn’t have today’s modern taxes (retail sales, VAT, payroll) to do so. They had only excise taxes on individual items like alcohol, salt and tobacco, and tariffs, commonly also on individual items.

June 16, 2020: The Evolution of Tax Technology

An “indirect” tax is a tax that is paid by a business, instead of an individual. These include sales taxes, or payroll taxes. A payroll tax looks a lot like an income tax, but the payroll tax does not require an individual to reveal any personal information. Also, payroll taxes, although there is a “worker” component, are typically paid by corporations. It is basically a sales tax on employment labor. Corporations also typically withhold taxes, so that an individual taxpayer does not have to make a payment directly to a government. Instead, they get a refund. However, the individual taxpayer is still directly liable, and must reveal personal information.

The Retail Sales Tax was the first of the new 20th century indirect tax innovations. In the United States, it became common in the 1920s. For many centuries, going at least as far back as the Muslim Caliphates of the 8th or 9th centuries, governments have experimented with sales taxes. However, this was typically conceived as a tax on all transactions. In the process of going to market, a product, or the raw materials from which the product was made, would be taxed many times. You would pay tax on the leather to make shoes, and then the shoes would be taxed when sold to the shoe store, and then the shoes would be taxed again when sold to the retail customer. Also, asset sales, like the sale of stocks, bonds or land, would be taxed. It was very easy for a tax like this to create big problems, even at a seemingly low rate.

The insight of the Retail Sales Tax was to tax a retail product only once, in the “final sale” to the consumer. All the steps of production in between were untaxed. Also, asset sales were excluded.

The Payroll Tax was first imposed, in the United States, in the 1930s, but it is similar to taxes in Britain in the 19th century. It is basically a sales tax on employment labor. There is only one rate. It is a very simple tax, and in 85 years, it has not been complexified in any meaningful way. There are no deductions and exemptions. There are no tax brackets — it applies to the first dollar earned. In other words, it is extremely Broad. Today, it has an upper limit on income to which it applies, but theoretically, that could be eliminated. It is important to see that the payroll tax differs from an income tax because we are not offsetting different forms of income, or in any way making rules based on an individuals’ situation. For example, in a regular income tax, you might have employment income, but then a loss on the sale of an asset, and also, exemptions and exclusions of various sorts. None of this exists for the payroll tax, except perhaps as one of many adjustments to an income tax. The payroll tax involves no paperwork of any kind for the employee. Today, the payroll tax generates about half of Federal tax revenue, and more at the State level, so it is very effective at raising revenue.

It has been found that retail sales taxes can become problematic at rates above 10%. Around that level, smuggling or other forms of tax evasion become tempting.

The desire to create a less-evadable form of Retail Sales Tax, and also to eliminate the need to distinguish between “retail” and “wholesale” transactions, and perhaps also to broaden the tax base to include services, gave rise to the Value Added Tax. Usually, people assume that a VAT is just a variant on the Retail Sales Tax, but it has significance that goes beyond this.

First, we have to figure out what Value Added means.

A company sells something and gets $100 of gross revenue. This $100 of revenue can be divided into three categories: 1) Expenses — all the money that is paid to various suppliers to the corporation, including both regular expenses and capital expenditures; 2) All employee labor costs, including all perks and benefits such as healthcare or pensions; 3) Corporate profit.

We can see that all of the $100 goes into one of these three categories. There is nothing left.

“Value Added” consists of categories 2+3. It is the value of the output of the corporation (the revenue), minus the value of the inputs to the corporation (Category 1, the expenditures). This is the amount of Value that was “Added” through the application of Capital (Category 3) and Labor (Category 2).

Let’s take WalMart for example. There is $100 of sales. $75 of this consists of the wholesale costs paid for the goods of the store. $10 consists of the cost of the various expenses of the company, such as property, utilities, legal, gross capex, advertising and so forth. $10 consists of the total employee costs. $5 is profit. The Value Added is $15, the employee costs and the corporate profit. The Value Added Tax is some percentage of this Value Added. So, at a 10% VAT rate, Walmart would pay $15*10%=$1.50 in taxes.

We can see that $85 is being paid to Walmart’s various suppliers and other expenses. These companies too have to pay a 10% on their Value Added, and their suppliers pay another 10% on their Value Added, and we can see that the total amount paid should eventually be about 10% of the final retail sales, here $100. But, since each company pays only a portion of this ($1.50 out of $100 in WalMart’s case, or only 1.5% of sales), the taxes that each company faces is relatively small, and not worth evading. (I am using “subtractive” taxes instead of “additive” here.)

We can also see that this is an indirect tax. No employee has to file a tax return. The corporations have to calculate Value Added, and are liable for its payment, but this is very easy. There is no complexification of the tax code, as we see for the Corporate Income Tax. The actual calculation of Value Added, in a real-life situation, is as easy as it is presented here.

There are some interesting points regarding the VAT:

There is no calculation of “income” including computation of depreciation. Capital expenditure is taken as a cash item, deducting from Value Added. This might seem as if capex in excess of depreciation (or sustaining capex) is not taxed, but actually it is taxed as part of the revenue of the vendors of capital goods. You could have capex in the form of employee expenses, such as R&D. A company is spending more on its employees than it is getting in revenue. This is not taxed, because, for now, no Value is Added. They are throwing Value down a hole in hopes of creating future value. When this future value appears, and the software product or pharmaceutical is available for sale, then that Added Value is taxed. Also, interest is not considered an expense. A corporation pays a tax on its Value Added, and then pays out interest. You could see interest payments as being not much different than dividend payments. This eliminates an important and distorting effect on the cost of capital between debt and equity, that arises from the non-taxation of interest.

Now, we have seen that Value Added is similar to Total Employee Expenses plus Corporate Profit, taking into account that “profit” is on a cashflow basis, after all capex. This is called the “VAT base.”

If we have a 10% VAT on Employee Expenses and Corporate Profit, we can see that this is starting to look a lot like an income tax, or a payroll tax. It is the same as a 10% tax on Employee Expenses (salaries and benefits), plus a 10% tax on Corporate Profit, again with a VAT base (no exemptions or exclusions). It is super-simple. You just have to calculate the Value Added. And, the same tax code applies to every employee and every corporation, the same way.

Now let’s look at the Payroll Tax. But, we will use a VAT base. In other words, the Payroll Tax rate includes all salaries paid, from the first dollar to the last, with no upper limit on income. Also, it includes all benefits, such as pensions and healthcare. This is basically the same as the VAT. (Inevitably, there will be real-world complications like employee stock options. But, these can be worked out appropriately.) Like a payroll tax, there is only one tax rate, and no “tax brackets.” There are no deductions or exemptions. There is no tax return. There is no tax liability to the employee, since the corporation pays it all.

Now, let’s look at common Flat Tax income tax proposals. There are a number of Flat Tax proposals, so we will use that of Robert Hall and Alvin Rabushka, described in The Flat Tax (1985). With some minor variations, this is the basic model also popularized by Steve Forbes or Jack Kemp.

The Flat Tax proposals also get rid of nearly all exemptions and deductions. There are only two tax brackets, a 0% bracket, and a Flat Tax bracket of perhaps 15% or so. There are no taxes on interest income, dividends, capital gains or inheritances.

This is now looking a lot like our Payroll Tax and also, the employee portion of the Value Added Tax. The corporate portion of the Flat Tax typically uses a VAT base, and is at the same tax rate as the personal Flat Tax rate. This looks a whole lot like the corporate profit portion of the Value Added Tax. So, when you combine a Flat Tax on the employee portion of the VAT (total employment compensation), and a Flat Tax on the corporate portion of the VAT, at the same rate, you have something very, very close to a regular VAT — which is also quite similar to a Retail Sales Tax, and quite similar to a Payroll Tax on employees, combined with a Flat Tax on corporations.

The similarities between the Flat Tax and the VAT are so great, especially when you use “VAT base,” that Hall and Rabushka, authors of The Flat Tax, have overtly called it a variant of the VAT.

The concept of replacing the current U.S. income tax system with a flat rate consumption tax is receiving congressional attention. The term “flat tax” is often associated with a proposal formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover th Institution. In the 110 Congress, Representative Michael Burgess’s proposal (H.R. 1040) would allow taxpayers to select a flat tax (based on the concepts of Hall-Rabushka) as an alternative to the current income tax system. Senator Richard C. Shelby’s proposal (S. 1040) and Senator Arlen Specter’s proposal (S. 1081) would replace individual and corporate income taxes and estate and gift taxes with a flat tax based on the Hall-Rabushka concept. This report discusses the idea of replacing the U.S. income tax system with a consumption tax. Although the current tax structure is referred to as an income tax, it actually contains elements of both an income and a consumption-based tax. A consumption base is neither inherently superior nor inherently inferior to an income base.

The combined individual and business taxes proposed by H-R can be viewed as a modified value-added tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension receipts. Part or all of an individual’s wage and pension income would be tax-free depending on marital status and number of dependents. The business tax would be a modified subtraction-method VAT with wages (and salaries) and pension contributions subtracted from the VAT base, in contrast to the usual VAT practice.

So, to summarize:

Retail Sales Tax = VAT
Payroll Tax ( VAT base on all income) = VAT on employee income = Individual “Flat Tax” on all income
Corporate “Flat Tax” = VAT on corporate income
Individual “Flat Tax” (VAT base on all income) = VAT on employee income = Payroll Tax
Corporate + Individual “Flat Tax” (VAT base on all income) = VAT tax = Payroll Tax + Corporate “Flat Tax”

There are, I have to admit, some differences in the particulars. For example, let’s take a startup company that has $200 million of revenue, $200 million of non-employee expenses, and pays its employees $200 million. Thus, there is Value Added of $0. The company received $200 million of revenue, and paid out $200 million of expenses. The employees did not add any measurable value, at least in this year. (Presumably, they are creating the basis for future profits.) Under a VAT, the company would pay $0. Under a Payroll Tax or Flat Tax, taxes on the $200 million of employee expenses would be paid somehow. However, under this plan, the corporation would take a loss of $200 million, which it would carry forward. Thus, $200 million of future corporate profits would be untaxed, while under a VAT, they would be taxed. So, it works out the same in the end, just the timing is different. The VAT system is business-friendly, since it doesn’t receive taxes (on employment), while the corporation is making losses and is in a cashflow-negative situation. The corporation pays the taxes later, when it has the cashflow. This is good, since it promotes business startups, leading to more employment.

A Retail Sales Tax is paid on consumption (sales), while a Payroll Tax or Flat Tax is paid on production (corporate activity). For example, if a corporation exports its products, then no Retail Sales Tax is paid; but, the Retail Sales Tax is paid on imports at the time of sale. To make the VAT more like the Retail Sales Tax, corporations are given tax rebates on exports, while imports are taxed on the VAT. It might be worthwhile to take a more production-oriented view of the VAT, more like a Flat Tax, and eliminate the export rebate provision.

Since the Retail Sales Tax is all paid by one entity, the retailer, instead of by the various corporations along the chain of production, that one entity faces a high tax rate, and the incentives toward evasion rise. In our example, Wal Mart pays only $1.50 in VAT tax on $100 of sales. The other $8.50 is paid by the various corporations along the supply chain. In a Retail Sales Tax, Wal Mart pays $10 (10% rate). In practice, it seems that Retail Sales Taxes above 10% can be problematic. This is a potential problem with proposals like the FairTax which includes a Federal Retail Sales tax of 20% or more, to which might be added existing State and Local Retail Sales Taxes. (You could add a Retail Sales Tax to a VAT, which might be useful in some situations.)

For these and other reasons, I concluded that the VAT is the best of these tax proposals. We have proven, in many countries, that it indeed produces a lot of revenue, at a relatively low rate of tax evasion. The problem arises with having a VAT in addition to a payroll tax and income tax, which is common in Europe. At the very least, I would overtly eliminate the Income Tax, in the U.S. case, repealing the 16th Amendment and replacing it with a statement that Federal taxes should be Indirect and also Uniform (one rate for everyone and all activity), reinforcing Constitutional principles.

This was also the conclusion of Larry Lindsey, as expressed in The Growth Experiment Revisited (2013).

The Flat Tax proposals arose among the conditions of their time. They express timeless principles, and also the political realities of the 1990s. The Flat Tax idea was always as a replacement of the Income Tax as it existed in the U.S. at that time. It kept the existing Payroll Tax intact. The Flat Tax had a flat rate, with basically a VAT base, on income above a certain threshold. The Payroll Tax had a flat rate, on employment income from the first dollar up to an upper limit on income. If you combine the two, and expand the base to the VAT base (including all employment compensation), then you end up with a simple VAT.

As it stood, there was an overlap between the Payroll Tax and the Flat Tax, so that employees would, on some income between about $50,000 and $100,000, be paying both taxes. This doesn’t really make much sense from the standpoint of ideals. It was a concession to the political realities of the time. I think it is important to introduce and reinforce the idea of Uniformity in taxes, which is actually a founding principle of the Constitution (it is in Article I Section 8, the “uniformity clause“). I wrote about this in the past:

May 28, 2019: “Uniformity” in Taxation Was Our Blueprint For Greatness

The combination of a Payroll Tax and a Flat Tax has substantial deviations from this idea of Uniformity. The Payroll tax does not treat all income uniformly. Some income is taxed; and then, above an upper limit, it is not taxed at all. The Flat Tax does not treat all income uniformly. There are actually two tax rates: 0%, and the Flat Tax rate. Also, salaries and non-salary compensation such as healthcare expenses may not be treated uniformly. One is taxed, and the other is essentially tax-free. The tax-free provision of healthcare by corporations, adopted as a stopgap during World War II, has been cited as a major flaw in the U.S. healthcare system today, and many conservatives, not normally given to higher taxes, have said that healthcare benefits should be taxed as a prerequisite to separating it from employment. Some Flat Tax proposals deviate from the VAT Base principle by introducing some exemptions and exclusions, such as for charitable contributions.

As I have argued, it makes sense from a technocratic standpoint, to have higher tax rates on higher incomes, and to tax the lowest incomes not at all. John Stuart Mill made these arguments in the 19th century, from a technocratic standpoint. However, it is a disaster from a political standpoint, especially in a democracy. Basically, it is an invitation by the Majority to tax the Minority — in short, to use the government’s monopoly on force to steal resources from the Minority and give them to the Majority.

Although the Flat Tax has a very simple tax return, perhaps postcard-sized, nevertheless there is a return, unlike a Payroll Tax. This is necessary to administer the Flat Tax’s effective two-rate structure, 0% and the Flat Tax rate, which itself arises due to the continued existence of the Payroll Tax. The individual, not the corporation, has to declare how much income there was, possibly from multiple jobs. Possibly, there will be some exemptions and exclusions, such as for charitable contributions. Unfortunately, no matter how idealized this Flat Tax might be initially, having a return at all invites future complication, and you can easily go from an effective two-rate structure to multiple tax brackets, and re-introduce exemptions and exclusions in unlimited number. This makes the Flat Tax a Direct Tax, because the individual has to declare how many charitable contributions were made, and adjust the tax liability accordingly. The tax can no longer be paid by the corporation, an Indirect Tax, because the corporation does not have this information. This tax is technocratically strong but politically vulnerable. The Payroll Tax, however, which needs no individual “tax return,” has persisted for decades with effectively no complication at all.

Business income, or income from Capital, is taxed as an effective Corporate Flat Tax, whether labeled such, or as an inherent part of a VAT. Dividends and interest income are both taxed at the corporate level, before distribution. Capital gains are untaxed, because the market value of an asset is basically a prediction of future Value Added, or corporate income. Capital will be taxed in the future, when those profits are made. Ideally, income from Capital and Labor should be taxed at the same rate. This is inherent in the VAT, which combines both as “Value Added.” Self-employment or Sole Proprietorship income, now part of the Individual income tax, becomes part of either the VAT or a Business (not Corporate) Flat Tax.

Let’s say there was a VAT-style Flat Tax on Income, from the first dollar to the last, and on all employment compensation (VAT base). The tax rate is perhaps 20%, the level that is predicted to produce about the same amount of revenue that the Federal Government gets today, as a percentage of GDP. This tax rate of 20% is a little higher than the 15.2% now paid on the first dollar of income via the Payroll Tax, although that does not take into account offsetting factors such as the EITC, part of the Income Tax. You might argue that a 20% rate on the lowest incomes is Too High — although it is still much lower than the payroll tax + VAT rates common in Europe. Germany, for example, has a Payroll Tax of 40% (employee and employer combined), plus a VAT of 19%. Plus, additional income taxes on top of that. So, 20% is not at all high, compared to the “worker’s paradise” of Germany.

Still, many might complain. This is good. When everyone faces the same tax rate, the political body is unified. They all face the same conditions, the same tax rate on the same tax base (no exemptions). It is not rich vs. poor. Everyone, from the lowest incomes to the highest, complain that the tax rate is too high. The solution is obvious: lower taxes! The Federal Government would be pushed into taxing less, and spending less. Not a bad thing.

This was basically the system in Britain during the 19th century. The result was that the tax rate never exceeded 6%, and the British Empire ruled the world. After multiple “progressive” tax rates were introduced beginning in 1910, the top rate soared to over 60% during World War I, and has never been below 40% since then. It is very easy for the Majority to conclude that the Minority (“the rich”) should pay any amount in taxes. This is Three Wolves and a Sheep deciding what’s for lunch. The British Empire almost immediately began to disintegrate, with Ireland leaving in violent rebellion in 1921.

So, I think that Uniformity should be a major goal of an optimized tax system, and this principle of Uniformity cemented into Constitutional authority, as it was in 1789. (The Uniformity Clause was never overruled or amended, just ignored after 1913.)

In the past, during the 1990s, people concluded that Federal taxes should be reformed independent of Federal spending. Yes, Federal spending was a big problem, but we can’t expect to solve all the problems in the world at one stroke. These tax systems were designed with the idea that Federal spending would basically remain intact, in the first instance, potentially to be reformed in the future.

I think we are entering a time when Federal spending might be completely altered, and that a tax reform can take place as part of that. Federal spending might be suddenly reformed in two key ways:

  1. Devolve all domestic spending to the States. This is the original design of the Constitution. All welfare/social spending including healthcare, education, needs-based welfare and so forth becomes State policy. This would radically reduce Federal spending.
  2. Substitution of Provident Fund systems for existing healthcare and public pension (Social Security) systems. A Provident Fund system, which is used in over thirty countries worldwide including Singapore and Hong Kong, is basically a mandatory contribution to an individual account. Like a payroll tax, it is mandatory, but the money goes into an account that is directly owned by the individual. This would be a Health Savings Account (basically, a bank account at a private bank), and something like an Individual Retirement Account. Additional needs-based welfare programs can be provided, in those cases where these individual accounts do not fully meet people’s needs. However, most people would get along OK, and only a few would fall into this “safety net” system.

In Singapore, for example, healthcare is basically funded via mandatory contributions to individual accounts, basically equivalent to the Heath Savings Accounts.

September 10, 2019: New Book Proves That The U.S. Can Have Better Healthcare At One-Quarter The Price

Singapore provides government subsidies for lower incomes, and it is basically a universal coverage plan. However, since most people can fund their own healthcare via the HSAs, Singapore’s goverment pays only 1.5% of GDP in the form of subsidies and assistance, compared to 8.5% of GDP paid by all levels of U.S. government today on healthcare. Obviously, the taxes can be much lower.

In practice, these “mandatory contributions” to privately-owned accounts are treated as an additional benefit paid by corporations, a welcome add-on to employment salary. Singapore also uses private accounts for retirement income, again backstopped by needs-based welfare programs if these are insufficient. For most people, it is enough.

The result of all this is that taxes can be much lower. Singapore’s tax revenue/GDP is 14.1%, compared to 27.1% in the United States. Basically, it is half. So, the unified VAT in the U.S. could also be basically half of what it would be, if it had to provide revenue to fund all existing programs. This much lower VAT rate could be much more politically attractive.

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Nathan Lewis was formerly the chief international economist of a firm that provided investment research for institutions. He now works for an asset management company based in New York. Lewis has written for the Financial Times, Asian Wall Street Journal, Japan Times, Pravda, and other publications. He has appeared on financial television in the United States, Japan, and the Middle East.
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