Q: Would you please explain the new flat sales tax that would replace income tax (ideally), or advise if I am completely misunderstanding what has been rumored? — Mary, Greensboro, N.C.
A: At the moment, there's not much more to the debate over tax reform than very vague, general concepts. So until a formal proposal is made, much of what you'll hear will be the "trial balloons" that precede any shift of policy in Washington.
The way this game is played, someone floats an idea — usually by leaking an "internal memo" to the press — and then stands back to see who shoots at it. The purpose is: 1) to see just how much support or opposition is out there and 2) to identify which groups you'll need to win over and whether you have enough political muscle to overcome that opposition. That's why so much of what you hear so far is just rumor and speculation.
Still, the general concept of a shift to a sales tax is fairly simple. Much of the Bush administration's tax reform to date has been aimed at cutting taxes on accumulated wealth and the income it generates. The idea is that by shielding this wealth from taxation, that money is more likely to be re-invested in new businesses, which helps the economy grow.
But if, as the White House has done, you cut taxes on interest, dividends, capital gains on investments, inherited wealth (through the phase-out of the estate tax), etc. you have to raise taxes somewhere else. Or you have to make big spending cuts. So far, the government has simply borrowed billions to cover the shortfall. (See last week's question below.)
Opponents of the Bush tax cuts argue that they have simply shifted the burden from rich people (who make more of their money from investment income) to middle- and low-income workers (who make most of their money from wages.)
Shifting to a sales tax would push this idea even further. The goal of taxing consumption (things you buy) instead of income (the wealth you create) would give people more incentive to save. In theory, such a shift could help whittle down the mountain of consumer debt we've all accumulated on our credit cards and help encourage Americans to save more. (The U.S. has one of the lowest savings rates in the developed world.) Then, in theory, this savings would be available to expand and create businesses as it's invested in stocks, bonds, CDs, etc.
The problem is that a sales tax also tends to hit low- and middle-income earners harder than the wealthy. If you buy a $25,000 car, for example, that purchase might gobble up, say, half of your annual income. For someone making millions, the sticker price for the same car represents a much smaller fraction of their total income. But you both pay the same tax.
Another goal of a shift from an income tax to a sales tax would be to simplify the tax code. Again, in theory, you wouldn't even have to file a tax return — you'd pay taxes year-round whenever you bought things.
But in the end, some provision likely would have to be made to exempt spending on basic necessities — like food, clothing and shelter. Once you start exempting specific spending categories, you're headed back down the same road that got us in the mess we’re in now — with armies of lobbyists winning special breaks and favors for their clients by twisting arms on Capitol Hill.
That's why — when and if the Bush administration actually proposes such a fundamental overhaul — the debate over tax reform is going to make the dustup over Social Security look like a tea party.