Could income tax be replaced by a consumption-based sales tax?

The U.S. tax system has its haters. More than two-thirds of Americans say they dislike or hate doing their taxes. A majority of us complain that our taxes are too high and that the wealthiest among us don’t pay their fair share. Without a top-notch accounting team, it’s easy to feel taken advantage of. Maybe that’s why nearly 60 percent of Americans say the tax system should be completely overhauled [source: Drake].

What’s the alternative? A growing number of economists, politicians, tax policy experts and public figures, including billionaire Bill Gates, say it’s time to abolish income tax altogether and replace it with a progressive federal sales tax on the consumption of goods and services [source: Gates].

This consumption-based tax would also replace payroll tax (like Social Security, Medicare and self-employment tax), gift tax, estate tax and even capital gains tax with a 23 percent sales tax. That means nothing taken out of your paycheck, no annual tax return to file, and no taxes on savings and investment earnings. The most comprehensive proposed national sales tax plan is known as the Fair Tax.

The Fair Tax is designed to encourage and reward high earners instead of overtaxing them. It does favor the wealthy, but the idea is that because wealthy people buy more, they will still be paying substantial taxes on big-ticket or luxury items. Meanwhile, investing in new business or charity would cost them nothing in taxes and help to strengthen the economy.

A Fair Tax could simplify the tax process for all Americans. There would be no complex deductions for the wealthy, but there would also be no tax credits to help lower income families. For those living at or near the poverty level, the Fair Tax proposal includes a “prebate” or upfront subsidy to help these individuals and families meet basic needs. Most everyone else would pay less than we do under the current system, proponents say, but the revenue generated would be the same — only much more stable.

Still, there are critics who say an overhaul of the U.S. tax system isn’t viable. In this article, we’ll take a look at how a Fair Tax or flat consumption tax would work – and why it might not actually happen.

A Bit of Tax History

If you think that our current tax system is unshakable, consider the fact that federal individual income taxes have not been around since the country was founded. In fact, formal income tax law is just over 100 years old. It was born as the United States Revenue Act, or Underwood Tariff Act, in 1913 as part of the ratification of the 16th Amendment.

There were, however, a couple of prior attempts made to establish a federal income tax. In 1861, President Lincoln introduced a Revenue Act that taxed personal incomes to help pay for the Civil War. Lincoln also established the IRS in 1862, but his federal income tax was abolished within 10 years of its birth.

The country even had a flat tax at one point. In 1894, the government enacted a flat federal income tax, which was abolished a year later when the Supreme Court ruled the tax was unconstitutional [source: Terrell].

It was 1913’s United States Revenue Act that stuck. The first federal income tax rates were 1 percent for income above $3,000. If your income was greater than $500,000 (significant cash in those days) you’d pay a 6 percent surtax. Compare that to today’s federal income rates, which range from 10 percent to nearly 40 percent for the top tax brackets [source:Pomerleau].

On top of that, 43 states also tax personal income. The highest-tax states? California at 13.3 percent, Oregon at 9.9 percent and Minnesota at 9.85 percent [source: Stone et al.].

Most states also impose a sales tax on purchases, a practice that’s been around since the era of the Great Depression, when states started looking for ways to generate revenue. In 2014, 45 states collected statewide sales taxes, and 38 states had local sales taxes. The highest sales-tax states today are Tennessee at 9.45 percent, Arkansas at 9.19 percent and Louisiana at 8.89 percent [source: Drenkard].

Added up, Americans are paying quite a bit in income and sales tax. Combining our tax burden into a single, one-time payment could ease tax burdens while stimulating both the economy and job creation, according to proponents.

How a Fair Tax or Consumption-based Tax Would Work

The Fair Tax or similar consumption-based tax would completely do away with federal income taxes, including personal, estate, gift, capital gains, Social Security and Medicare, self-employment, alternative minimum tax and corporate taxes. Instead, most purchased items would include a 23 percent tax that goes straight to the federal government. The tax would be collected only once, which means used items could be bought and sold tax-free.

The actual tax hit for individuals would be closer to 30 percent, because instead of paying an additional tax at the register, the tax would be built into the price of the item you’re purchasing. For example, if you purchased an item that is normally $100, the new price, including the tax, would be $130 ($30 is 23 percent of $130).

Social Security and Medicare would still be funded, proponents say, but the revenue would come from sales tax instead of income tax. Individuals could still receive Social Security income, but under a Fair Tax, they would not pay taxes on the income received from Social Security.

Consumption-based taxes are said to be generally regressive, meaning that lower income individuals pay a greater share than those with higher incomes. The Fair Tax is designed to be more of a progressive consumption tax, with the inclusion of a prebate that would help lower-income individuals and families consume necessities tax-free. The prebate is basically an allowance equal to 23 percent of an individual or family’s yearly consumption needs based on income [source: FairTax.org].

But the Fair Tax is not the only approach. Other consumption-based tax plans include a personal expenditure tax that would allow filers to compute their annual spending and then tax anything above that at gradually higher rates (so the biggest spenders pay the most).

There’s also the so-called Bradford X tax, which is similar to the Fair Tax, but would also include a progressive tax on wages and business earnings. Under the Bradford X tax plan, wages would be taxed at graduated rates above a certain exemption amount for the lowest wage earners. Businesses would be taxed on cash flow at a flat rate, equal to the highest wage-tax rate. All of these plans include tax credits or payments to lower-income workers [source: Viard].

Benefits of a Consumption-based Tax

Imagine keeping 100 percent of your paycheck. Better yet, imagine not having to file an income tax return every year. Those benefits alone could persuade anyone who has prepared a tax return to be in favor of a consumption-based tax.

Americans would also have a clearer view of exactly how much of their pay goes to the government. That’s not so easy for the average person to calculate under the current laws.

Despite appearances to the contrary, the system was not designed to be the complex machine it is today. The 16th Amendment, which could be considered the first tax code, was 27 pages long. Today, the Internal Revenue Code is more than 5,200 pages long. And a guide to help tax preparers, called the”Income Tax Service,” which was 400 pages in 1913, today comprises nearly 74,000 pages in 25 volumes [source: CCH]. What’s worse, tax laws change every year.

The amount of tax paid by the wealthiest Americans would most definitely go down under a Fair Tax. Instead of paying about 39 percent of income to the federal government, the wealthy would be paying about 30 percent, and only on purchases. But experts say the plan would still be revenue neutral. In fact, revenues would be more predictable under the Fair Tax because consumption is more stable than income [source: FairTax.org].

Beyond saving time and money preparing returns, a Fair Tax might also help with personal savings. Because savings and investments would not be taxed, individuals would be encouraged to save more than spend. There would also be more incentive for businesses to invest and grow with the money that is not being paid in payroll tax. And what about all of those companies leaving the U.S. to base headquarters in tax-friendlier countries? They could remain inside the country and employ American workers without taking a tax hit.

Some proponents believe that the Fair Tax will drive down prices by as much as 30 percent without the burden of existing federal taxes.

A Fair Tax might also make it more difficult to be a tax cheat. Regardless of the type of job you have, where your wages come from or your residency status in the country, you pay the same percentage when you buy goods and services. Under this system the only way to reduce your tax bill would be to buy less.

Would a Consumption-based Tax Work?

While a tax on consumption might be a possibility in the future, critics say there are many reasons why the Fair Tax is not a feasible plan.

One of the most vocal critics of the Fair Tax is Bruce Bartlett, a former U.S. Treasury Department official, who has said the Fair Tax would shift the country’s tax burden from the wealthy to the poor [source: Bartlett]. The prebate would help, but once that money is spent, it will be taxed too. Preliminary number-crunching finds that lower- and middle-income taxpayers could end up paying more tax than they do now.

Another problem is state taxation. States would have to adopt a similar type of tax policy or face having to create their own complex tax systems and codes. If states added an additional 10 percent or so onto the sales tax rate, the cost of goods and services could seem even more daunting.

What about home mortgages or even rent? Those would also presumably be taxed at this rate, Bartlett says. Would that make housing prohibitively expensive?

And those prices that could be lowered with this tax? That could also hurt the economy and impact wages.

Retirees or people subsisting on their savings would be unfairly penalized because they already paid tax on that income and will have to pay substantially more tax on future purchases.

Then there’s the messy business of doing away with the current tax system, which would mean abolishing the IRS as it exists today and upending the multi-billion dollar tax preparation industry. Further, who would monitor and audit the Fair Tax system? Would retailers bear the responsibility of getting it right?

Finally, Bartlett argues that a straight 23 percent (and even the more accurately stated 30 percent) would not be enough, and that the tax would have to be significantly higher to make the Fair Tax plan fiscally neutral. Additionally, he says, because the tax would apply to government spending, the federal government would have to tax itself.