FUNDAMENTALS OF TAXATION 101

 

This essay will examine the various taxation schemes governments have devised to fund their parasitic existence, and to fund their operations, both desirable and undesirable. In addition we will examine who pays for this largess, and show that with little exception all taxes are paid by the consumer.

To begin with it is desirable to categorize taxes into two groups, direct and visible taxes, and indirect and invisible taxes. The first group includes, among others, point of sale taxes, title taxes, excise taxes, real estate taxes, property taxes in general, and of course income and payroll taxes. The second group includes inflating the currency, tariffs, sales taxes that are embedded in the price, and oddly also all of the direct taxes, including income taxes. This latter point is little appreciated and the major impetus for this essay.

The fact that virtually all of group one taxes directly affect the price of goods and services purchased in the market leaves little doubt that these taxes are paid by the consumer. They either reduce the amount of money that the consumer has to spend in the market place, or they increase the price of the goods and services the consumer buys. The direct taxes are plainly visible and can be understood by every consumer that is affected.

On the other hand the indirect and invisible taxes require considerably more time and thinking to appreciate how much is paid and by whom. These taxes deserve a more thorough discussion.

Inflation of the money supply is only possible in the case of fiat currencies. Unfortunately virtually all of the major currencies in the world are now fiat currencies and can be increased at will by the controlling governments. In the case of the U. S. and the dollar, this is accomplished by the Federal Reserve, which is supposed to be independent of the government but is in fact a creation of the Federal Government and therefore ultimately under its control. Thus creation of more money by the U. S. government is not only possible but has been used more and more to cover deficits between income and spending. This is a tax on everyone that uses dollars in that the extra money created and spent by the government drives up dollar prices for everyone else.

President Trump has reintroduced tariffs, i.e. taxes on imported goods, both for income for the government and as a economic weapon against foreign countries. Tariffs can increase prices of imported goods to compensate for the increased prices of domestically produced goods due to various taxes paid by domestic producers, but in that case tariffs are paid by the U. S. consumer. However, if the foreign importer has enjoyed a windfall profit by pricing his goods the same as the domestic producer, he can eat some or all of the tariff. Unfortunately the American consumer still pays the same elevated price, but in a real sense the importer is paying the tariff.

In the U. S. most sales taxes are only applied on final retail sales, so the embedded sales tax is mostly irrelevant here. However, ALL the direct taxes – real estate taxes, retail sales taxes on capital expenditures, income and payroll taxes, etc. – that are paid by every U. S. entity involved in getting the goods and services to the consumer are also embedded in the price and are therefore paid by the consumer both in and out of the country.

This last point is the main takeaway from this essay. Every American that contributes to making goods and services available to the market has to include all the taxes he pays in his price for his contribution to net a desired or necessary profit to support his existence. Thus the fundamental fact is that the consumer pays virtually all the taxes, not the worker making the product, not the corporation he works for, not the rich ;individual who owns the corporation that the socialist claims will pay, not even the trucker who delivers and the retailer who sells the product. All of these pay taxes only to the extent that each of these consumes the goods in the marketplace. The consumer pays either by sales, excise, tariffs, etc. taxes embedded in the prices of the goods and services he buys, or by losing buying power with the income, real estate, personal property, etc. direct taxes he pays. Even the parasitic welfarite that lives off of government largess has his or her consumption reduced by the price increases representing the taxes added.

The principle presented in the last paragraph is why the Income Tax is such a bad idea, and why replacing it with a National Sales Tax is greatly preferred. Even if such a tax would be at a rate to replace the Income Tax revenue to the government, the consumer would not be paying more that he does now since he pays it all anyway. In fact, by eliminating the gargantuan IRS empire and the indirect costs to business of complying with the insanity of the Income Tax code, one would expect that effectively the consumer would pay less. It is almost impossible to put a number on the indirect costs referred to here, especially since currently every business decision is made worrying about the tax considerations. No wonder Marx listed a graduated income tax as a major tool in destroying a country.

One last consideration as to why the Income Tax is a terrible idea. The contribution of the Income Tax to the price of all goods manufactured in this country makes a major contribution to why American exports are non-competitive in world markets. This burden cannot be offset with tariffs or the like, and the elimination of such would go much further than tariffs to make the U. S. a dominant economic player in the world markets.

Years ago Milton Friedman stated the principle that the total taxes that a government takes in must equal the total expenditures. The U. S. government does not really operate with a 'deficit'; it just collects that part of its income from the indirect and invisible taxes. This author would add the principle discussed above that all taxes are ultimately paid by the consumer. These two principles should allow taxes to be understood in spite of all the noise surrounding the subject.

Income Taxes, Consumption Taxes and Tariffs

Currently (April 2018) there is considerable debate raging as to the wisdom of the Trump proposed tariffs. As one more opinion on the subject, I would like to frame the argument in terms of who pays for maintaining the U. S. marketplace rather than in terms of punitive actions and retaliatory reactions in the form of tariffs.

Since the government's income in the U. S. is primarily derived from taxes, and in particular from income taxes, the government's costs of providing the infrastructure - currency, roads, courts, etc. - is paid in this country by the individuals and companies (which again boils down to the individuals) that pay the income taxes. Thus the participation in the U. S. markets by foreigners is a free ride since they do not pay U. S. income taxes. This is why U. S. made goods do not compete in both domestic and foreign markets.

The use of tariffs to level the playing field does provide a mechanism to make foreign sellers contribute to the costs of maintaining the marketplace they are enjoying, but it requires much legislation and regulation to target which goods and who's selling them. This in turn engenders hostility in those targeted and invites the 'trade wars' that are the current concern of the chattering classes. A flat tariff might be preferred in that it would be less 'in your face' to the trading partners otherwise targeted, but it still reeks of hostility to 'free trade'. It also does nothing to make U. S. goods more competitive in foreign markets.

To this author, a better solution is to replace the income tax with a National Sales Tax on all new goods. With respect to incoming foreign goods this serves the same purpose as a tariff - it makes the foreign producer pay his fair share of the support of the U. S. market. It relieves the exported goods from the income tax burden that makes U. S. goods non-competitive internationally. It allows U. S. workers to compete with foreigners as well as non-taxpaying illegals. It invites less hostility since it applies to domestic as well as all foreign goods equally. It requires no additional infrastructure to assess and collect tariffs. And as a huge added incentive, getting rid of the income tax would do more to restore health to the U. S. economy than any other single action.

Replace the income tax AND potential tariffs with a National Sales Tax. A win-win-win solution.

Sales Taxes vs Tariffs

With the President pushing tariffs to level the international playing field for American producers, he and his administration should seriously consider a National Sales Tax (NST) as an alternative or at least in concert with targeted tariffs. By getting rid of the Income Tax (IT) and replacing it with a NST, the burden of maintaining the U.S. market is shared by all who participate in it.

Let's first look at the current situation with the cost of the U.S. Government being primarily carried by U.S. citizens under the IT. Even with the new 'tax reform', a dollar earned by a typical citizen is first reduced by 25 cents with federal IT and a nickel for payroll tax. Then in most states, at least another nickel is appropriated by state IT, and a further nickel in state sales tax on the products bought with the 65 cents remaining. Thus the American consumer loses a third of his buying power regardless of where the products originate.

The labor cost for the U.S. producer is the full dollar cited above plus the employer's share of the payroll tax, plus of course any additional overhead for health benefits, etc. If the employee then buys his company's product, he is in effect paying, say, $1.10 (just for the labor costs) for which he netted about 60 cents. His own labor is costing him twice what he received for it.

The additional cost of a tariff on the imports used in making a given product could vary widely, but even for an equivalent product (a TV or an auto) subject to a tariff, the consumer ultimately pays the extra amount with the reduced buying power of his taxed income.

If the income taxes (and payroll taxes) are replaced by a NST of 30% (the rate proposed by the Fair Tax), the consumer will pay $1.30 for the labor share of a domestic product for which he received $1.00, or about 30% more. He will still bear the extra amount of a tariff, but with a net income of the full dollar rather than 60 cents. The tariff will still penalize the foreign producer relative to the domestic producer, but the impact to the U.S. consumer is a third less.

Even without a tariff, a NST taxes the foreign product at the same rate as the domestic product. This not only levels the tax burden between the foreign and domestic producers, but considerably enhances the competitive position of the domestic producer in the foreign markets since there is no taxation on labor for exported products. And, since the product rather than the labor involved in producing it is taxed in the U.S. market, automation and foreign labor (or even undocumented labor) hold no advantage for the domestic producer.

As we see, in many respects the NST achieves the same result as an import tariff, with considerable benefit to domestic production and consumption as well. Since all imports are equally affected, a retaliation in the form of a 'trade war' is unlikely. If, alternately, a penalty is intended for a given country's products, selective tariffs can still be imposed for political reasons.

The use of a National Sales Tax instead of the fatally flawed Income Tax is a no-brainer, but implementation in the short run begs caution based on system engineering considerations. Step functions - a sudden major change in inputs or characteristics in a dynamic system - can produce wild deviations before ultimately settling out to the long term behavior. Thus, although the NST in the long run is to be preferred, ramping it up as the IT is ramped down (say over 5 years) may be necessary. However, in no way must the IT be allowed to exist past the phase-out period. Ultimately the 16th Amendment must be repealed, and ITs forever banished in the U.S.

Tax Reform - Yet Again

Once again, for the umpty-umpth time, Congress is going to come up with 'Tax Reform'. What we are likely to get again is (maybe) a slightly simplified version of the current tax law monstrosity, which will last until the next batch of politicians engage in the next round of vote-buying. The likelihood of meaningful reform, which would require eliminating the Income Tax, is remote.

The Income Tax, a treachery so heinous that it required amending the Constitution (the 16th Amendment) to be legal, should be temporarily eliminated. I say temporarily since the only way to effect even a semi-permanent elimination is a Constitutional Amendment, and as was shown by the 16th Amendment, even that can be undone. In any case, a law temporarily eliminating the Income Tax could be the basis of true Tax Reform. One could further hope that the wisdom of such an improvement would be sufficiently apparent to promptly re-amend the Constitution to eliminate the possibility of it reappearing with the next Congress.

To fully understand the virtues of eliminating income taxes it is helpful to consider the problem in somewhat different terminology. An income tax is primarily a tax on labor, with a secondary emphasis on taxing investment. Since taxing something is, in a sense, equivalent to penalizing it, income taxes penalize labor and investment, neither of which is a desirable policy.

Consumption, on the other hand, could easily withstand a modest tax burden. In fact, an alternative view of the consumption tax, or sales tax, is in part a tax on products. It seems fairly obvious that taxing products rather than labor is a more rational approach in general. But in terms of current American concerns it also has other desirable characteristics.

Taxing the product puts the American producer on the same playing field as foreign producers. Imported goods would suffer the same tax burden in the American market as domestically produced goods. In addition, by not taxing labor with the income tax, American goods would be more competitive in global markets. All the taxes on the American worker that are paid by him directly and by his employer directly and/or indirectly must be added to the price in and out of the country. No wonder we can't compete in international markets.

Another benefit relevant to current American concerns is how to level the playing field between the American worker and automation. By taxing products instead of labor, there is less of an advantage of replacing workers with machines unless efficiency is considerably enhanced, and one does not have to consider 'taxing robots' as one wag has suggested. In fact, the American worker then has an advantage over the foreign worker due to his higher productivity, and thus can command a higher wage without restricting trade imports.

Consumption taxes, or sales taxes, have of course been a favorite of State Governments for a century or more. These, however, have several drawbacks in their current form. Since American States are a common market, the main drawback is that different sales taxes in different localities cause considerable distortion to interstate and even intrastate commerce. There is a temptation to consumers to deal with retail outlets that are in low or zero taxed states, or by mail with out of state companies. States with higher taxes try to avoid this by supposedly requiring their citizens to forward a 'use' tax to the State tax authority, but in practice this is rarely done. A similar problem is found in State income taxes, where people with high incomes tend to move to low income tax states. Since the higher taxed states also tend to embrace more socialistic and welfare oriented policies, they will ultimately end up with all welfarites and no working schmucks, and therefore severe financial problems. Of course, the extreme example of this is the current influx of low-skilled indigents who may or may not seek menial labor jobs, but are also drawn by the lure of multitudinous welfare services and giveaways.

Another drawback with sales taxes as currently implemented by States is the collection method. Adding the sales tax at the point of sale is an annoyance both to the seller and the buyer. With electronic payment extracting small percentages on small sales is easily handled by computers, but sales taxes on cash sales are why we still have pennies in our currency. Due to inflation, the value of a penny is near zip, but to the state a penny extra from each sale is more loot to waste.

So implementation of a National Sales Tax should be carefully designed. Since the tax on a given product would be uniform across all States, the tax on retail products could be computed and remitted by the manufacturer, leaving the States to implement their point of sale taxes as is currently done. Federal Income Tax would be eliminated, but the States again would be free to keep or change their income taxes to compete for residents. Taxing new products is reasonably straightforward, but it is not obvious how to define 'services' to tax without in effect taxing individual income.

Notwithstanding the drawbacks and implementation challenges of a national consumption tax, the benefits far outweigh the negatives. It must be appreciated that most of the difficulty is due, as is often the case, with having the bad solution (income tax) to have gotten such a deeply embedded existence in our country. Any thing short of purging that demon and its burdens that have hampered American economic health for a century will not result in meaningful 'Tax Reform'.

The 'Fair Tax Act' is legislation which has been proposed to every Congress since 1999. It temporarily eliminates income taxes, estates taxes and payroll taxes and creates a National Sales Tax on all retail sales of new products and services. Since it includes provisions for refinement and includes a 'sunset' provision after a trial period if found lacking, it should be considered for a serious candidate for this iteration's 'Tax Reform'.

My book, Musings and Rants - 1985-2016 addresses the tax problem with several essays.

(c) Copyright 2017 Marcus Everett

marcus.everett@citlink.net