More Sales Tax, Fewer Taxes: The American Example

One of the ideas going around these days is to replace part of the income tax with a more aggressive sales tax. In Quebec, the suggestion was made in March by the Quebec Taxation Review Committee, presided over by Luc Godbout.

Essentially, the committee is suggesting lowering the income tax on individuals by $4.4 billion, but raising the Quebec sales tax (QST) by 1.03 percentage points ($1.3 million Canadian) and eliminating a set of tax exemptions ($1.1 million), among other things. The QST is more efficient in its collection than the other tax and does less damage to the economy.

Detractors maintain that the sales tax is regressive, unlike the income tax. In other words, it has the effect of taxing the poor the same way as the rich. The poor would be even harder hit since they use up all of the revenue that they earn.

Supporters of this change respond that credits are given out to the least wealthy to counter these effects. In addition, they say, the redistribution of wealth does as much good through social transfers as by taxation. In Scandinavian countries, taxation explains only 17 percent of the redistribution, versus 83 percent for social transfers. However, the sales tax (or more specifically the value added tax or VAT) is 25 percent in Sweden and in Denmark.

In any case, the idea of stimulating the VAT to eliminate income tax is gaining ground elsewhere. In the United States, Sen. Ben Cardin recently proposed almost completely eliminating the income tax and replacing it with a VAT similar to our federal goods and services tax (GST).

The senator’s proposal has been analyzed by the organization Tax Foundation in Washington, which judges that it would even be beneficial for low-income earners, while also stimulating economic growth. Ben Cardin has been the Democratic senator from the state of Maryland since 2006. His suggestion is inspired by the work of professor Michael J. Graetz from Columbia University.

Essentially, the senator is proposing entirely eliminating the income tax on households that earn less than $100,000, and reducing the federal tax on goods and services by half (from 39 percent to 17 percent). In exchange, he suggests establishing a federal VAT of 10 percent, which would be similar to our GST in the sense that it would tax the value added in all sectors. Currently, there is no tax of generalized federal sales, and the state sales taxes for businesses (which would not change with the reform) vary between 0 percent and 10 percent.

Sen. Cardin maintains that the goal is to preserve an equally progressive system of taxation (despite the new tax of 10 percent), which he is calling the “Progressive Consumption Tax“ (PCT). To get there, he is proposing, for example, offsetting the regressiveness of the tax with generous allocations for low-income families and the middle class.

The rest of the compensation for the middle class will come from the abolition of the tax for households that earn less than $100,000 (and individuals who earn less than $50,000). Those who make more would see their additional revenues taxed progressively from 15 percent to 28 percent. In addition, the capital gain in the long term would be taxed at 100 percent, like work earnings.

The senator and his team have evaluated the impact on taxpayers. Essentially, the 30 percent of taxpayers who earn the least would see their net income after tax and VAT rise by 6.6 percent to 11.2 percent, while the others would also have positive effects, varying from 3.9 percent to 6.6 percent. The projected increase would be about twofold, taking into account the dynamic effects of the reform on economic growth.

Yes, but how can they all win if the money going to the federal government is the same? In analyzing the proposal, the Tax Foundation rightly observed that the rate of 10 percent for the VAT proposed by Ben Cardin wouldn’t be enough to obtain the same level of tax yields. It would have to be closer to a tax of 14.2 percent to have a neutral effect.

“The model estimates that the plan would continue to be progressive even if the PCT’s rate is increased,” judges Michael Schuyler, analyst at the Tax Foundation.

The reform would allow American businesses, with the lowering of their taxes, to be more competitive. Currently, the combined rate of the federal government and the states is around 39 percent, one of the highest in the world, and it would go down to around 21 percent (the combined level of Quebec-Ottawa is 26.9 percent). In addition, individuals would be more motivated to work, since their incomes would be less heavily taxed.

Overall, these dynamic effects would make the American gross domestic product rise in the long term by 2.6 percent, according to the Tax Foundation’s estimate, even with a tax of 14.2 percent.

In short, the Godbout committee isn’t the only one thinking that a tax reform could be beneficial to the economy. It remains to be seen whether Quebec’s changes to the QST would make consumers run away, especially to the Internet, and whether the compensation for the less wealthy would be able to convince detractors.