Cain’s Tax Plan May Work Without a National Sales Tax

Published October 20, 2011

Republican presidential candidate Herman Cain has done Republicans and the nation a great service by proposing major changes in the Byzantine way the U.S. collects its revenue. Cain maintains that his so-called “999” plan restructures the nation’s tax system in a way that significantly boosts real growth. He also claims his program is revenue neutral. This means it is designed to replace the revenues generated by the current tax system.

Restructuring the U.S. tax system along the lines proposed by Mr. Cain has the potential to promote explosive growth. However, there can be serious problems with tax proposals that claim to be revenue neutral. One potential flaw is a tendency to assume individuals will behave the same way regardless of the tax system. If this were true, there would be no reason to change the current system.

The main reason to change the tax structure is to remove impediments to growth. If the new structure succeeds in doing so, it can improve economic activity and raise both incomes and revenues.

The failure to account for the dynamic impact of a positive structural change in taxes can inadvertently lead reformers to propose a system that increases the overall tax burden. This is the case for the proposed “Fair Tax” which would replace all federal taxes with a national sales tax.

Insisting on revenue neutrality tends to place the government’s need for revenue above the needs of individuals. In an effort to assure government receives the same claim to revenue as before, estimates of the necessary national sales tax often amount to 20 percent to 30 percent. While the structure of such a tax may appear superior to the current system, the immediate impact of an abrupt shift to such higher rates risks retarding rather than promoting growth.

Tax Burden Could Climb

In spite of the positive structural aspects of Mr. Cain’s plan, it could unintentionally provide a much greater initial tax burden than the current tax system.

There are numerous potential problems in estimating the economic and revenue implications of even the most detailed tax plan. I am not aware of all the details of the 999 plan so my analysis is clearly preliminary.

In an effort to make some revenue estimates, I have made various assumptions regarding the plan. Since any estimates are based on GDP numbers, which provide only a rough guide to economic activity, all estimates are rough, preliminary guides to the plan’s impact.

Revenues from the U.S. tax system have ranged from $2.1-$2.5 trillion over the past four fiscal years. The high end came in 2008 when the economy was stronger. In 2011, the tax system produced an estimated $2.2 trillion in revenues. More than $100 billion of U.S. revenue comes from various excise taxes. I assume these would remain unchanged under the 999 plan. If so, the plan would be considered revenue neutral under a static analysis if it would have collected roughly $2.2 trillion in fiscal 2011.

There are three components to the 999 plan. The first is a 9 percent individual tax on “gross income less charitable deductions.” The definition of individual gross income is vague. I assume it includes all employee compensation, but doesn’t include the rental income from a person’s homeownership. It also isn’t clear whether income to sole proprietors is included as “individual” income. The tax base for this tax in 2011 ranges from $8 trillion-$9 trillion depending on whether income from sole proprietorships is included. At a 9 percent tax, a static analysis would have produced $724 billion-$823 billion from this tax.

Cannot Deduct Compensation

 The second tax is a 9 percent business tax on gross income less all investments, all purchases from other businesses, and all dividends paid to shareholders.  This is essentially a gross receipts tax. It is a fixed cost of doing business. It is not an income or profits tax.

Businesses are not able to deduct the cost of their employees’ compensation.  Those favoring a large public sector tend to favor this type of tax since it provides a large and steady source of revenue to government even during economic downturns. The steady source comes at the expense of businesses which have to pay the tax even when they are losing money.

To determine the tax base on this tax I begin with an estimate for GDP in fiscal 2011. I subtract fixed capital consumption (which is slightly more than gross domestic investment). I also subtract dividend payments. My use of a gross investment figure assumes new houses are considered an investment and will not be subject to the tax. For fiscal 2011, these assumptions produce a tax base of $12.2 trillion and a revenue estimate of $1.1 trillion.

The third tax is a 9% national sales tax.  To determine the tax base it is necessary to assume what will be subject to the tax.  My assumption is all consumer spending on final sales will be included in the base.  I assume business investment is not subject to the tax.  Government spending (federal defense, federal nondefense, and state and local) may or may not be subject to the tax.  Hence, my estimate for the tax base for a national sales tax ranges from $9.4 to $11.5 trillion, with the higher number assuming the tax applies to all government purchases.  With a 9% tax rate estimated revenue for fiscal 2011 amounts to $845-$1,035 billion.

Hence, for 2011 the 999 tax (given the assumptions stated here) is estimated to have generated revenues of roughly $2.7-$3.0 trillion. This would represent a tax hike of roughly 30%-40% relative to the current tax structure.

Could Drop Sales Tax Component

Herman Cain’s plan for revamping the tax structure makes sense. However, these calculations indicate the plan would generate far more revenue than the current tax system. The increase burden on taxpayers could easily offset any potential positive impact on incentives and is more likely to retard growth than encourage it.

Interestingly, if Mr. Cain were to drop one of his three tax proposals his plan would be far more likely to produce the explosive growth he anticipates. The easiest proposal to drop would be the national sales tax. The static revenue loss would be roughly $200-$300 billion, an amount that would be overwhelmed by the boom in economic activity amid the increased incentives to create wealth.

The structure of any tax system is important to creating incentives for creating wealth. However, the initial revenue impact of a change in the structure of the tax system can initially be an even greater force impacting growth and prosperity. Any major pro-growth restructuring of the tax system should avoid the risk of initially raising the amount of tax revenue relative to the existing system. Doing so threatens to increase the tax burden on individuals and, hence, undermine the very benefits the restructuring would achieve.

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