With the introduction into Congress of Rep. Dick Armey’s (R-Texas) much-touted flat tax plan, many good arguments will be made about how alternatives to the income tax will promote saving, investment, and economic growth. But there is another reason for replacing the income tax: the massive cost of the paperwork burden generated by the income tax laws.
The Tax Foundation estimates that complying with the federal income tax system costs Americans $140 billion a year. Approximately two-thirds of the cost is borne by the business sector. Expenditures on compliance, which add nothing to our gross national product, are tantamount to a tax surcharge on all taxpayers. To comprehend the magnitude and economic waste of this surcharge, imagine putting every vehicle sold by General Motors in 1994 onto ships . . . and then dumping them all into the ocean.
If Congress were to replace the current federal income tax with any one of the three most popular alternatives–Armey’s flat tax, the USA Tax System sponsored by Senators Pete Domenici (R-N.M.) and Sam Nunn (D-Ga.), or a national retail sales tax–it could dramatically reduce America’s tax-related burden. The Tax Foundation has estimated how much each plan could reduce the current $140 billion tax surcharge:
Representative Armey’s flat tax could reduce the surcharge by 94 percent, to $8.4 billion, assuming that the current convention of annual tax filing is retained. However, if Armey achieves his goal of eliminating individual income tax withholding and moving to monthly tax payments, his flat tax would reduce the surcharge by 72 percent, to $39 billion.
The USA Tax System could reduce the surcharge by 76 percent, to $33.6 billion.
A national retail sales tax could reduce the surcharge by 92 percent, to $11.2 billion, assuming that the plan included a per-person rebate scheme to make it more progressive. If no rebate were part of the plan, a retail sales tax could reduce the surcharge by an estimated 96.5 percent, to $4.9 billion.
The Tax Foundation estimates are based on “pure” versions of the alternative tax systems. It is reasonable to assume that molding any of the alternative plans into a functioning tax code could increase its complexity, and therefore the associated compliance costs. Nevertheless, the alternatives are not likely to reach the level of complexity achieved by our current income tax.
The income tax ranks among the worst of the tax systems currently in operation around the world. Not only is it inherently complex, but it is subject to the dynamics of the political process, which increase the system’s complexity by continually expanding and revising the definition of taxable income.
The inherent complexity of an income tax results from the difficulty of defining what constitutes “income” and determining when to recognize income and expenses for tax purposes. And even a properly constructed income tax faces the added complications associated with adjusting for inflation.
Armey’s flat tax and the USA Tax System eliminate these timing-related complexities, and therefore their attendant compliance costs. Both plans accomplish this by moving to a cashflow tax base, rather than an accrued income tax base. Doing so also eliminates the complexities associated with depreciation and depletion allowances, foreign-source income rules, inventory capitalization, amortization of intangibles, and long-term contracting.
Although the flat tax, USA Tax System, or retail sales tax are inherently far less complex than even the most well-constructed income tax system, misguided political tampering can ruin the integrity of any system. Still, any one of these plans could be a sound replacement for the current federal income tax. They all can satisfy the current political demand for tax revenue; they stop punishing saving and investment; and, by offering the potential for huge reductions in the cost of compliance, they can eliminate hundreds of billions of dollars of pure economic waste.
Written for The Heartland Institute by Arthur P. Hall, Ph.D., senior economist at the Tax Foundation, a Washington, D.C.-based nonprofit research organization. Nothing in this Heartland Perspective should be construed as reflecting the views of The Heartland Institute, nor as an attempt to aid or hinder the passage of legislation.