Flat Tax Vs. Fair Tax Vs. Herman Cain’s 9-9-9 Plan

Flat Tax Vs. Fair Tax Vs. Herman Cain’s 9-9-9 Plan

October 13, 2011

(This item originally appeared on Forbes.com on October 13, 2011.)


For a number of years now, people have asked me whether I prefer a “flat tax” or a “fair tax.” Both are problematic.

The “flat tax” is typically conceived as a replacement for the existing personal income tax. This is fine, but it ignores the payroll tax, which is really just another form of income tax. So, it is only half of an income tax reform. In practice, quite a few countries have gone this route, beginning especially with Russia in 2001, and the results have been very good. These countries have generally replaced their income tax systems, but have kept what amounts to relatively high payroll taxes.

I would like to see a top-to-bottom income tax reform, which includes payroll taxes. Or, I should say, which does not include payroll taxes: I would like to see the payroll tax system eliminated entirely and integrated into a single income tax system. Neither Hong Kong nor Singapore, which are models of what can be achieved with a flat tax system (or nearly so in Singapore), have a payroll tax. The result is that taxation on the lowest incomes is very low, and the overall system has a high degree of progressivity despite modest top rates.

Hong Kong’s flat tax system, with no payroll or sales/VAT taxes, generates about 13% of GDP in revenue per year, with a top tax rate of 16%. This is quite good, and shows excellent efficiency and high compliance. However, 13% of GDP is still rather short of the 18.5% of GDP that the U.S. Federal tax system has generated over the past several decades. So, we would have to decide either to reduce spending considerably — which might be nice, but is a separate discussion — or generate more revenue somehow.

Now we come to the “Fair Tax,” a rather horrible name for a system which aims to generate all revenue from a single national VAT or sales tax. This would be equivalent to a 30% sales tax rate, as normally calculated (exclusive method).

There are a lot of positive things to be said about the Fair Tax, especially the elimination of the IRS and all of the intrusive bookkeeping involved with the income tax. By maximizing the taxation on consumption, we would be theoretically minimizing the taxation on investment, capital, and employment, with potentially excellent results.

The problems are that many states already have a sales tax (9.6% average rate in 2010), which means that the combined rate would either be 39.6% or that states would have to generate income by some other means. States also have income taxes, which presumably would be eliminated along with the federal income tax, thus generating another revenue issue.

We end up with a rather impressively high sales tax rate, which raises the question of tax evasion — the higher the rate, the greater the incentive for evasion — and also the problem of regressivity, putting the largest burdens on the lowest incomes.

I have argued in the past that conservatives should adopt the principle of progressivity as much as possible. The problem of “what to do with the poor” is as old as government itself. Instead of pretending the problem doesn’t exist, conservatives would do well to have their own, conservative-themed solution. Democrats promise government services and welfare, and we should recognize that that has had some success. So what should the conservative solution be? Even the most libertarian thinker can agree that, if you have no better solution – don’t take their money!

I conclude that the problem with the Fair Tax is much the same as the problem with the Flat Tax — by itself, it can’t generate enough revenue without becoming a caricature of the original principle.

Thus, it seems to me that the way forward would be to combine each of these systems: a flat tax of about 16% with a basic exemption that leaves the lowest incomes tax-free; no separate payroll taxes; and a national sales tax or VAT of perhaps 10%, which would work out to more like 20% when you include state-level sales taxes. Yes, you would have some danger of rising tax rates over time, but every tax system has that danger.

Personally, I would go with a national energy tax instead of a national sales tax: something in the realm of $1 per gallon of gasoline, or the equivalent on natural gas, coal and so forth. I calculate that this would produce about $1,035 billion of revenue per year at today’s rate of usage, or about 6.9% of GDP. If we add that to Hong Kong’s 13% revenue/GDP from its 16% flat tax, we get 19.9% of GDP, which is pretty close to our 18.5% bogey. (In practice, higher taxes on energy would result in less usage, so revenue would probably be a little lower.)

Yes, I know this is Al Gore’s idea. So?

One nice thing about an energy tax is that it would reduce our reliance on foreign oil and environmentally-destructive energy practices. The other nice thing is that it is easy to avoid – just use less energy. Those with the lowest incomes can find a way to avoid much of it, by turning down their thermostat and commuting by bicycle, while those with higher incomes can keep their heated swimming pools, Range Rovers and private yachts if they want to. Thus, I think it would have a natural progressivity, to counteract the regressivity inherent in a sales tax.

When you consider that people with lower incomes would no longer be paying payroll taxes, would be partially exempt from income taxes, and would be able to easily avoid the energy tax, we can see that their overall tax burden could be significantly reduced.

Another question is whether tax revenue of 26.9% of GDP (federal, state and local) in the U.S. is really what we want.  Singapore gets by on 14.2% of GDP, but still manages to provide all the services common to developed countries everywhere, including a universal health care system for all citizens.

After experimenting with minimalist government in the 19th century, and big government in the 20th, I think we will ideally migrate toward a solution that combines the best of both. In simple numbers, it would mean tax revenues of about 15%-20% of GDP. Let’s just take a midpoint number of 18%.

Out of this 18%, about 6% would cover state and local governments (police, fire, schools, roads), and 12% would go to the federal government. The federal budget would look something like this: 3% universal healthcare (the amount spent by Hong Kong and Singapore on their universal healthcare systems), 3% senior income insurance (replacement of Social Security), 2% defense, and 4% everything else.

As the need to raise tax revenue diminishes, the tax systems and tax rates themselves can become simpler and less burdensome.

Already Herman Cain is moving somewhat in this direction with his “999 Plan,” which he says is a combination of both “flat tax” and “fair tax” ideas. I think it is still a rather rough proposal, but it is enough to start a discussion. Voters realize that, by the time it went through Congress, some of the more problematic elements would be tweaked and fixed. The important thing is that he would be getting the process started. Maybe that’s why the pizza guy is rising in the polls?