Tuesday, July 20, 2010


Taxes: a Primer

In this time of extreme pressure between conservatives and liberals over national economic policy, a plethora of proposals have surfaced to radically change the way we pay for the benefits (?) of government. The only agreement seems to be that the present system is faulty and something new must be done to either replace or supplement our current tax system. With your permission, I would like to review some of the proposals and discus their impact on you, the taxpayer.

The VAT Tax
Representatives at the White House have said that in an attempt to reduce the enormous Federal deficit new taxes may be needed and that a VAT tax is "on the table". This is a system that has and is being used in Europe and is favored by the more liberal politicians. The letters stand for "Value Added Tax" and that is an appropriate description. Under this system, every time a person or entity 'adds value' to a product the government exacts a tax of a percentage of that 'added value' which is paid by that person or entity. The additional cost due to the tax is passed on to the next stage of the product, whether it be the final consumer or another activity that will add even more value. This may be a simple progression for some products, but can be a Gordian knot of complexity for a complex product. Let us say a hypothetical craftsman, George, makes wooden spoons. The product begins as a tree. This may be considered a raw material and not subject to the tax, or the act of cutting the tree down may be considered a value added. The tree, in the form of logs goes to a sawmill where it is reduced to lumber of convenient size and the added value of this process is taxed. A mill that caters to producers of wooden products takes boards and cuts them to length and rough mills them to an approximate shape of the finished product, in this case a spoon. Tax is paid again. George takes this blank and turns it into the finished product by turning it on a lathe, grinding, sanding, and applying a finish of oil or laquer. Tax is paid by George and he recovers that by adding to the price he gets for his product. As you can see, the ultimate payer of a value added tax is the consumer. The tax is collected every time the product changes hands for additional processing, but the cost of that tax is added to the price.
We have looked at a rather simple example, but now imagine the complexity of the taxation of a complex product such as an automobile. Thousands of parts made of dozens of materials using hundreds of processes will go into any car. Each part, many produced by outside suppliers from raw materials furnished by companies in that business adds to the burden of taxes which must be paid by the end user of the vehicle. A little recognized detail of this scheme is that you wind up paying taxes on the taxes. The steel mill pays a tax on his profit for turning raw materials into finished steel. Naturally he passes this on to the next user of the steel by adding the tax to his price. The next user machines the steel into a finished part. He, in turn pays a tax and passes the cost of the tax to the user of those parts. But part of the cost of his raw material was the tax on the 'value added' in making the steel. The tax multiplies with every step in the production of any product.
The end payer of these taxes is, as mentioned before, the consumer. This tax is somewhat progressive, a term we will more fully explore later, in that the wealthier consumer will purchase more products and products that have had more 'value added'. However, our society is so complex that everyone must have the use of manufactured products to survive. Even if one can not afford a car he must rely on a bus or other shared transportation system. If you wish to exempt the bus from the VAT taxes you run into the problem of maintaining separate inventories of taxable and tax exempt materials and intermediate stage components. The whole system is a cost accountant's nightmare and an invitation for the government to assert itself into the most minute details of the economy.

The Fair Tax
A tax sceme proposed by several notable conservatives is called the 'Fair Tax'. This is basically nothing more than a point of sale tax as is used by all states except New Hampshire (Live free or die!) The government exacts a percentage tax 'at the cash register' for all products sold. This is a system proposed by those who are disgusted by the complexities and abuses that are built in to our current income tax. It would replace the income tax as the primary source of government funding. It is a tax that would be levied equally on everyone and the wealthier consumer would pay more because he would buy more and more expensive products. Most states modify this by exempting certain necessary products from the tax. Food items are usually tax free as well as drugs in some jurisdictions. In this manner those less fortunate would be spared from taxes on their necessities, which account for most of their disposable income.
In Canada this is called the GS T and certain services are taxed as well as goods. Here, too, certain necessary services such as doctor's fees might be exempt. This makes the tax system somewhat progressive. A primary advantage is that we would not be taxed on savings. Since you pay the tax when you spend the money, you pay nothing on funds you put away. And substantial personal savings are a sign of a healthy economy. Our income tax system taxes your money as it comes to you. Therefore you have less available funds to put into savings. This has been modified slightly by allowing tax-free savings plans such as 401k and IRA accounts, but the benefits are not that great.
The biggest advantage of the 'Fair Tax' is that it is applied to everyone. I have seen figures showing that less than 50% of the people in America pay income taxes. Some of this is due to the myriad loopholes that have crept into our tax code, but more on that later. It is a simple system and does away with a whole army of persons now required to administer the system and others who provide consultation and preparation of returns. One thing must be incorporated or the 'Fair Tax' becomes indistinguishable from the VAT. A producer of goods and services must be exempt from paying taxes on materials used to produce what he sells. Otherwise the taxation at every step of bringing the components of commerce to market is the same pyramid scheme as the VAT. The Canadian province of Ontario currently collects 8% provincial tax and 7% GST for a total 'fair tax' of 15% in addition to a national income tax. As you can see, using the 'fair tax' as the means of financing the government would require a quite substantial percentage tax rate.
Stay tuned for the rest of this monograph at this location.
-Publius