1% Transaction Tax to Save the Country?

July 14, 2011

Tuesday on C-SPAN's Washington Journal, Representative Chaka Fattah (D-Pa) outlined his bold deficit fix, the "Debt Free America Act." According to Fattah, this proposal would "eliminate the national debt within 10 years" and "generate job growth and economic expansion," while simultaneously abolishing all federal individual and corporate income taxes. This can all be accomplished, purportedly, with a new 1% fee on all transactions that involve a payment instrument. Be it cash, credit card, debit card, check, or a transfer of stocks or bonds, all such payments would invoke the 1% fee. Transfers between personal accounts and deposits would be exempted, as would stock market purchases for the foreseeable future.

This transaction tax system is based on the premise that the annual volume of qualifying transactions in the American economy is $445 trillion. With a 1% rate, the tax would yield $4.45 trillion, roughly double what the federal government collected in 2010. But Fattah has also reported that under such a tax, "taxpayers would pay less than one percent of their income in taxes."

So hold on a second. Individual taxpayers would pay less than one percent of their income to the federal government (drastically less than at present), but federal revenues would soar to $4.45 trillion? Really?

No. Revenues might increase in the short term, but individual taxpayers would be the contributors. While individuals do not participate in so many transactions on a daily or annual basis, businesses do. The nature of most business operations demands endless cycles of purchasing and selling, and the typical business participates in substantial volumes of transactions whether or not it turns a profit. So without regard for the classic criterion of "ability to pay," Fattah is advocating to heap the vast majority of a $4.45 trillion tax burden on producers and businesses.

But businesses do not pay taxes. Only people pay taxes. Businesses simply collect taxes, serving as a conduit, passing the burden on to people. Taxes are passed on to consumers in higher prices, workers in lower productivity and wages, and owners in the remainder. For corporations, the owners are stockholders, a group to which nearly half of Americans households qualify. In sum, it is mathematically impossible for the proposed tax to generate $4.45 trillion without individual taxpayers paying more, and no one would go unaffected.

The primary problem with this system is that intermediate business inputs would be taxed multiple times, what economists call "tax pyramiding." As the Tax Foundation has noted, "This repeated taxing at each link in the production chain results in punitively high effective tax rates on complex products produced in stages by more than one company, and low rates on products with few production stages or that are produced entirely in-house." This creates massive discrimination in the tax code, with some products largely unscathed (particularly imports), and other items taxed into oblivion. On the issue of transparency, consumers would be unable to ascertain tax effects on prices.

While distorting prices and consumption decisions, such a system would also incentivize "vertical integration" of business and production operations—even when this would be inefficient in absence of the tax. Firms would look to bring chains of production under single ownership (mergers, buyouts, etc.) to avoid the hefty costs of buying from other entities. Retail sales taxes and value-added taxes exempt intermediate business inputs to avoid this problem.

The exorbitant tax costs embedded in "Made in USA" prices would make U.S. firms uncompetitive in all markets. International rival companies would greatly benefit from not facing the same pyramiding costs. As a result, there would be intense pressure for domestic U.S. operations to be moved abroad. This would likewise promote a shift of operations into the black market.

Business owners unable to pass tax costs on to consumers (say, if their product is highly substitutable or they face foreign competition) would see their bottom line swallowed up by Uncle Sam, and all such businesses would be forced to close. The domestic automobile industry, for example, might require weekly bailouts to stay afloat.

Under these conditions, individuals and businesses would respond. With fewer legal transactions, vertical integration of production processes, a hemorrhaging of business activity out of the U.S., and decline in U.S. business profitability, the $445 trillion tax base would soon dwindle like sand falling between the fingers of a gripping hand. The projected giant revenues would never materialize.

This type of tax has been enacted many times before at the state level, known generally as the gross receipts tax (GRT). States have learned through experience that the GRT is noxious and incredibly destructive, for the reasons outlined above. Michigan is the most recent state to repeal its version, which lasted all of three years.

The proposed bill has received no traction in Congress. One blogger has noted that it "has about as much chance of passing as a snowball does of surviving hell." This country faces serious fiscal challenges that require serious solutions. Congressman Fattah's proposal does not qualify as such.

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