Senator Ted Cruz of Texas has proposed a tax plan that involves a rather unusual tax not currently seen in the United States. I’m pre-emptively writing this post to try to help people understand how this taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. would work, because in my experience very few American journalists or even economists know how it would work. It’s actually a little simpler than the fancy nomenclature would suggest, and it can be explained through its similarities with existing U.S. federal taxes. I’ll try to make this a little easier here.
What Is Ted Cruz’s Business Flat Tax?
Ted Cruz’s “Business Flat TaxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. ” is what most tax policy experts would call a “tax-inclusive subtraction-method value-added tax” (VAT) or a “business transfer tax” (BTT). These terms are pretty technical, so I’ll try to distill them down into something a little bit easier.
What this means, in plainer terms, is that it’s a broad tax on all kinds of income, levied on businesses and organizations. You, personally, wouldn’t have to file it for yourself. Instead, it would be taken care of at the organizational level.
That does not, of course, mean it’s free. When businesses pay taxes on people’s behalf, it still ultimately means that the government gets some money that otherwise would have gone to people. Further on, we’ll talk about who would end up losing money from the existence of this tax.
How Would It Apply To an Ordinary Business’s Income?
The starting point for a subtraction-method value-added tax is pretty simple, especially when it comes to everyday private businesses. You start with all of a business’s revenues. (Most likely, this tax would be filed on a quarterly basis.)
However, you don’t stop there: a problem with counting all business revenues is that it ends up being a double-counting. For example, suppose you love watching Disney movies on Netflix. Netflix gets revenues from your subscription, and then it uses some of that money to pay Disney for the rights to Disney content. If we counted that money both at the Disney level and the Netflix level, we’d end up taxing the same basic product twice, merely because it involves two different companies. This is not good tax policy; that’s why modern tax systems try to avoid this.
The way the subtraction-method VAT fixes this is by, well, subtraction. Under this kind of tax system, Netflix would count all of its revenue, but then subtract the amount that it pays to other businesses, like Disney. Disney would then have to account for its own revenue and also file taxes. The result is that everything gets neatly single-counted, and nothing gets double-counted.
There’s also one other thing the tax subtracts: capital costs. That is, when Ford builds a new auto plant, it can deduct those business costs as well. This is an important aspect of the tax, and it marks a slight difference with corporate income taxes today (which also allow these costs to be deducted, but over a much more complicated schedule.)
What Kinds of Personal Income Does It Tax?
So what’s left after subtracting those things? It’s actually pretty simple: there’s profits that go to shareholders, and there’s wages, salaries, and other compensation to workers. Both get taxed at the same rate: in this case, sixteen percent.
In that sense, a subtraction-method value-added tax is actually just a simple combination of a sort of corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. and an ordinary payroll tax. (Fittingly, Senator Cruz’s plan uses this VAT to eliminate the corporate income tax and the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. .)
There is a simplicity and clarity to this way of doing things that I think could appeal to people; it certainly appeals to a lot of tax experts. It avoids concerns about people trying to re-label one kind of income as another kind, because everything is subject to the same rate.
It’s also important to note that this tax would apply to all organizations, including nonprofits and governments and such; much like they pay the payroll tax now, they wouldn’t get any sort of special exemption from this tax. For example, I work at a nonprofit right now, and my pay is subject to the payroll tax, at a total of 12.4 percent. Half of that tax is paid on my after-tax wages, half of it is paid by Tax Foundation before taxes. Under the Cruz plan, there would be no “payroll tax,” but Tax Foundation would still pay a 16 percent rate on my compensation.
This brings us to another important point about this kind of VAT.
Is It Like A Retail Sales Tax?
No, it’s not. You might hear that it is because VATs are sometimes called consumption taxes, and so are sales taxes. However, if you know taxes, and you’ve been reading closely above, you might have already spotted two critical differences between this kind of tax and a retail sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. .
The first of these differences is in how it’s collected: the kind of tax Senator Cruz is proposing would be calculated from corporate accounts and filed at the end of a reporting period, and not charged on each individual transaction.
The second of these is in what’s included. Sales taxes often don’t really apply to all of the goods and services we buy. They include a hodgepodge of goods that are named explicitly, and they often don’t really include things like legal services. This is different: the lawyers would pay. Furthermore, as I mentioned above, my salary at Tax Foundation is the kind of thing that is encompassed by this proposed tax, but not any kind of retail sales tax.
There’s also one more difference worth pointing out: sales taxes are tax-exclusive, while a subtraction-method VAT is, by virtue of its design, tax-inclusive. We’ll talk about that in the next section.
What Does Tax-Inclusive Mean?
Imagine there was a tax of ten percent on a $20 haircut. (Some places include haircuts in their sales taxes, but not all of them.) That would make the price $22 with two dollars of tax and twenty dollars going to the barber. Simple enough.
But suppose there was a subtraction-method value-added tax of ten percent. In that case, the business would first charge you an amount (say, $22.00, the same as you’d pay in the first example) and then calculate its taxes later. At a ten percent rate, it would result in $2.20 of tax being paid, and $19.80 going to the barber.
In the second example, the government gets more revenue, because the price of the tax is included in the amount to which the rate applies. As a result, a ten percent tax-inclusive rate is actually a higher tax than a tax-exclusive rate.
In the case of Ted Cruz’s rate of 16 percent, if you’d like to think of it as more like a sales tax, then the true rate would be closer to 19 percent.
Would This Kind of Tax Raise a Lot of Revenue?
Yes, it would. It’s a powerful tax that captures pretty much all of the income in the country. For one clear example of how powerful it is, it’s strictly larger than the payroll tax. A business transfer tax includes payroll and more. Furthermore, unlike the payroll tax under current law, a business transfer tax would not have a “cap” limiting the total amount that an individual can pay. As a result, it would be a much more powerful revenue raiser than the payroll tax, even at the same rate.
And the payroll tax is, of course, already a quite-powerful tax in itself. It has no exemptions or deductions, and most income in this country comes in the form of payrolls. In fact, many Americans pay much more in payroll taxes than they do in income taxes. If you look closely at your paychecks and wonder why a mysterious character named “FICA” is taking so much money from you, you’re probably already aware of this.
The Cruz plan would effectively eliminate the cap on the payroll tax and expand it from 12.4 percent to 16 percent (more, really, when you consider the tax inclusivity.) That’s a really, really big deal in itself, even before you consider the profits that would be taxed additionally.
Is It Like VATs in Europe?
Not exactly; while both have the name Value Added Tax, the taxes in Europe are closer to sales taxes in many ways. They’re charged on a transaction-by-transaction basis. In order to avoid duplication, businesses send paperwork (invoices) to each other, and then they get tax credits for taxes paid by previous businesses in the chain of production. This is called the “invoice-credit” system, and this is the tax used by the majority of OECD countries.
However, economists tend to believe that despite the different collection methods, these taxes end up actually being about the same in the end. So some comparison to invoice-credit VATs elsewhere in the world is worthwhile.
The Cruz plan would give us a rate of equivalent to 19 percent, by the invoice credit method. Furthermore, if you counted sales taxes levied at the state and local level, this plan would put our consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. rate at around 26 percent, tax-exclusive.
That is actually towards the high end of the range of ordinary OECD countries. For example, in Denmark and Sweden, the overall consumption tax rates are in the mid to high twenties. In Australia, the rate is ten percent, and in Japan and Switzerland, the rate is in the single digits.
With this high VAT revenue (and much lower government spending than other OECD countries) the U.S. could sustain low income tax rates, such as the ten percent proposed by Senator Cruz.
Is the Tax Regressive?
This is actually the most complicated question here. I’ve described the tax in terms of the income to which it applies; that is, the wages to workers and the profits to shareholders. But as we mentioned above, many economists think that this tax is effectively identical to an invoice-credit VAT in terms of the actual economic activity taxed.
This results in an interesting dilemma: does the tax fall on consumption? Or does it fall on income?
In truth, it’s actually hard to disentangle income from consumption. One person’s consumption is another person’s income. In practice, a lot of distributional tables tend to put sales taxes and invoice-credit taxes entirely on the consumption end, while income taxes go entirely on the income end. That makes things awkward for a tax that seems very much in the muddled middle.
This tax is ultimately structured close to a corporate income tax plus an employer-side payroll tax, and thus it falls on all income identically. A particularly important example in seeing this is the fact that my own salary at Tax Foundation is part of the base. It would obviously not be appropriate to “pass the burden on” from me to consumers based on some sort of consumption data. A tax on my salary at Tax Foundation pretty clearly falls on me.
The only part of GDP the tax excludes is investment; and perhaps you can call it “regressive” because it only taxes, say, the profits of freight rail companies, and not the value of the trains it owns. I don’t think that’s a sound mode of analysis, though. It’s the profits that put money in people’s pockets, not the money spent on building the company in the first place.
Ted Cruz calls the plan a “business flat tax.” While this isn’t the nomenclature I prefer, I think it adheres to the general principle, and it taxes all income equally.
Are VATs a Republican Idea or a Democratic Idea?
Both. Two of Senator Cruz’s senate colleagues have also proposed VAT plans: Rand Paul, a Republican from Kentucky, and Ben Cardin, a Democrat from Maryland, have both recently proposed tax plans involving VATs.
How Would One Best Summarize This Tax?
Ted Cruz has proposed combining the corporate income tax, the payroll tax, and some of the income tax into a single, larger, broader tax assessed on businesses. While the tax would be new in many respects, it would produce revenues from the same general kinds of economic activity taxed by the things it replaces.
It would not be similar to existing sales taxes, or the VATs in Europe, because it would not be levied on a transaction-by-transaction basis. Be skeptical of analysis that assumes this tax would be like a sales tax, or that it wouldn’t apply to nonprofit salaries like mine, and so on.
We have a full estimate of Ted Cruz’s tax plan available here, calculated with a full understanding of what a tax-inclusive subtraction-method value-added tax actually entails. It’s worthy of a look.
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