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Rand Paul’s Flat Tax Plan II

When I wrote about Senator Rand Paul’s new tax plan that he outlined in the Wall Street Journal on June 17th, I wrote that he advocated a 14.5 percent tax on both individual and corporate incomes. But that turns out to be not quite true, for Paul was more than a little disingenuous, as the New York Times pointed out Tuesday morning. 

Paul wrote,

I would also apply this uniform 14.5% business-activity tax on all companies—down from as high as nearly 40% for small businesses and 35% for corporations. This tax would be levied on revenues minus allowable expenses, such as the purchase of parts, computers and office equipment. All capital purchases would be immediately expensed, ending complicated depreciation schedules.

Since he is talking about bringing the taxes on corporations “down from as high as nearly 40 percent…” most people read that to mean the corporate income tax would be reduced to 14.5 percent. But notice, which I did not, the phrase “business-activity tax.” That is a euphemism for a value-added tax, or VAT. And a VAT is a very different beast than a corporate income tax.

The corporate income tax is laid on corporate profits. If a corporation makes a pretax profit of $1 million, it would owe the government $350,000 in taxes (ignoring all the infinite complications of the tax code). Since corporations are pieces of paper, corporate income taxes are actually paid by stockholders, in lower profits; workers, in lower wages; and customers, in higher prices. The particular distribution of the tax burden depends on the particular competitive situation of the company. (Figure out a formula for reliably determining the distribution in each case and you will have a Nobel Economics Prize on your mantel.)

A VAT works very differently. To oversimplify for purposes of illustration, say a bakery buys a plain cake for $2.00 and icing for $1.00. It ices the cake and plans to sell it for $5.00, a “value added” of $2.00. But with a VAT of 14.5 percent, the price tag on the cake would be $5.73. That 73 cents in tax is paid entirely by the customer. In other words, a VAT is a consumption tax not an income tax at all. Lay a 14.5 percent VAT and the price of everything goes up 14.5 percent the next morning. It would be indistinguishable from a severe bout of inflation.

And consumption taxes are inherently regressive, falling more heavily on the poor than on the rich and, indeed, the poorer you are, the more heavily they fall on you. The poor, by definition, must spend their entire income on necessities. So a VAT tax of 14.5 percent would reduce the purchasing power of the poor by 14.5 percent. Thanks, Senator. The rich, on the other hand, do not spend all their income, and the richer they are, the less of their income they spend, banking the rest. If a family has a take-home income of $10 million, they might live like kings on $2 million a year and add $8 million to their capital. So the man just getting by pays tax on 100 percent of his income while the Wall Street banker pays taxes on 20 percent of his income.

Governments love the VAT tax because, unlike a sales tax, which shows up on the receipt, it is hidden in the price of everything. Thus, it is politically easier to raise it as, again, it would appear as inflation. Every member of the OECD has a VAT, including Canada (5 percent) except the United States. We should keep it that way and not increase the tax burden on the poor.



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2 Responses to “Rand Paul’s Flat Tax Plan II”

  1. DAVID PATTEN says:

    Not sure I followed the economics lesson. Why isn’t the cake $5.29? The value added was $2.00 and the VAT was 14.5% So I’d calculate the total price to the consumer at $5.29. To arrive at the $5.73 figure, we would have to apply the VAT to the whole $5.00. But now it just looks like a sales tax.

    • John Steele Gordon says:

      You are correct. I should have put the VAT on the $2.00 value added. Of course, with a VAT, there would have been a tax on the wheat, on the flour, milk butter, eggs, sugar, spices, etc. before it ever got to the bakery. Every time a commodity passes from one business to the next, 14.5 percent of the increase in price is added to that price. So the final price would have been close to $5.73. But I was sloppy. Sorry. JSG




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