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Basic Taxation:  Income Tax
Consumption Tax and the Myth of Equity

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What's Wrong with the Flat Tax

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All articles "recovered" written ©Mark Joseph Young, originally published on TheExaminer.com.  All other articles written ©Mark Joseph Young.  This site is part of M. J. Young Net.

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Taxes are always an election issue, but few voters understand the tax process, why it is as it is, and what impact would come of changing it.  Thus it seemed reasonable to provide something of a primer on taxation, looking at what we do, why we do it, and how it might be changed, with what impact.

I had plans to continue this, gradually, when other issues are not pressing; we will see how they develop, although they are more likely to appear in the new blog, mark Joseph "young".

Basic Taxation:  Income Tax

Everyone complains about taxes.  We all think that they are in some way inequitable--mainly because every one of us believes he pays too much and that someone else is not paying enough.  Thus it is easy to get votes by claiming you have a way to fix the tax system--everyone assumes that this will mean he will pay less and someone else will pay more.  The question, though, is how we make the system "fair".  We have many kinds of taxes, and each is "fair" in its own way.

Our biggest tax is an income tax.  Among the earliest examples of such a tax is the tithing system of ancient Israel:  everyone paid one tenth of his gross earnings, whether crops or flocks or shekels.  Thus if you received a dollar, you would owe a dime, and if you received a million dollars you would owe a hundred thousand.  It was simple, and in some sense it was fair--everyone paid a share based on what he earned, and everyone paid the same share of what he earned.  Of course, it is more complicated than that--that is, the tax is simple, but the impact is not always "fair".  For example, if you really only earned a hundred dollars this month, you're going to have a hard time living on that money unless you are being supported by someone else; and if you earned a million dollars this month, you probably aren't going to miss a hundred thousand all that severely.  Thus we have what is called a graduated income tax--graduated in the sense that there are gradations, levels.  The person who earned a meager hundred dollars probably will pay nothing; his percentage is zero.  The person who collected a million dollars might have to pay fifty percent, half of it.  It suggests that we think it unfair to charge the poor at the same rate we charge the rich, and fair that the rich pay a larger share--that their "fair share" is a considerably larger portion of what they have earned.

How much money do you have to make before you pay anything at all?  There are always hiccoughs in the graduation system--if we assume that anyone making up to a hundred dollars pays nothing, but anyone making more than that pays one percent, the person making a hundred dollars keeps a hundred dollars while the person making one hundred one dollars keeps only ninety-nine dollars and ninety-nine cents, and there are such discrepancies at every level.  How much money should we take from those who make the most?  Some wealthy people work very hard for their money; if we take most of it from them, they will find that it is not worth the effort.  Some employ others to help earn their money, and if we take too much they will inevitably reduce the number they employ, possibly to zero--which apart from the human cost also means a lot of people no longer paying taxes.

There is also the problem of taxing gross earnings.  We know that grocery store chains collect billions from sales; small independent grocery stores of course do not reach those levels, but they do receive thousands of dollars in cash every day.  However, the typical "margin" in the grocery business--the amount of money earned after the costs of stocking the goods is deducted--is only about three to four percent.  That means for every thousand dollars they put in the cash drawer, they paid nine hundred seventy dollars on the products they sold and put thirty dollars in their pockets--out of which they have to pay their staff, their utilities, their property expenses.  Were we to tax that thousand dollars at ten percent, one hundred dollars to the government, our grocers would have paid nine hundred seventy dollars for the groceries which they sold for a thousand dollars, and paid one hundred dollars to the government from that thousand, and will then have seventy dollars less at the end of the day than they had when they started, with no money for the paychecks or the rent.

Because of this problem, our tax system targets net earnings rather than gross earnings--that is, not how much money you collect but how much is yours after you pay all the expenses entailed in making it.  The grocery store example is obvious on its face:  the store collected a thousand dollars of which nine hundred seventy paid for the groceries they sold, leaving them thirty dollars, of which ten percent would be three dollars.  Yet it is not so obvious.  As mentioned, the grocery store still has to pay its employees, its utilities, and its property costs (rent, mortgage) from that thirty dollars.  Perhaps at the end of the day they have ten dollars left; do we tax them based on the thirty dollars, or the ten dollars?  This is why we have "deductions"--called "loopholes" if you don't like them.  We are attempting to determine, on a fair basis, just how much money someone earned.  If the grocery store buys advertising to bring customers, is that an expense that can be deducted?  If the store owner pays for lunch for all his employees, does that get deducted from the income?  What if he buys his own lunch from the money in the till when he is working?  Does it matter whether he is buying just his own lunch or having lunch with someone, such as a wholesaler or his accountant?  What do we count as his income, and what do we consider part of the cost of doing business?  If in some third world country the company has to bribe some middle level official to get a contract because that is how business is done in that part of the world, is the bribe (illegal in our country) a legitimate business expense if it is reported as such?

This explains why some companies that "earn" billions of dollars pay no income tax:  at the end of the day, all of the money they collected from paying customers paid legitimate expenses of doing business.  Many companies operate "in the red" much of the time--in fact, in the United States the day after Thanksgiving is called "Black Friday" because it is the day on which most retail sales companies have finally earned enough money that they are "in the black"--writing their ledgers in black ink instead of red because they have finally earned enough to cover the costs of doing business.  They then have one month in which to make a profit before starting the new year with a fresh balance book and expenses that exceed income for the next eleven months.

So with income tax the tricky parts are figuring out how much someone earns and how much of that each should have to pay.  We will look at these problems in more detail in future articles, and also look at alternative ideas for taxes.

Consumption Tax and the Myth of Equity

Everyone, as we said previously, complains about the Federal Income Tax, because we all think that it is in some way inequitable--mainly because every one of us believes he pays too much and that someone else is not paying enough.  Thus it is easy to get votes by claiming you have a way to fix the tax system--everyone assumes that this will mean he will pay less and someone else will pay more.  The question, though, is how we make the system "fair".  We have many kinds of taxes, and each is "fair" in its own way.  One alternative that is often suggested is that we scrap the income tax system entirely and replace it with what is called a national "consumption" tax, or federal "sales" tax.

The theory behind a consumption tax is that if you have money you will spend it, and if you spend money it proves you have it, and so we tax you not on how much money you earn but how much you spend.  People who buy houses and boats and cars will pay more than people who buy groceries.  Yet there is an inherent inequity in this:  people who make much less money spend a much greater portion of what they earn on necessities such as food.  For this reason, the many states that have state sales taxes have long lists of exempt products.  In New Jersey there is no sales tax on edible groceries or non-alcoholic non-carbonated beverages, unless they are purchased as ready-to-eat products such as sandwiches; there is also no sales tax on such paper products as bath tissue.  However, clothing is taxed even though everyone needs it.  Arguably this is an area where the concept to some degree works--those who buy their clothes from Goodwill or Walmart will pay less sales tax than those who shop at Saks Fifth Avenue.  However, clothes are still nearly as much a necessity as food, and it is difficult to determine what products ought to be exempt so as not to burden the poor unduly.  After all, under the present income tax system, many of the poor pay no income tax, but all of them pay sales tax, and would pay considerably more with a federal sales tax.

There is also the question of the final sale.  A sales tax is generally paid by the end user of the product--the one who plans to eat the food or drive the car or wear the shoes.  (Technically it is paid to the government by the retailer, who is required to collect it from the consumer on behalf of the government making the retailer an unpaid government accountant, but it comes to a consumer tax.)  The retailer does not pay tax when purchasing product from the manufacturer; nor indeed is tax paid on transactions involving middlemen.  That avoids the inflation by taxes problem, and also levels the playing field some for the small businessman.  Were it otherwise, when a manufacturer sold a product for ten dollars with a ten percent sales tax, the buyer would pay eleven dollars and would have to mark up the price from there--let's say to twelve dollars, on which that same ten percent sales tax would again add a dollar twenty for a total of thirteen twenty to the customer.  But a manufacturer does not want to have to deal with millions of small businesses, so it will sell that product to a middleman for ten dollars, who would pay the tax and then resell at a markup, probably our twelve dollars, and the retailer pays the thirteen twenty to cover the tax and marks it up to fourteen dollars, so that with tax the consumer pays fifteen forty.  Making the sales tax an end-user tax eliminates this inflationary spiral.

However, it also raises the question of who is the end user.  A dressmaker buys fabric and sells dresses; he does not sell the fabric, but sells a different product produced from the fabric.  Should he be taxed on the purchase of fabric, and collect tax on the sale of dresses?  Or is fabric taxable if you buy it to make a dress for yourself, but not if you are making a dress to sell--and how does the system make that distinction?  If you make jewelry "for a living", is that different than if you make and sell pieces as a hobby that brings a bit of extra income?

What of other "business expenses"?  If your job requires you to buy your own "uniform"--defined as clothing you could not wear apart from your job--the income tax system allows you to deduct that cost from your income, as if it were money you did not really earn because you had to spend it to earn it.  Under a consumption tax system, you would have to pay for those clothes, but would you also have to pay tax on them?  And again, how would the retailer--who in a consumption tax system is the tax collector--determine, say, whether you are purchasing medical scrubs because you are required to wear them for work, or because you find them comfortable to wear around the house?

Perhaps this could all be addressed by taxing everything, and then at the end of the year allowing everyone to file for a tax refund, based on their receipts and information about their legitimate business purchases (fabric to make dresses, uniforms for work) and so receive a sales tax refund.  Yet that is not a simpler system than the income tax system--it is merely unfair in different ways, and a greater burden on the poor.  Those who advocate a consumption tax to replace the income tax are arguing for a tax which decreases in percent of earnings paid as income increases.

Which leads to the issue of a luxury tax, a very similar tax which will have to be covered in another article.

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