Free-market proposals suggest eliminating personal and corporate income taxes, replacing them with value-added tax (VAT) or a tax on consumption. Progressivity could be maintained by giving all taxpayers a guaranteed, fixed-sum subsidy. In the U.S. context, a VAT rate of about 20 percent would be sufficient to replace revenue from federal income tax.
Governments do not like simple rules and prefer to raise taxation by playing the populist card.
Such proposals have considerable merit in two respects. First, they simplify the tax system, since taxpayers would no longer spend time and resources computing their taxable income and finding ways of reducing it by converting expenses into costs (tax avoidance). Second, by adopting a constant marginal tax rate (i.e., the tax base is taxed at the same rate, regardless of its size), individuals are encouraged to produce and consume more. They are no longer penalized for working harder or for coming up with particularly bright (and potentially profitable) ideas.
Regrettably, this sort of tax system is unlikely to become law. Governments do not like simple rules and transparency. Instead, they prefer to raise taxation by playing the populist card. It is true that an across-the-board tax increase that spreads the burden evenly across the entire population would meet considerable opposition. By contrast, projects that promise more progressivity – especially if they involve substantial tax increases for the rich and modest or no burdens for the poor – are more likely to attract support.
Another risk of reform plans involving a new indirect tax is that they could encourage policymakers to supplement, rather than replace, direct taxes on income. In that case, one would end up with a copy of Europe’s complex systems, with VAT loaded on top of personal and corporate income taxes – definitely not a model of efficiency and moderation.
See Part I
See Part III