ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Taxes: Living Off the VAT of the Land?

February 20th, 2013

by Milton Ezrati

of Lord Abbett

The country has renewed its conversation about the way it should tax itself, whether to rely on income taxes or replace them with sales taxes. This latest buzz springs from plans by several Republican governors to reduce or eliminate their state income taxes.1 It has extended to talk about change at the federal level, including speculation about the introduction of a value-added tax (VAT) in addition to existing federal income taxes. Similar proposals surfaced in the 1990s and earlier in this century. They all came to nothing, at least at the federal level. Some states may make the switch, but a federal change will, as it has in the past, likely come to nothing.

The amount of tax reform going on in the states now is truly remarkable, certainly in contrast with Washington's sclerotic outlook. Oklahoma and Kansas have already begun to lower income-tax rates, while North Carolina, Indiana, New Mexico, Kentucky, and Arkansas have each set such reform as a priority. Governors in Nebraska and Louisiana, too, have made the elimination of state income tax a clear priority. Some states, following the path Alaska took after 1980, have looked to energy royalties as a substitute source of revenue, counting on the fracking boom. Oklahoma, Ohio, and North Dakota are particularly well positioned in this respect. But the talk at the federal level has grown from proposals in Louisiana, Nebraska, and Kansas to use sales taxes to replace income taxes.2

A lot of politics swirls around this choice in the states or at the federal level. Those who favor sales- or consumption-based taxes point to how much easier they are to administer, and how much less intrusive they are, than income taxes. The major argument against them has to do with equity. Because they have more disposable income, wealthier people tend to save a greater part of their income than others, and they naturally avoid more of a sales- or consumption-based tax than the poorer people who must spend every penny to survive. This lack of progressivity, in the jargon of tax analysis, or outright regressivity, is why New York Times columnist Paul Krugman refers to sales taxes as "reverse Robin Hoodism"3—a clumsy phrase, but one that gets attention nonetheless.

Important as such considerations are, the states considering the switch share a more pointed motivation. Questions of administrative ease or equity aside, the states see a reduction in or elimination of income taxes as a spur to growth. However much they may have to raise their sales taxes to regain lost revenues, the states know that corporate income tax relief will likely lure business from higher-tax states and that lower personal income tax rates will likely lure talented, high-pay workers in a similar way. The governors pushing their states along these lines are more or less explicit about their motivation, but the drive does have the economic evidence on its side. According to the Mackinac Center (which has done extensive research on this question), fast-growing states often have relatively heavy sales taxes, but all have relatively light or no income taxes. Slow-growing states all tend to have relatively heavy income taxes.

Though all this positioning in the states has renewed talk of a similar shift at the national level, such a movement is highly improbable. As in the past, objections at several levels would almost surely block an effort to substitute a broad federal sales tax for income taxes or even add consumption-based taxes onto the existing tax structure, as Europe has with its VAT.

The dichotomy of the progressivity/regressivity point is, of course, crucial in the left-right congressional debate that would accompany such a proposal. A big part of the Democratic Party would resist on that point alone, as would many Republicans, especially those from poorer districts and states. After all, some 47% of the country does not pay any income tax at all.4 A sales or consumption tax would hit this lower-income group hard—a clear motivation for opposition. Several who support such a tax change have tried to ease its regressive nature by proposing that the law include rebates to lower-income people or exclusions for certain staple products, such as food and clothing, as many states do. But no answer to date has fully relieved concerns about the regressivity of sales taxes. Besides, all the modifications proposed to answer objections about fairness would erase part of the appeal of a sales tax by making it more intrusive and more difficult to administer.

Additional questions of intergenerational equity could pose even bigger impediments to broad national sales taxes or a VAT. Because retired people have amassed their nest eggs under an income tax regime and so have paid taxes on much of the income they have saved, they would certainly object to paying taxes now with their spending. They would, not unjustly, see it as a kind of double taxation. There are, of course, winners and losers in any change, but making losers out of retirees invites the resistance of a large and politically potent group. Their objections alone could stop a change from income to sales-tax financing and even to the modest addition of a consumption-based tax. Resistance would harden still more because a switch away from income taxes would take away real estate tax deductibility and so lower house values, swelling the ranks of resistance with other concerned Americans, effectively if not directly represented in this case by the powerful real estate lobby.

Perhaps even more powerful than this resistance, the states themselves would almost surely resist such a federal tax move, and do so on several counts. In the first instance, it would raise their costs. Right now, they make no contribution to the federal government, but a federal consumption tax or VAT would be imposed on everything they buy—from police cruisers to paper clips, to office furniture, to consulting services—if this country were to follow the European model. Second, those states that rely on income taxes would lose the administrative and enforcement help they currently get from the federal code. Third, states that do rely on sales taxes would feel a tremendous and unwelcome pressure to conform to whatever system the federal authorities adopted, if only to avoid impossible administrative complications. Fourth, even if the states willingly conformed, federal sales taxes would still cause administrative difficulties by opening questions about which tax is applied first and if the second tax would go on top of an already administered tax, effectively a tax on tax. Finally, additional administrative difficulties would extend to all the cities and localities that rely on sales taxes of their own.

Those who take their cue from Europe argue that a federal turn is inevitable. All European nations, they argue, have added a consumption-like VAT to their income taxes. That may be true, but it is a more difficult path to travel for the United States than for European nations, because retirees are a more powerful voting and lobbying block here than in Europe, but still more because the federal nature of this country introduces 50 powerful state political actors that are unknown in European government, at least in the independent form they have here.

1 Richard Stevenson, "Governors Push Bigger Reliance on Sales Taxes," The New York Times, January 24, 2013.

2 "The State Tax Reformers," op-ed, The Wall Street Journal, January 30, 2013.

3 Paul Krugman, "Makers, Takers, Fakers," The New York Times, January 27, 2013.

4 Data from the Congressional Budget Office.

Note: This material is being provided as general information only and is not intended to be legal or tax advice; therefore, it is strongly recommended that you consult your legal or tax advisor.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.

© Lord Abbett

www.lordabbett.com

Website by the Boston Web Company