Cain's Plan May Not Need a Sales Tax

Republican presidential candidate Herman Cain has done the nation a great service by proposing major changes in the byzantine way the U.S. government collects its revenue.  Cain maintains that his so-called "9-9-9" plan restructures the nation's tax system in a way that significantly boosts real growth.  He also claims that his program is revenue-neutral.  This means that it is designed to replace the revenues generated by the current tax system.

Restructuring the U.S. tax system along the lines Cain proposes might promote explosive economic growth.  However, there are serious problems with tax proposals that claim to be revenue-neutral.  One potential flaw is a tendency to assume that individuals will behave the same way regardless of the tax system.  If this were true, there would be no reason to change the current system.

The main reason to change the tax structure is to remove impediments to economic growth.  If the new structure succeeds in doing so, it can improve economic activity and raise both incomes and revenues.

The failure to account for the dynamic impact of a positive structural change in taxes can inadvertently lead reformers to propose changes that increase the overall tax burden.  This is the case with the proposed "Fair Tax," which would replace all federal taxes with a national sales tax.

Insisting on revenue-neutrality places the government's need for revenue above the needs of individuals.  In an effort to ensure that government receives the same claim to revenue as before, estimates of the necessary national sales tax often amount to 20-30 percent.  While the structure of such a tax may appear superior to the current system, the immediate impact of an abrupt shift to such higher rates risks retarding economic growth rather than promoting it.  That will lead to a spiral of less-than-expected revenues, higher tax rates, and so on.

In spite of the positive structural aspects of Cain's plan, the plan itself could unintentionally create a much greater initial tax burden than the current tax system has.  The plan eliminates most current taxes such as the individual income tax, the corporate income tax, and all payroll taxes.  It is really a tax reform, and it does not deal with issues such as Social Security and Medicare payments or other entitlements.  One objective of the plan is to replace the revenues generated by the current tax system.

In an effort to make some revenue estimates, I have made various assumptions regarding the plan.  Since any estimates are based on GDP numbers, which provide only a rough guide to economic activity, all estimates are rough, preliminary guides to the plan's impact.

Revenues from the U.S. tax system have ranged from $2.1 trillion to $2.5 trillion over the past four fiscal years.  The high number was in 2008, when the economy was stronger.  In fiscal 2011, the tax system produced $2.3 trillion in revenues.  More than $100 billion of the revenue comes from various excise taxes, which remain unchanged under the 9-9-9 plan.  Thus, the plan would be considered revenue-neutral under a static analysis if it would have collected roughly $2.3 trillion in fiscal 2011.

There are three components to the 999 plan.  The first is a 9 percent individual tax on "gross income less charitable deductions."  The definition of individual gross income is vague.  I assume that it includes all employee compensation but doesn't include the rental income from a person's homeownership.  It also isn't clear whether income to sole proprietors is included as "individual" income.  The tax base for this tax in 2011 ranges from $8 trillion to $9 trillion depending on whether income from sole proprietorships is included.  At a 9-percent tax rate, a static analysis would yield $724 billion to $823 billion from this tax in 2011.

The second tax is a 9-percent business tax on gross income less all investments, all purchases from other businesses, and all dividends paid to shareholders.  This is essentially a gross receipts tax.  It is a fixed cost of doing business.  It is not an income or profits tax.

Businesses are not able to deduct the cost of their employees' compensation under this plan.  Those favoring a large public sector tend to favor this type of tax since it provides a large and steady source of revenue to government even during economic downturns.  However, the steady source comes at the expense of businesses that have to pay the tax even when they are losing money.

To determine the tax base for this levy, I begin with an estimate for 2011 GDP.  I subtract fixed capital consumption (which is slightly more than gross domestic investment) and dividend payments.  My use of a gross investment figure assumes that new houses are considered an investment and will not be subject to the tax.  For fiscal 2011, these assumptions produce a tax base of $12.2 trillion and a revenue estimate of $1.1 trillion.

The third tax is a 9-percent national sales tax.  To determine the tax base, it is necessary to assume what will be subject to the tax.  My assumption is that all consumer spending on final sales will be included in the base.  I assume that business investment is not subject to the tax.  Government spending (federal defense, federal nondefense, and state and local) may or may not be subject to the tax.  Hence, my estimate for the tax base for a national sales tax ranges from $9.4 trillion to $11.5 trillion, with the higher number assuming that the tax applies to all government purchases.  With a 9-percent tax rate, estimated revenue for fiscal 2011 amounts to $845 billion to $1.035 trillion.

Hence, estimated revenues for the 9-9-9 tax in 2011 (given the assumptions stated here) are roughly $2.7 trillion to $3.0 trillion.  This would represent a tax hike of roughly 30 to 40 percent above the current tax structure.

Herman Cain's plan for revamping the tax structure makes sense.  However, these calculations indicate that the plan would generate far more revenue than the current tax system.  The increased burden on taxpayers could easily offset any potential positive impact on incentives and is more likely to retard growth than encourage it.

Interestingly, if Cain were to drop one of his three tax proposals, his plan would be far more likely to produce the explosive growth he anticipates.  The easiest proposal to drop would be the national sales tax.  The static revenue loss would be roughly $300 billion to $400 billion, an amount that would surely be overwhelmed by the boom in economic activity resulting from the greatly increased incentives to create wealth.

The structure of any tax system has important effects on incentives for creating wealth.  However, the initial revenue impact of a change in the structure of the tax system can be an even greater force impacting growth and prosperity.  Any major pro-growth restructuring of the tax system should avoid the risk of initially raising the amount of tax revenue relative to the existing system.  Doing so threatens to increase the tax burden on individuals and, hence, undermine the very benefits the restructuring would achieve.

Robert Genetski is head of the economic consulting firm classicalprinciples.com and author of Classical Economic Principles & the Wealth of Nations.  He is a policy advisor on budgets and taxes for The Heartland Institute.

Republican presidential candidate Herman Cain has done the nation a great service by proposing major changes in the byzantine way the U.S. government collects its revenue.  Cain maintains that his so-called "9-9-9" plan restructures the nation's tax system in a way that significantly boosts real growth.  He also claims that his program is revenue-neutral.  This means that it is designed to replace the revenues generated by the current tax system.

Restructuring the U.S. tax system along the lines Cain proposes might promote explosive economic growth.  However, there are serious problems with tax proposals that claim to be revenue-neutral.  One potential flaw is a tendency to assume that individuals will behave the same way regardless of the tax system.  If this were true, there would be no reason to change the current system.

The main reason to change the tax structure is to remove impediments to economic growth.  If the new structure succeeds in doing so, it can improve economic activity and raise both incomes and revenues.

The failure to account for the dynamic impact of a positive structural change in taxes can inadvertently lead reformers to propose changes that increase the overall tax burden.  This is the case with the proposed "Fair Tax," which would replace all federal taxes with a national sales tax.

Insisting on revenue-neutrality places the government's need for revenue above the needs of individuals.  In an effort to ensure that government receives the same claim to revenue as before, estimates of the necessary national sales tax often amount to 20-30 percent.  While the structure of such a tax may appear superior to the current system, the immediate impact of an abrupt shift to such higher rates risks retarding economic growth rather than promoting it.  That will lead to a spiral of less-than-expected revenues, higher tax rates, and so on.

In spite of the positive structural aspects of Cain's plan, the plan itself could unintentionally create a much greater initial tax burden than the current tax system has.  The plan eliminates most current taxes such as the individual income tax, the corporate income tax, and all payroll taxes.  It is really a tax reform, and it does not deal with issues such as Social Security and Medicare payments or other entitlements.  One objective of the plan is to replace the revenues generated by the current tax system.

In an effort to make some revenue estimates, I have made various assumptions regarding the plan.  Since any estimates are based on GDP numbers, which provide only a rough guide to economic activity, all estimates are rough, preliminary guides to the plan's impact.

Revenues from the U.S. tax system have ranged from $2.1 trillion to $2.5 trillion over the past four fiscal years.  The high number was in 2008, when the economy was stronger.  In fiscal 2011, the tax system produced $2.3 trillion in revenues.  More than $100 billion of the revenue comes from various excise taxes, which remain unchanged under the 9-9-9 plan.  Thus, the plan would be considered revenue-neutral under a static analysis if it would have collected roughly $2.3 trillion in fiscal 2011.

There are three components to the 999 plan.  The first is a 9 percent individual tax on "gross income less charitable deductions."  The definition of individual gross income is vague.  I assume that it includes all employee compensation but doesn't include the rental income from a person's homeownership.  It also isn't clear whether income to sole proprietors is included as "individual" income.  The tax base for this tax in 2011 ranges from $8 trillion to $9 trillion depending on whether income from sole proprietorships is included.  At a 9-percent tax rate, a static analysis would yield $724 billion to $823 billion from this tax in 2011.

The second tax is a 9-percent business tax on gross income less all investments, all purchases from other businesses, and all dividends paid to shareholders.  This is essentially a gross receipts tax.  It is a fixed cost of doing business.  It is not an income or profits tax.

Businesses are not able to deduct the cost of their employees' compensation under this plan.  Those favoring a large public sector tend to favor this type of tax since it provides a large and steady source of revenue to government even during economic downturns.  However, the steady source comes at the expense of businesses that have to pay the tax even when they are losing money.

To determine the tax base for this levy, I begin with an estimate for 2011 GDP.  I subtract fixed capital consumption (which is slightly more than gross domestic investment) and dividend payments.  My use of a gross investment figure assumes that new houses are considered an investment and will not be subject to the tax.  For fiscal 2011, these assumptions produce a tax base of $12.2 trillion and a revenue estimate of $1.1 trillion.

The third tax is a 9-percent national sales tax.  To determine the tax base, it is necessary to assume what will be subject to the tax.  My assumption is that all consumer spending on final sales will be included in the base.  I assume that business investment is not subject to the tax.  Government spending (federal defense, federal nondefense, and state and local) may or may not be subject to the tax.  Hence, my estimate for the tax base for a national sales tax ranges from $9.4 trillion to $11.5 trillion, with the higher number assuming that the tax applies to all government purchases.  With a 9-percent tax rate, estimated revenue for fiscal 2011 amounts to $845 billion to $1.035 trillion.

Hence, estimated revenues for the 9-9-9 tax in 2011 (given the assumptions stated here) are roughly $2.7 trillion to $3.0 trillion.  This would represent a tax hike of roughly 30 to 40 percent above the current tax structure.

Herman Cain's plan for revamping the tax structure makes sense.  However, these calculations indicate that the plan would generate far more revenue than the current tax system.  The increased burden on taxpayers could easily offset any potential positive impact on incentives and is more likely to retard growth than encourage it.

Interestingly, if Cain were to drop one of his three tax proposals, his plan would be far more likely to produce the explosive growth he anticipates.  The easiest proposal to drop would be the national sales tax.  The static revenue loss would be roughly $300 billion to $400 billion, an amount that would surely be overwhelmed by the boom in economic activity resulting from the greatly increased incentives to create wealth.

The structure of any tax system has important effects on incentives for creating wealth.  However, the initial revenue impact of a change in the structure of the tax system can be an even greater force impacting growth and prosperity.  Any major pro-growth restructuring of the tax system should avoid the risk of initially raising the amount of tax revenue relative to the existing system.  Doing so threatens to increase the tax burden on individuals and, hence, undermine the very benefits the restructuring would achieve.

Robert Genetski is head of the economic consulting firm classicalprinciples.com and author of Classical Economic Principles & the Wealth of Nations.  He is a policy advisor on budgets and taxes for The Heartland Institute.