Review of the Transactions Tax

(Alternatively called Universal Transactions Tax, Automated Payment Transaction Tax. Not to be confused with the Financial Transaction Tax.)

Proposed by Professor Edgar L. Feige of the University of Wisconsin-Madison, this tax on all transactions (goods, services, financial) would replace the entire federal income tax system, with all its various base definitions, rates, exemptions, deductions and exclusions.) Proponents argue that a flat rate of 0.7% (0.007) on only half the dollar value of all transactions in the US in one year, payment to be split between buyers and sellers, would raise $3.5 trillion. The 2013 budget request contains $3.8 trillion in anticipated expenditures. Currently the federal income tax, corporate tax and social security taxes raise about $2.6 trillion. The 2013 budget anticipates revenues from all sources of only $2.9 trillion, with an expected deficit of $0.9 trillion.

The current federal tax system is massive, complex, expensive and, many feel, unfair. According to the Government Printing Office, the tax code is 13,500 pages long. A 2006 estimate of the cost of complying with the federal income tax rules amounted to 22% of the tax revenue actually raised. While most federal tax is paid by the wealthiest (the top 5% of earners pay nearly 60% of all federal income taxes) the Mitt Romney story from the election in 2012 reminded people of how “unfair” the tax system seems to be. By paying 14% taxes on $14million of income, Mitt seemed not to be paying his fair share.

Reform of the tax code and larger system has been a perennial topic for both politicians and economists. As the tax code added more provisions, the calls for simplification  increased. Every proposal has been based on a common fundamental set of economic principles: efficiency and equity. Tax revenue should be raised with the least amount of waste (of time, and resources) and it should be consistent with shared notions of fairness. While the equity problem offers many challenges to solve, the efficiency goal is relatively easy to achieve. The “best” tax system would raise any given amount of revenue without creating any distortions or waste of resources (the technical term is zero dead weight loss.) Unfortunately such a tax system has never been achieved in practice, mainly due to conflicts with notions of fairness, and a lack of political will to make some people very unhappy!

Because taxes alter the price of things (not to get too technical,) they change behavior. If the tax on liquor goes up by 10%, but the tax on beer remains unchanged, some people will buy less liquor and some people (maybe the same ones) will buy more beer. The relative price of liquor has increased and that of beer has decreased, simply by the change in tax. When people change their behavior for reasons that have nothing to do with what enjoyment or benefit they receive from the product (nothing about the liquor or the beer changed) the tax has created a distortion. Incentives to buy certain things, or do certain things, can be created by taxes, and taxes can also create disincentives. Some taxes are designed to take advantage of these (dis)incentives: mortgage interest is tax deductible to encourage home ownership while cigarette taxes are, in part, high to discourage young people from smoking. Tax distortions also create waste. It “costs” people time and resources to change their behavior. Both buyers and sellers could be better off without taxes, and even if we were to collect the tax revenue and return it to them, they would not be as happy as before.

Taxes make people worse off, even if we count the value of the tax revenue collected. What type of tax system would collect revenue with the least amount of subsequent buyer and seller “unhappiness?” Most flat tax proposals combine a single tax rate while reducing tax distortions by eliminating exclusions and exemptions. The biggest problem with flat tax proposals is the definition of the tax base: what activity or value is going to be taxed? Is it wage income, investment income (capital gains,) all income, income spent (consumption?) Is consumption on services taxed, what about food, housing (rent?) A flat tax system may simplify some elements of the tax system, but keep some old, and create some new, issues that cause distortions.

There are some generic types of tax systems based on what base or activity is being taxed. The most common is an income tax. But there is also a value added tax (VAT) and a consumption tax. Excise taxes and sales taxes are simply variations on these basic themes. In a clean, theoretical world it is possible to define bases and set tax rates to make all tax systems equivalent. Each will have associated with it an amount of lost value, where the loss in buyer and seller happiness exceeds the amount of tax revenue raised.

The Transactions Tax is intended to raise a relatively large amount of revenue while creating a small amount of distortion. It does so by applying a low tax rate (.7%) on every transaction throughout the economy. This means that almost every economic activity is taxed, with nothing escaping the tax. Buying a pizza will be taxed. That money will paid to the employee, which will be taxed. She will then spend it to see a movie, which will be taxed, and to get her hair done, which will be taxed. The hairdresser will take that money and use it pay her electricity bill, which will be taxed. The Gross Domestic Product of the US economy is about $15 trillion but estimates the value of all transactions in the US economy is $1000 trillion a year. How can these numbers be so different? GDP measures the total final value of goods and services produced in the economy, is the same as value added and avoids double counting. Transactions include each and every step in producing the final product, as indicated by the example above. By taxing the same thing repeatedly as it passes through the production process, the effective tax rate on final products under the Transaction Tax will be much higher than the advertised .7%.

The transaction tax is not magic, however. A dollar of taxes must be levied to raise a dollar of tax revenue. If the Transaction Tax raises $3.5 trillion dollars then someone (or many someones) is paying that amount to the Treasury. If federal taxes currently collect $2.6 trillion then some people will be paying a LOT MORE transaction taxes than they are currently paying in federal income, corporate or social security taxes.