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Thursday, June 28, 2007

Tax Pyramiding

Pyramiding in a tax system refers to the imposition of a tax on a tax. It typically happens with taxes that are imposed on goods or services, such as a sales tax. Pyramiding causes a tax to violate several principles of good tax policy, including transparency, efficiency, equity and neutrality. For example, in California, most food purchased at the grocery store is exempt from the sales tax. However, the price paid for that food includes sales tax paid by all businesses in the production and distribution chain to get that food into the store. When a business pays a tax, it is one of many costs factored into its operations that either goes into the price of what the business sells and/or reduces profits. This effect makes the sales tax fail the transparency principle in that when you buy an item (whether tax exempt or not), the true amount of sales tax included in what you pay is not obvious due to pyramiding; the sales tax paid is definitely more than what is noted on your sales receipt.

The degree of tax pyramiding varies from state to state depending on the types of sales tax exemptions they provide to businesses. For example, California exempts purchases for resale. So, when the California grocery store buys food, it doesn't pay sales tax. Yet, it has paid sales tax on all of the equipment and other tangible personal property used in the store (supplies for example). Some states have reduced pyramiding by providing sales tax exemptions for certain types of equipment purchased by businesses, such as that used in manufacturing. Typically the rationale for such exemptions is to entice businesses to locate their manufacturing operations in the state.

The remedy for tax pyramiding is to not have businesses pay sales tax. If they don't pay the tax, then it won't be factored into pricing. There are two big obstacles to fixing pyramiding though:
  1. Pyramiding has been around since the beginning of the sales tax and it generates revenue for the state (likely at least 20% of the state sales tax comes from businesses). How do you replace that revenue?
  2. Many people (including lawmakers) think that businesses have too many tax breaks and are not paying their fair share and would not support legislation to make all business purchases exempt from sales tax.

Despite these obstacles, there are reasons to remove pyramiding from the sales tax system and ways to deal with the obstacles. First, there are other reforms needed to the sales tax system, such as base broadening (along with rate reduction; see my Report #2a at the link below). Revenue generated from that change can cover the revenue generated from pyramiding and be a more equitable and transparent way to generate sales tax revenue. Removal of pyramiding would likely generate increased business activity in the state because the price of doing business here would drop - other tax revenues should go up from the change. Also, taxpayer education would help. Individuals need to see the hidden cost of pyramiding (which they pay; businesses pass most costs onto customers). It would be more clear to individuals how much sales tax they are paying if the sales tax shown on the sales slip is the total amount and that will only happen if pyramiding is removed from the sales tax system.

The pyramiding flaw is a U.S. one. All industrialized countries other than the U.S. use a value-added tax to tax consumption (rather than a sales tax). A VAT that does not allow for exemptions and special rates does not impose a VAT on businesses purchases.

For more information on the problems created by pyramiding, why it should be eliminated and ways to do so, see Report #2c at:

http://www.cob.sjsu.edu/nellen_a/TaxReform/21st_century_taxation.htm

What do you think?

2 comments:

Ian said...

An excellent article! And one that provides ample support for the FairTax replacement plan currently sitting in committee in the House (HR 25) and Senate (S 1025). The FairTax is now backed by five! presidential candidates [count 'em: Gravel (D), Huckabee (R - its most ardent supporter), Tancredo (R), Hunter (R) and Cox (R); even Ron Paul likes the basic idea of eliminating theIRS]. Readers are encourage to peruse YouTube, and prepare themselves to be surprised!

Here is why the FairTax will make a good U.S. tax system REPLACEMENT. The FairTax is:

• SIMPLE, easy to understand
• EFFICIENT, inexpensive to comply with and doesn't cause less-than-optimal business decisions for tax minimization purposes
• FAIR, loophole free and everyone pays their share
• LOW TAX RATE, achieved by broad base with no exclusions
• PREDICTABLE, doesn't change, so financial planning is possible
• UNINTRUSIVE, doesn't intrude into our personal affairs or limit our liberty
• VISIBLE, not hidden from the public in tax-inflated prices or otherwise
• PRODUCTIVE, rewards, rather than penalizes, work and productivity

Its benefits are as follows:

FOR INDIVIDUALS:
• No more tax on income - make as much as you wish
• You receive your full paycheck - no more deductions
• You pay the tax when you buy "at retail" - not "used"
• No more double taxation (e.g. like on current Capital Gains)
• Reduction of "pre-FairTaxed" retail prices by 20%-30%
• Adding back 29.9% FairTax maintains current price levels
• FairTax would constitute 23% portion of new prices
• Every household receives a monthly check, or "pre-bate"
• Pre-bate equals payback for taxes on spending to poverty level
• FairTax's pre-bate ensures progressivity, poverty protection
• Finally, citizens are knowledgeable of what their tax IS
• Elimination of "parasitic" Income Tax industry
• NO MORE IRS. NO MORE FILING OF TAX RETURNS by individuals
• Those possessing illicit forms of income will ALSO pay the FairTax
• Households have more disposable income to purchase goods
• Savings is bolstered with reduction of interest rates

FOR BUSINESSES:
• Corporate income and payroll taxes revoked under FairTax
• Business compensated for collecting tax at "cash register"
• No more tax-related lawyers, lobbyists on company payrolls
• No more embedded (hidden) income/payroll taxes in prices
• Reduced costs. Competition - not tax policy - drives prices
• Off-shore "tax haven" headquarters can now return to U.S
• No more "favors" from politicians at expense of taxpayers
• Resources go to R&D and study of competition - not taxes
• Marketplace distortions eliminated for fair competition
• US exports increase their share of foreign markets

FOR THE COUNTRY:
• 7% - 13% economic growth projected in the first year of the FairTax
• Jobs return to the U.S.
• Foreign corporations "set up shop" in the U.S.
• Tax system trends are corrected to "enlarge the pie"
• Larger economic "pie," means thinner tax rate "slices"
• Initial 23% portion of price is pressured downward as "pie"
increases
• No more "closed door" tax deals by politicians and business
• FairTax sets new global standard. Other countries will follow

It is essential that readers sign-up at FairTax.org, visit the "Co-Sponsors Gallery," and - if their representatives are not listed - contact their legislators to support the FairTax. Politicians only move under the force of constituent numbers. It's time to extract the embedded taxes that cause American exports price penalty of 22%, on average, and penalize capital and business formation on our shores.

Annette Nellen said...

Thanks for the post!

The Fair Tax calls for a national sales tax at a 23% rate that replaces income, payroll, estate and gift taxes. States would administer the tax so the IRS could be abolished.

This is an interesting proposal, but has some challenges including:

1. The rate is too high. Typically, rates above 10% tend to lead to tax evasion.

2. A few states do not have a sales tax. Also, isn't an IRS needed to administer the tax for these states and to help ensure uniform interpretation of the rules, as well as enforce compliance?

3. The federal sales tax doesn't match state sales taxes (which differ widely). Unless states conform to the federal (which will also make the rate greater than 23%), it will be confusing for states and taxpayers. Also, taxpayers are not ready to pay up to perhaps 31% when they buy goods. This is a very obvious tax compared to income tax withholding taken from paychecks. People will forget that there is no federal income tax withholding from their paychecks and just focus on the 23% federal and 4 - 8% state sales tax tacked onto all of their purchases of goods and services.

4. Most states with an income tax conform much of it to the federal income tax. If the federal income tax is abolished, states are unlikely to do the same due to revenue needs and the need to have a range of taxes. Most individuals will still have to deal with income tax calculations at the state level.

I view the Fair Tax as something to put into the tax reform debate so that a range of options and their pros and cons can be evaluated. I don't think it will be a viable tax, but some of its elements - such as not being a pyramiding tax (or at least to teh degree state sales taxes are today), are worth discussing in the broader tax reform debate.