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National Retail Sales Tax: How much avoidance and evasion would there be?

Advocates of the national retail sales tax claim that tax avoidance and tax evasion on legally generated income would decline and that tax revenue collected from the underground economy would rise significantly. Critics view these claims as somewhere between overoptimistic and nonsensical. The President’s Advisory Council on Tax Reform noted in its final report that "A federal retail sales tax assessed at a rate of at least 34 percent, added on to state retail sales taxes, would provide substantial inducement for evasion at the retail level."

  • By eliminating the current tax system, the national retail sales tax would eliminate the use of current avoidance and evasion schemes, but that does not mean it would eliminate avoidance and evasion. It would simply change the locus and nature of such activities.
  • The overall rate of evasion of the U.S. income tax is estimated at around 15 percent, or possibly a bit higher. But this figure masks great heterogeneity in evasion by form of income. At one extreme, for income where taxes are withheld and reported to government by a third party (predominantly wages), the evasion rate is about 5 percent. At the other extreme, where taxes are not withheld and there is no cross reporting, the evasion rate is as high as 50 percent. A national retail sales tax would feature no withholding and no cross reporting, and so the possibility of high rates of evasion needs to be taken quite seriously.
  • Individuals might engage in tax avoidance under a national retail sales tax in several ways. They might misreport personal consumption as business activity, for example using the company car for personal use. The treatment of property that involves mixed consumer and business use would also be a problem, as would the verification of retail goods purchases by business representatives for personal use (think of a bar owner purchasing a television or a restaurant manager buying cooking supplies).
  • Previous studies have found a 13 percent "delinquency" rate for state sales taxes. This rate of evasion is lower than what would be expected under a national retail tax, since the tax rate under a national plan would be significantly higher than the rates applied by the states. Underreported sales would be much higher under a national retail tax than under current sales taxes, for two reasons: enforcement currently relies on cross verification with federal and state income taxes, and the effective state sales tax rates are currently quite low. Under a national retail sales tax, both of these conditions would change.
  • One of the major claims of national retail sales tax advocates is that it would be more effective than the current system at raising revenue from the underground economy. The example frequently offered is that of a drug dealer who does not pay income tax on his earnings today but would be forced to pay the national retail sales tax if he took the funds and bought, say, an expensive car. The problem with this argument was laid out by former Congressman Dick Armey: "If there is an income tax in place, he [the drug dealer] won't report his income. If there is a sales tax in place, he won't collect taxes from his customers" and send them to the government. In the end, neither system taxes the drug trade.
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