National Retail Sales Tax: What transition rules would be needed?
Any tax reform that seeks to collect the same amount of revenue in a new way may redistribute tax burdens among taxpayers, affect asset values, and change price levels. Those who stand to lose often seek to prevent the reform or to secure "transition relief," which avoids or delays the full brunt of the new law. The national retail sales tax proposal illustrates these issues starkly, because it would impose a single tax rate on all consumption, with limited, or no special provisions and only limited transition relief. A practical question is whether such a proposal can withstand the inevitable political pressures to restore preferential treatment or introduce transition relief. The issue is pivotal, because adding these changes would fundamentally alter the character of the reform.
Determining how to handle these transition issues creates an interesting dilemma. At one extreme, the pure sales tax would allow no adjustments. At the other logical extreme, policymakers could choose to grant extensive "transition relief," by adjusting Social Security benefits, allowing consumption to be tax-free if financed by assets existing at the time of the reform, and so forth. In practice, the transition relief that has accompanied much smaller tax reforms has tended to turn into a bonanza of hidden tax breaks and subsidies.
- The economic case for transition relief depends on the impact of such relief on the simplicity, efficiency, and equity of the tax system. Not providing transition relief is, in a sense, simpler. Transition rules could prove very complex, and the transition period could stretch out for years. However, not providing relief would also cause complexity by instituting strong incentives for individuals to adjust their behavior before the tax takes effect.
- Not providing transition relief would also be more efficient. Because future consumption can be financed only from future wages or existing assets, a consumption tax is a tax on those wages and assets. A consumption tax that exempts old assets is just a tax on future wages. Whereas a pure consumption tax (one that taxes all old capital) is usually found to be more efficient than a pure income tax, a wage tax (which exempts all old capital) is usually found to be less efficient than a pure income tax. The reason is that not taxing existing assets requires higher tax rates on the rest of the tax base to raise the same revenue, and this creates more distortions of people's work decisions.
- Surely the strongest argument for transition relief is fairness. The assets that people own today were priced, purchased, and used under the current tax system. Is it fair to them to change the rules in midstream? But the answer may not be as obvious as it seems. First, a one-time implicit tax on existing capital would be very progressive. The distribution of such capital is more skewed toward wealthy households than is the distribution of overall wealth, which in turn is more skewed than the distribution of income. Second, within any age group, wealthy households do most of the saving. Since these households will benefit most from eliminating the double taxation on future saving, it is reasonable that they should pay for some of the costs. Third, older households tend to have more assets than younger ones, and therefore taxing existing capital places heavier burdens on older generations. But those older households have received transfers through Social Security and Medicare that far exceed what they have put in. And the vast majority of the income and wealth of most elderly households is in the form of earnings (which have not yet been taxed), housing (which receives extraordinarily preferential treatment under the current tax system), pension income (which already receives consumption tax treatment), Social Security benefits (which everyone agrees would be indexed for inflation with tax reform), and Medicare benefits (which are not taxed). Relatively few elderly households finance much of their living expenses from other assets, and those that do tend to be very well off.
- Ultimately, the political case for transition relief would determine whether such relief occurs. And political factors overwhelmingly suggest that it would. Even in much smaller tax reforms, the losers-households or businesses made worse off by the reform-have been compensated. Transition relief would therefore almost surely be needed to garner sufficient support for major tax reform.