The Flat Tax Is a Consumption Tax

Now that we’re finally beginning to talk about tax reform to stimulate economic growth, the “flat tax vs. sales tax” debate has resurfaced.

This time, it’s resurfaced in the form of Herman Cain’s “9-9-9 Plan” vs. the flat tax proposals of Governor Rick Perry and others.

It’s a legitimate and important discussion, but it’s important for people to understand some key principles of tax policy before they begin opining on the various merits and demerits of the plans.

For instance, we’ve recently heard some objecting to the flat tax because “we need a consumption tax, not an income tax.” But this distinction is a false and unhelpful one.

“Consumption tax” relates to the tax base, or which activities a tax system actually taxes. “Income tax,” at least in the case of the flat tax, refers to the point of collection rather than to the tax base.

In fact, the flat tax is a consumption tax.

Confused? You’re not alone. Here’s why:

Think about your family’s economics. All of your money (other than taxes themselves) goes to one of two places: either to saving and investment or to consumption. That’s it. Every dollar that you earn, every dollar that passes through your family, goes to either saving/investment or consumption.

Because the flat tax proposal exempts all saving and investment from taxation, the only thing left to tax is consumption. Therefore, even though the flat tax is collected at the point of income, the tax base for the flat tax is consumption and only consumption. It’s a consumption tax collected at the payroll level rather than at the cash register.

The real economic questions associated with tax reform are related to the tax base (what’s being taxed) and the tax rate (or rates). Whether the tax is collected at the point of income, at the cash register, or even at the corporate level is more about politics than about economic impact.

Of course, compared to the disaster that is our current tax code, almost any rational plan would be an improvement. And Cain’s, Perry’s, Huntsman’s and the other Republican flat tax proposals share at least one thing in common: they’re rational.