Learn how the economy actually functions and how all federal taxes can be eliminated and replaced by a low percentage sales tax. No income tax, no payroll taxes, no tax on capital gains or interest, no estate tax or gift tax, no saving receipts, no filing of tax returns. Sales tax collected by retail businesses is all we need to create a robust thriving economy.
Understanding the economy has been an elusive goal of economists, politicians, and the general population. A new tool which sheds light on the workings of the economy is the Tax Flow Diagram. It illustrates how money circulates in the economy as it is spent on goods and services and as it gets taxed by the government. The simplest Tax Flow Diagram has just one parameter, the federal tax rate, which we'll adjust to see its effect on prosperity.
Although we'll see that it's way too high, let's initially set the tax rate to 50% to keep the math simple. The economy consists of a group of people willing to participate in transactions with each other but they start out with no money.
The economy gets started when one of the people in the economy gets their paycheck for $1,000.
With a tax rate of 50%, they pay $500 to the government and spend the remaining $500 on goods and services. At this point already half of the money has been removed from the economy. The remaining $500 ends up in the hands of other people in the economy who collectively pay $250 in tax and spend the remaining $250.
The $250 spent winds up as income for more people in the economy who pay $125 in tax and spend the remaining $125. At this point the government has collected $875 of the initial $1000 and with each new transaction there is less money circulating in the economy.
Eventually the entire $1000 has been collected by the government as tax, and a total of $2000 of economic activity has taken place.
This process is repeated throughout the economy. Everyone's paycheck gets taxed over and over again until there's no money left to make transactions. All of the money winds up in the hands of the federal government. So where does the initial $1000 come from? It must be from the federal government! The first person in the Tax Flow Diagram is either a government employee or receives money from the government such as by Social Security.
The tax rate determines how much economic activity can take place. At 50%, we see that $1000 spent by the government leads to a total of $2000 in economic activity, a factor of 2, which is the reciprocal of the tax rate. This is called the Currency Availability Multiplier or CAM.
CAM = 1 ÷ TaxRate
With a CAM of 2, each $1000 of government spending yields just $2000 of economic activity, so if your economy is $22 trillion dollars, the government would need to spend at least $11 trillion. Obviously the government should not be this large, most economic activity occurs between non-government employees. Lowering the tax rate increases the CAM multiplier, so we can increase economic activity without any extra government spending.
When the tax rate is so high, there are skewed incentives. You earn $1000 but have to give half of it to the government. This means you gave your employer $1000 worth of work but only received half of your value. Or perhaps you only produced $500 worth of work and your employer paid twice as much for it.
Now let's look at what happens when the tax rate is reduced to 10%. The initial $1000 salary in the Tax Flow Diagram results in a tax bill of just $100, leaving the person with $900 to spend on goods and services. The government would worry that they're not taxing enough since the rate was cut 80%. The common thought is that raising tax rates increases revenue and cutting tax rates reduces government revenue. But this is not the case, the government still collects the entire $1000 income, it just takes more transactions since the payments are smaller.
The amazing thing is how much more prosperous everyone is. The first person gets to keep $900 after paying their tax bill, an 80% increase over their income when the rate was 50%. The second person fares even better. Instead of $250, they retain $810, an increase of more than three times. Overall the total economic activity is $10,000, a five fold increase. The CAM multiplier is 10, the reciprocal of the tax rate. To achieve a $22 trillion dollar economy, the government just needs a budget of $2.2 trillion.
Let's look at what happens when the tax rate is raised. The government might try raising the tax rate from 50% to 60% in an effort to increase revenue. We see from the Tax Flow Diagram that the initial $1000 paycheck leads to just $400 spending by the recipient, a decrease of 20%. The next person gives up $240 in tax and is left with just $160 in take-home pay, a reduction of 36%. It gets worse the further away you are from the first transaction.
Notice that the government still collects just $1000 since this is all there is! Raising the tax rate does not lead to more goverment revenue, it shrinks the economy. A 60% tax rate yields an economy with a CAM multiplier of 1 ÷ 0.6 = 1.667, a reduction of 17% from when the tax rate was 50%.
But raising the tax rate does increase revenue, so let's look at why this happens. The economy was working well at 50% but the government raised the rate to 60%. The first person saw a reduction in take-home pay to $400 instead of $500. Their expenses are still $500 so they use $100 of their savings to make up the shortfall. The next person still earns $500 but they have to give $300 to the government instead of $250, so they pull $50 out of their savings as well.
Overall government revenue has increased 20% to $1200 and the total economic activity has remained at $2000, the same as it was when the tax rate was 50%. But this is unsustainable. The increased revenue is the result of people spending their savings, which will eventually run out, forcing people to cut back. Or worse, people need to use credit cards to supplement their after-tax income, with little prospect of being able to pay them off.
Too-high tax rates caused the Great Depression by depleting the savings of the middle and lower classes.
Let's investigate how state and local governments are affected by high federal tax rates. The first example is again a total tax rate of 50% with a split of 40% federal tax and 10% local tax. The Tax Flow Diagram works the same way as when the tax rate was 50%, but a fifth of the tax revenue goes to the local government. The same amount of economic activity occurs, $2000, with the federal government collecting $800 and the local government earning $200.
But this is not the end of the story. The local government is just another actor in the economy so they spend their $200 tax revenue which kicks off another copy of the Tax Flow Diagram with an initial salary of $200 instead of $1000. The economy adds an additional $400 of transactions while the federal government collects another $160 and local government gets $40. The process repeats with local government spending the $40 tax revenue.
Total economic activity is $2,500, the CAM multiplier is equal to 2.5 since the federal tax rate is 40%. The federal government collects the entire $1000 initial salary, while the local government raises $250.
Something amazing happens when the federal government lowers its tax rate. Without making any changes itself, the local government sees much more revenue. When both the federal and local governments employ 10% rates, collections total $500 each and economic activity is $5000. But again, the local government spends the $500 it raised which kicks off another tax flow. The process repeats with the governments each earning $250, then $125, then $63, etc.
In total the local government earns $1000, the same as the federal government, four times as much as when the federal tax rate was 40%. Local governments will be able to not only balance their budgets, but they will be able to lower their tax rate too.
So far we have seen that the federal government collects every dollar it spends, which is the definition of a balanced budget. But the reality is there is often a budget deficit where the revenue from taxing the citizens doesn't equal the spending outlays. The culprit is the trade imbalance with foreign countries. When we purchase more imports than other countries buy our exports, the money spent leaves the economy so it does not participate in the Tax Flow Diagram or the Currency Availability Multiplier.
Consider the economy where the federal government taxes at 40% and 10% of citizens' spending is on imported goods. The first person in the Tax Flow Diagram earns $1000, pays $400 in taxes, spends $500 on domestic goods, and buys $100 worth of imports. The $100 of imports is gone, it's not taxable by the federal government. The next person earns $500, spends $200 on taxes and $50 on imports. The process repeats with more money leaving the economy due to the trade imbalance. Total spending on imports is $200, total economic activity is $2200, and total federal government taxation is $800.
In this example, there is a $200 deficit; the government spent $1000 but only received $800 in tax revenue. Politicians and economists declare that the budget is not balanced and look for ways to borrow the missing $200. The right way to treat the missing $200 is to simply put it in a new column of your budget spreadsheet for funds which have escaped the US economy. In this way the budget is always balanced, the federal government just spends what it's going to spend and receives revenue from taxing the citizenry according to the Tax Flow Diagram and Currency Availability Multiplier (CAM).
A deficit should not be looked at as undesirable. It's a sign that foreign countries want our dollars and are willing to supply us with products that are cheaper for them to make versus being made in the US. This situation has come about because our economy has some inflation (roughly 2%) every year, leading to rising prices. The same level of inflation is not seen in foreign countries so they are able to undercut US manufacturers, leading to more imported goods. If we can put a stop to inflation here in the US, eventually the value of the dollar in foreign countries will rise to match our own valuation and the budget deficit will shrink.
Now for an unexpected result, let's look at what happens when there is a federal budget deficit and no federal taxes at all. As before, the first person in the Tax Flow Diagram collects $1000 in salary and spends it all, without taxes, with $100 going toward the purchase of imports. The next person earns the $900 left over and spends $90 on imports and $810 on domestic goods. Total economic activity is $11,000, spending on imports is $1000, and no money was spent on taxes.
Forbes Magazine published in 2008 an economic tool called the Tax Misery Index. They looked at the various taxes each country levied on their population and added the rates together to come up with a misery score. The worst country in the study was France with a score above 160%. Obviously a government can't take more than 100% in taxes so there must be a better way to massage the data. I propose a better way by looking at how much is left over after each tax is levied, and determining the equivalent of a single tax. The CAM multiplier is easily found once you have reduced the data to a single tax, it is just the reciprocal of the effective tax rate.
In the case of France, the corporate income tax is 34.4%, so 65.6% of income is retained. Personal income tax is 51% so 49% remains. Forty−five percent disappears due to employer social security so 55% is kept. Employee social security takes 15%, leaving the person with 85% of earnings, and finally 19.6% VAT (Value Added Tax) leaves 80.4%. The effective tax rate is found by multiplying all of the retained funds together:
|RetainedFundRate||=||0.656 × 0.49 × 0.55 × 0.85 × 0.804|
|EffectiveTaxRate||=||1 − RetainedFundRate|
|CAM||=||1 ÷ 0.88|
Here are the Tax Misery rankings of a few of the countries highlighted in the 2008 report. When you look at the CAM multiplier you can see why the economies of the world are struggling. The multipliers are so low there is not enough currency available to make a thriving economy. The solution is to get rid of all taxes except for one, and to adjust the tax rate to achieve the appropriate CAM multiplier. The highest multiplier in practice today is achieved by Qatar's sole 12% corporate income tax.
We have seen from the Tax Flow Diagrams that we only need one tax to create a prospering economy, and the tax rate is chosen to provide a large enough CAM multiplier so that there is enough currency available to facilitate all of the transactions people want to make. Federal taxation is not about raising revenue to fund the government, the purpose is to slowly pull currency out of the economy to limit the economic activity to an appropriate size.
The Tax Flow Diagrams above all utilize an Income Tax with a single tax rate, but let's investigate whether there is a better tax to choose for creating a robust economy.
The arsenal of taxes available in the US are the Personal Income Tax, Corporate Income Tax, Social Security and Medicare Taxes (Payroll Taxes), taxes on Capital Gains and Interest, Estate Tax (also known pejoratively as the Death Tax) and Gift Tax, and various Excise Taxes (taxes on specific products). One tax that the US does not currently have is a federal Sales Tax, and it turns out that this is the best single tax to create a functioning economy.
The criteria for selecting a tax to be used in creating a robust
Let's look at how each of the taxes fares when trying to create a robust economy:
|Personal Income Tax||X||X||X|
|Corporate Income Tax||X||X||X||X||X||X|
|Tax on Capital Gains||X||X||X||X||X||X|
|Tax on Interest||X||X||X||X||X|
The only tax which checks all of the boxes is a federal Sales Tax. It's simple − all retail purchases have a tax added just like the state or local sales tax. It's extremely efficient since there is virtually no paperwork needed − people and businesses don't need to keep receipts or submit tax returns. One hundred percent of income earned is kept by workers which they can choose to invest or spend as their needs dictate. One hundred percent of capital gains and interest earned are kept by investors. One hundred percent of your assets go to your heirs when you die. Gifts of cash or property can be freely given to whomever you want with no limit and no payments to the government. The hundreds of billions of dollars spent annually on complying with the tax code and the billions of hours wasted can be put to better use.
The only records which need to be kept are sales taxes collected by retail businesses, which are remitted to the federal government. They already do this for local governments so the added burden will be minimal. The IRS or Federal Reserve can be repurposed to collect the sales tax and to monitor the economy to determine the sales tax rate and to adjust it as needed. As the economy grows, the sales tax rate must be decreased to increase the CAM multiplier.
The tax rate in the Tax Flow Diagrams assumes that the tax is an income tax with tax taken out of your paycheck. The sales tax is different; it's added onto purchases as funds are spent in the economy. There's a simple conversion for determining the equivalent sales tax rate:
SalesTaxRate = IncomeTaxRate ÷ (1 − IncomeTaxRate)
For example, if the income tax rate is 50% and $1000 is earned, $500 is spent and $500 goes to the government. Looking at the same example as a sales tax, 100% of the $500 spent is sent to the government.
The lower the income tax rate, the closer is the sales tax rate:
|Income Tax Rate||Sales Tax Rate|
Now let's look at all the other taxes to see why they're inferior to the Sales Tax.
We see from the Tax Flow Diagrams that an economy can function with a personal income tax with a single tax rate levied on everyone equally. The current income tax in the US is much more complicated, requiring thousands of pages of documentation to describe all of the intricacies. In its current incarnation, the personal income tax is not suitable due to the progressive tax brackets where higher income earners pay a higher percentage of their earnings. This is due to the erroneous thinking that federal taxation is meant to raise revenue to fund government activity.
A much simpler income tax with a single tax rate would be adequate to create a thriving economy, but it still requires payments to the government by each individual worker. These payments would likely be collected by their employers similar to how taxes are withheld today. A bigger problem with the personal income tax is the fact that it is taken out of a person's income before they have made any purchases or investments. A better way to collect taxes is as a sales tax which is directly linked to economic activity, and which is a much more efficient way to collect the tax.
Corporations are taxed based on their profits, not on products sold, so there is not a direct link between economic activity and taxes raised from businesses. Far from simple, much of the thousands of pages of the tax code deal with corporate taxes, and businesses waste a lot of time and money making decisions based on how their taxes will be impacted, rather than on the desirability of the decision.
Payroll Taxes are collected from employers and employees to fund the Social Security & Medicare programs. They are similar to a flat income tax, though there is a cap to the Social Security tax. With the cap lifted, the Payroll Taxes could be used to create a thriving economy by setting the tax rate according to the CAM multiplier of the Tax Flow Diagram. However, the efficiency of collecting the Payroll Taxes is no match for the simplicity and ease of collecting a Sales Tax.
Taxes on Capital Gains and Interest are relics of the erroneous thinking that taxes are meant to raise revenue for the federal government. Up to a third or more of profits from the sale of assets which have appreciated in value, or interest earned in a bank account, for example, is relinquished to the government. These taxes are devastating to investors who are trying to build an investment portfolio to fund their lifestyle and retirement.
For example, if you were to purchase a stock for $100 per share and the value increased over some time period to $200 per share, you would have to pay tax on the $100 gain. If the Capital Gains Tax rate was 35%, you would only receive $165 for your shares, much less than the value of the commodities. Or if you are unfortunately selling an asset which has gone down in value, the government doesn't offer a rebate on the loss.
Record keeping is onerous as well for the Capital Gains Tax since the tax is applied to the gains made over and above the purchase price. If you continually invest in stocks over many years, a list of the purchase price of each individual share must be kept in order to properly calculate the gains associated with the sale.
Tax on interest earned is even more insidious since it affects the performance of the investment. The "Rule of 72" is an approximation for how long it takes an interest−bearing investment to double in value at a given interest rate. For example, a loan which earns 6% annually will double in value in about 72 ÷ 6 = 12 years. However, when the federal government collects a third of the interest earned each year, you are actually only receiving a return of 4%, so by the Rule of 72, your investment takes 72 ÷ 4 = 18 years to double in value. Over many decades, this reduction in performance is a disaster.
At the end of your life, the federal government takes a hefty portion of your estate in an attempt to raise revenue. As has been said many times, the purpose of federal taxation is to create an economy of the appropriate size for the population, not to raise revenue for government operations, so taking assets from the estates of deceased persons is an antiquated concept. As much as 40% or more of a large estate can be demanded by the government, which is disastrous to the surviving heirs.
Since the estate will consist of appreciated assets, and maybe even a family business, there is not a pile of cash from which the 40% share can be gotten. To comply with the demand for 40% of the cash value of the estate, many of the estate's assets will need to be sold. In the case of a family business, it may not be possible to sell half of the business and still be a viable operation, destroying the legacy of the decedent. Also as mentioned, the Capital Gains Tax will apply to the sale of the appreciated assets, so more than 40% of the entire estate will need to be sold in order to net 40%.
The Gift Tax exists because the government wants to prevent you from giving your assets away before you die and not paying the Estate Tax. You are allowed to give a small amount of money away each year with no tax penalty, but this amount is barely above the poverty line. Giving money away to people in need should be encouraged since the recipients may need to rely less upon social welfare programs. Since the Estate Tax and Gift Tax were designed to raise money to fund the government, which we've learned is the wrong way to think about federal taxes, they are no longer needed.
Excise taxes are on specific products like gasoline, cigarettes and alcohol. These taxes are meant to raise revenue for the federal government in addition to attempting to influence behavior (i.e. they are trying to deter smoking and curb drinking alcoholic beverages). Since the purpose of taxation is to create an economy of a specific size, the one tax needs to cover all transactions, not just a small collection of products. Attempts to influence behavior by applying taxes to controversial products is unjust.
The US fortunately does not have a Value Added Tax as many other countries do. It's a complex scheme where businesses pay a tax on the amount of value they add to an item as it gets closer to sale. It's often conflated with being a form of sales tax, but it's not nearly as efficient since it requires a lot of bookkeeping.
One of the more successful economic theories is the Laffer Curve championed by economist Arthur Laffer. It attempts to find the optimal tax rate for the government to maximize its revenue.
It is simple to explain. If the federal government had a tax rate of zero percent, they would collect no revenue from economic activity. If instead the government taxed at 100 percent, taking all of your earnings, there would be no incentive to work so they would also get no revenue. A graph showing the tax rate on the horizontal axis and tax revenue on the vertical axis must start at zero revenue at a zero percent tax rate, rise to a maximum somewhere between zero and 100 percent tax rate, and then fall back down to zero revenue at 100 percent tax rate. The peak in the curve is at t*, the optimal tax rate for maximizing government revenue.
If the current tax rate is to the left of t*, then an increase in the tax rate will result in more government revenue, or if the current tax rate is to the right of t*, then a reduction in the tax rate will result in more revenue.
Occasionally economists on the news will ponder whether we're currently taxing more or less than the optimal rate, t* of the Laffer Curve and offering their opinion on what to do.
Unfortunately the Laffer Curve is defective and does not offer any insight into setting the tax rate. The problem, aside from the bigger question of why economists think the optimal government tax rate is where they harvest the most revenue from taxpayers, is that the horizontal axis is supposed to have only one varying parameter, the tax rate. But the Laffer Curve has full employment at a tax rate of zero percent, and a hundred percent unemployment at a tax rate of 100%. If the level of employment remained the same at each tax rate, the government would certainly raise a lot of revenue as the tax rate climbed.
We saw in the Tax Flow Diagrams above that the federal government can only collect in taxes the amount it spends in the economy (if people are not forced into spending their savings or borrowing on their credit cards). Government revenue is the same at every tax rate, the variable is the CAM (Currency Availability Multiplier) which determines the size of the economy. A more accurate version of the Laffer Curve follows:
The optimal tax rate, t*, is the reciprocal of the CAM multiplier, which is the Total Economic Activity (TEA, also known as the Gross Domestic Product or GDP) divided by government revenue.
|t*||=||1 ÷ CAM|
|=||GovernmentRevenue ÷ TEA|
Varying the tax rate changes the CAM multiplier. If the tax rate is increased above t*, the CAM goes down and the economy shrinks, resulting in less economic activity. The economy supports fewer transactions at a higher tax rate, forcing people to do with less, or to spend some of their savings or even to go into debt.
Reducing the tax rate below t* increases the CAM and leads to higher TEA/GDP. If the increase in CAM is small, the economy can absorb the added economic activity without leading to inflation. Too much and there aren't enough surplus goods to keep the size of the economy in check.
The US did not always have an income tax. Passage of the Sixteenth Amendment to the Constitution in 1913 marked the time when the personal income tax became a permanent US tax. The initial tax brackets were single digit percentages from 1% for the lowest earners up to 7% for the wealthy.
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