In recent testimony before the President's Advisory Panel on Federal Tax Reform, Federal Reserve Chairman Alan Greenspan floated the idea of a consumption tax to replace all or part of the current income tax.

Citing the escalating concern that the aging Baby Boomers have not saved enough to fund their retirement, Greenspan suggested that the consumption tax could provide an effective incentive to greater national saving.

"As you know," Greenspan said, "many economists believe that a consumption tax would be best from the perspective of promoting economic growth ... because a consumption tax is likely to encourage saving and capital formation."

Promoting savings would provide benefits beyond the obvious need to provide for the retirement of the Baby Boom generation. Money that is saved is money that is available for lending and investing, measures that keep interest rates low and inflation down.

With a consumption tax, money is taxed when it is spent, instead of when it is earned. Essentially, all savings would be treated in a manner similar to traditional individual retirement accounts, where neither the money deposited nor the earnings on that money are taxed until they are withdrawn.

In order to continue supporting the government in the fashion to which it has been accustomed (with the obvious omission of the costs associated with the Internal Revenue Service, an agency that would become obsolete), a national sales tax would be enacted, at a rate high enough to raise an amount of money similar to today's income tax.

Greenspan reminded panel members of the need for simplification of the tax laws and referred to the massive 1986 tax reform as a prime example of tax simplification. However, he added that, "Unfortunately, tax code drift since 1986 has evolved to a point where taxpayers are again confronted with great complexity." He pointed to the proliferation of the alternative minimum tax and the complexities of the Earned Income Tax Credit as examples of tax code drift.

"Indeed, an individual taxpayer may have difficulty even knowing his or her marginal tax rate because of the overlapping web of deductions and exemptions and the provisions that attempt to limit those deductions and exemptions," said Greenspan in his remarks to the panel.

Sample taxes

One example of a consumption tax under consideration, the Fair Tax Act, currently before Congress (H.R.25), proposes a national sales tax of 23 percent and would include taxes on items such as new homes, prescription drugs and health care that are not currently subject to sales tax. The tax would replace all federal income and payroll taxes, including gift, estate, capital gain, alternative minimum, Social Security, Medicare, self-employment and corporate taxes. Included with the bill is a rebate that would prevent taxes from being assessed on Americans living below the poverty level. And the act would repeal the 16th Amendment to the Constitution, so that the federal income tax could not be reenacted at a later date.

Joe Moore, a partner with the San Francisco Bay-area firm of Armanino McKenna LLP, speculated that the imposition of a consumption tax "would have a devastating impact on the tax system as we know it now. Take H&R Block for example. Would they be needed any more?" Moore pointed out that H&R Block's stock value dropped following Greenspan's comments about the consumption tax.

Greenspan warned that any attempts to enact a consumption tax would be most effective if the tax system were being created from scratch. But such a circumstance is unlikely, and he suggested that a more realistic scenario would involve a combination of the federal income tax and a national consumption tax.

Clint Stretch, director of tax policy for Big Four firm Deloitte, recently speculated that beginning with a hybrid of income and consumption taxes could help pave the way for a transition to a consumption system.

Any implementation of a consumption tax, or a hybrid combination of federal income and sales tax, would most certainly require some phase-in time. The National Retail Federation estimated that the implementation of a national sales tax would result in a three-year slump in the economy, a four-year decline in employment, and an eight-year decline in consumer spending.

"Consumers would simply stop spending on anything but the barest necessities for a prolonged period of time," said Steve Pfister, the NRF's senior vice president for government relations.

Many have expressed concern that the tax would hike the price of necessary purchases, thus placing an unfair burden on the less affluent members of society. "Generally speaking, a consumption tax is normally a little more repressive on lower-income people," said Moore.

Michael J. Boskin, a senior fellow at the Hoover Institution think tank and a professor of economics at Stanford, agreed that a national sales tax is most controversial in the area of dealing with low-income households, as well as the area of taxing old capital. He also points to a concern that a national sales tax would be used as a tool for expanding spending rather than replacing income tax. However, he stated, "If it could completely replace the corporate and personal income tax, a national retail sales tax probably in the end would be the simplest to administer and do the best job at getting at the underground economy."

Boskin suggested that replacing the tax structure with a consumption tax could improve gross domestic product as much as 10 percent per year. "This occurs because the increased saving and capital formation increase wages and future income."

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