U.S. Senator Ted Cruz (R-TX) at the 2015 Rising Tide Summit in Cedar Rapids, IA.
Photo credit: Dave Davidson (Prezography.com)
U.S. Senator Ted Cruz (R-TX) at the 2015 Rising Tide Summit in Cedar Rapids, IA.Photo credit: Dave Davidson (Prezography.com)
U.S. Senator Ted Cruz (R-TX) at the 2015 Rising Tide Summit in Cedar Rapids, IA.
Photo credit: Dave Davidson (Prezography.com)

Ted Cruz’s tax plan has many nice features, but the devil is in the details.  To be clear, every tax plan will have some problems. Almost every plan will be preferable to the current tax system. Cruz’s is an exception where the pitfalls outweigh the benefits despite benefits being substantial.

First of all,l what the plan does right. First of all, it gets rid of the Alternative Minimum Tax, the Payroll Tax,  and the Estate Tax while maintaining the Earned Income Tax Credit and Child Tax Credit, and replaces it all with a 10% Flat income tax. This would be a huge change and lead to Americans seeing a much larger share of their paycheck.

It’s a neat trick, and the question must be asked. How do they do it?  The answer is the same as with many other magic tricks: they do it with mirrors.

Corporate income taxes are replaced with a Business Transfer Tax of 16% which taxes all business income except for transfers to other businesses. What is taxed is every penny a company pays its own employees.

Senator Cruz bristled as Senator Marco Rubio’s suggestion in the last debate that his “Business Transfer Tax” was a VAT but as the Wall Street Journal says, “There’s no consumer-level tax, but economists across the political spectrum say it’s a subtraction-method value-added tax.”

The big problem with the tax is it’s completely non-transparent. The business is assessed the tax and it’s passed on to consumers in higher prices, shareholders in lower dividends, and workers in lower wages.

People who look favorably on Cruz’s plan point out that many thing Cruz replaces, such as the Estate Tax, the existing corporate Income Tax,  and the business portion of the payroll tax are already hidden from view.

These taxes are hidden, but they make up a much smaller portion of government revenues. In 2014, the employee portion of the payroll tax and the income tax, the two most transparent sources of revenue, accounted for 63% of Federal Receipts with 37% being more hidden taxes. However, based on an analysis by the National Tax Foundation, 71% of revenue under Cruz’s plan would come from this Business Transfer Tax. That 71 percent figure is before we even start to account for all the ways income taxes paid by business men and women, from plumbers to lawyers, are passed along to their customers.

The effect is to make the cost of government less transparent to the average taxpayer than under the current system. This lack of transparency in VATs has been used successfully by progressives in Europe to bring about tax increases to fund their big government programs.

When the Founding Fathers were crafting the Constitution, they looked at how different ideas worked around the world. When considering Cruz’s VAT, it’s helpful to consider how VATs the world over have grown and Diana Furgoth-Roth of the Manhattan Institute find VAT taxes grow dramatically over time:

…once the VAT is put in place, it is practically impossible to get rid of it. In countries that have it, the VAT rises over time incrementally and gives government immense power. Cruz and Paul are in favor of smaller government, but their suggested VATs would expand government clout. …parliaments, congresses, and assemblies don’t get rid of other taxes. They add the VAT on top of existing levies. …Due to their hidden nature, VATs tend to grow over time… From 1975 to the present, VAT rates have risen in the U.K. from 8% to 20%. …when imposed in 1967, Denmark’s VAT was 10%; it is now 25%… In 1968, Germany levied a 10% VAT…their VAT has risen “only” to 19%… Cruz and Paul make the VAT the centerpiece of their tax-reform plans. But America needs to move away from European policies, not towards them.

The problem with the tax as proposed by Cruz is it exacerbates the current system’s problem where the average taxpayer assumes they are getting government free or cheap when the cost of government is really going up. This point has real salience. Under Cruz’s proposed VAT, the average American will have no clue how much government costs them.

This will make life easier for demagogues, such as Bernie Sanders, who promise free stuff. How many people who receive a paycheck that shows Federal Taxes at less than 10% of their income in taxes are going to realize they are paying so much more through government indirectly in non-transparent hidden taxes? There’s some truth to the proverb a conservative is a liberal who got his first paycheck. If young workers never get sticker shock when seeing how much taxes come out of their paycheck, it could bring about the decline of fiscal conservatism in America.

Some future wrong could come with any tax reform, and I’m usually not sympathetic to that argument. Cruz’s plan is different for two reasons. First, the history of VAT taxes the world over shows how they go up. Second, we have the history of tax protests in the United States. In more than twenty years of following politics, I’ve seen lots of politicians get into trouble over raising taxes: income taxes, property taxes, sales taxes, and gas taxes. I’ve never seen mass tax revolt over a tax that does not affect people directly. That’s why there were not protests in the street when the Capital Gains Tax went up from 15 to 28% a couple years back. Simply put, it didn’t touch enough Americans directly for it to matter.

Further, Ted Cruz’s plan is a boon to outsourcing, where a company outsources certain of its functions to another company. The way these companies typically work is they offer large companies a chance to outsource their work, be it in manufacturing or customer service. The outsourcer may operate domestically in an area where they can pay lower wages or they may operate overseas.

The Cruz plan creates a perverse incentive for companies to outsource.  Imagine a tech company has technical support in Des Moines and they have a $10 million payroll and they pay their employees an average of $18 an hour. Under the Business Transfer Tax, if they keep their own employees in Des Moines, the company will have to pay a $1.6 million tax.  However, if the tech company contracts with an outsourcer to provide technical support for them for $10 million a year, they avoid the tax as the $10 million would be a transfer to another business.

Let’s say the outsourcer keeps operations in the U.S.  and ships the jobs to rural Kentucky where the outsourcer can get away with paying their employees an average $8.50-$9.00 an hour. The outsourcer will easily meets their payroll tax and pays their workers because they’re paying a lower wage. It becomes even easier if they ship the job to a country where they can pay $3-$4 an hour. A tax system that encourages companies sending jobs offshore has a serious problem.

Of course, there are other ways to get around the tax: hiring consultant businesses and temp workers rather than your own. The tax plan by Ted Cruz wouldn’t end the game corporate America plays with the tax code, only introduce new rules.

It also should be mentioned it doesn’t get rid of the IRS in a meaningful way. You can rename it Internal Review Reviewers, or the Department of Sunshine, Lollypops, and Unicorns. You can enact serious reforms in how the IRS operates. But, if you’re going to have a tax that requires Americans report all of their income, you’re going to need an agency like the IRS.

Ted Cruz’s tax plan would be a fiscal time bomb if enacted. Any of the conservative plans that flatten rates and increase transparency would be preferable.  The best of these, in my opinion, would be the Fair Tax which taxes consumption–once and transparently–at the point of purchase. Through its pre-bate mechanism, it makes sure the poor aren’t victimized by the tax, but that all citizens are aware of the cost of government at every purchase. It is the only plan under which the IRS can be meaningfully eliminated as we would be free of the requirement to report our income and its sources to the Federal Government. Our own money will be our own business and not Uncle Sam’s business.

The Fair Tax plan is championed by Mike Huckabee. I’d encourage citizens to support Huckabee if they want real tax reform that doesn’t open the door to European-style big government that a VAT invites.

Disclosure: Adam Graham has endorsed Mike Huckabee for President and is author of the ebook, Road to Victory: A Conservative’s Case for Mike Huckabee and is host of the Truth and Hope Report Podcast which is currently airing a series, “Our Man Huck.”

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