Replacing all federal personal and corporate income taxes with a national retail sales tax would have a dramatic favorable effect on the U.S. economy.

• The saving rate, now at about 2.5 percent, would immediately triple.

• After beginning slowly, U.S. capital stock would gradually increase at least 29 percent and potentially as much as 49 percent.

• Over time, the increase in capital stock would raise per capita productivity by 7 percentage points, and increase real wages by 6 percent.

The reason is that a consumption tax, such as a sales tax, provides more incentive to save and invest than does an income tax. Saving provides the funds that business uses to engage in investment, which in turn leads to more capital stock, greater output and productivity and higher real wages.

A computer model indicates that a national sales tax of about 17 percent on all goods and services would be needed initially to replace the income taxes. As the change stimulated economic growth, the national sales tax rate could fall to 11 percent and still generate the same revenue as a percent of GNP.

Adjustments could counter two main arguments against such a tax:

• It would reduce the progressivity of the tax system - but a graduated refundable tax credit could overcome this.

• It would shift tax burdens to older generations that would have to pay a consumption tax on earnings on which they had already paid income taxes - but compensating them directly, e.g., by raising Social Security benefits, could overcome this.

Source: Laurence J. Kotlikoff, "The Economic Impact of Replacing Federal Income Taxes with a Sales Tax," Policy Analysis No. 193, April 15, 1993, Cato Institute, 1000 Massachusetts Ave., NW, Washington, DC 20001, (202) 842-0200.

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