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How a national sales tax could solve America's inequality problem

February 18, 2014: 9:08 AM ET

If the U.S. uses a national sales tax to bolster the social safety net -- programs like Medicare, Social Security, food stamps, and Medicaid -- it could reduce income inequality, argues a new study.

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FORTUNE -- You may think you've been hearing a lot about income inequality lately, but just you wait. The November elections aren't going to be fun for Democrats, and the bad hand that the middle and working classes has been dealt is one of the few topics where Congressional Democrats will have an advantage with voters.

The problem for these politicians is that it isn't exactly clear how government power can address inequality, at least in a way that's politically palatable. Income taxes on the wealthy have already gone up significantly since the beginning of President Barack Obama's first term, while increasing entitlement benefits is dangerous given the already unsustainable path those programs are on.

MORE: Tom Perkins: Taxes will lead to 'economic extinction' of the 1%

So what's a left-leaning politician to do? Institute a national sales tax, argues Reuven S. Avi-Yonah, a professor of law at the University of Michigan. In a new paper, he lays out a case for taking action on inequality, providing this illuminating chart, which shows the differences in income inequality levels among several of the leading economies since World War Two:

gini index income disparity since world war ii

As you can see, the U.S. has seen a rise in income inequality, as measured by the Gini Coefficient, and ranks as one of the most unequal developed economies. What separates the U.S., with its high levels of inequality, from countries like Germany and Japan, which are more egalitarian? Well, one thing is a national sales tax, otherwise known as a value added tax. This is a bit counterintuitive since sales taxes are thought to hit the less affluent harder than income taxes. That's because sales tax rates are the same regardless of your income, and low-income earners spend more of their total income than the wealthy on sales taxable purchases.

MORE: The depressing reason you're about to get a raise

But Avi-Yonah argues that what's done with those sales tax receipts is more important. If we use a sales tax to bolster the social safety net -- programs like Medicare, Social Security, food stamps, and Medicaid -- then even a regressive tax could work to reduce income inequality. Stronger social security will help the baby boomer generation, which has lived through an era in which private companies have abandoned guaranteed pension schemes yet members of this generation have not saved for retirement by other means. Other programs will help those on the lower end of the income spectrum, who have been left behind amid a rapid transformation of the U.S. economy and the disappearance of medium-skill, middle-class jobs. In fact, such measures may be necessary to maintain social cohesion and an open economy, Avi-Yonah writes:

Strengthening the social safety net is important to sustaining growth. Open economies tend to have stronger safety nets, because the gains from having an open economy tend to impose risk on the people who lose from globalization, so that a strong safety net is in a democracy a precondition to obtaining widespread political support for openness, which in turn produces growth.

Why use a national sales tax, rather than a progressive income tax, to finance an expansion of the welfare state? First of all, it's easier to avoid income taxes than it is to avoid sales taxes. Wealthy Americans have all sorts of ways of sheltering their income, and such deductions make financing government spending difficult. Second, sales taxes are paid by all segments of society -- working and nonworking people alike -- giving it a broad financial base. Meanwhile, the current system for financing the safety net requires taxing young and productive workers to help older and unproductive workers, which Avi-Yonah argues is fundamentally unstable. Third, a sales tax is much cheaper to administer than income taxes.

The only catch, of course, is that enacting a new tax isn't exactly popular. But Avi-Yonah believes the example of countries like Australia makes him hopeful that it's possible to build this system in the U.S. "Good politicians like John Howard of Australia have managed to build a broad legislative coalition to enact a VAT even after promising not to do so, and win reelection decisively."

Then again, John Howard didn't have a Tea Party to deal with.

Editor's note: A previous version of this story incorrectly noted that Reuven S. Avi-Yonah is a professor at Michigan State University. Avi-Yonah is a professor at the University of Michigan. 

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