FairTax

FairTax is a proposal in the United States of America to impose a national sales tax and end the following federal taxes: personal income taxes, payroll taxes, corporate taxes, capital gains taxes, self-employment taxes, gift taxes and inheritance taxes. The FairTax plan will pay to all citizens a monthly entitlement equal to the average sales tax paid on necessities by similar individuals. The payment is meant to ensure that no American pays taxes on necessities up to a spending limit equal to the federal poverty level.

FairTax is essentially a national sales tax that includes a fixed monthly payment to all households.

Legislative overview

The FairTax bill was authored by Georgia Representative John Linder, a Republican.

2005

The FairTax legislation has been introduced in the 109th House of Representatives as H.R. 25 and in the Senate as S. 25. Its formal name is the Fair Tax Act of 2005. As of June 9, 2005, H.R. 25 has 36 co-sponsors. All sponsors are Republicans. John Linder remains the bill's primary sponsor, and House Majority Leader Tom DeLay and Speaker of the House Dennis Hastert support the bill. ^[1]

2003

The FairTax legislation was introduced in 2003 in the 108th Congress and had 56 co-sponsors. The bill did not move past the U.S. House Committee on Ways and Means.

The tax rate

In its current form, the FairTax legislation imposes a 23% inclusive sales tax and eliminates income, payroll, corporate, capital gains, gift and inheritance taxes. When paid, this would be a simple 30% federal sales tax. The FairTax legislation assesses taxes on the purchase of new goods and services. Used goods and education spending, as well as financial saving and investing would not be taxed. Families would receive monthly subsidy checks equal to the estimated amount similar families pay in sales taxes on necessities. The checks are meant to eliminate net federal sales taxes paid by families spending at or below the federal poverty line.

Due to the subsidy checks, the lowest effective tax rate under the FairTax plan is negative for families consuming less then the defined federal poverty line in new goods and services: the taxpayer receives more money from the government than they pay in sales tax. The effective tax rate to a family is variable, with a maximum rate of 23% for the most lavish spenders ^[2][3]. By choosing what to consume (used goods) or how much is consumed, the effective tax rate is in hands of the citizen.

When payroll taxes are factored in (7.65%), most taxpayers' federal tax liability is currently less than 23% of their adjusted gross income (AGI). The average income tax rate by itself in 2001 was 14.23% of AGI. ^[4] Together, the average income and payroll taxes replaced by the FairTax are 21.88%. While less than the stated 23% maximum rate of the FairTax, the average effective rate of the FairTax is much lower due to the monthly subsidy checks.^[5]

Other rate estimates

Congress’s Joint Committee on Taxation evaluated a similar proposal and determined that a revenue-neutral plan would require a sales tax rate of 36 percent inclusive, resulting in a national sales tax of at least fifty percent ^[6]. Other estimates range up to 50% inclusive, or a 100% sales tax on each purchase at the register. ^[7]

According to these estimates, adopting the FairTax proposal as written would require drastic cuts in government.

Inclusive and exclusive tax rates

When comparing tax rates, it’s important to understand whether the "tax inclusive" or "tax exclusive" rate is being quoted. One describes the rate with the tax included in the total, and the other, with the tax excluded from it.

The tax inclusive rate contained in HR 25 is 23%. This rate is comparable to the income tax, which is stated on a tax inclusive basis — that is, with the tax included in the wages. For example, if a person earns $40,000 and $9,200 in income tax and payroll withholding is taken from his paycheck, the $9,200 included in the wages, represents 23% of his income ($40,000 x .23 = $9,200). This leaves that person with $30,800 after taxes. Divide the $9,200 of taxes by the $30,800 in after tax wages to get the exclusive rate of 29.9%.

Under the FairTax proposal, if a person who makes a $100 purchase and $23 dollars of the purchase is tax, the tax inclusive rate is 23%. However, the $23 represents 29.9% of the $77 value of the goods purchased ($100 – $23 = $77). The 29.9% rate is called the "Tax Exclusive" rate. The two numbers are equivalent. If a person buys a $100 item, to pay the tax, a 30% sales tax will be added at the register, resulting in $130 out of pocket. This is the same rate, as $30 is 23% of $130.

Proposed changes to the tax system

FairTax supporters assert that it makes the true cost of government highly visible by explicitly stating the hidden taxes currently embedded in consumer products. Corporate taxes and compliance costs are embedded in the price consumer products and services because producers pass government-imposed costs to the consumer through higher prices.

The cost of preparing and filing all business and personal tax returns is estimated at over $250 billion each year. FairTax supporters argue that a simplified tax system will reduce these compliance costs and return a larger share of that money to the productive economy. If these costs are eliminated, free market pressures will force prices down an average of 22% for goods and 25% for services. Supporters state that consumers' net change will be near zero because the government can collect the same tax revenue in ways that are less damaging to the economy. This logic is endorsed by a recent letter to the commission on tax reform by dozens of leading economists.

The FairTax movement hopes to increase fairness in the tax system and reduce the bureaucratic costs of the current system, especially the Internal Revenue Service. Proponents claim that collecting taxes from retailers will produce lower compliance costs than collecting from individuals.

Opponents argue that the proposal would radically alter the distribution of tax burden among citizens. The federal income tax system is progressive, but sales taxes are regressive. Economist William G. Gale at the Brookings Institute writes: "Under the AFT proposal, taxes would rise for households in the bottom 90 percent of the income distribution, while households in the top 1 percent would receive an average tax cut of over $75,000." Gale continues, "If households are classified by consumption level, a somewhat different pattern emerges. Households in the bottom two-thirds of the distribution would pay less than currently, households in the top third would pay more." In addition, taxes as a percentage of disposable income for the wealthiest savers would fall nearly to zero, while rising the most for those just above the poverty line who have the least disposable income to save.^[8]

These conclusions are apparently contradictory; according to Gale, the FairTax proposal is regressive on income and progressive on sales. Classical economic analysis indicates that the marginal propensity to consume (MPC) decreases as income increases. Households at the lower end of the income scale are spending almost all of their income, while households at the higher end are more likely to devote a portion of income to saving. MPC tends to increase as wealth increases however. These facts explain the apparent contradiction in the data; households at the extreme high end of consumption often finance their purchases through dissaving, not income. This dissaving would be taxed as it becomes sales. Income earned and saved would not be taxed under the proposal. In other words, savings is spent at some point in the future and taxed according to that consumption.

Some economists believe that due to the subsidy checks, the tax burden would not necessarily shift from the wealthy to the less wealthy ^[9]. FairTax supporters claim that the tax burden shift is actually to those who do not pay taxes today.

Effects on Tax Code Compliance

Proponents of this tax say a key benefit of the FairTax is that underground industries in the United States (for example illegal drugs), which are estimated to total over $1 trillion each year, will be for the first time taxed (in the sense that even if the drugs themselves are not taxed, drug dealers will need to buy food, cars, etc, which will be taxed). That money will be directly taxed under the FairTax plan when illicit income is spent on consumption.

However, by FairTax supporters' own logic, underground industries are already taxed by the hidden taxes included in the price of goods and services, and the FairTax proposal will not actually change this. The primary difference is whether the tax is included in retail prices, or added on at the time of purchase.

Tax compliance

The current income tax system fails to collect on a significant percentage of taxes owed. The IRS estimates there are twenty additional cents of taxes owed on unreported income for every tax dollar collected. In 2001, the IRS estimated this shortfall to be over $312 billion ^[10].

Proponents of FairTax assert that a simplified tax mechanism will subject much of this unreported income to taxation. Some research supports the claim that simplified tax systems lead to greater compliance. The IMF found that Russia's transition to a flat tax increased income reporting from 52% to 68% in one year. Similar results have occurred in Slovenia ^[11].

For taxes such as ordinary personal income taxes on wages, where there is withholding and third party reporting to the federal government, tax evasion rates are about one percent. Where there is some reporting or withholding, the rate rises to 17 percent. However, for taxes such as the FairTax proposal that are not withheld and reported by an independent third party to the government, evasion rates rise to 30 percent or more. Evasion rates of only 20 percent would require raising the sales tax rate to over 51 percent. ^[12]

Black markets

Opponents of FairTax argue that imposing a national sales tax will drive transactions underground, creating a vast black market. This effect can occur for two primary reasons:

1. The first arises from the use of a sales tax rather than a value added tax (VAT). A VAT imposes a tax at every intermediate step of production, so the goods reach the final consumer with much of the tax already implicit in the price. Thus the retail seller has little incentive to conceal retail sales, since he has already paid much of the good's tax. Retailers are unlikley subsidize the consumer's tax evasion by concealing sales. In contrast, a retailer has paid no tax on goods under a sales tax regime. This provides an incentive for retailers to conceal sales and engage in "tax arbitrage" by sharing some of the illicit tax savings with the final consumer.
2. Under a sales tax regime, the purchase of intermediate goods is not taxed, since those goods are supposed to be used to produce a final, retail good that will be fully taxed. Individuals and businesses may be able to manipulate the tax regime by claiming that purchases are for intermediate goods, when in fact they are final purchases that should be taxed.

It is important to note that a VAT and a sales tax have no impact on who bears the tax burden. Rather, a VAT conceals most of that burden by distributing it along the value chain. In contrast, a sales tax explicitly identifies the entire tax amount on the consumer's receipt. Both tax strucures distribute the tax burden between the consumer and producer depending on a specific product's supply and demand characteristics.

Implementation hazard

If the FairTax bill is passed, elimination of the all other forms of taxation is not guaranteed, and passage of this measure may in fact simply add a new tax. The income tax is especially problematic, as it requires a repeal of the 16th Amendment to the Constitution of the United States to eliminate definitively ^[13]. Since passing this new tax plan would only require a simple majority in each house of Congress and the signature of the President, and repeal of a Constitutional Amendment must be approved by two thirds of each house of Congress, and three quarters of the individual states, it is very possible that passage of the FairTax bill will simply add another tax burden rather than replace an existing tax system.

Transition effects on savers

Because the FairTax proposal replaces various taxes with a single sales tax, individuals who live through the transition will experience unique effects.

In this case, individuals under the current system who accumulated savings from ordinary income (by choosing not to spend their money when the income was earned) paid taxes on that income before it was placed in savings. When individuals spend their money saved under the current system, that spending would be subject to new federal taxes. People living through the transition find both their earning and their spending taxed.

The FairTax proposal does not address the transition effect on taxpayers who have accumulated significant savings from after-tax dollars, especially retirees who have finished their careers and switched to spending down their life savings. Under the FairTax proposal, this money would be fully taxed again as it is spent. Critics have spoken out against the FairTax proposal, claiming that it would result in double taxation. ^{[14] [15] [16]}

FairTax supporters claim that the current system is no different; due to "hidden taxes" embedded in the current prices of goods and services, savings are being taxed a second time already when spent.

Other indirect effects

Like any government policy change, the FairTax proposal would cause several other consequences.

• States and municipalities would see their cost of debt increase- currently, the federal income tax system provides tax advantages to state and local government bonds. Specifically, the interest paid on those securities are exempt from federal taxation. This "tax discount" allows state and local governments to issue debt at low yields, which reduces their interest costs. The FairTax plan squashes the incentive for private investors to purchase tax-free bonds. State and local governments would have to offer higher interest returns to attract investors.
• The change would also disincentivize home ownership, as the elimination of the mortgage interest tax credit will make loans significantly more expensive in direct terms. However, supporters argue that lower interest rates will more than make up for this change. Not only that, but after a home is purchased, the mortgage payment is not taxed (including principal and interest), therefore making interest payments tax free, eliminating the NEED for a "dedcution". It should be noted that under the current system, no deduction can be taken for payroll taxes. Under the FairTax mortgage interest payments are treated fairly.

Changes in the retail economy

Implementation

Like other firms, retailers will enjoy a zero corporate tax rate.

Under the system, retailers would be required to collect the federal sales tax on all sales occurring within the United States. Retailers will receive a collection fee of 25 basis points on federal funds collected.

States that choose to conform to the federal base will have the added advantage of information sharing and clear interstate revenue allocation rules. The ability for the state to collect these heretofore-uncollected taxes would be a major incentive for states to conform their sales tax to the federal sales tax base. Retailers suffering from tax-free direct mail competition or from tax-free sales from out of state retailers would see a major competitive disadvantage removed. However, this would have the effect of discouraging consumers from purchasing items through the thriving mail-order industry, potentially hurting a multi-billion-dollar segment of the American economy.

Supporting theories of effect

Supporters estimate that the economy will be 10 to 14 percent larger within 10 years and consumption will grow very substantially. Some studies show the potential gains to be much higher. Under the current federal income tax system, as well as under the FairTax, consumption purchases must be made from after-tax dollars. Therefore, the primary difference between a sales tax and an income tax is not the way they impact consumption, but rather how they impact savings. Dale Jorgensen, head of the Economics Department at Harvard University, has presented theories that producer prices will drop between 15 and 25 percent after the switch to consumption-based tax. A substantial part of producer price reductions can be passed on to the consumer in the form of lower retail prices, which will increase consumer demand. But, while offering lower prices, retailers will be able to maintain their current profit margins.

Proponents of the FairTax state that the cost of domestic goods and services would decrease by approximately 23% after embedded taxes are removed leaving the cost nearly the same after taxes.^[17] This would not apply to imported products, so it would provide tax advantages for domestic production, thereby reducing the trade deficit.

A study prepared by Nathan Associates for the National Retail Institute, which made many adverse assumptions, represents supporters' worst case scenario for a consumption tax. The study predicts that the economy will grow only three percent more in ten years than it would have under the income tax and that the increase in consumption will be 1.15 percent less in the first year relative to what it would have been under the income tax. This study concludes that consumption will be higher in the fourth year and every year thereafter than it would have been under the income tax.

References

1. ^ H.R. 25 Co-sponsors
2. ^ National Retail Sales Association Calculator
3. ^ Effective Tax Rates ' Americans for Fair Taxation
4. ^ U.S. Internal Revenue Service (2001). SOI Bulletin article - Individual Income Tax Rates and Tax Shares (Table 6). Retrieved June 14, 2005. (Excel spreadsheet)
5. ^ The FairTax: A Trojan Horse For America? By Claire Wolfe & Aaron Zelman retrieved May 19, 2005)
6. ^ A National Sales Tax No Vote by Bruce Bartlett, National Review retrieved June 7 2005
7. ^ Wolfe, "Trojan Horse".
8. ^ Fair Tax America
9. ^ "Simplifying tax systems:The case for flat taxes." The Economist, 2005 April 14.
10. ^ The Economist, "Flat Taxes".
11. ^ TaxAnalysts TaxBreak, by William G. Gale "The National Retail Sales Tax: What Would The Rate Have To Be?", May 16, 2005; retrieved June 15, 2005
12. ^ Wolfe, "Trojan Horse".
13. ^ . President's Advisory Panel on Federal Tax Reform
14. ^ FairTax - Income Taxes vs. Sales Taxes (About.com)
15. ^ Wolfe, "Trojan Horse".
16. ^ Americans for Fair Taxation
17. ^ Don't Buy the Sales Tax by William G. Gale, March, 1998 retrieved May 19, 2005
18. ^ FairTax Blog
19. ^ FairTax would reduce, simplify farmers' tax burden, by Rep. John Linder retreived June 8, 2005

External links

• Americans for Fair Tax
• H.R. 25: Fair Tax Act of 2005 - text of bill