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FairTax

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Throughout this article, the unqualified term "dollar" and the $ symbol refer to the United States dollar.
The FairTax Book, co-authored by Neal Boortz and John Linder, was published on August 2, 2005, as a tool to increase public support for the FairTax Plan.

The Fair Tax Act (H.R.25/S.1025) is a bill in the United States Congress for changing tax laws to replace the Internal Revenue Service (IRS) and all federal income taxes (including Alternative Minimum Tax), payroll taxes (including Social Security and Medicare taxes), corporate taxes, capital gains taxes, gift taxes, and estate taxes with a national retail sales tax, to be levied once at the point of purchase on all new goods and services. The proposal also calls for a monthly payment to households of citizens and legal resident aliens (based on family size) as an advance rebate of tax on purchases up to the poverty level.[1][2] The sales tax rate is described by some as being 23% and is described by others as being 30% (see below, Tax rate). Because the U.S. tax system has a hidden effect on prices,[3] it is alleged that moving to the FairTax would decrease production costs due to the removal of business taxes and compliance costs, which is predicted to offset a portion of the FairTax effect on prices.[4]

With the rebate taken into consideration, the effective tax rate would be progressive on consumption and could result in a tax burden of zero or less for some taxpayers.[2] However, opponents of the tax argue that while progressive on consumption, the tax could be regressive on income,[5] and would accordingly decrease the tax burden on high income earners and increase the tax burden on the middle class.[6][7] The plan's supporters in turn claim that it would increase purchasing power,[8] and decrease tax burdens by broadening the tax base and effectively taxing wealth.[9][2] Many mainstream economists and tax experts argue that consumption taxes, such as the FairTax, would have a positive impact on savings and investment (not taxed), ease of tax compliance, increased economic growth, incentives for international business to locate in the U.S., and increased U.S. international competitiveness (border tax adjustment in global trade).[6][4][10] Others argue that a consumption tax of this kind could be difficult to collect, having challenges with tax evasion,[5][6] and that it may not yield enough money for the government, resulting in cutbacks in spending, a larger deficit, or a higher sales tax rate.[6]

The FairTax has generated a large grassroots tax reform movement in recent years, led by the non-partisan group Americans For Fair Taxation.[11] Increased support was created after talk radio personality Neal Boortz and Georgia Congressman John Linder published The FairTax Book in 2005 and additional visibility is being gained in the 2008 presidential campaign. While the proposed bill has yet to have a major effect on the tax system, the Fair Tax Act has the highest number of cosponsors among tax reform proposals (attracting 72 in the 110th United States Congress), gathering much stronger support than popular flat tax legislation. A number of congressional committees have heard testimony on the FairTax; however, it has not been voted on in either Chamber. The plan is expected to increase cost transparency for funding the federal government and supporters believe it would have positive effects on civil liberties and advantages with taxing illegal activity and illegal immigrants.[4][12] Because the FairTax plan would remove taxes on income, tax deductions would have no meaning or value, which concerns some law makers about losing this method of social incentive. The legislation calls for an aggressive repeal of the Sixteenth Amendment, to prevent Congress from introducing new income tax legislation in the future.[13]

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Legislative history

The FairTax plan was created by Americans For Fair Taxation, an advocacy group formed for tax reform. The group developed the plan and the name "Fair Tax" with economists based on interviews, polls, and focus groups of the general public.[14][6] Since the term "fair" is subjective, the name of the plan has been considered an oxymoron by some and deceptive by others. Georgia Republican John Linder first introduced the FairTax bill (H.R.2525) in July 1999 to the 106th United States Congress. He has reintroduced substantially the same bill in each subsequent session of Congress. While the bill attracted a total of 56 House and Senate cosponsors in the 108th Congress (H.R.25/S.1493),[15][16] 61 in the 109th Congress (H.R.25/S.25),[17][18] and 72 in the 110th United States Congress (H.R.25/S.1025),[19][20] it has not been voted on by either committee in the House or Senate. To become law, the bill will need to be included in a final version of tax legislation from the U.S. House Committee on Ways and Means, then obtain support from the Joint Committee on Taxation, pass both the House and the Senate, and finally be signed by the President.

The FairTax legislation has been introduced by Linder in the House and by Georgia Republican Senator Saxby Chambliss in the Senate. Its formal name is the Fair Tax Act of 2007. The legislation has been discussed with President George W. Bush and Secretary of the Treasury Henry M. Paulson.[21] A number of congressional committees have also heard testimony on the FairTax. The bill is cosponsored by former Speaker of the House Dennis Hastert but has not received support from the Democratic leadership, which now controls Congress.[19][18][22] Democratic Representative Collin Peterson of Minnesota and Democratic Senator Zell Miller of Georgia cosponsored and introduced the bill in the 108th Congress, but Peterson is no longer cosponsoring the bill and Miller has left the Senate.[15][16] In the 109th and 110th Congress, Representative Dan Boren has been the only Democrat to cosponsor the bill.[17][19] Linder claims that Nancy Pelosi has instructed House Democrats against cosponsoring the bill.[23] Other attempts to replace the U.S. tax system have attracted fewer cosponsors. The Freedom Flat Tax (H.R.1040), sponsored by Texas Republican Michael C. Burgess, has 6 cosponsors, with no other proposal in Congress having as many.[24]

Tax rate

The tax rate, as defined in the legislation, is 23% of the total amount paid, including the tax payment itself. Sales taxes are generally defined based on the pre-tax amount, and applying this more conventional definition would imply a tax rate of 30%.[6] The effective tax rate for any household would be variable due to the fixed monthly tax rebates that are used to "untax" purchases up to the poverty level.[2] The tax would be levied on all U.S. retail sales for personal consumption on new goods and services. Critics argue that the sales tax rate defined in the legislation may not be revenue neutral (that is, it would collect less for the government than the current tax regime), and thus would not yield enough money for the government.[6]

Sales tax rate

Technically speaking, the FairTax legislation would apply a 23% federal retail sales tax on the total transaction value of a purchase; in other words, consumers pay to the government 23 cents of every dollar spent in total (sometimes called tax-inclusive—as income taxes are calculated). The assessed tax rate is 30% if the FairTax is applied to the pre-tax price of a good like traditional U.S. state sales taxes (sometimes called tax-exclusive).[6] The FairTax legislation uses total transaction value (tax-inclusive) in presenting the rate; with an item purchased for $100 total, the retailer receives $77 and the remaining is collected for the federal government. However, American sales taxes have historically been expressed as a percentage of the original sale price (tax-exclusive); items priced at $100 pre-tax cost $130 with the tax added.[25]

The use of the tax-inclusive number in presenting the rate has been criticized as deceptive and misleading by the plan's opponents.[25][26] Proponents argue that the 23% number represents a better comparison to income tax rates, which are presented as inclusive rates (see below, Presentation of tax rate).[4] Critics also argue that the sales tax rate would need to be higher to be revenue neutral (see below, Revenue neutrality).[7]

The tax would be levied on all U.S. retail sales for personal consumption on new goods and services. A good would be considered "used" and not taxable if a consumer already owns it before the FairTax takes effect or if the FairTax has been paid previously on the good,[14] which may be different than the item being sold previously. Exports and the purchase of intermediate business sales would not be taxed, nor would savings, investments, or education tuition expenses as they would be considered an investment (rather than final consumption).[1] Personal services such as health care, legal services, financial services, haircuts, and auto repairs would be subject to the FairTax, as would renting apartments and other real property.[6] In comparison, the current tax system also taxes such consumption indirectly by taxing the income used for purchase. State sales taxes generally exempt these services in an effort to reduce the tax burden on low-income families. The FairTax would use a monthly rebate system instead of the common state exclusions. The FairTax would apply to Internet purchases and would tax retail international purchases (such as a boat or car) that are imported to the United States (collected by the U.S. Customs Service).[1]

Effective tax rate

Further information: Distribution of the FairTax burden

The effective tax rate for any household would be variable due to the fixed monthly tax rebates. The rebates would have the greatest impact at low spending levels, where they could lower a household's effective rate to zero or a negative rate. At higher spending levels, the rebate has less impact, and a household's effective tax rate would approach 23% of total spending.[27] For example, a household of three spending $30,000 a year on taxable items would devote about 6% of total spending to the FairTax after the rebate. A household spending $125,000 on taxable items would spend around 19% on the FairTax.[6] The lowest effective tax rate under the FairTax could be negative due to the rebate. This could occur when a household spends less and pays less in taxes than the average poverty level spending for a similar household size. The household's rebate would exceed actual taxes paid by that household. Buying or otherwise receiving used items can also contribute towards a lower rate. The total amount of spending and the proportion of spending allocated to taxable items would determine a household's effective tax rate.[13]

To determine the effective tax rate on consumption:
  • Let be the statutory tax rate. For a 23% rate, then
  • Let be the annual income spent on new goods and services.
  • Let be the annual rebate.

Monthly tax rebate

2007 FairTax prebate schedule based on poverty level spending according to the poverty guidelines.

Under the FairTax, households of citizens and legal resident aliens would receive a "Family Consumption Allowance" (FCA) based on family size (regardless of income) that is equal to the estimated total FairTax paid on poverty level spending according to the poverty guidelines published by the U.S. Department of Health and Human Services.[1] The poverty level guidelines vary by family size and represent the cost to purchase household necessities. The FCA is a tax rebate (known as a "prebate" as it would be paid in advance) paid in twelve monthly installments equal to 23% of poverty level spending for each household size. The rebate is meant to eliminate the taxation of necessities and make the plan progressive.[6] The formula used to calculate rebate amounts would be adjusted for inflation. To become eligible for the rebate, households would register once a year with their sales tax administering authority, providing the names and social security numbers of each household member. The Social Security Administration would disburse the monthly rebate payments in the form of a paper check via U.S. Mail, an electronic funds transfer to a bank account, or a “smartcard” that can be used much like a bank debit card.[1] The fiscally conservative Beacon Hill Institute estimated the overall rebate cost to be $489 billion (assuming 100% participation).[28]

The President's Advisory Panel for Federal Tax Reform cited the rebate as one of their chief concerns when analyzing their national sales tax, stating that it would be "the largest (entitlement program) in American history", and contending that it would "make most American families dependent on monthly checks from the federal government".[7] Based on the advisory panel's tax rate (which differs from the FairTax legislation),[28] "the Prebate program would cost more than all budgeted spending in 2006 on the Departments of Agriculture, Commerce, Defense, Education, Energy, Homeland Security, Housing and Urban Development, and Interior combined."[7] Proponents point out that income tax deductions, tax preferences, loopholes, credits, etc. under the current system was estimated at $945 billion by the Joint Committee on Taxation.[28] This is $456 billion more than the FairTax "entitlement" (tax refund) would spend to cover each person's tax expenses up to the poverty level. In addition, it was estimated for 2005 that the Internal Revenue Service was already sending out $270 billion in refund checks.[28]

Presentation of tax rate

Sales and income taxes behave differently due to differing definitions of tax base, which can make comparisons between the two confusing. For direct rate comparisons between sales and income taxes, one rate must be manipulated to look like the other. A 30% sales tax rate approximates a 23% income tax rate after adjustment. The current U.S. tax system imposes taxes primarily on income. The tax base is a household's pre-tax income. The appropriate income tax rate is applied to the tax base to calculate taxes owed. Under this formula, taxes to be paid are included in the base on which the tax rate is imposed (known as tax-inclusive). If an individual's gross income is $100 and income tax rate is 23%, taxes owed equals $23. The tax base of $100 can be treated as two parts—$77 of after-tax spending money and $23 of income taxes owed. The income tax is taken "off the top", so the individual is left with $77 in after-tax money.[14] Traditional state sales tax laws impose taxes on a tax base equal to the pre-tax portion of a good's price (known as tax-exclusive). Unlike income taxes, U.S. sales taxes do not include actual taxes owed as part of the base. A good priced at $77 with a 30% sales tax rate yields $23 in taxes owed. Since the sales tax is added "on the top", the individual pays $23 of tax on $77 of pre-tax goods.[14] By including taxes owed in the tax base, a sales tax rate can be directly compared to an income tax rate.

The FairTax statutory rate, unlike most U.S. state-level sales taxes, is calculated on a tax base that includes the amount of FairTax paid. In this manner, the FairTax, like European sales taxes, more closely resembles an income tax calculation. A final price of $100 includes $23 of taxes. Like the income tax example above, the taxes to be paid would be included in the base on which the FairTax is imposed. Neal Boortz has stated that the FairTax would be implemented as an inclusive tax, which would include the tax in the retail price (not added on at checkout) and display the tax on the receipt as 23% of the total.[29][23] The FairTax is presented as a 23% tax rate for easy comparison to income tax rates (the taxes it would be replacing). Proponents believe it is both inaccurate and misleading to say that an income tax is 23% and the FairTax is 30% as it implies that the sales tax burden is higher, when in fact the burden of the two taxes is precisely the same—either both taxes are 23% or both taxes are 30%. The plan's opponents call the semantics deceptive. FactCheck called the presentation misleading, saying that it hides the real truth of the tax rate.[26] Laurence Vance, writing for the Ludwig von Mises Institute, goes so far as to call the rate presentation a "lie".[25] Bruce Bartlett, writing in the Wall Street Journal, also called the presentation confusing and deceptive based on the conventional method of calculating sales taxes.[30]

Comparison to a typical sales rate:
  • Let be the FairTax rate. For a 23% rate, then
  • Let be the rate in terms of a typical sales tax.
  • Let be the price of the good (including the tax).
The revenue that would go to the government:
The revenue remaining for the seller of the good:
To convert the tax, divide the money going to the government by the money the company nets:
Therefore, to adjust any rate below to that of a traditional sales tax, divide the given rate by 1 minus that rate.

Revenue neutrality

Main article: Revenue neutrality of the FairTax

A key question surrounding the FairTax rate is the ability to be revenue-neutral; that is, whether it would result in an increase or reduction in overall federal tax revenues.[14] Economists, advisory groups, and political advocacy groups disagree about the tax rate required for the FairTax to be truly revenue-neutral. Various analysts use different assumptions, time-frames, and methods that result in dramatically different tax rates making direct comparison among the studies difficult. The choice between static or dynamic scoring further complicates any estimate of revenue-neutral rates,[31] with the rates presented below based on a static scoring analysis.

One of the leading economists supporting the FairTax is Dr. Laurence Kotlikoff of Boston University. A detailed 2006 study published in Tax Notes by Beacon Hill Institute at Suffolk University and Dr. Kotlikoff concluded the FairTax would be revenue-neutral for the tax year 2007 at a rate of 23.82% (31.27% tax-exclusive) assuming full taxpayer compliance.[32] The study states that if state and local governments continue to collect the same real revenues from their taxpayers, they will be able to maintain their real spending levels, despite the requirement that they pay the FairTax on their purchases.[32] The Argus Group and Arduin, Laffer & Moore Econometrics each published an analysis that defended the 23% rate.[33][34][35] While proponents of the FairTax concede that the above studies did not explicitly account for tax evasion, they also claim that the studies did not altogether ignore tax evasion under the FairTax. These studies implicitly incorporated some degree of tax evasion in their calculations simply by using National Income and Product Account based figures that presumably understate total household consumption.[32] Moreover, these studies did not account for the expected capital gains that would result from a reduction in the real nominal value of U.S. government debt and the increased economic growth that economists believe would occur.[10][32]

In contrast to the above studies, one of the leading economists opposing the FairTax, William Gale of the Brookings Institution, published a detailed 2005 study in Tax Notes that estimated a rate of 28.2% (39.3% tax-exclusive) for 2007 assuming full taxpayer compliance and an average rate of 31% (44% tax-exclusive) from 2006–2015 (an increase that accounts for the replacement of an additional $3 trillion in revenue collected through the Alternative Minimum Tax (AMT) impacting the middle class over the 10 year period).[6][36][37] The study also concluded that if the tax base were eroded by 10% due to tax evasion, tax avoidance, and/or legislative adjustments, the average rate would be 34% (53% tax-exclusive) for the 10 year period. The study did not take into consideration the increase in economic activity that Gale expects would result from the imposition of the FairTax. The President's Advisory Panel for Federal Tax Reform performed an analysis to replace the personal income tax (excluding other taxes) with a retail sales tax and found the rate to be 25% (34% tax-exclusive) for 2006 assuming at least 10% evasion.[7] The rate would need to be substantially higher to replace the additional taxes replaced by the FairTax (payroll, corporate, capital gains, estate, and gift taxes). The Treasury Department has refused to release for peer review the detailed figures and methodology used in the tax panel analysis.[28] FairTax proponents, including the Beacon Hill Institute and Dr. Kotlikoff, have criticized the President's Advisory Panel's study as having altered the terms of the FairTax and using unsound methodology.[32][28]

Distribution of tax burden

Boston University study of the FairTax. Lower rates claimed from a larger tax base, replacing regressive taxes, and wealth taxation.
President's Advisory Panel's analysis of a hybrid National Sales Tax. Higher rates claimed on the middle-class for a personal income tax replacement.
Main article: Distribution of the FairTax burden

The FairTax's impact on the distribution of taxation or tax incidence (the effect on the distribution of economic welfare) is a point of dispute. The plan's supporters argue that it would broaden the tax base, be progressive, decrease tax burdens, and start taxing wealth, while opponents argue that a national sales tax would be inherently regressive and would decrease tax burdens paid by high-income individuals.[6] Sales taxes are normally considered regressive, but the FairTax provides a rebate that supporters argue would create a progressive effective rate on consumption. For example, a family of four (a couple with two children) earning about $25,000 and spending this on taxable goods and services, would consume 100% of their income. A higher income family of four making about $100,000, spending $75,000, and saving $25,000, would consume only 75% of their income on taxable goods and services. According to economist William G. Gale of the Brookings Institution, the percentage of income taxed is regressive (using a cross-section time frame).[5] However, when presented with an estimated effective tax rate, the low-income family above would pay a tax rate of 0% on the 100% of consumption and the higher income family would pay a tax rate of 15% on the 75% of consumption (with the other 25% taxed at a later point in time, as savings is tax-deferred).[38] The effective tax rate is progressive on consumption,[2] as a person spending at the poverty level would have an effective tax rate of 0%, whereas someone spending at four times the poverty level would have an effective tax rate of 17.2%.[38]

Households at the lower end of the income scale spend almost all their income, while households at the higher end are more likely to devote a portion of income to saving; households at the extreme high end of consumption often finance their purchases out of savings, not income.[5] These savings would be taxed when they become purchases. Income earned and saved would not be taxed immediately under the proposal. In other words, savings would be spent at some point in the future and taxed according to that consumption. FairTax advocates state that this would improve taxing of wealth. Economist Laurence Kotlikoff of Boston University states that the FairTax could make the tax system much more progressive and generationally equitable.[2] "Their view that taxing sales is regressive is just plain wrong. Taxing consumption is effectively the same as taxing wages plus taxing wealth."[2] Kotlikoff finds that the FairTax significantly reduces marginal taxes on work and saving, which substantially lowers overall average remaining lifetime tax burdens on current and future workers at all income levels.[9] The fiscally conservative Beacon Hill Institute at Suffolk University concluded in a 2007 study on distributional effects that "replacing income and payroll taxes with the FairTax would make the United States federal tax system more progressive than it is now and would benefit the average individual in almost all expenditures deciles."[39]

Economist William Gale analyzed a National Sales Tax (though different from the FairTax in several aspects[33][39]) and reported that the overall tax burden on middle-income Americans would increase while the tax burden on the very rich would drop.[5] According to the President's Advisory Panel for Federal Tax Reform report, which compared the personal income tax (excluding other taxes the FairTax replaces) to a sales tax with rebate,[7][28] the percentage of federal taxes paid by those earning from $15,000 – $50,000 would rise from 3.6% to 6.7%, while the burden on those earning more than $200,000 would fall from 53.5% to 45.9%.[7] FairTax supporters argue that replacing the regressive payroll tax — a 12.4% Social Security tax on wages up to $97,500 and a 2.9% Medicare tax (a 15.3% total tax that is often split between employee and employer), corporate tax, and capital gains tax (not included in the Tax Panel study) greatly changes the tax distribution and that the FairTax would relieve the tax burden on middle-class workers.[7][2] The FairTax would broaden the tax base to include all 300 million Americans and an estimated 30 million to 40 million foreign tourists and visitors.[40] In a study on tax base and rate, the Beacon Hill Institute concluded that the FairTax would offer the broadest tax base and increase the federal government's net base to $9.355 trillion from $7.033 trillion of taxable income, which allows the FairTax to have a lower tax rate than current tax law.[41] A study on marginal and average tax rates by Kotlikoff concluded that the FairTax would reduce most households’ average lifetime tax rates.[42] Economists from Boston University and the Centre for European Economic Research concluded that the long term effects of the FairTax would reward low-income households with 26.3% more purchasing power, middle-income households with 12.4% more purchasing power, and high-income households with 5% more purchasing power.[8]

Predicted effects

Main article: Predicted effects of the FairTax

Some economists and tax experts believe consumption taxes, such as the FairTax, would have a positive impact on economic growth, incentives for international business to locate in the U.S., and increased U.S. international competitiveness (border tax adjustment in global trade).[6][4][10] The FairTax is expected to increase cost transparency for funding the federal government and supporters believe it would have advantages with taxing illegal activity and illegal immigrants.[4] The FairTax would be tax-free on mortgage interest (up to the basic interest rate as determined by the Federal Reserve) and donations; however, some law makers have concerns about losing social incentives on home ownership and charitable contributions. There is also concern about the impact to the income tax industry and the difficulty with the aggressive repeal of the Sixteenth Amendment, which would prevent Congress from introducing new income tax legislation in the future.[13]

The FairTax is, however, a source of disagreement among economists and other analysts. [1] [2]

Economic

For more details on this topic, see Predicted effects of the FairTax: Economic effects
U.S. Rep John Linder holding the 132 page Fair Tax Act in contrast to the more than 60,000 pages of tax code laws and regulations currently in effect.

The FairTax proposal would have effects in many areas that influence the United States. FairTax proponents assert that the proposal would provide tax burden visibility and reduce compliance costs. The cost of federal government would be highly visible as consumers would see most of this cost in a single tax paid every time they purchase a good or service.[2] Under the current tax system, the federal government collects revenue through a wide variety of taxes on individuals and businesses, which may not be fully visible to individual citizens.[43] The efficiency cost of the current tax system—the output that is lost over and above the tax itself—is between $240 billion and $600 billion every year according to a 2005 report from the U.S. Government Accountability Office.[44][45] Supporters argue that the FairTax system would reduce these compliance and efficiency costs by 90% and return a larger share of that money to the productive economy.[2][46] In addition, an estimated $11 trillion is held in foreign accounts (largely for tax purposes), which former Federal Reserve Chairman Alan Greenspan predicts would be repatriated back to U.S. banks if the FairTax were enacted, becoming available to U.S. capital markets, bringing down interest rates, and otherwise promoting economic growth in the United States.[4][47]

Eighty economists, including Nobel Laureate Vernon L. Smith, wrote an open letter to the President, the Congress, and the American people, stating that the FairTax would boost the United States economy.[10] According to the National Bureau of Economic Research and Americans For Fair Taxation, GDP would increase almost 10.5% in the year after the FairTax goes into effect.[46] In addition, the incentive to work would increase by as much as 20%, the economy’s capital stock would increase by 42%, labor supply by 4%, output by 12%, and real wage rate by 8%.[48] A study in 2007 by the Beacon Hill Institute of Suffolk University stated that within five years real GDP would increase 10.7% over the current system, domestic investment by 86.3%, capital stock by 9.3%, employment by 9.9%, real wages by 10.2%, and consumption by 1.8%.[49] Further, studies of the FairTax at Boston University and Rice University suggest the FairTax will bring long-term interest rates down by as much as one third.[48][50] As falling tax compliance costs lower production costs, exports would increase by 26% initially and remain more than 13% above present levels.[46] According to Professor Dale Jorgenson of Harvard University’s Economics Department, revenues to Social Security and Medicare would double as the size of the economy doubles within 15 years after passage of the FairTax.[51] Opponents offer a study commissioned by the National Retail Federation in 2000 that found a national sales tax would bring a 3 year decline in the economy, a 4 year decline in employment and an 8 year decline in consumer spending.[52]

Global corporations consider local tax structures when making planning and capital investment decisions. Lower corporate tax rates and favorable transfer pricing regulations can induce higher corporate investment in a given locality. The United States currently has the highest combined statutory corporate income tax rate among OECD countries.[53] Bill Archer, former head of the House Ways and Means Committee, asked Princeton University Econometrics to survey 500 European and Asian companies regarding the impact on their business decisions if the United States enacted the FairTax. 400 of those companies stated they would build their next plant in the United States, and 100 companies said they would move their corporate headquarters to the United States.[14][54] In addition, the U.S. is currently the only one of the 30 OECD countries with no border adjustment element in its tax system.[55] Proponents state that because the FairTax is automatically border adjustable, the 17% competitive advantage, on average, of foreign producers would be eliminated, immediately boosting U.S. competitiveness overseas and at home.[13]

Transition

For more details on this topic, see Predicted effects of the FairTax: Transition effects
Stability of the Tax Base: A comparison of Personal Consumption Expenditures and Adjusted Gross Income.

If the FairTax bill were passed, permanent elimination of income taxation would not be guaranteed; the FairTax bill would repeal much of the existing tax code, but the Sixteenth Amendment would remain in place. The elimination of the possibility that income taxation would return (through a separate Congressional bill), requires a repeal of the Sixteenth Amendment to the United States Constitution along with expressly prohibiting an income tax.[13] This is referred to as an "aggressive repeal". Separate income taxes enforced by individual states would be unaffected by the federal repeal. Since passing the FairTax would only require a simple majority in each house of the United States Congress along with the signature of the President, and enactment of a constitutional amendment must be approved by two thirds of each house of the Congress, and three-quarters of the individual U.S. states, it is possible that passage of the FairTax bill would simply add another taxation system. If a new income tax bill was passed after the FairTax passage, a hybrid system could develop. However, there is nothing preventing a bill for a national sales tax or value added tax (VAT) on top of today's income tax system. The Americans For Fair Taxation plan is to first pass the FairTax and then to focus grassroots efforts on HJR 16, that calls for the repeal of the Sixteenth Amendment.[13][56] John Linder plans to include a sunset provision in H.R. 25 during the 111th Congress that would repeal the Sixteenth Amendment within 5 years after the implementation of the FairTax or the FairTax goes away.[57]

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 above the poverty level with money saved under the current system, that spending would be subject to the FairTax. People living through the transition may find both their earnings and their spending taxed. Supporters of the plan argue that the current system is no different, since compliance costs and "hidden taxes" embedded in the prices of goods and services cause savings to be "taxed" a second time already when spent. The rebates would supplement accrued savings, covering taxes up to the poverty level.[14] The income taxes on capital gains, social security and pension benefits would be eliminated under FairTax. The FairTax would also eliminate what some claim to be the double taxation on savings that is part of estate taxes. In addition, the FairTax legislation adjusts Social Security benefits for changes in the price level, so a percentage increase in prices would result in an equal percentage increase to Social Security income.[1] Supporters suggest these changes would offset paying the FairTax under transition conditions.[4]

During the transition, many or most of the employees of the IRS (105,978 in 2005)[58] would face loss of employment.[32] The Beacon Hill Institute estimate is that the federal government would be able to cut $8 billion from the IRS budget of $11.01 billion (in 2007), reducing the size of federal tax administration by 73%.[32] In addition, income tax preparers (many seasonal), tax lawyers, tax compliance staff in medium-to-large businesses, and software companies which sell tax preparation software (such as Drake Software, TaxCut, and TurboTax), could face significant drops, changes, or loss of employment.[13] However, IRS testimony from 2004 stated that 45% of revenue agents and officers would become eligible for retirement in the following 5 years and there is concern about the loss of their work force as their hiring efforts struggle to keep pace with attrition.[59] In addition, the IRS would not go completely out of commission until 3 years after the FairTax was enacted, providing employees time to find other employment.[1] Proponents claim the projected 10.5% growth in the economy during the first year of the FairTax would provide plenty of new jobs to these workers that are typically well educated and well equipped with transferable skills.[13] In the period before the FairTax was implemented, there could be a strong incentive for individuals to buy goods without the sales tax using credit. After the FairTax was in effect, the credit could be paid off using untaxed payroll. If credit incentives do not change, opponents of the FairTax worry it could exacerbate an existing consumer debt problem.[60] Proponents of the FairTax state that this effect could also allow individuals to pay off their existing (pre-FairTax) debt more quickly,[4] and studies suggest lower interest rates after FairTax passage.[48][50]

Other indirect effects

For more details on this topic, see Predicted effects of the FairTax: Other indirect effects

The current federal tax law allows individuals to deduct the home mortgage interest costs, and donations to certain charities, from taxable income. Someone paying a 25% income tax rate would pay $250 in taxes on a $1,000 donation or mortgage interest payment, and then receive $250 back from the government as the $1000 deduction is removed from taxable income.[61] The FairTax is tax free on mortgage interest up to the basic interest rate as determined by the United States Federal Reserve and donations are not taxed.[1] In a 2007 study, the Beacon Hill Institute concluded that total charitable giving would increase under the FairTax, although increases in giving would not be distributed proportionately amongst the various types of charitable organizations.[62] The FairTax may also affect State and local government debt as the federal income tax system provides tax advantages to state and local municipal bonds.[63] Other areas affected may be law enforcement as avoidance of income tax is sometimes used to prosecute members of organized crime syndicates to convict on charges of tax avoidance and tax evasion when insufficient direct evidence exists for other crimes. Under the FairTax proposal, this avenue of law enforcement would disappear as there would be no income tax and, therefore, no income tax evasion. Instead of being guilty of income tax evasion, they would be guilty of failing to submit sales tax. Advocates claim the FairTax would provide incentive for illegal immigrants to legalize as they would otherwise not receive the FairTax rebate.[4] Illegal immigrants would pay the maximum effective tax rate.[1] There would also be no federal tax savings to companies that hire illegal immigrants. Proponents also believe that the FairTax would have positive effects on civil liberties that are sometimes charged against the income tax system, such as social inequality, economic inequality, financial privacy, self-incrimination, unreasonable search and seizure, burden of proof, and due process.[12][64]

Changes in the retail economy

See also: Tax: Economics of taxation, Effect of taxes and subsidies on price

Since the FairTax would not tax used goods, the value would be determined by the supply and demand in relation to new goods.[65] The price differential/margins between used and new goods would stay consistent, as the cost and value of used goods are in direct relationship to the cost and value of the new goods. Because the U.S. tax system has a hidden effect on prices, it is expected that moving to the FairTax would decrease production costs from the removal of business taxes and compliance costs, which is predicted to offset a portion of the FairTax effect on prices.[4]

Value of used goods

Since the FairTax would not tax used goods, there is a common misunderstanding that this would create a differential, equal to the FairTax, between the price of new and used goods. Such a differential would certainly impact the sale of new goods like vehicles and homes. However, like the income tax system that contains embedded tax cost (see Theories of retail pricing),[3] used goods would contain the embedded FairTax cost. While the FairTax would not be applied to the retail sales of used goods, the inherent value of a used good includes the taxes paid when the good was sold at retail. The value is determined by the supply and demand in relation to new goods.[65] The price differential / margins between used and new goods would stay consistent, as the cost and value of used goods are in direct relationship to the cost and value of the new goods.

Theories of retail pricing

Standard supply and demand diagram illustrating taxes' effect on prices.

Retail prices are inflated due to embedded taxes and compliance costs passed to the consumer by producers and suppliers.[3] John Linder states the FairTax would eliminate almost all federal taxation costs from the supply chain, which could lower production costs by up to 30%.[46] Americans For Fair Taxation has claimed that the production cost of domestic goods and services could decrease by approximately 22% on average after embedded taxes and compliance costs were removed, leaving the sale nearly the same after taxes.[13] This is based on a study conducted by Dr. Dale Jorgenson, who found that producer prices would drop between 15% and 26% (depending on the type of good/service) after the switch to a consumption based tax.[4] However, Jorgenson's research included all income and payroll taxes regardless of whether they were paid by employees or employers in the 22% embedded tax estimation. (It is also important to note that the Jorgenson model did not capture any reduction in the cost of compliance associated with changing from a complex income tax system to a simpler consumption tax.) This means that Jorgenson assumed that businesses would pass on all the cost savings from the repeal of payroll taxes and income tax withholding to consumers in the form of lower prices. Mathematically, this would have to result in employee take-home pay (net income) remaining unchanged from pre-FairTax levels.[6][66]

If businesses instead provided employees with their gross pay as expected (including income tax withholding and the employee share of payroll taxes),[32] Arduin, Laffer & Moore Econometrics estimated production costs would decrease by a minimum of 11.55%.[35] This decrease would offset a portion of the FairTax amount reflected in retail prices. These embedded costs include corporate taxes, compliance costs, and the employer share of payroll taxes (see Effect on tax compliance costs). The Beacon Hill Institute shows that it would not matter whether prices fall or rise—the relative tax burden remains the same because if prices increased with the addition of the FairTax, wages would also rise accordingly; or if the federal reserve did not decide to accommodate (does not increase the money supply), then prices would fall and wages would remain at their net rates. Purchasing power for buying consumer goods and services in either situation would remain essentially the same, and the FairTax rate would be the same.[32]

The decrease in production cost would only slightly apply to imported products, so, according to proponents, it would provide tax advantages for domestic production and increase U.S. competitiveness in global trade (see Border adjustability). Such logic is endorsed by a recent letter to the commission on tax reform by dozens of economists, including Nobel Laureate Vernon L. Smith.[10] To ease the transition, U.S. retailers will receive a tax credit equal to the FairTax on their inventory to allow for quick cost reduction. A study prepared by Nathan Associates for the National Retail Federation, which made many adverse assumptions, represents supporters' worst-case scenario for a consumption tax. The study predicts that the economy will grow only 3% more in ten years than it would have under the income tax and that the increase in consumption will be 1.15% 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.[67]

Effects on tax code compliance

FairTax supporters state that black market or illegal economic activity is largely untaxed under the current tax system. Economists estimate the underground economy in the United States to be between one and three trillion dollars annually.[47][68][69] By imposing a sales tax, black market activity would be significantly taxed when proceeds from such activity are spent on legal consumption. For example, the sale of illegal narcotics would remain untaxed (instead of being guilty of income tax evasion, dealers would be guilty of failing to submit sales tax), but drug dealers would face taxation when they used drug proceeds to buy consumer goods such as food, clothing, and cars. By taxing this previously untaxed money, FairTax supporters state the black market would be paying part of their share of what would otherwise be uncollected income and payroll taxes.[4]

Microeconomist Mike Moffatt argued that if there were no net change in retail prices or tax burdens, the licit consumption of goods and services by the underground economy would continue to bear the same tax burden as before. Legal purchases under the current tax regime carry the hidden cost of implicit taxes. When an explicit tax replaces those taxes, the consumption purchases would still bear the same tax burden.[70][unreliable source?] However, the cost paid by the underground economy through embedded taxes is the cost associated with those paying into the income tax base. If black market activity were taxed today, the tax burden on the rest of the population would decrease from the larger base. Likewise, the large base of consumption would have illegal activity paying into the FairTax base.

Tax compliance

"No, No! Not That Way"—Political cartoon from 1933 commenting on a general sales tax over an income tax.

The current income tax system fails to collect on a significant percentage of taxes. The IRS estimates twenty additional cents of taxes are owed on unreported income for every tax dollar collected. In 2001, the IRS estimated this shortfall to be over $312 billion.[71] These figures do not include taxes lost on illicit sources of income, such as illegal drug dealing. Proponents assert that the transparency and simplicity of the FairTax would subject much of this unreported income to taxation. The number of tax collection points would significantly reduce under the FairTax, as only retailers would file a tax return compared to every income earner. The FairTax would reduce the number of tax filers by about 80% (from 145 million to 25 million) and reduce the filing complexity to a simplified state sales tax form.[72][46]

Research supports the claim that simplified tax systems lead to greater compliance. The International Monetary Fund 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.[71] The Government Accountability Office, among others, have specifically identified the negative relationship between compliance and the number of focal points for collection. The federal government would be able to concentrate its entire tax enforcement efforts on a single tax—the FairTax. Retailers would receive an administrative fee equal to the greater of $200 or 0.25% of the remitted tax as compensation for compliance costs.[1] In addition, the overwhelming majority of purchases occur in major retail outlets, which are very unlikely to evade the FairTax and risk losing their business licenses.[32] Economic figures show that 47% of all retail sales are made by just 688 businesses ("Big-Box" retailers). 87% of retail sales are made by 193,000 businesses, which is 3.7% of U.S. businesses.[47]

FairTax opponents believe that compliance decreases when taxes are not automatically withheld from citizens. Compliance rates also fall when taxed entities, rather than a third party, self-report their tax liability. For example, ordinary personal income taxes can be automatically withheld and are reported to the government by a third party. Taxes without withholding and with self-reporting, such as the FairTax, can see higher evasion rates. In other countries, similar VAT taxes have an average evasion rate of 20%.[28] William Gale has estimated that erosion of the tax base by 10% due to evasion would require an average sales tax rate of 34% (53% tax-exclusive) from 2006–2015 (which also accounts for the additional $3 trillion in revenue collected through the AMT impacting the middle class over the 10 year period) and evasion of 20% would have an average rate of 39% (65% tax-exclusive) for the 10 year period.[36] FairTax proponents, including the Beacon Hill Institute, disagree with those conclusions and published a study which challenges the findings.[33][28]

The FairTax is a national tax, but can be administered by the states rather than a federal agency.[1] This has a bearing on compliance, as the states' own agencies could monitor and audit businesses within that state. The 0.25% retained by the states amounts to $5 billion the states would have available for enforcement and administration. For example, California should receive over $500 million for enforcement and administration. According to the California 2004–05 budget analysis, this is more than the $327 million California is spending on the state's sales and excise taxes.[73] The FairTax is simpler, but extends to cover services which are not currently subject to the California sales tax. Because the federal money paid to the states would be a percentage of the total revenue collected, John Linder claims the states would have an incentive to maximize collections.[4] Proponents believe that states that choose to conform to the federal tax base would have advantages in enforcement, information sharing, and clear interstate revenue allocation rules.[1][74] Economist Bruce Bartlett suggests that the State may not have sufficient incentive to enforce the tax and that sales taxes have long exempted all but a few services because of the enormous difficulty in taxing intangibles.[30] University of Michigan economist Joel Slemrod argues that states would face significant issues in enforcing the tax. "Even at an average rate of around 5 percent, state sales taxes are difficult to administer."[75]

Underground economy

Opponents of the FairTax argue that imposing a national retail sales tax would drive transactions underground and create a vast underground economy.[6][76] Under a retail sales tax system, the purchase of intermediate goods would not always be taxed, since those goods would produce a retail good that will be taxed. Individuals and businesses may be able to manipulate the tax system by claiming that purchases are for intermediate goods, when in fact they are final purchases that should be taxed. Proponents point out that a business is required to have a registered seller's certificate on file, and must keep complete records of all transactions for six years. Businesses must also record all taxable goods bought for seven years. They are required to report these sales every month (see Personal vs. business purchases).[1]

While many economists and tax experts support a consumption tax, problems could arise with using a retail sales tax rather than a value added tax (VAT).[6] A VAT imposes a tax at every intermediate step of production, so the goods reach the final consumer with much of the tax already in the price, along with some extra overhead. The retail seller has little incentive to conceal retail sales, since he has already paid much of the good's tax. Retailers are unlikely to subsidize the consumer's tax evasion by concealing sales. In contrast, a retailer has paid no tax on goods under a sales tax system. 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.[77]

In the United States, a general sales tax is imposed in 45 states plus the District of Columbia (accounting for over 97% of both population and economic output). Most states also collect a variety of local sales taxes including county, city, and transit taxes.[78] The United States has a large infrastructure for taxing sales that many countries do not have. Proponents respond to the underground economy argument by pointing out that, whereas tax evasion under the current income tax system requires only one person (the payer) to lie on their tax forms, tax evasion under the FairTax requires collusion of both the payer (the retail purchaser) and the payee (the retail seller). Furthermore, the number of individuals required to file taxes drops from approximately 145 million to 25 million, a drop in excess of 80%. This drop in the number of collection points will allow the tax administration to view tax fraud with greater scrutiny.[72] Proponents of the FairTax see a substantial amount of additional tax revenue from those engaging in the black market, as a sales tax would require all who consume to be taxed (see Effects on tax code compliance).

Personal vs. business purchases

For an individual to purchase items tax-free for business purposes, the business would be required to be a registered seller with the state sales tax authority, and thereby be subject to audit. The state would issue the business a registered seller's certificate. This would enable the business to purchase tax free from wholesale vendors, but they must give a copy of their registration certificate to the vendor to leave an audit trail.[1] When an item is purchased for business use from a retail vendor, the business would have to pay the tax on the purchase and take a credit against the tax due on their sales tax return. Taxable property and services purchased by a qualified non-profit or religious organization 'for business purposes' would not be taxable.[79]

Businesses would be required to submit monthly or quarterly reports (depending on sales volume) of taxable sales and sales tax collected on their monthly sales tax return.[14] During audits, the business would have to produce invoices for the "business purchases" that they did not pay sales tax on, and would have to be able to show that they were genuine business expenses.[1] Since 145 million individuals would no longer be filing tax returns, there would only be about 25 million businesses that could be audited.[72] Advocates claim that this would greatly increase the likelihood of business audits, making tax evasion behavior much more risky. Additionally, the FairTax legislation has several fines and penalties for non-compliance and authorizes a mechanism for reporting tax cheats and obtaining a reward.[1] To prevent businesses from purchasing everything for their employees, in a family business for example, goods and services bought by the business for the employees that are not strictly for business use would be taxable.[1] Health insurance or medical expenses would be an example where the business would have to pay the FairTax on these purchases.

FairTax movement

Grassroots supporters organize in Orlando, Florida for a FairTax Rally on July 28, 2006.

The origins of the FairTax began with a group of businessmen from Houston, Texas, who initially financed what has become the non-partisan political advocacy group Americans For Fair Taxation (AFFT), which has grown into a large grassroots tax reform movement.[11] This organization, founded in 1994, claims to have spent over $20 million in research,[80] marketing, lobbying, and organizing efforts over a ten year period and is seeking to raise over $100 million more to promote the plan. AFFT includes a staff in Houston and a large group of volunteers who are working to get the FairTax enacted.[14] Bruce Bartlett has charged that the FairTax was devised by the Church of Scientology in the early 1990s;[30] however, Representative John Linder told the Atlanta Journal-Constitution that Bartlett confused the FairTax movement with the Scientology-affiliated Citizens for an Alternative Tax System.[81] Leo Linbeck, AFFT Chairman and CEO, stated "As a founder of Americans For Fair Taxation, I can state categorically, however, that Scientology played no role in the founding, research or crafting of the legislation giving expression to the FairTax."[80]

Much support has been achieved by talk radio personality Neal Boortz. Boortz's book (co-authored by Georgia Congressman John Linder) entitled The FairTax Book, explains the proposal and spent time atop the New York Times Best Seller list. Boortz stated that he donates his share of the proceeds to charity to promote the book.[82] In addition, Boortz and Linder have organized several FairTax rallies to publicize support for the plan. Other media personalities have also assisted in growing grassroots support including radio and former TV talk show host Larry Elder, radio host and former Senatorial candidate Herman Cain, Fox News and radio host Sean Hannity, and ABC News co-anchor John Stossel.[83] The FairTax has received additional visibility as one of the issues in the 2008 presidential election on the issue of taxes and the IRS. At a debate on June 30, 2007, several Republican candidates were asked about their position on the FairTax and many responded that they would sign the bill into law if elected.[84][85] The most vocal promoters of the FairTax in the election are Republican candidate Mike Huckabee and the only Democratic candidate to support the plan, longshot Mike Gravel. The Internet, blogosphere, and electronic mailing lists like Yahoo! Groups have contributed to informing, organizing, and gaining support for the FairTax. Many grassroots web sites have been created by supporters to help organize the effort and promote the plan.

See also

Part of the U.S. Taxation series
FairTax
FairTax subarticles


Notes

  1. ^ a b c d e f g h i j k l m n o p q "H.R. 25: Fair Tax Act of 2007". 110th U.S. Congress. The Library of Congress. 2007-01-04. Retrieved 2007-01-14. {{cite web}}: Check date values in: |date= (help)
  2. ^ a b c d e f g h i j Kotlikoff, Laurence (2005-03-07). "The Case for the 'FairTax'" (PDF). The Wall Street Journal. Retrieved 2006-07-23. {{cite news}}: Check date values in: |date= (help); Cite has empty unknown parameter: |coauthors= (help)
  3. ^ a b c Forbes, Steve (2007-03-22). "The American Dream Improving Our Lot". Forbes. Retrieved 2007-03-26. {{cite news}}: Check date values in: |date= (help)
  4. ^ a b c d e f g h i j k l m n Boortz, Neal (2006). The FairTax Book (Paperback ed.). Regan Books. ISBN 0-06-087549-6. {{cite book}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
  5. ^ a b c d e Gale, William (March 1998). "Don't Buy the Sales Tax". The Brookings Institution. Retrieved 2006-07-23. Cite error: The named reference "wgale" was defined multiple times with different content (see the help page).
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  8. ^ a b Kotlikoff, Laurence (2007-04-24). "Simulating the Dynamic Macroeconomic and Microeconomic Effects of the FairTax" (PDF). Boston University & Centre for European Economic Research. Retrieved 2007-05-13. {{cite web}}: Check date values in: |date= (help); Unknown parameter |coauthors= ignored (|author= suggested) (help)
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  66. ^ Boortz, Neal (2005-09-15). "The FairTax - Straightening out some confusion". Cox Radio. Retrieved 2006-08-04. {{cite web}}: Check date values in: |date= (help)
  67. ^ "Why retailers should support the FairTax" (PDF). Americans For Fair Taxation. Retrieved 2006-07-24.
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  69. ^ Schlosser, Eric (2004-04-01). Reefer Madness: Sex, Drugs, and Cheap Labor in the American Black Market (Reprint ed.). Mariner Books. ISBN 978-0618446704. {{cite book}}: Check date values in: |date= (help)
  70. ^ Moffatt, Mike (2006). "FairTax Quandry". About, Inc. Retrieved 2006-09-06.
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  72. ^ a b c "What the federal tax system is costing you – besides your taxes!" (PDF). Americans For Fair Taxation. 2007-02-19. Retrieved 2007-03-27. {{cite web}}: Check date values in: |date= (help)
  73. ^ "California Sales Tax Enforcement Costs - Analysis of the 2004–05 Budget Bill". Legislative Analyst's Office. February 2004. Retrieved 2006-07-25.
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  76. ^ Franks, Dale (2004-12-08). "The NST v. the VAT". QandO. Retrieved 2006-08-12. {{cite web}}: Check date values in: |date= (help); Cite has empty unknown parameter: |coauthors= (help)
  77. ^ Franks, Dale (2005-08-25). "Fair Tax Supporters: Whistling Past the Graveyard". QandO. Retrieved 2006-07-25. {{cite web}}: Check date values in: |date= (help)
  78. ^ "Sales Tax FAQ". Sales Tax Institute. Retrieved 2006-08-11.
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  81. ^ Galloway, Jim (2007-08-28). "On John Linder and Scientology". The Atlanta Journal-Constitution. Retrieved 2007-08-30. {{cite news}}: Check date values in: |date= (help)
  82. ^ Boortz, Neal (2005-09-07). "Nealz Nuze". Cox Radio. Retrieved 2006-08-07. {{cite web}}: Check date values in: |date= (help)
  83. ^ Boortz, Neal (2006-05-25). "Nealz Nuze". Cox Radio. Retrieved 2007-02-26. {{cite web}}: Check date values in: |date= (help)
  84. ^ "Candidate Questions Answered". Retrieved 2007-08-02.
  85. ^ Davis, Teddy (2007-07-31). "Thompson Flip Flops on Taxes?". ABC News. Retrieved 2007-08-02. {{cite news}}: Check date values in: |date= (help)

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