The FairTax is a bad idea.

Remaining from a September debate, I owe regular commenter Scott my analysis and opinion of a national sales tax. To be upfront, I began my search against the idea. Not because I wanted to hate it, although I do hate it. Yet, as I’ve thought about my 15-year support for a flat tax plan – and I acknowledge that it has its problems – I’ve considered some of the basics of a national sales/consumption tax. The economics and politics of a national sales tax fail miserably.

From Americans for Fair Taxation, I roamed through some of the finer points of what is now under consideration. I used this recent editorial to focus mostly on the ideas. For example:

What emerged from this research is that a national retail sales tax is a preferred method of taxation among most Americans surveyed.

A majority of Americans supported slavery at our nation’s beginning. Segregation was hunky-dory for most well into the 20th century. Even today, a majority of Americans believe that surgically altering the healthy genitals of their male children is reasonable. Of course income versus sales tax is not comparable to those sorts of oppression, but forgive me if I fail to be swayed by such arguments in favor of any position. Mob desire is irrelevant because good intentions do not guarantee good outcomes. The details matter.

Research on the price of consumer goods reveals that up to 20% of all prices today represent hidden income taxes and payroll taxes. Once these taxes are repealed and replaced with the FairTax, it is likely that market pressure would force retail prices to fall.

This is either ignorant or dishonest. The FairTax will not eliminate embedded taxes; it will merely change the source of which businesses collect taxes from individuals. Even something as simple as an apple will have embedded taxes.

The apple will require a seed to create an apple tree. That seed will have a sales tax. The tree will require fertilizer to make grow. That fertilizer will face a sales tax. The fertilizer will need to be transported from producer to apple grower. That fuel will face a sales tax. The distributor needs a truck to haul the fertilizer. That truck will face a sales tax. The truck will require gas to operate from A to B. That fuel will face a sales tax. And so on, all the way to my cupboard.

Now, imagine something more complicated, with multiple ingredient raw materials. Think that iPod that Americans love doesn’t consist of parts purchased from vendors with an “s” for plural who all require inputs to make their products? The disappearance of embedded taxes is a myth, unless we assume that someone who currently fails to absorb hidden costs will suddenly absorb non-hidden costs. I will not assume something quite that silly.

Which leads to this, perhaps the boldest claim:

The FairTax would collect revenue from the underground economy.

How, exactly, when basic logic suggests the FairTax would push more of the U.S. economy underground, not less? There would be evasion everywhere. Need to get your hair cut? Here’s $20 cash. Need your lawn mowed? Here’s $40 cash. Never doubt the human capacity to subvert rules. Simplicity is important, but reducing the burden of complying is much more effective. Absent that, reducing the ability to bypass the system is important. I don’t have to believe that taxes are good to push the idea that collecting as close to the assumed amount is wise. Otherwise, reality will be destroyed by the theoretical estimate and actual receipts. The rate would increase more the greater those two figures differ.

As the FairTax advocates own figures indicate, the sales tax is not 23 percent. That’s only the tax-inclusive rate offered because it looks better² than the tax-exclusive – the common metric – rate of 30%. Dividing 30¢ sales tax by the final price of $1 and 30¢ gives a 23% tax-inclusive rate. But in Virginia, if I go into the store and buy a bottle of water, I see the price of the water as 99¢ and the final price as $1.01 after the 2% sales tax is added. No one pretends that the rate is 1.98%.

In the end of the editorial, this:

Significantly, the FairTax eliminates all loopholes, gimmicks, exemptions and deductions from the federal tax system.

The “prebate” is certainly an exemption, and given the details, I’d call it a gimmick. The details:

Another benefit of the FairTax is that, unlike other sales taxes, it would not hit the poorest Americans the hardest. The FairTax proposal calls for sending every American a “prebate” check to offset the cost of the national sales taxes paid by those living in poverty. This feature would effectively exempt those living below the poverty line from paying taxes to the federal government, and provide all taxpayers with a reimbursement of a portion of taxes paid.

Who’s administering this “prebate”? How are differences in regional cost of living factored into the “prebate”? Are the differences factored in? According to the following document, “The Prebate Explained” (pdf):

Poverty level spending represents what it costs families of varying household size and composition to buy their necessities.

All consumers are alike. Every central planner believes that and the “prebate” requires the adoption of central planning. You need four chickens, two gallons of milk, one dozen eggs, and eight ounces of cheese. That’s normal. Except it’s not, because the government can’t know everyone. It can only assume and expect you to fit that mold. Some people will receive a larger “prebate” than they should and some will not receive enough. It’s inevitable.

And what about those people who spend their “prebate” on lottery tickets, for example? I’m not offering that as an expectation of what “the poor” will spend their “prebate” on or as a judgment on lottery tickets. I think people should be able to spend their money on whatever they want. But this plan specifically relies on government-managed handouts, in advance and tied to no actual spending, to make the plan plausible and not regressive. How do we prevent such wastefulness among citizens when it leads to further reliance on the government to pay for necessities? There will be people who waste their “prebate”, just as there are now millions of Americans who believe that their tax refund is found money rather than an interest-free repayment of excess taxes paid as many as 16 months prior. There will be a call to further assist these people through government resources. The loopholes, gimmicks, exemptions, and deductions aren’t going anywhere.

Neither is the intrusion of government into each person’s privacy. To get the “prebate”, Americans must do the following (according to the pdf above):

The registration form requires only the following information:

  1. The name of each family member who shares the residence;
  2. the Social Security number of each family member;
  3. the family member to whom the monthly prebate check should be paid;
  4. a sworn statement that all listed family members are lawful residents, that all family members sharing the common residence are listed, and that no listed family members are incarcerated;
  5. the address of the shared residence; and
  6. the signature of all family members 21 years of age and older.

Failure (unwillingness) to adhere to those instructions results in no “prebate”. And again, who will be managing this information and
distributing monthly checks to millions of households? Maybe the IRS goes away, but why should I believe its replacement will be any better? (Who validates that my claim of 6 children is correct? Fraud and waste, anyone?)

The effect of eliminating regressive payroll taxes is commonly overlooked when analyzing the FairTax, but it would have a very significant impact, as these taxes represent the single largest tax burden on these income earners.

I agree with fixing the burden of payroll taxes. It is inherently regressive. Making it “fair” would be a huge tax increase on higher earners, but it wouldn’t help our economy. So what to do?

Eliminating the tax is a great idea, but the FairTax only seeks to fund the underlying flawed entitlement through a sales tax without addressing the fundamental flaw in seeking to be revenue neutral to maintain ineffective programs. And since when has Congress been expenditure-neutral? Why should I believe it will suddenly find fiscal responsibility? Taxes are bad¹ and should be lowered as much and as soon as possible, but we need to cut expenditures first. Without that measure, we’re engaging in diversionary games³.

Finally, and most damning from a practical path, how do we transition from an income tax to a sales tax? The Y2K nonsense was overblown. Flipping the switch from Income Tax on December 31, 20xx to Sales Tax on January 1, 20xx would be a realized nightmare, but I’ve seen nothing other than that simplistic transition implied. That’s foolish.

I also used this chain of entries from Kip at A Stitch in Haste as research.

¹ We have a $9,124,016,501,555.91 national debt, as of today. That has to be repaid.

² For another example of this sleight-of-hand marketing, read this.

³ There is one final caveat looming large. We’d have to repeal the 16th Amendment.

11 thoughts on “The FairTax is a bad idea.”

  1. “All consumers are alike. Every central planner believes that and the “prebate” requires the adoption of central planning. ”
    Right on!
    The flat tax, as well as the current system (or any system of involuntary contribution, for that matter) neglect to concern themselves with the qualitative differences between myriad individuals, which cannot be seen at an aggregate, macroeconomic level.
    And per Rothbard: “The consumption tax… can only be regarded as a payment for permission-to-live. It implies that a man will not be allowed to advance or even sustain his own life, unless he pays, off the top, a fee to the State for permission to do so. The consumption tax does not strike me, in its philosophical implications, as one whit more noble, or less presumptuous, than the income tax.”

  2. In your analysis you seem to forget or not realize that b to b transactions are not taxed. Therefore in your apple example, the seed, the fertilizer,the fuel, the delivery truck and any other costs incurred up to the point where you place the apple in your shopping cart are not taxable transactions and therefore do not add imbedded taxes to the product.
    The $20 for a haircut and $40 for a mowed lawn and about millions of other cash transactions that occur on a daily basis don’t get taxed today either, but with a consumption tax, when that $40 you give to the neighbor’s kid to mow your lawn is spent on a video game or whatever else he chooses to buy he would have to pay the consumption tax, this concept also applies to prostitutes, drug dealers and the rest of the underground economy, where the income tax leaves the money totally untaxed. With the FairTax we don’t care about how the money is earned as much as how you spend it, true there will be many services and elicit goods sold tax free but the procedes from these illgotten funds will more than likely be taxed.

  3. “In your analysis you seem to forget or not realize that b to b transactions are not taxed.”
    Which of course requires a neo-IRS to decide, as a matter of law and penalty, what is and is not a “business.”
    I also find fascinating the obliviousness of FairTax advocates who point out, as somehow a “plus,” the proposition that new home sales would be taxed but pre-existing home sales would not. Good luck trying to make that work.

  4. John,
    Point partially conceded. However, the overall point is still problematic. If all of these embedded taxes go away, how does the consumption tax add up to revenue-neutral? I don’t see it. I’m open to convincing, although the larger point about the plan’s practicality remains.
    My examples of $20 for a haircut $40 for mowing were meant differently. Let’s say I now pay a lawn service to manage my yard. I pay them x per week. Under the FairTax, I’m paying them (x – previously embedded taxes + FairTax). With all of the exemptions like business-to-business and new-vs.-used, the math simply does not add up to revenue-neutral.
    As I’ve argued in the past, I’m not committed to revenue-neutral. It’s a stupid constraint to place on tax reform. It leaves the assumption that what the money is spent on is legitimate and/or valuable. I don’t assume that. But FairTax advocates are claiming revenue-neutral, as far as I can tell, which suggests to me that the intent is to continue spending the same amount of revenue.
    And Kip’s point about new versus used homes is huge. It’s a vital industry. We already have too much central planning. Such an exemption will force more, as it strongly discourages new construction. In some areas, that’s probably not as much a problem. But in growing cities like the D.C. metro area where I live, new construction is everywhere.
    And what kind of regulations, incentives, and other nonsense will Congress offer to counter the inevitable harm to individual groups? There is no way the FairTax causes Congress to get out of the special interest game. None.

  5. revenue neutral? The answer to how it could be revenue neutral is 2 fold part one is by taxing the underground economy(est $1 trillion) and tourists(est.40 million tourists annually) on everything they spend and the second part is increasing everyone’s spendable income by 25% or more by removing taxes from their paychecks and with embedded taxes eliminated you buy what you bought before and the extra 25% will also get spent, because Americans love to spend money. So there are several tax collection points that are not able to be accurately measured due to the illeagal nature of the underground economy which is why the 23/30% figure was calculated using the GDP and many believe if spending levels stayed where they are now that percentage could drop drastically.
    I agree with the need for spending controle more than revenue neutrality but let’s deal with one prob at a time.
    the housing market? i work in the building industry and i can tell you that the tax on new houses will not be a problem for 2 reasons, 1) the cost will be the same 100K with imbedded taxes= 100K after FairTax so if you would buy now you’ll buy then and 2)now to pay for a 100K home you need to earn $150K min to have 100K after taxes so even assuming imbedded taxs stay(they won’t) you only need to earn 130K to buy the house with the Fairtax added, result homes are more affordable.

  6. 1. The underground economy is not going away. As long as it’s possible to evade, people will evade. The higher the burden of complying, the more they will evade. A 30% tax on top of the item is a high burden. Maybe the price is equal or lower to what they are now. I doubt it, but maybe. Still, evasion will save yet another 30%. That’s a strong incentive. The underground economy is not going away.
    2. It is not the responsibility of tourists to fund our government. That shifts the burden from citizens, who will now believe they can receive more for nothing. That’s a bad incentive on controlling spending.
    Taxing tourists also discourages tourism. Vicious cycle.
    3. Maybe my spendable income increases by 25%. But my purchasing power does not. I can still buy roughly the same number of goods. I’m no better off from rearranging those deck chairs. Any claim to the contrary is fiction.
    4. Dealing with taxes before spending only encourages higher taxes to cover the spending. That would be a flaw in the flat tax I favor, or any tax reform. But we must acknowledge it as the significant problem it is and try to force the right priority.
    5. Even if I assume that new homes stay the same price from shifting taxes around, existing homes are not taxed. They either drop in value because of the tax exemption, which is an incentive away from new homes, or existing home owners see an artificial bump in their property values, which would likely act as an incentive for new housing against existing housing. Why would I pay someone thousands of dollars for no added value when I could get a new home for the same price?

  7. Economist Dale Jorgensen, Harvard University, was commissioned to find out what portion of current prices were represented by costs for complying with the federal income tax code (i.e., embedded tax costs). He concluded that 22% (average) of every retail dollar, spent by consumers, constituted a price-embedded tax. Thus, in addition to individual income tax and FICA withholding, individuals are unwittingly paying these unseen, embedded business tax costs with every purchase of a new product, or service.
    Under FairTax, prices would fall, due to removal of embedded business tax-related costs. Concurrently, wages may rise due to a mix of factors, including reversion of withheld pay (or some portion thereof) to employees, advancement opportunities due to business expansion resulting from retained earnings, and/or increased demand for labor accompanying increased competition (from that expansion). Where profits (or wages) appear lucrative, competition will move into the market space, driving out excesses (immediately present after FairTax is enacted), arriving at new “market-adjusted” prices.
    For FairTax to constitute 23% of new transaction cost (i.e., “market-adjusted” price plus FairTax), a mark-up of 29.9% (tax exclusive rate) on the new “market-adjusted” price is necessary. (Before balking, consider what we’re paying now if income tax rates are converted to tax-exclusive sales tax rates on net income instead of percentage of gross income. The following figures can be compared to the 29.9% FairTax mark-up: Fifteen pct bracket = 17.6%, twenty-five pct bracket = 33.3%, twenty-eight pct bracket = 38.9% (! really), and thirty-five pct bracket = 53.8% (! that’s how bad it is).
    In order to make FairTax a progressive consumption tax (such as that recently called for by Warren Buffett), all citizen-families are simply sent a monthly consumption [tax] allowance, called a “prebate.” This prebate is intended to reimburse taxes on necessities for every citizen family without need for record-keeping or reporting. Moreover, the direct payment bypasses the creation of a tax code specifying exempted products and services around which a lobbyist industry could grow. The amount is variable, based on family size, and is equal to the FairTax rate on poverty-level spending, as defined by the Dept. of Commerce. At present, a family of one would receive ~$200/month, a family of four, ~$500/month. Thus, the “effective” FairTax rate paid by citizens, will *never* equal the full 23%. Of course, U.S. visitors (legal, and illegal) will pay the full FairTax when they purchase anything new, at retail (used are not taxed again). Under FairTax, working families will have their whole paychecks (minus any state or local income tax withholding) plus their monthly family prebate.
    Additionally, citizens will no longer have to spend the average 50 hours per year preparing their federal tax returns. Having more monthly income may result in using credit less, and saving more. Larger savings will make it easier to purchase a home, at a lower interest rate and monthly payment. (Thus, mortgage deductions are no longer applicable when income is not the basis for taxation).
    But is FairTax actually “fairer”? To provide substantive answers, Prof.’s Kotlikoff and Rapson (10/06) have concluded,

    “…the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.
    “Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax.”

    Further, per Jokischa and Kotlikoff (2005)

    “…once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there’s a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent.”

    The current income-based tax system is also more expensive to run, because of the manner in which the tax code is gamed by politicians and lobbyists. Politicians realize great power, and attract constituencies for support, by granting tax favors (i.e., credits, deductions, exemptions) through lobbyists. Fully, fifty-three percent of Washington lobbyists are there because of the tax code! The tax code is continually changing, making it more complex – more difficult to understand. And, the salaries and costs of tax lawyers and lobbyists end up in higher prices of the products and services we buy. Additionally, the time and money required to keep records, file returns, report for audits, retain accounting and legal help, pay IRS penalties and interest, is time and money lost for other productive, or recreational, activities. Depriving us of the use of withheld wages increases our expenses through zero-interest withholding, inflation, return preparation time, and interest paid on credit cards and loans that otherwise may not have been necessary. Summed up, the cost of tax compliance, nationally, has been estimated to range anywhere from $265 billion to twice that amount, depending on the extent to which tax-avoidance consultation is sought and utilized. These expenses constitute a substantial hidden tax which is incomprehensible to the average working American. And the FairTax gets rid of all of it for most Americans, and most of it for business owners.
    We, as FairTax advocates, believe that government should serve We, the People, with a fair tax system that will not enable politicians to pit poor against rich (creating barriers to achieve wealth, adding tax penalty to the sacrifices made for personal success). Nor do we want politicians to continue using business as a tool to hide taxes from consumers, often villifying business, which discourages entrepreneuship, personal achievement, economic growth. Liberty and happiness depends on restoring the fruits of labor to those who produce them. We believe that the tax function should align with economic growth, not against it, that government should be paid for in the same manner as working Americans – when, and because, something is sold!
    As things stand at present, the system primarily benefits politicans who cater to special interests through lobbyists who game the tax code. The politician seeks to capture them as constituent voting blocks, dependent on continued syphoning of taxpayer dollars to their members’ benefit. This is increasingly repugnant to the average working American who often finds it difficult to meet the needs of his, or her, own family in an environment where federal and state business income taxes substantially contribute to trade inequities resulting in the loss of American jobs! Thus, the Sovereign are continually degraded by features of Congress’s income tax policy. The most rapidly-growing needs-based “special interest” group has become the Citizens! You see? Congress has nearly all the power; and We, the People, have become We, the Serfs, robbed and enslaved. Getting the federal government’s hands out of our family paychecks is the single most important reason to replace the income tax with a consumption tax, the FairTax.
    Many of us have joined in order to build a national movement to free ourselves, our family pocketbooks, and our businesses from confiscation of income, and punishment of productivity. And this we say to our federal representatives,
    “Either scrap the code and enact the FairTax, or we intend on replacing you with someone who will.”
    (May reproduce in whole or part. – Ian)

  8. This is speculation without proof. There’s no evidence provided to logically suggest what the FairTax promises will actually occur. I’m not happy designing a system based on what we might see.
    Beyond that, the primary problem with what you write here rests here:

    Politicians realize great power, and attract constituencies for support, by granting tax favors (i.e., credits, deductions, exemptions) through lobbyists.

    That is not changing just because we go to a FairTax. Nor is the current problem conducive to enacting the FairTax.

  9. I come back from my vacation (and a trip to the hospital for one of the worst cases of stomach flu ever) only to discover that the long-awaited NST debate came and went in my absence. Aaaaaaargh!

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