The Fair Tax is a proposal to reform the federal tax code and eliminate the IRS. As proposed, it would eliminate existing federal income taxes, both individual and corporate, payroll taxes, gift taxes, and estate taxes. In their place, it would substitute a single national consumption tax, applied once, at the point of purchase on all new goods and services for personal use.
The proposal also provides a monthly payment to all households of legal residents as an advance rebate (called prebate) of the tax paid on purchases up to the poverty level. This proposal was first introduced in Congress in 1999 by Georgia congressman John Linder and has been reintroduced every year since.
Before getting into specifics of the Fair Tax reform proposal, I want to examine the name given to this plan. After all, what’s in a name? Specifically, why use the word “fair?”
We are told the name was selected after conducting numerous interviews and polls of average taxpayers. I suggest, somewhat cynically perhaps, that the name was not chosen at random. In an era of political spin, this name serves two purposes. First, it avoids the term sales tax which generally meets political and popular resistance due to a commonly held understanding that a sales tax is regressive.
Second, this name pejoratively asserts that this tax is fair and thus implies that all other taxes must be unfair. Like beauty, however, the determination of what is or isn’t fair under any tax code is likely in the eye—more likely wallet—of each taxpayer.
Many believe that fairness requires every person to pay some federal tax. That does not happen now given the multitude of IRC exceptions, exclusions, deductions and credits. However, as currently proposed, the effect of the Fair Tax on families whose income falls below the poverty level, or prebate threshold, is that they also would not pay any federal tax. Using this definition, the name of this tax is a misnomer.
Many others hold that a tax is fair if everyone pays the same percentage. If so, one is compelled to ask, “Percentage of what?” It is hard for me to use the word fair to describe a system under which a family of four, with a household income of $60,000, pays an additional 23% for the purchase of a loaf of bread, for clothes for the children, while a taxpayer somewhat better heeled pays 23% for the purchase of a luxury car. Yes, the price tag for that car would produce tax revenue in the thousands, even tens of thousands of dollars. But, remember, this taxpayer is likely paying something significantly less than 23% of his total income in taxes, allowing him to accumulate even greater wealth.
A final interpretation of fairness could be that, as taxpayers earn more, they incur a higher tax bill in actual dollars. In truth, the Fair Tax, just as almost any income or consumption tax system, marginal, flat, or otherwise, produces that result. Those who make and spend more would pay a higher tax bill in actual dollars. Whether applying this criterion is the best way to determine whether the result is fair or not, I leave to you.
Under this proposal, Americans may find themselves asking, “Where fair art thou?”
Let’s get into it. In plain English, the Fair Tax calls for the implementation of a national sales tax—replacing all existing federal taxes (other than excise and use taxes) with a tax on consumption. This tax would be levied at the time a retail sale occurs—that is, the sale of a good or service to the ultimate end user. As proposed, the sales of all new goods and services, other than tuition for higher education and the purchase of business inputs (i.e. Cost of Goods) would be taxed. The sale of used goods would not be taxed under this proposal
Although the proposal sets the initial rate at 23%, the actual effective rate has been the subject of debate. Proponents assure us that the tax rate is 23%. Opponents argue that it is actually 30%. As I warned, both sides are using the argument that best supports their position.
The actual language in the law that has been introduced states “…23 percent of the gross payments…” But note the word “gross”. If an individual pays $100 for an item, this amount includes $23 that must be paid over to the federal government. This methodology is referred to as “tax inclusive.” Advocates argue that this methodology is the best way to compare the actual tax paid under the Fair Tax to the tax paid under existing income tax methods.
To demonstrate, if Form W-4 provides for 15% to be withheld from wages for income tax, an employee who earns $100 would actually receive $77.35 ($100 less $15.00 FIT less $7.65 FICA). In this case, we would typically say he has paid 22.65% in federal taxes.
However, those who oppose this plan argue that when the buyer pays $100 for the item, $23 is for federal sales tax and $77 is for the item. Comparing those numbers with the general manner that we talk about sales tax, the rate paid is 30% ($23 divided by $77). This approach is referred to as "tax exclusive."
Debate over the actual rate is not the only argument that has arisen between proponents and opponents. Disagreement exists over whether the plan is revenue neutral (will it raise the same amount of revenue as the taxes it replaces) and whether it would adversely impact compliance. Frankly, those arguments are more smoke and mirrors than substantive debate. How much revenue can be raised is a function of the rate assessed. Compliance is a problem for any tax system.
A much more heated dispute arises over the actual distribution of the tax burden under this proposal. Said in another way, will implementation of the Fair Tax make America’s tax system more or less progressive.
Supporters argue that the plan is progressive, that implementation will broaden the tax base, and that it will decrease overall tax burdens and begin to effectively tax wealth. Opponents counter that a national sales tax is inherently regressive. They contend that it will decrease the tax burden on high-income individuals.
To put this argument in perspective, consider two taxpayers. The first, with income approximating $5MM, spends $2MM to maintain his lifestyle. The Fair Tax paid would total $460,000. Said differently, this person would pay less than 10% of income in federal tax (disregarding prebate.) A second taxpayer earns $125,000 and spends $90,000 on taxable good and services. The net amount fair tax paid, actual tax less prebate, approximates $15,000, or 12% of income. You can draw your own conclusions regarding the different outcomes, but the example is reasonably accurate.
One major difference between the two views on progressivity is semantics. Although, perhaps this difference is not a result of semantics as it is of the different methodology each camp uses.
Those favoring this plan suggest that taxing “consumption” would be progressive. Those below the poverty threshold pay no tax. As spending rises, the amount of tax paid, as a percentage of “spending” increases. Simply, the impact of the prebate is diminished as the level of spending increases. The tax paid approaches a perfect 23% at very high levels of spending. Hence, taxing spending would meet the definition of a progressive tax. Those opposed continue to bring the debate back to the calculation of tax paid as a percentage of income.
Regardless of one’s view, implementing the Fair Tax would clearly bring about a major reform of our current system, changing it from one based primarily on income taxes, to one that would only tax consumption. Said differently, the United States would tax what everyone—Americans, immigrants, legal and illegal, and visitors to America—spends as opposed to what they earn.
This reform proposal has been the subject of a best-selling book and the topic of numerous blogs and radio talk shows. For more information, you can read The Fair Tax Book, written by Neal Boortz and Congressman John Linder or the actual text of the Fair Tax Act.
As the screen goes dark, it is fair to wonder, “Whither must I wander?” I am wandering to a local oasis to read some labels on various beer bottles. Who knows, maybe I will learn something.