The FairTax

In Full Archive by Nathan Lewis

I decided that it was time to give the FairTax a fair hearing.

The FairTax Book (2005), by Neal Boortz and John Linder
FairTax: The Truth (2008), by Neal Boortz and John Linder
The FairTax Fantasy (2009), by Hank Adler and Hugh Hewitt

All in all, I came away rather impressed. I don’t find that the idea has any obvious problems, although it does have certain characteristics, which might be considered a feature or a flaw depending on one’s perspective. I think it is a workable plan as-is, and since eventually we have to agree on something, I think this is something we can agree on.

To summarize, the FairTax plan proposes eliminating the personal and corporate income tax, and the payroll tax, and replacing them with a simple national retail sales tax designed to generate the same amount of revenue. To this is added a “prebate,” which is basically a compensation for the sales tax paid up to the household poverty level, thus rendering purchases up to this level effectively tax-free. This “prebate” is paid to all households, whatever their income.

The prebate, as of 2005, would be basically $188 per month per adult, and $65 per child. One option to administer this would be something like a debit card which is credited for the prebate amount per month, a system that is already used for some welfare programs, and has the advantage of being very cheap to administer (allowing monthly payments rather than annual) as opposed to sending checks in the mail.

The estimated tax rate is 23%. This is an “inclusive” rate, as a percentage of the gross purchase price. Thus, if a total of $100 is paid, then $23 would go to the government and $77 would be the ex-tax cost of the item. This is somewhat different than sales taxes are commonly calculated today, but it is the same as income taxes are calculated. This used to bother me, but I don’t have much problem with it now. the FairTax fans imagine that retail receipts will regularly show how much of their purchase price is going to the government. It is estimated that if there were no “prebate,” the tax rate could be lowered to 20%.

For a long time, people have argued between “Flat Taxes” and the “FairTax.” Unfortunately, as is common in these things, this argument stems largely from a sort of cultural difference, rather than the essentials of the plans themselves. The Flat Tax idea emerged in the early 1980s, as part of the tax reform efforts of that time, and was formalized in The Flat Tax (1985), by Robert Hall and Alvin Rabushka. It seems that everyone has their own tweaks on this plan, with similar (but different) plans offered by Steve Forbes, Jack Kemp, Art Laffer and others. A little culture or society has emerged around these ideas, including think tanks like the Hoover Institute, Heritage Foundation, Empower America, and so forth. The FairTax emerged about ten years later, from a completely different direction. It was created among a group of businessmen centered around Houston, Texas, apparently in the late 1990s. Quite a lot went into its perfection, including (reportedly) over $22 million spent on various forms of research and inquiries of regular Americans, and the involvement of several economists and tax experts. A large grassroots organization involving hundreds of thousands of volunteers exists, centered around fairtax.org. The first bill in Congress, the FairTax Act (HR 25) was introduced in 1999.

For the most part, the Flat Taxers don’t like the FairTaxers (it’s “FairTax” by the way, not “Fair Tax”), and vice versa. Bruce Bartlett makes a cameo appearance in FairTax: The Truth, apparently claiming that the plan comes from the Church of Scientology (it doesn’t). But, I think they are both good ideas.

On the surface, they seem very different. But, as Hall and Rabushka argued back in the 1980s, actually the Hall/Rabushka Flat Tax is surprisingly similar to a Value-Added Tax, which itself is similar to a retail sales tax. The main advantage of the Flat Tax apparently is to introduce an element of “progressivity” by allowing a basic deduction. The FairTax accomplishes this with the “prebate.”

Flat Tax: An Overview of the Hall-Rabushka Proposal

Prepared for Members and Committees of Congress

The concept of replacing the current U.S. income tax system with a flat rate consumption tax is
receiving congressional attention. The term “flat tax” is often associated with a proposal
formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover th
Institution. In the 110 Congress, Representative Michael Burgess’s proposal (H.R. 1040) would
allow taxpayers to select a flat tax (based on the concepts of Hall-Rabushka) as an alternative to
the current income tax system. Senator Richard C. Shelby’s proposal (S. 1040) and Senator Arlen
Specter’s proposal (S. 1081) would replace individual and corporate income taxes and estate and
gift taxes with a flat tax based on the Hall-Rabushka concept. This report discusses the idea of
replacing the U.S. income tax system with a consumption tax. Although the current tax structure
is referred to as an income tax, it actually contains elements of both an income and a
consumption-based tax. A consumption base is neither inherently superior nor inherently inferior
to an income base.

The combined individual and business taxes proposed by H-R can be viewed as a modified value-
added tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension
receipts. Part or all of an individual’s wage and pension income would be tax-free depending on
marital status and number of dependents. The business tax would be a modified subtraction-
method VAT with wages (and salaries) and pension contributions subtracted from the VAT base,
in contrast to the usual VAT practice.

To the extent that this is valid, we find not so much difference between the two at all, at least in broad principle. To be honest, I still have difficulty with this idea, and have not worked out all aspects of it to my personal satisfaction. I hope to return to this topic in the future.

One of the main differences is that the Flat Tax leaves the existing payroll tax alone, and the FairTax eliminates it. Actually, the payroll tax is already ameliorated somewhat by the Earned Income Tax Credit. Some Flat Tax proposals allow for the continuation of the EITC until it can be somehow resolved. I am not so sure that I like the idea of making the lowest incomes effectively tax-free. This is a common notion in America that I once embraced, but today I am interested both in the idea of payroll taxes as a sort of fee-for-service for socialistic government services (as it is already structured in the U.S. and Europe), and also, the idea of a uniform tax that applies to everyone, from the first dollar earned. But, realistically, that is not going to pass in the U.S. A uniform FairTax (no “prebate”) at a 20% rate is not so much higher than the 15.3% existing payroll tax rate, but if you consider also the EITC then it is a lot higher. Anyway, one argument for the “prebate” is that it eliminates all discussion (we hope) of exempting certain goods and services, like food or medicine, from taxes on the grounds that they are “necessary. ” These exemptions can quickly become complicated. The FairTaxers argue simply that the first $xxx for a household ($26,400 for a family of four in 2005) is “necessary” and effectively tax-free under the “prebate.” All in all, I think it is a pretty good system. The “prebate” is “uniform” in the sense that everyone receives it, regardless of income. All you need is a Social Security number.

Eliminating the payroll tax may help foster future entitlement reform, such as making Social Security means-tested, and eventually phasing it out in favor of a provident fund arrangement.

Among the most important advantages of the FairTax is that it eliminates the Internal Revenue Service, and also, eliminates the “tax return.” If you have a tax return, even if it is a very, very simple one, then you have an avenue for future complication. It is still a “direct tax,” paid by a person, rather than a charge on a transaction (sales tax or payroll tax). It still involves the government investigation into one’s personal affairs, of the sort that is in direct opposition to the Fourth Amendment (ratified, of course, in a time without an income tax).

The FairTaxers are rather adamantly opposed to the VAT, oddly enough. Boortz cites Milton Friedman: “The VAT is the most efficient way to raise taxes and the most effective way to increase the size of the government.” They argue that the VAT is hidden in every stage of the production process, while the FairTax (retail sales tax) is transparently applied at the final transaction. And yet, I find it hard to imagine that Europeans paying VAT are not aware of the official VAT tax rate. One advantage of the VAT is that, by taxing in several small steps, it becomes hard to evade. A retail sales tax has more potential for evasion, I think, but I am willing to give it a try and see what happens. You can institute a VAT later if things don’t work out.

By taxing consumption rather than income, the FairTax effectively becomes a sort of tax on wealth. Retirement wealth is taxed during retirement, when it is spent. The very wealthy might find their wealth taxed when it is spent by their descendants.

One of the most important FairTax concepts is the idea of “embedded taxes.” All goods and services have the cost of embedded taxes in them. For example, if you pay an employee $5000, and after taxes, they get $3500, then you have to raise the price of the product or service to pay the extra $1500 of embedded taxes. After the FairTax reform, one of two things would happen: the price of goods and services remain unchanged, plus the FairTax sales tax is imposed on top of that, raising the final purchase price; but people get the full $5000 of their income instead of $3500. Or, as seems more likely, corporations would be able to pay their employees $3500, and since their personnel costs have now fallen from $5000 to $3500, the cost of the product could also be reduced, such that the final cost including the FairTax is about the same as the cost without the tax today. In other words, the price of the $100 item, with $23 of embedded taxes, would fall to $77, plus the $23 FairTax, for a final cost of $100.

Obviously, this would also make U.S. corporations vastly more competitive internationally, since they would be selling without those embedded costs. In European countries, VAT is commonly refunded on exports, thus removing the embedded cost of VAT. But, U.S. embedded income/payroll tax costs are of course not refunded. The FairTax would allow U.S. corporations to export without the cost of embedded taxes. And, of course, there would be no corporate income tax. This is a rather nice combo for any major corporation. A survey of major international corporations found that, if the U.S. adopted a FairTax, the U.S. would become the most attractive location for expansion. Some managements said that they would migrate and become U.S. corporations.

I think we are coming to a time when major reform of the Federal government will be possible, and even necessary. I think this should take the form of devolving all socialistic programs — healthcare, welfare, education, etc. — down to the State level. Social Security could be replaced by a provident fund system. This would reduce the size of the Federal government’s budget by about two-thirds, which would allow a FairTax rate of about 8%. Since State governments are likely to also use the FairTax for their own tax systems, and would also be responsible for all welfare/socialistic programs, the combined Federal/State rate would still be pretty high. But, it would be up to State policy, and States could have some interesting competition in this regard.

Much of the Flat Tax/FairTax debate comes down to personal preferences regarding the continuation and reform of existing institutions (income tax/payroll tax) or their replacement for something that promises to be better. Any big change to societies inevitably introduces unforseen effects, and these can be negative. With all of that said, I think I like the FairTax plan better.