Fair Tax Fantasy

For over a hundred years our Federal government has taxed the money coming into our bank accounts. Lately there’s a growing minority of people who think it’d be clever to tax the money going out instead.

It’s called a “consumption tax”. The most popular version of it is called the “Fair Tax” (www.fairtax.org). The idea is to abolish all income taxes and replace them with a flat 23% (inclusive in the price) tax on spending. This includes spending on all retail goods and services: food, clothing, shelter, utilities, medical care – nearly everything except stocks and education.

Critics are quick to point out the “inclusive in the price” 23% number is misleading because sales tax is always calculated “exclusive from the price”. When figured this way, the real number is actually 30.4%. In truth, both numbers are correct in different ways. To simplify:  If you were to pay a 50% sales tax on a $100 item, your total bill would come to $150. Of that $150, $100 goes to the store (66%), and $50 goes to the government (33%). So is your tax rate 50% or 33%? Your tax rate is 33%; the tax is inclusive in the price because 33% of your $150 went to the government. However, the sales tax on the item is 50%; the tax is exclusive from the price because the item cost 50% more than it used to. So under the “fair tax” plan, our individual tax rates would be 23%, and the sales tax on all goods and services would be 30.4%. Of course, they prefer to publicize the former and hide the latter because it makes the plan more inviting.

Regardless of how we define the rate, if we instill this plan without deductions, it becomes an extremely regressive tax. This is because, on average, poor people spend a greater portion of their income than rich people. Poor people making 15K a year would likely spend 100% of their income on food, shelter, clothing, and medical bills – whatever it takes to survive. The government would take 23% of all this spending, so they would effectively pay a 23% tax on their income. A wealthy person who makes 10 million a year might spend 2 million and invest the rest. 23% of 2 million in spending is $460,000. So their effective tax paid on 10 million of income would be 4.6% — about one fifth what a poor person pays.

This is why the “fair tax” plan would institute something called “Prebates” [pdf].  At the beginning of every year, families would receive a check from the government valued between $2,392 and $10,580  (depending on how many children they have). This would effectively cancel out sales tax paid on the first 10K-40K spent.

At first blush, this appears to be a great idea as it clearly protects the poor. Further inspection, however, reveals it does nothing to increase taxes on the rich accordingly, so the total revenue raised becomes insufficient.

For instance, if we assume an average prebate cancels out taxes on the first 20K spent, we get a distribution that looks something like this:

Someone making 20K might spend it all on living expenses, however their prebate equals their tax, so they effectively pay 0% tax.

Someone making 100K might spend 85K. The prebate effectively takes care of the first 20K of spending, leaving 65K to be taxed at 23% — a payment of $14,950, an effective 14.95% tax on 100K of income.

The owner of a software company might clear 100 million and only spend 10 million. Subtract his prebate and he pays 23% of $9,980,000 which is $2,295,400 or 2.3% tax on his original 100 million profit.

It does protect the poor, but it also allows the rich to accumulate masses of wealth tax free.  In fact, if you look at these numbers, it’s clear that everyone gets a huge tax cut. This is the appeal of course. The only problem is that we will not be able to generate sufficient revenue.

We can actually do a quick and dirty calculation of what the sales tax would have to be to bring in the same money we currently bring in with income tax by using this chart:

By subtracting even the minimum prebate from every income group and assuming the average American spends a hefty 85% of their income on retail goods and services, we find a tax rate of 34% (not 23%) is necessary to generate the same revenue as our current tax system. Even if we assume every American spends 100% of what they earn, then we still need a consumption tax of 29% to match our current revenue.

The people at fairtax.org suggest a 23% rate is possible.  In fact, they’ve published this wildly optimistic paper to show how everyone can get a huge tax break and the government can bring in the same revenue we do now.

How do they get it to add up? To begin with, they suggest they will make up much of the difference by taxing a hidden 1.5 trillion dollar underground economy that consists of illegal immigrants and drug dealers who aren’t paying income tax.

Thankfully, they are no so bold to suggest the illegal immigrant gardener is going to collect sales tax on his services.  Their argument is a little more nuanced than that. They admit the gardener will forgo sales tax just like he forgoes income tax, but when he spends the money he earned, he will be taxed, a fate he cannot avoid (unless he sends the money home). At first glance this seems somewhat interesting, but ultimately it overlooks the big picture of how taxation works.

Consider the following: Money moves back and forth between people. People pay businesses in the form of spending, businesses pay people back in the form of wages. Any individual dollar is taxed numerous times throughout its lifetime. Income tax taxes the “wage” step of this cycle. Sales tax taxes the “spending” step in this cycle. Since spending is the very next step after paying your gardener, it appears we’re getting tax via the sales tax where we would have gotten none through the income tax, but they fail to mention that we would lose income tax on the first step (our employer paying us). Basically, they’re playing a shell game.

For example: suppose a software engineer from Apple hires an illegal immigrant to mow his lawn. Will we get more revenue out of the system of sales tax or the system of income tax? Let’s follow a dollar bill through both cycles and compare:

The Income Tax Cycle

The Sales Tax Cycle

Of course, this chart makes it look like Income tax is bringing in twice the revenue as sales tax would – that’s not entirely fair. A better comparison would allow the national sales tax chart to start and end on a taxable transaction.

The Sales Tax Cycle amended

Either way, it’s quite clear that the “Underground” transaction robs both systems of one and only one tax cycle of the chain. The ONLY way to get this cycle back and actually profit off the so-called 1.5 trillion dollar “underground” economy is to manage a way to tax the very transaction that is being hidden – either by sales tax or income tax.  There is an easy way to do this of course – make illegal immigrants legal, but that’s another article.

Their second claim to justify their wildly optimistic numbers is to suggest the fair tax will generate revenue from tourists spending money in America that our income tax ignores. This is true, but they fail to mention that we will lose money from Americans’ spending overseas with money that wasn’t taxed via income tax.  How much more do foreign tourists spend here than Americans’ spend overseas? The latest numbers suggest we score a net gain of 8.6 billion dollars per year. Tax that at 23% and we have almost 2 billion dollars, or a whopping 0.03% of our national budget.  Looks like our problems are solved.

The third tenet of their defense asserts their system is simpler and will close loopholes. It’s quite obvious our current income tax system is painfully complex and filled with many loopholes, however a three hour perusal of their system shows it’s not a walk in the park.

It takes a 40 page book [pdf] to explain the fair tax in “Plain English”. The actual bill is considerably more complex. And just like our current system of income tax, confusion creates fertile ground for exploitation.

The bulk of the problems revolve around the fact that “intermediary costs” or “wholesale” costs are not taxed. Need a coffee machine? Buy one for the office tax free. What about the car you use for business? Just like in our current income tax system, you must decide what percent of it is used for business and what percent is used for your personal life. Want to give that car to your child after 2 years? Then you must determine the value at the time of the gift and charge your child sales tax – a seemingly unlikely prospect.

Services rendered are even more ripe for exploitation. Is your baby sitter going to charge you tax? How about the boy that mows your lawn? Need to hire a computer consultant? Pay 30 percent sales tax. However, you can put that person on payroll as a part time employee and her services come tax free.

What about internet and mail orders? I order over the internet right now to avoid a 5 percent sales tax. Can you imagine what effect a 30% sales tax would have? What about a 66% sales tax?  Why pay a massive tax at Best Buy when you can order on the internet from Canada tax free?  I can’t think of a larger incentive to steer clear of American goods.

Oh yes, did I mention that the government has to pay itself sales tax whenever it pays for a good or service? (Page 666, section B [pdf]) If that’s not the essence of bureaucracy, I don’t know what is.

That said, there is a conceivable  advantage of the fair tax system that is worth noting. It could cut down on foreign tax havens. It does not do any good to incorporate in the Bahamas if your products are sold and taxed  in America.  It’s estimated that we lose roughly 100 billion per year in tax revenue due to these offshore havens.  However, the idea that it would all be won back if we were to switch to the fair tax assumes 1) These companies are selling all their goods in America (most of them are international) and 2) They would not exploit the ability to sell their products outside our borders (via mailorder) and ship them in. (The products are likely made outside our borders, and they show little regard for following the rules). Furthermore, there’s nothing that says we can’t crack down on these cheaters from within the system we already have. In fact, Obama is moving to do exactly that.

Their last claim as to why their optimistic numbers will work is perhaps the most insidiously deceitful. They have the gall to declare that the wealthy will pay more under their tax system. To illustrate this, they draw up a wildly unlikely scenario of a trust fund baby that has absolutely no income and lives entirely off their trust fund and spends at least as much as he or she make in interest so the size of their trust fund doesn’t grow . If all these conditions are met, and Obama doesn’t let the drastically low Bush capital gains tax cuts expire, then yes… it’s true, these trust fund babies will pay 23% instead of 15%. To suggest that this narrow definition characterizes “the wealthy” or to indicate that the few that meet these criteria will have a measurable effect on government revenue is so wildly misleading that it can only be called lying. (The point will be impossible to make after Obama raises the capital gains tax anyway.)

All in all, it’s pretty sad. Our current income tax system needs overhauled and I honestly wanted to like the “fair tax”. But a quick look at their numbers show it would be wildly regressive, would generate woefully insufficient revenue, and is filled with mind boggling complexities that make it ripe for exploitation.

What do I suggest in its stead? A flat tax with deductions. I believe that idea to be superior in every way.