FairTax

The FairTax is a proposed change in United States tax laws to replace all federal personal income taxes, payroll taxes, corporate taxes, capital gains taxes, self-employment taxes, gift taxes and inheritance taxes with a national retail sales tax and monthly tax rebate to all households.

Although the FairTax is a proposal for a nationwide federal retail sales tax, the proposal allows for the retail sales tax to be administered by the individual states' existing sales tax administrations rather than a federal agency like the IRS.

Legislative history

Georgia Representative John Linder (R), first introduced the FairTax Bill in July 1999 to the 106th United States Congress and has reintroduced the bill in each subsequent session of Congress. The bill has seen the most support in the 108th and 109th sessions of Congress, attracting more cosponsors than any other fundamental tax reform bill introduced in the House of Representatives.

The FairTax legislation was introduced in 2003 to the 108th Congress with cosponsor Democrat, Collin Peterson of Minnesota and gathered 56 cosponsors. The bill did not move past the U.S. House Committee on Ways and Means. The Senate bill sponsored by Republican Senator Saxby Chambliss, with Democrat cosponsor Senator Zell Miller, never moved past the U.S. Senate Committee on Finance.

The FairTax legislation was introduced in 2005 to the 109th United States Congress as H.R. 25 in the House of Representatives and as S. 25 in the Senate. Its formal name is the Fair Tax Act of 2005. On May 22, 2006, the legislation had 55 cosponsors in the House and Senate. John Linder remains the bill's primary sponsor, and former House Majority Leader Tom DeLay and Speaker of the House Dennis Hastert support the bill.^[1] The Senate bill is sponsored by Republican Senator Saxby Chambliss of Georgia.

There has been no difference in any form of the FairTax legislation since it was originally filed in the 106th Congress as HR 2525, except for the dates (when it was submitted to each Congress, when it would take effect, etc.).

For the 2008 U.S. presidential election, Republican candidates John H. Cox and Michael Charles Smith along with Democrat candidate Mike Gravel promote replacing the current tax system with the FairTax.

Tax rate

In its current form, the FairTax legislation applies a 23% federal retail sales tax on the total transaction value of retail goods and services purchases; consumers pay to the government 23 cents of every dollar spent. When you go to the store and purchase an item for $100, the retailer receives $77; the remaining is collected for the federal government. The assessed tax rate is 30% if the FairTax is added to the pre-tax price of a good like traditional sales taxes; items priced at $1.00 pre-tax cost $1.30 with FairTax added (refer to Comparison of tax rates for tax rate calculations). However, since the FairTax abolishes most of the federal taxes and compliance costs that become embedded into the price, supporters assert that the pre-tax price of items will decrease (see Supporting theories of effect).

The FairTax legislation assesses taxes on the purchase of new goods and services. A good is considered used and not taxable if it is already owned by a consumer before the FairTax takes effect or if the FairTax has already been paid on the good. The FairTax would tax all services provided at the retail level. Education and training would be considered an investment and would not be taxed. Saving and financial investing are also tax exempt.

Revenue-neutral rate studies

Economists and political advocacy groups have calculated different revenue-neutral rates for FairTax. A revenue-neutral rate is that tax rate which has no impact on the total dollar amount of federal tax collected. The rates presented below adhere to the legislative framework of the FairTax bill which calculates rates as a percentage of total spending. To adjust any rate below to that of a traditional sales tax, divide the rate by 1 minus the rate (refer to Comparison of tax rates for tax rate calculations).

Any assessment of proposed policy relies on multiple simplifying assumptions. Different researchers use different time frames and methodologies that make direct comparison among estimates difficult. The choice between static or dynamic scoring further complicates any estimate of revenue-neutral rates. ^[2] Each estimate below relies on the individual researcher's choices, so it is not possible to identify a single best estimate of the revenue-neutral rate.

Dale Jorgenson, Professor of Economics at Harvard University and past President of the American Economics Association, estimated the revenue-neutral rate to be 22.9%. Jim Poterba of the Massachusetts Institute of Technology estimated a rate of 23.1%. Laurence Kotlikoff of Boston University found a rate around 24%. Researchers at Stanford University, The Heritage Foundation, The Cato Institute, and Fiscal Associates have calculated revenue-neutral rates between 22.3% and 24%. However, this research was funded by the Americans for Fair Taxation and they have not made these studies public.

Economist William Gale of the Brookings Institution estimates a rate around 31% assuming full taxpayer compliance.^[3][4] Congress’s bipartisan Joint Committee on Taxation evaluated a proposal similar to FairTax that included additional exemptions and estimated a revenue-neutral rate of around 36%. ^[5][6]

Effective tax burden

File:Effectiverate.jpg

The effective tax rate for any household is variable due to the fixed monthly tax rebate checks. The checks have the greatest impact at low spending levels, where they can 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 approaches 23% of total spending.^[7][8] For example, a household of three spending $30,000 a year on taxable items would devote about 6% of total spending to FairTax after the rebate. A household spending $125,000 on taxable items would spend around 19% on FairTax. The total amount of spending and the proportion of spending allocated to taxable items determines a household's effective tax rate.

The lowest effective tax rate under FairTax can be negative due to the rebate checks. This occurs when a household spends less and pays less in taxes than the estimated average spending for similar households. In this case, the household's rebate check exceeds actual taxes paid by that household.

Monthly tax rebate checks

Under the FairTax, households will receive monthly tax rebate checks (known as a "prebate") 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. The poverty level guidelines vary by family size and represent the cost to purchase household necessities. The checks, paid in advance each month, are meant to eliminate the taxation of each household’s purchase of necessities. The government will assume that a household spends an amount equal to the federal poverty level for a household of that size. The annual rebate, paid in twelve monthly installments, equals 23% of poverty level spending for each household size. The formula used to calculate rebate amounts will be adjusted for inflation.

To become eligible for the rebate, households will 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 will disburse the monthly rebate payments.

Comparison of tax rates

The current tax system primarily assesses taxes on income. The tax base is a household's pre-tax income. The appropriate income tax rate is applied to the tax base in order to calculate taxes owed. Under this formula, taxes to be paid are included in the base on which the tax rate is assessed. 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.

Traditional sales taxes assess taxes owed on a tax base equal to the pre-tax portion of a good's price. Unlike income taxes, 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 a sales tax is added "on the top", the individual pays $23 of tax on $77 of pre-tax goods.

Since sales and income taxes behave differently due to differing definitions of tax base, direct rate comparisons between the two can be confusing. For direct rate comparisons between sales and income taxes, one of the rates must be manipulated to look like the other rate. However, this can cause some confusion when not explained properly. A 30% sales tax rate approximates a 23% income tax rate after adjustment. From the example above, an individual pays $23 of tax on $77 of goods. Total spending (pre-tax price and taxes owed) for that transaction equals $100. The $23 of taxes on $100 of total spending yields a 23% rate. By including taxes owed in the tax base, a sales tax rate can be directly compared to an income tax rate.

The FairTax rate, unlike most sales taxes, is calculated on a tax base that includes the amount of FairTax paid. In this manner, it more closely resembles an income tax instead of a sales tax. A final price of $100 includes $23 of taxes. Like the income tax example above, the taxes to be paid are included in the base on which the FairTax is assessed. FairTax is often presented in this manner as a 23% tax rate for easy comparison to income tax rates.

Comparison to a typical sales rate.

Let $r$ be the FairTax rate. i.e. if the rate was 30%, then $r=0.30$

Let $a$ be the FairTax rate in terms of a typical sales tax.

Let $p$ be the price of the good.

Then, the amount that goes to the government is:

$r\times p$

This means the amount remaining for the company is:

$p-r\times p$

In a traditional sales tax system, sales tax is calculated as the fraction of the money going to the company that must be paid to the government. For example, with a traditional 10% sales tax, the government would receive $10 when a company receives $100. Thus, to convert the tax we divide the money going to the government by the money the company nets:

$a={\frac {r\times p}{p-r\times p}}={\frac {r}{1-r}}$

This means that to adjust any rate below to that of a traditional sales tax, one can divide the given rate by 1 minus that rate.

Predicted benefits

Tax burden visibility

FairTax supporters assert that the proposal makes the cost of federal government highly visible—consumers will see most of the cost of the federal government in a single tax paid every time they purchase a good or service. Under the current tax system, the federal government collects revenue through a wide variety of taxes on individuals and businesses. Thus the cost of government is spread out among many different avenues and may not be fully visible to individual citizens. For example, corporate taxes and compliance costs are passed partially from producers to final consumers when producers include those costs in the retail price of goods and services.

U.S. Rep John Linder holding the 132 page FairTax Act in contrast to the more than 50,000 pages of tax code laws and regulations currently in effect.

Effect on tax compliance costs

The cost of preparing and filing all business and personal tax returns is estimated to be $250-$300 billion each year. Approximately the same amount of money was estimated for calculating the tax implications of business decisions. That means approximately $450 billion was spent in the process of collecting roughly three times as much in taxes. According to a 2005 report from the U.S. Government Accountability Office, the efficiency cost of the tax system--the output that is lost over and above the tax itself--is between $240 billion and $600 billion every year.^[9][10] Supporters argue that the FairTax system will reduce these compliance and efficiency costs by 90% and return a larger share of that money to the productive economy. With the FairTax system, the cost of compliance is built into the tax by allowing the business and the State to keep 1/4 of 1% of taxes collected.

Promotion of economic growth

A number of economists have stated that a national retail sales tax would boost the United States economy.^[11] 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. Real investments could increase by as much as 76% initially and remain 15% above present levels. 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%. 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. As falling tax compliance costs lower prices, exports would increase by 26% initially and remain more than 13% above present levels. 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 fifteen years after passage of the FairTax.^[12][13] Opponents offer a study commissioned by the National Retail Federation in 2000 that found a national sales tax would bring a three-year decline in the economy, a four-year decline in employment and an eight-year decline in consumer spending.^[14] Proponents point out that the study done by the NRF does not take into account the drop in prices that will occur when corporate income taxes are removed.

Effect on international business locality

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. Such investment may translate into higher economic growth. Ireland's real GDP growth was almost three times higher than the European Union average between 1991 and 2000. During the decade, Ireland taxed corporate profits from manufacturing at 10%.

Bill Archer, former head of the House Ways and Means Committee, asked Princeton University econometricists 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. 100 companies said they would move their corporate headquarters to the United States.

Effects on Tax Code Compliance

FairTax supporters state that underground or illegal economic activity is largely untaxed under the current tax system. Economists estimate that the underground economy in the United States exceeds $1 trillion annually. By imposing a sales tax, underground economic activity will be significantly taxed when proceeds from such activity are spent on legal consumption. For example, the sale of illegal narcotics will remain untaxed, but drug dealers will face taxation when they use drug proceeds to buy consumer goods such as food, clothing, and cars. By taxing this previously untaxed money, FairTax supporters state the underground economy will be paying more of their share of what would otherwise be uncollected income and payroll taxes.

Most economists believe retail prices are inflated due to embedded taxes and compliance costs passed to the consumer by producers and suppliers. The FairTax will eliminate almost all federal taxation costs from the supply chain, which could lower retail prices by up to 25% (refer to Supporting theories of effect for embedded cost estimations). Proponents believe the addition of the FairTax will roughly counteract the removal of embedded costs, resulting in relatively minor changes in purchasing power.

If there is no net change in retail prices or tax burdens, the licit consumption of goods and services by the underground economy will continue to bear the same tax burden as before. Legal purchases under the current tax regime carry the hidden cost of implicit taxes. When those taxes are replaced by an explicit tax, the consumption purchases will still bear the same tax burden.

Tax compliance

The current income tax system fails to collect on a significant percentage of taxes owed. The IRS estimates there are twenty additional cents of taxes owed on unreported income for every tax dollar collected. In 2001, the IRS estimated this shortfall to be over $312 billion.^[15] These figures do not include taxes lost on illegal sources of income, such as drug-dealing.

Proponents assert that the transparency and simplicity of the FairTax will subject much of this unreported income to taxation. The number of tax collection points would significantly reduce as only retailers would file a tax return compared to every income earner. Some research supports the claim that simplified tax systems lead to greater compliance. The IMF 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. ^[16] The FairTax would reduce the number of tax filers by 80% and reduce the filing complexity to a simplified state sales tax form. Eighty percent of tax collection would be concentrated on less than 15% of retailers. Retailers would receive one quarter of 1% as compensation for compliance costs.

FairTax opponents believe that tax compliance rates decrease when taxes are not automatically withheld or collected as tax liability is incurred. 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 FairTax, can see evasion rates of 30% or more. William Gale has estimated that an evasion rate of 20% would require a FairTax rate of 39% in order to replace revenue lost through evasion. ^[17][18] This would be a 65% rate when presented as a traditional sales tax.

The FairTax is a national retail sales tax, but can be administered by the states rather than a federal agency. This has a bearing on compliance as the state's own agency could monitor and audit businesses within that state. The .25% paid to the states amounts to 5 billion dollars the states will have available for enforcement. As an example, California should receive over $500 million for enforcement. According to the California 2004-05 budget analysis^[19], this is more than the $327 million California is currently spending enforcing its own much more complex sales tax and excise taxes. 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 for enforcement is a percentage of the total revenue collected, the states will have an incentive to maximize collections -- FairTax supporters speculate that a reward system may be used by the states.

Black markets

Opponents of FairTax argue that imposing a national retail sales tax will drive transactions underground, creating a vast black market. This effect can occur for two primary reasons:

1. Under a retail sales tax system, the purchase of intermediate goods is not taxed, since those goods are supposed to be used to produce a final, retail good that will be fully 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. At present, however, some business owners overstate business expenses or claim that expenses that are largely or solely personal are business expenses. No income tax would mean no business expense deduction.
2. The second arises from the use of a retail sales tax rather than a value added tax (VAT). A VAT imposes a tax at every intermediate step of production, so the goods reach the final consumer with much of the tax already implicit in the price. Thus 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.

It is important to note that a VAT and a retail sales tax have no impact on who bears the tax burden. Both tax structures distribute the tax burden between the consumer and producer depending on a specific product's supply and demand characteristics.

Proponents respond to the black market argument by pointing out that, whereas tax evasion under the current income tax system requires only one person (the payor) to lie on their tax forms, tax evasion under the FairTax requires collusion of both the payor (the retail purchaser) and the payee (the retail seller). Furthermore, the number of individuals required to file taxes drops from approximately 140 million to 20 million. This ~86% drop in the number of collection points will allow the federal tax administration to assess tax fraud with greater scrutiny.

Personal vs. business purchases

In order for an individual to purchase items tax-free for business purposes, the business must be a registered seller with the state sales tax authority who will collect the FairTax along with the state sales tax. The state will issue the business a registered sellers certificate. This will 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. When an item is purchased for business use from a retail vendor, the business will have to pay the tax on the purchase and apply for a refund. They will be required to keep documentation. Also, the business will be required to submit monthly reports of taxable sales and sales tax collected on their retail sales to the state sales tax authority.

This will subject the business to being audited by the state. During such an audit, the business will have to produce the invoices for all the "business purchases" that they did not pay sales tax on, and will have to be able to show that they were bona fide business expenses. Since 132 million individuals will no longer be filing tax returns, there will only be about 16 million businesses that could be audited. Advocates claim this will greatly increase the likelihood of business audits, making tax evasion behavior much riskier. Additionally, the FairTax legislation has a number of fines and penalties for non-compliance and authorizes a mechanism for reporting tax cheats and obtaining a reward.

In order to prevent businesses from purchasing everything for their employees, in a family business for example, goods and services bought by the business on behalf of the employees that are not strictly for business use will be taxable. Health insurance and/or medical expenses would be an example where the business would have to pay the FairTax on these purchases.

Distribution of tax burden

Many economists believe that due to the rebate checks, the tax burden would not necessarily shift from the wealthy to the less wealthy.^[20] The bipartisan President's Advisory Panel for Federal Tax Reform, with the help of the Treasury Department, concluded that the FairTax would remove the most taxation burden from the low-income population.^[21] FairTax supporters claim that the tax burden shifts to those who do not pay taxes under the current system. The FairTax would dramatically broaden the tax base to include all 295 million Americans and an estimated 30 million to 40 million foreign tourists and visitors. This more than doubles the federal government's tax base. Other economists have claimed that the FairTax would be a significant tax break for high net-worth individuals, so it should be combined with a wealth tax. Such a system would allow a lower tax rate on consumption while maintaining current levels of taxation on high net-worth individuals. Proponents offer that the FairTax is a tax on wealth unlike the current system that taxes income.

FairTax opponents argue that the proposal would alter significantly the distribution of tax burden among citizens. Economist William G. Gale at the Brookings Institution writes: "Under the AFT proposal, taxes would rise for households in the bottom 90% of the income distribution, while households in the top 1 percent would receive an average tax cut of over $75,000." Gale continues, "If households are classified by consumption level, a somewhat different pattern emerges. Households in the bottom two-thirds of the distribution would pay less than currently, households in the top third would pay more." Gale is referring to absolute tax dollars—ranked by income, households at the lower end of the distribution will tend to pay more in absolute taxes, while households at the higher end will tend to pay less in absolute taxes. Ranked by spending or consumption, households that currently spend less on consumption would pay less total taxes, while households that currently spend more would pay more. A low income family may spend $25,000 on goods and services consuming 100% of their income. A higher income family making $100,000 may spend $80,000 on goods and services and save $20,000. The higher income family is consuming only 80% of their income on taxable goods and services. 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 80% of consumption.

These conclusions are apparently contradictory; according to Gale, the FairTax proposal is regressive on income and progressive on sales. Classical economic analysis indicates that the marginal propensity to consume (MPC) decreases as income increases. Households at the lower end of the income scale are spending almost all of their income, while households at the higher end are more likely to devote a portion of income to saving. MPC and income elasticity of demand tends to increase as wealth increases however. These facts explain the apparent contradiction in the data; households at the extreme high end of consumption often finance their purchases out of savings, not income. This savings would be taxed when it becomes sales. Income earned and saved would not be taxed immediately under the proposal. In other words, savings is spent at some point in the future and taxed according to that consumption. FairTax advocates state this improves taxing of wealth. Under the current system, low-income high-wealth Americans pay little as a percentage. FairTax supporters would also add that the payroll tax system, the largest tax burden for the poor, is regressive on income taxing only the first $90,000 from wages, and none earned from capital investments or interest. Under the FairTax, it would be eliminated.

Transition effects

Source: Ross Korves, chief economist (retired), American Farm Bureau Federation.

Because the FairTax proposal replaces various taxes with a single sales tax, several areas may experience unique effects through the transition.

Repeal of 16th Amendment

If the FairTax bill is passed, elimination of income taxation is not guaranteed; the FairTax bill repeals much existing tax code, but the 16th amendment is still 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. The 16th amendment, however, does not require an income tax, it only allows one. Many states also have separate income taxes, and these, too, would be unaffected.

Since passing the FairTax would only require a simple majority in each house of Congress and the signature of the President, and repeal of a Constitutional Amendment must be approved by two thirds of each house of Congress, and three quarters of the individual U.S. states, it is possible that passage of the FairTax bill will simply add another taxation system. If a new income tax bill was passed after FairTax passage, a hybrid system could develop. However, there is currently nothing preventing the addition of a national sales tax, or VAT tax, 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, sponsored by Congressman Steve King (R-IA), that repeals the 16th amendment.

Effect on savers

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 earning and their spending taxed.

Critics have claimed the FairTax would result in unfair double taxation for savers and suggest it does not address the transition effect on some taxpayers who have accumulated significant savings from after-tax dollars, especially retirees who have finished their careers and switched to spending down their life savings.^{[22] [23] [24]}

Supporters of the plan argue that the current system is no different, since compliance costs and "hidden taxes" embedded in the current prices of goods and services cause savings to be taxed a second time already when spent. The rebate checks would supplement accrued savings, covering taxes up to the poverty level. In addition, the income taxes on capital gains, social security and pension benefits are eliminated under FairTax. The FairTax would also eliminate the double taxation on savings that is currently part of estate taxes. Supporters suggest these changes would mostly offset paying the FairTax under transition conditions.

In contrast to ordinary savings, money in tax-deferred savings plans such as IRA, 401k, etc. would be withdrawn tax free. There is currently $11 trillion in such accounts. This represents a future tax revenue owed to the Federal government under the income tax system which has been estimated at $3 trillion. ^[25] This revenue would then fall under the FairTax system for collection.

Time Arbitrage

In the period before the FairTax is implemented, it would create a strong incentive for individuals to buy goods without the sales tax using credit. After the FairTax is in effect, the credit could be paid off using untaxed payroll. Opponents of the FairTax worry it could exacerbate an existing consumer debt problem. On the other hand, proponents of the FairTax note that this effect will also allow individuals to pay off all their existing (post-FairTax) debt quicker.

Changes in the retail economy

Implementation

Like other firms, retailers will enjoy a zero corporate tax rate. Under the FairTax, however, retailers would be required to collect the federal sales tax on all sales occurring within the United States. Retailers will receive a collection fee of .25% on federal funds collected.

States that choose to conform to the federal base will have the added advantage of information sharing and clear interstate revenue allocation rules. The ability for the state to collect these heretofore-uncollected taxes would be a major incentive for states to conform their sales tax to the federal sales tax base. Retailers suffering from tax-free direct mail competition or from tax-free sales from out-of-state retailers would see a major competitive disadvantage removed. However, this would have the effect of discouraging consumers from purchasing items through the thriving mail-order and online industry, potentially hurting a multi-billion-dollar segment of the American economy.

Supporting theories of effect

Dale Jorgensen, chairman of the Economics Department at Harvard University from 1994-1997 and currently the Samuel W. Morris University Professor at Harvard University, has presented theories that producer prices will drop between 15 and 25% after the switch to consumption-based tax. A substantial part of producer price reductions can be passed on to the consumer in the form of lower retail prices, which will increase consumer demand. But, while offering lower prices, retailers will be able to maintain their current profit margins. This would only slightly apply to imported products, so it would provide tax advantages for domestic production, thereby increasing U.S. competitiveness in global trade. Such logic is endorsed by a recent letter to the commission on tax reform by dozens of economists, including Nobel Laureate Vernon L. Smith. ^[26]

Proponents of the FairTax state that the cost of domestic goods and services could decrease by approximately 22% on average after embedded taxes and compliance costs are removed leaving the sale nearly the same after taxes.^[27] However, Dr. Jorgensen's research included income and payroll taxes in the 22% embedded tax estimation. If employees received their net income after the FairTax, prices would reduce by 22%. It is more likely, however, that employees will receive their gross income (income taxes and their half of payroll taxes). Under this situation, prices are estimated to fall closer to 10%. These embedded costs include the other half of payroll taxes, corporate taxes, and compliance costs (see Effect on tax compliance costs). Purchasing power for buying consumer goods and services in either situation remains essentially the same.

A study prepared by Nathan Associates for the National Retail Institute, which made many adverse assumptions, represents supporters' worst case scenario for a consumption tax. The study predicts that the economy will grow only three percent 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.

Other indirect effects

Like any policy change, the FairTax proposal would create several effects in other markets:

Home mortgage interest deduction

The current federal tax law allows individuals to deduct the interest cost on home mortgages. Home mortgage interest is one of the few personal expenditures that is treated in this manner. While there is no deduction for payroll taxes and most do not itemize the income tax deduction for full benefit, this preferential treatment of mortgage interest encourages households to spend relatively more of their income on housing than would otherwise be the case.

The FairTax is tax free on mortgage interest up to the basic interest rate as determined by the Federal Reserve. The interest above the basic rate applied by the lender is a financial intermediation service and is subject to the FairTax. Payroll and income taxes are not paid under FairTax, so there would be little change in the tax cost of the loan. However, since there are several areas that are considered tax free under the FairTax plan, it may decrease the incentive to spend more on homes in favor of savings, education, or other investments.

Charitable giving

Like the home mortgage interest deduction, charitable giving receives preferential treatment under current tax law allowing individuals to deduct donations to certain charities. While most do not itemize the deduction for full benefit, this encourages households to donate more of their income to charity than would otherwise be the case. As the FairTax only taxes new retail purchases, donations to charity would also be tax exempt. FairTax advocates state that total philanthropy as a percentage of GDP has held steady at around 2% for at least two decades regardless of changes in income tax deductibility. According to the National Bureau of Economic Research, GDP would increase almost 10.5% in the first year after the FairTax goes into effect. FairTax advocates claim this economic boost, along with an estimated 8% real wage increase, strengthens charitable giving. The FairTax would also remove the prohibition of political speech by non-profits therefore removing the threat to non-profit status.

Housing prices

The FairTax will apply to new homes. Many economists estimate that the embedded cost in new home construction is around 25%. As with all other retail prices that currently include an embedded cost, home prices could be expected to fall a relative amount. Since the FairTax will not be applied to existing homes, and since their cost is closely linked to new home prices, any cost change in new home prices will also be reflected in used home prices. If new home costs were to inflate, homeowners would enjoy a capital gain on the value of their home. Conversely, non-homeowners (future homebuyers) would face a loss as their future expenditure on a home would rise.

State and local government debt

Currently, the federal income tax system provides tax advantages to state and local government bonds.^[28] Specifically, the interest paid on such securities is exempt from federal taxation. This tax discount allows state and local governments to issue debt at low yields, which reduces their interest costs. By eliminating income taxes, FairTax removes the tax advantage of holding state and local bonds as all investments would become tax free. Issuers would have to offer higher interest rates to attract investors.

Financial markets

In general, FairTax would exert upward pressure on the value of most financial securities. Since a security's present value is based on all future cash flows adjusted for time, falling interest rates raise the present value of future cash flows. The effect on specific securities is indeterminate, however, because FairTax represents sweeping changes to the economy. The current pricing of financial securities includes assumptions that the basic rules of the tax code will remain largely unchanged. For example, FairTax will end corporate taxation. This eliminates the tax benefit which partially offsets many corporate expenses. In the case of non-cash expenses, they will reduce corporate earnings by their full amount rather than by the ~70% of their amount under the current tax regime. In another example, FairTax will cause investors to favor certain types of securities over others. Such cases illustrate that it is difficult to predict how the FairTax will effect the value of a single security or an asset class.

Effect on law enforcement and crime

Under current tax law, 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. The most famous example of this is the 1931 conviction of Al Capone, but this tactic continues to be used today. Under the FairTax proposal, this avenue of law enforcement would disappear as there would be no income tax and, therefore, no income tax evasion. However, it affords opportunities to bring charges of failure to collect the tax on illegal products and services, a tactic already employed using "tax stamp" laws. Additionally, under the FairTax the relative profitability of collecting illicit income through illegal means such as extortion would decrease significantly, as doing so would no longer carry a tax advantage when illicit income is spent on most consumption goods. This effect could somewhat reduce the incentive to violate the law in these ways and reduce the rate of certain kinds of crime.

Illegal immigration

The current system of taxation, in many cases, provides incentives for illegal immigrants and companies that employ them. It is estimated that approximately 5 million illegal immigrants are paid off the books in cash allowing employee and employer to avoid paying federal taxes estimated at $35 billion a year.^[29] Advocates claim the FairTax would provide incentive for illegal immigrants to legalize as they would otherwise not receive the FairTax rebate. Illegal immigrants would pay the maximum effective tax rate. There would also be no federal tax savings to companies that hire illegal immigrants. However, employers could still benefit by not providing other payment options such as unemployment and workers' compensation. Due to the FairTax burden, wage increases would be required for illegal immigrants to retain the same buying power. This would allow Americans to more effectively compete for jobs held by illegal immigrants.

References

1. ^ H.R. 25 Co-sponsors
2. ^ Doesn't Anyone Know the Score? By Newt Gingrich and Peter Ferrara
3. ^ TaxAnalysts TaxBreak, by William G. Gale "The National Retail Sales Tax: What Would The Rate Have To Be?" May 16, 2005; retrieved June 15, 2005
4. ^ Rebuttal of the William Gale papers
5. ^ The FairTax: A Trojan Horse For America? By Claire Wolfe & Aaron Zelman retrieved May 19, 2005
6. ^ Rebuttal of the Joint Committee on Taxation (JCT) letter
7. ^ National Retail Sales Tax Association Calculator
8. ^ Effective Tax Rates ' Americans for Fair Taxation
9. ^ Summary of Estimates of the Costs of the Federal Tax System by the U.S. Government Accountability Office
10. ^ The Times is still wrong on taxation By Bruce Bartlett
11. ^ Economists' Endorsement
12. ^ Clean out America’s Economic Arteries
13. ^ FairTax FAQ
14. ^ Retailers Question Greenspan on Consumption Tax
15. ^ "Simplifying tax systems:The case for flat taxes." The Economist, 2005 April 14.
16. ^ ibid.
17. ^ TaxAnalysts TaxBreak, by William G. Gale "The National Retail Sales Tax: What Would The Rate Have To Be?" May 16, 2005; retrieved June 15, 2005
18. ^ Rebuttal of the William Gale papers
19. ^ California Sales Tax Enforcement Costs
20. ^ Fair Tax America
21. ^ Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means
22. ^ FairTax - Income Taxes vs. Sales Taxes (About.com)
23. ^ op. cit., Wolfe
24. ^ Future Income Tax Revenue from Deferred Accounts
25. ^ Economists' Endorsement
26. ^ Americans for Fair Taxation
27. ^ How would tax reform effect financial markets? by John E. Golob
28. ^ Types of Bonds Yahoo Finance
29. ^ The Underground Labor Force Is Rising To The Surface Bear Stearns

External links

• FairTax.org - Americans for Fair Taxation
• H.R.25: FairTax Act of 2005 - text of bill H.R.25
• S.25: FairTax Act of 2005 - text of bill S.25
• John Linder's FairTax Site - Author of the bill
• FairTax Video (23 min 35 sec) - An introduction to the FairTax
• FairTax Groups - National FairTax message forums
• Grassroots Sites - Americans for Fair Taxation grassroots sites

For FairTax

Associations

• Americans for Fair Taxation
• The FairTax Foundation (FairTax.net)
• American Farm Bureau Federation
• Associated General Contractors (AGC)
• Heritage Foundation
• National Retail Sales Tax Alliance (NRSTA)
• National Small Business United (NSBU)
• National Taxpayers Union (NTU)
• Small Business Survival Committee (SBSC)
• National Small Business Association (NSBA)
• National Bureau of Economic Research (NBER)
• Council of Smaller Enterprises (COSE)
• Associated General Contractors (ASG)

Books

• The Fair Tax Book by Neal Boortz and John Linder ISBN 0060875410
• America's Best Kept Secret: Fairtax : Give Yourself a 25% Raise by Al Ose ISBN 1403391890
• Fair Not Flat : How to Make the Tax System Better and Simpler by Edward J. McCaffery ISBN 0226555607

Against FairTax

Associations

• Institute on Taxation and Economic Policy (ITEP)
• National Retail Federation
• NESARA Institute an alternative national retail sales tax / payroll tax hybrid plan

See also

• Flat Tax
• Income tax
• NESARA
• Progressive tax
• Regressive tax
• Sales tax
• Value added tax