Is the Fair Tax really fair?

In the January 29, 2008 MSN article "Is the Fair Tax really fair?," Jeff Schnepper says "Some tax-system critics, including GOP candidate Mike Huckabee, want to get rid of income taxes and payroll taxes and replace them with a national sales tax. Here are the plan's pros and cons."

Let's be fair. Our current tax code is a disgrace. It often makes no sense. It's tough on taxpayers trying to fill out their returns. It penalizes some people who should not be penalized.

Some people hate it so much that they want to get rid of it.

That's what Republican presidential candidate Mike Huckabee wants to do. The former Arkansas governor wants to junk personal and corporate income taxes and federal payroll taxes and replace them with a national sales tax called the Fair Tax.

I should note that the idea isn't actually Huckabee's. It comes from Atlanta radio talk-show host Neal Boortz, U.S. Rep. John Linder, R-Ga., and the Americans for Fair Taxation. The group is chaired by Leo Linbeck, who runs a big Houston construction company and is prominent in Republican circles in Texas.

How the Fair Tax would work

We now have an income tax -- a tax on what the courts have called an accession to wealth, clearly realized, over which you have dominion. Generate the income, and you're taxed immediately. It really doesn't matter what you do with the income. Unless it's exempt by statute, such as employer-provided health insurance premiums, or under the Constitution, like municipal-bond interest, it's part of your taxable base.

Our income tax system is also progressive. At certain break points, you pay a higher marginal rate on additional income. The more money you make, the greater the percentage you pay on additional income. For 2008, a married couple pays 10% on the first $16,050 in taxable income. But the couple pays 35% on all taxable income in excess of $357,700.

The Fair Tax is a whole different game. Instead of taxing income, this tax would hit consumption. Its proponents want to substitute what's often described as a flat 23% national sales tax on nearly all goods and services. But that 23% figure is a mirage. You'd actually pay 30% at the cash register, according to the proponents' Web site.

Think of it as a tax on your buying power. Fair Tax proponents say income taxes now make up about 23% of the cost of goods sold. Take away that tax and the cost of a $100 good, they say, would drop to $77. The Fair Tax would collect that $23 discount as a straight sales tax, which works out to 30% added to the price of goods and services. State and city taxes could be added on top of that.

The Fair Tax would include a complicated rebate system to shield the poor. According to Huckabee, "All of us would get a monthly rebate that will reimburse us for taxes on purchases up to the poverty line." By "us," he means you, me, Bill Gates and Oprah Winfrey.

What the Fair Tax might do for the economy

Would the Fair Tax make for a better economy? The Huckabee team says yes, and here are the arguments:

* Retail prices could fall. Fair Tax supporters say 20% of all prices today represent the hidden income and payroll taxes embedded in the price of everything we buy.

* Eliminating corporate income taxes and capital-gains taxes would make the United States a more desirable place to do business. Cut transaction costs, and you encourage more people to get into the game.

* There would be reduced losses of tax revenue from the underground economy.

*Illegal immigrants, many of whom do not report income or pay taxes, would be forced to pay their share of the Fair Tax. So would the 40 million foreign tourists who visit the U.S. each year.

*Social Security and Medicare taxes could be eliminated. These regressive taxes are probably the largest tax burdens on lower-income taxpayers. The Social Security Administration will get 6.2% of all wages and salaries up to $102,000 in 2008. Medicare gets an additional 1.45% from all wages and salaries.

*The Fair Tax would minimize the congressional tinkering and behavioral manipulation that permeates our current tax code. Special benefit provisions and lobbyist-generated deductions and exclusions would be gone.

*Substituting the Fair Tax could mean that the Internal Revenue Service could be disbanded. (That might sell the deal.)

Savers and investors would win big

The biggest winners under the Huckabee plan would be most savers and investors. A consumption tax gives savers something like an unlimited-deductible individual retirement account. There would be no tax hit until the dollars were actually spent. While the money was saved or invested, it would grow fully tax-free.

Financial companies would get an enormous windfall. Most of their expenses are payroll-related, and, relatively speaking, they spend little on goods and services. Much of their profit is generated by investments. That wouldn't be taxed until spent.

Investors should also gain by the increased value of shares in companies that they bought or owned. That's because of the elimination of both corporate income and payroll taxes.

And the wealthy, who now pay 35% on their marginal income, would rejoice at a big tax break down to 30% of their consumption expenditures. In other words, a round of golf at Pebble Beach would cost them, but merely collecting dividends would not.

What's not to like about the Huckabee plan

The opponents have strong arguments of their own. Here's a rundown:

*How much must pretax prices go down before you're comfortable paying an additional 30% on your home purchase, kid's tuition and doctor appointments? Increasing the cost of buying a home by 30% would not stimulate the housing market. On a house currently selling for $200,000, a 30% tax means you have to borrow $60,000 more just to get in the door. That doesn't make a lot of sense.

*Arguments that the Fair Tax would eliminate the underground economy are less than persuasive. Add a 30% federal hit to a 6% state sales tax, and you have created a golden opportunity for smuggling. Look at what happened to cigarettes when states increased their prices with higher sales taxes. They're now marketed out of the trunks of cars. Those cheating on their income taxes would cheat on their sales taxes. Just substitute the term "black market" for underground economy.

*The idea that the Fair Tax would eliminate complexity in the tax code also fails to recognize reality. Special interests would almost certainly hire lobbyists to propose exemptions for such things as home purchases, medical services and education. I spent some time in Washington, D.C., and I never met a lawmaker who wanted to run for re-election on the platform of hitting housing, medical services and education with a 30% tax.

*The poor would get little from the Fair Tax because they really don't pay income taxes under our current system. For 2008, if you're married with one child under 17, you have no tax on your first $31,400 in income. The Fair Tax can't beat a zero tax liability. Any real savings would come from the elimination of Social Security and Medicare taxes.

*Bush administration economists have projected that the Fair Tax would actually increase taxes for those making more than $30,000 and less than $200,000. That's because a flat 30% rate on their gross consumption would suck more dollars than a graduated rate on taxable income, after deductions, exemptions and the like. Taxpayers in that range would lose the benefit of the 10%, 15%, 25% and 28% rates on their taxable income.

*Transition rules -- the rules that would apply as one shuttered income taxes and started up the Fair Tax -- would cause chaos. Consider your Roth IRA account. You've already paid income taxes on those dollars. You wouldn't be happy when you spent the money and had to pay a tax again.

*Somebody would have to enforce the sales tax law or it would have no teeth. So, in practical effect, the plan would not eliminate the IRS. The plan would just convert its function from income-tax compliance to sales-tax compliance. Some agency would have to step in.

*Would the national sales tax be enough to raise as much revenue as our current system? Yes, if the rate was high enough, no if it wasn't. I'd bet everything I have that the rate wouldn't remain fixed.

The biggest losers: Municipal bond holders

A subgroup of the wealthy -- those who escape income tax under the current system by investing in federal-tax-free municipal bonds -- would be big losers here. Under the Fair Tax, current tax-free dollars would be hit when they were spent. That would decrease the attractiveness of such investments and potentially increase their cost.

Higher interest rates for state and local projects would result in increased costs for schools, bridges and jails that are normally financed with tax-exempt bonds. Or it might mean higher state and local income and real-estate taxes to cover those costs.

Home values -- and people who work in the real-estate industry -- would suffer. So would those who sell high-priced goods. Cars, appliances and high-ticket items like, say, Tiffany jewelry, could immediately become 30% more expensive. Would the corporate income and payroll tax savings be enough to offset this addition cost? It's arguable, and economists disagree. Personally, I have my doubts.

My biggest fear is the inability of Congress, no matter which party is in control, to control spending.

We raise more tax money today than ever before in our history. The problem is that we increase spending faster than we increase tax revenues. We may end up with both an income tax and a national sales tax. Wouldn't that be a kick in your wallet?