Tax Reform

I am willing to consider reforms of the tax system. I have attended rallies for the "flat tax," the "fair tax," and a few others. One thing they have in common is that EVERYONE in attendance (that I talked to) thinks he or she will pay less under the proposed new system, despite claims that the proposals are revenue neutral. The rich, middle-class, and poor all think they will pay less. But they cannot all be right if the new tax will generate the same revenue as the taxes it replaces. So who is being deceived? My bet (and that of most economists) is that the poor and middle-class are being mislead (again). The wealthy and powerful have a potent propaganda machine.

The National Retail Sales Tax: What Would the Rate Have To Be?

In "The National Retail Sales Tax: What Would the Rate Have To Be?", William G. Gale argues the tax rate would need to be 44%:

This report addresses a technical issue regarding the national retail sales tax: What would the required tax rate have to be? According to the report, the four principal results are:

First, as long as real federal revenues and real federal spending are maintained during the transition to a sales tax, the required sales tax rate would not depend on whether federal purchases are subject to tax or whether consumer prices rise after the sales tax is imposed.

Second, H.R. 25, a recent legislative proposal, would replace the existing income, corporate, payroll, and estate and gift taxes with a 23 percent tax-inclusive (30 percent tax-exclusive) sales tax on almost all private consumption, a significant portion 23 percent (tax-inclusive), the revenue loss would exceed $7 trillion over the next decade relative to current law.

Third, with plausible allowances for avoidance, evasion, and tax exemptions for some private consumption and some state and local purchases, both the required tax rates and the revenue loss from imposing a sales tax at a 23 percent tax-inclusive rate climb significantly higher.

Fourth, the commonly cited 23 percent tax-inclusive rate in H.R. 25 was derived using a set of assumptions about changes in the price level that are not consistent with each other and that lead to an estimated tax rate that is systematically and substantially too low.

The Fair Tax Act of 2007

The Fair Tax Act of 2007 - a plain English summary, provided by its proponents at FairTax.org, fails to specify who will pay more in taxes under this proposal and who will pay less.

A 2007 analysis by FactCheck.org provides the answer:

The Fair Tax “will collect more money from those earning between $15,000 and $200,000 per year and less from those earning more than $200,000 per year.”

Book Reviews: 'The Fairtax Book' and 'Flat Tax Revolution'

The New York Times review of 'The Fairtax Book' and 'Flat Tax Revolution' says:

November 13, 2005
'The Fairtax Book' and 'Flat Tax Revolution': 1040EZ — Really, Really EZ

By Joel Slemrod
Almost everyone agrees that our tax system could be a lot better - simpler, fairer and less of a drag on the economy. However, opinions about how to fix it vary widely. Earlier this month, a bipartisan reform panel created by President Bush presented two reform options that straddle the standard liberal and conservative positions. While the headlines focused on the reduction or elimination of popular breaks like the mortgage interest deduction, the report also suggested fundamental changes in how business and capital income are to be taxed.

These two new books, both coming from the right, suggest that merely reforming the current system is too timid. The correct policy medicine, the authors say, is to junk the income tax entirely and replace it with a consumption tax with a single tax rate for all Americans.

In "The FairTax Book," the syndicated radio host Neal Boortz and Representative John Linder, Republican of Georgia, claim that replacing all federal taxes - income, payroll and estate taxes - with a national sales tax would increase the average household's purchasing power by about 20 percent, end the need for the I.R.S. and turn April 15 into just another spring day. "Once the FairTax takes effect," they declare, "you'll be receiving 100 percent of every paycheck, with no withholding of federal income taxes, Social Security taxes or Medicare taxes - and you'll be paying just about the same price for T-shirts and other consumer goods and services that you were paying before the FairTax."

For a book that claims in its introduction to be "about honesty," this statement falls far short. No reputable economist of any political stripe would support it. The honest truth is that replacing the current tax system with any system that raises the same amount of revenue (as Boortz and Linder claim their plan does) may make us better off, but only by redirecting our resources away from dealing with complex filing requirements and improving our incentives to work, save and innovate - not by creating the kind of free-lunch miracle suggested here.

As for "saying goodbye" to the I.R.S., the authors' plan does so only by passing the responsibility for tax collection to the states. And what a responsibility it would be. In order to fully replace all federal taxes, the sales tax would probably have to be at least 40 percent - possibly even more than twice the 23 percent rate the authors claim, and certainly far higher than anything ever levied by any country. The enforcement problems would be different than those the I.R.S. now faces, but they would not necessarily be smaller. Even at an average rate of around 5 percent, state sales taxes are difficult to administer. Apparently the authors have not talked much to administrators who have to deal with, among other things, ineligible people declaring themselves to be businesses to qualify for the business exemption.

Oh, yes, Boortz and Linder's claim that their plan would make April 15 another ordinary day is true, because no individuals - just retail businesses - would have to file tax returns. Instead, every day is tax day as people pay their taxes on every trip to the grocery store, the car dealer or even the doctor, since the FairTax base extends to services that nearly all states exempt.

There's one more problem. Moving to a national sales tax would drastically shift the tax burden away from high-income families and toward low-income families. To remedy this, under the FairTax plan the government would send each taxpayer a monthly "prebate" based on family size, which would amount to $492 per month for a married couple with two children. But Boortz and Linder offer few details about the costs and complications of this vast system of transfers.

Steve Forbes is also pushing a tax plan, one he claims would "free America" from "the tyranny of the federal tax code." At first glance, his "flat tax" - which he has been pushing at least since his unsuccessful 1996 presidential campaign - looks like the current income tax, in that both businesses and individuals would file an annual return. But there are some big differences. Under the flat tax, there would be no deduction for mortgage interest, state and local taxes or charitable contributions. A 17 percent rate would apply to all taxable income, whether the taxpayer is Bill Gates, Steve Forbes or the mechanic who fixes their cars. Investment income would not be taxed at all under the individual tax, which by itself benefits predominantly higher-income taxpayers. The flat tax would indeed represent a significant simplification over the current system. (On the book's cover, Forbes is shown brandishing a postcard printed with "The Steve Forbes Flat Tax Form" - though, to be fair, the current 1040EZ would fit on the same card.) And cleaning up the tax base would, on balance, allow the economy to operate more efficiently and reduce the extent to which one's tax burden depended on arguably irrelevant factors such as whether one rented or owned a home. These benefits, however, have nothing to do with having a single tax rate. In fact, one of the architects of the flat tax, Robert E. Hall of Stanford University, now favors a plan, known as the X-Tax, that would apply a graduated rate structure to this simplified tax base.

Aspects of the flat tax deserve serious consideration. Unfortunately, Forbes's book does not provide it. Instead, like "The FairTax Book," it promises a free lunch. "Everyone" gets a tax cut under his plan. To guarantee that sound-bite feature, he would give people the choice of computing taxes under the flat tax or staying with the old tax system. That stunning concession guarantees that the nine million words of the current tax code and regulations would not go away after all but would be expanded by hundreds of thousands of new words laying out the flat tax rules and, inevitably, the new rules governing the consequences of going back and forth between the two systems. And then there's the hundreds of billions of dollars that Forbes's plan would add to the deficit. Forbes says that his plan will stimulate the economy so much that the apparent revenue shortfall doesn't materialize. If only this were true. Serious analyses suggest that a flat tax would be good for the economy, but would not produce the economic nirvana needed to close the huge revenue gap.

Tax reform deserves objective analysis of the sort these books do not provide. Fortunately, the president's tax reform panel has done a much better job. They considered the retail sales tax, but dismissed it. Both the proposals they outline simplify the tax base, though they retain a reduced mortgage interest break (in the form of a flat credit rather than an itemized deduction, which reduces the tilting of the benefits toward wealthier taxpayers). Both retain a graduated personal rate structure and try to maintain the current distribution of the tax burden. As the criticism following the panel report reminds us, truly revenue-neutral tax reform creates winners and losers, and the losers cry louder than the winners sing. To be sure, the Bush administration's tax cuts have in no way prepared Americans for fiscal sacrifice.

Contemplation of radical tax alternatives is exhilarating, and could help to avoid the kind of loophole-to-loophole combat that tax war veterans recall from 1986, the last time we made wholesale changes in the system. But much progress toward these goals - including eliminating the need for most Americans to file tax returns - can be made within the basic framework of the current system.

These books, to use the language on the jacket of "Flat Tax Revolution," are calls to join a crusade. We'd be better off just starting a conversation.

Joel Slemrod is a professor of economics at the Stephen M. Ross School of Business at the University of Michigan and the author, with Jon Bakija, of "Taxing Ourselves: A Citizen's Guide to the Debate Over Taxes."

Proposals for Tax Reform - Value-added Tax and National Sales Tax (Fair Tax)

President's Advisory Panel on Federal Tax Reform. Final Report. Washington: GPO, 2005.

Taxing Sales Under the FairTax: What Rate Works?

In a 2006 paper entitled "Taxing Sales Under the FairTax: What Rate Works?", Paul Bachman, Jonathan Haughton, Laurence J. Kotlikoff, Alfonso Sanchez-Penalver, and David G. Tuerck conclude that based on 2006 levels of government spending (which have subsequently increased) the required national sales tax rate would be 31.27% on a tax-exclusive basis. This tax would be in addition to existing sales taxes that generate revenues for state and local governments.

The Fair Tax - A 2007 Analysis by FactCheck.org

According to a FactCheck.org analysis of the Fair Tax (as proposed by presidential candidate Mike Huckabee in 2007):

We stand behind our earlier analysis of the FairTax. The proposal to which Gov. Huckabee referred is not a 23 percent tax, but rather a 30 percent tax. And it is revenue-neutral only through an accounting trick. It will collect more money from those earning between $15,000 and $200,000 per year and less from those earning more than $200,000 per year. It is possible that the FairTax would make most people better off, but much of that gain would be a direct result of making the tax code less fair.

The Fair Tax - What Advocates Say

According to the FairTax.org website:

The FairTax plan is a comprehensive proposal that replaces all federal income and payroll based taxes with an integrated approach including a progressive national retail sales tax, a prebate to ensure no American pays federal taxes on spending up to the poverty level, dollar-for-dollar federal revenue neutrality, and, through companion legislation, the repeal of the 16th Amendment.

The FairTax Act (HR 25, S 296) is nonpartisan legislation. It abolishes all federal personal and corporate income taxes, gift, estate, capital gains, alternative minimum, Social Security, Medicare, and self-employment taxes and replaces them with one simple, visible, federal retail sales tax administered primarily by existing state sales tax authorities.

The FairTax taxes us only on what we choose to spend on new goods or services, not on what we earn. The FairTax is a fair, efficient, transparent, and intelligent solution to the frustration and inequity of our current tax system.

The FairTax:
Enables workers to keep their entire paychecks
Enables retirees to keep their entire pensions
Refunds in advance the tax on purchases of basic necessities
Allows American products to compete fairly
Brings transparency and accountability to tax policy
Ensures Social Security and Medicare funding
Closes all loopholes and brings fairness to taxation
Abolishes the IRS

The fairtax.org website does not explicitly say who will pay more in taxes under the Fair Tax proposal and who will pay less. A 2007 analysis by FactCheck.org provides the answer:

The Fair Tax “will collect more money from those earning between $15,000 and $200,000 per year and less from those earning more than $200,000 per year.”

Consumption Taxes

Consumption Taxes

Some people advocate replacing income taxes with taxes on consumption. These might include a national sales tax, additional excise taxes on particular products, a value-added tax (VAT), or customs duties on imports or exports. Proponents of consumption taxes claim income taxes reduce people’s incentive to work, but consumption taxes do not. Instead, consumption taxes discourage consumption and thus encourage saving. Increased savings provide more financial resources that can be used for economic investment by businesses or the government. Increased economic investment generally leads to higher economic growth. Thus, consumption taxes do not distort incentives for the economy to save and invest. This should lead to greater economic growth.

Prior to the creation of the current income tax system in 1913, the U.S. relied heavily on import duties and excise taxes to finance federal government expenditures. Taxation of imports and exports reduces the volume and benefits of trade and may reduce a country’s welfare. Consequently, many consumption tax proponents favor value-added taxes. A value-added tax (VAT) is a type of consumption tax that is based on the additional value of a product added at each stage of the production process. The VAT differs from traditional sales taxes because it is collected from producers rather than retailers. It is collected from the factory that makes the product, not the stores that sell it. And unlike sales taxes, the VAT is included in the prices of products instead of being added onto the sales price at the time of purchase. The U.S. is the only major industrialized country without a value-added tax. A VAT has been proposed numerous times in the U.S. Congress, but has never received any significant support.

A national sales tax is another type of consumption tax. Sales taxes are quite common in the U.S. at the state and local level. Some people advocate creating a national sales tax to replace some or all or the federal income tax. If the U.S. relied on a national sales tax as a primary source of revenue for the federal government, the tax rate might need to be 25%. This means that every time a consumer made a purchase, 25% of the price would be added to support the federal government. Critics of a national sales tax complain about the regressive structure of such a tax. The imposition of a national sales tax would shift much of the tax burden away from the wealthy to middle and low income Americans.

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?

Unspinning the FairTax

In the May 31, 2007 article Unspinning the FairTax the consumer advocacy group FactCheck.org analyzes the proposed FairTax:

We look at the numbers behind the numbers.

Summary

In our recent article on the second GOP debate, we called out Gov. Mike Huckabee as well as Reps. Tom Tancredo and Duncan Hunter for their support of the FairTax. We wrote that the bipartisan Advisory Panel on Tax Reform had “calculated that a sales tax would have to be set at 34 percent of retail sales prices to bring in the same revenue as the taxes it would replace, meaning that an automobile with a retail price of $10,000 would cost $13,400 including the new sales tax.” A number of readers pointed out that H.R. 25, the specific bill mentioned by Gov. Huckabee, calls for a 23 percent retail sales tax and not the 34 percent used by the Advisory Panel on Tax Reform. That 23 percent number, however, is misleading and based on some extremely optimistic assumptions. We found that while there are several good economic arguments for the FairTax, unless you earn more than $200,000 per year, fairness is not one of them.

Update June 14: In a letter, Americans for Fair Taxation wrote to say that it disagrees “very strongly” with FactCheck’s analysis of the FairTax. For their objections and our response, see the end of the “Analysis” section.

Analysis

How to Make 30 Look Like 23

Americans for Fair Taxation offers the following plain-language interpretation of H.R. 25:

Americans for Fair Taxation: A 23-percent (of the tax-inclusive sales price) sales tax is imposed on all retail sales for personal consumption of new goods and services.

It is the parenthetical that is important, for it hides the real truth of the tax rate.

First consider the way in which sales tax is normally figured. A consumer good that carries a $100 price tag might be subject to a 5 percent sales tax. That means that the final bill for the item is $105. The 5 percent figure is the amount of tax that is charged on the original purchase price. But now suppose that instead of pricing the item at $100, the shop owner simply priced the item at $105, then sent $5 directly to the state. The $105 price would be a tax-inclusive sales price. But $5 is just 4.8 percent of $105. That 4.8 percent number, however, is relatively meaningless. You are still paying exactly the same 5 percent tax on the item.

The 23 percent number in H.R. 25 is the equivalent of the 4.8 percent in the previous example. To calculate the real rate of the sales tax, we have to determine the original purchase price of an item. We can begin with the same $100 item, keeping in mind that a price tag that reads $100 has sales tax already built in. If our tax rate is 23 percent of the tax-inclusive sales price, then of the $100 final price, $23 of those dollars will be for taxes, meaning that the original pre-tax price of the item is $77. To get $23 in taxes on a $77 item, one must impose a 30 percent tax. In other words, a 23 percent sales tax on the tax-inclusive sales price is equivalent to a 30 percent tax on the actual price of the item.

FairTax proponents object to the 30 percent number, claiming that critics use the larger number to frighten people. Americans for Fair Taxation claims that it uses the tax-inclusive number to make it easier to compare the FairTax to the income tax that it will replace (since most of us think of income tax rates on an inclusive basis). But we are not accustomed to thinking of sales taxes inclusively. The result is that many FairTax supporters (about 15 percent of those who wrote to us, for example) do not understand that the 23 percent figure is tax inclusive.

Our analysis of the FairTax used a figure of 34 percent as the basic exclusive tax rate. One e-mailer complained that our number was at least 10 percentage points “higher than [the FairTax] is” because we calculated it as an addition to retail prices. But our 34 percent number is not 10 percentage points higher than the legislation. A 34 percent exclusive number is equivalent to a 25 percent tax inclusive rate – only 2 percentage points higher than the FairTax bill. We think that, intentional or not, the use of the tax-inclusive 23 percent rate has misled a lot of FairTax proponents.

But 30 Is Not 34 Either

Americans for Fair Taxation, however, has complained that H.R. 25 calls for a 23 percent inclusive (or 30 percent exclusive) rate, not a 34 percent rate. Our number came from the President's Advisory Panel on Tax Reform (scroll to chapter 9 for the panel's discussion of the FairTax), which calculated that a 34 percent rate on the actual price of consumer goods would be necessary to make the program revenue-neutral. Americans for Fair Taxation has said that the Advisory Panel did not use the FairTax as detailed in the legislation but instead made up its own plan. This complaint is disingenuous. The Advisory Panel did in fact begin with the 30 percent figure that proponents of the FairTax submitted. But the panel rejected those figures, claiming that they were based, at least in part, on the unrealistic assumption that there would be full compliance with the FairTax. In other words, proponents assume that no one will cheat on taxes. However, the Treasury Department estimates that the evasion rate for the entire U.S. tax system under current law is approximately 15 percent. The Advisory Panel accordingly assumed a 15 percent evasion rate for the FairTax.

More significantly, however, the panel found that FairTax supporters were employing questionable accounting. In calculating federal revenue, proponents assumed that purchases made by the federal government would be taxed at the full 30 percent rate. But when calculating federal expenditures, FairTax proponents did not factor in the additional costs of the 30 percent sales tax. The Advisory Panel thus threw out the revenue from federal purchases, noting (correctly) that increased revenue from taxing federal purchases is exactly canceled by increased costs in the federal budget. Unfortunately, the Advisory Panel has thus far refused to release its methodology, making it difficult to reconcile its projections with those of Americans for Fair Taxation.

Using a formula that corrects for the faulty assumption about government spending, William Gale, director of the economic studies program at the Brookings Institute, calculates that a 39.3 percent exclusive rate would be necessary for revenue neutrality. (We used the lower Advisory Panel number). A more recent study by FairTax supporter and Boston University economist Laurence Kotlikoff – working from Gale’s formula and adopting the same basic assumptions – determines that a 31.2 percent exclusive (or 23.8 percent tax-inclusive) rate would be sufficient.

Even if Kotlikoff is correct that a 31.2 percent rate is revenue-neutral, there remains some reason to doubt that the rate actually would be that low. The FairTax proposal assumes a 100 percent tax base on consumption. By way of contrast, most states that have sales taxes have roughly a 50 percent tax base. With the FairTax’s 100 percent base, consumers would pay taxes on a great many things that may not intuitively seem like consumption. The list would include:

• Purchases of new homes
• Rent
• Interest on credit cards, mortgages and car loans
• Doctor bills
• Utilities
• Gasoline (30 percent in addition to current taxes, which would not be repealed)
• Legal fees

At today’s prices, gasoline would cost almost $1 per gallon more. A $150,000 new home would run $195,000 – plus the 30 percent tax that the buyer would pay on the interest on the mortgage. In short, the FairTax taxes everything that one buys, with the one notable exception of education. Any exceptions to the tax base (for instance, eliminating rent or credit card interest from the tax base) would require an offsetting increase in the rate.

But the FairTax Will Lower Prices

Proponents of the FairTax point out that prices on consumer goods contain what are called “hidden taxes.” Under current law, corporations have to pay taxes on their earnings. Moreover, businesses have to pay social security taxes for each employee. The money to pay these taxes has to come from somewhere, and FairTax supporters argue that the cost is passed on to the consumer. In fact, the best-known proponent of the FairTax, talk-show host Neal Boortz, argues that 22 percent of the price of a consumer good is really a “hidden tax.” Get rid of corporate and social security taxes, Boortz argues, and consumer good prices would drop by 22 percent. Even with the 23 percent FairTax, prices stay the same, and with the elimination of income taxes, paychecks will get bigger. Everyone gets a raise and the federal government still gets its revenue. About 10 percent of the e-mail messages we received from FairTax proponents trumpeted this kind of magic act. It is easy to understand the confusion on the issue, as Boortz himself made similar assertions in the hardcover edition of his book. (He later issued a corrected version in paperback.)

A bit of critical analysis shows that this cannot be right. The FairTax is revenue-neutral. That means that for every tax dollar collected under the current system, the FairTax has to collect a dollar. If the FairTax exactly equaled embedded taxes, then it could not possibly be revenue-neutral, since embedded taxes do not take into account personal income or estate taxes. The FairTax rate would have to be high enough to replace embedded taxes plus income and estate taxes.

Chris Edwards, the Cato Institute's director of tax policy studies, points out that prices do not really matter; corporate, payroll, income and estate taxes currently generate approximately $2.4 trillion, and a revenue-neutral FairTax would still require that taxpayers pony up $2.4 trillion. Nor is it clear that the 22 percent embedded tax figure is particularly meaningful. David Burton, chief economist of the Americans for Fair Taxation, calls it "simplistic" to think that the entire cost of corporate taxes is borne by consumers. Cato's Edwards suggests that while consumers do pay at least part of the costs, producers also bear some of the burden. That is, employees pay part of the costs of hidden taxes (in the form of lower wages), and corporate shareholders pay another portion (in the form of lower returns on their investments).

The FairTax: Is It Regressive?

Sometimes sales taxes are called regressive, meaning that the poorest pay higher rates than the wealthy. Strictly speaking, sales taxes are flat, since everyone pays the same rate. But because the poor tend to spend a high percentage of their income on basic consumer goods such as food and clothing, sales taxes do require the poor to pay a higher percentage of their income in taxes.

The FairTax plan, however, helps to alleviate this difficulty by exempting sales taxes on all income up to the poverty level. Taxpayers would receive a "prebate," which Edwards calculates to be about $5,600 annually. The Treasury Department estimates that the prebate program would cost between $600 billion and $700 billion annually, making it the largest category of federal spending. Americans for Fair Taxation disputes the Treasury Department numbers, claiming that the actual cost would be closer to $485 billion per year. The Treasury Department has so far refused to release its methodology, making it difficult to determine whose estimate is correct.

Who Really Pays?

With the prebate program in effect, those earning less than $15,000 per year would see their share of the federal tax burden drop from -0.7 percent to -6.3 percent. Of course, if the poorest Americans are paying less under the FairTax plan, then someone else pays more. As it turns out, according to the Treasury Department, “someone else” is everybody earning between $15,000 and $200,000 per year. The chart below compares the share of the federal tax burden for different income groups under the current system and under the FairTax. Those in the highest and the lowest brackets will see their share decrease, while everyone else will see their share of taxes increase.



Americans for Fair Taxation rejects the Treasury Department analysis, objecting that Treasury considers only the income tax. By leaving out payroll taxes (which are actually regressive) Treasury’s chart makes the FairTax look worse by comparison. We found that including all the taxes that the FairTax would replace (income, payroll, corporate and estate taxes), those earning less than $24,156 per year would benefit. AFT’s Burton agreed that those earning more than $200,000 would see their share of the overall tax burden decrease, admitting that “probably those earning between $40[thousand] and $100,000” would see their percentage of the tax burden rise.



Why Be Progressive?

It is easy to look at charts like the one above and dismiss the FairTax as simply another way to help the rich get richer. But there is an economic argument for a less progressive tax system, though that argument is extremely technical. Kotlikoff has asserted that the FairTax will lower the marginal tax rate for all earners. (The marginal rate is the tax rate paid on the last dollar earned.) Because marginal rates are lower, each extra dollar of income will result in greater purchasing power. The decrease in marginal rates is progressive – that is, marginal rate reductions are greater for the working- and middle-classes than for the wealthy.

Moreover, even FairTax critics like Gale agree that consumption taxes increase the size of the economy. Many studies show that long-term incomes would rise under a consumption-based tax system. Optimistic accounts show a 10 percent rise in income over time, but even the more cautious studies show gains of 5 percent to 7 percent. Because the FairTax will grow the economy, workers will eventually see increases in their income. FairTax proponents claim that the growing economy, coupled with the reduction in marginal tax rates, will offset the increased tax burden. Burton argues that "the FairTax is a positive-sum game," one in which purchasing power will grow faster than the tax burden. The size of any such gains is disputed, however; Americans for Fair Taxation consistently chooses from among the most optimistic growth projections.

Upon Further Review

We stand behind our earlier analysis of the FairTax. The proposal to which Gov. Huckabee referred is not a 23 percent tax, but rather a 30 percent tax. And it is revenue-neutral only through an accounting trick. It will collect more money from those earning between $15,000 and $200,000 per year and less from those earning more than $200,000 per year. It is possible that the FairTax would make most people better off, but much of that gain would be a direct result of making the tax code less fair.

- by Joe Miller

Correction, May 31: In the Analysis portion of our original story we stated that "Taxpayers with very low incomes would receive a 'prebate'." In fact, all taxpayers would receive the prebate for sales taxes on purchases up to the poverty level.


Update June 14: Americans for Fair Taxation wrote us to say that the organization disagrees “very strongly” with FactCheck’s analysis and that we have “uncritically accepted many misleading arguments” made by FairTax critics. As a courtesy to AFT, and as a service to our readers, we are posting the letter in our “Supporting Documents” section. We stand by our article, and our comments on AFT’s letter are below.

Our mission at FactCheck.org is not to rule on issues of public policy but rather to reduce the level of deception and confusion in U.S. politics. We found that, whatever Americans for Fair Taxation’s intentions, there remains much confusion about the FairTax.

AFT disputes our conclusion that the 23 percent number is misleading. We stand behind it. Sales taxes, as AFT notes, “are almost always expressed in an ‘exclusive’ manner,” which in our view makes 30 percent the logical figure to use when describing the FairTax.

We don’t actually call the FairTax “regressive,” as AFT implies that we do. We reiterate, however, that those earning between $15,000 (or perhaps as much as about $24,000 – see our addition to the “Who Really Pays” portion of our article above) and $200,000 per year – virtually all middle-class Americans – would pay a higher share of the tax burden under this proposal. Those earning more would see their share drop, as even AFT economists admit.

We did not ignore Americans for Fair Taxation’s research. Much of that research is publicly available and is listed among our sources. We do, however, approach all evidence with a healthy skepticism – including research that is funded by the very group whose claims we are investigating. Where possible we rely upon neutral sources, such as the bipartisan President’s Advisory Panel on Federal Tax Reform, and on opinions from third-party scholars from think tanks like the Brookings Institution and the Cato Institute.

Sources

Bachman, Paul, et al. "Taxing Sales Under the FairTax: What Rate Works?." Tax Analysts 13 Nov. 2006: 663-682.

Boortz, Neal and John Linder. The FairTax Book. New York: Harper Collins, 2005.

Edwards, Chris. "Options for Tax Reform." Policy Analysis 536 (2005): 1-44.

FairTax. -1 2007. Americans for Fair Taxation. 22 May 2007.

The Fair Tax Act of 2007 -- H.R. 25 / S. 1025 Plain English Summary. -1 2007. Americans for Fair Taxation. 17 May 2007.


Gale, William. "Comments on 'Taxing Sales Under the Flat Tax'." American Enterprise Institute, Washington, DC. 28 Feb. 2007.

Gale, William. "A Comparison of Income and Consumption Taxes." President's Advisory Panel on Tax Reform, Washington, DC. 16 Feb. 2005.

Gale, William G.. "The National Retail Sales Tax: What Would the Rate Have to Be?." Tax Analysts (2006): 889-911.

Kotlikoff, Laurence. "Taxing Sales Under the FairTax: What Rate Works?." American Enterprise Institute, Washington, DC. 28 Feb. 2007.

Linder, John. “The Fair Tax Act of 2005.” H.R. 25. Introduced 4 Jan. 2005.

Office of Management and Budget. The Budget for Fiscal Year 2008, Historical Tables. Washington: GPO, 2007.

President's Advisory Panel on Federal Tax Reform. Final Report. Washington: GPO, 2005.

Slemrod, Joel. "'The Fairtax Book' and 'Flat Tax Revolution': 1040EZ -- Really, Really EZ." New York Times. 13 Nov. 2005.

U.S. Retail Gasoline Prices. 21 May 2007. United States Department of Energy. 24 May 2007.