Fair tax?
Ezra Klein points to a recent Slate article singing the praises of the FairTax. The FairTax, would replace our current income tax with a tax on consumption (the purchase of goods or services). It also happens to be supported by presidential hopeful Mike Huckabee. Ezra, like myself, seems skeptical. Unlike myself, Ezra plans to give the issue more thought before writing about it. I don’t blame him, since about 1000 times more people read his blog, plus it’s his job.
Under the FairTax, we would basically all pay a “national sales tax” on goods and services, but we would not pay a tax on our income, and more importantly, our savings/investments (as well as tuition payments). In his Slate article, Steven Landsburg likens this to having no limit on how much you can put in your IRA (in a traditional IRA, you invest pretax income, then pay taxes on your investments later when you withdraw this money). Professor Landsburg also informs us that many economists support unlimited IRAs “on highly technical grounds”. This may be true, but I’m a little skeptical of Steven’s comparison.
First, in an IRA you pay a penalty if you withdraw your money too soon (before you are 60). Second, you eventually have to withdraw your money, and when you do you pay an income tax. Under the FairTax, neither assumption holds, so I don’t think it’s reasonable to simply cite support for unlimited IRAs to convince readers that the tax is a good idea. What’s more, the Slate article doesn’t actually cite anyone, so I can’t even check if these assumptions matter. Instead, I’ll just list several of my own concerns with the FairTax. As far as I can tell, these concerns do not apply to unlimited IRAs.
1. The most obvious concern with the FairTax is that a tax on consumption, or national sales tax, is regressive. In other words, we’d all pay a flat rate, but since less wealthy people spend most of their total income, they end up paying a larger fraction of their income in taxes. To fix this problem, the government could provide a tax rebate to low income households. The FairTax, however, would give a rebate to all households based on their number of children.
Any form of monthly rebate is a logistical challenge, but having a rebate that is not based on income basically simultaneously ensures that the rebate is small. For example, an individual making $60,000 a year will get a rebate of at most a few hundred dollars a month. As a result, their tax rate will necessarily be very close to that of a person earning $2,000,000 dollars a year. In other words, even if the FlatTax is technically “progressive”, tax rates flatten out very quickly. Meanwhile our income gap is rising, as the top 1% of house household incomes accounted for over 21% of all reported income in 2005.
2. Supporters of the FairTax often claim that, eventually, people spend what they make, so it’s not as if rich people avoid paying tax on most of their income. This just isn’t true. If you find yourself earning several million dollars a year, you will likely invest most of that money. These investments would generate a substantial amount of interest, and under the FairTax, are not taxed.
In four or five years, you will have a very large sum of money. It will be earning enough interest for you to live on, and you will have never paid taxes on any of it money. If you live modestly (spending say, a few hundred thousand dollars a year), your investment will continue to grow tax free. Since the FairTax does away with the Estate Tax, you’ll be able to pass your mass of cash on to your children, and no one will have every paid taxes on any of it. In short, the FairTax is great if you’ve just won the lottery or received a ginormous holiday bonus, but it’s not nearly as hot if you’re building up your nest egg by saving %10 percent of your income each year.
3. The most appealing aspect of the FairTax is probably its apparent simplicity. Rather than dealing with a bunch of deductions and tax loop holes, we simply all pay taxes whenever we spend money, then we get rebates. Still, providing every household in America with a monthly rebate, seems like a real challenge. Furthermore, a simple rebate scheme, one that doesn’t depend on income or spending, isn’t particularly fair (see point 1 above). A more elaborate rebate scheme, however, could end up being quite complicated as well as susceptible to fraud.
Furthermore, under a FairTax, all purchases aren’t actually taxed, since you need to avoid taxing the same good twice. If you own a clothing store, for example, you can buy clothes tax free, if you then sell them in your store. Also, used goods are also not taxed. I’m not clear that it’s always so easy determine what should be taxed, however. If you buy fabric, pay taxes on it, and then use that fabric to make a suit, what tax should be paid on the suit? Also, what about if I fix up my car myself before selling it? According to Wikipedia, the concern here is that the FairTax is retail sales tax rather than a value added tax.
Another issue with the FairTax is the potential for a large underground economy. For example, goods that were never properly accounted for could be sold directly for cash. Similarly, a retailer might artificially mark down prices, but accept cash from customers on the side. There are lots of ways that one could imagine selling goods in a tax free fashion, but there are also lots of ways one can avoid paying taxes now. This isn’t necessarily a short-coming of the FairTax, but it is a reason to be skeptical of it’s simplicity. Perhaps FairTax supporters should just focus on simplifying existing tax code instead.
January 14th, 2008 at 1:44 pm
It is funny that you say “If you live modestly (spending say, a few hundred thousand dollars a year), your investment will continue to grow tax free. ”
You should realize that if a person spends $200K a year under that FairTax he will pay almost the full 23% or $46,000 in taxes. Under today’s system, if he is smart, he has his millions invested either in tax-free municipal bonds where he pays no tax at all, or an investment account where he is currently taxed at only 15% capital gains rate.
Also under the FairTax, the term “used” means that the tax has already been paid on it. Therefore, even if a sewing machine is used by a business for a decade, if it transfers to private ownership it is considered new (not yet taxed), the tax due is 30% of the fair market value .
I can’t wait to see what Ezra comes up with after he studies it some.
DavidFlorida@gravel2008.us
January 14th, 2008 at 2:08 pm
That is a very reasonable point, but under today’s system the person in question would have already paid taxes on the millions they initially invest. How much they’ve already paid is another question. I am certainly not happy with today’s 15% capital gains rate, but changing that hardly requires the FairTax.
January 14th, 2008 at 5:23 pm
Ok, here’s a couple of points to ponder. The Fair Tax “pre-bate” will not be much more of a “logistical challenge” than distributing the current Social Security checks that go out monthly to millions of people. This a a great article and I can tell that you would give reasonable consideration to the Fair Tax rather than some of the typical, Un-intelligent banter that typically comes out of skeptic opponents. So, I hope that you WILL consider looking further into the details of the plan. There are FULLY drawn out Calculations on the progressivity of the Fair Tax and how it effects different levels of income, etc. These calculations aren’t simply a couple of guys pounding out numbers on a calculator, they were well renown economists from across the country who helped develop the Fair Tax plan.
Even aside from all that you might learn additionally through further research I found it interesting that you didn’t follow even your own theory through on what would happen with the Savings or Extra income from the “Super Wealthy”. So, if they are not able to spend the money as fast as they make it….what happens? Their Savings account balance and …(Key) Investments ..INCREASE. So even if they are not being taxed on the Multi-Millions of dollars they’ve managed to save, those sizeable bank accounts and investment funds, etc. sure will be a Boon to the rest of the Economy! Also, to follow your point, but to disagree slightly….a Very Frugal person earning $50,000 yr. or so, living on $30,000, and saving and investing the rest …TAX FREE, absolutely WILL be FAR better off under the Fair Tax, and may in fact end up a Multi-Millionaire …without having to win the Lottery.
January 14th, 2008 at 8:06 pm
I’ll concede that the “logistical challenge” is not my main objection. I would be more worried of that aspect of the tax if rebates were tied to income level, or spending, but clearly that’s something the FairTax is trying hard to avoid.
I’ll also agree that encouraging people to save is a selling point of any consumption tax, but even so, many people will fail to do so. I remain concerned that the FairTax will widen the gap between the rich and poor, much like today’s low capital gain’s tax. It’d definitely be interesting to look at how various income levels accumulate wealth over time under both systems. I’ll try to do this for a follow up post.
Finally, I was aware that the “Super Wealthy” person’s investments could continue to accumulate. In some sense, this would be “a boon to the rest of the economy”, but that argument also sounds like trickle-down economics. I’m curious to see what other’s have to say.
January 15th, 2008 at 9:46 am
Prior to getting on board with the FairTax 6 years ago I did my own research, just as I’ve done with the current system over the past 20 years.
I read the FairTax bill, all 133 pages of it. Yes, far shorter than the current 60,000 + pages of the current code. Since I do my own taxes I “ve made a comparison each year. My wife and I are, by anyone’ s definition, middle class. The result of my comparisons is a net gain of about $15,000 per year in spendable income. When taking our overall spending into consideration with the FairTax in place, I assure you, had the FairTax been in place for the last 30 or 40 years we would have risen from the middle class long ago. We may even have reached the same financial status as some of the country’s drug dealers.
The number one reason the FairTax may never become law, A TOTAL LACK OF SELF INDUCED KNOWLEDGE ABOUT IT BY THE GENERAL PUBLIC . The number two reason, THE APATHIC ATTITUDE OF THE GENERAL PUBLIC. It is up to We The People . For those among us who have avested interest in the current sytem, since your above average intelligence, why not go into the investment field and embrace the FairTax.
A closing word about the FairTax Prebate . It is much fairer than the current welfare benefit so called the” earned income credit.”