Bruce Bartlett has a well-written piece on the so-called "Fair Tax" proposal. Bruce Bartlett, Why the Fair Tax Won't Work, 117 Tax Notes 1241 (Dec. 24, 2007). The arguments he makes aren't really new, since various people (myself included) have criticized the Fair Tax proponents for trying to have their pie and eat it too.
The Fair Tax proposal calls for elimination of the income and payroll taxes (and the withholding and IRS audit and enforcement machinery that stands behind them) and replacement with a national sales tax. The sales tax would purportedly apply to every purchase, without exception, including state and local government purchases. The proponents claim it would be able to generate sufficient revenues at a flat (tax-inclusive) rate of 23%. They also make various claims that people will be able to keep all their paychecks and that prices won't rise, there will be no compliance failures, and life will be hunky-dory ever after.
Bartlett effectively debunks these exaggerated and downright misleading (and often contradictory) claims. Here are a few of the points he makes.
First, the fair tax would be highly regressive, resulting in a huge tax break for those in the top quintile of the income distribution (roughly, those earning $200,000 and up annually) and crushing burdens for those at the bottom. This is because the poor consume all of their income, and the wealthy do not. Consumption decreases with wealth.
In order to make the "fair tax" even somewhat palatable, there'd have to be a mechanism for relief for those at the bottom. The Fair Tax proposal provides for a monthly government check to every person in the US. But single parents with children will be discriminated against compared to married couples without children, getting a much smaller rebate. The rebate isn't based on income or amount of consumption or the cost of living or the cost of raising children; it is not even a rough justice measure of who merits it. It's based at most on an arbitrary back-of-the-envelope calculation from the 1960s determining the poverty level. Bill Gates will get the same check that the beggar on the corner gets. This is an immense new governmental entitlement program, that will require reams of disclosure (number of people residing in the household each year, ages, social security numbers). Nothing "fair" about any of that. And nothing simple either. Maybe there's no IRS (more on that later) but there's certainly a lot of big brother mechanism just to figure out the rebate for each household.
Bartlett notes that this is just the kind of situation that brings out the political negotiator in every politician. One will press for extra help for single parents with multiple children, and another will think of another group needing extra care and attention. Pretty soon the "fair" and "flat rate" tax will be riddled with different rates because of special exemptions for all those special interest groups. And it won't stop there. Some goods just aren't meant to be taxed--many states don't tax groceries, for example. And services--look at the debacle in Michigan when the legislature tried to initiate a services tax.
The Fair Tax would tend to penalize the young--who need to "over consume" by borrowing to begin to build up assets (homes and cares and all the things required to start a family). It would also penalize the old-o-who saved for retirement under an income tax and now will be taxed harshly when they spend that savings, instead of being able to spend it freely without further tax. (Politicians would of course create more exemptions and exceptions to try to deal with this.)
Proponents of the Fair Tax also make all kinds of misleading and simply erroneous claims. Bartlett calls it a "double free lunch" claim--claiming that prices will fall once the income taxes currently embedded in them are gone, but acting as though wages will not fall as well. In fact, as Bartlett notes, either prices will stay up or wages must fall. Neither gives the ordinary guy the windfall that proponents appear to promise. Of course, if prices really fell, no rebate would be needed so long as everybody is satisfied with a large pay cut while prices steady themselves down lower. That, Bartlett notes, simply will not happen. So there will be no windfall gain compared to the income tax.
Oh, about that 23% rate. It's not really 23%--at least, not if you calculate it the way we ordinarily calculate sales taxes. We think of the price without taxes ($100) and the tax that must be added on as a percentage of that price( a 23% tax-exclusive rate yields a $23 tax), giving a total cost of $123. But that's not what proponents of the Fair Tax are talking about. They are looking at a $30 add-on tax on a $100 price. 30/130 = 23%. So we can describe the rate as a 23% "tax inclusive" rate or a 30% "tax exclusive" rate. We ordinarily talk about sales taxes as tax exclusive rates. We pay $10 for the item, we pay a 7% sales tax which will be 70 cents on the $10 price. Most Americans would not be very happy with a sales tax of 30% on every item purchased (and every service purchased), especially when applied to doctors' and hospitals' bills, health and car insurance, and other big ticket items (like large appliances, cars, even houses). So FairTaxers disguise the negative impact of their proposal by using a tax-inclusive rate.
As for taxing government to raise government revenues, this is no benefit. It may mean states have to increase their taxes to pay the taxes to the federal government, which won't provide relief to ordinary taxpayers. Bartlett estimates that states that pay for their increased costs due to the FairTax by raising sales tax rates would tend to increase the average rate from about 6.5% to 11%.
The FairTax assumes about 80% of the GDP would be taxed. But no country currently succeeds with that kind of a sales tax. In small countries where cheating is harder, maybe 48% can be covered by a VAT, but in the EU, only about 38% can be covered by VAT. The sales tax is less efficient and more prone to abuse than the VAT, so even less than that would be realistic. That's a lot of slippage compared to the sales pitch from FairTax proponents. No state taxes anywhere near as broad a base as the proposed FairTax base--services are hardly taxed at all (partly because taxes on them are easier to evade) and of course states don't currently tax imputed rent to homeowners, as the Fair Tax would require (else homeowners would be sitting pretty compared to renters).
Barlett concludes that "[m]assive evasion is inevitable with the FairTax because all revenue would be collected at just one point in the entire economic system." And since the states would be doing the collecting for the federal government, the collectors' incentives to engage in the extra administrative hassle would be minimal. States would have complicated jobs to do, since their sales taxes are not very similar to the proposed FairTax. With no backup to the collection the retailer on the front line is required to do, no withholding, and no other points of tax collection, the tax collection process will be "fragile", says Bartlett. (A wreck might be a more apt description.) Fake Social Security numbers such as those used by illegal immigrants (I was the one that first informed Barlett about this problem) would magnify noncompliance--invent a Social Security number for your invented dependent, and claim an additional rebate amount. Tax evasion would probably necessitate a much higher rate--at least 35% or 40% on a tax-exclusive basis, quite possibly as high as 65%, according to one Brookings Institution study. Id. at 1252 n.55. (See also this 2005 Urban Institute study by William Gale on the topic.) In fact, once politicians do their thing to start creating exemptions and special provisions for the most needy (or the loudest special interest groups), it is quite likely that the higher end forecasts would be the more accurate ones.
And remember that problem with the states doing the collecting? Their sales tax doesn't match the FairTax, so they have two likely options--make it match or get rid of their sales tax and institute a bigger income tax now that the federal income tax is out of the way. Bartlett is betting on the second choice, and I think that is highly probable. Most states already have both sales and income taxes, so expanding the income base would be relatively easy. Most states with income taxes don't exactly copy the federal income tax, so it appears they wouldn't be likely to do so for the sales tax either, especially since their sales taxes have been in place for some time, and they won't be eager to go through the bruising local political battles to make changes that increase the sales tax base.
Complexity will vanish, you say? Not likely. As long as states retain an income tax, taxpayers will have to retain their records and face potential audits, etc. As politicos make changes to make the FairTax more palatable, there are likely to be further recordkeeping requirements.
Are Americans beginning to get more sophisticated on these tax issues, or will they continue to be gullible about these proposals being pushed by groups with ulterior motives about the desired shape of the tax and spending system? Here's hoping that the 2008 campaign will help focus attention on the issues. As candidates like Huckabee hawk the FairTax, perhaps the other candidates will start making some of these obvious points about its problems. I think if ordinary taxpayers get enough information about it, they will soundly reject the idea.
If we want to do something with the tax system, let's have a deliberative consideration of how to improve the income tax system that we are already well familiar with, that an overwhelming majority of Americans complies with, and that satisfies most Americans concept of fairness by providing for a progressive rate structure.
For more on Barlett's criticisms of the FairTax proposal (especially comments from FairTax proponents), see the following:
FairTAx, Flawed Tax, Bruce Bartlett Op-Ed in the Wall St. J. (Aug., 2007)
FairTax.org (organization pushing the FairTax proposal, and responding quickly on any blog that posts Bartlett's criticisms with reiterations of the "double free lunch" claims--see comments on "Freedom Talks" blog, below)
Cato.org (an early 1997 piece praising the FairTax proposal and setting forth various of the flawed arguments highlighted by Bartlett, such as the claim that states can readily administer the system in spite of having different sales tax bases, and the failure to account for the funding needed to provide a payment to the states for so doing).
FreedomTalks (a blog that argues for lower taxes no matter what, but still ran an article on the problems wih the FairTax; the comments are from dyed-in-the-wool FairTaxers who continue to make the same "double free lunch" claims about their pet project that Bartlett debunks--that prices will go down, workers will still keep all their income, and the economy will soar in spite of the need for a high rate of tax on all transactions)
TaxProf Blog's gathering of responses to Bartlett's Wall Street Journal Op-Ed.