The FairTax Is Fair!

Max: The FairTax is a radical tax reform with a strong contingent of devotees …. In this campaign season, the tax is being promoted by presidential hopefuls Governor Mike Huckabee of Arkansas, Rep. Ron Paul of Texas, and Senator Mike Gravel of Alaska.

Adakin: Sir, only Huckabee and Gravel have expressed outright support for the FairTax. Congressman Paul (as well as Senator John McCain) said he would, as president, sign HR-25 if it made it through congress, but Paul advocates the outright abolition of the income tax and replaces it with nothing. Also part of that “strong contingent of devotees” are the 74 bipartisan congressional cosponsors of the bill in both the U.S. House and Senate that support HR-25/S1025, also known as the FairTax.

Max: As things stand the poor pay no federal income tax. Most families with children under median income levels owe little or no income tax. The vast bulk of individual income tax is paid by those well above the median.

Adakin: Yes and no. Even though “the vast bulk” pays no federal income tax, they all pay employment taxes, which when combined with what the employer contributes totals over 15% of a worker’s compensation. While a low-income worker sees only $92.35 from every $100 earned, an employer hiring someone at $100 per unit of work pays $107.65, with the overage being the employer’s side of FICA, for a total of $15.30 going to the Fed.

With the FairTax, a worker would get the promised $100 plus that additional $7.65. So passage of the FairTax would result in a 16.6% increase in take-home pay for those that “pay no federal income taxes.”

Max: The bottom 60 percent of households contribute a grand total of 2.4 percent of individual and corporate income tax revenues.

Adakin: Yes, but FICA taxes are spread pretty much evenly over the entire wage-earning spectrum and this is the group that would benefit most from the “prebate” function of the FairTax.

Max: What would the FairTax rate be? Some of its supporters claim it would be 23 percent. Let me familiarize you with their arithmetic. They are talking about a thirty percent rate applied to retail purchases. A $20,000 car would cost $26,000. A new $300,000 house would cost $390,000. If the product costs a dollar, the price including tax is $1.30. Thirty divided by a dollar and thirty cents is 23 percent.

Adakin: Your point regards the debate between inclusive versus exclusive taxes. The reason the FairTax people use the inclusive rate of 23% is that it replaces an inclusive tax rate. Currently, income tax is scored as an inclusive tax rate. For example, the 25% tax bracket implies that 25% of gross earnings is tax, leaving the wage earner with 75%. The FairTax people simply want to be consistent in the manner in which the two systems are portrayed. If you inclusively look at your income tax as a percentage of gross earnings, then let’s also look at the FairTax as a percentage of gross spending. Hence the $30 is 23% of the gross amount spent.

For comparison, let’s do the reverse and apply an exclusive scoring method on a typical middle-income wage earner in the 25% tax bracket and paying FICA taxes at 7.65%. The total amount of tax liability for that person is (25% + 7.65%) almost 33%. I guess that if Max is to be consistent, this person would be considered to be in the 50% tax bracket since 1/3 is half of the 2/3; she is paying almost half of her net income in taxes.

As far as a new $20,000 car costing $26,000 or a new $300,000 home costing $390,000, Max never mentions the fact that the current tax code creates hidden or “embedded” taxes within the cost of virtually everything we buy.

Several years ago, Roger Smith, the then-General Motors CEO, testified before Congress that embedded taxes comprise over 30% of the cost of a new car. Economists say that taxes and tax-related compliance costs comprise, on average, 22% of the cost of all new goods and services. Based on that figure, that new $20,000 auto should cost around $15,600 once the embedded taxes are removed from the cost of production. Now, add back the 23% FairTax and the final retail price of that new car is $20,280, or pretty much the same price it was when the Fed was removing 1/3 of your gross pay.

Think about what a new $300,000 home would cost if there were no embedded taxes factored into the cost of building it. Imagine if the builder, all of the sub-contractors, the developer, the architect, engineer, real estate broker, and appraiser no longer had to pay taxes on their profits. Or if the material suppliers selling the lumber, the concrete, the plumbing, the roofing, the wiring, and the appliances didn’t have to pay taxes on the profits that they made in their “B-to-B” dealings with the homebuilder. Once all these embedded costs are removed, that $300,000 home would suddenly cost around $234,000. Now add back the 23% FairTax and we’re back to around $304,200.

Home purchases typically require a 20% down payment. Under current tax law, that 25% tax bracket homebuyer would have to first earn almost $90,000 in order to save the $60,000 needed for a down payment. With the FairTax, the down payment requires only $60,000 of earnings. That $1440 monthly house payment would also require first earning $2160. The homeowner would then have to factor the mortgage interest deduction, saving around $250 each month. Even considering the MID the monthly payment would still require earning over $1900 so as to be able to pay that $1440. Using untaxed earnings, the FairTax would require earning only $1440.

Max: Whether it is 30 or 23, the rate on the above-mentioned worker would still exceed that of the payroll tax.

Adakin: Really? With the FairTax, that same low income worker would have 16.6% more in take-home pay. If she buys a used car, or a used home, or pays tuition, or makes any purchases not subject to the FairTax, she would be spending untaxed earnings, which would substantially lower her effective tax rate. And when the prebate factor is considered, it’s easily possible that a prudent low-income consumer could actually have a negative tax rate. Bottom line: the worker gets to choose how much he/she is taxed based on how she spends her untaxed earnings.

Max: If the tax is reimbursed for all income below the poverty line, there is still some pay rate well short of “rich” where your FairTax would be higher than your payroll tax. For a nuclear family of two parents and two kids in 2007, the poverty line is $21,027.

Adakin: Let’s look at your “poverty line” family earning $21,027. The FairTax prebate would be 23% of $21k, or $4830. Adding the prebate to their gross income plus the employer’s side of FICA (7.65%) provides that family with just over $27,400 in total spendable income. If we assume that ALL of that was spent on taxable items, this family would pay $6302 (23% of $27,400 scored inclusively). Deduct the prebate from the tax ($6302-$4830) and the net effective tax is $1472, or 7.0% of the original $21k earned, which is just under the worker’s FICA amount that is currently withheld.

The above example assumes 100% of their income is spent on taxable purchases. If this family spends 20% of their gross income on non-taxable spending, like a used car or tuition for a child or payments on an existing home, the effective tax rate drops to just 1.0%.

Point being, with the FairTax the worker is in control over how much taxes they choose to pay.

Max: Thirty percent of the earnings of such a family in excess of $21K catches up with 15.3 percent of earnings from the first dollar at around $42K. In other words, as you escape lower class and hit the bottom rung of the middle class income ladder, you start to pay more under the FairTax than you would have under the old payroll tax.

Adakin: Of course you “start to pay more” as income increases. That’s because consumption increases proportionally as income increases. As spending increases, the percentage of benefit derived from the prebate diminishes. The FairTax is a progressive tax. Max’s statement implies an assumption that every income quintile spends all of their earnings. Lower-income people buy the necessities of life and the prebate reimburses them for the taxes they pay up to the poverty level. As income increases a consumer could choose to spend some of their increased earnings on both taxable and non-taxable items or buy investment property or simply save it. With the FairTax, whether you earn a million bucks or a thousand, if you don’t spend it you aren’t taxed. You choose when and how much you want to pay for the government that you get.

Max: Bruce Bartlett, former Reagan tax guru, points out that the bottom 80 percent of households pay less than 23 percent of their income in all federal taxes. And the bottom 90 percent pay less than 30 percent of income.

Adakin: Yes, that’s true. But their entire paycheck is taxed before they ever see it. Bartlett makes the assumption that we all spend 100% of our earnings on taxable items. The last time I purchased a new car was in 1975, I spend at least a thousand bucks a year on educational tuitions, and I’ve never bought a new home, only existing homes. None of these items would be subject to the FairTax. So the real focus should be on how you choose to spend your earnings. By the way, you can find an excellent rebuttal to Mr. Bartlett’s flawed comments by Laurence J. Kotlikoff, Professor of Economics at Boston University, here.

Max: On the high side of the income spectrum, it should be clear that those who are able to save, or spend their income in other countries, or buy stuff by mail or internet in other countries and have it shipped to them here, will pay less tax than presently. The FairTax should be great for Canada and Mexico.

Adakin: Again, Max makes the assumption that the FairTax adds 30% to the current prices of goods and services with no consideration given to the fact that the hidden costs of embedded taxes would disappear.

Max: FairTax advocates … claim the current income tax is “built into the price of the product,” so you would not be paying more out of pocket than presently. The implication is that when we switch from income tax to sales tax, the product price including tax does not change. This can only mean that income and payroll taxes on individuals and corporations are really paid by consumers. It also means your take-home pay would not increase.

Adakin: Max is assuming that the primary component of embedded taxes in a corporation or business is their employee’s payroll taxes. As an economist, he should know that the cost of employing people is contractually a fixed expense and is not an expense imposed by government fiat.

Employment taxes are a tax on each individual employee, not the employer. If you hire people, you have a contractual obligation to pay 107.65% of whatever you agreed to compensate them and that cost remains constant. The amount doesn’t change when the tax law changes. The real embedded cost reduction comes from elimination of the tax on the company’s profits and elimination of the double taxation on “after-tax” dividends paid to its shareholders.

In addition, the cost of maintaining the detailed tax records on income, expenses, capital improvements, deductions, and depreciation are all part of the hidden documentation costs imposed by the current tax law. Another consideration is the substantial “opportunity cost” that is caused by the current tax law. Most corporations and businesses pay CPAs and tax attorneys to advise them before making business or investment decisions or capital expenditures. With the FairTax, these business decisions would be based on the intrinsic benefits of the company instead of being based on the tax aspects of these decisions.

No, Max, the employees would still see their entire paycheck and the employer would see a substantial reduction in their corporate tax burden, documentation costs, and consulting expenses, leading to an increase in efficiency and profit. The lowered costs could allow the business to price their products more competitively with their overseas competitors, thus obtaining a higher market share, increasing demand for their goods and services, and creating a need for expansion, new hiring, and more jobs for Americans.

Max: One noted by Bartlett is that the government will tax its own purchases from the private sector. In other words, it will charge itself and count the proceeds as net revenue. Second, state and local governments would be liable for the FairTax on their purchases. The FairTax rates do not take into account the impact on tax burdens in the state-local sector. Third, purchase of new homes and some mortgage interest are included in the FairTax tax base. The politics of a clean FairTax base are not easy.

Adakin: When federal, state, or local governments buy goods or services, it’s assumed that the vendor is making a taxable profit on that purchase. The vendor sells their product to the government, then turns around and pays the government the taxes earned from that sale. Max is again ignoring the embedded tax component that comprises a substantial part of the production costs for each of the above items. And he assumes the government purchaser will be paying an additional cost over and above the embedded tax costs that will disappear with the FairTax.

With the FairTax, the hidden tax on the profits disappears but remains in the transaction as a sales tax where everyone can see it. The FairTax is designed to be revenue-neutral, so why does Max feel that government should unfairly benefit from these untaxed goods once those hidden taxes are removed?

Max: The FairTax calculations take no account of tax compliance. Presently the biggest rates of non-compliance in the income tax are among the self-employed, proprietors, and unincorporated businesses. Under the FairTax, these parties would have the responsibility of collecting the entirety of federal revenue, not just their own portion of the income tax. There would be a huge new incentive for tax evasion, and no IRS to walk the beat. This factor alone leads most tax economists to dismiss the FairTax as unworkable, aside from its other disadvantages.

Adakin: The IRS processes almost 200 million individual tax filings and over 30 million business filings each year. The FairTax would collect its revenue from just those 20 or 30 million retail vendors, substantially reducing the exposure to potential fraud or corruption.

Those retail businesses are already complying with their state revenue agencies that currently collect their state sales taxes. HR-25 would simply have those same state revenue agencies provide the collection and oversight of these vendors so there would be no need for duplication of services. Max says: “Under the FairTax, these parties would have the responsibility of collecting the entirety of federal revenue, not just their own portion of the income tax.” (Income tax? What income tax?) HR-25 contains a provision to compensate these retail businesses for their acting as tax collector, similar to the way that many state revenue agencies currently compensate their retail merchants for this service. There is a long history of sales tax collection, so this is not rocket science. Millions of retail merchants simply record the sales and send in the revenue each month already.

Besides, limiting the number of “tax collectors” makes oversight far easier. For example, in Florida, a state with no income tax, less than 6% of all retail businesses collect over 90% of all sales tax revenue (i.e., Wal-Mart, Home Depot, Target, etc.), again making oversight much more efficient. In addition, it only takes one person with the current system to perpetrate fraud by filing a bogus tax form. With the FairTax, it would require the cooperation of both the customer and the vendor, substantially increasing the risk of detection.

Max: The income tax badly needs fixing, but the FairTax is an unlikely remedy. The IRS ain’t going anywhere. And we’re all going to die eventually. Some things are not going to change anytime soon.

Adakin: As noted earlier, HR-25/S-1025 currently has over six dozen congressional cosponsors in the current Congress. That’s 15% of Congress, more than any other tax reform proposal on the Hill. By comparison, the Steve Forbes/Dick Armey Flat Tax bill has just four cosponsors and has gone nowhere over the past ten years.

The FairTax would turn our nation into the world’s tax haven, allowing American goods to cost less and be far more attractive to foreign consumers since the tax component would be gone and the FairTax would not apply to exported items. This competitive edge would attract billions in foreign investment capital and would reverse the flight of American jobs going overseas. As the cost of home ownership would be reduced, our depressed housing industry could get back on its feet, putting our construction industry back in business. The same can be said for our auto and other manufacturing enterprises that would export untaxed products overseas.

The FairTax is fair because if Bill Gates, Warren Buffet, Oprah Winfrey, you, or me buy that bottle of Pepsi and a Big Mac, we will all pay the same amount of tax. No longer would someone in Washington need to know your personal business, your earnings, your marital status, whether you own or rent, or what you invest in or what you buy. Your privacy is yours again. No longer does a mortgage payment get preferential treatment over a rent payment. No longer is hard work and achievement punished as income increases. No longer would risk-taking and investment capital be penalized while failure is rewarded. Everyone pays the same sales tax and everyone gets the same prebate, yet Mad Max asks “How fair is the FairTax?”

Bottom line: the FairTax is fair because it takes the politics out of revenue generation. With the FairTax, Washington would no longer be able to use the tax code to reward their cronies and punish their enemies. The FairTax gives people the freedom to choose when and how much they want to pay for the government they desire. And that’s what really scares the people inside the Beltway.

“Adakin Valorem” is a real estate investment analyst for the Federal government. The view expressed in this column does not represent the official views of his employer.