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How Fair is the FairTax?

Many are disappointed by dismal growth in the fruits of their labor. The temptation is strong to reach for a tax solution that could increase take-home pay in a stroke. The FairTax is a radical tax reform with a strong contingent of devotees, not least among those who roam that series of tubes we know as the internet. 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. Huckabee is winning some primaries and has done the most to elevate the idea.

In a nutshell, the FairTax is a national retail sales tax that would replace all other federal taxes. The tax would be collected by state governments and the Internal Revenue Service would be abolished. The poor would be effectively exempted from the tax by the provision of a national “prebate.” That’s the theory.

Naturally your first thought is: how can I make this work for me? It should be obvious that if the feds collect the same amount of revenue as now, some are likely to pay more and others less. 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. The bottom 60 percent of households contribute a grand total of 2.4 percent of individual and corporate income tax revenues.

Of course, the payroll tax falls on the first dollar of earnings for the lowliest wage earner. Most economists, myself included, believe the employer-paid portion of the payroll tax is shouldered by the worker, so the total effective rate on earnings below the cap of $97,500 is 15.3 percent.

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. Whatever.

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

What about combined rates for income and payroll tax? 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.

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.

FairTax advocates will argue that people who save will pay the tax later, but for any given year, it should be clear that those in the middle face a greater burden shifted onto them from both ends. When you are financially pressed, postponing FairTax by saving some of your money is not going to help you cover living expenses.

FairTax advocates have gone to some lengths to assure their audience that the sticker shock of a 30 percent rate would not be so bad. They 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.

All this would be a surprise to devotees of the Bush tax cuts. They were under the impression that cuts in income tax rates and assorted other goodies in the form of expanded deductions, credits, and whatnot increased their after-tax incomes. By some cruel hoax, according to FairTax economics, their after-tax incomes were not affected at all. Instead, consumers were treated with lower retail prices. (I seem to have missed that drop in prices.)

In reality, mileage would vary all over the place. A switch from income to sales taxation would raise take-home pay and consumer prices at the same time. Some would win and others lose. The progressive income tax is a higher share of income as income grows. The FairTax is a lower share of income as income grows. A switch from income tax to FairTax disadvantages those who pay relatively little income tax in favor of those who pay relatively more. A disproportionate impact would be felt by retired and elderly with little income tax, who are spending down their assets. The same holds for many young married couples who spend some time as net borrowers before beginning to accumulate wealth. The income tax is based on ability to pay. The FairTax is based on disability to pay: the less able you are, the more you pay.

Would 30 percent of the nation’s retail sales replace the current level of federal revenue? Or are we looking at a creative new way to blow up the federal deficit? The FairTax group’s calculations of the 23/30 percent rate(s) rest on some questionable premises. 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.

Some economists like the FairTax because it is a consumption tax. Desire for a consumption tax does not imply the need for a national retail sales tax. There are other types of consumption taxes, such as the value-added tax (VAT) or the so-called “direct consumption tax.” The VAT is widely employed in most every industrialized nation except the U.S., though in no country is it the sole source of public revenue. The direct consumption tax exists nowhere, though it has been the object of study for decades. In a nutshell, a direct consumption tax would look a lot like the current income tax, except the taxpayer would be allowed an unlimited deduction for net savings and no restrictions on when such savings could be drawn down (and taxed in the process).

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.

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.

Max B. Sawicky is an economist in the Federal government. The view expressed in this column do not necessarily represent those of his employer.