The Problems with the Fair Tax

Ah, the Fair Tax.  It seems hard to argue with a Tax that has ‘Fair’ right in the name, doesn’t it?  It also isn’t a half bad idea; taxing spending rather than income, greatly simplifying the labyrinthine maze of taxes that currently exist, and making taxes more transparent and obvious are all arguably good goals.  Heck, in my early days as a blogger (almost a year ago to the day, actually), I was pretty strongly in favor of the Fair Tax, and I’m still more in favor of it than I am of our current tax system.  (Not that that’s saying much; there are few tax systems that would NOT be an improvement on our current situation.)

In the time since I first published that post, though, I’ve become more disenchanted with the tax; the flaws (included some I mentioned in that initial post) are shining more brightly while the advantages seem to be tarnished.  So, when Joe Plemon asked if the Fair Tax was too good to be true, I had to respond with a resounding YES, and provided several points that I’ve yet to see addressed by the Fair Tax supporters.  Here’s three points I raised in my comment, ones which I’d love to see addressed by Fair Tax supporters:

1) The Fair Tax is more complicated than it looks: One of the major selling points of the Fair Tax is that it’s much simpler than the current tax system; just a single flat tax rate on all purchases (with some exceptions; see below for more on these), a ‘prebate’, or monthly check to everyone in the country, (which is equivalent to the Fair Tax on income up to the poverty level), and that’s it.  No complex forms to fill out every April, no need to wade through piles of old receipts to maximize your return, and no (or a greatly reduced in size) IRS!  It sounds like a dream, right?

Well, it’s not that simple; even the Fair Tax has its complications.  For example, it exempts corporate spending from taxation, as well as the sale of used goods.  These exemptions do make logical sense; corporate taxes are passed along to the consumer (corporations, being legal fictions, can’t truly pay taxes), while taxes on used goods would be a form of double taxation, on the original sale and on the used product.

But in order to track all of this, you end up having to make things more complicated.  How are purchases for businesses going to be distinguished from personal expenses?  Won’t we see the same sort of abuses of ‘business expenses’ as we see under the current system?  (For example, luxury airplanes considered as business necessities.)  Used items represent another problem; the need for the seller to keep receipts (or have some other way of proving that the item is used) in order for the buyer to save on taxes.  Given the difficulty people have keeping receipts when it saves them money on taxes, why would they be any more responsible when it’s not their money they need to worry about?

2) The Fair Tax tax rate would need to be higher than claimed to generate enough income: Proponents of the Fair Tax maintain that the tax rate of 23% they tout will be adequate to (more than) generate the current level of income from all the taxes it would replace (not only the income tax, but corporate taxes, Social Security Taxes, estate taxes, etc.).  That number is little bit odd; it’s tax inclusive, meaning it incorporates the amount of tax in the total from which the percentage is derived.  If you read it as a normal sales tax (which is tax exclusive), it would be 30%.  A $100 item (before Fair Tax) would have a $30 Fair Tax added; $30/$130 gives us 23%

All of that said, in order for the Fair Tax rate to be as low as proponents maintain (whether you consider it a 23% tax or a 30% tax), the number of goods that fall under the tax has to be significantly larger than those currently subject to sales taxes.  As FactCheck.org notes, for the Fair Tax to provide the income amount it claims at the noted tax levels, many things we don’t currently pay sales taxes on would have to be taxed.  These include things like purchases of new homes, rent, doctors’ and lawyers’ fees, and interest on credit cards and mortgages.  If you start exempting any of these items from the Fair Tax, you’ll have to make up the income in some way, likely by increasing the rate of taxation on everything else.  (FactCheck, in that same link, also makes a decent case that the rate would have to be higher than the 23%/30% being discussed in order to make everything revenue neutral anyway, in part because people would inevitably cheat on the tax as they do on taxes now.  They found research suggesting a 34-39% tax exclusive rate would be needed for revenue neutrality.)

3) How will foreign nations react to the Fair Tax?: This, more than any of the my issues so far, seems to be something that nobody has answered.  The Fair Tax website makes quite a few claims about how the Fair Tax will boost US competitiveness in the global market; it’ll make US exports cheaper to other countries, foreign imports will become more expensive (since the Fair Tax will add on top of the taxes the foreign manufacturer paid in their own country), and jobs and investment money will flow into the United States.  It’ll be a golden time for Americans!

But the problem is, changes like this don’t occur in a vacuum; other countries will react, perhaps badly.  Imagine for a moment that the shoe was on the other foot; say the European Union decided to switch over to a Fair Tax style system, and all the predictions the Fair Tax supporter are making come true to benefit them.  The EU becomes a competitive dynamo; their exports are cheaper in our stores, our products are more expensive over there, and businesses start to uproot to relocate in Europe, taking jobs with them.  Heck, even sales of American items to tourists declines, since all goods purchased in a foreign country are subject to the Fair Tax on being imported.

Given this situation, you’d expect the US to respond in some fashion, possibly imposing tariffs on imported goods, possibly insisting that US made goods be sold Fair Tax free, possibly by switching over to the Fair Tax ourselves to negate the competitive advantage.  As America goes in this little example, so goes Europe (or possibly some of our other major trading partners) if America opts for the Fair Tax.  At best, the advantages of the Fair Tax would be blunted (if the Europeans enact their own version), at worst, it could spark a tariff war that leaves everyone worse off.  Without having some idea of how the other major countries of the world will react, it’s impossible to say whether switching to the Fair Tax will be a net benefit to the country.

Those are the three big issues I see with the Fair Tax; but there are some other ones to consider.  While not as potentially harmful to the case for the Fair Tax as those mentioned above, they could change some opinions if people knew the Fair Tax:

  • Can be regressive.  For a short example, consider this: you and I spend the same amount, paying the exact same amount in Fair Tax.  But if you earn twice as much money as me, your tax rate (as a proportion of your income) will be lower than mine.  (For a longer example, FactCheck’s article (near the end) notes that people who earn between $15k and $200k will pay more under the Fair Tax, while those who earn above $200k will pay less.)
  • Could encourage ‘under the table’ spending.  Taxes on income lead people to hire workers off the books, so as to avoid paying said taxes; in the same way, sales taxes, particularly one as sizable as the Fair Tax (however you want to calculate it) can drive purchasers to the black market.
  • Would devastate the tax preparation market. There is a fairly sizable market out there devoted to helping people prepare their taxes each year, covering computer programs, accountants, and any number of tax guides.  If the Fair Tax is passed, there’s much reshuffling of these businesses (and the IRS, for that matter) which will need to be done.

Readers, What’s your take on the Fair Tax?  Am I being too critical of a great tax plan?  Did I miss any flaws in the system?  Any non-Americans who can give me more insight into how foreign government would react to the US enacting this tax plan?

13 Responses to The Problems with the Fair Tax

  1. Like you I believe almost anything is better than what we have.

    Nothing is perfect and you raise some very good questions but so far I still like this better than the VAT option as an additional tax that is being explored now.

    While we explore and hopefully reform our tax system I think it is more important we reform our spending habits.
    .-= LeanLifeCoach´s last blog ..Thought Experiments – Detroit =-.

    • Read up on the so called Fair Tax. They won’t be looking for your tax returns, they will be looking for your sales receipts.

  2. item 1- you say it makes it more complicated that used good and business expenditures aren’t taxed. ummm, it’s a retail tax. how hard is that to understand?

    item 3- our domestic tax policy is ours. countries al over the world have their own diverse domestic tax policies. countries starting tarriff wars with the united states has absolutely nothing to do with domestic u.s. tax policy. if a country wants to start a trade war with the u.s., we can completely shut down our market to their products. what country on earth do you think is going to do this. the eeu would be destroyed by such a trade war and if the eeu countries the fairtax and the united states motors toward marxism, them i’ll head in the direction of liberty.

  3. @LeanLifeCoach: I do think that the Fair Tax would make more sense than a VAT (particularly if the VAT is in addition to all the current tax laws, rather than instead of). And yes, from a personal perspective, it’s much better to focus on saving, spending, and investing wisely, so you’re prepared no matter what happens to the tax system.

    @MJ: It would certainly simplify things at tax time, I won’t argue with you there.

    @christo: For the first item, my point was merely that the Fair Tax, while promoted as easy and straightforward, has more twists and turns and could easily end up requiring as much money and time to enforce as our current over-bloated tax policy. To cite but one example, the requirement of paying the Fair Tax on goods bought overseas that I mentioned under the foreign reaction section. If you think dealing with the IRS is bad, wait until you have to provide detailed receipts for everything in your luggage every time you come back into the country.

    As for item 3, yes, our tax policy is our own, and we shouldn’t let the possible reactions of foreign countries deter us from doing what’s in our own best interest. That said, if one of your major points in favor of a particular plan is ‘It will give us a huge advantage over those foreigners, ha ha!’, I don’t think it’s being too much of a globalist to consider that they might just react in a way that hurts us, too.

  4. I as a small wage earner over 30 years… tried to start a business… and now having over $30,000 in unpaid income taxes.. from the sale of a good growth stock that I borrowed money for the start up… truly hates the IRS…. and income taxes… I want the FairTax.

    • You tried to start a small business and now you have over $30,000 in unpaid income taxes and you blame the IRS because of it? One thing, you did some lousy bookkeeping. I had a small business and I never had problems like that. You think this so called Fair Tax is any better? If this so called Fair Tax ever enacted, businesses such as retail and services will have to keep records and bookkeeping, any business. They are going to come after you sales receipts. Even with this so called Fair Tax, there is going to be an IRS type of Federal agency watching over this.

  5. @James: True, the IRS doesn’t have a very good reputation (not that the government in general is known for its common sense and compassion). Still, the point of this article is simply to point out that while there would be advantages to the FairTax, it’s not all happiness and roses.

  6. “Would devastate the tax preparation market.”

    Seriously? This is a valid argument against Fair Tax? The tax prep market is around because people one, don’t want to pay taxes and are trying to find a way to pay less and two, the code is so complicated they need someone to figure it out.

  7. @Mike: Well, as I noted, it’s hardly that big a reason; goodness knows, most people aren’t going to oppose a change to tax system because H&R Block might go out of business. If that was the ONLY problem with the Fair Tax, we’d probably be using that as we speak (or at least, there’d be a lot more support for it). Still, changing to the Fair Tax would have an impact on the tax prep field (more than likely wiping it out completely, so it is something to keep in mind that most Fair Tax supporters don’t seem to mention.

  8. They will still need a Federal agency to process and handle the so called Fair Tax plus they will need a Federal agency to process and handle the so called pre-rebates. It will cost the Federal government over $700 billion to process and send out the so called pre-rebates making it one of the largest entitlements ever. A waste.

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    Monserrate´s last blog post ..Monserrate

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