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 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?

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