I’ve been thinking quite a bit lately about the Fair Tax.  For those of you who have not encountered this concept, the basic idea is to replace the income tax (along with payroll taxes, Social Security taxes, estate taxes, and all other federal taxes) with a nationwide sales tax set at a rate of 23%.  This is coupled with a ‘prebate‘, a payment sent to each taxpayer that is equal to the Fair Tax on an amount up to the poverty rate.  (With the poverty level for a single individual set at $10,400 per year in 2008, the prebate payment would 23% of $10,400, or $2392 annually).

The advantages are pretty well laid out by the Fair Tax site, and include some of the following:

-A much simpler tax system – No longer would people spend hours on April 14th (or ideally, earlier) frantically gathering their financial data and trying to fill out arcane forms.  In fact, since the only form that the Fair Tax people claim you will need is the prebate registration form, filling it out will probably become a source of joy.  (Imagine how people would think of April 15th if they were sure to get a tax refund, and the only question was what size it was going to be.)  Plus, it would also replace other income based tax systems, such as the capital gains tax, Social Security taxes, corporate taxes, and the Alternative Minimum Tax

-More widespread tax collection – Since all the tax would be on sales, there are fewer points of collection.  Further, because there would be a tax on all (non-used good) retail sales, the Fair Tax can catch people who don’t earn a taxable income, such as drug dealers, as well as foreigners shopping in the United States.  (Which probably won’t be a big selling point for tourists, but that’s a point for another day.)

-Progressive taxation – Thanks to the prebate, the Fair Tax system is progressive (meaning, the larger the taxable amount, the higher the overall rate of taxation).  Someone spending just an amount equal to the poverty line would have a prebate large enough to nullify the taxes they pay.  Somone spending at twice the poverty amount would have an effective tax rate (after factoring in prebates) of 11.5%, and someone spending such a large amount that the prebate is essentially meaningless to their income would be paying the full 23% in taxes on every purchase.

-Greater control over how much you are taxed – Since the Fair Tax is at its heart a consumption tax, you can determine how much you pay in taxes by how, and how much, of your income you choose to spend.  The more money you save (or spend on used goods, which are exempted from the Fair Tax), the lower percentage of your income you will spend in taxes.  (Although, this is a bit of a double-edged sword, as we will see in just a minute.)

Of course, as with any major poicy, all is not rainbows and gummy bears; there are some serious criticisms of the Fair Tax, as well:

-The actual tax rate is 30% – Alright, this one will take a moment.  For every $100 in goods you would buy under the Fair Tax system, you will pay $30 in taxes, for a total of $130 in total cost.  If we take $30 in tax divided by the $100 price of our goods, we have a tax rate of 30%.  This is the tax-exclusive rate, the rate calculated as a percentage of the purchase price.  However, if we take the $30 tax and divide by the grand total of $130, we get a tax-inclusive rate of, yes, 23%.  (The Weakonomist makes this point rather well in his post on the Fair Tax.)

To be fair to the Fair Tax, the income tax rates we commonly cite are also tax-inclusive, so this is a more accurate way to compare to the two systems.  If you pay $25 of your last $100 in income in tax, it’s 25% as a tax-inclusive rate ($25/$100) , but 33% as a tax exclusive rate ($25/$75, after subtracting the tax).  So, to truly figure out if the Fair Tax would result in less or more taxes for you, you would have to take the amount of money you pay in taxes under the current tax system, divide by your total pre-tax income, and compare that percent to 23%.

-The Fair Tax isn’t as easy as it seems – One problem with the Fair Tax is that it doesn’t tax all purchases.  Rather, it exempts the purchase of used goods, as well as purchases for business expenses, but not goods that were originally purchased for a business but then sold.  In order to collect taxes on items initially sold to businesses but then sold to individuals, there would have to be a system in place to monitor any ‘business expense’ items until they are sold, in order to collect the tax due when they pass into private hands.  All of which complicates the implementation of any Fair Tax system and will require extra monitoring of corporate purchases.  Plus, the question arises of how a self-employed individual would go about avoiding the tax for purchases related to their business (if I were to buy a new computer to keep blogging, for example), which do not seem to addressed on the Fair Tax website.

-Lower-earners MAY pay a larger portion of their income – This is the other side to being able to control the relative amounts you pay in taxes; weathier people with greater flexibility in how much they spend may pay less as a percentage of their income than people with lower income.  For example, a single earner making $40,000 who spends all his money would pay an effective tax rate of 17% (23% of $40,000 is $9200, less $2392 is $6808, or17% of his income).  However, someone making $100,000 who spends $80,000 will pay only 16% of her income in taxes (23% of $80,000 is $18,400, or $16,008 after factoring in the prebate, which is 16% of $100,000).  And in theory, by cutting her spending down to $40,000, our high wage earner could enjoy a 7% tax rate ($6808 divided by $100,000) while still enjoying the same lifestyle as our low wage earner.

Admittedly, this last scenario is a bit far-fetched; few people (other than the occasional PF blogger) would be willing to live that far below their means.  And making the math work requires that the lower income individual (a) is making much more than poverty level wages (thanks to the prebate, very low income people effectively pay a tiny portion, if any, of their income in taxes under this system) and (b) that said individual save much less than the higher income individuals (if our $40,000 a year earner only spend 80% of his income, his effective tax rate drops under 13%).  Still, this is an issue that should be considered with such a change in tax policy.

My View: Overall, I think that the Fair Tax is a pretty good idea.  Yes, it has a few flaws (what tax plan doesn’t?), but overall, it strikes me as simpler, more inducive to good financial behavior, and yes, fairer, than our current hodge-podge of income-based taxes.

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