Fair Tax, Flawed Tax

Does adding 30% to the price of every house sold sound like a good idea to you?

Former Arkansas Gov. Mike Huckabee’s unexpectedly strong second-place showing in the recent Iowa Republican straw poll is widely attributed to his support for the FairTax.

For those who never heard about it, the FairTax is a national retail sales tax that would replace the entire current federal tax system. It was originally devised by the Church of Scientology in the early 1990s as a way to get rid of the Internal Revenue Service, with which the church was then at war (at the time the IRS refused to recognize it as a legitimate religion). The Scientologists’ idea was that since almost all states have sales taxes, replacing federal taxes with the same sort of tax would allow them to collect the federal government’s revenue and thereby get rid of their hated enemy, the IRS.

Rep. John Linder (R., Ga.) and Sen. Saxby Chambliss (R., Ga.) have introduced legislation (H.R. 25/S. 1025) to implement the FairTax. They assert that a rate of 23% would be sufficient to replace federal individual and corporate income taxes as well as payroll and estate taxes. Mr. Linder’s Web site claims that U.S. gross domestic product will rise 10.5% the first year after enactment, exports will grow by 26%, and real investment spending will increase an astonishing 76%.

In reality, the FairTax rate is not 23%. Messrs. Linder and Chambliss get this figure by calculating the tax as if it were already incorporated into the price of goods and services. (This is known as the tax-inclusive rate.) Calculating it the conventional way that every other (This is called the tax-exclusive rate.)

The distinction is confusing, but think of it this way. If a product costs $1 at retail, the FairTax adds 30%, for a total of $1.30. Since the 30-cent tax is 23% of $1.30, FairTax supporters say the rate is 23% rather than 30%.

This is only the beginning of the deceptions in the FairTax. Under the Linder-Chambliss bill, the federal government would have to pay taxes to itself on all of its purchases of goods and services. Thus if the Defense Department buys a tank that now costs $1 million, the manufacturer would have to add the FairTax and send it to the Treasury Department. The tank would then cost the federal government $300,000 more than it does today, but its tax collection will also be $300,000 higher.

This legerdemain is done solely to make revenues under the FairTax seem larger than they really are, so that its supporters can claim that it is revenue-neutral. But for the government to afford to purchase the same goods and services, it would have to raise spending by the amount of the tax it pays to itself. The FairTax rate, however, is not high enough to finance the higher spending it imposes. Therefore the proposal only works if federal purchases are cut by 30%, close to $300 billion–the increased cost imposed by the FairTax.

Similarly, state and local governments would have to pay the FairTax on most of their purchases. This means that it is partly financed by higher state and local taxes. It’s also worth remembering that state sales taxes now average 6%, which means that the total tax rate will be 36% on retail sales.

State sales taxes have long exempted all but a few services because of the enormous difficulty in taxing intangibles. But the FairTax would apply to 100% of services, including medical care, thus increasing their cost by 30%. No state comes close to taxing services so broadly.

Consumers would also find themselves taxed on newly constructed homes. Imagine paying 30% to the federal government on top of the purchase price of your next house.

Since sales taxes are regressive–taking more in percentage terms from the incomes of the poor and middle class than the rich–some provision is needed to prevent a vast increase in taxation on the nonwealthy. The FairTax does this by sending monthly checks to every household based on income.

Aside from the incredible complexity and intrusiveness of tracking every American’s monthly income–and creating a de facto national welfare program–the FairTax does not include the cost of this rebate in the tax rate. As noted earlier, the FairTax is designed only to match current revenues and does not cover any increased spending that it may require. Since the rebate will cost at least $600 billion the first year, either federal discretionary spending would have to be cut by 60% or the rate would have to be five percentage points higher than advertised.

Rejecting all the tricks of FairTax supporters and calculating the tax rate honestly–by including the higher spending that it mandates and by being realistic about what could actually be taxed–professional revenue estimators have always concluded that a national retail sales tax would have to be much, much higher than 23%.

A 2000 estimate by Congress’s Joint Committee on Taxation found the tax-inclusive rate would have to be 36% and the tax-exclusive rate would be 57%. In 2005, the U.S. Treasury Department calculated that a tax-exclusive rate of 34% would be needed just to replace the income tax, leaving the payroll tax in place. But if evasion were high then the rate might have to rise to 49%. If the FairTax were only able to cover the limited sales tax base of a typical state, then a rate of 64% would be required (89% with high evasion).

I’ve emphasized problems with the FairTax rate because public opinion polls have long shown that support for flat-rate tax reforms is extremely sensitive to the proposed rate, with support dropping off sharply at a rate higher than 23%. But there are also massive technical and administrative problems with collecting all federal taxes at the checkout counter and relying entirely on state governments to collect the federal government’s revenue.

Among the problems: What possible incentive would the states have to be vigorous in their federal tax collections? What is to stop them from slacking off and giving their citizens a tax cut at federal expense? What about states with no sales taxes? What’s to stop people from bypassing retail outlets and buying their goods from producers or at wholesale, tax-free?

Perhaps the biggest deception in the FairTax, however, is its promise to relieve individuals from having to file income tax returns, keep extensive financial records and potentially suffer audits. Judging by the emphasis FairTax supporters place on the idea of making April 15 just another day, this seems to be a major selling point for their proposal.

Yet all but six states now have state income taxes. So unless one lives in one of those states, this promise is an empty one indeed. In short, the FairTax is too good to be true, and voters should not take seriously any candidate who supports it.

Mr. Bartlett was deputy assistant secretary of the Treasury for economic policy from 1988 to 1993.

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