The Unrepentant Individual

...just hanging around until Dec 21, 2012


August 18, 2005


The FairTax Plan – my response

(Note, this is the first half of a two-part series. In this half, I will explain the plan, what I think is right about it, as well as some of my own reservations about the plan. In the second half, found here, I have rebutted some of the criticisms that I’ve found elsewhere.)

The Fairtax Plan – A primer

Given our current tax plan and tax structure, the question must first be asked whether it needs to be changed. I think the answer to that is an outright affirmative, but let me explain. First, the current structure is complicated. Billions of dollars are spent every year complying with that system, billions are spent trying to exploit it to reduce tax burdens of individuals and corporations, and billions are spent by companies to lobby politicians to change it in their favor. It is so complex that almost nobody understands it, and that works in the lobbyists and politicos favor, as nobody can pay attention to them when they game the system. But compliance is only a small part of the problem. The biggest problem is that it is punitive to businesses that want to operate here. The tax component of the price of goods makes our goods uncompetitive compared to foreign imports, and uncompetitive in our export markets. This, coupled with the high corporate income tax, one of the highest in the industrialized world, gives our businesses an incentive to flee this country as fast as they can. These businesses take jobs with them, making us all poorer. Our individual income tax structure is not horrible compared to other countries, but individuals leaving this nation aren’t a problem. Our high corporate taxes, and easily-refunded VAT taxes other countries put on exports, cause businesses to avoid operating in the US. The businesses that leave are a big problem. The current system serves nobody except politicians, lobbyists, and tax accountants, and presents a tremendous drag on everyone else. It needs to be changed, the question is how.

Enter the Fairtax. The first thing to note is that this is not a tax cut, it is a tax reform. It is designed to be revenue neutral. The FairTax replaces all income, corporate, payroll, estate, capital gains, and other taxes (excise taxes and import tariffs, I believe, will still exist). That means that when you get paid, you have absolutely zero taxes withheld! In each paycheck, you receive 100% of the money you earn. The FairTax is a 23% sales tax rate, targeted on retail goods and services. (Note, please wait for part 2 to question me about the 23% vs. 30% rate issue, rest assured that I will address it) Spend $100 on a new coat? $23 of those dollars go to the feds. Spend $100 on a used coat? None of it goes to the feds. That’s right, it is purely on new goods, not used. You’re an audio company, and you buy screws from your supplier for use in a product? No tax. Sell that product to an end customer? The tax is paid. THIS IS NOT A VAT! It only comes at the final stage of sale. The product is imported from China? The tax is applied! The product is manufactured here and sold in Europe? No tax! Invest $5,000 in the stock market and double it? That money isn’t taxed. Put it in a bank account earning interest? No tax. You don’t need a 401K or other tax-deferred investment, because there’s no tax to defer. Last, but not least, this also applies to services? You’re a massage therapist, and you charge your customer $200 for a massage? $46 of that goes to the feds. Services are taxed.

But it’s a lot more complex than that. The first question popping into most people’s heads is “well, for the drop in taxes I see, all the goods I buy will be 23% more expensive, so how does this benefit me?” These goods will not be more expensive. Rough estimates show that about 22% of the cost of every product you buy, every service you consume, is taxes. Sure, you don’t see those taxes, so it’s difficult to quantify. But each step of the manufacturing, procurement, marketing, shipping, sales force, human resources, accounting, and all other business processes have taxes as a component of their cost. This cost component is passed on and built into the price of every good and service you buy. Take out all that cost, and you will see an immediate decrease in prices, offsetting the sales tax. I’ll leave the math to the experts, but economists projections show the embedded taxes and the FairTax will result in products roughly the same cost to the end consumer.

The next objection that comes up (well, not for us heartless Libertarians) is that this will put an undue burden on the poor. How letting someone keep their entire paycheck, and then not see any real increase in the end cost of goods is a burden, I do not understand. But to sweeten the pot, the FairTax has another treat: the prebate. The government keeps records of the costs of goods and services for households living at the poverty level. Every month, the government will give every head of household a check equal to the FairTax paid on goods and services up to the poverty level for a household of that size. So the tax burden on the poor is zip. Zero. Nada. The poor pay absolutely no tax whatsoever.

Sounds like a pretty sweet deal to me. Sure, I’ve completely oversimplified the FairTax in the last 3 paragraphs. For a full explanation, read the book or visit fairtax.org.

Positive Effects of the FairTax

First and foremost is the effect on business. Our politicians vilify those companies who outsource as “Benedict Arnold CEOs”. They hem and haw over low-tax countries as “tax havens”, stealing businesses away from the USA. It is their own policies, however, that send those CEOs packing. Once America is the biggest, most stable tax haven in the world, the foreign investment and economic growth will be incredible. As Boortz suggests in his book, economists have predicted economic growth of over 10% the first year. Instead of businesses fleeing our shores, they’ll be coming in droves to set up shop in the US. Right now, our government is finding its only way to compete, whether it is textiles from China, or steel, is through protectionism and tariffs. In one fell swoop we can accomplish the same goal of competing by liberalizing our system and cutting out the punitive anti-growth policies. In addition to removing the competitive barriers the tax system causes, it will remove the dead weight of compliance costs. We won’t have lobbyists fighting for unfair changes to the tax code, we won’t have all our decision making tied up in schemes to reduce our tax burden.

Next, it will finally give Americans encouragement to save and invest. Bush’s “ownership society” will be much easier to accomplish if we no longer have punitive taxes on savings and investment. Taxes are only paid when you choose to purchase new goods on the retail level, so you can voluntarily control your tax burden as you see fit. Removing the embedded taxes will affect mortgage companies just as much, which will result in plummeting interest rates and lowering the cost of home ownership, furthering that ownership society.

The positive effects of the FairTax will transform our society. It will finally unleash the latent, wasted potential our current tax system has crushed. And the best part? We will no longer have a government that thinks they own the fruits of our labor and lets us keep what they think is enough for us. We will no longer live in fear of an audit by the IRS. April 15 will just be another day.

Downsides to the FairTax

There are, of course, a few problems. And, of course, they were glossed over or not covered at all in the FairTax book.

First, is the claim that once the FairTax goes into effect, you’ll start getting 100% of your paycheck, but goods won’t increase in price. The idea, of course, is that once the embedded taxes are gone, that prices will drop roughly 22%, offsetting the 23% tax. There’s one major problem with this hypothesis: taxes on labor will disappear, but employees will expect their pre-tax earnings to stay constant. When I spoke the other day about the principle of TANSTAAFL, this is the false free lunch that I saw. If you’re making $40K per year, you’ll probably clear $30K or so after taxes. If your employer tells you that your income and payroll taxes are going to disappear, but he’s dropping your compensation by $10K a year, you’re going to be pretty upset. The crucial point is that while that money will not be collected as taxes, it won’t just disappear from companies’ costs. In the short run, prices will have to increase, and wages and salaries, while they may not go down, will stagnate while the economy grows. This, more than anything, is the major benefit of the prebate. For the poor, or those on fixed incomes, the prebate will allow them to survive this intermediate step when the market adjusts.

This brings me to my second issue. This is a major change to the way that taxation and commerce will occur in the US. For a period of time, there will be confusion, wild price fluctuations, and general instability. Of course, as the market is known to do, it will settle, probably in the span of a few months, and almost certainly within the first year. We can see how things are now, and can get a general estimation of where they would be after everything stabilizes. But we don’t know the path in between. Are we going to see a month where milk sits at $4/gallon? Perhaps. Are we going to see a temporary drop in the new car market or housing market as people adjust to the new system, and are reluctant to make big purchases? It can happen. Such things are a definite possibility, and will make that transition period a lot more uncomfortable than is being suggested.

Last, the writers of the FairTax book suggest that tax avoidance will be highly unlikely. The reason for this, they surmise, is that it will be a lot harder for two people to come together and cheat than it would be for one person. But how many people now work on a strictly cash basis? How many people now get paid under the table, and don’t exist on the IRS’ radar? Quite a few. And that is a willing buyer and willing seller of labor who are working outside the system. That will continue to occur. It may not occur in the major retail or highly visible service markets. But if you have someone come in and clean your house every week, how are you to know whether they’re giving that 23% to the government? If you purchase baked goods at a Mom & Pop bakery in your town, how do you know they’re reporting all their sales? Fraud will still exist. The writers acknowledge this, but downplay its possible effects. I think the effects will be larger than they are claiming. Of course, it exists just as much in our current system as it will in the new system, but we shouldn’t be Pollyanna’s and think it won’t occur as often under the FairTax.

But all this, in my opinion, is not a reason to reject the FairTax. Any tax system will have benefits and downfalls. The real question is how the FairTax compares to our current systems, and how it would compare to alternative systems. I think when all is said and done, the FairTax is the most beneficial tax system that we can have in this country, and thus I support it. Sure, it has a few problems, but show me a tax system that doesn’t? The benefits to the economy and to personal savings will more than make up for those problems. As I can see, the time for tax reform is now, and I’m tossing my vote in with the FairTax.

(As mentioned, this is the first of a two part series. The second part will consist of my response to another blogger’s well-thought-out concerns about the FairTax. I would prefer, if you have objections that I have not raised, please wait until part 2 before you bring them up. For anything related to what I’ve said, however, flame away…)
(Note: part 2 is now available here. Open season on Brad.)


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Posted By: Brad Warbiany @ 7:58 pm || Permalink || Comments (7) || Trackback URL || Categories: Uncategorized

7 Comments

  1. As I’ve said to Stephen Littau, the “prebate” is the single reason I completely oppose a national sales tax to replace income taxes. The “prebate” makes it unfair.

    Just how is this “average” to be determined? A uniform prebate for the entire U.S. might give a small surplus to someone who lives in Kokomo (regarded as one of the cheapest places to live), but not enough to cover the expenses of someone who lives in New York City. There are wide discrepancies even within a county, like my area of Westchester County versus Mount Vernon (basically an extension of the Bronx).

    So the government can hire more economists and analysts, who’ll break it down within county, and perhaps by town/village/city. But even within a city there can be differences in price, like the Bronx versus Manhattan. Determining what is “average” becomes too much of a headache — and we’re only dealing with geography, without getting into individual family demographics.

    Another possibility to consider is that a nationally uniform prebates can skew the housing markets. Some people will move to cheaper places where the “prebate” will give them a little profit. More expensive areas might see a housing drop as people move. (There will be a little negative feedback as increased populations mean increased demand, possibly causing slightly higher prices. Similarly, decreased populations might lead to slightly lower prices.) Now, perhaps it’s good that housing markets be more equalized, but that’s not for government to determine.

    And then there’s the bureaucracy of distributing the prebate on a monthly basis. Granted we’d no longer have the IRS, but we don’t want to replace it with another bureaucracy.

    The simple solution is to not tax food. Several states, like Utah (where I grew up), already have a state sales tax on food. I consider that immoral, though there’s something to be said for levying a tax on every bit of consumption (the same could be said for taxing income).

    Ultimately I find a single fatal flaw with such a high national sales tax, the same one that Jon Henke of QandO does. At 23%, it will encourage an extremely high rate of tax avoidance. This isn’t entirely a bad thing, because it will starve the beast. But at the same time, the federal government will have to institute a massive IRS-like bureaucracy to ensure tax compliance.

    The most economically optimal tax is a head tax, where everyone, rich and poor, pay the same amount. This is what Milton Friedman promotes. A head tax is truly fair because nobody will benefit any more than he pays in. Therefore the majority of people, who have the least amount of money, cannot vote themselves to the money of the highest earners. This means a head tax encourages the least amount of government possible.

    It won’t work, though, because Americans are so unfortunately ingrained in the myth of “the rich can afford to pay more.” They won’t even go for a flat tax, because they believe the 1992 Clinton lie that the rich ought to pay their fair share.

    Comment by Perry — August 19, 2005 @ 9:12 pm
  2. Yeah, a head tax doesn’t have a chance. It will be (considering 2.5 trillion for a budget), 8333 per head. That means a family of four making $45,000 will pay about $34,000 in taxes… It could work as far as starving the beast, or starting a tax revolt (which I wouldn’t mind), but I don’t think it’ll ever have a chance of happening.

    Regarding your specific issues:

    I prefer the prebate over exempting certain classes of products, for the simple reason that it creates a new class of lobbyist and political wrangling. As Boortz says, you’ll have lobbyists for every industry trying to claim their industry is necessary (which will, of course, immediately exempt housing and health care as well), pushing the taxes on other goods much higher than that 23%. The prebate avoids all that. I wouldn’t like the prebate on its own merits, of course, but the FairTax cannot get passed without it (IMHO, of course).

    As to the tax avoidance, I agree that it will occur. But I don’t think the 23% will be the major factor, as so many other taxes will be missing. Jon Henke’s talk about sales taxes over 12% being high enough to force tax avoidance assumes those taxes *on top of* everything else in the system. The question (and I don’t think Boortz really covered this in the book) is how big of a problem will it be? We have to compare this to the current level of tax avoidance and compliance costs. Is it better than that system? Probably. Is it better than that system and also such a big economic growth engine to make it worth it? I’d say definitely.

    Last, regarding the prebate being unfair due to different areas of the country. That is a good point, and one I hadn’t considered. But wouldn’t our current progressive tax structure have the same problem? It’s very easy if you live in New York or San Francisco to hold the same job at a lower standard of living, but your income is higher than that person in Kokomo and thus you’re in a higher tax bracket. Is that fair? Of course not. Again, the FairTax isn’t perfect. I’d consider variations in the prebate to be better than a simple flat income tax, because the FairTax takes away all that corporate taxation that will adversely affect the economy.

    Good points though. I’d love to hear your rebuttal to the above…

    Comment by Brad Warbiany — August 19, 2005 @ 10:37 pm
  3. You see, then, how a head tax would force the ideal of limited government, and a massively decentralized one at that? The federal government originally received money strictly from the legislatures of the several states. Congress had no power to tax American citizens until the 16th Amendment, and until the 14th it had no constitutional jurisdition over state citizens. It was federal jurisdiction over all Americans, then the income tax, that bred gigantic government.

    The census was important not just to determine representation, but how much a state legislature was obligated to send to Congress. If New York had 5% of the population, it was accountable for 5% of federal spending. Article I of the Constitution mandates that no state may “make any Thing but gold and silver Coin a Tender in Payment of Debts,” so a state couldn’t just print paper money to send to the federal Treasury. Since New York was obligated for a set amount of federal spending no matter what, its people would elect Congressmen, and its legislature would send senators (the original method by which they were chosen), that would want as minimal a federal government as possible.

    Lobbyists seeking to get certain items exempted couldn’t be any worse than all those today who are looking for subsidies, tariffs and tax breaks. So there wouldn’t be a new class, but a replacement for the current one. But if the federal government is disciplined enough to pass real tax reform, then it can have the discipline to refuse the special interests. It can define a very simple categories for food, perhaps clothing under a certain amount. Connecticut does that for its state sales tax, and it works extremely well.

    But if exempting a certain class of consumption has many flaws, and a prebate has many flaws, let’s not make this a “lesser of two evils” decision. If both methods are faulty, we need a new system.

    The point about tax avoidance applies even after prices stabilized lower. It’s human nature, both on the buyer and seller side. “Underground” cash transactions would proliferate, because people are fundamentally greedy and wouldn’t think anything wrong about being an occasional free rider, even if the taxed price is cheaper than before. Would this promote enough economic growth to offset any lost taxes? Maybe, but why not a better system that won’t (or can’t) encourage avoidance?

    Now, the tax might work at a lower rate, say, 15%, which would deny the federal government a lot of money it likes to throw around.

    It’s true that a progressive tax structure (which is one of the planks of the Communist Manifesto, remember) has similar flaws, but states tend to tailor their own tax systems when the federal burden is relatively high. Utah, for example, has a lower state sales tax and much lower property taxes than New York. Connecticut has no sales tax on food but compensates with a property tax on automobiles. Some states have no income tax. So methods vary, and generally a more expensive state will have higher-grade jobs that pay more, otherwise its residents couldn’t afford to live there. But this still doesn’t mean we should trade a flawed system for one with basically the same flaws.

    Comment by Perry — August 19, 2005 @ 11:49 pm
  4. Okay. So what tax system, that has a snowball’s chance in hell of becoming a reality, do you propose? As I mentioned, a head tax, with our current size of government, brings a quick calculation of $8000 per individual. While I want to starve the beast as as anyone, that is simply not a feasible system, politically or economically.

    People are going to cheat on their taxes, regardless of the system. Yes, a prebate has flaws, although I consider those to be much less critical flaws than exempting goods, but yes, there are flaws. The FairTax gets rid of the lobbyists (or at least a large portion of them, as I’m sure issue lobbyists will still be there).

    Perry, you’ve got a strong economical mind. Look at a cost-benefit analysis of transition to the FairTax from our current structure. It unleashes the tremendous latent potential of our economy. It destroys the competitive disadvantage our goods are at in a global market. It reduces the costs and complexity of our current compliance and legal tax avoidance system. It brings people outside our current tax system (like drug dealers, prostitutes, etc) into the tax base. And the costs? Probably no worse than what we have in the current system, most likely a damned sight better. A difficult transition period, to be sure. But overall, I think it’s highly positive when you do the cost-benefit analysis.

    I understand that you think a head tax would be better. Let’s say you’re the head of GM. You want to produce a low-emission and high-MPG vehicle. You have a choice of producing another 5.7L V8 SUV, a tiny conventional vehicle with a 1.3L 3-cylinder engine like a Geo Metro, a hybrid that makes decent horsepower and gets decent mileage, or a car the extracts free atmospheric energy and converts into motion.

    I’ll break it down. The V8 SUV is our current tax structure. Wasteful, and it doesn’t in any way accomplish our goals. The 1.3L car would be the flat income tax. Fixes a few problems, to be sure, but doesn’t actually solve some glaring issues. It may be good on MPG, but it will be slow and nobody wants to buy it. The hybrid is the FairTax. It will be good for people, good for the environment. It has a big downfall, in that it’s still based on fossil fuels, but it’s the best thing we have available. And the free energy car? That’s your head tax. It’s wonderful, glorious, and imaginary.

    Comment by Brad Warbiany — August 20, 2005 @ 9:31 am
  5. If you purchase baked goods at a Mom & Pop bakery in your town, how do you know they’re reporting all their sales? Fraud will still exist.

    Never did understand how one commits fraud
    on a thief.

    Comment by jomama — August 21, 2005 @ 12:14 pm
  6. [...] e, I’ll direct you to the two posts that prompted Joshua to ask me to join. First, my analysis of the FairTax (nothing new to many of you), including som [...]

  7. Carnival of Liberty

    Welcome to Carnival of Liberty the Eighth!

    The Law:

    He walks into the room,
    He’s got a briefcase like a bomb
    A smile on both faces
    And he calls it aplomb
    (Al Stewart, “License to Steal”)

    Trackback by Searchlight Crusade — August 23, 2005 @ 5:02 am

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