Monthly tax rebate
Under the FairTax, households of citizens and legal resident aliens would receive a "Family Consumption Allowance" (FCA) based on family size (regardless of income) that is equal to the estimated total FairTax paid on poverty level spending according to the poverty guidelines published by the U.S. Department of Health and Human Services. The poverty level guidelines vary by family size and represent the cost to purchase household necessities. The FCA is a tax rebate (known as a "prebate" as it would be paid in advance) paid in twelve monthly installments equal to 23% of poverty level spending for each household size. The rebate is meant to eliminate the taxation of necessities and make the plan progressive. The formula used to calculate rebate amounts would be adjusted for inflation. To become eligible for the rebate, households would register once a year with their sales tax administering authority, providing the names and social security numbers of each household member. The Social Security Administration would disburse the monthly rebate payments in the form of a paper check via U.S. Mail, an electronic funds transfer to a bank account, or a “smartcard” that can be used much like a bank debit card.
Opponents of the plan criticize this tax rebate due to its costs. Economists at Suffolk University and Boston University estimated the overall rebate cost to be $489 billion (assuming 100% participation). In addition, economist Bruce Bartlett has criticized that the rebate would create a large opportunity for fraud, treats children disparately, and would constitute a welfare-payment-regardless-of-need.
The President's Advisory Panel for Federal Tax Reform cited the rebate as one of their chief concerns when analyzing their national sales tax, stating that it would be "the largest (entitlement program) in American history", and contending that it would "make most American families dependent on monthly checks from the federal government". Based on the advisory panel's tax rate (which differs from the FairTax legislation), "the Prebate program would cost more than all budgeted spending in 2006 on the Departments of Agriculture, Commerce, Defense, Education, Energy, Homeland Security, Housing and Urban Development, and Interior combined." Proponents point out that income tax deductions, tax preferences, loopholes, credits, etc. under the current system was estimated at $945 billion by the Joint Committee on Taxation. This is $456 billion more than the FairTax "entitlement" (tax refund) would spend to cover each person's tax expenses up to the poverty level. In addition, it was estimated for 2005 that the Internal Revenue Service was already sending out $270 billion in refund checks.
Presentation of tax rate
Sales and income taxes behave differently due to differing definitions of tax base, which can make comparisons between the two confusing. For direct rate comparisons between sales and income taxes, one rate must be manipulated to look like the other. A 30% sales tax rate approximates a 23% income tax rate after adjustment. The current U.S. tax system imposes taxes primarily on income. The tax base is a household's pre-tax income. The appropriate income tax rate is applied to the tax base to calculate taxes owed. Under this formula, taxes to be paid are included in the base on which the tax rate is imposed (known as tax-inclusive). If an individual's gross income is $100 and income tax rate is 23%, taxes owed equals $23. The tax base of $100 can be treated as two parts—$77 of after-tax spending money and $23 of income taxes owed. The income tax is taken "off the top", so the individual is left with $77 in after-tax money.[15 Traditional state sales tax laws impose taxes on a tax base equal to the pre-tax portion of a good's price (known as tax-exclusive). Unlike income taxes, U.S. sales taxes do not include actual taxes owed as part of the base. A good priced at $77 with a 30% sales tax rate yields $23 in taxes owed. Since the sales tax is added "on the top", the individual pays $23 of tax on $77 of pre-tax goods.[15 By including taxes owed in the tax base, a sales tax rate can be directly compared to an income tax rate.
The FairTax statutory rate, unlike most U.S. state-level sales taxes, is calculated on a tax base that includes the amount of FairTax paid. In this manner, the FairTax, like European sales taxes, more closely resembles an income tax calculation. A final price of $100 includes $23 of taxes. Like the income tax example above, the taxes to be paid would be included in the base on which the FairTax is imposed. Congressman John Linder has stated that the FairTax would be implemented as an inclusive tax, which would include the tax in the retail price, not added on at checkout — an item on the shelf for $5 would be $5 total and the receipt would display the tax as 23% of the total. The FairTax is presented as a 23% tax rate for easy comparison to income tax rates (the taxes it would be replacing). Proponents believe it is both inaccurate and misleading to say that an income tax is 23% and the FairTax is 30% as it implies that the sales tax burden is higher, when in fact the burden of the two taxes is precisely the same—either both taxes are 23% or both taxes are 30%. A common reverse comparison is for supporters to quote the income tax system exclusively; a 25% income tax and 7.65% FICA tax, a total 33% inclusive tax, is equal to a 50% exclusive tax. The plan's opponents call the semantics deceptive. FactCheck called the presentation misleading, saying that it hides the real truth of the tax rate. Laurence Vance, writing for the Ludwig von Mises Institute, goes so far as to call the rate presentation a "lie". For example, Bruce Bartlett stated that polls show tax reform support is extremely sensitive to the proposed rate, and called the presentation confusing and deceptive based on the conventional method of calculating sales taxes.
Revenue neutrality
A key question surrounding the FairTax rate is the ability to be revenue-neutral; that is, whether it would result in an increase or reduction in overall federal tax revenues. Economists, advisory groups, and political advocacy groups disagree about the tax rate required for the FairTax to be truly revenue-neutral. Various analysts use different assumptions, time-frames, and methods that result in dramatically different tax rates making direct comparison among the studies difficult. The choice between static or dynamic scoring further complicates any estimate of revenue-neutral rates, with the rates presented below based on a static scoring analysis.
One of the leading economists supporting the FairTax is Dr. Laurence Kotlikoff of Boston University. A detailed 2006 study published in Tax Notes by the fiscally conservative Beacon Hill Institute at Suffolk University and Kotlikoff concluded the FairTax would be revenue-neutral for the tax year 2007 at a rate of 23.82% (31.27% tax-exclusive) assuming full taxpayer compliance. The study states that purchasing power is transferred to state and local taxpayers from state and local governments. To recapture the lost revenue, state and local governments may raise taxes in order to continue collecting the same real revenues from their taxpayers. The Argus Group and Arduin, Laffer & Moore Econometrics each published an analysis that defended the 23% rate. While proponents of the FairTax concede that the above studies did not explicitly account for tax evasion, they also claim that the studies did not altogether ignore tax evasion under the FairTax. These studies implicitly incorporated some degree of tax evasion in their calculations simply by using National Income and Product Account based figures that presumably understate total household consumption. Moreover, these studies did not account for the expected capital gains that would result from a reduction in the real nominal value of U.S. government debt and the increased economic growth that most economists believe would occur.
In contrast to the above studies, one of the leading economists opposing the FairTax, William Gale of the Brookings Institution, published a detailed 2005 study in Tax Notes that estimated a rate of 28.2% (39.3% tax-exclusive) for 2007 assuming full taxpayer compliance and an average rate of 31% (44% tax-exclusive) from 2006–2015 (an increase that accounts for the replacement of an additional $3 trillion in revenue collected through the Alternative Minimum Tax (AMT) impacting the middle class over the 10 year period). The study also concluded that if the tax base were eroded by 10% due to tax evasion, tax avoidance, and/or legislative adjustments, the average rate would be 34% (53% tax-exclusive) for the 10 year period. The study did not take into consideration the increase in economic activity that Gale expects would result from the imposition of the FairTax. The President's Advisory Panel for Federal Tax Reform performed an analysis to replace the individual and corporate income tax with a retail sales tax and found the rate to be 25% (34% tax-exclusive) for 2006 assuming at least 10% evasion. The rate would need to be substantially higher to replace the additional taxes replaced by the FairTax (payroll, estate, and gift taxes). The Treasury Department has refused to release for peer review the detailed figures and methodology used in the tax panel analysis. FairTax proponents, including the Beacon Hill Institute and Kotlikoff, have criticized the President's Advisory Panel's study as having altered the terms of the FairTax and using unsound methodology.
Distribution of tax burden
The FairTax's impact on the distribution of taxation or tax incidence (the effect on the distribution of economic welfare) is a point of dispute. The plan's supporters argue that it would broaden the tax base, be progressive, decrease tax burdens, and start taxing wealth, while opponents argue that a national sales tax would be inherently regressive and would decrease tax burdens paid by high-income individuals. Sales taxes are normally considered regressive, but the FairTax provides a rebate that supporters argue would create a progressive effective rate on consumption. For example, a family of four (a couple with two children) earning about $25,000 and spending this on taxable goods and services, would consume 100% of their income. A higher income family of four making about $100,000, spending $75,000, and saving $25,000, would consume only 75% of their income on taxable goods and services. According to economist William G. Gale of the Brookings Institution, the percentage of income taxed is regressive (using a cross-section time frame). When presented with an estimated effective tax rate, the low-income family above would pay a tax rate of 0% on the 100% of consumption and the higher income family would pay a tax rate of 15% on the 75% of consumption (with the other 25% taxed at a later point in time, as savings is tax-deferred).[44 The effective tax rate is progressive on consumption, as a person spending at the poverty level would have an effective tax rate of 0%, whereas someone spending at four times the poverty level would have an effective tax rate of 17.2%.
Households at the lower end of the income scale spend almost all their income, while households at the higher end are more likely to devote a portion of income to saving; households at the extreme high end of consumption often finance their purchases out of savings, not income. These savings would be taxed when they become purchases. Income earned and saved would not be taxed immediately under the proposal. In other words, savings would be spent at some point in the future and taxed according to that consumption. FairTax advocates state that this would improve taxing of wealth. Economist Laurence Kotlikoff of Boston University states that the FairTax could make the tax system much more progressive and generationally equitable. "Their view that taxing sales is regressive is just plain wrong. Taxing consumption is effectively the same as taxing wages plus taxing wealth." Kotlikoff finds that the FairTax significantly reduces marginal taxes on work and saving, which substantially lowers overall average remaining lifetime tax burdens on current and future workers at all income levels. The Beacon Hill Institute at Suffolk University concluded in a 2007 study on distributional effects that "replacing income and payroll taxes with the FairTax would make the United States federal tax system more progressive than it is now and would benefit the average individual in almost all expenditures deciles."
Economist William Gale analyzed a National Sales Tax (though different from the FairTax in several aspects) and reported that the overall tax burden on middle-income Americans would increase while the tax burden on the top 1% would drop. According to the President's Advisory Panel for Federal Tax Reform report, which compared the individual and corporate income tax (excluding other taxes the FairTax replaces) to a sales tax with rebate,[30 the percentage of federal taxes paid by those earning from $15,000 – $50,000 would rise from 3.6% to 6.7%, while the burden on those earning more than $200,000 would fall from 53.5% to 45.9%. FairTax supporters argue that replacing the regressive payroll tax (not included in the Tax Panel study) — a 12.4% Social Security tax on wages up to $97,500 and a 2.9% Medicare tax (a 15.3% total tax that is often split between employee and employer) greatly changes the tax distribution and that the FairTax would relieve the tax burden on middle-class workers.[42 The FairTax would broaden the tax base to include all 300 million Americans and an estimated 30 million to 40 million foreign tourists and visitors.[46 In a study on tax base and rate, the Beacon Hill Institute concluded that the FairTax would offer the broadest tax base and increase the federal government's net base to $9.355 trillion from $7.033 trillion of taxable income, which allows the FairTax to have a lower tax rate than current tax law. A study on marginal and average tax rates by Kotlikoff concluded that the FairTax would reduce most households’ average lifetime tax rates.[48 Economists from Boston University and the Centre for European Economic Research concluded that the long term effects of the FairTax would reward low-income households with 26.3% more purchasing power, middle-income households with 12.4% more purchasing power, and high-income households with 5% more purchasing power.
Predicted effects
According to Money magazine, many mainstream economists and tax experts like the idea of a consumption tax, but many of the same people point to serious evasion and revenue neutrality problems with the FairTax plan. Economists argue that a consumption tax (the FairTax is one such tax) would have a positive impact on economic growth, incentives for international business to locate in the U.S., and increased U.S. international competitiveness (border tax adjustment in global trade). The predicted effects of the FairTax are, however, a source of disagreement among economists and other analysts. The FairTax is expected to increase cost transparency for funding the federal government and supporters believe it would have advantages with taxing illegal activity and illegal immigrants. The FairTax would be tax-free on mortgage interest (up to the basic interest rate as determined by the Federal Reserve) and donations; however, some law makers have concerns about losing social incentives on home ownership and charitable contributions. There is also concern about the impact to the income tax industry and the difficulty with the aggressive repeal of the Sixteenth Amendment, which would prevent Congress from introducing new income tax legislation in the future.
Economic Effects
The FairTax proposal would have effects in many areas that influence the United States. FairTax proponents assert that the proposal would provide tax burden visibility and reduce compliance costs. The cost of federal government would be highly visible as consumers would see most of this cost in a single tax paid every time they purchase a good or service. Under the current tax system, the federal government collects revenue through a wide variety of taxes on individuals and businesses, which may not be fully visible to individual citizens. The efficiency cost of the current tax system—the output that is lost over and above the tax itself—is between $240 billion and $600 billion every year according to a 2005 report from the U.S. Government Accountability Office. Supporters argue that the FairTax system would reduce these compliance and efficiency costs by 90% and return a larger share of that money to the productive economy. Beacon Hill Institute of Suffolk University concluded that the FairTax would save $346.51 billion in administrative costs and would be a much more efficient taxation system.[53 In addition, an estimated $11 trillion is held in foreign accounts (largely for tax purposes), which former Federal Reserve Chairman Alan Greenspan predicts would be repatriated back to U.S. banks if the FairTax were enacted, becoming available to U.S. capital markets, bringing down interest rates, and otherwise promoting economic growth in the United States.
Eighty economists, including Nobel Laureate Vernon L. Smith, wrote an open letter to the President, the Congress, and the American people, stating that the FairTax would boost the United States economy. According to the National Bureau of Economic Research and Americans For Fair Taxation, GDP would increase almost 10.5% in the year after the FairTax goes into effect. In addition, the incentive to work would increase by as much as 20%, the economy’s capital stock would increase by 42%, labor supply by 4%, output by 12%, and real wage rate by 8%. A study in 2007 by the Beacon Hill Institute stated that within five years real GDP would increase 10.7% over the current system, domestic investment by 86.3%, capital stock by 9.3%, employment by 9.9%, real wages by 10.2%, and consumption by 1.8%. Further, studies of the FairTax at Boston University and Rice University suggest the FairTax will bring long-term interest rates down by as much as one third. As falling tax compliance costs lower production costs, exports would increase by 26% initially and remain more than 13% above present levels. According to Professor Dale Jorgenson of Harvard University’s Economics Department, revenues to Social Security and Medicare would double as the size of the economy doubles within 15 years after passage of the FairTax. Opponents offer a study commissioned by the National Retail Federation in 2000 that found a national sales tax bill filed by Billy Tauzin, the Individual Tax Freedom Act (HR 2717), would bring a 3 year decline in the economy, a 4 year decline in employment and an 8 year decline in consumer spending. Wall Street Journal columnist James Taranto states the FairTax is unsuited to take advantage of supply-side effects and would create a powerful disincentive to spend money.
Global corporations consider local tax structures when making planning and capital investment decisions. Lower corporate tax rates and favorable transfer pricing regulations can induce higher corporate investment in a given locality. The United States currently has the highest combined statutory corporate income tax rate among OECD countries. Bill Archer, former head of the House Ways and Means Committee, asked Princeton University Econometrics to survey 500 European and Asian companies regarding the impact on their business decisions if the United States enacted the FairTax. 400 of those companies stated they would build their next plant in the United States, and 100 companies said they would move their corporate headquarters to the United States. In addition, the U.S. is currently the only one of the 30 OECD countries with no border adjustment element in its tax system. Proponents state that because the FairTax is automatically border adjustable, the 17% competitive advantage, on average, of foreign producers would be eliminated, immediately boosting U.S. competitiveness overseas and at home.
Transition
If the FairTax bill were passed, permanent elimination of income taxation would not be guaranteed; the FairTax bill would repeal much of the existing tax code, but the Sixteenth Amendment would remain in place. The elimination of the possibility that income taxation would return (through a separate Congressional bill), requires a repeal of the Sixteenth Amendment to the United States Constitution along with expressly prohibiting a federal income tax. This is referred to as an "aggressive repeal". Separate income taxes enforced by individual states would be unaffected by the federal repeal. Since passing the FairTax would only require a simple majority in each house of the United States Congress along with the signature of the President, and enactment of a constitutional amendment must be approved by two thirds of each house of the Congress, and three-quarters of the individual U.S. states, it is possible that passage of the FairTax bill would simply add another taxation system. If a new income tax bill was passed after the FairTax passage, a hybrid system could develop. However, there is nothing preventing a bill for a national sales tax or value added tax (VAT) on top of today's income tax system. The Americans For Fair Taxation plan is to first pass the FairTax and then to focus grassroots efforts on HJ 16, that calls for the repeal of the Sixteenth Amendment. John Linder plans to include a sunset provision in H.R. 25 during the 111th Congress that would require the repeal of the Sixteenth Amendment within 5 years after the implementation of the FairTax or the FairTax goes away.
Individuals under the current system who accumulated savings from ordinary income (by choosing not to spend their money when the income was earned) paid taxes on that income before it was placed in savings (such as a Roth IRA or CD). When individuals spend above the poverty level with money saved under the current system, that spending would be subject to the FairTax. People living through the transition may find both their earnings and their spending taxed. Critics have stated that the FairTax would result in unfair double taxation for savers and suggest it does not address the transition effect on some taxpayers who have accumulated significant savings from after-tax dollars, especially retirees who have finished their careers and switched to spending down their life savings. Supporters of the plan argue that the current system is no different, since compliance costs and "hidden taxes" embedded in the prices of goods and services cause savings to be "taxed" a second time already when spent. The rebates would supplement accrued savings, covering taxes up to the poverty level. The income taxes on capital gains, social security and pension benefits would be eliminated under FairTax. The FairTax would also eliminate what some claim to be the double taxation on savings that is part of estate taxes. In addition, the FairTax legislation adjusts Social Security benefits for changes in the price level, so a percentage increase in prices would result in an equal percentage increase to Social Security income. Supporters suggest these changes would offset paying the FairTax under transition conditions.
During the transition, many or most of the employees of the IRS (105,978 in 2005) would face loss of employment. The Beacon Hill Institute estimate is that the federal government would be able to cut $8 billion from the IRS budget of $11.01 billion (in 2007), reducing the size of federal tax administration by 73%. In addition, income tax preparers (many seasonal), tax lawyers, tax compliance staff in medium-to-large businesses, and software companies which sell tax preparation software (such as Drake Software, TaxCut, and TurboTax), could face significant drops, changes, or loss of employment. However, IRS testimony from 2004 stated that 45% of revenue agents and officers would become eligible for retirement in the following 5 years and there is concern about the loss of their work force as their hiring efforts struggle to keep pace with attrition. In addition, the IRS would not go completely out of commission until 3 years after the FairTax was enacted, providing employees time to find other employment. Proponents claim the projected 10.5% growth in the economy during the first year of the FairTax would provide plenty of new jobs to these workers that are typically well educated and well equipped with transferable skills.
In the period before the FairTax was implemented, there could be a strong incentive for individuals to buy goods without the sales tax using credit. After the FairTax was in effect, the credit could be paid off using untaxed payroll. If credit incentives do not change, opponents of the FairTax worry it could exacerbate an existing consumer debt problem. Proponents of the FairTax state that this effect could also allow individuals to pay off their existing (pre-FairTax) debt more quickly, and studies suggest lower interest rates after FairTax passage.
