Other indirect effects
The current federal tax law allows individuals to deduct the home mortgage interest costs, and donations to certain charities, from taxable income. Someone paying a 25% income tax rate would pay $250 in taxes on a $1,000 donation or mortgage interest payment, and then receive $250 back from the government as the $1000 deduction is removed from taxable income The FairTax is tax free on mortgage interest up to the basic interest rate as determined by the United States Federal Reserve and donations are not taxed. In a 2007 study, the Beacon Hill Institute concluded that total charitable giving would increase under the FairTax, although increases in giving would not be distributed proportionately amongst the various types of charitable organizations. The FairTax may also affect State and local government debt as the federal income tax system provides tax advantages to state and local municipal bonds. Proponents believe environmental benefits would result from the FairTax through environmental economics and the re-use and re-sale of used goods. The significant reduction of paperwork for IRS compliance and tax forms is estimated to save about 300,000 trees each year. Advocates claim the FairTax would provide incentive for illegal immigrants to legalize as they would otherwise not receive the FairTax rebate. Illegal immigrants would pay the maximum effective tax rate. There would also be no federal tax savings to companies that hire illegal immigrants. Proponents also believe that the FairTax would have positive effects on civil liberties that are sometimes charged against the income tax system, such as social inequality, economic inequality, financial privacy, self-incrimination, unreasonable search and seizure, burden of proof, and due process.
Changes in the retail economy
Since the FairTax would not tax used goods, the value would be determined by the supply and demand in relation to new goods. The price differential/margins between used and new goods would stay consistent, as the cost and value of used goods are in direct relationship to the cost and value of the new goods. Because the U.S. tax system has a hidden effect on prices, it is expected that moving to the FairTax would decrease production costs from the removal of business taxes and compliance costs, which is predicted to offset a portion of the FairTax effect on prices.
Value of used goods
Since the FairTax would not tax used goods, some critics have argued that this would create a differential between the price of new and used goods, which may take years to equalize. Such a differential would certainly influence the sale of new goods like vehicles and homes. Similarly, some supporters have claimed that this would create an incentive to buy used goods, creating environmental benefits of re-use and re-sale. Conversely, it is argued that like the income tax system that contains embedded tax cost (see Theories of retail pricing), used goods would contain the embedded FairTax cost. While the FairTax would not be applied to the retail sales of used goods, the inherent value of a used good includes the taxes paid when the good was sold at retail. The value is determined by the supply and demand in relation to new goods. The price differential / margins between used and new goods should stay consistent, as the cost and value of used goods are in direct relationship to the cost and value of the new goods.
Theories of retail pricing
Retail prices are inflated due to embedded taxes and compliance costs passed to the consumer by producers and suppliers. John Linder states the FairTax would eliminate almost all federal taxation costs from the supply chain, which could lower production costs by up to 30%. Price changes after the FairTax would largely depend on the response of the Federal Reserve monetary authorities. Non-accommodation of the money supply would suggest retail prices and take home pay stay the same—embedded taxes are replaced by the FairTax. Full accommodation would suggest prices and wages rise by the exclusive rate (i.e. 30%)—embedded taxes become windfall gains. Partial accommodation would suggest a varying degree in-between.
Based on a study conducted by Dr. Dale Jorgenson, proponents state that production cost of domestic goods and services could decrease by approximately 22% on average after embedded taxes were removed, leaving the sale nearly the same after taxes (non-accommodation). The study concludes that producer prices would drop between 15% and 26% (depending on the type of good/service) after the switch to a consumption based tax. Jorgenson's research included all income and payroll taxes regardless of whether they were paid by employees or employers in the 22% embedded tax estimation. (It is also important to note that the Jorgenson model did not capture any reduction in the cost of compliance associated with changing from a complex income tax system to a simpler consumption tax.) Jorgenson assumes that businesses would pass on all the cost savings from the repeal of payroll taxes and income tax withholding to consumers in the form of lower prices. Mathematically, this results in employee take-home pay (net income) remaining unchanged from pre-FairTax levels.
If businesses instead provided employees with their gross pay (including income tax withholding and the employee share of payroll taxes), Arduin, Laffer & Moore Econometrics estimated production costs would decrease by a minimum of 11.55% (partial accommodation). This reduction would be from the removal of the remaining embedded costs, including corporate taxes, compliance costs, and the employer share of payroll taxes. This decrease would offset a portion of the FairTax amount reflected in retail prices, which proponents suggest as the most likely scenario. The Beacon Hill Institute shows that it would not matter, apart from transition issues, whether prices fall or rise—the relative tax burden remains the same because if prices increased with the addition of the FairTax, wages would also rise accordingly; or if the Federal Reserve decided not to accommodate, then prices would fall and wages would remain at their net levels. Purchasing power for buying consumer goods and services in either situation would remain essentially the same, and the FairTax rate would be the same. Bruce Bartlett argued that it is unlikely that nominal wages would be reduced, which he believes would result in a recession, but that the Federal Reserve would likely increase the money supply to accommodate price increases.
The decrease in production cost would not fully apply to imported products, so according to proponents, it would provide tax advantages for domestic production and increase U.S. competitiveness in global trade (see Border adjustability). Such logic is endorsed by a recent letter to the commission on tax reform by eighty economists, including Nobel Laureate Vernon L. Smith. To ease the transition, U.S. retailers will receive a tax credit equal to the FairTax on their inventory to allow for quick cost reduction. Retailers would also receive an administrative fee equal to the greater of $200 or 0.25% of the remitted tax as compensation for compliance costs, which amounts to around $5 billion.
Effects on tax code compliance
FairTax supporters state that black market or illegal economic activity is largely untaxed under the current tax system. Economists estimate the underground economy in the United States to be between one and three trillion dollars annually. By imposing a sales tax, supporters state that black market activity would be significantly taxed when proceeds from such activity are spent on legal consumption. For example, the sale of illegal narcotics would remain untaxed (instead of being guilty of income tax evasion, dealers would be guilty of failing to submit sales tax), but drug dealers would face taxation when they used drug proceeds to buy consumer goods such as food, clothing, and cars. By taxing this previously untaxed money, FairTax supporters state that non-filers would be paying part of their share of what would otherwise be uncollected income and payroll taxes. Other economists and analysts have argued that the underground economy would continue to bear the same tax burden as before, stating that you receive the same effect with the current tax system—while illicit income is not taxed directly, spending results in business income and wages that are taxed.
Tax compliance and evasion
The current income tax system fails to collect on a significant percentage of taxes. The IRS estimates twenty additional cents of taxes are owed on unreported income for every tax dollar collected. In 2001, the IRS estimated this shortfall to be over $312 billion. These figures do not include taxes lost on illicit sources of income, such as illegal drug dealing. Proponents assert that the transparency and simplicity of the FairTax would subject much of this unreported income to taxation. The number of tax collection points would significantly reduce under the FairTax, as only retailers would file a tax return compared to every income earner. The FairTax would reduce the number of tax filers by about 80% (from 100 million to 14 million) and reduce the filing complexity to a simplified state sales tax form.
Research supports the claim that simplified tax systems lead to greater compliance. The International Monetary Fund (IMF) found that Russia's transition to a flat tax increased income reporting from 52% to 68% in one year. Similar results have occurred in Slovenia. The Government Accountability Office (GAO), among others, have specifically identified the negative relationship between compliance and the number of focal points for collection. The federal government would be able to concentrate its entire tax enforcement efforts on a single tax—the FairTax. Retailers would receive an administrative fee equal to the greater of $200 or 0.25% of the remitted tax as compensation for compliance costs. In addition, the overwhelming majority of purchases occur in major retail outlets, which are very unlikely to evade the FairTax and risk losing their business licenses. Economic Census figures for 2002 show that 48.5% of merchandise sales are made by just 688 businesses ("Big-Box" retailers). 85.7% of all sales are made by 92,334 businesses, which is 3.6% of American companies. In the service sector, approximately 80% of sales are made by 1.2% of U.S. businesses.
FairTax opponents believe that compliance decreases when taxes are not automatically withheld from citizens, and that massive tax evasion could result by collecting at just one point in the economic system. Compliance rates can also fall when taxed entities, rather than a third party, self-report their tax liability. For example, ordinary personal income taxes can be automatically withheld and are reported to the government by a third party. Taxes without withholding and with self-reporting, such as the FairTax, can see higher evasion rates. In other countries, similar VAT taxes have an average evasion rate of 20%. Tax publications by the Organisation for Economic Co-operation and Development (OECD), IMF, and Brookings Institution have suggested that the upper limit for a sales tax is about 10% before incentives for evasion become too great to control. According to the GAO, 80% of state tax officials opposed a national sales tax as an intrusion on their tax base. Opponents also raise concerns of legal tax avoidance by spending and consuming outside of the U.S. (imported goods would be subject to collection by the U.S. Customs Service).
The FairTax is a national tax, but can be administered by the states rather than a federal agency. This has a bearing on compliance, as the states' own agencies could monitor and audit businesses within that state. The 0.25% retained by the states amounts to $5 billion the states would have available for enforcement and administration. For example, California should receive over $500 million for enforcement and administration, which is more than the $327 million budget for the state's sales and excise taxes.[88 Because the federal money paid to the states would be a percentage of the total revenue collected, John Linder claims the states would have an incentive to maximize collections. Proponents believe that states that choose to conform to the federal tax base would have advantages in enforcement, information sharing, and clear interstate revenue allocation rules.[89[86 A study by the Beacon Hill Institute concluded that, on average, states could more than halve their sales tax rates and that state economies would benefit greatly from adopting a state-level FairTax.
Economists from the University of Tennessee concluded that while there would be many desirable macroeconomic effects, adoption of a national retail sales tax would also have serious effects on state and local government finances. Economist Bruce Bartlett stated that if the states did not conform to the FairTax, they would have massive confusion and complication as to what is taxed by the state and what is taxed by the federal government. In addition, sales taxes have long exempted all but a few services because of the enormous difficulty in taxing intangibles — Bartlett suggests that the state may not have sufficient incentive to enforce the tax. University of Michigan economist Joel Slemrod argues that states would face significant issues in enforcing the tax. "Even at an average rate of around 5 percent, state sales taxes are difficult to administer." The President's Advisory Panel for Federal Tax Reform stated that if the federal government were to cease taxing income, states might choose to shift their revenue-raising to income. Absent the Internal Revenue Service, however, it would be more difficult to maintain viable income tax systems.
Underground economy
Opponents of the FairTax argue that imposing a national retail sales tax would drive transactions underground and create a vast underground economy. Under a retail sales tax system, the purchase of intermediate goods and services that are factors of production are not taxed, since those goods would produce a final retail good that would be taxed. Individuals and businesses may be able to manipulate the tax system by claiming that purchases are for intermediate goods, when in fact they are final purchases that should be taxed. Proponents point out that a business is required to have a registered seller's certificate on file, and must keep complete records of all transactions for six years. Businesses must also record all taxable goods bought for seven years. They are required to report these sales every month (see Personal vs. business purchases). The government could also stipulate that all retail sellers provide buyers with a written receipt, regardless of transaction type (cash, credit, etc.), which would create a paper trail for evasion with risk of having the buyer turn them in (the FairTax authorizes a reward for reporting tax cheats).
While many economists and tax experts support a consumption tax, problems could arise with using a retail sales tax rather than a value added tax (VAT).[32 A VAT imposes a tax at every intermediate step of production, so the goods reach the final consumer with much of the tax already in the price, along with some extra overhead. The retail seller has little incentive to conceal retail sales, since he has already paid much of the good's tax. Retailers are unlikely to subsidize the consumer's tax evasion by concealing sales. In contrast, a retailer has paid no tax on goods under a sales tax system. This provides an incentive for retailers to conceal sales and engage in "tax arbitrage" by sharing some of the illicit tax savings with the final consumer. Laurence Kotlikoff of Boston University has stated that the government could compel firms to report, via 1099-type forms, their sales to other firms, which would provide the same records that arise under a VAT.
In the United States, a general sales tax is imposed in 45 states plus the District of Columbia (accounting for over 97% of both population and economic output). Most states also collect a variety of local sales taxes including county, city, and transit taxes. The United States has a large infrastructure for taxing sales that many countries do not have. Proponents respond to the underground economy argument by pointing out that, whereas tax evasion under the current income tax system requires only one person (the payer) to lie on their tax forms, tax evasion under the FairTax requires collusion of both the payer (the retail purchaser) and the payee (the retail seller). Furthermore, the number of individuals required to file taxes drops from approximately 100 million to 14 million, a drop in excess of 80%. This drop in the number of collection points will allow the tax administration to view tax fraud with greater scrutiny. Proponents of the FairTax see a substantial amount of additional tax revenue from those engaging in the black market, as a sales tax would require all who consume to be.
Personal vs. business purchases
For an individual to purchase items tax-free for business purposes, the business would be required to be a registered seller with the state sales tax authority, and thereby be subject to audit. The state would issue the business a registered seller's certificate. This would enable the business to purchase tax free from wholesale vendors, but they must give a copy of their registration certificate to the vendor to leave an audit trail. When an item is purchased for business use from a retail vendor, the business would have to pay the tax on the purchase and take a credit against the tax due on their sales tax return. Taxable property and services purchased by a qualified non-profit or religious organization 'for business purposes' would not be taxable.
Businesses would be required to submit monthly or quarterly reports (depending on sales volume) of taxable sales and sales tax collected on their monthly sales tax return. During audits, the business would have to produce invoices for the "business purchases" that they did not pay sales tax on, and would have to be able to show that they were genuine business expenses. Since 145 million individuals would no longer be filing tax returns, there would only be about 25 million businesses that could be audited. Advocates claim that this would greatly increase the likelihood of business audits, making tax evasion behavior much more risky. Additionally, the FairTax legislation has several fines and penalties for non-compliance and authorizes a mechanism for reporting tax cheats and obtaining a reward. To prevent businesses from purchasing everything for their employees, in a family business for example, goods and services bought by the business for the employees that are not strictly for business use would be taxable. Health insurance or medical expenses would be an example where the business would have to pay the FairTax on these purchases.
FairTax movement
The origins of the FairTax began with a group of businessmen from Houston, Texas, who initially financed what has become the non-partisan political advocacy group Americans For Fair Taxation (AFFT), which has grown into a large grassroots tax reform movement. This organization, founded in 1994, claims to have spent over $20 million in research, marketing, lobbying, and organizing efforts over a ten year period and is seeking to raise over $100 million more to promote the plan. AFFT includes a staff in Houston and a large group of volunteers who are working to get the FairTax enacted. Bruce Bartlett has charged that the FairTax was devised by the Church of Scientology in the early 1990s. Representative John Linder told the Atlanta Journal-Constitution that Bartlett confused the FairTax movement with the Scientology-affiliated Citizens for an Alternative Tax System. Leo Linbeck, AFFT Chairman and CEO, stated "As a founder of Americans For Fair Taxation, I can state categorically, however, that Scientology played no role in the founding, research or crafting of the legislation giving expression to the FairTax."
Much support has been achieved by talk radio personality Neal Boortz. Boortz's book (co-authored by Georgia Congressman John Linder) entitled The FairTax Book, explains the proposal and spent time atop the New York Times Best Seller list. Boortz stated that he donates his share of the proceeds to charity to promote the book. In addition, Boortz and Linder have organized several FairTax rallies to publicize support for the plan. Other media personalities have also assisted in growing grassroots support including radio and former TV talk show host Larry Elder, radio host and former Senatorial candidate Herman Cain, Fox News and radio host Sean Hannity, and ABC News co-anchor John Stossel. The FairTax has received additional visibility as one of the issues in the 2008 presidential election on the issue of taxes and the IRS. At a debate on June 30, 2007, several Republican candidates were asked about their position on the FairTax and many responded that they would sign the bill into law if elected. The most vocal promoters of the FairTax in the election are Republican candidate Mike Huckabee and Democratic candidate Mike Gravel. Republican candidate Ron Paul does not directly endorse the FairTax, but has voiced similar proposals of abolishing the IRS and income tax. The Internet, blogosphere, and electronic mailing lists like Yahoo! Groups have contributed to informing, organizing, and gaining support for the FairTax. Many grassroots web sites have been created by supporters to help organize the effort and promote the plan.
