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Sunday, 27 September 2009 17:05

The "Fair Tax"

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The Fair Tax (H.R. 25)
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The American public generally dislikes being taxed; this is a truth most politicians understand. During the 1990's, one group of anti-Income Tax activists created what they saw to be a remedy to the taxation of paychecks: a flat retail sales tax.
Americans for Fair Taxation, the originators of the Fair Tax idea in its current form, describe H.R. 25 thusly: A 23-percent (of the tax-inclusive sales price) sales tax is imposed on all retail sales for personal consumption of new goods and services.
AFT claims that the percentage of retail sales taxed is 23%, but it's truly 30%. breaks the hidden numbers down:
The 23 percent number in H.R. 25 is the equivalent of the 4.8 percent in the previous example. To calculate the real rate of the sales tax, we have to determine the original purchase price of an item. We can begin with the same $100 item, keeping in mind that a price tag that reads $100 has sales tax already built in. If our tax rate is 23 percent of the tax-inclusive sales price, then of the $100 final price, $23 of those dollars will be for taxes, meaning that the original pre-tax price of the item is $77. To get $23 in taxes on a $77 item, one must impose a 30 percent tax. In other words, a 23 percent sales tax on the tax-inclusive sales price is equivalent to a 30 percent tax on the actual price of the item.
Supporters of the Fair Tax dispute this analysis and claim that there isn't a viable difference between the two numbers because making the number tax-inclusive makes it more like the Income Tax it aims to replace. But at 23%-inclusive or 30%-exclusive, the Fair Tax will not generate enough revenue to replace the current system. The tax-exclusive percentage that it would need to be: 34%.
(The bipartisan) President's Advisory Panel on Tax Reform, which calculated that a 34 percent rate on the actual price of consumer goods would be necessary to make the program revenue-neutral. Americans for Fair Taxation has said that the Advisory Panel did not use the FairTax as detailed in the legislation but instead made up its own plan. This complaint is disingenuous. The Advisory Panel did in fact begin with the 30 percent figure that proponents of the FairTax submitted. But the panel rejected those figures, claiming that they were based, at least in part, on the unrealistic assumption that there would be full compliance with the FairTax. In other words, proponents assume that no one will cheat on taxes. However, the Treasury Department estimates that the evasion rate for the entire U.S. tax system under current law is approximately 15 percent. The Advisory Panel accordingly assumed a 15 percent evasion rate for the FairTax.
Some economists, such as William Gale of the Brookings Institute estimate that the tax-exclusive percentage would have to be, in fact, 39.3% to achieve revenue-neutrality. There is much disagreement about the actual mechanics since AFT uses faulty accounting practices and the Advisory Panel and Treasury refuse to release some of their calculation methods. But just as important as the rate are the actual items to be taxed. While many people, progressives and conservatives alike, may like the idea of taxing goods at a higher rate, how many would agree that the following are 'consumption'?: Purchases of new homes Rent Interest on credit cards, mortgages and car loans Doctor bills Utilities Gasoline (30 percent in addition to current taxes, which would not be repealed) Legal fees In short, because of the Fair Tax's 100% base tax rate, everything is taxed except education.
Proponents of the FairTax point out that prices on consumer goods contain what are called "hidden taxes." Under current law, corporations have to pay taxes on their earnings. Moreover, businesses have to pay social security taxes for each employee. The money to pay these taxes has to come from somewhere, and FairTax supporters argue that the cost is passed on to the consumer. In fact, the best-known proponent of the FairTax, talk-show host Neal Boortz, argues that 22 percent of the price of a consumer good is really a "hidden tax." Get rid of corporate and social security taxes, Boortz argues, and consumer good prices would drop by 22 percent. Even with the 23 percent FairTax, prices stay the same, and with the elimination of income taxes, paychecks will get bigger...
The FairTax is revenue-neutral by its very definition - the rate of taxation would have to be high enough to replace embedded taxes plus income and estate taxes. Chris Edwards of the Cato Institute points out that a neutral FairTax would still require that taxpayers pony up $2.4 trillion. Edwards insists that it isn't just the works who are burdened - producers of goods also bear a sizable chunk of production costs. That means that employees pay part of the costs by way of low wages and corporate shareholders pay "hidden taxes" in the form of low returns on their investments.
 The Fair Tax is not regressive (i.e., where the poor pay the most), it it flat by definition; every citizen is taxed the same since the tax is on goods. But low-income individuals spend a much larger percentage of their paychecks on basic consumer goods than do middle-or-upper class people; some in reality, the poor are in fact paying a higher percentage of their income in taxes than anyone else if the Fair Tax plan is implemented in its purest form. AFT, however, realizes this and:
helps to alleviate this difficulty by exempting sales taxes on all income up to the poverty level. Taxpayers would receive a "prebate," which Edwards calculates to be about $5,600 annually. The Treasury Department estimates that the prebate program would cost between $600 billion and $700 billion annually, making it the largest category of federal spending. Americans for Fair Taxation disputes the Treasury Department numbers, claiming that the actual cost would be closer to $485 billion per year.
The accounting methods of the Treasury have not been released so it is unclear as to whose numbers are most correct. Fair Tax lowers the tax burden of the poorest Americans by nearly 6%. But with such a large decrease, who picks up the slack? Well, everyone else. That is, everybody earning between $15,000 and $200,000 per year. Here are two graphs from that illustrate some of the above economic effects well:
It is easy to look at charts like the one above and dismiss the FairTax as simply another way to help the rich get richer. But there is an economic argument for a less progressive tax system, though that argument is extremely technical. Kotlikoff has asserted that the FairTax will lower the marginal tax rate for all earners. (The marginal rate is the tax rate paid on the last dollar earned.) Because marginal rates are lower, each extra dollar of income will result in greater purchasing power. The decrease in marginal rates is progressive -- that is, marginal rate reductions are greater for the working- and middle-classes than for the wealthy.
So will the Fair Tax stimulate economic growth, despite its flaws? Optimistic accounts show a 10 percent rise in income over time, but even the more cautious studies show gains of 5 percent to 7 percent. Works will in fact eventually see bigger paychecks because of the growth. But considering buying trends in the real world, it is very likely the public will at first get "sticker shock" at the high prices of goods because of the added tax and buy even less, resulting in a large recession that may take years to remedy (with the eventual realization of slightly bigger paychecks and no Income Tax). The size of any such gains is disputed, however; Americans for Fair Taxation consistently chooses from among the most optimistic growth projections.
So it is worth it?
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