Why the Fair Tax is Unfair for America, Part 2

Steve Forbes once wrote “The federal income tax code and all of its attendant rules and regulations [has] 9 million words and rising. An appalling fact about the tax code is that no one really knows what's in it” (Forbes, S., 2007, ¶9). One solution to the complex and confusing tax code is Georgia Republican John Linder’s tax reform bill H.R. 25/S. 1025, also known as the Fair Tax. This bill seeks to create a sweeping overhaul of the current American tax system and simplify the tax code by implementing a national sales tax system in place of the current Federal tax code. The Fair Tax would tax all purchases by individuals at a 30% nominal rate, with a 23% effective rate. One author wrote of the Fair Tax that “paying a 30 percent retail sales tax when one spends one’s income or wealth is the same as facing no retail sales tax, but having one’s income and wealth reduced by 23 percent” (Jokisch, S., Kotlikoff, L., 2007, ¶2).

Because the current tax system has a hidden effect on the price of goods and investment decisions, the Fair Tax seeks to remove this price increase by removing business taxes and compliance costs to achieve tax standards imposed upon businesses. Although retail prices would be affected negatively with the implementation of the Fair Tax, the proposed simplicity of the tax system would significantly decrease the compliance costs associated with the Fair Tax.

Additionally, Congressman John Linder has said that he believes “the Fair Tax could double the economy in 15 to 16 years through economic growth. Americans would go from 158 million taxpayers to 300 million” (Lee, S., Andrews, T., 2006, ¶1). Many accountants and tax professionals agree with Congressman Linder that the Fair Tax reform would simplify the tax system and create more income for the Federal government. Several other benefits proposed in the Fair Tax legislation include creating a national sales tax as the Federal tax base, eliminating payroll taxes, instituting tax rebates instead of using tax deductions, and reducing overhead and labor tax charges that rise each year from business expansion.

The Fair Tax reform would repeal the income tax structure created by the Tax Reform of 1986, and replace it with a national sales tax system as the Federal tax base. The Fair Tax reform is similar to the current sales tax imposed by many states, which charges a percentage of tax for every retail purchase made by individuals. Each state would be required to collect the Federal tax using their current sales tax offices to collect, report, and issue the income to the Federal government.

One reason that a national sales tax has received so much attention is that state sales taxes have rarely gone down through the years. Author John Mikesell conducted a study showing that although the sales tax base to personal income has decreased from 52.74% in 1970 to 39.12% in 2003, the weighted average sales tax rate has increased from 3.65% in 1970 to 5.40% in 2003 (Mikesell, 2004, ¶5). This study shows the strength of individual state sales taxes through a period of changing economic times, and that even with a decreasing tax base sales taxes retain their expected level of output and more. Another important factor of the national sales tax system is that it removes the threat of double taxation, since H.R. 25 §1 specifically states “To tax all consumption of goods and services in the United States once, without exception, but only once” (Fair Tax Act of 2007). Additionally, the move to a national sales tax should create less changeover costs, since each state already has a state sales tax organization collecting taxes on individual and business consumption purchases.

One of the major caveats of change included in the Fair Tax bill is the repealing of all current payroll taxes levied against business and employees. In a study conducted for the Fair Tax bill, it was determined that “payroll taxes and self-employment taxes (1) raise the cost of employment; (2) destroy jobs and cause unemployment; and (3) have a disproportionately adverse impact on lower income Americans” (Fair Tax Act of 2007). Social Security and Medicare, with tax percentages of 6.2% and 1.45% for 2007 respectively, are the two primary payroll taxes the Fair Tax reform would repeal.

A major issue with repealing the Social Security tax is how retirement benefits will be funded to retired workers; the Fair Tax bill defers to 42 USC §201, which outlines the funding for Social Security using the government’s General Fund to help float payments made from the Social Security Trust Fund. Currently, there is over $2 trillion in assets available for payments from the Trust Fund to make payments to current enrollees of Social Security (Social Security Administration, ssa.gov). The Trust Fund assets would be used to make payments until an adjustment is needed from the General Fund to cover expenditures relating to new enrollees of Social Security. Many studies have been conducted on how Social Security will continue to make payments as the Baby Boom Generation retires and the nation’s workforce begins to shrink from this outflow of workers. The answer for this situation provided by the Fair Tax is to simply make adjustments using the General Fund on an “as needed” basis.

Not only would repealing payroll taxes help relieve taxes levied on employees, but it also helps businesses to increase their investment in the labor pool. Labor is commonly the largest expense of a business, and the collecting and reporting of payroll taxes is an additional expense businesses must pay for each worker. While larger companies may be able to absorb the collection and reporting compliance aspect of payroll taxes, many smaller companies face increased expenses for each worker hired. In addition to workers hired for a job, many construction companies face legal and tax battles over using independent contractors and whether or not the company is liable for withholding payroll taxes from the independent contractors. The Fair Tax bill, allowing a significant reduction in compliance costs with more capital available for investing in employees, would eliminate the aforementioned situations.

A unique change to the tax system offered by the Fair Tax is the repealing of all standard deductions and allowances, which would be replaced by a single tax rebate. Under the current tax system, exemptions, itemized deductions, and standard deductions vary according to each taxpayer’s situation. By implementing a tax rebate system, the non-refundable tax credit would affect the taxpayer’s lowest Marginal Tax Rate (MTR); this would create more revenue for the government and lower the MTR for taxpayers (Luttman, S., Spindle, R., 1994, ¶2-3). Since the Fair Tax would create a single national sales tax system covering all consumption purchases, the tax rebate would help lessen the tax burden imposed on families from the taxation on necessities. Additionally, the tax rebates would be adjusted for inflation, creating a “smoothing” effect to help maintain a taxpayer’s marginal tax rate year over year.

Tax rebates created by the Fair Tax also have a positive effect on both high-income and low-income taxpayers, because both groups would receive appropriate benefits according to their tax base. Traditionally, higher-income taxpayers have more incentives from the current tax system because of their MTR. Lower-income taxpayers see these increased incentives for high-income individuals as a tax inequality, since significantly fewer incentives can be achieved from having a lower MTR. This perceived inequality was the reason why some low-income taxpayers prepared inaccurate tax returns, attempting to earn benefits they did not deserve. Creating a tax rebate credit would help level the playing field for all taxpayers, since:

“A uniform refundable credit is not related to a household's marginal tax rate and provides cash payments to qualifying households even if they owe no income tax. Such credits would thus provide a much more even and widespread motivation for socially valued behavior than the current set of tax incentives” (Batchelder, L., Goldberg Jr., F., Orszag, P., 2006, ¶3).

By implementing a tax rebate credit, the Fair Tax bill eliminates the technical nature of itemizing deductions, which many lower-income taxpayers cannot take advantage of because of the minimum limits required by the tax code. Additionally, by using tax rebates the wealthier taxpayers receive fewer benefits for their higher income, removing the feelings on tax inequality from the lower-income taxpayers.

References

Batchelder, L., Goldberg Jr., F., Orszag, P. (2006). Efficiency and Tax Incentives: The Case for Refundable Tax Credits. Stanford Law Review, October 2006, p. 23.

Fair Tax Act of 2007, H.R. 25.

Forbes, S. (2007). Improving Our Lot. Forbes, March 2007, p. 1.

Jokisch, S., Kotlikoff, L. (2007). Simulating the Dynamic Macroeconomic and Microeconomic Effects of the Fair Tax. National Tax Journal, June 2007, pp. 225-252.

Lee, S., Andrews, T. (2006). John Linder on the Fair Tax, Gaming the Current System, and Why the Left Will Finally Get It. Journal of Financial Planning, May 2006, p. 20.

Luttman, S., Spindle, R. (1994). An Evaluation of the Revenue and Equity Effects of Converting Exemptions and Itemized Deductions to a Single Non-Refundable Credit. The Journal of the American Taxpayer Association, Fall 1994, p. 43.

Mikesell, J. (2004). Grading the Sales Taxes. National Tax Association - Tax Institute of America. Proceedings of the Annual Conference on Taxation, Washington, 2004, p. 66.

Social Security Administration (2007). Retrieved November 8, 2007 from http://ssa.gov/.