I urge you to read these books to familiarize yourself with the "fair tax," so that this essay will make more sense. (They are very short books.) By way of introduction, I concede that the ¨fair tax¨is the best approach to funding government that has been proposed. I would like to see us implement something similar. This essay is meant to show my perception of the shortcomings; the books do a fine job of showing the strengths.
I can't support the legislation whole-heartedly or expect it to get a broader base of support, until and unless the following issues have been adequately addressed. It is for that reason that I'm writing this essay. Something like the "fair tax" is needed -- and soon. While the "fair tax" solves many problems, I think it would be a mistake to implement the tax as currently designed, but some tweaking might make it effective as well as fair.
The website fairtax.org is available if you want quicker access to the fundamentals of the “fair tax.” On the main page “About the Fair Tax,” the following characteristics of the tax are listed:
Enables workers to keep their entire paychecks
Enables retirees to keep their entire pensions
Refunds in advance the tax on purchases of basic necessities
Allows American products to compete fairly
Brings transparency and accountability to tax policy
Ensures Social Security and Medicare funding
Closes all loopholes and brings fairness to taxation
Abolishes the IRS
Of these 8, I absolutely agree with all except #7. I partially agree with #7, since loopholes are, indeed closed. In the following essay, you will read my concerns about fairness. Note: even if the IRS is abolished, some agency will have to be empowered to collect the “fair tax,” whether it's easier to collect than income taxes or not.
First, the trivial objections:
Keep to the Facts
Neal resorts to one of his favorite ploys throughout his books. He writes “the federal income tax was indeed a tax on the 'evil and hated rich.'” Whom is he quoting when he refers to the “evil and hated rich?” He doesn't provide a footnote or reference. I'd certainly like to know who originally said “evil and hated rich.” Many of his arguments are valid, but this approach makes one suspect. As he says elsewhere, let's argue the merits of the issue, not the politics.
Documentation, please
Throughout the book, he cites statistics without documentation. He footnotes almost none of his data statements. I suspect that many of his statements are true, but I have no way to verify without a reference to check.
Second, the false assumptions:
Who will benefit?
Many who might support the “fair tax” agree with the redistributive intents built into the current Income Tax structure and believe that wealth (ability to pay) is a valid measure on which to base tax burden, at least in part. There is little or nothing in Neal's books showing the anticipated relative tax burdens on various groups in the economy; just because the name of the tax is "fair tax" does not make it fair. Perhaps there are charts or graphs elsewhere. See my reference to a study, below.
If the tax can be shown to burden the wealthy at least proportionally the same as the middle class, then it will win many converts. A tax does not have to be confiscatory to meet the requirements of most in this group of people. It's simply that the middle class sees itself as put upon more than the wealthy (and the very poor, but that's a different story). An analysis of the current design of the "fair tax" would show that the middle class would be paying a higher percentage of income or wealth as taxes than the more wealthy.
There is a distinction between a) taking money from one group and giving it to another and b) requiring one group to pay more taxes, even proportionally higher. Taxes pay for government services and most such services benefit an individual more or less proportionally to income or wealth. Take the protection afforded by our armed forces, courts, FBI and CDC. They are providing 10 times the value to an individual with $10 million net worth than to the person with $1 million net worth just on face value alone; that argues strongly for a tax that has a proportional burden on all, based on total net worth, independent of consumption or income. It could be argued that those services are valued by the individual even more than 10 times as much, but let's save that for another discussion.
Opportunity Costs of Withholding
He says that if we could keep our tax money until it is due, we could decide what to to with it – citing that as an opportunity cost of withholding. There would likely be no significant difference in the timing of tax collection from American workers. In fact, under the “fair tax,” the money would also come out of your pocket at about the same rate over the course of the year. Otherwise, how would the government collect effectively the same amount of money during the year to keep government running? People will be making taxable purchases over the entire year.
Double Counting
Writing about the embedded cost of taxes in commodities that we purchase, Neal concludes a paragraph at the top of p.55 in The Fair Tax Book, “... on average, 22 percent of what you spend is supporting the federal government. That is in addition to the money taken out of your check in income taxes and payroll taxes.” By saying this, he is double counting, because his calculations already include the inflated costs of labor in the production costs. The withheld taxes were calculated in the cost of products; he can't legitimately count them again.
Growing Economy Means More Tax Revenue
On p. 122 of Fair Tax: the Truth, Neal makes a parenthetical comment that “the Fair Tax ... brings in money based on the size of the economy.” This is true only to the extent that consumption follows the size of the economy. As shown in an example (below), if the growth of the economy occurs in companies that sell primarily abroad, there may be little or no added tax revenue. Increases would reflect only the added wealth of workers and owners, who might already be satiated or might want to save most of their increased earnings.
Encouraging Saving
One of the most exciting prospects of the “fair tax” is that it would likely discourage consumption and encourage saving, as people find themselves with more disposable income. (Neal has called the “fair tax” a voluntary tax; if you don't want to be taxed, then don't consume.) Increased saving is a goal towards which our country should be striving. Saving is essential to economic growth.
To the extent that we are successful in increasing savings (and decreasing consumption), tax revenues could take a big hit. Actually, it discourages domestic consumption. Many people will use their new-found wealth to travel to foreign countries, where they will buy spheres with the Eiffel Tower in a snowfall or wine and dinner or hotel stays or motorbikes or who knows what. No tax revenue there.
Compliance
I don't understand why we would experience a substantive difference in compliance. Indeed, the drug dealer will pay taxes when he buys gasoline, milk, and bread. But the methods for non-compliance today will give way to new methods. We will begin to see
Fewer cash transactions to avoid income and FICA taxes
More cash transactions to avoid “fair tax,” especially among service providers.
More bartering, especially among service providers
More purchases abroad, maybe even purchases of made-in-USA products
Certainly Neal would not advocate a level of policing that would or could interdict such behavior. Never underestimate the American's ingenuity as applied to avoiding taxes.
Finally, the real problems that must be addressed to get people to think critically to come on board:
Regressive or Progressive (fair)?
The website and the books effectively and accurately dispel the idea that the “fair tax” is regressive vis-a-vis the impact on low income families. But their description of the relative burden on the wealthy is inaccurate. They repeat a mantra that claims to tax the wealthy at a rate of 23% -- the same as everyone else. Remember, though, that the taxation rate applies only to consumption; thus the tax rate relates only to what people purchase.
The fairtax.org website refers to a study on the progressivity of the “fair tax,” A Distributional Analysis of Adopting the FairTax: A Comparison of the Current Tax System and the FairTax Plan. This is exactly the type of study I am looking for, but this study makes some assumptions that I believe are inappropriate. The particular assumption with which I differ is that expenditure is a better measure of wealth than income. I would suggest a combination of measures, including all three – wealth, income, and consumption, with a weighting algorithm (which I certainly haven't come up with yet). Thus, the study shows that as a percentage of total consumption the rich pay a higher percentage as taxes. But this counts as proportional (or progressive) only if you accept that consumption is the best measure of wealth.
One assumption of the study with which I agree is that “the ratio of spending ... to income ... declines as income rises,” and it calls that behavior a burden of the tax. I don't think you can call a voluntary reduction in consumption a burden of the tax. That is the very condition that assures lack of proportionality – let alone progressivity. In other words, the “fair tax” is not even proportionally applied, if income or wealth is used as the measure of ability to pay. Just because the higher income populations pay more taxes than the lower income populations does not make the tax progressive; in fact, by the calculations in the Analysis, the tax burden is shown to be regressive – where the richer pay a lower percentage of income as taxes than the less rich.
Who Really Pays?
Neal describes how the "fair tax" will cause US companies to stop moving offshore and foreign companies to desire to do business in the US. In summary, his argument is that by taxing only consumption, the production process is tax-free and therefore attractive to the firm. He is certainly correct about that, but there's a fly in the ointment.
Let's take an extreme argument here:
A company that sells primarily (or exclusively) to foreign markets sets up business in the US under the "fair tax" structure. They manufacture, package and sell bison horn aphrodisiac for a particular Asian market. Their headquarters are in Montana.
This company employs several field workers who herd bisons, a few stockyard workers who corral them, some butchers, and some processors and shippers. In addition they use some machinery. They ship their product by truck from Montana to a west-coast port, where it is sent to Inner Slobovia, high in the Heralaya Mountains. Effectively none of the product is consumed in the US.
The plant workers are all low-wage earners except a few engineers on the production line and the company executives. Therefore, much of the workers' consumption tax ("fair tax") will be rebated at the end of each month. The components of the production process pay a very small total net consumption tax – if any at all.
At the same time, they use federal highways to ship their goods, the services of homeland security that xrays their shipping containers, the US customs service to police their shipments, the US Coast Guard to protect the shipping, the State Department to help maintain relations with Inner Slobovia, and other federal goods and services, not to mention Social Security, Medicare disability, and probably other services for their employees.
Who pays for those goods and services? Not the company; not most of its employees; and certainly not its foreign customers.
The argument is strong that business will be drawn to the US, but who pays for all the services provided to companies that sell abroad? What benefit is it to Americans to host firms that sell abroad? Surely, they appreciate the employment, but they will have to pay for services through their taxes.
Perhaps my example is a bit extreme, but it illustrates the free ride that is available under certain circumstances. It might actually be economically prudent for a foreign company to relocate to the US even if they have no market here, once the “fair tax” is in place. Jobs would be nice, but who pays the bills? Think: third world countries where multinationals produce their products, where taxes are low, and where infrastructure is maintained by an insufficient tax base, primarily local payers.
Countries that have VAT frequently rebate the tax to travelers as they leave the country. But the VAT was collected (tediously) at every step of production; thus, they don't lose all their tax revenues. How will we get foreign consumers to pay for the services (indeed, for the democratic environment) that make it possible to manufacture here under the “fair tax” system?
(Note: I would not argue for a VAT; I'm asking a procedural question about enforcing equity.)
By the way, under the current taxation system, foreign buyers of US-made goods and services pay a share of our tax because of the embedded nature of our tax collection. Under the “fair tax,” we would no doubt sell more to foreigners, but they would pay less to our government, as I see it, because there is no embedded tax.
Transition
Neal discusses transition costs, and for the most part dismisses them. But he writes primarily about these transaction costs:
What will new cash registers cost?
Will people be able to learn how to keep necessary records?
What about existing inventories?
All of these transition costs are negligible.
My concern about transition is that there is likely to be a long period during which the market will not have corrected itself. For many months (or years?)
Prices will not react to the lowering of embedded taxation – or will react very slowly.
Wages will go through renegotiation, some faster than others
This will cause serious dislocations with some people placed in advantageous or disadvantageous positions due to nothing more than the luck of the draw. For example:
On January 1 the “fair tax” goes into effect.
You and I are both employed at the same salary of $1000 (from which, currently, withholding is taken). The employers are effectively on the hook currently for $1065 because of the 6.5% contribution to FICA. Your salary net of FICA is approximately $906 (6.5% + 2.9%, i.e., retirement + Medicare).
You have a contract with your employer that states your salary as $1000
I don't have a contract.
On January 1, your employer is bound by your contract and must continue to pay you $1000. They start saving $65.
On January 1, my employer starts paying me $906, figuring that I am no worse off than before, and they can save $159.
Surely even Neal would not attribute my disadvantage to my having made a bad decision – not to have a contract. This is Georgia, after all.
Other examples could be made on the supply side, where some industries will correct their prices quickly, while other industries will not. My misfortune is that I use a lot of product from the industries that have not corrected, while you use disproportionately more products from the industry that has quickly corrected. Again, my disadvantage will be entirely serendipitous.
Something must be thought out that makes these dislocations less punishing.
Conclusions
The urgency of tax reform makes it essential to solve at least these problems before some will support the “fair tax.”
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