Monday, December 14, 2009

The Fair Tax: The best idea you've probably never heard of...

Have you ever seen one of those movies where some guy lights a cigar with a $100 bill? Most of the time the character is some arrogant scoundrel who looks down with disdain upon those little people to whom $100 is a lot of money. Such a character does exist in real life, and unfortunately for you and me it’s not his money burning… it’s ours. Every year American citizens are forced under the threat of prison to essentially set fire to $300 Billion. And it’s not some rotund character with a top hat who’s directing the fire, it’s Congress and the 60,000 page IRS Tax Code.

According to the Tax Foundation, (here and here) Americans spend approximately $300 Billion a year complying with the federal Tax Code. That does not include the taxes themselves, nor the costs borne in adjusting their business operations to reduce the negative impact of the Code in the first place. Another part of the Tax Code is the opaque nature of the individual taxes that eventually make it into the price of goods. Harvard economist Dale Jorgenson suggests that 22% of what Americans spend at retail is the cost of aggregated taxes. Now imagine, every one of those taxpayers or retailers has to try and comprehend their piece of that 60,000 page IRS Tax Code… a code that neither our Treasury Secretary, Timothy Geithner, (The guy the IRS works for!) nor Congressman Charlie Rangel (The guy who runs the committee that writes the Tax Code!) are smart enough to figure out... or that's what they claim.

Which brings me to the world’s best idea you may never have heard of… The Fair Tax. What is the Fair Tax? Basically it is a proposal where all current federal taxes: income, Social Security, Medicare, capital gains, etc… would be eliminated and replaced with a 23% tax that is added at the retail level. Below is a very simple demonstration of how the Fair Tax works.

Let’s assume it costs $1.00 for a loaf of bread. According to Jorgenson, $.22 of that $1.00 represents the aggregated federal taxes paid by the baker, the distributor, the retailer and every other person who had a hand in putting that bread on the store shelf. That includes not only their taxes, but also those they withheld from the checks of employees. The bottom line for you as a consumer however is that you pay $1.00 for a loaf of bread. (For ease of discussion, i.e. eliminating taking numbers to six decimal points, throughout this piece I use the Jorgenson’s 22% and the Fair Tax’s 23% interchangeably.) Under the Fair Tax, all of those aggregated taxes would be eliminated. As a result, the cost of the loaf would be 77 cents, a number which includes all of the inputs and profits from the Farmer, Distributor, Retailer etc. When 23 cents of taxes are added to that $.77, the price of the loaf of bread for you is the same, $1.00.

Given the fact that the price of the bread stays the same and all of the players who are involved in putting the bread on the shelves are making the same amount of money, one might ask “What’s the point?” Well, there are actually quite a number of them, not the least of which is the fact that you get to keep 100% of your paycheck. Under the current system, when you earn $100, you get a check for $75. Under the Fair Tax, when you earn $100, you get a check for $100. Below is a list of ten great reasons to implement the Fair Tax:

    1. Keep your Paycheck:
You get to keep 100% of your paycheck – although some states have state income tax, your check would be 100% free of federal government taxes.

    2. Spur Investment in America:
In this difficult time, when unemployment is officially at 10% and is likely much higher, there is no single thing Congress could do that would more effectively spur investment in the United States economy. This change would motivate American corporations and individuals who have trillions of dollars in unrealized profits outside the country to repatriate those dollars. Simultaneously it would induce investors and corporations from around the world to invest in America (and her people) because they would be able to keep more of their profits relative to any other country on the planet.

    3. Spur Entrepreneurship:
Most employment in the United States is driven by small businesses. Most of those small businesses are owned by individuals who report their income on their personal tax forms. By removing that 22% tax liability and allowing the most entrepreneurial amongst us to keep more of the money they earn, the more motivated they are going to be to invest in their businesses and grow their workforces.

    4. Limit Congresses’ Power:
Remove Congress’s ability to manipulate the tax code in order to punish particular industries, give favor to pet projects or to simply increase member’s individual and collective power.

    5. Save Half a Trillion Dollars Per Year:
In possibly the single biggest shot in the arm of the American economy, the Fair Tax would allow individual taxpayers and businesses of all sizes to save the collective $300 billion dollars per year they pay to accountants and consultants in order to comply with the IRS Tax Code.

    6. Focus Financial Decisions:
The Fair Tax would allow consumers and businesses make financial decisions based on what is best for them, their families or employees as measured by objective factors such as cost, aesthetics or efficiency rather than on how it will impact their taxes. This would involve everything from buying large ticket items such as cars or office equipment to deciding what industries to invest in or expand into.

    7. Increased Competition and Innovation:
As efficiency returns to the market and more entrepreneurs are motivated to start businesses, competition will increase, which leads to more innovation and lower prices. For consumers that will mean that not only will they be able to keep more of their money, but eventually that money will go farther due to lower prices and better products.

    8. Collect Taxes from Underground Economy:
Collect taxes from those in the underground economy who currently pay little or no taxes such as drug dealers or employees who are paid in cash.

    9. Eliminate the IRS:
Does this need any elaboration?

    10. Boost for the Poor:
The fair tax provides for every family in the country to receive a monthly stipend equal to the amount of that would be paid by a family living at the poverty level. As a result, every family in America who is living at the poverty level would essentially receive a 22% increase in their income.

The Fair Tax is not a panacea. It will not solve all of America’s problems; it won’t cure cancer or eliminate war or the vagaries of the business cycle. Nor is it without debate, as can be seen by the fact that it has been attacked by players as different as the The Wall Street Journaland the not always so factual

Nonetheless, the FairTax does some important things. First, it put’s the United States on the strongest footing possible to compete on the global stage by spurring productivity across the spectrum of business and society. Second, it frees up individuals and businesses to focus 100% of their attention to starting and expanding their businesses in the most effective and efficient ways possible. In doing so they will drive employment and spur our economy. Thirdly, and perhaps most importantly, it would be the first step in reigning in the imperial federal government. By removing the exigencies forced upon them by the leviathanian Tax Code they created, and eliminating Congresses’ ability to manipulate that code, we would be taking the first step in returning America to its true foundation. That foundation is an understanding that the primary function of government is to guarantee its citizens’ freedoms and give them an opportunity to pursue success and happiness unfettered by the tyranny of an oppressive state. That alone would be make the Fair Tax a worthwhile endeavor.


  1. Thanks for laying this out as simply as you have. While it is true that the Fair Tax is imperfect, it is far more equitable than the system which we currently have in place.

    I believe that the reason it has been cast in such a negative light by some is that it would initially result in substantial unemployment by tax professionals (accountants and lawyers). This would seem to be the underlying reason for the WSJ's dislike. The reason which others (who tend to be opposed to the WSJ position on just about everything else) do not like it, is that the FairTax removes government from interference (read: control) at multiple levels of the goods production process.

    Here's hoping that this proposal gains traction in concert with citizens requiring greater accountability from their government--at all levels.

  2. I hope it made it bit easier to understand. I'd like to see it as a center of a 2010 version of the Contract with America.

    You're 100% right, it's all about power. That's what made Washington our greatest president. Twice he was offered the throne and twice he walked away. I don't think there are too many like him around today...

  3. A bit of correction is in order regarding your statement that you would get to keep 100% of your paycheck under the Fair Tax. You can see here for a detailed explanation of why. But the bottom line is that after passage of the FairTax, either: (a) you will continue to take home your current after-tax pay; or (b) you will get some or all of your federal income tax withholding, but retail prices will be proportionally higher.

    Still, the Fair Tax is much better than what we have now.

  4. Hi Jeffery,

    I read your post and it is an outstanding discussion of the issue. While there are certainly different potential outcomes, I think you hit on the key point when you talk about whether or not it would be legal for employers to keep the money. I don’t think it would be. Employees contract with employers to work for a set amount... whether $10 per hour or $100,000 a year. The fact that taxes get taken out is an issue between the government and the employee, (hence the W-4, which impacts different employees differently) even if the government forces the employer to act as the middleman. That holds true for not only the W-4 income taxes, but also for the Medicare and FICA taxes. Of course employers would be able to keep their matching FICA taxes, but that is their money in the first place.

    Now, of course it may be the case that employers may choose to try and realign their compensation schedules with their employees, but employees are not obliged to agree. If an employer says that now that the government is not taking $2.50 an hour out of your check I’m going to drop your wages from $10.00 to $7.50 per hour, I’m confident that most employees would not accept that. In addition, wages are largely driven not by the amount of taxes the government takes, but the minimum wage laws. As that foundation will likely not change, I would not expect that wages would change.

  5. I agree that it would be difficult, from a legal standpoint, for employers to unilaterally cut employees' gross salaries so as not to give them all the income tax that was formerly held. More likely employees will begin to receive 100% of their gross salaries, upon institution of the Fair Tax.

    But, what that means is that after removal of embedded taxes, prices will NOT drop by 22% as has been widely touted by Fair Tax advocates. That figure -- 22% -- was calculated based on the assumption that employees' salaries would remain the same, and that the reduced costs to employers will be passed on to consumers.

    Consequently the real story is that prices will likely only drop by 10%-12%.

  6. There again your post is spot on when you quote Daniel Dennett – “There’s nothing I like less than bad arguments for a view that I hold dear.” While some people make the argument that prices will drop 22%, that is a red herring of sorts, and just wrong. The whole idea behind the Fair Tax is that initially prices at the register will be exactly the same as they were before. While competition, efficiencies and market forces may indeed drive prices down, they will not be going down 22% as a result of removing the embedded taxes.

    Given the increased competition and other factors that impact prices, I would expect that you are in the right ballpark and that prices would probably decline 10% -15% over time.

  7. Sorry to be so late to the discussion about Fairtax prices, but a lot of bad information is being presented, imho. The 1997 Jorgenson study that concluded that there was an average of 22% in tax costs also assumed that employees would settle for their current net pay after tax withholding. The instant anyone claims that everyone will receive 100% of their gross pay, roughly two thirds of that 22% goes away. Only by reducing payroll costs can producer costs be reduced by 22%. Furthermore, Jorgenson failed to include compliance costs in his study. The bottom line is that business tax costs can be reduced by 10% on average, and retail prices will rise by an average of 17% after adding the 30% sales tax. (Note that one has to add 30%, not 23%, in taxes to producer costs in order to achieve a 23% tax inclusive price).

    There are many other reasons why the Fairtax is not the best tax reform you have never heard of, including the constitutional issue of federal taxation of State and Local government consumption, the unfairness of forcing retirees to resume paying for their pension and health care benefits with their sales tax dollars, double taxing all current after tax savings, the absurd proposal to set up a $600 billion cash grant entitlement known as the prebate, and the risky proposal to transition to the Fairtax overnight when no other nation has ever sucessfully funded their central government with a sales tax.

    The focus of this piece erroneously continues the Fairtax myth about keeping all your pay and retail prices remaining the same. It's just not true!
    There is no free lunch!!!

  8. Hello Dutchman,

    Better late than never I say, particularly as it’s taken me a while to get back with this…

    There is actually a lot of debate about what will occur when the taxes are taken out of the system. It is my suspicion that we will find that the inefficiencies and distortions of the markets due to the tax code are actually much more significant even than Jorgenson’s 22%.

    As for the question of employees, taxes, and 100% of their check, you are likely correct, there will be some adjustment on that measure. What level that adjustment will take will likely vary greatly depending on a wide variety of factors such as competition, union penetration, industry (service vs. manufacturing) and political geography.

    While you bring up a number of good points, I have to disagree with your basic premise that the FairTax is a myth. I will admit that it is not perfect, but as the tagline of this blog states, Perfect is the enemy of the good! While logistically the prebate and collection do offer challenges, neither is the reinvention of the wheel and both are but child’s play when compared to trying just to understand the current code, never mind trying to act in a way that allows one to stay within the law. While it may sound like retirees would now have to pay more in taxes, the basic premise of the FairTax is that they are already paying them, they just don’t see it.

    The bottom line I would suggest is that the current system is sufficiently wasteful, corrupt, corrupting and pernicious that if we replaced it with a bully on every corner who smacked us around and took half our lunch money every day, we’d be far better off than we are now. At least we’d know what to expect and could deal with that reality, as opposed to trying to navigate the constantly shifting system we have now. Our current Tax Code is not only an incomprehensible and inefficiency inducing monstrosity, but it is wielded with malice by politicians and an unaccountable bureaucracy with scant understanding or appreciation of what made this country great in the first place. Freedom and ability to pursue the American Dream are the cornerstones upon which the American juggernaut was built and the Tax Code, perhaps more than any other single government tool, has been used to try and bludgeon the spirit (and money) out of the American people who power that juggernaut. As such, I’d be more than willing to trade the current system for one that was flawed but straightforward. Donald Rumsfeld once said “You don’t go to war with the Army you want, you go to war with the Army you have.” The FairTax may have issues, but at the root it is straightforward, opaque and would strip from the government and the politicians to use the power of the Tax Code to slowly strangle the goose that lays the golden eggs. That’s a tradeoff I’d make ten times out of ten.

  9. Vince,

    I didn't write that the Fairtax was a myth, just the "free lunch" myth about getting all your pay and prices remaining the same. Can't happen, and there is general agreement by AFFT and economic experts that you will get all your pay and the price issue will rest with businesses to solve.

    I also would support a national sales tax. The arguments for doing so are compelling. I just don't support the transition plan as described in HR25. AFFT tried to do too much too quickly. Without repeating all my complaints, here is an alternative tax reform plan that largely eliminates the complexities of the Fairtax. I call it Fairtax-Lite.

    Fairtax-Lite is a 12% revenue neutral national sales tax that replaces just the income tax with no exemptions, no taxation of government consumption, no inventory tax credits, a targeted Family Consumption Allowance (prebate) to protect the poor from a regressive sales tax, retains FICA and the estate/gift taxes, and phases in over five or ten years. If you really want to get rid of the IRS, Fairtax-Lite would have a much better chance of Congressional approval, imho.

  10. Hey Dutchman,

    Points well made. I think the truth is, regardless of exactly what the final numbers look like, it is an uphill battle, as there are few George Washingtons left in Washington – twice offered the keys to the kingdom and twice walked away – I can’t see Barney Frank, Chris Dodd or Charlie Rangel doing that… The AFFT may indeed have tried to do too much at one time, but frankly, I’d rather they reach too far and be forced to retreat slightly than I would see them take tentative steps towards a solution we never actually get to.