I "graduated" several years ago from the flat tax to the FairTax and, if you are currently a fan of the flat tax, you should too. This discussion is important because tax reform will take center stage in Congress this spring. The three leading tax reform proposals before Congress are:
- The FairTax,
- A flat-rate income tax, and
- Today's tax code, but eliminating loopholes and deductions.
Let's dismiss proposal three. Today's tax code -- even if simplified -- remains murky, inefficient, costly to economic growth, and unfair.
President Reagan tried to reform the tax code in 1986, but he was unsuccessful. The code was simpler for a while, but it quickly grew to a new colossus of over 70,000 pages of statutes, regulations, and revenue rulings. Nobody could have tamed it. This is reason number one of seven why I became a flat tax "alumnus."
First, however, we need a primer on what the remaining two tax reforms are. The flat tax is an income tax with a flat rate of 17 percent on wages, salaries, and business income. Estate and gift taxes go away.
Earlier versions of the bill taxed investment income, but only to businesses. In these versions the FICA/FUTA and Medicare taxes stayed in place. These taxes were eliminated in one of last year's versions. Businesses can expense out capital goods rather than depreciate them. Deductions that are not "business inputs" are eliminated. To be fair to low-income people, the flat tax features high exemptions.
The FairTax is a bill in Congress with 58 sponsors. The measure repeals all income taxes, both corporate and individual, payroll and self-employment taxes -- which are some of the most regressive taxes today -- and estate, gift, and generation-skipping taxes.
The FairTax replaces these taxes with a national retail sales tax on consumption of new goods and services, without exception, but once and only once.
FairTax vs. Flat Tax
To make the tax fair, the FairTax features a prepayment from the Social Security Administration to citizens and lawful residents. Based strictly on household size and not on income, the prepayment cancels out tax on consumption of necessities. The FairTax also phases out the Internal Revenue Service.
The flat tax retains the institution of the IRS and can easily morph back into today's income tax. After the IRS is phased out under the FairTax, the income tax no longer can come back.
Reason number two for preferring the FairTax is related. The flat tax would invite a VAT or a sales tax as an add-on as Congress will certainly cast about for new revenue sources.
The FairTax not only repeals Subtitles A, B, and C of the Internal Revenue Code and phases out the IRS, it also sunsets if the Sixteenth Amendment to the U.S. Constitution -- providing for an income tax -- is not repealed in seven years. Therefore, both income and consumption taxes are an unlikely result of the FairTax.
The third reason for preferring the FairTax is that it stops taxing exports and reinvested earnings. The FairTax lets the economy grow. The flat tax imposes a tax on both these items.
Additionally, the FairTax captures the shadow and underground economy. Criminals and undocumented non-citizens have to buy food, shelter, clothing and medicine, and the FairTax taxes these groups when they consume these items. The flat income tax does not.
The FairTax also helps governments control their spending. Based on consumption, the FairTax has a more stable and growing revenue base than the flat tax has. Revenue rises less in times of economic expansion and curbs the appetite of governments to spend. Revenue then falls less in times of recession, when demands on social services increase.
The sixth reason for preferring the FairTax is related to the last reason. The FairTax helps Social Security and Medicare in two ways:
- By stabilizing and growing revenue streams.
- The FairTax helps workers by eliminating the payroll tax.
The final reason speaks to those politicians who contend the flat tax is easier to do. It isn't. The flat tax, albeit for worthy reasons, hands detractors the argument that it is a tax break for the rich. The flat tax taxes wages but leaves investment income and estates alone.
Other flat-tax critics bewail the loss of favored deductions, such as the mortgage interest deduction. For that reason, the National Association of Realtors opposes the flat tax but is neutral on the FairTax.
For those seven reasons, I "graduated" from the flat tax. So have fifty-eight members of Congress by last count.