FairTax critics reflexively attack the FairTax as regressive. Such castigation is fitting for most sales taxes, but the FairTax is not regressive. Here's why:
The FairTax is a bill in Congress calling for a national retail sales tax to replace Subtitles A, B and C of the Internal Revenue Code and phase out the IRS. The taxes that disappear under those subtitles are corporate and individual income taxes, payroll and employment taxes, estate, and gift and generation-skipping taxes. Conventional thinking is that sales taxes are regressive -- i.e. unfair to the poor and middle class -- and perhaps for good reason.
The argument is that sales taxes do not consider the ability of the taxpayer to pay. States that have retail sales taxes typically mitigate that problem by exempting supermarket food (not restaurant food), ordinary clothing (not minks), rent, and medicine. Such items are non-discretionary.The FairTax offers no such exemptions. All new tangible goods and services, sold at retail, are subject to the tax. The absence of exemptions enables the FairTax to capture much of the shadow and illegal economy, but still, why is this tax fair? Tweet this article: Tweet
The first part of the answer lies in the nature of the taxes that are being eliminated. The federal payroll tax is one of the culprits. This tax is levied today on wages up to $113,700.00. A hamburger flipper at Wendy's earning minimum wage pays the same rate on his or her wages as the better-paid executive.
Wages above $113,700.00 are not taxed at all (neither are benefits paid in retirement on those wages). Also, the tax is limited to wages, and it is not levied on investment income.
The other regressive tax that is eliminated by the FairTax is less evident. This tax is the set of indirect taxes that consumers pay when producers and providers pass them on in the form of higher prices. These taxes include business income taxes and employer payroll taxes, together with compliance costs. These taxes raise the price of food, clothing, rent, and medicine.
It is difficult to estimate the impact of these hidden taxes and compliance costs on retail prices. The response of markets depends on the degree of competition in any given field and on elasticity of demand; economist Dr. Karen Walby suggests a figure of 12.5 percent. With any modicum of competition, pre-tax prices under the FairTax should fall by that amount.
Assuming the Federal Reserve does nothing to accommodate the FairTax with changes in the money supply, a pre-tax price drop of 12.5 percent would represent a post-tax price rise -- once only -- of 14 percent, using a static model based on a nominal tax-inclusive rate of 23 percent. Most working people would gain 12 percent in purchasing power.
Retired seniors living on Social Security are not forgotten. Social Security benefits rise, under the bill, to accommodate any rise in the cost of living due to the FairTax.
Not only does the legislation eliminate regressive taxes and built-in costs, and protect seniors, the FairTax is fair for another reason.
The legislation provides for a prepayment in advance (the Family Consumption Allowance), to all citizens and lawful residents. It is based strictly on household size and on cost-of-living estimates from the Health and Human Services. The marriage penalty is removed. The purpose of this prepayment is to cancel out the tax on consumption of essentials.
This prepayment, on its face, makes the FairTax progressive. Simple arithmetic indicates that a household of four that consumes $32,260 effectively pays 0 percent tax; a household that consumes $60,520 effectively pays 11.8 percent tax; and a household that consumes $242,080 effectively pays 20.2 percent tax. As household consumption rises, the effective rate approaches the nominal tax-inclusive rate of 23 percent.
The prepayment rewards people for improving themselves because everyone gets it. Today's Earned Income Credit, by contrast, is different. Economist Dr. Laurence J. Kotlikoff writes extensively about "welfare loss" today as a cost of choosing work over leisure. The FairTax differs by rewarding work.
The prepayment is another reason why the tax is made fair to seniors. Seniors are less able to adapt to changes. A senior couple living exclusively from Social Security will clearly see its purchasing power rise from the prepayment because there is no marriage penalty. Because of the prepayment, seniors with additional income would need to spend $60,000 - $80,000/year before they would notice any difference under the FairTax. Then, they would see an offsetting drop in income taxes.
In addition to repealing regressive and hidden taxes, offering a prepayment, and protecting seniors, the FairTax is fair for a more philosophical reason. Wealthy people, it is true, are able to save more and avoid tax on savings. However, savings and investment represent deferral of present gratification to the saver, and a benefit to society. The FairTax, unlike the income tax, is a wealth tax. Tax is collected when wealth is consumed at retail and economic gratification is no longer deferred. Tweet quote: Tweet
Economist Dr. David Tuerck, expressing his results using Gini coefficients, determined that the FairTax is actually more progressive than all other federal taxes except for gift and inheritance taxes. The poor and middle class benefit disproportionately.
Indeed when it comes to the FairTax, the label "regressive" does not fit. The label "fair" does.