Monday, August 27, 2007

The FairTax: It's Fair, but Is It Good?

My parents always told me that if it sounds too good to be true, it is. With very few exceptions, that advice has proven to be extremely valuable throughout my life. A few times I have ignored this advice, only to end up learning a lesson the hard way. The very few exceptions to this rule that I have seen are more like flukes; like someone winning the lottery.

Economist Bruce Bartlett makes a strong argument in this WSJ article that the FairTax is one of those things that is just too good to be true.

For those that are new to this debate, the FairTax is a type of flat tax proposal that would exchange the current federal income tax system for a national sales tax. Unlike value added tax (VAT), where taxes are levied at every exchange between initial producer and final consumer, the FairTax would be levied only at the final exchange. This is an important point, because VAT tends to hide taxes, while the FairTax would make taxation more transparent.

The main selling point of the FairTax is the claim that it would get rid of the IRS and government intrusion into the lives of individuals. Proponents argue that taxes would be collected through the same mechanisms that currently collect state and local sales taxes. They note that these organizations work directly with retailers and rarely directly interface with consumers.

While this sounds nice, Bartlett asserts, “Perhaps the biggest deception in the FairTax, however, is its promise to relieve individuals from having to file income tax returns, keep extensive financial records and potentially suffer audits.” What is he talking about? He is talking about the fact that the FairTax is not, in fact, a flat tax, but is a progressive tax. The progressive nature of it is applied at the back end rather than at the front end, as occurs in our current system.

The whole argument behind progressive taxation is that a flat tax is not fair. A tax of 10% of a poor person’s income creates a much greater burden on that person than is created on a rich person by a tax of 10% of his/her income. The FairTax realizes this. Since everyone would pay the same percent of taxes on their purchases up front, the FairTax would send out monthly rebate checks to every household based on household income. In other words, some agency would still be collecting information — and performing audits — on personal income. FairTax proponents can argue that this agency would not be as intrusive as our current IRS, but there is simply no way they can prove this would be the case. The IRS by any other name ….

Bartlett goes to great length in his article to criticize the FairTax’s proposed 23% tax rate. He shows how this is a smoke and mirrors deception that hides the actual 30% tax rate. Bartlett demonstrates that the only way the proposed rate could work is for government spending to be simultaneously cut by a whopping 60%. I’m a small government type, so I think government spending should be cut. But does anyone reasonably think that cutting spending 60% is realistic?

The alternative is a tax rate of about 57%. Bartlett notes that it could be as high as 89% in a worst case scenario. He purposefully points this out because “public opinion polls have long shown that support for flat-rate tax reforms is extremely sensitive to the proposed rate, with support dropping off sharply at a rate higher than 23%.”

Bartlett includes a number of other criticisms, including the fact that the tax would be levied not only on goods, but also on services that have traditionally been exempt from sales tax. Imagine your medical bills immediately increasing by 30%. Bartlett discusses the fact that federal government would also pay the tax. FairTax proponents include in their calculations the revenue this would generate, but ignore the added expense to the government, as if it simply wouldn’t exist. Bartlett says that FairTax proponents ignore the costs of collecting the tax and distributing welfare checks to a huge percentage of the population.

FairTax proponents will say that Bartlett’s criticisms are over the top, fail to consider the economic growth that would result from the program, fail to consider the overall reductions in prices that would result from fewer taxing points, and/or ignore answers that have already been provided. That’s OK. They can say that. But frankly, their economic growth numbers are simply too good to be true.

Bartlett is not the first to point out shortcomings with the FairTax proposal, but I have yet to encounter cogent arguments that would satisfactorily counter all of the criticisms he raises. Perhaps more cogent posts will be forthcoming, but as of post time, the only FairTax proponent arguments I could find to specifically counter Bartlett’s contentions were devoid of substance but filled with ad hominem attacks. And many of these came from “esteemed” economists.

What we know for sure is that flat tax proposals play well with many audiences throughout America. Flat taxes play particularly well with conservative audiences. At least they play well at first blush. A broad swath of Americans also wants to make sure taxes are not too oppressive for those that can least afford it. Many people are in both camps. The FairTax seems to fit the desires of both camps — until you look under the covers and see all of the problems with the program.

FairTax proponents do not want to hear criticisms of the program. I’ve had too many discussions where proponents act like the three monkeys that can hear, see, and speak no evil of the proposal. They don’t care about the counter arguments; they simply feel that the FairTax should be enacted anyway. I suppose you’d call this faith-based legislation. That is not a good formula for creating national policy.

6 comments:

steve u. said...

Thanks for the detailed analysis. I am drawn to the Fair Tax proposal, but mostly in a theoretical sense.

Policy better take into account human nature and enforcement difficulties. With sales tax rates as high as the Fair Tax would require, a huge black market would arise as people work to avoid the 20- to 50-percent tax. I can't imagine how such black market sales could ever be tracked -- unless some agency like the IRS or an even more intrusive one were to take on the task.

Democracy Lover said...

The Fair Tax as you describe still requires a great deal of government intrusion and is, in that respect, little better than the IRS.

I think we need to look much more closely at the VAT. Here is a tax that is collected generally by businesses who have more accounting transparency and reporting requirements already and can accomplish the same goals as a sales tax without putting the burden of payment directly on the individual.

I think any VAT, however, should exempt certain products: food for example. That would go part way toward insuring that the burden does not fall harder on those less able to pay.

I would heartily support imposition of a nationwide VAT provided we eliminated income taxes on wages, the payroll tax for SS, and replaced that revenue with the VAT.

This is another one of those arguments that is largely academic. The corporate owners of our political system are not likely to permit the shift taxation onto themselves and off the backs of working men and women.

Bradley said...

These are interesting reasons to oppose the concept. I appreciate you pointing me to the article since I hadn't noticed it when it came out. My opposition is actually strongest based on the notion of every person in America receiving a check from the government every month in the form of a "prebate." That just feels weird.

Frank Staheli said...

The Fair Tax not nearly as simple as it sounds, like you say, and thus it's going out on quite a limb to say that it would be fair. It will only work if (among other things) government never wants to influence any social outcomes.

I read recently (probably here on RU!) that the consumption tax is a much better way to go. After thinking more about it in recent days, I prefer a consumption tax much more than income and even property taxes.

Ian said...

Detailed rebuttal follows:

1) Reach: "Economist Bruce Bartlett makes a strong argument in this WSJ article that the FairTax is one of those things that is just too good to be true."

Fact: The Bartlett piece has been repudiated in the days following its publication. Bartlett is no stranger to criticizing a national sales tax.

2) Reach: "While this sounds nice, Bartlett asserts, 'Perhaps the biggest deception in the FairTax, however, is its promise to relieve individuals from having to file income tax returns, keep extensive financial records and potentially suffer audits.' What is he talking about? He is talking about the fact that the FairTax is not, in fact, a flat tax, but is a progressive tax. The progressive nature of it is applied at the back end rather than at the front end, as occurs in our current system."

Fact: Bartlett's alleged "biggest deception," is NO deception at all! There ARE NO income tax returns required! The ONLY records required to be kept are BUSINESS SALES for which BUSINESSES file their usual (in most states) state sales and use tax returns. Also, there is no "back end" progressivity to the FairTax - as you state - because the monthly advance rebate (called a "prebate") is UP FRONT. It is the CURRENT SYSTEM that confiscates workers' pay that is "back end" as citizens are forced to file an annual tax return - many to get their own money back WITHOUT interest.

3) Reach: "[Under FairTax] everyone would pay the same percent of taxes on their purchases up front, the FairTax would send out monthly rebate checks to every household based on household income. In other words, some agency would still be collecting information — and performing audits — on personal income."

Fact: Better said, the FairTax UNTAXES every citizen's spending up to the poverty-level via the prebate. HOWEVER, PREBATES ARE NOT BASED ON INCOME, THEY ARE BASED ON FAMILY SIZE. No audits of income under FairTax.

4) Reach: "FairTax proponents can argue that this agency would not be as intrusive as our current IRS, but there is simply no way they can prove this would be the case. The IRS by any other name"

Fact: I just did prove this, above. NO MORE IRS under FairTax. 90% FEWER POINTS OF COLLECTION are handled by the states. However, since states collect taxes, presently, true federalization of tax collection occurs. 50 smaller, leaner agencies will breed innovation, and will collect taxes more efficiently, and at less cost, to citizens.

5) Reach: "Bartlett goes to great length in his article to criticize the FairTax’s proposed 23% tax rate. He shows how this is a smoke and mirrors deception that hides the actual 30% tax rate. Bartlett demonstrates that the only way the proposed rate could work is for government spending to be simultaneously cut by a whopping 60%."

Fact: The 2005 President's Tax Panel also tried to make this case.

6) Reach: "Bartlett includes a number of other criticisms, including the fact that the tax would be levied not only on goods, but also on services that have traditionally been exempt from sales tax. Imagine your medical bills immediately increasing by 30%."

Fact: Not true. Prices AFTER FAIRTAX will be similar to prices BEFORE FAIRTAX (within the first year, to allow market response) - remember, FairTax is revenue neutral. Here's why: Kotlikoff and partners calculated the cost of business tax compliance under the current code and determined that (average) 22% of retail prices are due to taxing businesses (which FairTax eliminates). Bartlett COMPLETELY IGNORES this post-FairTax, "price-efficiency" effect as businesses seeking to keep prices high (despite lower costs) confront competitors seeking to gain market share.

7) Reach: "FairTax proponents will say that Bartlett’s criticisms are over the top, fail to consider the economic growth that would result from the program, fail to consider the overall reductions in prices that would result from fewer taxing points, and/or ignore answers that have already been provided. That’s OK. They can say that. But frankly, their economic growth numbers are simply too good to be true."

Question: From whence do you derive your conclusions? The Wm Gale rebuttal does justice to this.

8) "[Ad hominem attacks against Bartlett] And many of these came from “esteemed” economists.

Question: Please cite examples. Bartlett's "argument" - as you can see from this rebuttal - was worthy of the wide-spread criticism it's getting. And those who stand to gain from the FairTax (which are the citizens) will be hurt if these misrepresentations are permitted to stand, unopposed. Consider prospective effective percentages that different income groups would pay under FairTax. Prof.'s Kotlikoff and Rapson (10/06) have said,

"...the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.

"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."

And, in another paper, Kotlikoff states,

"...once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."

9) Reach: "FairTax proponents do not want to hear criticisms of the program."

Response: I would say that FairTax naysayers do not want to consider the problems of the CURRENT expensive and intrusive income tax system! Larry Kotlikoff believes that the current tax system IS bringing the country to nothing less than an "economic meltdown by virtue of the invisibility of actual taxes paid. If Americans do not understand the true cost of their government, they're unlikely to hold Congress accountable - thus the enabling mechanism to continued profligate spending.

Even with the foregoing notwithstanding, do FairTax naysayers really believe:

• Workers love having their pay confiscated, hourly, through gov't withholding and don't mind getting their money back by involuntary servitude - to the tune of 50 hours/year (on average) - preparing an annual tax return?

• That certifying the number of persons in your family (annually, and, ancillarily, upon change in household) is an abrogation of our freedom - more intrusive and complex than filing a tax return every year subject to threats and intimidation by theIRS.

• It's better to have theIRS fishing through citizens' income transactions (complete with audits, interest, penalties, and threats against individuals, families, businesses as well as confiscation of their homes, property, and bank accounts) rather than - Gawd forbid - issuing a gov't check to an individual (while pretending that Social Security payments disbursement logistics really can't work for "prebates")?

• That an monthly advance tax rebate is the same thing as "being on the dole" ? (Only lobbyists, special interests, and business deserve "handouts" ? - the politician gets a payoff from a lobbyist, the lobbyist gets a payoff from its client, and the citizen gets higher taxes and/or prices that pay for it all.)

• "Hidden taxes" in higher prices are fine because they're not "taxes," per se? (Hey, forget that families are really paying business's costs for complying with a business income tax code - staff, consultants, submittals, etc.)

• That the work by notable economists (paid tens of millions of $'s by Americans for Fair Taxation) doesn't carry weight because it was paid for by private funds instead of some gov't / quasi-gov't enterprise?

• That FairTax's backing by many economists ( http://snipurl.com/econsopenletter ) doesn't carry any weight because (the Brookings') Wm Gale's testimony before the President's Commission on Tax Reform is - somehow - above all that?!

NOTE: The Commission/Gale made up their own "consumption tax" requirements, as if that constituted a legitimate rebuke of the FairTax plan. Dr. Kotlikoff has requested - but never received - Gale's technical "modus operandi" which would definitively explain just how Gale's conclusions can be reconciled with Kotlikoff's well-documented technical work.

Reach Upward said...

Ian, thanks for your detailed rebuttal of Bartlett's criticisms. I do not think you acquitted yourself very well with respect to Bartlett's claim of needing to cut spending 60%. As I read different FairTax advocacy information, I see conflicting information about whether the prebate is based solely on family size or whether income is factored in. Either way, people will be incetivized to cheat, and that will result in audits.

After reading your resrouces, I cannot conclude that the FairTax system is ultimately better than our existing system: it's just different. Yes, it's better in some ways, but it's worse in others.

I am not arguing in favor of our current system. Mind you, I spent part of my career working as an IRS tax auditor. I know from the inside out how nasty our current system is. But Americans are going to have to buy the idea the the devil they don't know is better than the devil they do know.

There's going to have to be a much better sales job before that happens. Businesses are going to have to buy into it. They're going to have to be reassured that they won't get hurt in the transition. Politicians -- lots of them -- are going to have to buy into it. And frankly, that's a double-edge sword, because when politicians start to like the program, it immediately becomes suspect.

I'm afraid that Bartlett is probably correct when he asserts that the FairTax is never going to actually become law. I'm also afraid that if it does, it will be bastardized by the politicians to the point of it being more detrimental that our current awful system.