Evaluating the Fair Tax

The Fair Tax is a classic example of a too good to be true set of claims. FactCheck.com has already evaluated some of these claims. But at this site we will do some more evaluating to encourage critical thinking. When we see political and economic claims we should habitually test them. Higher level math is not needed, just a willingness and ability to compare ideas we can see using numbers. When we do this with the Fair Tax claims, they prove doubtful, at best. Below we look at four problems relating to the claims about the Fair Tax.

Last Update: March 14, 2011

1: The Fair Tax is not fair
Both FactCheck.com and FairTax.org admit that the Fair Tax would increase the taxes on the middle class and decrease the taxes on the rich. Very few people actually believe that making the middle class pay a higher tax rate than the rich would be fair. We must remember the term Fair Tax is a title created for marketing purposes; it is not a description of that tax.
The problem can be demonstrated with a simple contrast. Picture two families, one with an income of \$20,000 and another with an income of \$2 million. The first family will spend about 100% of its income on consumption and still feel economic stress. Thus, 100% of their income will be taxed. The second family can live a luxurious life by spending \$200,000, just 10% of their income, on consumption, while investing the rest. Thus, the lower classes would have about 100% of their income taxed and the rich would have only about 10% of their income taxed.
There's an obvious consequence to this. After the tax on the rich drops from its current rate (nearly 30%) down to its "Fair" tax rate of about 5%, somebody will have to make up the difference. That would be those of us in the middle. If your income is below \$100,000 you should be concerned. The Fair tax would increase your taxes.

2: The Fair Tax would be larger than 30%
FairTax.org claimed the Fair tax would be about 23%, FactCheck.com says about 30%, and BusinessWeek reports about 60%. With a little reasoning we can see that the Business week estimate would be the closest to correct.
Right now, you pay about 25% to 30% of your income, minus a few deductions, in taxes. You spend about 90% if you are middle class, about 70% if you are wealthy, and less than 40% if you are rich and invest the rest. Not all of your spending is consumption. Since, your consumption spending is less than your income, and the consumption spending of the rich is small compared to their income, the tax on consumption would have to be larger than the tax on income. Recognize also that not all spending is consumption, thus the tax on consumption would have to be much larger than the tax on income. The rate of the Fair Tax would also have to cover the cost of the prebate. On top of all that, the Fair Tax website bases its claim of 23% on the assumption that consumption will remain at an unsustainable 120% of income. All these pieces together, and it is clear that the Fair Tax rate would have to be larger than 30%, significantly larger.

3: The Fair Tax will not be simple nor eliminate audits
The Fair Tax may actually lead to more paperwork and more audits. The initial proposal for the Fair Tax appears simple, but it contains all the inherent flaws that make our current tax system complicated. Most significantly, consumption is very hard to define. It is the gray definition of consumption that leads to most loopholes, and consequently audits. We will consider a few examples to demonstrate how this occurs. (1)
(a) Business sales: Imagine a hobby shop. It must charge the consumption tax to all of its customers, right? No; what happens if one of its customers buys beads to create jewelry for sale? The bead purchases are no longer consumption, they are now a value-added. The hobby shop does not tax the jewelry maker. The jewelry maker must tax her customers. How do we know what is value-added (not taxed) and what is consumption (taxed) and what is cheating? We must fill out the forms and we must audit. The problems demonstrated by this example will apply to many types of businesses and all work from home.
(b) Construction: Some contractors fix up old houses and resell them. A resold house does not get taxed because it is not "re-consumed." But the materials and labor required to fix up the house are consumption. They do get taxed. So how do we determine what part of the selling price of the house is non-consumption, and what part is consumption? This will require complicated paperwork that will get audited. This difficulty defining what is getting consumed, and what is getting resold, and what is getting reused will apply to all businesses. It will require audits.
(c) Home gardens: If you grow vegetables in your garden you do consume them. But should they be taxed? What if you give these vegetables to your neighbor? What if you sell them in a corner stand? With the Fair tax on food being between 30% and 60% your motivation to grow your own food will increase as a form of tax relief. Again, this specific example can be generalized to all behaviors where people will try to avoid a large tax cost by doing the work themselves.
Take time to think about all the transactions in your life that are more complex than buying a piece of candy at the market, which is most of them. You will see that all of these transactions involve situations where the distinction between consumption, value-added, spoilage, and reuse is unclear. Consequently, complicated paperwork with frequent audits would be required to ensure the correct tax is being paid.

4: The Prebate will fluctuate politically. It will probably be reduced significantly.
The prebate is the strongest marketing tool the Fair Tax movement has for getting poor and middle class citizens to identify with the movement. But the prebate is the least politically reliable of ideas behind the Fair Tax.
The prebate would cost over \$400 billion annually. Being one of the 3 largest expenditures of the federal government, it would be the easiest target for the deficit hawks to attack. The prebate would also be attacked by the anti-socialism movement who complain about poor people living off handouts and illegal immigrants getting money they don't deserve. If these political movements stay strong in our national dialogue, then the prebate would be reduced significantly, or even eliminated. This would result in the tax rate on the lowest classes being much higher than the tax rate on the wealthiest classes.
We can put parts 1, 2, and 4 together to estimate the effective tax rates under the Fair Tax. When we do this, we graph a very disconcerting unfairness to the Fair Tax. Even with the prebate, the poor will pay the highest rate, and the rich will pay the lowest rate. The Fair Tax would prove to be totally regressive.

 The Fair Tax rate for the poor could be as high as 100%! But for the rich it won't go above 20%, or about 1/4 the rate to poor would pay. (2)

Why doesn't the graph at FairTax.org show this? First, they base their graph on a known false assumption, shown on the bottom of their graph "Annual income = annual spending." We know this assumption to be false. The rich invest most of their income, not spend. The poor must spend more than the total prebate just to survive. Second, their graph does not even show the incomes and tax rates for the superrich. This ignores a critical part of the data. Third, they ignore the probability that the actual Fair Tax rate would be higher than advertised, and that the prebate will probably be lowered to reduce the deficit.

References

Related pages at this site:

Summations:
Using common experiences, obvious contrasts, and critical thinking we can show that the Fair Tax would have some serious problems. The Fair Tax would not be fair, simple, or good for the poor and middle class. This is just a sample demonstration of the importance of critical thinking for citizens in a democracy. We hear misleading claims all the time. We must be skilled at evaluating those claims. If we are not we will vote against our own best interests and the best interests of our country.

Footnotes:

1. The complexity results from the distinction between a value-added tax and a consumption tax. A consumption tax only gets charged at the purchase of consumption. Cumbersome accounting must occur to determine which purchases are for consumption and which are for adding value. In contrast a value added tax could be simple by taxing all purchases. However, taxing all purchases would strongly favor multinational conglomerates and disadvantage small businesses. Small businesses would have to pay taxes on purchases from other businesses. But conglomerates could simply have to transfer materials between departments and factories without a taxed purchase.
2. The graph at FairTax.org is labeled as produced "PhD." This is an appeal to authority. No advanced thinking or skill is demonstrated in the creation of the graph. The graph demonstrates no education or skill above the 8th grade level of curriculum.