Updated February 26, 2008

FairTax / FlawedTax
Why the National Sales Tax is Bad for America

Over the past few years, the so-called “FairTax” has gained attention in limited circles through talk radio, blogs, YouTube and MySpace. Despite its lack of support from any credible economist, that attention has been bleeding into mainstream media.

So what is the so-called “FairTax”? It’s a proposed national sales tax that would, in theory, replace all other federal taxes. Advocates of the plan argue that it would “simplify” the tax code by getting rid of the estate tax, personal income tax, payroll tax, corporate income taxes and the IRS itself.

The FairTax, however, would only replace one government agency with another, while shifting the tax burden onto middle- and low-income families.

The 50% Sales Tax

The plan is rife with distortions. For example, supporters claim the FairTax is a 23% sales tax. That claim, however, uses misleading math. For example, if you bought a $100 item, and a $30 tax were added to the price of that item, you would incur a 30% tax, right? That’s certainly the way every other sales tax in the nation is calculated. In FairTax math, it would be a 23% tax, since 23% of the final price ($30/$130 = 23%) is the tax.

That’s only the beginning. In calculating how much of a sales tax it would take to replace all other federal taxes, the crafters of the FairTax included purchases made by the government itself. So, if the government buys a bomber, it would pay itself a tax. If the government builds a school, it would pay itself a little more. The problem here is that the government paying itself does not actually raise revenue. When this type of circular math and other distortions are taken out of the tax equation, it would take a sales tax of over a 50% to replace current federal taxes. Imagine paying a 50% sales tax on the next house you buy (Yes, it would apply to new homes)!

Even the Bush Administration’s tax reform panel recognized these gross miscalculations and chose not to endorse the national sales tax idea. The panel noted that the tax rate would have to be between 34 and 49 percent just to replace the federal income tax, let alone every other federal tax.

Another Tax Break for the Rich

On top of the distortions, the FairTax would shift taxes onto middle and lower-income families. Like Tennessee’s sales tax, it would not apply to purchases, such as stocks and bonds, savings and private school tuition, typically made by higher income families. At the same time, applying it to such things as medical expenses and hospitalization, would essentially kick people when they’re down. Since these medical expenses could easily surpass families’ income during a crisis, the FairTax would force them to pay much higher taxes as a portion of their income in bad years.

In the end, what progressive features our federal tax system has left, after years of tax breaks for the rich, would be replaced with a tax system where the more you make, the less you would pay.

Proponents of the plan attempt to blunt this fairness argument by offering rebates for the amount of sales tax paid on family purchases up to the poverty level. Even with the rebates, low-income families would still lose, as would most families. A state-by-state analysis from the Institute on Taxation and Economic Policy (ITEP) found that under the FairTax plan, taxes would rise an average of $3,260 a year for the bottom 80 percent of Tennessee taxpayers. Only the top 5% would actually save, while the richest 1% of Tennesseans would get an annual tax cut of $162,000 each. See table.

Source: “The Effects of Replacing Most Federal Taxes with a National Sales Tax: A State-by-State Distributional Analysis,” Institute on Taxation and Economic Policy, September 2004.

In short, the FairTax would just be more of the same, failed, trickle-down policies that have enriched a small handful of Americans, stagnated incomes for most and weakened the nation’s economy as a whole.

The New IRS

Even the argument that the FairTax would allow us to get rid of the IRS, and thus government bureaucracy, falls flat upon further examination. In part, this is because when a tax rate reaches as high as 50%, the incentives to find creative ways to avoid the tax grow even stronger.

Since the intent of the FairTax is to tax only end-user consumption, business-to-business transactions would not be taxed. This opens up an entire host of tax-evasion opportunities. Employers would find ways to provide their top executives with tax-free corporate cars, homes, meals and even clothing.

The tax-evasion opportunities would go beyond business-to-business transactions. Shady retailers would be tempted to sell items at steep discounts to people who pay cash, because retailers can more easily hide cash sales. Some would even find ways to “barter” for goods as a way of avoiding the tax.

On top of all the policing, someone in the federal government would have to administer the rebate program. In short, someone would have to track current addresses, process applications, verify the number of children people claim and issue checks.

In the end, the IRS would simply be replaced with another government agency to administer the rebates, ensure people don’t claim more children than they actually have, conduct extensive audits of businesses, track purchases, monitor retailers and make its best effort to curb the extensive tax evasion that would occur under such a plan.

Summary

As long as we have schools, police, highways and other public infrastructures, we will need ways to raise the money and pay for them. Proposals such as the so-called “FairTax” do little but shift taxes back onto the backs of middle- and lower-income families under the guise of “tax simplification.”

Additional Links:

• Click here to download an earlier PDF fact sheet