A Look at the 'Fair Tax'

•1)     What is the Fair Tax?

At its core, the Fair Tax[1] is a national retail sales tax coupled with the following additions:

• A monthly government "prebate"ck to "untax" purchases up to the poverty level. The prebate check is based on characteristics, such as family size. The prebate would not be income based.
• An exemption for all business inputs, so that unlike existing state sales taxes, the Fair Tax would fall on all final consumption.
• Elimination of personal and corporate income, Social Security, self-employment, Medicare and estate/gift taxes.
•  Retaining of import duties, miscellaneous excise taxes, and sin taxes.

•2)     Does the Fair Tax Spur More Growth?

Whether or not the Fair Tax spurs more economic growth than the current tax system, is an empirical question without many answers. One group of researchers estimate that in the year after enactment, the Fair tax would increase GDP output by 7.9%  over current output and that increase would go over 10% for the next 20 years.[2]  However, William Gale of the Brookings Institution estimates that "generous transition relief or erosion of the tax base would drive the growth effects to zero quickly."[3]

•a)     How to think about the Fair Tax

In the absence of robust empirical evidence, how can one intuitively evaluate the Fair Tax viz a viz the current tax system? One intuitively evaluates the Fair Tax by asking whether the Fair Tax increases savings and whether the Fair Tax is efficient vis-à-vis the current system.

 Most economists prefer consumption taxes to income taxes, because consumption taxes do not affect saving and saving is considered key to economic growth. By removing taxes on saving, the Fair Tax contributes to long run economic growth.   Whether or not the Fair Tax spurs growth will also depend on the complex interplay of at least two factors: i) transition costs and ii) tax evasion costs.

•b)    Example

            The following example shows a snapshot of the complex issues surrounding the Fair Tax. A hypothetical New York City retailer selling a 100 dollar air conditioner faces upwards of a 30 percent (22 percent federal Fair Tax rate and an 8 combined percent state local sales tax rate) tax markup, for selling an air conditioner to a consumer.  Rather than face that high tax rate, the retailer has tax evasion options like, not reporting the sale, stating that the consumer is a business and thus exempting that sale from sales tax.  Rather than face that high tax rate the consumer has tax evasion options lie using a legitimate business exemption from the Fair Tax to purchase the air conditioner for personal use. If exercised, the tax evasion options will reduce GDP, because the air conditioner sale is not reported to the government.

If the consumer does not evade taxes and pays the retail tax rate for a total price of 100 dollars, the consumer could be double taxed on that purchase, if the consumer paid for the air conditioner out of savings that he accumulated  ( and was taxed on) before the Fair Tax. [4] The double taxation is one form of transition costs.

Despite the inefficiencies painted in this example. It is possible that the other benefits of the Fair Tax outweigh costs like the ones mentioned here and the resulting benefit is robust economic growth.  However, it is preferable to achieve growth in the most efficient manner possible, so that resources are used where resources are most needed.

Admittedly, one could paint more efficient picture of the Fair Tax, but unless there is more research on the on the economic growth effects of the Fair Tax there cannot be a definitive Fair Tax picture.[5]

•3)     A Better (but not perfect) Fair Tax

A VAT approach is a simple way to decrease the costs of the fair tax. Most countries in the world use a Value Added Tax (VAT). A Vat is similar to the Fair Tax, with a key distinction being that businesses are taxed on the value they add to a good or service.  With each business reporting its contribution to the final product, there is a lower chance of tax evasion. However, like the Fair Tax the economic growth of a VAT still depends on its transition costs and the rates needed to achieve needed government revenue.

•4)     Conclusion

Tax reform is a complex topic. The Fair Tax may be a step in right direction, if it shifts the public eye towards consumption taxes. As one commentator states "

[i]n academic circles, the shift reflects a new consensus (widespread if not

universal) that an ideal consumption tax is more efficient than an ideal income tax and

can be equally progressive."[6] The Fair Tax could be a step towards the ideal consumption tax, but before the Fair Tax is implemented more research should be done on the Fair Tax and its potential effects on the American economy.

[1] FairTax Act (HR 25, S 1025)

[2] D. G. Tuerck et al, 'The Economic Effects of the FairTax: Results from the Beacon Hill Institute CGE Model'  The Beacon Hill Institute at Suffolk University, Boston.(September 2006, b.).

[3] W. G. Gale, The National Retail Sales Tax (2005) <http://www.urban.org/url.cfm?ID=1000781>.

[4] By contrast, a person who accumulates savings only during the Fair Tax period, never pays tax on savings.

[5] There is relatively more research on  ways to implements the Fair Tax on a revenue neutral basis. For an overview of the Fair Tax and different revenue simulations, see Chapter 9 of the Presidents Tax Reform Panel report. http://www.taxreformpanel.gov/final-report/TaxReform_Ch9.pdf

[6] D. Shaviro, 'Replacing the Income Tax with a Progressive Consumption Tax' (2004) 102 Tax Notes 91.