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Wednesday, May 11, 2005

The FairTax is Still the Answer

There was recently a letter presented to the Americans for Fair Taxation for answers. Karen from Iowa needed some help answering several questions that her son, Michael, had. I decided to take the questions that Michael had and answer them in a public forum. The following questions and comments were presented, in red text. My responses are in black text (and bold).

He opens with: The Tax Gap is an interesting topic, and unfortunately one that is rife with holes. Did you realize that most of the tax gap is attributed to illegal trade? Not cheating on taxes, but actually selling drugs, prostitution and the like.?

Ok, nonetheless, we still have a tax gap and the FairTax would solve most of the problem by putting a sales tax in the face of prostitutes and drug pushers. Also, only retailers would be taking on tax form filing, which reduces the number of filers by 80%, and subsequently compliance and cheating.

One of the problems with a consumption tax vs. an income tax is that consumption taxes increase the incentive to shop on the black market.Because the drug dealers are already not paying taxes on the product they sell, having a consumption tax will not provide much more of this $300B (tax gap) to the government. Yes, the dealers will pay taxes when they buy homes or fancy cars, but a consumption tax will create black markets for these types of goods, and the drug trade takes money out of the hands of the drug users that is then not taxed when they consume the money by purchasing drugs.

Illegal drugs will not be taxed – correct. But, are they taxed now? Not quite. We’re looking for better alternatives than the current system. It would be great if there was a perfect option that has been as researched as the FairTax, but there isn’t.

Keep in mind that used items are not taxed under the FairTax. Tax avoidance with the FairTax will dramatically decrease (not go away) with the FairTax. There will be stiff penalties in place for retailers that cheat the system, which will be the only filers.

There actually are many downsides to HR-25. If you want to champion this cause, you'll need to find these and understand the cost/benefit trade off. There is no black and white.

Correct. I’ll go ahead and tell you the downsides. Current Roth IRA holders will have a disadvantage with this system. Municipalities that use tax-free bonds for debt will have a disadvantage under the FairTax, compared to the current system (when only considering that aspect of the plan). However, compared to other bond holders, there is no disadvantage. But overall; even tax-free bond debt holders; everyone will thrive under the FairTax system.

The important thing to take from this is to come up with a solution for the little problems that need tweaking, along the way. Slamming the whole system because of these issues does no good. Optimism can do you good! No one could disagree that the FairTax in general is much better than the current system.

On a separate note, sometimes there is black and white in this world.

For example, consumption taxes increase black-market activity. Will anational sales tax create a new federal criminal class of people who trade on the black market? i.e: you can go to the Federal Pen with Martha Stewart for selling Grandma's collectable jewelry and not reporting it?

Once again, used items are not taxed at trading time. So, the answer is “no”. Taxes will be collected at the retail level (i.e. Wal-Mart and Target).

Where should the tax be applied, only at the end-consumer (a sales tax as proposed) or at every exchange in the process (a value-added tax)? A sales tax will encourage cheating by people starting fake businesses. How do you regulate this? Will it take another Federal entity like the IRS?

The FairTax bill explicitly states that the only tax that will be collected will be at the cashier’s register, as an end-consumer, only once. Fake business entities are a possibility, but will be regulated, at a much smaller cost and size than the current IRS, I might add. The states already regularly regulate activity such as this for business licenses.

Like (I asked on a different occasion), do you allow a "poverty line", or any exemptions to the sales tax, like home-sales? When you start doing this, who should make the decisions about what "favored industries" will get this very large and lucrative tax break? If we exempt home sales, how much does that increase the taxes on clothing sales? Remember that food, clothing, housing and transportation are four of the five largest consumer expenses - the largest is taxes. What about college tuition?

The FairTax plan explicitly includes a monthly rebate for a set amount for every American at the sales tax (30%) times the poverty level already set by the Health and Human Services. This creates, like you stated, a way to avoid favoritism, which is most efficient and reduces lobbyists. This will create the effect of progressivity, which many Americans feel is important for a tax system. The only items that will not be taxed, which are technically not retail items, are education expenses, charitable contributions, and interest payments. Education is considered to be a human investment. This is essentially the same thing as an income tax deduction for charity and mortgage interest. Which, I might add is more efficient than the current system of deductions because workers will be able to donate and pay for their home with pretax dollars.

Consumption taxes also go against "family values", because they increase the tax burden on young, working families that need to spend more money than older established families do. A young family needs a home to live in, affordable appliances, diapers, bed-sheets, and more groceries than older couples. Because of this, younger families are also likely to purchase lower-quality durable goods (appliances), that need to be replaced (and taxed again) sooner than an older couple. If I buy a new house, I need to get a washer, dryer, fridge and stove - and let’s say for $2,000, but these appliances are of such quality that they only last for 10 years. An older couple who has an irreparable stove can elect to spend $1,000 on a new high-quality stove - that will last for 30 years. So the average annual taxes are higher on the young couple for the exact same service, just because they don't have enough money to afford the better quality durable goods with a lower per-year tax rate.

I’m sure you will agree that young people grow old eventually, right? I wish there was a fountain of youth, but there is not one, yet. Everybody’s entire life spending pattern will be the same, eventually. This is a transition issue, and it is understood what you are saying, but it will all work out in the end. Once again, no tax reform plan is perfect.

I also need to get you a copy of (the book) How to Lie with Statistics. The article (you quoted in another text) uses bad statistics because it tags a "flat surtax" against a floating allocation system. (Our) taxes were not $4,000 too high last year because of tax cheat(er)s. $312 billion divided by $2,052 billion (the national budget) is a tax increase of 15.11%. (We) will pay approx(imately) $8,000 in Federal taxes this year. So if the drug dealers had paid their taxes instead of me, and the government was nice enough to lower the tax rates so that I could keep this money, I should only pay $6,800. This means that (we) only get socked for $600 each ($1,200 / 2 people), not $2,000. The proper statistical number is that "Federal income taxes could be lowered by 15% without reducing Federal expenditures if the cheat(er)s paid this money". This is because the top 5% of earners ($250,000+ a year) pay approx 75% of the income taxes.

You are correct. I’m sure somebody had their math wrong on that one. It’s still an issue that would be helped by the FairTax, no matter how much it is. About the high taxes of the top income-earners... isn’t social redistribution awesome?

A consumption tax is a good idea, but one that is fraught with pitfalls and unknowns. There is a much more simple solution. IRS tax simplification is a concept that few politicians talk about anymore.They made a feeble attempt in the late 80's, and Ross Perot championed the idea, but Congress soon started mucking the process up again under Clinton and Bush.

In 1913, when the income tax was enacted, our system of income taxation was simple. From there, it all fell apart. I would agree that tweaking the current system would be easy and not require much change for the very courageous politicians that we have in Washington. But, we would still have the IRS and the ability to muck up the system, just one year later with lobbyists and new rules. You remember 1986; you said it yourself. No matter how much simplification, (unless completely redone) there will be too much room to get where we are today.

Tax simplification is easy to understand. There are only 3 brackets, poor, middle class, and rich. When I looked at this in college, the numbers were not too complicated. For each person in a family (including children), you can get your first $10,000 in income with no tax and no social security. The next 20,000 pays approx 10% federal tax and 5% FICA. Everything over 30,000 pays 35% federal tax and 8% FICA. Simple, (right)? It is a postcard system for the 80% of American's who only earn W-2 salary, interest and pensions. A family of (four) gets the first 40,000 tax free, pays 15% on the next 80,000, then 43% on everything over 120,000.

As I was saying, the Flat Tax (which is what you are championing) is a good idea in theory. It won’t work though. The 1913 tax legislation started out as a Flat Tax, even more so than you are proposing. In fact, after listening to the Tax Reform Panel’s meeting today, I’m more convinced. Even called a Flat Tax, there are already plans for loopholes and deductions. We have to scrap the system and start over. We have to cut our losses. There is no way out without getting rid of the IRS completely and the income tax. Why are we so stuck on taxing work anyway? We need to open the door for people to get ahead, not to be taxed on everything they make.

Again, in college, this decreased total taxes on the poor (bottom 20% of taxpayers) by just a little bit, decreased taxes by about 10% on the middle class (21% to 90%) and increased taxes on the rich by only 5% (top 10% of taxpayers). Since the mid-1990's, the tax burden has shifted more to the middle class from the rich, so I would expect the top-tier increase to be somewhat higher if somebody recalculated this today. The brackets would also need tuning, maybe $15,000 for the poor and $25,000 for the middle class.

One problem with your theory is that, unlike the FairTax, it hasn’t been researched. You mention that a set range of income has not been set. The FairTax has been researched for more than a decade and is ready to go, with legislation already in the House.

Another problem is that your plan’s burden of taxes shifts from one class to another. We don’t need class warfare. The FairTax only shifts the burden from current taxpayers to current non-taxpayers, which increases the tax base significantly. Virtually all current taxpayers will benefit under the FairTax. An increased tax base comes from prostitutes, drug dealing income-earners, tourists, illegal aliens (millions of people that use our federal services now), and tax cheaters.

I also need to add that a system like this focuses on "family values". A truly fair system would not be based on family size; after all, it is my decision to have 3 or 4 children, so why should retired people or people without kids pay more in taxes than I do?

I would agree. I hate it when welfare recipients have children just to get more money from the government. The current income tax system with child credits is exactly like you say. The FairTax (I guess similar to the current system), however is based on the logic that more goods and services are needed for each individual, child or adult. Because the monthly prebate is given to everybody, it covers the tax on essential goods and services for one person. The tax system is not based on family size; it is based on individuals that just happened to be in a single family.

To add some more comments, I would suggest that everybody read about the bill at and, and contact your congressperson in support of the bill.


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