James Leroy Wilson's blog

Saturday, August 02, 2008

Does the Fair Tax Encourage Higher Taxes and Big Government?

The Fair Tax would abolish our personal and corporate income tax codes and replace them with a consumption or "sales" tax on all new goods and services. At the same time, however, the program distributes monthly tax rebates in advance, or "prebates" equal to the poverty line multiplied by the Fair Tax tax rate. This essentially means that people making below the poverty line will not have to pay taxes, as the tax they pay at the sales counter is more than made up for by what they have received in their prebate check. This is intended to make the Fair Tax "progressive." The more you spend/consume, the more you pay in taxes.

There are several reasons the tax is appealing. Among them:

1. Corporate income taxes are abolished. The USA will therefore attract businesses, not drive them away.
2. Income taxes are abolished. Nobody will have to pay taxes on what they earn or save, only on what they spend. Since necessities will usually be paid for by the prebate check, it amounts to a "voluntary" tax on "extras" or luxuries: the more you spend, the more taxes you pay; the more you save, the less in taxes you pay.
3. Following on point #2, the Fair Tax may encourage real wealth-building, as opposed to debt-based, economically-destructive "economic growth," as I discuss in my piece "Environmentalism and the Fair Tax."
4. Most states already have a sales-tax collection infrastructure the Fair Tax would piggy-back on, and states and businesses would be reimbursed for collecting the tax.

And there are other potential benefits I won't get into detail here, such as removing the costs of tax compliance from the production process, which reduces the cost of goods to the consumer.

So what's the problem?

Maybe there isn't any, but this statement from FairTax.org is troubling and needs clarification:
"All valid Social Security cardholders who are U.S. residents receive a monthly prebate equivalent to the FairTax paid on essential goods and services, also known as the poverty level expenditures. The prebate is paid in advance, in equal installments each month."
What this means is, if the FairTax rate is 23% (which is the current proposal), then each household would get a monthly government check of 23% of poverty-line income for a household of that size. If you make less than the poverty line, you get this amount, which means your (non-credit card) purchases will in essence be partially subsidized by the government. And if you make a million dollars, you get the same amount. (See the chart here.) So if you make a million but spend only up to your household size's poverty-line income, you will essentially pay no tax.

"Fair" enough, but here's the rub: under the Fair Tax, all households that make up to double the poverty line will be in favor of tax-rate increases, because this will increase their prebate checks. And they will be opposed to any tax-rate cuts, because they will lose money on the deal.

A family with two parents and two children have a $28,000 poverty line, no matter how much they actually make. At 23%, this means they will get $6,440 a year in prebate checks, or $537 per month. What if the federal government begins to downsize, budget surpluses are created, and therefore the tax rate falls to 20%? This means the tax prebate rate will fall accordingly. So if the Smith family makes and spends exactly the $28,000 poverty line of their household, instead of getting $6,440 a year in prebates, they will get $5,600. This tax "cut" will essentially cost them $840 per year.

In other words, tax cuts will punish the poor, and indeed everyone who makes up to twice the poverty line, though in ever-smaller amounts. The Smith family would have to make and spend twice the poverty line for the falling tax rate to have no effect on them, though in decreasing amounts.

For if the Smiths make and spend $55,000, the tax "cut" would cost them. At 23%, they would receive $6,440 and spend $6,210 in taxes - a $230 difference; at 20%, they would receive $5,600 and spend $5,400 - a $200 difference. The "cut" will cost them $30. That seems small, but what we are saying is that this 3% tax cut will cost them. Only at $56,000 would they come out even, and only if they made and spend more than that would they come out ahead.

Of course, not every household is a family with two parents and two kids, but median household income is $45,000. It's safe to say that more than half of all U.S. households make less than double the poverty line, and under the Fair Tax they would stand to lose from tax-rate/prebate cuts, and stand to gain from tax-rate/prebate increases.

Heck, they'd benefit most of all from a "Fair Tax"/prebate rate of 100%! For the Smiths, this would mean everything they spend up to the poverty line would be paid for by the government. Unless they make more than twice the poverty line, they would come out ahead on this deal.

Their incentive would be to increase tax revenues, which would then be spent on . . . government! More prisons for non-violent "felons," a bigger military, higher-paid bureaucrats, more special favors, more pork-barrel spending, etc. And, especially, more on their precious "prebate!"

I raised this concern with a libertarian Fair-Tax proponent a while ago. He didn't see why the "prebate" rate had to be connected with the tax rate. Although he didn't use the words, in his view the "prebate" would work essentially as a welfare program or "citizens dividend," and his goal was to use the Fair Tax to apply downsizing pressure on the federal government. That is, keep the prebate at 23% of one's household's poverty-line income, and the raise or lower the actual tax rate based on need. That sounds like an imperfect but reasonable plan, because it will encourage even the poor to desire government tax rates and spending to decrease, so that the federal government pays for the "prebate" program, and very little else.

I like that idea. But honesty requires that this means separating the "prebate" rate from the Fair Tax rate, and calling the prebate what it is: a universal welfare program that provides monthly payments of 23% of the poverty line to all households. Provided that is paid for, the Fair Tax rate could rise above or below 23% according to need.

That is something I could support in a non-ideal world. But a FairTax/prebate scheme that provides incentives for much if not most of the middle class to call for tax hikes and more government? I can't get on that bandwagon. If I am mistaken about this, I don't think it's really my mistake but an absence of clarification on the FairTax.org site. If the Fair Tax makes it profitable for the middle and lower classes who constitute the majority of the American people to support tax rate cuts, then I'm for it. If it instead encourages them to increase Fair Tax rates, I'm against it.


  1. Anonymous9:17 AM PDT

    This is quite a stretch. If the govenment downsizes it will need less revenue, therefore the tax rate could fall. This would offset any decrease in the prebate. In any case the benefits of the FairTax far out weigh our current system. The FairTax by no means brings about Utopia. I for one want to become one of the wealthy. The FairTax will help by all standards. That's what our country is all about.

  2. Anonymous7:34 AM PDT

    First, nobody would loose anything from a drop in the Fair tax rate/prebate amount because the difference in the prebate would be exactly the same as what we would save at the register- for spending at the poverty level. If you spend more than the poverty level, you would save more from a tax cut than the difference in the prebate.

    Second, the prebate is NOT a government subsidy or a walfare check. It's a tax refund. The less taxes we pay at the register, the less the government needs to refund back to us.

  3. For consumers to benefit from tax rate cuts, retail prices would have to fall accordingly with a drop in the tax. That is a dubious proposition. If the people were willing to pay $100 for an item which includes a 23% tax, is unlikely the price will fall if the tax rate falls to 22% or lower; the price indicates the level the people are willing to pay regardless of tax. Sellers would just keep the difference as profit.

    Prices will only go down if people, having lower amounts in their prebate checks, refuse to pay $100 for the item anymore. But that adjustment will take time. If prices do not fall on necessities, the poor would be screwed by Fair Tax cuts.

  4. Anonymous5:54 PM PDT

    This comment has been removed by a blog administrator.

  5. Anonymous8:04 PM PDT

    Also note, if the tax rate is reduced and prices remain constant, it only means pre-tax prices have increased by the same percentage. At 23%, $77 out of $100 pays for the goods and $23 pays for the tax. At 20%, $80 out of $100 pays for the goods and $20 pays for the tax. The total cost for consumers remains the same. $100 buys the same amount of goods and services regardless of what the tax rate is. The only difference is how much goes to the retailer vs the government.

  6. Anonymous8:49 PM PST

    I think zod and Anonymous covered the concern of the writer. The website for the fairtax.org is always being updated please go there and read up on it. The fair tax will bring 10 trillon dollors to the us and that is a rescue plan the fed cannot barrow or print.
    Just to comment on the post from James Leroy Wilson. Compation will bring lower prices that you can count on. And if you see a business that dosn't call them out open and be there direct compation. Its not that hard to do when theres no payroll taxes to do for your employes. If you pay $15 an hour thats what there check will be for NO withholdings under the fairtax!!!!! :)

  7. Anonymous10:26 AM PST

    If you earn and spend $1000 a month, you'll be paying $230 in fair tax. That means you'd only be buying $770 worth of goods. If I then start mailing you rebate checks for $230 on the first of each month, I'm not raising your income to $1230 rather I'm raising it to $1000- same as you would have if you weren't paying the tax.

    The only reason anyone would think that the poor would get screwed directly by a cut in the tax/rebate rate is if they're making the mistake of counting the rebate as extra income.

    Cutting the tax rate only increases incomes for retailers. If retailers decide not to immediately cut prices by the same percentage, they would screw the poor, not the fair tax.