More on the Fair Tax

I missed a key point in my Fair Tax piece below. I imagined that any household that spent less than the poverty line would have an incentive to have a Fair Tax rate of 100%.

But I was wrong, because it is impossible for the Fair Tax rate to be 100%.

You see, in the Fair Tax plan, the tax rate is "tax-inclusive." What if a sales tax doubled the price of a good? In tax-exclusive terms, it would be a tax rate of 100%. But in "Fair Tax," tax-inclusive terms, it would be a tax rate of 50%. If the tax doubles the price from $20 to $40, Fair Tax logic would say that it's a 50% tax, because 20 is 50% of 40.

So what if the tax doubles the prices of goods and services? If the Smith Family makes and spends the poverty line of $28,000, and a 100% tax rate is imposed (or 50% in Fair Tax logic), their expenses would rise to $56,000, but their "prebate," being 50% of the poverty line, would be $14,000, leaving them with combined income and prebates totaling $42,000 and a $14,000 shortfall.

And if the Smiths were frugal and spent just $20,000 of their $28,000 income, and the Fair Tax doubled their expenses, their expenses would increase to $40,0000 and their income plus prebate would be $42,000. In other words, they would be saving $2,000 instead of the $8,000 they had been, amounting to a 75% tax on their savings.

Indeed, if taxes increased the price a thousandfold, under "Fair Tax" logic the tax rate would be 99.9%, and the "prebate" the Smiths would get would be 99.9% of the poverty line, or $27, 972, even as their expenses go up to $2 million.

Under the proposed Fair Tax, the price of a good would rise by 30%, but the tax "rate" would be 23%. In other words, the Smiths, if they spent all their $28,000 income, would see prices rise by 30% but their prebate would only be 23%, a shortfall of $1,960. If they were frugal and were spending just 77% of their income would they come out even on the deal, or come out ahead if they spent an even lower percentage.

It is probable that the repeal on all taxes on the cost of production will lower the cost of goods substantially, offsetting the Fair Tax taxes to some degree. This may have to be the case, because otherwise consumer purchasing will fall substantially and, contrary to claims, the Fair Tax would be quite regressive.

Indeed, this could only really fly if the poverty line was re-calculated to reflect the Fair Tax price inclusion. They should calculate what the poverty line would be if all costs of production would be removed, and then add 30%. Only at this new line would a 23% prebate actually make the Fair tax progressive.

And even so, my point from the last post still stands about how, once the Tax is in place, many people will be disadvantaged by tax rate cuts. The benefit of reduced taxes seems predicated on prices falling proportionally to tax rate cuts, benefiting consumers. But it is more than likely that prices will not fall, or at least not fall so far as the rate cut. Instead, sellers are more likeley to keep the difference as profit. So people making up to twice the poverty line will see their rebate checks fall, but not see a corresponding fall in prices. Therefore, it will still be in their interest to keep the tax as high as possible.

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.