FairTax, Flawed Tax. A Fisking

On August 25, the Wall Street Journal published an op-ed piece by former deputy assistant secretary of the Treasury, Bruce Bartlett. The piece, entitled "FairTax, Flawed Tax," was absolutely stunning in how utterly wrong it was about nearly every point it made about the FairTax. I've seen a few people offer corrections to parts of it here and there in the blogosphere and in the letters to the editor of the WSJ but no comprehensive point-by-point rebuttal, otherwise known as a fisking. If anything cries out for a thorough fisking, this is it and seeing as nobody else seems to be getting around to it and I've never done one before, I thought I'd have a go. So, here is my attempt. The article's original text is in block-quoted text. My rebuttal is in normal text.

"Former Arkansas Gov. Mike Huckabee's unexpectedly strong second-place showing in the recent Iowa Republican straw poll is widely attributed to his support for the FairTax.

For those who never heard about it, the FairTax is a national retail sales tax that would replace the entire current federal tax system. It was originally devised by the Church of Scientology in the early 1990s as a way to get rid of the Internal Revenue Service, with which the church was then at war (at the time the IRS refused to recognize it as a legitimate religion). The Scientologists' idea was that since almost all states have sales taxes, replacing federal taxes with the same sort of tax would allow them to collect the federal government's revenue and thereby get rid of their hated enemy, the IRS."

No quibbles about the first paragraph. He's just setting up the argument to follow. As we will see, it is largely a series of straw man arguments.

The FairTax has nothing whatsoever to do with the Church of Scientology. As Neal Boortz, co-author of The FairTax Book explains, Mr. Bartlett is confusing the group that has championed the FairTax, Americans for Fair Taxation (AFFT) with another group, Citizens for an Alternative Tax System, which actually was a Scientology front group. Neal has plenty of supporting links and background in his post that I won't reiterate here (a fisking should be succinct!). On with the op-ed:

"Rep. John Linder (R., Ga.) and Sen. Saxby Chambliss (R., Ga.) have introduced legislation (H.R. 25/S. 1025) to implement the FairTax. They assert that a rate of 23% would be sufficient to replace federal individual and corporate income taxes as well as payroll and estate taxes. Mr. Linder's Web site claims that U.S. gross domestic product will rise 10.5% the first year after enactment, exports will grow by 26%, and real investment spending will increase an astonishing 76%."

So far so good, this is just a recitation of claims the sponsors of the FairTax Bill are making for it.

"In reality, the FairTax rate is not 23%. Messrs. Linder and Chambliss get this figure by calculating the tax as if it were already incorporated into the price of goods and services. (This is known as the tax-inclusive rate.) Calculating it the conventional way that every other sales tax is calculated, with the tax on top of the price, yields a rate of 30%. (This is called the tax-exclusive rate.)"

Now he's setting himself up to completely misconstrue how to compare how pricing and taxes work under the FairTax to how things work under our present tax system by making an apples to rocks comparison between an income tax and a consumption tax system.

"The distinction is confusing, but think of it this way. If a product costs $1 at retail, the FairTax adds 30%, for a total of $1.30. Since the 30-cent tax is 23% of $1.30, FairTax supporters say the rate is 23% rather than 30%."

He's right. It is confusing and he demonstrated as much by getting confused himself. AFFT tries to uses the common denominator of the dollar spent as a baseline. He is missing a critical step in the process of understanding this (did he actually do any homework on it?). In mathematics, in order to compare two fractions you must first find the lowest common denominator. In this case, Mr. Bartlett fails to do that by comparing $1 at retail now with $1 at retail after enactment of the FairTax. To make a valid comparison you first have to account for the effect of income taxes on the $1 under the current system and how and when you apply it. AFFT claims a 23% tax rate and Mr. Bartlett and the other critics claim a 30% rate. AFFT is using the $1 of spending as the measurement baseline. The critics move the goal post. Under AFFT's example, the $1 spent includes the tax. The real price of the good is $0.77 and the tax is $0.23. This is 30% of the $0.77, and where the critics come up with that figure, but 23% of the total $1 spent. As 23%, it's an inclusive rate (included in the $1) but as 30% it's an exclusive rate (added to the $0.77). In a sense, both sides are right but are measuring against a different denominator. I don't know that AFFT necessarily helps its case by doing it this way. But as proposed, the FairTax will be adminsitered as an inclusive 23% tax. I prefer to look at the impact of the removal of embedded taxes on prices. i.e., more in the tax-exclusive mode, as easier to understand.

Currently, the corporate tax rate averages 34%, which is embedded in that $1 retail price and levied on the profit left after deducting costs. As a percentage of the retail price, it varies between about 15% and 26%, averaging out to around 22%. When a company works out the retail price of a good, it doesn't start at the $1, start deducting costs and hope there's something left when it's done. It starts with the profit (the shareholder's compensation for putting their capital at risk) it wants to make after all costs, including taxes, are accounted for. From there it starts adding back the cost of labor, materials, etc., and when all of that is accounted for then you have your $1 retail price. All those other costs, by the way, have taxes on the suppliers of the material and labor embedded in them too. I realize that competition in the market affects the ability of the company to actually get either the $1 price or the profit the shareholders desire but for purposes of this exercise, we'll let that go for the time being. The central point is that we need to be able to make an apples-to-apples comparison and Mr. Bartlett isn't doing it.

AFFT and the FairTax sponsors in Congress assert that with elimination of this embedded income tax, retail prices for goods and services will decrease. You may ask why retailers and service providers wouldn't just hold prices where they are and pocket the amount they no longer have to fork over to the government. The answer is that the marketplace, aka competition, will see to that. So how does it work then you ask? I'll borrow the comparison table from the AFFT article linked above:

	Income Tax System		Spending Tax System
	Joe	Government	Joe	Government
Receives Gross Pay	$125		$125
Pays Tax On Income	-$25	+$25	$0	$0
Has Left To Spend	$100		$125
Pays Tax On Spending	$0		-$25	+$25
Amount of Goods Purchased	$100		$100*
Taxes As % of Pay	20%		20%
Taxes As % of Spending	25%		25%

*includes the $25 tax.

In this example, Citizen Joe earns $125. Under the income tax system, he pays $25 on that income right off the top (This represents 20% of his income and is a tax-inclusive rate). In fact it's withheld from his paycheck and he never even gets his hands on it. He has $100 left to spend and if he spends all of it then the $25 tax represents 25% of his spending but 20% of his gross pay. Under the FairTax, Citizen Joe earns $125 in income and keeps all of it. He doesn't even file a tax return. If he goes and buys $100 worth of goods and services, he still pays $25 tax but it's based on the value of the goods and services purchased and paid only when he makes that purchase. If he decides he doesn't really need that HDTV right now, he doesn't pay it. The $25 is still 20% when compared to income but 25% when compared to spending. In other words, it's the same thing, a wash and it doesn't matter whether you call it inclusive or exclusive. In order to make an apples-to-apples comparison, AFFT quotes it both ways.

The difference this table does not take into account is that under the FairTax, the $100 will buy a lot more goods and services because the retail price will have come down by the amount of embedded income tax the retailer/service provider no longer has to account for. Let us proceed.

We get into a series of misunderstandings and/or misrepresentations here, basically all variations on the same basic error:

"This is only the beginning of the deceptions in the FairTax. Under the Linder-Chambliss bill, the federal government would have to pay taxes to itself on all of its purchases of goods and services. Thus if the Defense Department buys a tank that now costs $1 million, the manufacturer would have to add the FairTax and send it to the Treasury Department. The tank would then cost the federal government $300,000 more than it does today, but its tax collection will also be $300,000 higher.

This legerdemain is done solely to make revenues under the FairTax seem larger than they really are, so that its supporters can claim that it is revenue-neutral. But for the government to afford to purchase the same goods and services, it would have to raise spending by the amount of the tax it pays to itself. The FairTax rate, however, is not high enough to finance the higher spending it imposes. Therefore the proposal only works if federal purchases are cut by 30%, close to $300 billion -- the increased cost imposed by the FairTax."

The tank that now costs $1 million doesn't cost $1 million any more because the manufacturer no longer has to include the income taxes he'd pay in its pricing calculations. The price comes down accordingly and the government ends up paying the same $1 million. Uncle Sam pays the 30% now and it comes right back to his own pocket. It will be no different after the FairTax is enacted. The difference is transparency.

"Similarly, state and local governments would have to pay the FairTax on most of their purchases. This means that it is partly financed by higher state and local taxes. It's also worth remembering that state sales taxes now average 6%, which means that the total tax rate will be 36% on retail sales."

Most states will probably want to revise their tax rules but if they follow the FairTax lead and tax all goods and services, they will probably end up reducing rates because they will have a broader base of taxable items. Even if they don't, let's remember that Mr. Bartlett keeps trying to tell us that after the Fairtax the $1 spent will be $1.30, i.e., tax exclusive. Wrong, it will still be $1 spent, inclusive of the FairTax. So, even if the states do nothing and levy taxes on the $1 spent as they do now, nothing changes.

"State sales taxes have long exempted all but a few services because of the enormous difficulty in taxing intangibles. But the FairTax would apply to 100% of services, including medical care, thus increasing their cost by 30%. No state comes close to taxing services so broadly."

Service providers set their prices in the same way as any other business, as described above. Your doctor figures in her estimated taxes when setting her service rates so that when those and all her other costs (like office staff and malpractice insurance premiums) are taken into account she gets the return she needs to make all the agro of putting up with health insurance companies, patients who won't do as they're told, lawyers, etc., worth it. Under the FairTax, she just figures out her fees without having to account for the income tax (or the cost of figuring it out), tacks on the FairTax and sends it on in. Whether the tax is embedded in the fee, as it is with the income tax, or transparent, as it is with the FairTax the result is neutral.

"Consumers would also find themselves taxed on newly constructed homes. Imagine paying 30% to the federal government on top of the purchase price of your next house."

He's just compounding his previous error here. One more time; with the embedded tax taken out of the price, the price quoted for a given size of home will decrease by the amount of the embedded tax. Paying the FairTax on top of the newly lowered cost of the home gets you right back to the price you would have paid under the current system.

"Since sales taxes are regressive -- taking more in percentage terms from the incomes of the poor and middle class than the rich -- some provision is needed to prevent a vast increase in taxation on the nonwealthy. The FairTax does this by sending monthly checks to every household based on income."

The regressivity is dealt with by exempting everyone on the estimated expenditures for the basic necessities of every family up to the poverty level.

"Aside from the incredible complexity and intrusiveness of tracking every American's monthly income -- and creating a de facto national welfare program -- the FairTax does not include the cost of this rebate in the tax rate. As noted earlier, the FairTax is designed only to match current revenues and does not cover any increased spending that it may require. Since the rebate will cost at least $600 billion the first year, either federal discretionary spending would have to be cut by 60% or the rate would have to be five percentage points higher than advertised."

Once again Mr. Bartlett shows every indication of never laid eyes on the FairTax Bill. The FairTax rebate feature, (actually a "prebate", it comes in advance) does not rely on tracking anybody's income. It is paid to everyone, regardless of income, based on a formula taking into account the number of persons in the household and the current poverty level. Every head of household will receive a check based on the sales tax that would be payable on what the family is estimated to spend on goods and services. When they buy those goods and services, the Treasury just gets it back. The family must send in an annual registration with the names and social security numbers of each family member, information they already provide on their tax return anyway. There is no income reporting and no income test. As to the second paragraph, wrong again Mr. Bartlett. The 23% FairTax rate AFFT has put forward accounts for all of this. It is revenue neutral even after the rebate.

"Rejecting all the tricks of FairTax supporters and calculating the tax rate honestly -- by including the higher spending that it mandates and by being realistic about what could actually be taxed -- professional revenue estimators have always concluded that a national retail sales tax would have to be much, much higher than 23%."

I think we've pretty well established by now that the FairTax would not drive higher spending at all. Mr. Bartlett never did catch on to the concept that without income taxes embedded in the price of everything, prices would go down.

"A 2000 estimate by Congress's Joint Committee on Taxation found the tax-inclusive rate would have to be 36% and the tax-exclusive rate would be 57%. In 2005, the U.S. Treasury Department calculated that a tax-exclusive rate of 34% would be needed just to replace the income tax, leaving the payroll tax in place. But if evasion were high then the rate might have to rise to 49%. If the FairTax were only able to cover the limited sales tax base of a typical state, then a rate of 64% would be required (89% with high evasion)."

Now he's just throwing out large random numbers to scare you, FUD (Fear, Uncertainty and Doubt) if you prefer. This is a similar tactic to his assertion in the second paragraph of the article that the whole thing is a devious Scientologist plot. He's trying to discredit the FairTax by associating it with some, to put it mildly, out-of-the-mainstream cult religion. Evasion will be pretty difficult because any business selling to a consumer is responsible for remitting the tax, even if it fails to collect it. Also, evasion is high now due to somewhat elastic definitions of what constitutes income and a nearly impossible to understand tax code. There's nowhere to hide under the FairTax.

"I've emphasized problems with the FairTax rate because public opinion polls have long shown that support for flat-rate tax reforms is extremely sensitive to the proposed rate, with support dropping off sharply at a rate higher than 23%. But there are also massive technical and administrative problems with collecting all federal taxes at the checkout counter and relying entirely on state governments to collect the federal government's revenue."

Nonsense. Retailers deal with this everyday right now. In my neck of the woods, there are as many different sales tax rates as there are towns. There is a basic state sales tax rate then various local option add-ons. Program it into the POS system like you do every other tax, or temporary on-sale discount price. Done. Let's move on.

"Among the problems: What possible incentive would the states have to be vigorous in their federal tax collections? What is to stop them from slacking off and giving their citizens a tax cut at federal expense? What about states with no sales taxes? What's to stop people from bypassing retail outlets and buying their goods from producers or at wholesale, tax-free?"

Taking the last point first, retailers already report gross receipts to the states that have an income tax on a monthly basis and remit the sales taxes collected. States that don't have a sales tax (there are only five) may either contract with another state to collect it on their behalf or they may contract with the federal government to do it or they can do nothing and the federal government will administer it directly.

Slacking off? States levy their own taxes because they need to pay for things their citizens want that the federal government doesn't provide. Mr. Bartlett seems to be implying that the federal government will automatically pick up the slack if the states reduce their taxes. If the states reduce their own taxes it will mean they can't provide the services those taxes were funding. That is a matter between the state government and the citizens of that state. The federal government doesn't come into it at all.

"Perhaps the biggest deception in the FairTax, however, is its promise to relieve individuals from having to file income tax returns, keep extensive financial records and potentially suffer audits. Judging by the emphasis FairTax supporters place on the idea of making April 15 just another day, this seems to be a major selling point for their proposal."

The only information an individual or family would need to provide is the names and social security numbers of the family members so that the Social Security Administration knows a) who to send the prebate check to and b) how much it should be made out for. The only consequence for not doing this is that you wouldn't get a check.

"Yet all but six states now have state income taxes. So unless one lives in one of those states, this promise is an empty one indeed. In short, the FairTax is too good to be true, and voters should not take seriously any candidate who supports it."

The person that should not be taken seriously is the person who either didn't do his homework or is intentionally misrepresenting the FairTax and how it would work. I'd say Mr. Bartlett's op-ed bears all the hallmarks of having been written for him by someone else, someone with a vested interest in preventing the FairTax from ever being enacted, which would be just about anyone in Washington DC who benefits from the current system where the tax code is used to pick winners and losers, and makes possible the incredible corruption rampant in the US Congress today. If it were my name going in the byline of this article, I'd have made very sure that what was being put forth in my name was accurate and true. Almost none of this article is.