Is the Fair Tax Fair?

Is the Fair Tax Fair?
The word "taxes" is seen engraved at the headquarters of the Internal Revenue Service (IRS) in Washington, on May 10, 2021. Andrew Kelly/Reuters
Jeff Carter
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Rep. Earl Carter (R-Ga.) introduced a new tax proposal called the “fair tax.” Predictably, Democrats politicized the proposal. Sen. Catherine Masto (D-Nev.), for example, posted a typically uninformed statement on Twitter:

“On average, Nevadans are paying nearly $6 for a carton of eggs. If House Republicans passed their 30 percent national sales tax proposal, our families would have to pay over $7.80 per dozen. That’s ridiculous. We need to lower costs, not raise them.”

The first thing you need to know about Ms. Masto’s logic is that it is woefully flawed. She applied to the issue accounting principles instead of the principles of economics. This misuse of logic can cause you to make bad decisions. Her statement ignores the fact that the price of eggs isn’t fixed. It’s derived from supply and demand in the market. It’s also derived from regulations that are passed that affect raising chickens and getting their eggs to market—and a massive outbreak of avian flu. I wouldn’t rely on Senator Masto for financial or economic advice.

It’s clear our progressive tax system is broken. The very wealthy and corporations spend millions of dollars per year to avoid taxes. Interestingly, you don’t hear much about former President Donald Trump’s taxes anymore since everything he did was within current tax law.

The proposed fair tax eliminates personal taxes, capital gains taxes, alternative minimum taxes, corporate taxes, estate and gift taxes, payroll taxes, and eliminates the entire Internal Revenue Service. It replaces them with a national sales tax. Business investment is exempt, so it is a tax on what you consume. If you are poor, each household would receive a monthly check so that purchases up to the poverty line are not taxed. The United States would have to repeal the 16th Amendment to institute the fair tax. The tax rate being proposed is tax inclusive rate of 23 percent which is a tax exclusive rate of 29.8 percent. Either way, it sounds like a lot!

To understand the difference between the tax inclusive rate and the tax exclusive rate, here is an example. Suppose an item costs $100 before tax and is subject to a $30 sales tax. The tax-exclusive tax rate would be 30 percent, as the tax is 30 percent of the pretax selling price. The tax-inclusive rate would be about 23 percent, which is obtained by dividing the $30 tax by the total cost to the consumer ($100 + $30). The difference is whether or not the tax paid is included in the denominator when calculating the tax rate. The tax-inclusive rate is always lower than the tax-exclusive rate. The difference increases as rates rise.

Instead of the spin and politics, let’s look at what the fair tax would actually look like for a family that made $100,000 per year. It’s hard to be exact because we don’t know the real deductions of interest, charitable contributions, and other potential decreases of gross income. But we have to start somewhere. So we start:
  • Gross annual salary: $100,000.00
  • Total federal income tax: $14,260
  • [insert state income tax]: [—]
  • Social Security tax: $6,200.00
  • Medicare: $1,450.00
  • Salary after tax and deductions: $78,090
That net salary is roughly $6,500 per month to cover your bills, save for retirement, put some rainy-day savings away, and take a vacation.
Under the fair tax, your net income would look like this. Plus, you don’t have to fill out federal taxes or pay an accountant to do it. April 15 becomes just another day on the calendar. So:
  • Gross annual salary: $100,000
  • [insert state income tax): [—]
  • Salary after tax and deductions: $100,000 (assuming you live in a zero percent tax state)
Your net salary is $8,333 per month, or an increase of 28.8 percent per month. Hence, if the fair tax were less than 28.8 percent, you’d be ahead of the game. The real question is how would the fair tax change not only your income but perhaps your behavior. If you are working and earn money, the fair tax should be a net benefit to you. Already, you can see how your behavior might change if you were taxed on consumption and not on income.

For example, retirees might be affected more than others. They have already paid tax on their savings, so they’d be taxed again. Implementation of the fair tax would have to recognize that and give them abatement. For other retirees, they might have saved in a 401(k) plan or a self-directed plan. They paid no tax on the gains in those plans, but under the fair tax plan, they will pay no tax when they pull the money out of them.

A national sales tax is a far more economically efficient way to tax people. The wealthy won’t be able to employ accountants and lawyers to figure out ways to avoid taxation.

In academic circles, they have debated the positives and negatives of implementing a fair tax for years. There is no doubt there would be some short-term events that might be very beneficial and some that might be challenging. One study projects that GDP growth would increase by 10.5 percent with the fair tax. Increased growth would increase employment, increase stock market value, raise standards of living, and salaries. Another academic article postulates that it would take 20–25 years for the full effect of the change in the tax code to work its way through the entire economy.

It is also important to note that the fair tax is different from a flat tax. A flat tax is a tax on income. The fair tax is a tax on consumption. When it comes to business decisions, and decisions you make for yourself as a consumer, the fair tax is more efficient than a flat tax. Not only is it more transparent and simpler, it also helps you make better choices for yourself. Here are important charts to consider when you think about the fair tax:

(Source: "The economic effects of the fair tax," Bhattarai et al., May 2016)
Source: "The economic effects of the fair tax," Bhattarai et al., May 2016

As you can see based on the academic models cited in the study, the poor and middle classes benefit greatly from the fair tax when compared to keeping our current system of taxation. Their standards of living and well-being rise at a faster rate than the wealthy. The very wealthy would benefit as well. Who would lose? Based on the cited academic models, people who made $50,000–75,000 would lose in the short run. However, in the long run, they’d benefit as well because their incomes would increase enough to cover the difference between the fair tax and current income taxes. A switch to the fair tax would be best for everyone in the entire country, regardless of income levels 20-25 years into the future because all incomes would rise—and capital stocks and business investment would rise as well.

The fun parlor game would be to envision how individual states and citizens would respond to the fair tax. Currently, we see flight from high-tax states to no income-low tax states. If all states followed suit and ended their income taxes, where would people choose to live?

Jeff Carter
Jeff Carter
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Jeff was an independent trader and member of the CME board, started Hyde Park Angels and West Loop Ventures in Chicago. He has an undergrad degree from the Gies College of Business at Illinois, and an MBA from Chicago Booth.
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