This paper analyzes the Fair Tax Act of 2003, a legislative proposal to abolish federal income and payroll taxes and replace them with a national retail sales tax administered by the states. The paper systematically addresses common objections to the plan, arguing that fears about inflation, reduced economic growth, harm to low-income Americans, and government revenue shortfalls are unfounded. Drawing on research from the Cato Institute and other economists, the paper contends that embedded business taxes already inflate consumer prices, that compliance costs would drop sharply, that a monthly poverty-level rebate would protect low-income households, and that a 23% sales tax rate would generate sufficient federal revenue.
The purpose of the proposed Fair Tax Act of 2003 is "to promote freedom, fairness and economic opportunity by repealing the income tax and other taxes, abolishing the Internal Revenue Service, and enacting a national sales tax to be administered primarily by the states" (Boortz, 2003). Unfortunately, many beliefs about the proposed legislation are simply not true. Fears range from inflation and lower economic growth to unpredictable revenue shortfalls and unfairness to the poor. This paper explains that these concerns are not only unfounded, but that the exact opposite is true in most instances.
One common misperception of the Fair Tax Act is that it will fuel inflation and dramatically impact demand for goods with high price elasticities. However, the sales tax would likely have minimal impact on prices. This is because embedded taxes already exist on all products and services purchased at the retail level, estimated at approximately twenty-two percent of their costs (Boortz, 2003). This twenty-two percent represents the payroll taxes and corporate business and income taxes paid by manufacturers, shippers, wholesalers, merchandisers, and retailers. With regard to prices, the Fair Tax Act would essentially replace embedded taxes with an equivalent direct sales tax, producing no significant change in the prices of goods and services for the consumer.
Any change in prices would indirectly result from the lower interest rates the Fair Tax Act is expected to produce. Economic researchers predict that interest rates would drop toward the current tax-free interest rate as the tax differential between pre-tax and after-tax rates of return was removed (Burton and Mastromarco, 1997). It is difficult to estimate exactly how much interest rates would fall, because demand for credit would also rise given the increased after-tax rate of return on capital investment under a national sales tax approach. The standard prediction is a 200 basis-point decline in interest rates. This would lower federal borrowing costs by as much as $75 billion annually and make it cheaper for individuals and businesses to borrow money, likely spurring increased business investment.
Some fear that a consumption-based tax would reduce overall demand for goods and services, thereby harming businesses and the country's growth. Although savings and investment may increase while domestic consumption falls, many other factors must be considered in the productivity equation. In 1995, businesses and individuals in the United States spent more than $150 billion to comply with the federal income tax system (Burton and Mastromarco, 1997). Compliance costs averaged an estimated twenty to fifty percent of the total revenue raised by the tax system, and between 1.9 and 4.1% of Gross Domestic Product. Small businesses bore a disproportionate share of this burden, enduring compliance costs 3.8 times the tax actually collected from them.
By replacing income taxes with a national sales tax, compliance costs for businesses and workers would fall by more than ninety percent. This means the Fair Tax Act would remove the cost of corporate taxes and compliance costs from the price of American exports, placing them on a level playing field with foreign competitors (Thumbnail sketch of the FairTax). Lower prices would increase demand for exports from the United States, thereby boosting job creation in American manufacturing sectors.
"Sales tax attracts foreign capital to the US"
"Poverty-level rebate makes FairTax progressive"
"23% rate replaces income tax revenue fully"
The Fair Tax proposal represents a solid plan to replace federal income and payroll taxes, a system that is expensive for businesses and individuals to comply with and costly for the government to enforce. By integrating features such as a progressive national retail sales tax, a rate high enough to ensure dollar-for-dollar revenue replacement, and a rebate ensuring that no American pays federal taxes up to the poverty level, the Fair Tax Act wisely avoids the potential pitfalls of a poorly implemented national sales tax (Thumbnail sketch of the FairTax). Unfortunately, public perception is such that these features remain relatively unknown, generating considerable anxiety that may seriously limit the chances of the Act ever being passed.
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