The “Fair Fax” Just Ain’t Fair

Reading Jon Wakefield’s op-ed in Monday’s TD, “Tax Code Change Would Benefit All” (http://www.inrich.com/cva/ric/opinion/oped.apx.-content-articles-RTD-2007-12-17-0062.html) might lead you to believe that he had discovered Nirvana. Mr. Wakefield has apparently become a true believer in the so-called “Fair Tax” proposal. In his article he spits back the arguments made by Americans For Fair Taxation on their website (http://www.fairtax.org ). And it sure is a compelling argument. The Fair Tax proposal would repeal all federal income-based taxes and replace them with a 23% federal sales tax on all purchases made in the United States. It would eliminate everybody’s nemesis, the Internal Revenue Service, and would convert April 15 into just another beautiful spring day. No more loopholes, no more tax cheating, no more expensive tax lawyers or CPAs, no more H&R Block commercials all winter, no more anxiety-producing tax forms, no more keeping of receipts. It would truly be a taxpayer’s heaven. But, would it be fair?

A tax system should have only one purpose—raising revenue for the government to carry out the functions that the representatives of the citizens have assigned to it. In addition, under the theory that those who accumulate the most wealth derive the most benefit from the country or state, the tax system should be progressive. Those who earn the most should pay a higher percentage of their income in taxes than do those who earn the least. Finally, a tax system must not only be fair, it must also be perceived as fair by the citizens.

Under these standards, our current tax system ranks low. First, rather than being only a mechanism for raising revenue, our current system is used continuously by the government as a mechanism for controlling the behavior of individuals and corporations in our society. When the government wishes to encourage certain activities it offers tax incentives to those who abide by those wishes. Likewise, when the government wishes to discourage certain behaviors it places tax costs on those behaviors. This management of our society by use of the tax code is probably as old as the code itself and has been used by both Republican and Democratic governments. It explains why the Internal Revenue Code is thousands of pages rather than only a few pages long.

Second, our tax system is unfair and is perceived by most citizens as unfair. It is set up as a yearly game between the citizens and the IRS. The objective of the IRS in this game is to maximize the amount of taxes each citizen pays. The objective of each citizen is to minimize the amount of taxes he, she or it pays. The rules of the game are tens of thousands of pages long, and those who can afford expensive CPAs or tax lawyers who have mastered those rules are going to play the game much better than those who can’t. A tax system in which the amount you pay depends on how clever you and your tax preparer are is not a fair system. And it cannot be perceived as fair. Many taxpayers get the feeling that somehow they are paying more than their fair share of taxes. They fear that their neighbor has discovered a hidden deduction that they don’t know about. Or they fear the dreaded audit in which the IRS will discover that they have claimed more in deductions than the law allows.

The unfairness of the system extends into its progressiveness. Although our tax system is, on its face, progressive, the presence of so many loopholes and deductions and credits and shelters reduces the tax burden on those with higher incomes. The result is that in many cases individuals with high incomes may be paying a lesser percentage of that income in taxes than do individuals with lower incomes.

Look, I would love to see our present system replaced with a fair tax system. I would love to see the IRS disappear. I would love to eliminate the anxiety I suffer every year in playing the 1040 game. However, I see no purpose in replacing one unfair system with another unfair one.

By their very nature sales taxes are not progressive. In a state with a 5% sales tax, everybody who makes a purchase in the state pays the same 5% tax regardless of their income. Further, since lower income families spend a far higher percentage of their incomes on subsistence items such as housing, clothing, food or fuel, the 5% percent tax they pay on each purchase is more onerous. The Fair Tax proponents are, of course, aware of this inequity. They have tried to deal with it by creating a mechanism called the “prebate”.

Under the Fair Tax prebate, the Social Security Administration (you read me right) would mail a check to every household in the United States each month. The purpose of this prebate would be to compensate each household, in advance, for the amount of sales tax it pays on subsistence. The Fair Taxers have established an “annual consumption allowance” for each household that varies with the number of persons residing in that household. For example, for 2007 had the Fair Tax been in effect, the consumption allowance for a single adult household with three children would have been $20,650. For a two adult household with one child the allowance would have been $23,900. The sales tax that would apply on the amount of this allowance is calculated and constitutes the annual prebate. One twelfth of this amount would be sent to the household each month--$396 for the first household above, $458 for the second household. (If this sounds complicated, blame the Fair Taxers, not me).

The Fair Tax proponents prepared a chart that demonstrates that with the addition of the prebate feature the federal sales tax would actually be progressive. There are two problems with the chart. The first is the assumption that a household’s annual income and its annual spending will be the same. The second is the calculation of the tax rate as a percentage of the amount the household spends rather than as a percentage of the household’s income. If we look at a hypothetical real world (how’s that for an oxymoron), however, things are not as fair as they seem.

Let’s look at some examples:

The Smiths have an annual income of $50,000. They would like to put away part of their income in a savings account. However, with the cost of living in their city being so high, they are unable to save and end up spending all their income. The 23% federal sales tax they pay on their $50,000 consumption amounts to $11,500. Based on the size of the Smith household, they receive a prebate of $5,497. Therefore, the actual federal tax they will have paid is $6,003. As a percentage of their income, they are paying a tax of about 12%.

At the other end (but not the far end) of the income spectrum are the Jones. The Jones household has an annual income of $1,000,000. Because the Jones are not conspicuous consumers they spend only $200,000 and are able to save or invest $800,000. The 23% federal tax they pay on their consumption amounts to $46,000. Like the Smiths, the Jones receive a prebate of $5,497. The actual federal tax paid by the Jones is therefore $40,503. As a percentage of the household’s annual income, the Jones are paying a tax of a whopping 4%.

Let’s review. Under the so-called Fair Tax, the Smiths with an income of $50,000 would pay a 12% tax. The fortunate Jones, however, with an income of $1,000,000, would pay a tax of only 4%. I don’t know about you, but to me this is not a fair tax.

Despite Mr. Wakefield’s assertion, the Fair Tax plan also has its loopholes. If our Jones household wishes to be less frugal they may choose to buy a $500,000 yacht with the amount of their income they don’t need to live on. If the Jones buy that yacht in Newport News, they will pay a federal sales tax of $115,000. However, if the Jones are smart (and I assume they are), they will buy their yacht from some boat yard in the Bahamas. They will then pay a federal sales tax of zero. And, this loophole does not only apply to the wealthy few. It is also available to those of us who live along the Canadian border. Why buy a $25,000 car in Detroit and pay $5,750 in federal tax on that purchase when you can go across the river to Windsor and buy your car without paying any federal tax.

I can discuss other unfairnesses that I have found in the “Fair Tax,” but this post is already much too long. When the Fair Taxers fix these inequities, I will be happy to support their proposal.