Sometime during the next two years — we don’t yet know when — the House of Representatives will be hosting a public orgy. House Speaker Kevin McCarthy, R-Calif., has promised to hold a floor vote on the FairTax Act of 2023 (H.R. 25).
The promise was one of multiple concessions McCarthy made to the Freedom Caucus to become speaker. As we shall see, the FairTax is nothing if not an exuberant orgy of nontaxation.
Now, you may find yourself tempted by this fiscal seduction. There’s a visceral titillation at the thought of not paying income tax and never again dealing with the bureaucracy of the IRS. But caution is well advised. On close inspection, the FairTax is one apple that you don’t want to bite into.
In case you missed it, the main feature of the FairTax is that it would eliminate all federal income taxes, for both individuals and corporations. They’d be replaced with a 23 percent national sales tax, which would apply broadly to goods and services. The FairTax would also dissolve the IRS.
The proposal would eliminate all federal payroll taxes, as well — which are technically separate from income taxes, although they’re imposed on your wage earnings. That includes the payroll taxes that fund Social Security and Medicare. The proposal would also eliminate withholding taxes, estimated taxes, self-employment taxes, the estate and gift tax, and the alternative minimum tax. That’s a mother lode of repealing things.
The congressional debate over the FairTax will center on whether we want our federal government to be funded primarily by revenue mechanisms based on a person’s ability to pay. The salient point about an income tax is that it allows for a progressive rate structure, in which those of us with higher annual incomes pay more than folks with lower annual incomes. And by “more” I mean both in gross terms and proportionally. That’s what it means for a tax framework to be based on the ability to pay.
By contrast, a consumption tax is conceptually divorced from a person’s ability to pay. These taxes are inherently blind to the consumer’s economic status or income level. The amount of sales tax a billionaire pays when buying a six-pack of Coca-Cola is identical to the sales tax a homeless person pays on the same purchase. You might regard that outcome as fair, or you might regard it as a perversion of economic justice. Either way, that’s how all sales taxes operate.
Here are two other things to note about the FairTax.
First, it claims to be revenue neutral. That is, it intends to neither expand nor reduce the overall volume of tax receipts collected by the federal government each year. This point is highly disputable. Mathematically, there’s some rate at which a national sales tax would produce receipts equivalent to what we collect under current law. Nobody knows exactly what that rate is, and it might be a lot higher than the proposed figure of 23 percent.
On the matter of revenue, I suspect that proponents of the FairTax might derive pleasure if the resulting yield were less than that of all the taxes it would replace.
People in this camp have a track record of regarding diminished taxation as an effective constraint on government spending. You often hear advocates of small government comment on the need to “starve the beast.” Realistically, the FairTax is a platform for doing just that.
Second, the FairTax promises price stability. That is, the introduction of a national sales tax would not increase retail prices. The claim seems dubious, but here’s what they are getting at. Tucked away within every current retail price is an economic component that corresponds to the embedded costs of each party in the supply chain, from providers of raw materials to manufacturers to wholesalers and retailers. Some of those embedded costs are attributable to the current system of income and payroll taxes — both the taxes themselves and the accompanying compliance costs.
The theory goes that once Congress repeals all income and payroll taxes, the related embedded costs would simply disappear. They would vanish into the ether, by force of the invisible hand of the marketplace. Conveniently, their elimination almost perfectly offsets the effect of the new sales tax. Et voila, price stability.
For some sectors of the economy, removal of embedded costs is projected to more than compensate for the introduction of the new tax — such that prices of those goods and services will actually decline. Imagine that — a 23 percent retail sales tax that makes prices go down. It’s almost too good to be true. Hint, hint . . . It is.
As a self-professed tax policy nerd, I’ll admit that I retain a measure of fondness for the idea of a consumption tax. The concept has some intellectual merit. Compared with the income tax, consumption taxes are pro-growth because they functionally exempt savings, which fosters capital formation.
Despite the known growth effects, no country in the world funds itself exclusively through a national consumption tax. There’s a good reason for that. Growth potential, while important, isn’t the only objective.
Most nations couple their progressive income tax with a broad-based consumption tax (namely, a VAT). This is a classic pattern. It acknowledges that consumption taxes are regressive, but justifies their presence because the resulting tax receipts can enable a wide variety of federal spending — which would be difficult to support solely through other revenue resources.
The key point is that these consumption taxes supplement the income; they do not replace it.
The dominant trend in international taxation over the last 25 years has been for countries to reduce their corporate tax rates as they increase VAT rates. This is usually done for the sake of global competitiveness. In effect, these governments are incrementally trading away the taxation of capital income for the taxation of consumption.
The United States can’t participate in this global trend because we don’t have a VAT, or some other national consumption tax, to make up for the lost revenue. In effect, the FairTax is saying we can bypass the trade-off by dispensing with income taxation altogether. That’s a high-risk proposition. It swaps a progressive revenue source for a regressive one.
Despite my fondness for the consumption tax, I can’t jump on the FairTax bandwagon. If it’s enacted, the fiscal implications would be severe, as would be the cultural implications. Stripped naked of all distractions — spurious claims of deprived liberty — the FairTax is revealed to be more about those lusty cultural changes than it is about the dry and academic business of tax reform.