A Weak Attack on the Fair Tax - Island of Sanity

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Taxes & Spending

A Weak Attack on the Fair Tax


The Attack

I just came across an article attacking the "Fair Tax". The article was written by a college professor named Hank Adler. I don't know if Prof Adler is particularly influential, but he brings up most of the objections to the "Fair Tax" that I've heard before and quite a few new ones, so I think an analysis of his arguments is productive.

What is the "Fair Tax"?

For those unfamiliar with the "Fair Tax", let me briefly summarize it. For a more complete discussion, see the web site created by it's advocates, fairtax.org, which includes the text of HR 25, the bill actually introduced in Congress.

Like most bills introduced in Congress, it's pretty tedious reading. But the principle is pretty simple: Replace personal and corporate income taxes; gift, estate, and capital gains taxes; and social security taxes with a national sales tax. This tax would be 23% of the price of anything you buy.

Every family would receive a "prebate" of the amount of the tax times the official poverty level for a family of that size on a monthly basis. For a family of four in 2006, this was $27,380. So if a family of four spent $27,380 in a year, they would get back exactly as much in prebates as they paid in taxes, and their net tax rate would be zero. If a family spent double the amount of the poverty rate, $54,760 for a family of four, they would get back half of what they paid, so their effective tax rate would be half of 23% of 11 1/2%. Etc.

No tax is paid on money not spent. That is, if you put your money in the bank or the stock market or a retirement fund, you pay no tax until you take it out and spend it.

The tax is only paid once on each product. If you buy a used car, there would be no tax because the tax would already have been paid when the car was originally bought new.

Likewise, there is no tax on business purchases. When a retail store buys a product with the intent to resell it, the tax is paid at the time of sale to the consumer, not when the retailer buy it. There is no tax on equipment used to produce products for sale. (But if a business owner decides to take an untaxed product home for his personal use, he must then pay the tax.)

The cost of every product you buy includes money to pay business taxes, like corporate income taxes and capital gains taxes. Eliminating these taxes would result in a drop in prices. The Fair Tax advocates say that these taxes come to an average of 22%.

Adler's article is a little rambling and he repeats himself a lot, so let me pick out the highlights.

Let's quickly deal with two technicalities.

1. Prof Adler begins by objecting to the term "Fair Tax" as a biased name. I agree. So I'll follow his example and refer to it by the name of the bill in Congress, HR 25, or by the term "national sales tax", for the remainder of this article.

2. HR 25 advocates say they are proposing a 23% sales tax. Adler insists that the tax rate is really 30%. The difference is in whether you calculate it "inclusive" or "exclusive". Pro-HR 25 people say the tax should be calculated inclusively, by which they mean that if the price marked on a product in the store is, say, $100, then when you take it to the checkout line you will pay $100, of which $23 is paid in tax to the government and the remaining $77 goes to the seller. Adler says that the product should have a price tag that says $77, and when you go to the checkout line they should add the $23 on top of that to make a total bill of $100. You're paying the same tax in both cases, but in the first method 23% of the price is taken out for tax, in the second case about 30% is added on to make the tax. State sales taxes are normally calculated exclusively, but income taxes are calculated inclusively. That is, if your salary is $50,000 per year and the government says you have to pay 20% in taxes, your employer doesn't come up with another $10,000 to pay the tax. Rather, it comes out of the $50,000 they already gave you. The argument of pro-HR 25 people is that the purpose of the national sales tax is to replace taxes on income, which are calculated inclusively, so to make the numbers comparable, it should also be calculated inclusively. Prof Adler insists that it should be calculated exclusively. His stated reason is because this is how state sales taxes are calculated, though it is not clear why this is relevant, as no one is suggesting that the national sales tax would in any way replace state sales taxes.

But to the substantive points.

Adler's argument My thoughts
With all of its complexity, the current Internal Revenue Code is a more evenhanded approach to collecting necessary Federal revenues than H.R. 25. This is not to say that the author believes the current Internal Revenue Code is the right long term answer for the United States; it is to say that H.R. 25 is not the right long term answer. Okay. Let's look at his objections.
In any state where there is a decision to eliminate their state income tax, the combined Federal, State, and local flat sales tax rate could easily exceed 43%. Technicality: Adler calculates the 43% exclusively, as discussed above. If we calculate inclusively this would come to 30%.

Either way, clearly Adler's intent is to emphasize that this is a big number, that we could be paying a huge tax rate here. But HR 25's 23% number was carefully calculated to result in the federal government collecting the same amount of tax that it does now. So for the average taxpayer 23% minus prebate should come to the same amount he's paying now. Adler then calculates an equivalent sales tax to come up to the same amount that state and local governments are now collecting and adds this in. So assuming that all the calculations are correct, this 30% (or 43% if you want to insist on the exclusive calculation) is the same amount that we are paying now. Adler's argument here appears to be that paying one tax of 30% is way too much, but paying ten different taxes that add up to 30% is fine and reasonable.

H.R. 25 would result in an immediate reduction in purchasing power upon implementation for existing savings which have previously been subject to U.S. income taxes (double taxation). This is true. Suppose that today, under the income tax, you earn $1000. The average American pays about 18% in taxes, so let's assume you pay $180. You keep the remaining $820 in your piggy bank. Then HR 25 passes. You open the piggy bank and spend the money. 23%, or another $129, is paid in sales tax. You've been taxed on the same money twice.

On the other hand, this is a "transition" problem. Once HR 25 was in effect, you would not pay income tax on any new money you earned, but only sales tax. This would mostly be a problem for very wealthy people who had large accumulated savings. For poor people who can barely survive on what they earn and are not able to save much or any money, this would be a non-issue.

Note this would not affect most Americans' retirement money, because that is mostly in IRAs and 401ks which were not charged income taxes when earned: You are supposed to pay the tax on that when you withdraw the money from the retirement plan. So instead of paying an income tax when you withdraw it, you would pay a sales tax (assuming you promptly spend it). The net effect is about the same.

So HR 25 would impose a substantial one-time tax hit on the very rich. For the rest of us, this is a non-issue.

The ability of the wealthy to pass along exceptional levels of never taxed wealth, tax-free, generation to generation, seems a prescription for a feudal system. This is completely false. The wealthy would be required to pay the sales tax on inherited money just as they would on any other money. I suppose you could say that under HR 25, a family could pass money down, generation to generation, without paying any taxes, as long as they never spent it. But so what? Once they spend it, they have to pay taxes. For this purpose, what difference does it make whether they pay the tax when they earn the money or when they spend it?

A curious thing about this objection is that it comes just a few paragraphs after his objection about double-taxation on savings. HR 25 is bad because it would impose a large tax on the savings of the wealthy, and it is bad because it fails to impose a large tax on the savings of the wealthy. Both objections can't be true! In fact the first one is factually correct. Whether that is a problem to agonize over is another question. (Maybe if I was rich myself I'd be screaming about the unfairness there.)

H.R. 25 anticipates that virtually every state will willingly agree to become a sales tax administrating authority. Given the proposed fee for this administrative task and the political risk that would accompany this decision, it is possible that not a single state would decide to become a sales tax administrating authority.

The administration required to implement and thereafter continuously administer H.R. 25 might be beyond the capability of Federal and state government. It may also be far more expensive than administration of the current Internal Revenue Code. (The proposed collection fees alone under H.R. 25 approximate the total annual budget for the Internal Revenue Service.)

The very notion of initially and annually registering 300,000,000 lawful citizens, providing a monthly check to each and believing this can be accomplished confidentially, efficiently and without fraud has at least a touch of unreality to it.

First he says that the state governments might rebel against the idea of administering this tax because it would cost more to run than the feds would reimburse them. Then he objects that the amount that the states would be reimbursed is too large. Which is it?

This only makes sense if you suppose that HR 25 would be incredibly expensive to administer. Adler talks about the huge effort involved in registering people for the prebate. But why should this be such a big deal? The government already knows the names, addresses, and social security numbers of every American taxpayer and every member of their families. You give them this information every year when you fill out your tax return, and they keep it all on their computers. Yes, there are some number of Americans who presently make too little money to be required to pay federal taxes but who would be eligible for the prebate. These people would have to be registered. But it's not like the government would have to work hard to track them down. The point of registering is to receive the prebate from the government. People have every incentive to sign up: it's to receive money. If some number of people fail to sign up, so what? The government can go ahead and collect the tax without 100% registration. It just means less money paid out in prebates.

Adler says that to do this "confidentially, efficiently and without fraud has at least a touch of unreality to it". Why should it be any more difficult to be confidential and efficient and without fraud when registering people's names and social security numbers for the purpose of giving a tax prebate then when this exact same information is gathered for the purpose of collecting taxes? The government would be collecting a lot less information about people under HR 25 then under the present tax code. Under HR 25 all it would ask is name, address, and social security number. Compare this to the amount of information you supply on a tax return. While there would be a few more people, the total volume of information would be way less.

Of course the phrase "fraud free" is absurd. Yes, any idea that this will be done with 0% fraud is unrealistic. Of course there will be people who will try to register twice and the like to get extra prebate checks. But are we comparing HR 25 to some idealized method of tax collection that may be used in Heaven, or to our current system? Does Mr Adler claim that our present tax system is absolutely, 100% fraud free? I think a good case could be made that there would be less fraud under HR 25 for the simple reason that there's less to lie about. Yes, you could lie and claim family members who don't really exist, or someone could claim that he is living alone and entitled to a rebate at the same time that his parents claim him as a member of their family to increase their rebate. But this should be relatively hard to get away with: The government could easily check for non-existant social security numbers or the same social security number being used twice. All that information should be in the government's computers, they don't even have to leave the building to check it. I'm sure creative criminals have found ways to get bogus social security cards and no doubt there will be smart people who will come up with other ways to beat the system. But compare this to all the things you could lie about under our present income tax system, from failing to report that second job where you were paid under-the-table in cash, to claiming charitable deductions for contributions you never made. Checking any of that requires an auditor to personally examine your records.

H.R. 25 is fraught with legal uncertainty. There are constitutional arguments that H.R. 25 would be unconstitutional with respect to constitutional limits of Federal taxing power. I don't see why it would be constitutional for the federal government to impose a national income tax, but not to impose a national sales tax. I don't doubt that there are people who would bring constitutional challenges to the new tax. Such a challenge would take years to work it's way through the courts. If it did finally make it to the Supreme Court after the new tax had been in effect for years ... well, I have news for Prof Adler: There is no way in a million years that the Supreme Court would rule that the federal government had to stop collecting taxes and shut down. Much as some Americans might like to see that happen, the courts are just not going to do that. If you want to suggest that the courts will rule some detail or other unconstitutional and require changes, sure, I don't doubt they will. But abolish all federal taxation completely? No way.
State & local legal issues could be raised including the relationship of taxing authorities with Immigration Customs & Enforcement. Would the state sales tax authorities attempt or be required to inform Immigration Customs and Enforcement of the location of families which included unlawful residents. Under HR 25, only legal residents of the U.S. would be eligible to receive the prebate. Prof Adler brings this up repeatedly as a problem: he objects to it in principle, and he argues that others will object to it enough to bring court challenges and other forms of opposition. He brings this objection up over and over with slightly different wording.

I don't doubt that someone might bring a court challenge over this: it only takes one person to complain and a lawyer who will take the case. But I have a hard time imagining someone winning such a case. Under what legal principle can an illegal alien claim that the government is obligated to provide him with a benefit? There is a lot of debate today about whether the children of illegal immigrants should be admitted to public schools or be eligible for other government benefits. But all of these debates center around whether denying such benefits to children of illegals is punishing children for the crimes of their parents, or whether giving them the benefit would be rewarding them for the crimes of their parents. In all the debate I don't recall hearing anyone argue that illegal aliens have a constitutional right to receive welfare or be allowed to vote. Why should they be entitled to a tax prebate?

Indeed, the pro-HR 25 people often cite this as an advantage of their proposal: Illegal aliens normally do not pay income taxes because they are trying to hide from the federal government, not call attention to themselves, sometimes with their employers' cooperation. But under HR 25 they would have a hard time evading sales tax. So instead of getting a free ride, illegal aliens would be paying taxes. Without the prebate, they'd be paying a higher tax rate than legal residents.

As to registration for the prebate being used to track down illegal aliens: If you're thinking that this could be a great new tool to crack down on illegal aliens, I'm afraid you're in for a disappointment. If you think this is an unconstitutional tactic, relax. Registering for the prebate is voluntary. Any illegal alien with an ounce of brains will simply not register, so the issue will never come up. Anyone who goes to a government office and says, "I'd like to register to receive a government check, but I'm sorry I can't give you my social security number because I'm an illegal alien" should be immediately deported on the grounds that we don't want him to add his stupidity to our gene pool.

Challenges might arise with an interpretation of the law to be effectively requiring national identity cards. Yes, no one could imagine thinking of a social security card as a sort of national identify card until HR 25 came along. Get real. Every American is already required by law to have a social security card by the time he is 2 years old. If you object to that on civil liberties grounds, fine, so do I. How does HR 25 make it worse?
The concept of purchasing power vs. raw data clearly confuses the strongest supporters of H.R. 25. The following is copied from the Fairtax.org website: ...
For older, low-income households, the FairTax generates a major reduction in remaining lifetime taxes. Again, the reason is that the elderly not only continue, under the FairTax, to receive the same real Social Security benefits, they also receive the FairTax prebate. The average Social Security benefits for a retired couple living solely on Social Security are $18,776. The FairTax prebate for this couple is $4,697 which is $381 more than the FairTaxes the couple would have to pay if they spent the entire $18,776 on taxable consumption.

Every word of the above paragraph is accurate. However, the inference that the result is good for this retired couple is incorrect. Under H.R. 25, the purchasing power of the retired couple referred to in the example is actually decreased under H.R. 25 from $18,776 to $18,704.

Without going into the details of Prof Adler's calculation, his point is that the claim he quotes from the fairtax.org web site adds the prebate to the hypothetical retiree's income but fails to calculate the sales tax that would be paid on any purchases made with that prebate. I haven't checked to see if he is quoting fairtax.org accurately, but if he is, than his criticism is correct. The quoted calculation is sloppy; a retiree would have slightly less after-tax income under HR 25 than under present tax law.

On the other hand, it should be recalled that HR 25 also repeals business taxes that are built in to the price of every product. If even 5% of these tax cuts are reflected in lower prices, then the retiree will still come out ahead. I'm sure business owners would love to just pocket this money, but in the real world competition is going to force them to use most of this reduced cost to lower prices and increase salaries of their employees. Even if somehow business managed to keep 100% of the reduced taxes as higher profits, then any retiree with an IRA or a 401k will get a huge boost in earnings -- something like 700% more. The size of that increase is part of why it's extremely unlikely business would be able to keep it all. Surely somebody would decide to use a little of it to cut prices so he'll get higher sales, which would force his competitors to follow suit.

At implementation, high earning citizens with deferred income from such items as pension plans and stock options would have immediate increases in purchasing power. Under the present system they pay income tax once they withdrew the money from the tax-deferred account. Under HR 25 they pay sales tax once they spend it. What's the difference?
At implementation, all of the social and business incentives, benefits and disincentives included in the Internal Revenue Code disappear ... Individual retirement plans, self employed pension plans, pension plans for businesses – encouraging saving for retirement This is just like the previous point, and equally nonsense. Under present law, money in retirement plans is generally "tax deferred", meaning you don't pay income taxes until you withdraw the money from the plan after retirement. Under HR 25, you wouldn't pay income taxes until you spend the money. As people presumably don't normally withdraw money from their retirement plan until they're ready to spend it, there's little difference between the two systems.

Indeed, HR 25 has a distinct advantage here: No bureaucracy. Under present law, you, your employer, and the investment company have to fill out all sorts of government forms and comply with all sorts of regulations, all of which is designed to insure that this is really a legitimate retirement plan and not an illegal scheme to evade income taxes. Under HR 25, it all becomes a moot question. Whether you put money into an investment account for retirement, to save up for your children's education, to buy a home, or just because you don't have anything in particular you want to spend the money on right now, it's all non-taxable until you withdraw it and spend it. So all the forms and regulations associated with IRAs, 401ks, SEPs, and all the other retirement plans would go away. You'd just put money in the account and the government wouldn't know or care.

At implementation, investors would have the ability to sell investment assets without Federal taxes. The proceeds of such gains would be immediately available for reinvestment without any Federal tax consequence. This is normally given as an advantage of a national sales tax: It encourages investment by deferring taxes until you spend the money.
At implementation, all of the social and business incentives, benefits and disincentives included in the Internal Revenue Code disappear ... [such as:] Lower tax rate on capital gains - encouraging investment; Lower tax rate on dividends - encouraging investment. This objection comes just a paragraph after the previous objection. His argument is that the present system where long term capital gains and dividends are taxed at a lower rate is good because it encourages investment, but reducing taxes on investments to 0% is bad because ... why?
At implementation, all of the social and business incentives, benefits and disincentives included in the Internal Revenue Code disappear ... Home interest deduction – encouraging home ownership; Contribution deductions - encouraging contributions to charity; Adoption credits – encouraging adoption Energy credits – encouraging protection of the environment; These are true. But then the question becomes, Should the purpose of a tax system be to raise money to run the government, or to encourage behavior that the government thinks is good? Take his first example: home mortgage deduction. Personally, I own a house and I get a substantial tax benefit from this. But should I really? Suppose Allen buys a house and pays $1000 a month in mortgage payments. Meanwhile Bob rents an identical house next door and pays $1000 a month in rent. Allen will be entitled to income tax deductions for the interest on the morgage, the property taxes he pays, and some other specialized deductions. If he's in a middle income bracket these would be worth somewhere around $200 per month. (Initially: It will go down as he pays off the house.) Bob will not receive any such deductions. Why should Allen pay lower taxes then Bob because he bought a house while Bob is renting? Often Bob is renting because he makes less money and can't afford a down payment, so the tax law says that the richer person gets a tax deduction while the poorer person doesn't. That hardly seems fair.
Research & development credits – encouraging research & development That's simply not true. Under HR 25 R&D costs are a business expense, and thus not taxed.
[E]xisting alimony agreements would become a serious problem. Such agreements contemplate increased buying power for the payor of alimony through tax deduction and decreased purchasing power for the recipient through the payment being taxable income. Well, Prof Adler is seriously confused on the specific case here, but he brings up a good general point. Alimony would not be a problem at all. Under present law, the person who pays alimony can deduct it from his income (let's assume it's paid from a "he" to a "she" for convenience with the pronouns), so he effectively pays no tax on the money. The person who receives alimony must declare it as income, so she does pay tax. Under HR 25, the tax is paid when the money is spent, which would presumably be by the recipient. So either way, it's the receipient of the alimony who pays the tax.

On the other hand, there are surely many existing contracts, court orders, and the like assume that present tax laws will continue indefinitely, and such a dramatic change in the tax law would provide an unexpected benefit to one party and loss to another. I agree that this is a problem. Prof Adler would have been better to bring up court-ordered child support, where under present law the payer of child support pays the income tax, and the receiver does not. Under HR 25 the receiver would pay the tax (when she spent the money). Thus all child support payments would suddenly be worth less.

On the third hand, (a) HR 25 is not the first proposed change to tax law in history. When the 2002 tax cuts passed that doubled the child tax credits, this had a profound affect on the net benefit to many divorced people. Businesses have to deal with complex changes in tax law all the time. But still, HR 25 is probably the most dramatic change in U.S. tax law in decades. (b) While HR 25 does not provide any specific relief in such cases, surely people could renegotiate contracts and seek to have court orders revised in particularly dramatic cases. Perhaps it would be a good idea for states to pass a law automatically adjusting all child support payments in light of the tax law change, without the need for each individual recipient to go to court to plead her case.

For many individuals, the compliance requirements of H.R. 25 would be significantly increased. Service providers, investors owning property, and people performing part time jobs would be required to file monthly sales tax reports with the sales tax administrating authority. This is at best partially true and certainly very misleading. Most Americans would see their compliance costs go down a lot. A very small number might see a very small increase.

For everyone who does not own a business, which is surely the vast majority of Americans, compliance costs would drop to almost zero. If you want to receive the prebate, you would have to fill out a form listing your address and the names and social security numbers of everyone who lives with you. That would be it. There would be no more 1040, no W-2, no schedules. No need to keep any tax records at all. (You might still need to keep tax records for the state, but we're talking about the federal here.)

For any business that does not sell to the general public, compliance would be absolutely zero. There would be no forms at all.

For a business that does sell to the general public, they would have to file monthly reports on sales, similar to what they currently file for state sales tax in most states. They would no longer have to file income tax forms. If they're in a state that charges sales tax, they are already collecting the required information. It should not be difficult to program the computers to spit it out in a slightly different format for the feds, and I'm sure all the makers of business accounting software will be adding features for this to their products. In any case the sales tax form would be much simpler than the present income tax form, so they'd be better off.

For a business that presently provides a product or a service that is not subject to state sales tax, like many professional services, yes they would have to start collecting sales information and reporting it to the government. This would be a new compliance burden that they never had before. But they are surely presently filing income tax forms that would no longer be required under HR 25, so the total paperwork to be done would be less. They'd have to learn the new system, which would surely be a pain. And I suppose there would be a few people who had particuarly complex sales records to keep and particularly simple income taxes under the present law, who actually would have a higher compliance cost. But such people would be very few.

Self employment benefits would be calculated differently for the self-employed following implementation of H.R.25. Income calculated in a traditional manner would no longer be the basis for social security benefits for the self employed. Self-employment income for social security purposes would exclude all self-employed individuals who are selling non-taxable products or delivering non-taxable services, resulting in a total loss of social security benefits True. Under HR 25, people would no longer pay social security taxes. Social security would be funded through the national sales tax. Their income would still be used to calculate benefits. A self-employed person's income would basically be calculated as taxable sales minus wages paid to his employees. This would appear to mean that someone in a business that made only non-taxable sales, such as a used car salesman or an accountant serving business customers, would have no income for social security purposes and thus would not be eligible for any benefits. This does sound like a problem.
If self employment income was calculated in the traditional manner, the taxpayer would be required to calculate taxable income under the current Internal Revenue Code after implementation of H.R. 25. This would require the continuance of the Internal Revenue Code and the continuing requirement of a calculation of taxable income for the self employed. It would result in the promise of lesser compliance costs and the elimination of the Internal Revenue Code being inaccurate. This is an absolutely bizarre criticism. HR 25 is bad because if it did something that the writer just criticized it for not doing, but if it did do that, that would be bad.
It is uncertain whether the administrative tasks required by the Federal government including the Social Security Administration and the participating states can be accomplished in a timely and fraud free manner. It is uncertain whether the costs of implementing and administrating H.R. 25 would be less than, equal to, or greater than the current costs of the Federal government and the states of administrating the current Federal income tax. ... Administrative costs of implementing the tax system could easily grow under H.R. 25. Under HR 25, there are two things to administer: the prebate and sales tax collection. For the prebate the government has to know every taxpayer's name, address, and social security number. The government is already collecting this information on individual income tax forms -- plus a whole lot more. For the salex tax the government would have to know the name, address, and registration number of each retail company and its total taxable sales. The government is already collecting this information on business income tax forms -- plus a whole lot more. So Prof Adler's argument here is that for the government to process a five line form will take more time and cost more than it takes to process the present hundreds of questions on pages of forms and attached schedules. He can't even argue that the one or two questions under HR 25 are somehow harder to deal with than the hundreds of questions under present law, because these questions are already included on the present forms.
[Each] state would be required to consider whether it should or could continue to administer its own income tax. Without a state eliminating its own income tax, the promise of a reduction in compliance costs and activities for the residents of that state are lost. In states which continued their income tax, the residents would be required to complete state individual and corporate tax returns nearly identical to the current Federal income tax return along with beginning to comply with the requirements of H.R. 25. ... Virtually every state relies on the Federal income tax system in some major part to administer their state income tax system. Most state individual and corporate tax returns begin with the Federal taxable income of the individual or entity filing the state tax return. Most states refer directly and indirectly to the Internal Revenue Code, and Regulations and case law to provide much, if not all of their legal underpinnings for their law. Yes, it is true that most states that have a state income tax use the "adjusted gross income" from the federal form 1040 as the starting point for their tax calculations. If HR 25 passed and a state decided that it not only wanted to keep its state income tax, but also that it wanted to be sure that it imposed exactly the same amount of tax on every taxpayer that it would have imposed if HR 25 had not passed, then, yes, the state would have to incorporate all the now-obsolete federal tax forms and schedules as state forms and enact all the obsolete federal income tax laws and regulations as state laws and regulations. This would create a lot of work for the state tax authorities to administer and audit, and it would mean that taxpayers in that state would not get the huge reduction in the time and effort required to comply with present tax laws that HR 25 was supposed to accomplish.

That's why such an action on the part of a state government would be a pretty stupid thing to do. Let's think carefully now: Why do states use the adjusted gross income from the federal 1040 as the starting point of their state income tax calculation? Is it because they have carefully considered all the possible tax laws that they could have, and concluded that, by shear good fortune, the tax laws used by the federal government are the best possible laws that anyone could imagine? Umm, probably not. It's more likely that they do this because it's easy for both the state and the taxpayer. Take the form you've already filled out for the feds and go from there. If the feds abolished this form, many states would surely switch to piggybacking a state sales tax on top of the national sales tax. Those that chose to keep their state income tax would have to come up with some other set of rules for calculating income for tax purposes. Most would come up with a much simpler set of rules than the present federal income tax, for exactly the reasons why Prof Adler says that it would cause all sorts of trouble if they did not.

If you assume that people will respond to a new law by seeking out the most wasteful and generally stupid way possible to comply with it, then any new law would look pretty dangerous. (Like, we dare not pass a new safety rule requiring every balcony to have a railing, because people might respond by burning down every building found to not have such a railing, maybe even with all the people still inside, rather than, say, putting in a railing.)

Prebate - H.R. 25 provides that all lawful residents receive a monthly check, a prebate equal to the Federal income taxes imposed on the expected retail purchases of an individual at the poverty level. The prebate provides a national sales tax exemption at precisely the poverty level. H.R. 25 provides this prebate to all lawful residents regardless of income or wealth. No amount is provided for unlawful residents. Wealthy would receive exactly the same prebate as America’s poorest legal residents. But the wealthy then pay a 23% tax on all spending above this amount. So under HR 25, a family earning poverty level or less -- about $27,000 for a family of four -- would pay zero taxes. A family earning twice that, or $54,000, would in effect pay the national sales tax on only half their purchases, so they are paying 23% on half their money, which effectively means 11 1/2%. Someone making $1 million a year will pay the 23% tax on $973,000, or 97% of his money, for an effective tax rate of 22%. In other words, the prebate makes the tax highly progressive, just like our present income tax: If you make more money, not only do you pay more tax, but you pay a higher percentage of your income in tax. True, the top bracket is lower -- 23% instead of 38% -- but all of the deductions are gone, so the wealthy can't hide their money in tax shelters.
There is no mechanism to ensure that the prebate would be spent on sales taxes for the necessities of the individual or his family. There would be no assurance that a child would not go hungry and the funds spent on books, drugs, alcohol or chocolate bars. Presumably this objection is as compared to current tax law, where it is guaranteed that the per-child deduction and the child tax credit are spent only on things that benefit the child. If an irresponsible father tried to take his present income tax refund and spend the portion that came from the per-child tax credit on beer and football tickets ... oh, I guess nothing would stop him from doing that. So what's the difference?
While not politically correct to state, there is the possibility of social instability if prices are raised to the poor, regardless of a prebate or not. Prof Adler assumes here that people will notice that they have to pay more for products because of the new sales tax, but will not notice that they no longer have to pay income taxes and that they are now getting a check in the mail from the government every month.

Surely there would be enough publicity surrounding the total change in tax laws that anyone with an ounce of brains would know that the increase in prices is connected to the check he now gets in the mail. And if someone is paying so little attention that he doesn't get the message and is too dumb to make the connection -- liberals should be overjoyed about this possibility. Such people will be grumbling about the evil big corporations that raised all their prices, and be grateful to the benevolent government that is now sending them checks.

Tax planners will be attracted to H.R. 25 like bees to honey. In the initial planning to decrease taxable income in the final year of the current income tax system and in making retail purchases proceeding [sic] the first year of the national sales tax, tax planners would puncture expected Federal revenues in both years. ... Maybe the point isn't clear from this brief quote, but Prof Adler argues that in the year that HR 25 went into effect, people who planned ahead could reduce their taxes by shifting some actions around to time them to the change in law. To take a couple of simple examples, if the national sales tax was to go into effect on January 1: It would be smart to make some purchases in December that you might otherwise have waited to make until January, to avoid paying the new tax. If you were planning to withdraw money from your 401k in December, it would be better to wait until January, and thus avoid paying income tax. Smart people would figure out many more complex maneuvers. Plenty of these would be completely legal. If enough people figured out enough ways to avoid taxes by taking advantage of the changeover, the government could see significantly reduced tax revenues in the year before and after the change.

All of which is completely true, and I readily concede this could be a problem with HR 25. On the other hand, this is not a problem that is unique to HR 25. Every change in tax laws has this effect. As HR 25 is a more dramatic change than most, perhaps the impact is bigger.

Impact of H.R. 25 on Relative Position of Home Buyer and Rental Residence Investor – H.R. 25 provides that the purchase of a new home by a buyer with the intent of occupying the home for his or her family is subject to the flat rate national sales tax. H.R. 25 provides that an investor purchaser of that same residence would not be subject to the flat rate national sales tax. That taxpayer would charge his renters the flat rate national sales tax. The result is that the investor buyer would have a 30% price advantage in competing with the home buyer for new residential property. The purchase price for the investor would be $300,000; the young couple would pay $390,000. True, but so what? An individual buying a house to live in would roll the tax into his mortgage, and so pay a little bit of it each month. An investor buying a house to rent out would pay the tax at the time he collects rent, a little bit each month. The investor expects to collect more rent over time than the purchase price, or this would not be a profitable investment, so in the end he's going to pay more tax than the individual.

Under present law, a retail store does not pay sales tax on items bought for resale, because it is understood that the tax will be paid when the item is sold to the consumer. It is not clear how it is unfair that Wal-Mart can buy a toaster without paying sales tax while I can't: Wal-Mart doesn't get any use out of the toaster, they don't get any benefit until they sell it to me and get the money. Why should a house be any different, other than costing a lot more?

Further data needs to be collected with respect to the volatility of the securities markets that H.R. 25 could create. The elimination of all Federal taxation of securities transactions would eliminate any potential for an investor to wait out a sudden drop in the marketplace because of income recognition and tax payment issues. This might or might not cause some level of instability in the securities markets. In other words, present tax law is good because it encourages investors to stick with a bad investment, because the tax that would have to be paid to dump the bad investment can be more than the real loss. To say that investors should be pressured to keep their money in unproductive operations for the sake of "stability" doesn't sound like good economic policy to me. If forcing people to invest in companies that are losing money is really good government policy, why not do it directly by passing a law requiring every investor to put a certain percentage of his money in companies that are in the middle of bankrupcy?
One of the abilities lost in H.R. 25 is the ability of Congress to stimulate the economy through tax reductions in times of economic decline or malaise. This tool would be permanently lost with a passage of H.R. 25. There is nothing that says that the 23% rate can never be changed. Congress would have the power to amend the law to change the rate, just as it now changes income tax rates.
[H]igh volume products with traditionally low margins would have resultant and instant price increases under H.R.25. Safeway Corporation currently pays approximately 1% of its sales for its products in Federal income taxes. Without study of any other factors and assuming that there is very little in the way of U.S. income taxes paid by its suppliers in its costs (farmers do not generally earn dramatic profits from their products), to achieve the same after-tax profit with the elimination of the Federal income tax and the implementation of H.R. 25, Safeway would have to increase prices by about $ 11.5 billion dollars a year. This equates to an approximate 27% increase in the price of food. I cannot find any further explanation in Prof Adler's article of why this should be so. He says that grocery stores presently pay very little in income taxes as a percentage of their sales. That's true. I don't know the exact number, so let's accept his 1% as accurate. Under HR 25, they would pay zero in income taxes. They presently pay zero in sales taxes on the food that they buy for resale to the consumer. Under HR 25 they would continue to pay zero in sales taxes on the food that they buy for resale to the consumer. So their taxes would go down by only 1%, compared to other businesses that would see drops of 20% or more in their costs through the elimination of corporate income taxes. Too bad for the grocery store, but exactly how does he get from a 1% drop in costs to having to increase prices by 27% to have the same profit? Perhaps there's some logic and calculation behind this that makes sense, but if so, he didn't include it in the article.
Tax fraud ... logically expands as opportunities increase. ... The issue of performing a task as a local maintenance person etc. with a price of $500 cash or $650 with a credit card or check cannot be overlooked. As opposed to the present income tax, where 100% of income is consistently reported.

Yes, there will surely be fraud under a national sales tax. The relevant question is, will there be more or less than under the present income tax?

Sure, an independent service man could offer to forget the sales tax if a customer pays him in cash. Just like an independent service man today can forget to include a sale on his income taxes if he is paid in cash.

There are some reasons to believe that there would be less fraud under a national sales tax. The rules are much simpler than present income tax rules, so there are far fewer opportunities for complex schemes. Sure, a retailer could under-report his total sales, or claim that things were bought for business use when they were really for the owner's personal use. But under our present income tax law retailers are required to report this same information as part of the calculation of net income, plus a whole lot more. HR 25 doesn't do anything to make any of these tax frauds easier.

If nothing else, HR 25 would make auditing tax returns a whole lot easier. Most Americans would no longer file tax returns. The only possible fraud an individual could commit is to give false social security numbers on the prebate registration. Only retail businesses would file tax returns. The total number of taxpayers would plummet from over 110 million to perhaps 5 million. And about the only thing they would have to investigate is total taxable sales.

Conclusion

You should draw your own conclusions, of course. I encourage you to read arguments on both sides. That's what I've been doing, and the more I read, the more I've been coming to like the national sales tax. I'm not completely sold yet. But when I read an attack like Prof Adler's, and I notice that he routinely mis-states the facts, makes wild assumptions, and regularly contradicts himself -- simultaneously faulting a proposal for doing X and for not doing X -- this pushes me toward the other side. In fairness, I've read some of the arguments in favor of the national sales tax and they also have flaws. But they're not on the same scale.

© 2007 by Jay Johansen


Comments

Mehmet Jul 23, 2014

What kind of savings anccuot?If this is a regular anccuot at the bank, you pay tax on the interest income each year but nothing when you take the money out.If it's a brokerage anccuot invested in mutual funds, then there can be capital gains when the mutual funds are sold (and you have to sell them to get the money out). The tax is only on the GAIN, not the entire amount. Commonly called UGMA and UTMA anccuots.If this is a tax deferred savings anccuot (529 plan or coverdell ESA), then you don't pay taxes each year, but then look at what the money is spent on when it's withdrawn. If it's used for qualified educational expenses, it's tax exempt. If not, tax + 10% penalty.

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