Anyone who’s prepared and filed a tax return knows the United States’ tax system is complex and difficult to understand. Many people also feel corporations, wealthy individuals, and special interest groups have unfair access to loopholes and exemptions that help them avoid paying their fair share.
One idea for fixing this system is called the FairTax, which seems to resurface every few years. Simply put, the proposed FairTax plan would eliminate all federal income taxes, payroll taxes, gift taxes, and estate taxes and replace them with a flat national sales tax. Proponents of the flat tax believe this initiative would eliminate loopholes, evenly spread the tax burden, and eliminate hassle without diminishing federal tax revenues.
But opinions vary widely, and opponents contend the plan would require the middle class to pay the most in taxes, while the wealthy would enjoy an even lighter tax burden.
To figure out where you stand on this high-profile issue, get the facts, weigh the pros and cons, and draw your own conclusions.
History of the FairTax Plan
FairTax legislation was first introduced in the House in 1999 by Georgia Republicans John E. Linder and Rob Woodall. While it didn’t gain much traction that first year, similar bills were introduced in each subsequent session of Congress.
During former President George W. Bush’s term in office, his tax reform panel considered a national sales tax. However, they ultimately rejected the idea.
Because of these obstacles, this proposal has very little chance of becoming law as written.
Despite these findings, Woodall hasn’t given up hope. He most recently introduced the FairTax Act of 2019 (H.R. 25), suggesting a national sales tax to replace income taxes, payroll taxes, and estate and gift taxes. The bill would set the sales tax rate at 23% for 2021, with adjustments to the rate in subsequent years.
What Is the FairTax Plan?
The FairTax concept proposes that the federal government stop collecting many different types of income tax, including:
- Personal income tax
- Self-employment tax
- Payroll taxes (including Social Security and Medicare)
- Estate and gift taxes
Instead, the government would generate tax revenue by instituting a national sales tax on most purchased items — the FairTax. Businesses would collect the tax at the point of sale and send the revenue to the federal government. Your tax bill would no longer have anything to do with how many dependents you claim or whether you rent or own a home. Instead of having taxes withheld from your paycheck, your take-home pay would simply be exactly how much money you make: tax-free.
To prevent a national sales tax from negatively impacting low-income individuals, the FairTax would also give all households a “prebate,” or a monthly payment for the amount of tax a household spending a poverty-level income would pay.
The FairTax legislation would also repeal the 16th Amendment, which means the federal government would no longer have the right to levy income taxes. However, states and local governments would still collect revenue via income and sales taxes at their discretion.
How a National Sales Tax Would Work
The proposed sales tax would amount to 23% of the total payment on just about all purchases. Sounds like you’d simply pay a 23% sales tax, right? Not quite. It actually works out to be a 30% sales tax rate.
Currently, Americans pay an “exclusive tax,” meaning they tack sales tax onto your purchase at the register. Under a FairTax system, sales tax would be an “inclusive tax,” meaning they include it in the item’s price from the get-go.
For example, under a FairTax system, an item marked $100 would already include the sales tax within it — in this case, $23. In other words, the cost of the item without the tax would be $77. But $23 paid on a $77 purchase is roughly 30% the way we’re used to calculating it. While 30% is steep, you’d be working with a much larger paycheck because your employer wouldn’t have withheld any federal tax.
According to FairTax.org, proponents of the FairTax use the 23% figure to compare the FairTax to our current income tax system, not our current sales tax system. As explained in the website’s frequently asked questions:
“Note that no matter which way it is quoted, the amount of tax is the same. Under an income tax rate of 23 percent, you have to earn $130 to spend $100. Spend that same $100 under a sales tax, you pay that same tax of $30, and the rate is quoted as 30 percent.”
Further, the FairTax plan attempts to solve the issue of double taxation. Currently, businesses pay sales tax on the materials they use to create the goods they sell, which then get taxed again. In effect, the same material gets taxed twice. But under the proposed legislation, new goods purchased directly by businesses could avoid the sales tax and thereby avoid being double-taxed. That should bring the wholesale cost of your purchase down and, in theory, reduce the retail price.
The prebate — or advanced tax refund — is designed in part to relieve poverty-level Americans by providing a monthly check that would essentially offset all their sales tax expenditures. The amount of the allowance would be based on the U.S. poverty-level guidelines and would increase for larger families.
According to the 2020 FairTax Prebate Factsheet issued by Americans for Fair Taxation, the prebate would range from $2,935 to $10,148 annually for a one-adult household or $5,870 to $13,082 for a two-adult household, depending on the number of dependents living in the household.
Similar to a universal basic income, the prebate is geared toward poorer families. But everyone would receive monthly checks, regardless of income. The prebate brings up yet another point of contention between critics and supporters. It is the most expensive element of the entire plan, would be the most extensive entitlement program in American history and would constitute a welfare payment, even for those without a need. In other words, a two-parent billionaire household with two kids would receive the same monthly prebate as a two-parent, two-child household getting by on $20,000 per year.
The FairTax plan may be advantageous to many groups, especially the wealthy and those at or below the poverty line. Significant benefits include:
- Paying Tax Only on What You Spend. Our tax system is currently based on tax brackets: The more you make, the more you pay in taxes. Under the FairTax plan, only the amount of income you spend gets taxed. For example, someone who makes $200,000 and spends $100,000 would pay only 11.5% of their income to taxes.
- Helping Investors. Because the capital gains tax would be eliminated, individuals who can afford to invest will enjoy tax-free compound growth. That would be similar to having an individual retirement account (IRA) in which you could invest as much as you want and withdraw funds at any time without taxes or penalties. (Under current IRA rules, you can only invest a certain amount per year and must be 59 1/2 to withdraw funds without penalty.)
- Making Tax Revenues Easier to Predict. Because consumption rates are much more stable than income, figuring out tax revenues will likely be simpler, and estimates will be more accurate.
- Benefiting Businesses. Under the FairTax system, business-to-business purchases aren’t taxable. Only sales to consumers are taxed. Along with eliminating double taxation, the proposed plan would get rid of corporate income taxes, self-employment taxes, payroll taxes and taxes on capital and investments. That change could substantially benefit small businesses and corporations. Proponents of the FairTax say consumers would also benefit because wages and employment would increase and businesses would pass their savings on to consumers in the form of lower prices. However, there’s no guarantee that will happen.
- Eliminating Tax Administration and Filing. Simply put, you’d no longer need to file a tax return with the IRS each year.
- Providing Prebates. The monthly check would help offset some portion of every household’s sales tax payments, especially for families near and below the poverty line.
While the FairTax plan sounds reasonable in theory, some economists say it would wreak havoc upon the middle class. That includes Alan Viard of the American Enterprise Institute, who studies federal tax and budget policy and sat for an interview about the subject with AEI.
Major concerns include:
- Penalizing the Lower and Middle Classes. Detractors say that individuals and families above the poverty level and considered middle class will bear the brunt of the tax burden for the country. It’s billed as a progressive tax, which means that the wealthy pay more and the poor and middle class pay less as a percentage of their income. But that’s only true if individuals spend 100% of their incomes on taxable expenditures. In reality, very high-income taxpayers save a larger percentage of their income than low- and middle-income people. So this plan would indeed be regressive — meaning those with less money end up paying a higher percentage of their income in taxes.
- Increasing Potential for Tax Evasion. One of the reasons Bush’s tax reform panel scrapped the FairTax idea was concern that a high sales tax rate would result in widespread tax evasion, possibly through trade and purchasing goods in other countries.
- Eliminating Tax Deductions and Credits. Currently, many tax deductions and credits incentivize specific social policy goals, such as buying a home, giving to charity, getting a college education, and saving for retirement. The FairTax’s prebate is designed to make up for those lost deductions. However, because it’s given to all households rather than encouraging people to spend their income in certain ways, people may be less motivated to take certain actions that could benefit them in the future.
- Making State Income a Bigger Burden. Though federal income tax would go away, state income tax would remain, and it would no longer be deductible against federal taxes. The effect would be a great burden on residents of high-income tax states like California and Hawaii. Moreover, unless you live in a sales-tax-free state, like Oregon or New Hampshire, you could pay your state’s sales tax on top of the FairTax — and on top of your state’s income tax. For a family living in Los Angeles making $100,000, that would be well over 40%!
- Depending Too Much on Spending. This tax is dependent on spending. But since many wealthy individuals already invest on their own and in other businesses, they may be further motivated to do so. Those moves could benefit the economy overall, but since these activities would be nontaxable, the national burden shifts to the lower economic classes.
- Increasing Costs for Immigrants. Prebate checks would only go to U.S. citizens. That would significantly raise the cost of living for lower-income immigrants, permanent residents, and visa holders. It could also deter highly educated foreign workers with highly sought-after expertise, such as doctors, engineers, and technology sector workers, from immigrating.
What Does It Mean for You?
The FairTax is gaining traction because many people feel our current income tax system is needlessly complex and unfair. But though proponents of the FairTax plan claim it’s a simple and fair replacement, that might not be accurate.
Consider that many families can currently get their effective federal tax rate down far below 30%.
For example, let’s consider a married couple who files a joint tax return and has two dependent children. Assuming they claim the standard deduction, we can estimate their federal income tax bill as follows:
|Federal Income Tax Analysis|
|Tax liability before credits||$8,629|
|Child tax credits||–||$4,000|
|Estimated tax liability||=||$4,629|
They also have an additional $7,650 of their wages withheld for Social Security and Medicare, making their total tax paid to the federal government $12,279. That means their effective tax rate is just over 12% — far less than the FairTax effective tax rate of 30%.
Take a look at your tax return to find your effective tax rate. If you use a service like H&R Block, it is likely on one of the forms that accompany your tax return. How much more (or less) would you pay under the FairTax plan?
Almost everyone agrees that our current income tax system is too complicated. For that reason, it’s easy to get behind the idea that throwing out our current tax system is the only answer.
But tax reform is rarely so simple.
When lawmakers float a FairTax proposal, read the text of the bill and analyses from reliable sources. Run the numbers for yourself. Then you can decide whether the FairTax is really fair or just a catchy sound bite.