Wednesday, January 11, 2006



In my entry of 19 December 2005 I raised the subject of the Fair Tax, a US suggestion for a consumption tax to replace all other taxes. I said then that I thought it factually flawed. Today I want to explain why.

But first what is the attraction of replacing income tax and other direct taxes by a consumption tax? The many advantages claimed for the fair tax are:

1. Taxpayers (other of course than retailers) will be relieved of the costs of complying with tax laws – which the (US) Tax Foundation estimates at $194 billion.

2. Most of the 100,000 people who work for the IRS (the US equivalent of the direct tax and VAT collection side of HMRC (the US Customs Service handle the Customs side) will be able to be redeployed to more useful occupations (the authors of the book suggests as assistants in burger bars, which some might question whether is really a more useful occupation).

3. Every one will have more money as they will receive their gross earnings and prices are likely to adjust downwards to such an extent that the FairTax inclusive price will be roughly equal to current prices – so everyone will be better off by the amount of tax that they currently pay.

4. US multinationals will close down their international operations and bring everything back home so as to avoid paying foreign taxes.

5. The US will be so competitive internationally that overseas companies will rush to set up in the US and employ US workers.

6. It will put an end to the black economy (or the underground economy, or invisible economy as it is now often called in the PC world).

7. As the government will pay the FairTax on its purchases whereas private business won’t, it will be unable to compete with private business and will have to divest itself of business such as electricity generation or garbage collection.

8. A tax on consumption encourages savings, which in turn encourages investment. It also incentivises people to work harder and earn more untaxed income that they can save.

9. The rich can avoid income tax but won’t be able to avoid the Fair Tax. Indeed because they spend more than the poor they will pay more tax than the poor.

Sounds good. Why won’t it work? Because the arithmetic seems to me to be flawed. And if the arithmetic is flawed most of the above benefits are illusory.

This hit me when the authors explained “The FairTax is not a VAT or value-added tax similar to European VATs. VATs are added at every stage of production and hide tax costs in the price of goods. In contrast the FairTax is levied once and once only – at the retail cash register – and it is printed on the sales receipts for all to see”.

Firstly this demonstrates that the authors do not understand VAT. VAT is not a cascade tax which is levied again and again at each stage of production. It is a tax on the value added. In its purest form a seller charges VAT only on the difference between his selling and purchase price. Accordingly if the VAT at all of the stages of production is added together the total is exactly the same as the single charge under a FairTax. (The European VAT system does not wholly achieve this as it is imperfect and sometimes inconsistent because of the effect of exemptions, multiple rates and exclusions, but a perfect VAT system would have the same result as a consumption tax charged at the retail stage only). Yes the amount of VAT included in the price of an item is hidden, but who really cares how much of the price that they pay for something is tax? The FairTax envisages a tax inclusive price so a person will not know how much tax he is being asked to pay before he buys; he will need to study the till slip - and when he gets that it is too late to be deterred by the tax.

Secondly a VAT is superior to the FairTax as it is more difficult to evade. The authors claim that evading the FairTax will require collusion between the customer and the retailer and that is unlikely to occur. They also believe that most of us are inherently dishonest. It is accordingly unclear why they dismiss (or possibly overlook) the risk that retailers or their staff will simply charge the tax to the customer and not account for it to the IRS. That is far more likely than collusion. With a fair tax it is the entire tax that will be stolen. With a VAT it is normally a proportion only of the tax, normally that on the value added at the final stage, as the purchaser at an intermediate stage is likely to want to ensure that his vendor pays the tax as he wants to claim credit for it.

But that is not the fatal flaw. That is simply what got me thinking about the author’s arithmetical competence. The fatal flaw is the assumption that prices will fall by 23% to compensate for the tax. Take WalMart for example. It’s 2005 accounts show sales of $285,222m, total operating costs of $51,105m and pre- tax income of $16,105 on which it paid tax at an effective 34.7%. Assume half of the cost of sales is wages attracting employee’s social security at 7.65%. That comes to $5,588m corporate tax plus $1,955m social security, a total of $7,543m or 2.65% of its sales. Its FairTax bill at 23% on $285,222m would be $65,601m, an increase in its overall tax liability of $58,058m. If it didn’t have to pay the existing taxes its net profit would be $23,648m. So how is it going to absorb $65,601m and stay in business. Answer: It can’t.

I suspect that in looking at existing taxes the authors have counted in payroll taxes. But their starting point is that workers’ take home pay increases, i.e. that they keep their existing earnings but pay no tax on them. On that basis Walmart does not benefit from the tax saving; its employees do. And if Walmart does not obtain the benefit of the saving it clearly cannot pass the cost of that saving on to it’s customers. Of course there is some embedded tax in Walmart’s expenses and its $219,793 cost of sales (i.e. taxes paid by its suppliers), but that is likely to be at a similar rate to Walmart’s 2.65%.

The authors also do not say what happens if customers drive to Canada or Mexico for their major items of shopping. Unless FairTax is charged at the border that will reduce US sales and therefore the US tax yield. So will not charging tax on second-hand goods. Currently every time something is sold it attracts tax. And what about refurbishing second-hand goods prior to sale. There will be no FairTax on that either. Accordingly the taxbase will be much smaller than at present, which makes even the 23% figure look suspiciously low.

All in all the FairTax looks to me to be an idea that has not been thought through very far. It seems to me to be completely unworkable.

Robert W Maas


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