What is the Fair TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ?
The Fair Tax is a proposal to replace all major sources of the federal government’s revenue—the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. , corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , estate and gift taxA gift tax is a tax on the transfer of property by a living individual, without payment or a valuable exchange in return. The donor, not the recipient of the gift, is typically liable for the tax. es, and payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. —with a national sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. and rebate, abolishing the Internal Revenue Service (IRS)The Internal Revenue Service (IRS) is part of the U.S. Department of the Treasury and is responsible for enforcing and administering federal tax laws, processing tax returns, performing audits, and offering assistance for American taxpayers. in the process. Overall, the plan would likely result in a significant reduction in federal tax revenue and a more regressive tax system as measured by tax rates on income.
What is the history of the Fair Tax, and why is it back in the discussion?
The FairTax Act was first introduced in 1999 by then-Congressman John Linder (R-GA). It has since been introduced in each new Congress, only garnering a small number of cosponsors and never moving out of committee. The FairTax Act has also received attention in presidential campaigns, most prominently in 2008.
As part of deliberations over the House Speakership, Speaker Kevin McCarthy (R-CA) reportedly committed to holding a House floor vote on the FairTax Act as introduced by Rep. Earl “Buddy” Carter (R-GA). It would be the first time the proposal has been given a floor vote, and it could happen sometime this year.
Is the Fair Tax a consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. ?
A consumption tax is a tax on what people spend, as opposed to an income tax on what people earn. As a retail sales tax, the Fair Tax is one form of a consumption tax.
In general, consumption taxes are more economically efficient than income taxes because they do not place an economic burden on investment or saving, but they do still place a burden on labor by reducing the after-tax return to work. Consumption taxes also tend to be regressive because lower-income households tend to spend more of their incomes than they save.
What is the Fair Tax rate?
Tax rates can be stated in tax-inclusive or tax-exclusive terms. Tax-inclusive rates compare the tax paid to the total price including taxes. Tax-exclusive rates compare the tax paid to the price excluding taxes.
The FairTax Act proposes a tax-inclusive rate of 23 percent, but taxpayers will be more familiar with the tax-exclusive rate, which is how state sales taxes are typically described. The FairTax Act would result in a tax-exclusive sales tax rate of about 30 percent (29.8 percent), meaning for every $1 spent, taxpayers would pay about 30 cents in sales taxes to the federal government.
What would the Fair Tax tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. include?
The Fair Tax would apply a national retail sales tax to goods and services broadly, estimated to cover about 90 percent of all consumption—or about 61 percent of GDP. The proposal would repeal the federal individual income tax, capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. es, corporate income tax, payroll taxes, and estate and gift taxes.
It would be important for the Fair Tax to maintain a broad tax base on final consumption, which is an existing challenge for state sales taxes. A narrower tax base would require a higher tax rate to raise equivalent revenue, which would distort consumption decisions.
The Fair Tax would also need to ensure in practice that it exempts business inputs. Including them would tax consumption more than once, leading to tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. and distorted business decisions. It would require a simple process to exempt business purchases from sales tax if they were within the sales tax base.
Who would administer the Fair Tax?
The FairTax Act would abolish the IRS and outsource the administration of the national sales tax to the governments of the 50 states and the District of Columbia. Currently, 45 states and D.C. collect statewide sales taxes. In states without a sales tax, the Secretary of the Treasury (or another state) would administer the national sales tax.
Each state’s sales tax base varies, ranging from a breadth of 20 percent in Massachusetts to 111 percent in Hawaii. States could conform to the national sales tax base definition, or administer two separate sales tax systems. Ensuring compliance would also be difficult due to the relatively high national sales tax rate, which would create a large incentive for evasion.
States would retain 0.25 percent of the revenue they collect to help offset administrative costs. Similarly, businesses would receive a “taxpayer administrative credit” of 0.25 percent of the amounts collected as compensation.
For example, if the national sales tax was levied at a high enough rate to generate enough revenue to maintain current levels in 2023 ($4.6 trillion), states and businesses would retain about $11.5 billion for administrative costs. The IRS budget in FY 2022 was $11.9 billion, implying no cost savings.
How would the Fair Tax rebate work?
The FairTax Act would provide a “family consumption allowance” to each household worth the amount of national sales tax paid on goods and services up to the poverty level. It would effectively exempt households at or below the poverty line from the tax and make the plan more progressive than it would be without the allowance.
One trade-off is that the rebate would reduce the amount of net revenue raised. For example, based on 2023 poverty guidelines, a single-person household would receive a $279 monthly rebate. It has been criticized as a form of universal basic income for American households.
|Persons in Family/Household||Poverty Guideline||Monthly Rebate (single)||Monthly Rebate (married)|
Source: HHS Poverty Guidelines for 2023 and author calculations.
What effect would the Fair Tax have on federal tax revenue?
According to the Congressional Budget Office, the individual income tax, corporate income tax, payroll taxes, and estates and gift taxes raised a combined $3.8 trillion in revenue in 2021 (16.8 percent of GDP). Over the next decade, CBO projects the four revenue sources will raise a combined $53.5 trillion.
Estimates indicate a 23 percent inclusive (29.8 percent exclusive) tax rate would fall short of maintaining current levels of tax revenues. The Fair Tax rebate would further reduce the revenue raised under the proposal. Past analysis by economist Bill Gale suggests a tax rate of at least 44 percent, not the proposed 29.8 percent, would be needed to approach revenue neutrality.
How would the Fair Tax impact the distribution of federal taxes?
The FairTax Act would be less progressive than the existing federal tax system as measured by income. The likely regressivity is because higher-earning households consume a smaller portion of their income than lower-earning households, even after adjusting for the Fair Tax rebate.
Some economists argue the Fair Tax plan would be progressive if measured by consumption because the rebate is a smaller portion of consumption for higher earners.
One distributional challenge for the Fair Tax is how the tax would apply to taxpayers who are not paying much in income tax under the current system but who would pay increased sales tax. That group would include retirees, large families, and students who would not benefit from the tax cuts under the plan but would see a tax hike on consumption.
What are the trade-offs of moving to the Fair Tax?
Moving the federal tax system away from taxing income and toward taxing consumption is a step in the right direction for a pro-growth and simpler tax code. Taxing consumption is a less economically damaging way to raise revenue than taxing income and would potentially be less complex for individual taxpayers to navigate than the current complicated system.
However, devolving the administration of the federal tax system to the states would have its own challenges, as taxpayers would have to navigate up to 51 different agencies rather than a single IRS. While compliance costs for taxpayers would fall under the Fair Tax, those collecting sales taxes would still need to coordinate on tax collection and remittance, receive and interpret guidance, and have credible enforcement under the plan.
The Fair Tax would also run into distributional challenges compared to the current system, even after the rebate. Policymakers could instead consider alternative ways to tax consumption progressively, which would deliver economic benefits without dramatically changing the distribution of the tax burden or the administration of the tax system compared to current law.
What would the transition from the current tax system to the Fair Tax plan look like?
Imposing a new national sales tax would lead to some double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. in the transition period. One way to think about it is like a one-time tax on existing wealth—all consumption, including consumption paid for out of existing savings, would be subject to the new tax. The double taxation, then, occurs when households face the new tax on spending paid for by income already taxed under the old income tax system. This specific impact would be progressive, as saving is positively correlated with higher incomes.
Some exceptions to double taxation would apply. For instance, income saved in 401(k) plans or individual retirement accounts (IRAs), would not face a double tax because contributions are deductible against the individual income tax.
The FairTax Act may also have transitional impacts on retirees in particular. The Fair Tax proposal attempts to mitigate this by adjusting Social Security benefits for the tax and by providing the rebate. Even so, retirees may still face a higher burden as they would not benefit from income tax repeal if they do not plan to earn additional taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. , and they currently benefit from reduced taxes on Social Security benefits.
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