Does the FairTax Go After the Underground Economy?

August 17, 2007

With the Fred Thompson for President campaign now in full swing, his tacit support for the FairTax has become an issue in the race. The question is, Does he support the FairTax or doesn’t he? Many other candidates, mostly on the Republican side (as well as Gravel on the Democratic side), support switching to the FairTax, or a national retail sales tax.

One of the arguments commonly made in favor of such a plan is that it would make people involved in illegal activity pay since they tend to spend the income they earn illegally on legal goods, such as food and cars. However, as we discussed briefly in a previous blog post, there is one problem with this argument: the buyers of the illegal goods, who are currently paying income taxes, would now be earning income tax-free. Here’s an illustration:

Suppose there are six people in the economy: a drug dealer who pays no income tax and five people who work regular jobs and pay income tax and also buy drugs from the dealer. Each person earns $50,000 and the five regular employees each spend $10,000 on drugs per year, which they purchase from the dealer, who thereby earns $50,000 himself. Assume that each person spends his/her entire income and that we have a 20 percent flat income tax. Under this income tax system, each regular employee would pay $10,000 in taxes for a total of $50,000, while the drug dealer’s $10,000 would escape taxation. So we have $50,000 in tax revenue and $10,000 escaping taxation as a result of the illegal drug market.

Now suppose we have a 20 percent sales tax and no income tax. Now the drug dealer, who purchases regular products other than drugs, would pay $10,000 in sales taxes, and the regular employees would pay $8,000 each in sales taxes as 20 percent of their income still goes to purchasing drugs. If the dealer is currently avoiding income tax, it’s safe to assume that he would not charge sales tax when selling drugs, so his customers would avoid the sales tax. That brings us to $50,000 in total tax collections and $10,000 escaping taxation due to its use in the drug trade. These numbers are exactly the same as in the previous flat-income tax scenario.

Assuming income taxes are borne fully by the worker and sales taxes fully by the consumer, the only difference the brought about by the switch to a sales tax is that $10,000 is transferred from the drug dealer to the five drug buyers.

However, as the FairTax group has pointed out, it is often the case that those who are the drug buyers are also earning income currently tax-free. Assume one of those five regular workers is currently paid under the table. While that person would now be taxed on those earnings in the form of purchasing power, it would still do nothing to the drug trade. The extent to which that person would now be taxed on his purchases is the same as the drug dealer. Those who are buying the services from that drug buyer (however he earns his income) would likely not pay sales tax on that service.


Related Articles