January 25, 2023

FairTax FAQ

The FairTax is a proposal to replace all major sources of the federal government’s revenue—the individual income tax, corporate income tax, estate and gift taxes, and payroll tax—with a national sales tax and rebate, abolishing the Internal Revenue Service (IRS) 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.

The Fair Tax 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 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 plan 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.

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 FairTax 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.

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 Fair Tax 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 Fair Tax 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.

The FairTax 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 taxes, corporate income tax, payroll taxes, and estate and gift taxes.

It would be important for the FairTax 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 FairTax would also need to ensure in practice that it exempts business inputs. Including them would tax consumption more than once, leading to tax pyramiding 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.

The FairTax 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.

The FairTax 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.

FairTax Rebates Based on 2023 Federal Poverty Guidelines
Persons in Family/Household Poverty Guideline Monthly Rebate (single) Monthly Rebate (married)
1 $14,580 $279 n/a
2 $19,720 $378 $559
3 $24,860 $476 $657
4 $30,000 $575 $756
5 $35,140 $674 $854
6 $40,280 $772 $953
7 $45,420 $871 $1,051
8 $50,560 $969 $1,150

Source: HHS Poverty Guidelines for 2023 and author calculations.

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 FairTax 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.

The FairTax 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 FairTax rebate.

Some economists argue the FairTax would be progressive if measured by consumption because the rebate is a smaller portion of consumption for higher earners.

One distributional challenge for the FairTax 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.

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 FairTax, 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 FairTax 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.

Imposing a new national sales tax would lead to some double taxation 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 may also have transitional impacts on retirees in particular. The FairTax 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 income, and they currently benefit from reduced taxes on Social Security benefits.

Banner image attribution: StockPhotoPro

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