# FairTax Proposal

The current tax system is complex.  If a researcher would want to correctly model the current tax system, they would have to take into account the myriad of deductions in the federal tax code (e.g.: Earned Income Tax Credit, Child Tax Credit, mortgage interest deduction, etc.) as calculate these deductions for each type of household.  One would also have to take into account: the FICA payroll tax (for Social Security, Medicare and Unemployment Insurance), the effect of extra current earnings on future Social Security benefits, the corporate income tax, and any implicit tax from loss of transfer programs such as TANF, Medicaid and Medicare.

Many economists have proposed a simpler solution.  Milton Friedman proposed a Negative Income Tax, the Europeans rely heavily on the Value Added Tax, and a recent NBER working paper by Laurence Kotlikoff and David Rapson (“Comparing average and marginal tax rates under the FairTax and the current system of federal taxation“) proposes a flat 23% federal retail sales tax which they decide to name the ‘FairTax’.

The ‘FairTax’ proposal is elegant and does not favor any specific group.  Below I review my opinions of the pros and cons of the proposal.

Pros

1. Simple – This proposal is simple and theoretically elegant.  It eliminates the loopholes many wealthy individuals use to drastically reduce their tax liability.
2. Progressive during the Transition phase – Since a sales taxes current and future earnings at the time of consumption in addition to taxing current wealth as it is spent on goods and services, this tax is somewhat progressive.  During the implementation phase of the tax, those who saved money and paid income taxes on their earnings will now also have to pay a large retail sales tax on these savings.  The income tax only taxes current and future earnings, but does not tax existing wealth.  As you can see below, (Y=current assets, L=labor income, w=wage, c=compution, τ=tax rate), the income tax and the retail sales tax are mathematically equivalent except for the fact that the retail sales tax also is a tax on existing assets.
• Y+wL=c*(1-τ)
• 1/(1+τ)*[Y+wL]=
3. Incentive to save – Since only spending is taxed, the ‘FairTax’ will give individuals an incentive to save more.  If an income tax rate is 25%, currently an individual can only save 75% of their earnings (excluding 401(k) and IRA options).  Under the ‘FairTax’, an individual saves 100% of their earnings and one is only taxed when the money is spent in retirement.
4. Decreases the marginal tax rate of most workers – Kotlikoff and Rapson show that a married couple with \$35,000 of earnings with two children faces a marginal income tax rate of 47.6% (mostly due to EITC takeback rates).  In their paper, Kotlikoff and Rapson show that marginal tax rates will be reduced for nearly all individuals.  Lower marginal tax rates gives workers an incentive to work more hours as well.

Cons

1. Tax Evasion – With only 1 type of tax, tax evasion may become a significant problem.  Small and medium sized business may decide not to record transactions in order to reduce the retail sales tax they must pay.  The tax literature suggests that many small taxes through a variety of channel (i.e.: income tax, sales tax and a corporate tax) may be empirically superior to one single tax, since using a portfolio of taxes reduces the incentive for individuals to evade the tax.
2. Politically Difficult to pass– most politicians like to target favored groups with tax cuts.  The child tax credit appeals to families and the mortgage interest tax deduction appeals to homeowners.  It will be difficult for these strong constituencies to agree to have their tax deductions taken away.
3. Elderly – Since it is the retired elderly who have wealth but no earnings, this tax will hit them the hardest.  The authors propose increasing Social Security benefits by 23% to compensate for the tax, but do we really want to be increasing public pension benefits as the Baby Boomers retire?  This may be a fiscally destabilizing proposal.
4. Eliminates sound policies – The EITC has brought many people into the work force.  The elimination of tax deductions for charitable giving may reduce the amount of funds NGOs receive and the federal government may have to provide more welfare programs to cover the shortfall.  Do we want a completely impartial system which may not be Pareto optimal or do we want a less ‘fair’ system than could improve economic efficiency for all.
5. Medicaid – There will still be high implicit tax rates for some individuals.  Since benefits such as Medicaid are ‘lumpy’, those who are at the margin for Medicaid eligibility will still face a high implicit tax rate (likely greater than 100%).