Evasion potential of the FairTax
For those of you on the libertarian side of the aisle, you undoubtedly are familiar with QandO. It is one of the larger blogs in the libertarian section of the ’sphere, and full of contributors that I highly respect.
Through the course of my correspondence, they have brought up some serious concerns. Several of them are more than covered in the FairTax Book, such as regressivity, the “increase” in the cost of goods*, and some of the concerns about the broadening of the tax base. Those won’t be addressed in this article, although I’ll be more than happy to handle them separately, should Jon and Dale request I do so.
In addition, Dale (who wrote the FairTax articles at QandO) also is very much against the myriad of personal income, corporate income, dividend and capital gains taxation that currently exists. He supports a VAT over the FairTax as the sole method for financing government, so much of my response will be based on that comparison.
Dale’s main concern is with tax evasion. He supports the VAT because the VAT requires a constant feedback loop. At every stage of production the VAT is levied, and such it makes it very easy for the enforcement body to watch for holes in the process. You find a hole, and it’s likely someone is not paying their taxes.
And the last caveat (I promise!), I will not addressed in depth his concern that the rate is the main evasion concern is the rate. I think that fighting tax evasion is a function of the enforcement mechanism and the penalties for being caught. As the rate goes up, the other two must increase as well, but if a suitable enforcement/penalty scheme is put together, the rate can be collected.
As you can see, the VAT allows the IRS to track the VAT very closely, because, at every stage of production, they are getting both a payment from the seller and the buyer, giving them two sources to find the same VAT payment. Also, at every intermediate stage, it’s in everyone’s interest to pay their VAT, because their customers are certainly going to deduct the VAT they’ve paid from their own VAT payments. So, if the IRS starts getting a lot of VAT deductions and no matching payments, they’ll not only know that something smells fishy, they’ll also have a pretty good idea where the smell is coming from. The enforcement strength of the VAT, and the incentive to avoid evasion, is that your tax payments are always reported by the third party.
Conversely, a NST is only levied once, at the point of final purchase. That means that nobody has to keep any tax records at all except the final seller. This provides a bit of perverse incentive. A retailer can simply fail to report all sales, and keep the sales tax for himself. Buyers can present a fraudulent sales tax exemption, or use their valid tax exemption for intermediate goods to buy capital goods or even personal items for which they should pay the tax. Both buyers and sellers, in other words, have an incentive to avoid paying sales taxes, and both have an incentive to report less-than-actual transaction costs. A tax system that provides a built-in incentive to tax evasion, along with increased difficulty in enforcement probably isn’t workable in the real world. The only reason it works in the states–and, by the way, often not even there, since states are constantly prosecuting sales tax evaders–is that state sales taxes are almost universally below 10%.
Allow me to act like Boortz for a moment. Boortz has the annoying habit, anytime someone brings up some false statement about the plan, wildly exclaiming “Sir, you don’t understand the plan.” I hate it, because it sounds so much like what a snake oil salesman would say. But I’ve got to do it:
Dale, you don’t understand the plan. 
First, let me explain the two main evasion methods that I can see. The first is sellers of goods and services just simply not reporting their sales, and thus not paying their taxes. The second is buyers who have “business exemptions” going into a store, flashing their “exemption certificate”, and thus not being charged the tax.
What makes either of these possible is the idea that the taxes are tracked only at the final retail level of sale. I.e. that business-to-business (B2B) transactions are never even reported to the tax agency. Thus, there is no way to detect at the final point whether this has been paid.
And that is where it is false. I refer at several points in this section to the FairTax Act of 2003. I recommend occasionally referencing the sections that I mention if you’d like to fact-check me.
First, the possibility of just flashing your exemption card and not paying tax. In the FairTax bill (sec 509), for a business to sell goods without collecting the tax, they must have the companies exemption certificate on file, and must keep complete records of all transactions for a period of 6 years. Purchasers must keep a record of all taxable goods bought for a period of 7 years. Thus, for a business to sell you goods without charging you tax, they need to have complete information on your business on file, and they need to report (sec 501.a.2) every month on those sales. This will limit most companies willing to sell you anything without charging you the tax mainly to B2B transactions.
This means that for most of what we consider “retail” transactions, the tax will always be charged. You can’t walk into Walmart, flash a card, and not pay the tax. When you do pay, then, the cashier will give you a reciept (sec 510) that contains all the necessary information for you to claim a refund of that tax when you file your monthly reports. This means that if you sell goods or services, and you don’t report that to the government, I wouldn’t suggest trying to get the refund for the goods you purchased. I think that will toss up a major red flag in their system.
Under the FairTax, any seller of taxable goods and services is required to report all sales at every step to the tax administration agency. This means that if I am a primarily B2B seller, I need to report the sale and that the tax was not charged to my customer. It works exactly like a VAT in the reporting stage. For example, I work for a company which makes computer equipment, and 99% of our revenue is B2B transactions. Thus, for any of our major customers, we’ll have their exemption certificates on file. For any new customers, just as we may have different credit terms, we will be forced to charge the tax and provide a proper receipt. Even though we’re almost exclusively B2B (and it wouldn’t matter if we were exclusively B2B), it is required that we take note of whether our customers are or are not tax exempt. And frankly, we’re not going to put our butts on the line to save them from their taxes.
Last, the point is often made at “just how easy” it will be to get that exemption certificate. Section 502 covers this matter. The rules will be about the same as current IRS rules, including the exemption and rules for “Hobby Activities” (sec 701). I’m sure it won’t be hard to get a certificate, but the usual people that claim you can just declare your blog a business (which I’ve already considered trying) so that you can buy whatever you want tax-free won’t hold water.
Now, of course, the VAT has a much heftier paperwork requirement than the NST does, which is, of course, what makes it so much harder to evade. But this isn’t the drawback that some claim. After all, we are talking about replacing the income tax with it, and the income tax itself has extremely hefty paperwork requirements. Indeed, after looking at the Tax Code, one could argue that the administrative burden of a VAT would be substantially less than the current burden of corporate income taxation.
As we see, the FairTax has very substantial paperwork requirements. Boortz and Linder don’t hype this in the book, of course, because they’re trying to sell the plan. But Dale is right that without this, the plan is not enforceable, and they’re prepared for that.
Thus, for anyone who lives “on the grid”, there is a built-in feedback loop. There is no difference between “business sales” and “retail sales”, all sales are treated as retail. Exemption certificates will be mainly a function of B2B sales, and your average small business who runs to Office Depot for supplies will have to submit that form to have their tax refunded every month (and thus alert the government to the fact that they’re not reporting actual sales of anything). Therein lies the beauty. Since the tax is essentially withheld and is always reported if it is not, anyone who chooses not to report their sales to the government will end up paying the tax on anything they buy.
This still leaves off people who live largely “off the grid”. For example, people who sell mainly services that don’t have a large capital cost, such as people who clean gutters, sell little artisan goods, etc, won’t have any real incentive to try to claim a refund on their paid sales tax, and thus can sell their goods or services tax-free. But here’s the thing. Those people already are probably operating on a cash basis, and thus won’t really pay income taxes. And a VAT certainly won’t be able to catch them. It’s a problem in any tax system, and thus doesn’t play a big part here. But, of course, when they go out and spend their money on other goods and services unrelated to their business, they will again be paying the tax at the retail level, so they’ll still be paying.
But how can this be effectively enforced? I think one of the things Dale brings up is that a very large number of nations have tried this, and have left it for a VAT.
The path of experience is also instructive here. In 1965, 19 of the OECD countries had some form of national retail sales tax. By 1995, every one of them had switched over to a VAT in order to end the compliance problems–and revenue shortfalls–caused by rampant tax evasion and avoidance.
As we have already seen, the FairTax has reporting requirements much like that of a VAT. This will be one major difference with in the experience of history.
Even bigger, however, is a matter of computing power. He notes that these countries had all ended their experiments with a national sales tax by 1995. That date is significant. We have much more powerful computers for tracking and looking for patterns than we had at that time. I make the analogy to online poker. In online poker, the biggest threat is collusion: two or more players at the same table working together to cheat. All the online poker houses have to do to solve the problem is to study the behaviors normally associated with collusion, and set up software routines to look for those behaviors. When one is spotted, they investigate, and correct if necessary. Any tax enforcement agency can do the exact same thing. Keep an enormous bank of servers looking for reporting patterns consistent with tax evasion. When one is found, investigate. Maybe a company bought a lot of products tax-free, but had a bad sales month and didn’t claim many sales. They’re not committing fraud. Another company, however may have bought a lot of products tax-free, and is using them for consumption rather than a true B2B purpose, and they’re going to get nailed. The enforcement options go hand-in-hand with the reporting requirements, and as computing power increases, it will be more and more capable of solving these problems.
In conclusion, from reading Dale’s article, I agree completely with him that a national retail sales tax, as he envisions it to exist, would be an enforcement nightmare. But most of the criticisms he has raised are covered in the legislation. The reporting will be hefty, and for most of the “retail” style purchases, the tax is effectively “withheld”, forcing someone with intent to avoid taxes to report that they need a refund, but that they have no taxes to pay. I still have concerns (i.e. should enforcement be federal rather than state, as the feds have a vested interest in enforcement?), but I think the basic fundamentals of the plan are designed with tax evasion in mind. I think, at the very least, that the example of nations who tried 10-40 years ago to enforce the tax, without the advantages that I mention above, may not completely apply here.
*I think in the short-term, prices will increase, as a portion of the embedded taxes are labor costs, which won’t simply disappear. Workers will demand their entire paycheck at current salary rates, meaning the embedded taxes will be paid as salary rather than disappear. The market will correct, and eventually that 22% will be gone, but it will take a matter of years. Immediate change may be 10-15% of the cost removed in the embedded taxes, depending on to what extent income tax and half of payroll taxes are a part of the embedded tax, but not the full 22%.
Excellent article. You answered some questions that no one else has. Fair Tax. Org should put this up in their faq – which seems to me to gloss over this problem.
I think I may have a solution for the service and small business industry. It took a while for me to think of this since I had to look at things in a new way. First there are three points I would like to make relating to the mindset of the Fair Tax vs. Income Tax. I use the same example throughout.
1. It would not be worth the 15% kick back to the consumer to go along with a scam. Say you get some plumbing work done that costs $400. Your kick back is $60 - now when you consider that if you ever have a problem with the service, you are out of luck because can’t bring any legal action without getting caught in Tax evasion and fraud. Besides, are you going to trust someone who knows you can’t complain if they do a poor job? Fudging on your taxes to get an extra $60 only involves you. It requires an extra level to conspire to commit fraud than if you do it privately and secretly.
2. Along the same lines, if Mr. Plumber keeps the 30% ($120) for himself, it is much easier to see how he has stolen the taxes you paid for himself, increasing the burden on everybody. Currently, it is the opposite – you see how much the government has taken from your hard earned income. It is harder for you to see how this hurts others, when you are just trying to keep what you earned, especially when others get exemptions you feel you should get but don’t.
3. Businesses that use MC or Visa, cash registers tied into computers (99.999% are, but someone may use an antique), can’t afford to keep the tax because there is a paper trail and they are audited on sales volume. This is different from our system now. While it is difficult to fudge on sales volume as entered above, it is easy to find a way to make this expense a deduction. I am sure a creative accountant could figure how to turn a $400 plumbing problem into a $4,000 tax write off. But with the Fair Tax, the consumer pays the tax to get the service. It’s the plumber we worry about withholding, and if entered with a paper trail, it is easier to just forward the tax, rather than figure out how to forge the figures to keep it.
Ok, so here is how we might get the folks off the books, on the books. Now this still won’t stop folks who are (for example) mowing lawns on the side for extra cash. (And there is a provision for your Baby Sitter, and hobby income. - $2,000 yr I think before they collect tax.) But for our Plumber who does a cash or check only business, with every 3rd transaction off the books – this might work.
Each month “Pete’s Plumbers” gets a bunch of bar code stickers. The Smiths get a (or 3-4?) prepaid post card with their monthly prebate check. In order for any warranty or guarantee, the Smiths must mail in the card with the sticker. (It could also be done over the net – just log in to your family’s prebate account and enter the sticker # - or over the phone with the family’s pin) All the sticker needs to do is ID Pete the Plumber as providing an unknown service in an unknown amount. The info can even just “pass through” with a unique code (one to each source) to mark a tally on Pete’s # of sales transactions, thus ensuring the privacy of the Smiths, and the honesty of Pete.
Now when Pete reports his sales, it should be greater than or equal to the total reported for his business. He should not have a whole bunch of sales reported from the same source.
Not everyone will report those services. They don’t have to, just a big enough percentage to make keeping the tax like playing Russian Roulette.
These stickers would mainly be for service industry that did not have other means of enforcement. For small items like mowing the lawn, or house cleaning, most people will turn the other cheek and be cash only to avoid a 30% increase in these services. Frankly I don’t begrudge this small amount. Besides, most of what Carol earns cleaning houses will go out in sales tax for almost all she buys. And if she is so poor that none of it is recovered because of the prebate, then she (even in aggregate) is too small potatoes to worry over.
[...] Dale Franks of QandO has responded to my earlier post regarding evasion of the FairTax. A commenter named Kirk has done much of the heavy lifting regarding a response to Dale’s concerns. Nobody is claiming that the FairTax will be without evasion, but Dale has not yet made the case that the VAT is better. [...]
[...] In response to Brad Warbiany’s article “Evasion Potential of the FairTax,” Dale Franks at QandO wrote “Fair Tax Supporters: Whistling Past the Graveyard,” in which he asserts that tax evasion would be significantly harder under the VAT tax, compared to the FairTax. [...]
>> I think I may have a solution for the service and small business industry... [snip]...
Well, why couldn’t it be easier? Assuming the person who hire the plumber gets a receipt. If he reports it to the IRS, he will get a rebate/credit (whatever we call it, it’s after all, money.) This gives incentives for the consumer to report the transaction. The IRS will then be able to tax the service provider. I think this is more inline with the primary mean of collecting tax — making one side of the transaction willing to report the transaction, so that the other side will not be able to evade the tax.
Now, I am not saying that the consumer and the service provider won’t work out a deal. The service provider may be willing to reduce the fee in exchange for the consumer’s agreement of not reporting the transaction. But come to think about it, when the fee is lowered, the money will go back to the consumer’s pocket. Assuming that sometime later he spends the money to buy something, a portion of the money will still be end up in the system. So, the loss of the tax will not be 100%. Plus, the incentive fro the consumer to deal is not high — he can get money back from IRS anyway. Unless the service provider is willing to give a discount that’s greater than the tax credit/rebate, there will be no deal.