Enforcement Mechanisms of the FairTax

May 8, 2006  ·  Filed under: Education

Common in the FairTax debate are the questions of avoidance and evasion. Due to these incredibly common questions, and the fact that the answers are not easy to find (even in The FairTax Book), I hope to give a full accounting here.

First, allow me to clear the air. I don’t believe that the claims that this will be collected and enforced by the state sales tax agencies to hold one iota of water. To the extent that some of the actual collection may be done this way may be true, but true enforcement will be handled by the feds. You see, the federal government can’t force states to collect the tax. States which choose to do so will, but any state which doesn’t opt into the “administering state” guideline will have the FairTax administered by the feds (HR 25, secs 401-404,).

Why would a state choose to be an “Administering State”? Well, they can get a quarter of a percent of the sales tax they collect as an administration fee. Something tells me they’re not going to take on the enforcement headache for that.

Even if they do, however, there will still be a federal agency devoted to information sharing and enforcement. Some states without a state sales tax cannot administer the FairTax, and thus the federal agency will be immediately required. And since so much commerce these days travels between states, you need a central information-sharing repository to track payments and sales. While the IRS may cease to be the IRS, it will be replaced by another agency. Of course, it’s still a net gain, because that agency won’t have the ability to look into my own personal finances the way they can with an income tax, so I’m not so worried about it. But let’s be fair, the tax enforcement agency, no matter its name, is not going away.

So that brings me to the meat of the arguments. How is the FairTax enforced? How do we ensure that people who purchase items, specifically people associated with a business, pay the tax on the item if it’s for personal use? As a first step, let me explain how a Value Added Tax (VAT) works, as it will make it much easier to understand how the FairTax will be enforced.

Consider the manufacture and sale of any item, which in this case we will call a widget.

Without any sales tax

  • A widget manufacturer spends $1 on raw materials and uses them to make a widget.
  • The widget is sold wholesale to a widget retailer for $1.20, making a profit of $0.20.
  • The widget retailer then sells the widget to a widget consumer for $1.50, making a profit of $0.30

With a VAT

With a 10% VAT:

  • The manufacturer pays $1.10 ($1 + 10%) for the raw materials, and the seller of the raw materials pays the government $0.10.
  • The manufacturer charges the retailer $1.32 ($1.20 + 10%) and pays the government $0.02 ($0.12 minus $0.10), leaving the same profit of $0.20.
  • The retailer charges the consumer $1.65 ($1.50 + 10%) and pays the government $0.03 ($0.15 minus $0.12), leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The businesses have not lost anything directly to the tax, but they do have the extra paperwork to do so that they correctly pass on to the government the difference between what they collect in VAT (output VAT, an 11th of their income) and what they spend in VAT (input VAT, an 11th of their expenditure).

Note that in each case the VAT paid is equal to 10% of the profit, or ‘value added’.

The advantage of the VAT system over the sales tax system is that businesses cannot hide consumption (such as wasted materials) by certifying it is not a consumer.

So you can see that at every stage of production, there is a reporting requirement and a payment requirement. At every stage, the government collects a tax and knows what’s happening. Thus, if there is a problem, it’s very simple: follow the money. If there are 6 companies in the production chain, and Company 4 doesn’t send you the tax, but Company 5 tells you they received product from Company 4, you know the system is broken, and it’s time to pay a visit to Company 4.

Now, let’s examine the same option, two different ways:

First, assume each company has a business-to-business (B2B) relationship, and their paperwork is in order. This is the simplest option.

  • The manufacturer of the raw materials sells them to the widget company for $0.80. No tax is paid, but the sale is reported to the enforcement agency as a B2B transaction.
  • The widget-maker turns the raw materials builds a widget, and sells the widget to the retailer for $1.00, a profit of $0.20. No tax is paid, but the sale is reported to the enforcement agency as a B2B transaction.
  • The retailer sells the widget to the consumer for $1.56, at a $0.20 profit. $0.36 (23% of the purchase price) is sent to the government as tax.

Notice what happened here. Each company in the chain had the same reporting requirements as a VAT, but the tax was not collected until the final step. Now, one more example:

Now, assume the retailer and widget-maker do not have a business-to-business (B2B) relationship!

  • The manufacturer of the raw materials sells them to the widget company for $0.80. No tax is paid, but the sale is reported to the enforcement agency as a B2B transaction.
  • The widget-maker turns the raw materials builds a widget, and sells the widget to the retailer for $1.30, a profit of $0.20, and a tax of $0.30 to the government.
  • The retailer sells the widget to the consumer for $1.56, at a $0.20 profit. $0.36 (23% of the purchase price) is sent to the government as tax. They then send the government the receipt and report of their purchase from the widget maker, getting $0.30 sent back to them as a rebate on previous taxes paid.

Notice the difference? The price to the consumer didn’t change. The tax was paid twice, but the retailer, as a business, was able to recoup the tax they paid on the original sale. (Obviously, in the real world, the retailer would only send $0.06 to the government, and wouldn’t receive a rebate, but I simplified it). Essentially, if the companies in the chain don’t have a B2B relationship, they must pay the tax, and the system acts exactly as a VAT. If they do have B2B relationships, the reporting is identical to a VAT, but the tax is only paid at the final step.

So what constitutes a B2B relationship? Before we go there, first we need to understand what constitutes a business. Well, that one is simple, and the rules for what constitutes a business are largely lifted from the current income tax code. Essentially, anyone who provides goods or services is a business. The full explanation is provided in HR 25. But if you are registered as a business, you have the responsibility to report sales of goods and services, and you have a certificate of registration that you can use to buy goods without paying the tax.

So there it is, all you need is that certificate, and you can go buy a Lexus without paying tax, right? Well, it’s not quite that simple. In my above examples, I provided one example where the players had their B2B relationship and all paperwork in order, and one where they did not. The paperwork is a big thing. For a business to sell anything without collecting the tax, they have to have the certificate of registration from the buyer, and they need to keep that on file for 7 years.

That’s right. If I want to sell you something without collecting the tax, I need to keep a heck of a lot of paperwork on hand. What does that mean? If I’m the owner of a Lexus dealership, and you come in waving your exemption certificate, I’m going to make you pay the tax on that car. If you can prove to the enforcement agency that it’s a legitimate business expense, they’ll refund you that tax, but I don’t want to do the paperwork. Right here is the first step in enforcement: making it hard for you to buy something tax-free, and forcing you to request a refund.

Now, if I’m a Lexus dealer, and you’re a company who buys 10 cars a year as an employee fleet, I might choose to do the paperwork, and allow you to buy the cars without collecting the tax from you. Maybe if you’re trying to scam one extra car tax-free for your wife, you might pull one over on the government, but no tax system is completely avoidance-free. The reporting requirements make sure that it’s at least difficult to evade the tax.

Next, of course, would be the end company, who might want to avoid paying the tax. Let’s say I clean houses for a living. As a provider of a service, I should be collecting taxes on that service. Of course, I don’t want to collect those taxes, so I decide not to register with the government. That, in itself, is a small cog in the process. Why? Because if I’m not registered with the government, I will then pay taxes on all the raw materials I purchase. If I try to procure advertising for my business, I pay the tax for that service. If I’m buying a vehicle to transport myself and my supplies, I pay tax for that vehicle. I may not be collecting taxes on my service, but I am paying taxes on my inputs. Here is the second step in enforcement: ensuring that someone at the end of the process must at least pay taxes on their inputs, even if they don’t pay on their own sales.

Last is evasion in a middle step. Now, this is a lot harder to detect. Let’s say, for example, that I run a technology company, and routinely purchase a lot of computer equipment. A couple of my employees want home PC’s, and I know I can get those PC’s for them tax-free and call them a business input. Or, I know that I can get some PC’s tax-free and sell them to my friends directly. This comes down to combining the reporting requirements with extensive pattern-matching. It’s simple. The enforcement agency is going to have the capability to spot trends in businesses, based on behavior. If businesses with 20 employees are buying 40 computers a year, it will raise a red flag in the enforcement agencies computers. Suddenly, your company might be getting a visit asking where all those computers went, and you’re up a creek. While this won’t have a chance at stopping small-scale evasion, ensuring the price of getting caught is high will deter much of this. Of course, over time the pattern-matching will get better, and become more effective at spotting those who evade and reducing false positives. So this is the last step in enforcement: extensive study of patterns and behavior to spot possible evaders.

Every tax system can be evaded, and the FairTax won’t be an exception. However, when trying to combat tax evasion, you need to do three things: make it as difficult as possible, create enough reporting that people worry they’ll be caught, and make the penalties for being caught stiff. In this system, you clearly make evading hard, by giving sellers incentives NOT to sell anything without collecting tax, unless they have a strong business relationship with the buyer. Second, the system has built-in enforcement mechanisms. If you are constantly buying things tax-free, but not selling very much, the government is going to wonder where that inventory is going. Third is penalties. If the new enforcement agency is anything like the IRS, I don’t think we need to worry those will be lax. The FairTax has more built-in enforcement than our income tax code, which typically relies on self-reporting of unverifiable facts. And since it is targeted at businesses (a smaller group of the population than workers), it’s even easier to target enforcement investigations at the possible offenders.

I’m not an economist, but I have a hard time believing the evasion potential of the FairTax is worse than our current income tax, and it could quite possibly be considerably easier to enforce.

Posted by Brad Warbiany  ·  Trackback URL  ·  Link
13 Responses to “Enforcement Mechanisms of the FairTax”
  1. FairTax.org has a pretty good research paper on compliance at http://www.fairtax.org/pdfs/tax_evasion.pdf.

    I was also under the impression that states would jump at the chance to collect the FairTax along their sales taxes for the money they could keep.

    I believe the sale of items that could be personal or b2b from normal retail outlets would be taxed and the businesses would apply for the refund so it leaves a paper trail. Large scale purchases b2b purchases from wholesalers by businesses with exemption certificates would be immediately tax free after the seller runs the numbers through the system similar to what happens to some non-profits/famers today.

    At one point I exchanged emails with their researcher. I’d suggest you shoot them an email if you have questions.

    Moshe  ·  May 8, 2006 at 10:58 pm  ·  Permalink
  2. Moshe,

    Good link. I personally don’t think states will jump at the chance to do the enforcement, but I haven’t looked at how much money it will be relative to their budget. Either way, there will still be a large federal agency, because so many transactions are interstate in our economy.

    Brad Warbiany  ·  May 9, 2006 at 7:20 am  ·  Permalink
  3. The old saying that “the devil is in the details” was never more applicable than here. I appreciate your speculation and can only hope that the enabling regulations are as simple and straight forward as in your hypothesis. The fact remains that only after the legislation is passed is the enabling regulations written and our friends in government service have a history of creating mountains on flat land.

    I too, am a supporter of the FairTax and a volunteer speaker on its behalf. Passage of the legislation is only the first step and we need to remain active in our observance of the regulatory creation which follows.

    Duane Neighbors  ·  May 9, 2006 at 11:37 pm  ·  Permalink
  4. I also believe the states will move to do the enforcement. Here are some numbers: The 25 basis points paid to the states amounts to 5 billion dollars the states will have available for enforcement. As an example, California should receive over $500 million for enforcement. According to the California 2004-05 budget analysis, this is more than the $327 million California is currently spending enforcing its own much more complex sales tax and excise taxes. Because the federal money paid to the states for enforcement is a percentage of the total revenue collected, the states will have an incentive to maximize collections.

    Jeff  ·  May 10, 2006 at 9:40 am  ·  Permalink
  5. Duane,

    I completely agree. Thankfully, the legislation gives a decent outline of the enforcement, which is what I used as the basis for the post. It’s certainly possible that federal regulators can screw it up, but there’s not much we can do now to take care of that.

    Brad Warbiany  ·  May 10, 2006 at 1:52 pm  ·  Permalink
  6. Brad,

    I respectfully disagree with most of your analysis.

    First off, it is clear you have either not researched the numbers or you are not familiar with state government. Pick any state that has an existing sales tax and then calculate what the state’s cut would be. No state will walk away from that kind of money. Post your findings here because perhaps you are miscalculating and do not see the money pit the states will be jumping in.

    Secondly, the FairTax does not require businesses to report B2B transactions like a VAT. One of the strenghts of the FairTax is that it lessons the pain on businesses. A VAT-like reporting structure is a nightmare worse than the current system. If they were going to report like a VAT they might as well collect tax like a VAT. Having worked for a State’s Tax Authority, their existing sales tax collections mechanisms are far less cumbersome and already have a far greater enforcement rate than their income tax mechanisms. Sales Taxes are far cheaper and easier to collect and enforce for states than income taxes. A VAT-like enforcment mechanism is not cost effective and no state that I am aware of force this upon its businesses currently.

    You write well and have your heart in the right place, but there is not one assertion in this blog that is close to being a truth.

    FairTaxChad  ·  May 10, 2006 at 3:17 pm  ·  Permalink
  7. Chad,

    On the State issue, I admit I may be wrong. 0.25% of the tax collected seemed fairly small, and I didn’t really run the numbers. As was pointed out above, for a state like California, the amount they would receive may actually be larger than what they spend enforcing their own sales tax, in which case they’ll jump at the chance to enforce it. That still doesn’t mean there won’t be a moderately-sized federal bureaucracy to administer the tax to states who don’t have a sales tax, and to be a central clearinghouse of information and regulation for interstate sales.

    As for reporting, though, Secs 501 and 509 of the FairTax legislation say that each registered seller must prepare a report every month detailing any tax collected, any credits claimed, and “other information reasonably required by the Secretary or the sales tax administering authority for the administration, collection, and remittance of the tax imposed by this subtitle.” Do you think they won’t be required to report the sales that are not taxed? And Sec 509 clearly states that records must be kept for any sales for which the tax is not collected (due to the buyer having an intermediate and/or export sales certificate) for 7 years.

    It probably won’t be as difficult to figure out as a VAT (i.e. because they don’t have to compute added value, just sales price), but there will be reporting steps at every stage of production. At least, that’s what it looks like it the legislation, can you explain why I’m wrong?

    Brad Warbiany  ·  May 11, 2006 at 7:20 am  ·  Permalink
  8. […] I don’t know if ya’ll have figured this out yet or not but I fully support the FairTax. When talking to people about the FairTax one of the questions that comes up that I just don’t have good answers for is on how it will be enforced. Brad Warbiany gives us a good explanation here. Common in the FairTax debate are the questions of avoidance and evasion. Due to these incredibly common questions, and the fact that the answers are not easy to find (even in The FairTax Book), I hope to give a full accounting here. […]

    Larry’s Log » Blog Archive » FairTax Enforcement  ·  May 11, 2006 at 10:23 am  ·  Permalink
  9. […] For any of you with concerns that the FairTax would create an environment where every person becomes a business to avoid paying taxes, just read this excellent description of the FairTax enforcement mechanisms. […]

    Flashpoint » FairTax Enforcement  ·  May 15, 2006 at 3:37 pm  ·  Permalink
  10. Today the states [with sales tax] already do enforcement for their own sales tax. While the exact examples that Brad provided are not appropriate, because VAT like reporting will not occur, his thought process is correct. Registered businesses will submit sales tax returns. A few simple items such as gross sales will be included on the monthly reports. Remember, registration will also require some simple information such as business name, address and function. With just gross sales and business function, the sales tax agency can analyze returns and flag the odd returns for audits. If they ask a few more questions during registration and require a few more numbers on monthly reports, they can find even more anomalous returns and investigate accordingly.

    Go ahead and establish a business under the Fair Tax to avoid the tax. Buy all your personal goods as a business expense. Then expect to spend some time in jail. The number on your tax returns will root you out.

    If you have a viable business, try and buy a ring for your wife as a business expense. Is it really worth risking fines and loosing the privilege of conducting commerce to cheat on a fair tax system? I think not. Some will, most will not.

    States already know how to enforce sales tax compliance – and they are good at it.

    H.R.25 talks about “Conforming State Sales Tax.” The act assumes that states will elect to modify their own state sales tax laws to conform to the national sales tax standards. States will elect to collect state sales tax on the sale of new goods and services. So, the state sales tax base would be the same as the national sales tax base. State use tax would be eliminated and all business to business transactions would be free of tax. The same justifications for the structure of the national sales tax are also applicable to state sales tax. [I’m sure some states will find a new way to impose new use taxes. Where there is a will, there is always a way to tax. Any such tax would be a different state add-on tax outside of the realm of the state/national sales tax. ]

    The big benefit for business here is not that sales tax is eliminated. Sure business will like that, but they will just pass any tax along to their customers. Business will like the change because it will simplify their sales tax reporting. It will reduce their state sales tax compliance costs – then compliance costs for the national sales tax will be minimal. Once the state sales tax report is done, the appropriate number is multiplied by 0.23 and the national sales tax compliance is done. Simple! National sales tax compliance costs are almost zero.

    There are two big carrots leading the states to changing their laws to conform to the national sales tax law. First, any state that keeps a use tax will drive corporations to any other state that does conform. Second, if a state does conform, then the federal government will authorize the additional collection of the same amount of tax on interstate sales as would be collected on a sale in the destination state.

    Loss of sales tax on catalog, internet, and out of state sales is a big issue with the states. The Fair Tax will eliminate this tax loophole for states with conforming sales tax laws.

    It is a no brainer that the states will enforce collection of their own sales tax. For a conforming state, any investigation needed for enforcement of the national sales tax will already be done. The agent would simple multiply the same total established for state liability by 0.23 and also demand a check in that amount. Sure, the state may cash the check for their 2-3% sales tax first, but they will also fill out the proper line on the form to get a cut of the federal tax.

    States with conforming sales tax laws will enforce collection of the national sales tax. States will also change their tax laws to conform to federal laws.

    We are all just plain Joe’s here. However, considering all of our contributions, I think we have an even better understanding of how easy it will be to enforce the Fair Tax. Easy enforcement = less cheating. We will all pay our fair share of tax. The Fair Tax will work.

    Bill Rook  ·  May 19, 2006 at 8:31 am  ·  Permalink
  11. This might be the wrong spot to ask this question, but I will anyway. I sort of understand the b2b part but am wondering how the Fair Tax will work with things like diesel fuel for truckers? When a trucker stops on the road for fuel will he be paying the 23% retail tax even though it is part of the manufacturers or retailers cost of doing business? Also what about any other business vehicle that stops and buys gas at the corner gas station?

    I guess I just am not sure where the wholesale parts fit into the Fair Tax system. If they don’t then it seems to me that the final retail prices won’t drop because somewhere along the line there will be retail tax paid before it get to the consumer.

    I hope this post makes sense.

    Jerry Stark  ·  Aug 7, 2006 at 12:30 pm  ·  Permalink
  12. The Americans For Fair Taxation (fairtax.org) are on a mission to squash out any public criticism of the FairTax plan and are attempting to exploit the federal trademark system for the ADMITTED purpose of being able to shut down anti-FairTax websites during the upcoming elections. They have an open application to obtain a service mark for the word “FairTax.” Genie Hayes, the communications director for AFFT, openly admitted that the goal of AFFT is to get this service mark and be able to yank any anti-FairTax websites as well as to have total control over any shirts, bumper stickers, or anything of that nature that is printed with the word FairTax. They are attempting to get the strong arm of the federal government to back them up in hindering free speech and open/honest debate.

    The FairTax is promising to become a rather prominent issue in the upcoming Congressional elections–and if AFFT succeeds in obtaining this service mark, they are going to be in an excellent position to keep people from criticizing the FairTax Act.

    The time for opposition to their application is fast approaching. I know that an application for a service mark can’t be opposed just because the applicant’s motive is unethical. However, I do believe that there is a very STRONG case that AFFT doesn’t meet the legal requirements for obtaining a service mark. The strongest argument is all around us–the phrase “Fairtax” is SYNONYMOUS with H.R. 25 and the Fair Tax Plan.

    Unfortunately, as it stands right now, I think they’ll win their service mark and they’ll be on the road to having the power to tell people that they cannot participate in public debate regarding H.R. 25. Perhaps, at least, the public will be informed of this attempt to filter open and honest critiques.

    MoMospy  ·  Aug 22, 2006 at 3:53 pm  ·  Permalink
  13. […] There is a big difference between collecting taxes from a few tens of thousands of businesses and hundreds of millions of individuals. How many IBMs or Targets or even a local restaurant are likely to try to stiff the government out of the sales tax owed? So, yes, the objection is correct – there will have to be a group to audit and enforce a sales tax…uh, just as there is today! And at way lower levels than required for the income tax. The IRS as we know it will go away with the FairTax. Reference: Enforcement Mechanisms of the FairTax […]

    The FairTax: Attacks and Facts « The Third Rail  ·  Apr 14, 2007 at 11:58 pm  ·  Permalink