What Makes the FairTax Fair?

August 29, 2006  ·  Filed under: Education

Quadrupole left an excellent comment on our discussion of Mr. Rich vs Mr. Average Joe.

It’s so good, in fact, that I’m going to quote it here in its entirety:

Let us consider for a moment the question of ‘Fairness.’ We have been conditioned to think of fairness in terms of taxes collected as a percentage of income. I would maintain this is the wrong measure. Why, you may ask?

Well, think about what it is about the rich that people tend to think is unfair. What most people think of as unfair with the rich is their conspicious consumption. That is what we are taxing with the FairTax.

Consider the following example:

The Frugals are a married couple with two kids making $150k a year. They consume $50k a year, and take $100k a year and invest it, creating jobs and economic growth.

The Gluttons are a married couple with two kids making $150k a year, and consuming it all. They invest nothing.

Would it be fair for the Gluttons and the Frugals to pay the same amount of tax? They make the same income, they have the same sized family, but the Gluttons consumed three times as much as the Frugals. They got to ‘eat’ three times as much stuff as the Frugals. I for one wouldn’t feel right about one family getting three times as much stuff as another and paying the same tax. It would give them a much lower effective tax on what they got.

I would maintain that what is ‘fair’ is for the Frugals to pay the same amount of tax as any other family of four that got $50k worth of stuff, and the Gluttons, who got three times as much stuff, to pay more.

Ah, you might say, but how is it fair for the Frugals to pay the same amount of tax as the Smiths who only made $50,000 and consumed it all. The Frugals still have $100k in investments. To this I would reply: we will get them in the end. :)

You see there are really only two things the Frugals can do with that $100k they invested: they can reinvest it, thus generating more and more economic growth, or they can consume it later. For long enough values of later they will eventually consume that $100k. This is what everyone instinctually realizes, and resents. But when that $100k is eventually consumed it is FairTaxed. In effect it’s taxation has only been defered for as long as the Frugals keep it invested.

This is the central fallacy people run into when they look at effective tax rates in terms of income, rather than consumption. You can talk about what income is made in a given year, but not all income made in a given year is consumed at that time — but eventually, it is consumed. If you don’t believe me, look around at how few family fortunes survive to the fourth generation.

All you do when you tax income instead of consumption is reduce investment, and thus economic growth.

Well said. This is the crux of why the FairTax is so much more fair than the income tax.

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10 Responses to “What Makes the FairTax Fair?”
  1. Thank you for the many small formating and punctuation corrections :)

    quadrupole  ·  Aug 29, 2006 at 10:45 pm  ·  Permalink
  2. Not convincing. Rich people get a lot of stuff without “buying” it. How about a wealth tax – a death tax but, on the bright side, you don’t have to die!

    Martin Gugino  ·  Dec 15, 2007 at 7:04 pm  ·  Permalink
  3. Two things are wrong with your (quoted) argument:

    (1) An assumption that people “get” nothing out of investing. People act in their own self-interest; if they choose to save their earnings, it’s because this is in their benefit to. With the hypothetical Frugals and Gluttons, given the same income and circumstances, etc, one family gets more goods, while the other family gets the security of money in the bank. Obviously, this is important to them, or they wouldn’t save. ( There are obvious value judgments, reflected in the families’ names. There’s also an assumption that only saving, and not consumption, improve the greater economy, which isn’t the case. )

    (2) This is highly regressive, as it shifts the tax burden onto the poor, who are less equipt to shoulder it. A key difference separating “rich” and “poor” is that one tends to spend every dollar that comes their way. Under this plan, Bill Gates ( who claims to eat fast food and run a several-year-old PC ) would pay comparable income tax to your or I. By way of analogy, we all know that buying cheap goods costs more in the long term.

    It seems like a truly fair fair tax would tax income, rather than wages.

    Forrest  ·  Feb 19, 2009 at 8:23 pm  ·  Permalink
  4. in regards to your #2, Forrest.

    the FT is not “highly regressive”. the ‘prebate’ function of the FT untaxes the basic spending of every family. I will agree that the poor spend a larger portion of their consumable income than the rich do, but you’ll have to agree that the poor have less to spend than the rich do.

    in order to be taxed, one must spend more than the poverty level..taxation does not begin until AFTER consumption surpasses poverty.

    just for simple math, we are going to assume whole numbers and provably ridiculous spending patterns.

    let’s assume the poverty level for a single person is $10,000/yr.

    Mr Frugal’s bachelor brother (Really Frugal), makes a $10,000/yr salary. since he probably spends 100% of his income, we would pay $2300 in FT on his purchases over the year. The prebate would give him $2300 over the year, resulting in a $0/0% tax burden.

    Mr Frugal’s widowed sister (Spend Thrift), makes a $20,000/yr salary, and she spends 75% of it, paying $3450 in tax…but she gets the same $2300 prebate, so she has a $1150 tax burden. she’s paying a 5.75% tax as compared to her income.

    she makes more than her brother, she spends more than her brother, she is taxed more (both in dollars and in rate) than her brother….

    so far, so fair.

    meanwhile, Mr Glutton’s ex brother in law (Fat Bastard), makes $20,000/yr and spends every nickel of it. he pays $4600 in FT, he gets $2300 in prebate, so he has a net tax burden of $2300. that’s a 11.5% tax rate compared to his income.

    he makes the same as Ms Thrift does….but spends more….so he pays a higher amount (in dollars and in rate) than she does.

    Finally, Mr Glutton’s father (Really Gluttonous…his son dropped the ending when he got older). is semi-retired. he spent years and years amassing a great fortune..and spending wads of cash every year. He’s kept up his lifestyle of spending $20,000/yr, even tho he’s only making $10,000/yr at his part time job. he spends $4600 in FT, he gets $2300 in prebate, and he has the same $2300 tax burden his ex son in law has…but since he is spending previously untaxed wealth his tax rate is 23%.

    he makes as much money as Really Frugal, but he spends as much as Fat Bastard…and his tax rate as a function of his income is the highest of the group (tho his dollar amt is not).

    the poorest guy in the example has no net tax burden. the wealthiest guy in the example has the highest tax burden.

    now…how is this regressive?

    Justin  ·  Feb 20, 2009 at 11:50 am  ·  Permalink
  5. Forrest,

    The Fairtax is still regressive in classic terms. Google “regressive tax” and you will be hard pressed to find any definition that isn’t related to income. In terms of income, the prebate simply moves the point of regresivity from zero to the AFFT adjusted poverty level amount. From there on, the Fairtax is certainly regressive by currently accepted definitions.

    This isn’t the only term that requires a reeducation of the American public in order to understand the Fairtax. For instance, the word “prebate” isn’t even a word, at least not in my dictionary. And to confuse matters further, the prebate is defined by AFFT as a tax refund in advance. Which it isn’t. It is a cash grant entitlement which can be spent and taxed, or saved as desired. It is not related to taxes paid, but only family size.

    Of course, the most egregious change in commonly accepted terms is the insistence that the Fairtax be couched in inclusive terms. Sales taxes are mostly expressed in exclusive terms, so a reeducation of 300 million Americans will be necessary.

    Everyone is familiar with explicit service charges, but under the Fairtax, we now have to become familiar with implicit charges. See HR25, Section 801-806 for more information. You are above average if you understand that section on the first try?

    And my favorite is in Section 905. Here, the legislation lays on a 23% tax on income from operations in the USA by foreign owned individuals or companies. But it really isn’t an income tax according to AFFT, it’s a tariff?

    Prebate/rebate, progressive/ regressive, inclusive/exclusive, explicit/implicit/ income tax/tariff??? I’m too old to put up with all this newfangled language. But it seems to be necessary in order for the Fairtax to prosper? Good luck!

    Hank Van Gieson  ·  Feb 20, 2009 at 7:40 pm  ·  Permalink
  6. Let’s see . . .

    Paris Hilton inherits a billion dollars under the FairTax. She pays no estate taxes because they have been eliminated under the FairTax. She makes an average of 10% per year in capital gains, which is $100 million per year. She spends $10 million per year in taxable goods and services in the US, and, at a 23% tax inclusive rate, pays $2.3 million per year in taxes.

    That translates to a tax bill of 2.3% of her annual income. So, please explain to me again how the FairTax is “not regressive?”

    Hayden Kepner  ·  Feb 21, 2009 at 11:47 am  ·  Permalink
  7. The prebate is only one of the features that makes the Fair Tax progressive. There are several others. First, the Fair Tax eliminates the two most regressive taxes today: the payroll tax and the tax costs embedded in the prices of goods and services. These two taxes have the greatest impact on low-income people.

    Furthermore, viewing resources through a multi-year window and discounting them back to present value, which is the way economists look at resources, the Fair Tax benefits lower-income people disproportionately. This happens partially because, on a first-in-first-out basis, all wealth is consumed. It is just a question of how quickly. The Fair Tax gets at wealth. Income and payroll taxes do not.

    Ignoring economic growth as a direct result of the Fair Tax, the Fair Tax comes in only behind the Estate-Gift-GST Tax in terms of progressivity. Its Gini Coefficient score of 0.647 places it ahead of Payroll Taxes, Individual Income Taxes and Corporate Income Taxes as a more progressive tax when proper methodology is applied. See Tuerck et. al., “A Distributional Analysis of Adopting the Fair Tax: A Comparison of the Current Tax System and the Fair Tax Plan,” 2007.

    ~Jim Bennett
    Summit, NJ

    Jim Bennett  ·  Feb 21, 2009 at 4:33 pm  ·  Permalink
  8. Of course, the Turek study assumed a tax rate of 23% which, as we’ve discussed ad naseum, would be woefully inadequate.

    Also, the idea that “all wealth is consumed” and would thus all be taxed under the FairTax also flies in the face of reality, but we’ve discussed that before as well.

    Hayden Kepner  ·  Feb 22, 2009 at 4:40 pm  ·  Permalink
  9. Hayden @ 6…

    Let’s see… I have a feeling that the Hilton family has a veritable army of accountants and lawyers on retainer, and I would guess that there is going to be extremely little paid via the estate tax. In addition to this, I’m pretty sure that poor Paris is going to probably be paying a lower tax rate that I do on her 10% capital gains thanks to this same army.

    One last fallacy with your example here… Paris Hilton only spend $10 million in a year??? Now that’s laughable. Does she spend like a cool million just throwing herself a birthday party?

    And your stab here at the 23% rate… You claim it to be woefully inadequate, yet many others find the rate if not accurate, then within a couple of points. I think that you are one of naysayers who claim it would have to be something ridiculous like 55% exclusive or more. A lot of this is based upon your beliefs of evasion/avoidance (I think), and this is highly debatable. You make the statement that 23% would be “woefully inadequate” as if this is an accepted fact, and not your opinion. At least be honest enough to say ” the assumed tax rate of 23% COULD end up being woefully inadequate”.

    Scott  ·  Feb 26, 2009 at 8:06 am  ·  Permalink
  10. Scott — I’m afraid you are mistaken as to how easy it is to avoid the estate tax. Once you accumulate assets above a few million dollars, the only way to avoid the estate tax is to donate your estate to charity. Now, you might be able to set up a charitable foundation controlled by your children, which will certainly get them invited to a lot of neat parties, but they don’t actually get the money.

    But, you make a common argument, that the wealthy in this country will hire an “army of accountants and lawyers” to enable them to mimize their tax liabilites under our current system, whether income taxes, estate taxes or capital gains taxes. Others claim that the wealthy engage in tax fraud, by hiding billions overseas in secret bank accounts.

    Now, assume that is all true. If the rich in this country are so adverse to paying taxes under our current system that they would spend a boat-load of money on accountants and lawyers, and risk being thrown in jail for committing fraud, don’t you think the same folks would do the same thing under the FairTax? And, in fact, since there would be so many perfectly legal to avoid paying the FairTax (by simply living overseas, for example), don’t you think they would do so?

    Many concervative talk-radio folks constantly complain that our current system relies heavily on tax revenue generated from the incomes of highly compensated people. But they seem to ignore that the FairTax would rely heavily on the spending habits of rich folks. Don’t you see the same problem here that I do?

    Two more quck points. If we switched to the FairTax and Paris Hilton were to throw a $10 million birthday party for herself, I am reasonably confident that her “army of accountants and lawyers” would ensure that it was a tax-free business expense. Or she’d just do it in Morrocco a la Malcolm Forbes.

    Any, yes, I am one of those “nasayers” who believe the FairTax would need to be 55% or more on a tax-exclusive basis. Take a look at the “Resarch” tab at the top right of this website. Also, read the Tax Reform Commission’s Report from 2005 (Chapter 9) and the 2000 report from the Joint Committee of Taxation.

    I agree with you that it is impossible to say for sure just what the tax rate would need to be and that the most honest thing to do would be to say there is a dispute among economists over what the tax rate would need to be and that it would probably be somewhere along a range somewhere. I would say the range would probably be between 50%-70% on a tax-exclusive basis. You might say the range would be between 30%-50%. In order to complete the picture, you would also need to disclose what your estimate of non-compliance would be, the effect to state sales tax, and what the deficit would likely be.

    If you assume 100% compliance, ignore state sales taxes, and assume a high deficit (as the Beacon Hill Institute did in their 2006 study), you can get the rate fairly low. If you assume high non-compliance rate, factor in the increased state sales taxes (beccause state spending would be taxed under the FairTax) and assume that eventually we will need a balanced budget, you will get estimated tax rates more along the lines of twhat he Tax Reform Commission, the Joint Committe on Taxation, and William Gale found.

    But for ten years, it has been impossible to get any major proponent of the FairTax to admit this. They insist that the number is 23% (tax-inclusive) and will not budge, no matter how many studies show otherwise. So, when you can get them to admist that “the assume tax rate of 23% COULD end up being woefully inadequate,” then the country could actually begin to have a serious discussion of the FairTax.

    Hayden Kepner  ·  Feb 26, 2009 at 7:08 pm  ·  Permalink