Fixing the Fair Tax

Let me state at the outset that I am a Huckabee supporter. Readers of my Christian Libertarian Party blog will know why. It is not because of the Fair Tax. I have no fear, however, that the Governor, if elected President, will be able to enact the Fair Tax as written and I am pretty sure he knows that. The Presidency is a bully pulpit, but so is the Chairmanship of the House Ways and Means Committee – and Charlie Rangel is not going anywhere. The purpose of this essay is to lay out how the Fair Tax proposals can be altered to counter some of their flaws. My hopes are that the Governor’s people will see this essay and use it accordingly and that those who might support him save for the problems of the Fair Tax can see that with modifications such a tax can be salutary for the Republic.

What is the main attraction of the Fair Tax to most people? It doesn’t take a rocket to answer this one, especially during tax season. Except for those truly twisted souls that enjoy filling out and sharing with the Government forms regarding their personal financial status, the Income Tax is seen as an onerous burden to be done away with at the first available opportunity. Indeed, abolishing the IRS is touted as its main attraction (although the agency will be replaced by something else, so the likely effect will be to change the nameplate on the building, nothing more).

The Fair Tax has its problems, although these can be resolved in negotiations with Congress, which will likely be Democratic after the election. Let me address a few of these and their likely solutions.

The Fair Tax, as proposed, taxes government purchases. This will lead to drastic cuts in government services. What will happen instead is an increase in the Fair Tax rate to enable agencies to buy the same amount of hardware or the gutting of the non-entitlement, non-defense budget in order to pay for much needed weapon systems for the War in Iraq – or else a continued scarcity of much needed equipment.

Perhaps there needs to be an exemption for weapons – however any exemption will require a higher tax rate, so this is no help for the Fair Tax purists. The more likely scenario is the dropping of this part of the strategy, which will increase the Fair Tax Rate to 50% of the base cost of goods and services (up from the current 30% estimate – the touted 23% rate is the share of the tax as the total purchase price).

At this rate, there will be a large industry in tax avoidance. Soon, everyone will be buying wholesale – of course buying wholesale won’t be the answer for long, since wholesale buyers must then file Fair Tax returns on their retail sales. If they have none they will be caught by whatever agency succeeds the IRS. Clearly we have a problem here.

The way the Fair Tax impacts housing raises eyebrows. Not only will the deduction for mortgages go away, but rent and some new houses will be taxable, while investment and used houses will not be. As a result, the price of new housing will go down unless it is clearly earmarked for rental while the cost of used and investment homes will go up as these properties will be more attractive to home buyers and past renters. Some renters who cannot afford to buy a house will pay the tax, although their incomes will be higher due to the lack of an income tax and the payment of a Prebate. Rental rates will go down as well, as these currently include the income tax on rent. Making this cost explicit will lower the base rent but leave the monthly cost the same. These effects are not entirely unwelcome, except to the home lending and building industries, which prefer to build new homes and upper income apartments and who benefit from the subsidy paid to borrowers. The hew and cry over these provisions may kill the Fair Tax or lead to the carving of an exemption in the law. Such an exemption would make the Fair Tax rate on the remaining economy so high that it could not be passed. Another possible solution is to treat the purchase of a home on credit as a wholesale transaction and apply the tax to the Principal as the loan balance is paid off.

Another problem with the Fair Tax is that it forecloses the possibility of Personal Accounts for Social Security. These can only come about if there is a payroll tax to be diverted. If the payroll tax is abolished Social Security is an entirely governmental affair. To add insult to injury, employers will still be required to report incomes to Social Security, so the vaunted paperwork savings will not take place.

Excluding the retirement savings and redistribution portion of payroll taxes from conversion to the Fair Tax allows the creation and expansion of Personal Accounts until they eventually replace government provided Social Security for most workers. Frequent readers of my blog already know the details I propose. For others, a simple search will reveal them. Taking this step will decrease the Fair Tax required by 11% (preserving a payroll tax rate of 10% of income, of which 4% will be transferred to Personal Accounts - the impact on the 23% rate is about 8%, leaving a Fair Tax rate of 15% before governmental purchases are added back).

A main criticism of the Fair Tax is that it transfers the cost of payment to the middle class from the wealthy. The Prebate will keep the poor from paying tax, thus replacing the Earned Income Tax Credit; however those above the poverty line will be paying much more of their income in taxes while the wealthy will be paying much, much less in hope that they will invest it to grow the economy. This is the classic supply side argument, which ignores the very real fact that no productive investment in plant and equipment is ever made unless there is an underlying demand for the product produced. Shifting taxes to consumption will dampen the need for productive investment. When this occurs, speculative investment increases. Vehicles such as Real Estate Investment Trusts are created. We all know what happened with that. Eventually, the wealthy will be called upon to invest in public debt, since overseas investors must eventually stop buying it. When this happens, the economic logic for not taxing the same money being borrowed from the wealthy goes away, since these monies are taken out of the private economy and put into the public economy either way – the difference being that borrowed money must be paid back with interest – thus creating a privileged aristocracy of bond holders. My impression was that abolishing aristocracy was one of the reasons this nation was founded.

A way around this problem is to retain an Income Surtax on high income individuals (not high income families). This tax would fund overseas military adventures; net interest on the debt and debt retirement; the transition to Social Security, Civil Service and Military Retirement Private Accounts and the forgiveness of bad international debt held by the World Bank/IMF. After these items are fully funded, the surtax would be suspended. The higher this tax rate is, the faster the surtax is suspended. Excluding these items from the Fair Tax will drastically lower the Fair Tax rate to a somewhat more palatable level. Retaining the Surtax as an individual, rather than a business assessment also allows those who would pay the tax to keep this information private from their employers or investments. All personal income, including liquidated inheritances, would be subject to tax, although assets held would not be. All individual income under $100,000 would be included. Family income would not be taxed (so two earners making $90,000 each would have no liability to pay the Surtax).

To further lower the Fair Tax Rate, tax business income rather than retail transactions. Taxes would still be generated by sales, but it would not matter if the sale were retail or wholesale. Enforcement is also easier, since purchases by businesses would be exempt if reported to the IRS, with taxation on the Value Added. This tax could be explicit or included in the price of the item – or some combination of the two. The explicit VAT would be some minimum percentage required to fund direct government services and would satisfy the desire by libertarians to show the true cost of services provided by the government in the tax structure, thus providing an incentive to cut government.

The included portion could be used to fund the Prebate for employees, as well as other tax expenditures demanded by organized interests. A higher Prebate could be paid under this scheme on the order of a living wage of about $520 per dependent per month (or $120 per week). The Prebate would be paid to everyone working or participating in an educational program to overcome welfare dependency. As such it would be a pro-life measure. The reason that abortion rates go down in Democratic administrations is that they provide more generous benefits to such families. For the Republicans to truly call themselves Pro-Life, they must do the same. So that firms don’t fund their entire payroll using the Prebate, a higher taxable minimum wage of $12.00 per hour would also be instituted.

Deductions or credits could also be instituted in the Business Income Tax portion for health care or insurance costs and mortgage interest, as failing to do so will likely doom the package. Note that at the local level there would be a charitable contribution credit designated by the employees and paid to accredited social welfare and education agencies, such as Catholic Charities, Lutheran Social Services and parochial schools. This credit, which could be partially matched by a Federal credit, allows for the privatization of welfare, public education and even corrections (although corrections and mental health costs might be more effectively funded by a Land Value Tax or property taxes). If retiree health care is paid for explicitly or through a fund sponsored by the former employee’s house of worship, Medicare and Medicaid can be dispensed with, removing the government from the health sector as well.

To me, it makes much more sense to use the Fair Tax to actually shrink government rather than using it to anger taxpayers enough to demand that services be cut.