What Is the Fair Tax Plan? Pros, Cons, Effect

How the Fair Tax Plan Isn't Fair to You

Man in shock after seeing how high prices rise with Fair Tax plan
The Fair Tax Plan would increase prices by 40%. Photo: Tetra Images/Getty Images

The Fair Tax Plan is a sales tax proposal to replace the current U.S. income tax structure. It abolishes all federal personal and corporate income taxes and all taxes on gifts, estates, capital gains, alternative minimums, Social Security, Medicare and self-employment. It replaces them with a federal retail sales tax of 23 percent to be administered by existing state sales tax authorities. The sales tax would not apply to imports, commodities used to produce other products or used goods.

  A group known as Americans for Fair Taxation developed the Fair Tax Act of 2003.

The Fair Tax would require the repeal of the 16th Amendment. It would disband and defund the Internal Revenue Service.

Normally, a 23 percent sales tax would impact the poor the most. To address this, the Fair Tax Act proposes that all Americans receive a monthly “prebate." The prebate would be equal to the 23 percent tax on the monthly cost of living at the poverty level. According to the Department of Health and Human Services, the poverty level for a family of four is $24,600 in 2016. Those below this poverty level would a receive $5,658 prebate. 

Advantages

The most obvious advantage is the elimination of the annual income tax headache and cost of tax preparers. Government spending would be reduced by eliminating the IRS. Proponents argue that, since workers would keep 100 percent of their wages, the increased consumer spending would lead to an increase in gross domestic product, jobs, productivity and wages.

Studies That Support the Fair Tax

The Beacon Hill Institute calculated that the base for the Fair Tax would be 81 percent of 2007 GDP, or $11.2 trillion. A 23 percent sales tax would collect $2.6 trillion, which is $358 billion more than the income tax that it would replace.

The study also uses a model that shows:

  • GDP increase of 7.9 percent in year 1 on up to 10.3 percent year 25.
  • Domestic investment is 74.5 percent higher in year 1, on up to 65.2 percent higher in year 25.
  • Consumption drops slightly in the first two years (0.6 percent and 0.8 percent) but is 6 percent higher by year 25. Spending is fueled by an average 1.7 percent increase in disposable income. 

Disadvantages

The Fair Tax could be unfair to those not earning an income, such as seniors. For the first generation of seniors, it would especially unfair as they paid income taxes all their lives and would have to start paying higher sales taxes as well. The advantage for seniors is that they wouldn't have to pay taxes on their withdrawals from savings.

An agency would still be needed to send out the prebate checks, settle disputes and collect taxes from the states. It would also need to enforce the tax and go after cheaters. For example, business expenses that are used to create the final product would not be taxed. Small business owners could declare a purchase a business expense to avoid the sales tax. Compliance could become very expensive to monitor and enforce. 

Studies That Don't Support the Fair Tax

William Gale of the Brookings Institute noted that the FairTax it isn’t accurate to refer to the Fair Tax as 23 percent.

The rate is actually 30 percent. FairTax defines the sales tax as "$0.23 out of every dollar spent." This means there is a $0.23 tax added to every $0.77, not to every dollar, and $0.23 is 30 percent of $0.77. Gale also points out that the tax rate would likely need to be raised even higher. With no IRS to determine wages, states would need to abolish their income tax. This lost state revenue would require an additional 10 percent sales tax to replace it.

Another 5 percent would need to be added to recoup revenue from those who have figured out how to avoid the sales tax. For example, many people would declare more purchases as business expenses, which wouldn't be taxed.

These three adjustments estimate the sales tax at 45 percent. If Americans successfully protested including food and healthcare in the tax, the effective rate could skyrocket to 67 percent.

 

Gale's calculations show that the Fair Tax would cause taxes to rise for 90 percent of all households. Only those in the highest 10 percent of incomes would get a tax cut. Those in the top 1 percent would receive an average tax cut of over $75,000.

If the Fair Tax Plan was adjusted so households are classified by consumption level, then those in the bottom two-thirds of the distribution would pay less, while those in the top third would pay more. But those at the very top would still pay much less, again receiving a tax cut of about $75,000.

How Will It Affect the U.S. Economy?

Without being able to closely examine the calculations and assumptions of each study, it is difficult to determine how the Fair Tax would affect the economy. If the Fair Tax act is ever passed, implementation would need to be slow and consistently evaluated.

Perhaps the best approach is a gradual shift from the income tax to the Fair Tax. Or perhaps a small state could be used as a test market to iron out the problems. The scale of change alone would probably make this plan unworkable unless a great deal more research is done. (Sources: "Summary of Recent Research,"  Beacon Hill Institute. "Don't Buy the Sales Tax," Brookings Institute, March 1998.)