Fair Tax Plan: Pros, Cons, and Effects

How the Fair Tax Plan Isn't Fair to You

Man in shock after seeing how high prices rise with Fair Tax plan
••• 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 ends all taxes on gifts, estates, capital gains, alternative minimums, Social Security, Medicare, and self-employment. The plan replaces them with a federal retail sales tax of 23% to be administered by state sales tax authorities. The sales tax would not apply to imports, commodities used in production, or used goods.  

A group known as Americans for Fair Taxation developed the Fair Tax Act of 2003. It would require the repeal of the 16th Amendment, and it would disband and defund the Internal Revenue Service (IRS). A 23% sales tax is regressive because it impacts the poor the most. To make it more progressive, the Fair Tax Act proposes that all Americans receive a monthly “prebate," which would be equal to the 23% 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 was $24,600 in 2018, so the prebate would be $5,658 a year.

Advantages

  • Eliminates annual tax preparation headache and costs.

  • Eliminates IRS.

  • Boosts income and possibly consumer spending.

Disadvantages

  • Unfair to seniors who have already paid income taxes.

  • Needs a new agency to enforce it.

  • Sales tax rate would be prohibitively high to replace lost revenue.

Advantages

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

Disadvantages

The Fair Tax is unfair to those not earning an income, such as seniors. For the first generation of seniors, it would be especially unfair as they paid income taxes all their lives and would have to start paying higher sales taxes as well.

Although the IRS would be eliminated, another agency would take its place. It would have 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 Support the Fair Tax

The Beacon Hill Institute calculated that the base for the Fair Tax would be 81% of the 2007 gross domestic product (GDP) or $11.2 trillion. A 23% 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 a GDP increase of 7.9% in the first year, and up to 10.3% in year 25. Domestic investments are projected to be 74.5% higher in the first year, onward up to 65.2% higher in year 25, and consumption drops slightly in the first two years (0.6% and 0.8%) but is 6% higher by year 25. The spending is fueled by an average 1.7% increase in disposable income. 

Studies That Don't Support the Fair Tax

William Gale of the Brookings Institute noted that it isn’t accurate to refer to the Fair Tax as 23%—the rate is actually 30%. Fair Tax defines the sales tax as "$0.23 out of every dollar spent," which means there is a $0.23 tax added to every $0.77, not to every dollar.

Gale also points out that the tax rate would likely need to be raised even higher. With no IRS to determine wages, states would also need to abolish their income tax, and this lost state revenue would require an additional 10% sales tax to replace it. Another 5% 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 push the sales tax at 45%. Many Americans would protest having such a high tax on essentials such as food and health care. If these weren't taxed, then the effective rate could skyrocket to 67%. 

Gale's calculations show that the Fair Tax would cause taxes to rise for 90% of all households, and only those in the highest 10% of incomes would get a tax cut. Those in the top 1% 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 It Affects the U.S. Economy

Without being able to examine the calculations and assumptions of each study closely, 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 of more research is done.

The Bottom Line

The Fair Tax Plan is a 23% sales tax that would replace the current U.S. income tax. Since it is simple, it would reduce the headache of annual tax preparation, but it would raise the tax burden for 90% of taxpayers. Only the top 10% of incomes would see a tax cut.