The Fair Tax Plan is a sales tax proposal that would replace the current U.S. income tax structure. It abolishes all federal personal and corporate income taxes, as well as the alternative minimum tax. It ends taxes on gifts, estates, capital gains, Social Security, Medicare, and self-employment. The plan replaces all these taxes 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.
About the Fair Tax Plan
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" that would be equal to 23% of the monthly cost of living at the federal poverty level. The poverty level for a family of four is $26,500 in 2021, according to the Department of Health and Human Services, so the prebate would be $6,095.
Eliminates annual tax preparation the headache and associated costs
Eliminates the IRS
Boosts income and possibly consumer spending
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.
The most obvious advantage of the plan is the elimination of the annual income tax headache and the cost of hiring tax preparers. Government spending would also be reduced by eliminating the IRS, and some advocates argue that increased consumer spending would lead to an increase in gross domestic product, jobs, productivity, and wages. Workers would keep 100% of their wages.
The Fair Tax is unfair to those who aren't earning an income, such as seniors. It would be especially unfair to the first generation of seniors because they paid income taxes all their lives and would have to start paying higher sales taxes in addition to the taxes they've already contributed over decades.
Although the IRS would be eliminated, another agency would take its place. This agency would have to send out prebate checks, settle disputes, and collect taxes from the states.
It would also have to enforce the tax and go after cheaters. For example, business expenses that are used to create the final product wouldn't be taxed. Small business owners could therefore declare that a purchase was 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 used a model showing a GDP increase of 7.9% in the first year, and up to 10.3% in the 25th year. Domestic investments are projected to be 74.5% higher in the first year, up to 65.2% higher in year 25. Consumption drops slightly in the first two years (0.6% and 0.8%) but it's 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 has noted that it isn’t accurate to refer to the Fair Tax as 23%. He indicates that the rate is actually 30%. Fair Tax defines the sales tax as "$0.23 out of every dollar spent," which means that a $0.23 tax is 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 because states would have to abolish or significantly alter their income tax systems without the IRS to determine wages. This lost state revenue would require an additional 10% sales tax to replace it.
Another 5% would have to be added to recoup revenue from those who have figured out how to avoid the sales tax.
These three adjustments push the sales tax to 45%. Many Americans would protest having such a high tax on essentials such as food and healthcare. The effective rate could skyrocket to 67% on other items if food and healthcare weren't taxed.
Gale's calculations show that the Fair Tax would cause taxes to rise for 90% of all households. Only those in the highest 10% of incomes would really get a tax cut. Those in the top 1% would receive an average tax cut of over $75,000.
Those in the bottom two-thirds of the distribution would pay less if the Fair Tax Plan was adjusted so households would be classified by consumption level, 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
It's difficult to determine how the Fair Tax would affect the economy without being able to examine the calculations and assumptions of each study closely. Implementation would have to be slow and consistently evaluated if the Fair Tax Act is ever passed.
Perhaps the best approach would be a gradual shift from the income tax to the Fair Tax, or perhaps a less-populous 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.
- The Fair Tax Plan is a 23% sales tax that would replace the current U.S. income tax.
- It would reduce the headache of annual tax preparation because it's simple, but it would raise the tax burden for 90% of taxpayers.
- Only the top 10% of incomes would actually see a tax cut.