A new agency would be created to administer and oversee the Fair Tax, the Sales Tax Bureau (“STB”). It would be vested with audit and collection powers similar to those of the IRS, as would the state sales-tax authorities working with the STB to run the system. The Fair Tax bills introduced in Congress contain provisions to establish a toll-free telephone violation-reporting system and create a rewards program for private parties who assist the STB authorities in discovering or prosecuting Fair Tax evaders.
By James K. Jeanblanc l August 11, 2015
Photo Credit: Luke Sharrett/Bloomberg
The dreadful state of our income tax explains why so many want the entire system scraped in favor of the Fair Tax. This wish has strong organizational and website backing, and bills have been introduced in Congress to enact it into law. The Fair Tax is promised to be a simple, easy-to-comply-with, and less-intrusive taxing system. But, will it live up to these promises? Could it become as disliked, inefficient, and unfair in its application as the income tax is now viewed?
History calls for caution. Few realize that our now-hated income tax was born 100 years ago as loved as any tax could be. It met the ideal of a simple, easy-to-understand, and non-intrusive tax. Structured with a generous personal income exemption allowance, only the rich paid the tax. But, it came with a birth defect, a dependency upon the filing of personal income tax returns. This mechanism has been its Achilles Heel, allowing the income tax base to be eroded and individualized, fostering unfathomable complexity and disparate treatment of taxpayers. Surely, those who worked so hard for adoption of the 16th Amendment and enactment of the income tax would be aghast today if they could see what a monster their baby has become.
The Fair Tax would replace that income tax (including the alternative minimum tax, the individual and corporate income taxes, and the capital gains tax), the payroll taxes (including the Social Security and Medicare taxes), the gift tax, and the estate tax. In their place, the Fair Tax would be a 23% national sales tax imposed on the purchase of all goods and services used or consumed within the United States, including imports. Goods and services purchased for business or investment purposes would be exempt from the tax, as would export sales. Used goods, already taxed, would not be taxed again.
Unlike the Value Added Tax (VAT), the Fair Tax would be imposed at the retail level, separately charged and stated visibly on the purchase receipt to be given to every purchaser. Tax collection largely would be the responsibility of the states. State sales taxes, if made conforming, could be piggybacked onto the Fair Tax. (Not mentioned by the Fair Tax proponents is that piggybacking states could achieve their long-denied goal of being able to tax all interstate sales to their residents.)
Retail businesses would be FairTax registered, regulated, and bonded. They would collect the tax on every retail sale and pay the tax collected to the states which, in turn, would remit the tax revenue to the Treasury. Both the retail businesses and the states would be entitled to deduct a collection fee. The IRS would be abolished, but a new agency would be created to administer and oversee the Fair Tax, the Sales Tax Bureau (“STB”). It would be vested with audit and collection powers similar to those of the IRS, as would the state sales-tax authorities working with the STB to run the system.
Because a sales tax of 23% would be burdensome to many families, every household would be provided a “family consumption allowance.” This allowance would be paid as a monthly rebate (sometimes called a “pre-bate”) to offset what would be the sales tax burden at the lowest level
of family consumption (at the “poverty level”). The amount would be based solely upon the number of members in the family, regardless of household income.
Every family would file an application to become registered to receive its allowance for the upcoming year. The annual application would provide details as to whom, how, and where the allowance is to be paid. It would also list the name and social security number of every family member and certify that all family members are lawful residents, all are listed in the application, and none are incarcerated (i.e., under institutional care). This annual registration system is necessary to assure proper payment and that no family member is double-counted in another family. But, the downside from building such a mechanism into the Fair Tax is that, once established, it can be expanded to require the reporting of even more individual and personal details. This would enable easy use of the Fair Tax for purposes other than the raising of revenue, the Achilles Heel of the Fair Tax (more about this below).
During its first year, the Fair Tax rate would be 23%. For subsequent years, the rate would be the sum of three component rates – the “general revenue rate” (legislatively set at 14.91%), the “old-age, survivors and disability rate,” and the “hospital insurance rate,” the latter two rates to be set by the Department of Health and Human Services (HHS) each year. (The initial 23% rate is roughly equal to the sum of these three components).
Some might object to a sales tax rate being determined in the Executive Branch, and not through the Congressional process. But, the Fair Tax is designed to replace the Social Security and Medicare taxes, and this mechanism would allow the HHS to make timely modifications in the tax rate to assure there will be sufficient incoming revenue to keep these programs operating in the black. (However, not mentioned by the Fair Tax proponents is that this provision would allow Congress to expand these programs without the current restraint of having to vote for an increase in the payroll taxes to pay for it).
At the time the Fair Tax first becomes effective, the income tax and other taxes would be repealed. The IRS would be defunded (i.e., abolished) two years later, and all of its records would be destroyed (except those needed for Social Security purposes and continuing tax litigation).
The Fair Tax proposal lacks critical transition rules. For example, during the last income-tax year, many taxpayers will defer income into the first sales-tax year and accelerate deductions into their last income-tax year. Legal under existing income tax rules, this would be detrimental to government tax revenue. Other transition issues should be faced, such as cases of allowed income-tax credits subject to recapture in a subsequent taxable year. Moreover, the last year of the income tax (with the IRS soon to be gone) is likely to see a reduction in the number of tax returns filed and less income reported on the returns that are filed.
And, the Fair Tax itself provides no transitional relief to lighten the sales-tax burden on people making purchases with funds saved under the income tax. These people may have struggled to build up savings for retirement or to purchase a new home. They will claim the Fair Tax is not
“fair” and is mis-named. Their argument will be, “If used goods are not to be taxed again, then why should my savings?”
A problem not easily addressed, if it should be, is the impact upon businesses running smoothly under the income-tax regime. Low-margin businesses such as grocery stores and many restaurants pay a small percentage of their gross sales in income taxes, but likely will face depressed sales once their customers begin seeing goods higher-priced under the Fair Tax (“pre-bates” aside). And, builders of new homes are likely to be upset if existing-home sales undercut their new-home sales (property owned by private persons before the Fair Tax would be exempt from sales taxation).
The Fair Tax will face compliance problems not faced under current state and local sales taxes. It will have a much higher tax rate, over three times the rate of the average sales tax (and higher yet, where states piggyback). It will have an expanded coverage applying to services, and reaching such things as interest on home-mortgage and consumer loans, rent, and wages paid for household help. And, it will have many complicated aspects, particularly in its application to employee fringe benefits and financial services.
The structure of the Fair Tax itself invites non-compliance. Specifically, fraudulent business-use and investment-use certificates are likely to be submitted to unsuspecting retailers to evade the tax. Many barter exchanges (services for goods) will go unreported and the tax unpaid. Property purchased under a business, investment, or export exemption and converted to personal use, would be taxable, but many of such conversions are likely to go unreported and untaxed. All this will pressure the STB and state sales-tax authorities to become aggressive and intrusive as they seek out cases where the tax might be owed.
Routine audits are to be expected, not only of the retailers but also the exempt purchasers who may have allowed their purchases to be converted to personal use. Untaxed barter transactions will need to be uncovered. The public could possess untaxed articles and thus will not be immune from tax inquiry. If non-compliance is deemed to be a major issue, examples will have to be made of caught evaders to inspire compliance.
Most persons are tax compliant, but the Fair Tax authorities can be expected to assume there will be some who come into possession of goods or receive services with the tax unpaid. This is where retention of that purchase receipt from your retailer mentioned above becomes very important. It’s the proof the tax has been paid, needed should the authorities ever ask. Also, if one were to purchase used goods or receive a gift of used goods, it will be critical to obtain the original purchase receipt to be able to prove the goods to be exempt “used” goods. Just because the article in question appears to be in used condition is not proof it has already been taxed.
The Fair Tax bills introduced in Congress contain provisions to establish a toll-free telephone violation-reporting system and to create a rewards program for private parties who assist the STB authorities in discovering or prosecuting Fair Tax evaders. If you were ever to be reported as a possible evader, a sales-tax investigator might appear at your home asking to see all your purchase receipts and to have them matched to all your possessions. Failing on this, you could be exposed to a second tax, plus penalties. So, under the Fair Tax system, it would be prudent to maintain a solid record-retention system inventoried to all one’s possessions (including documentation on what is already owned before the Fair Tax start date). This likely would be good advice to those who happen to be controversial or flashy figures.
Over time, the Fair Tax will experience inevitable change. For sure, there will be pressure on Congress to lighten the sales tax burden on lower-income groups. Exemptions and lowered rates are likely to be enacted for certain purchases, such as for medicines and basic grocery items. To “pay” for this, the 23% sales tax rate might be increased, if not generally, then on luxury goods and services.
And, that Achilles Heel of the Fair Tax mentioned above is likely to be exploited. To give the middle-class a break, Congress might raise the family allowance to say, 130% of the poverty level of consumption. Next, it might limit the allowance to only those in need. To do this, the annual application form could be easily expanded to require the reporting of household income and the family allowance phased-out for those with higher incomes, the semblance of an income tax.
Semblance or not, this mechanism even could make the Fair Tax work like a negative income tax. If the sales tax rate were raised, the monthly allowance could be increased for those middle and lower classes. For example, raising the sales tax rate to 40% might permit the allowance to be, say $2,000 per month for a family of four earning less than $100,000 (or, perhaps $1,500 per month, if income is between $100,000 and $125,000).
The mechanism would be an easy vehicle for more possibilities. Suppose, for example, the annual application were to be modified to allow a family to request a “top-up” of its allowance for a special purchase (such as a new car under the “cash-for-clunkers” program). If the request were approved, the family would receive a special “pre-bate” coupon which could be presented to the retailer in lieu of being charged the tax on the purchase. Further modifications might include “top-ups” in the allowances for families with special needs, such as for home-nursing or child care. About all this, time would not be on the side of the Fair Tax. Its integrity as a simple, even-handed tax likely cannot be maintained with a mechanism of this nature built into it.
Keep in mind that the originators of the income tax never dreamed of the non-revenue raising purposes to which their income tax has been put. Admittedly, much of the above is wild speculation, but is not misplaced considering the sad history of our income tax. Our income tax’s dependency upon the filing of personal returns has been largely responsible for its debasement as a pure tax on income into a personal taxing system of complexity, intrusiveness, and disparate treatment for all concerned. That same fate is likely to be repeated should the Fair Tax be enacted as proposed.
The Fair Tax is likely to have a short life. As proposed, it is to automatically sunset if, within seven years after enactment, the 16th Amendment is not repealed. The author believes adoption
of a constitutional amendment to repeal the 16th Amendment would be a very difficult feat, to be made even more difficult by groups wanting to have included a requirement for a balanced budget and still others unhappy with the high sales tax and insisting on a sunset.
By the way, to merely repeal the 16th Amendment authorizing an income tax, would not guarantee the proponents’ wish to end income taxation. Guarantee would come only if the repeal amendment were to go further and outlaw income taxation. A future Supreme Court, feeling heat from a Congress and President pleading for more revenue, might be motivated to move away from its 19th-century decision outlawing the income tax of that day, this decision having led to the adoption of the 16th Amendment. That particular income tax had been viewed lawful under the Constitution, not requiring specific 16th Amendment authorization. And, so might a new income tax enacted after the Fair Tax’s mere repeal of the 16th Amendment. This new income tax would be represented to the Supreme Court as very different and free of the constitutional impediments which doomed that old 19th-century income tax.
Regardless, under the proposal, if the Fair Tax were to sunset, none of the repealed taxes would be resurrected. Sunset would place the nation in tax limbo – with no Plan B.
James K. Jeanblanc is a CPA and Tax Counsel to the law firm Grove, Jaskiewicz & Cobert in Washington, DC. He is also Senior Fellow for Tax Policy at the Selous Foundation for Public Policy Research, author of The FreedomTax and a contributor to SFPPR News & Analysis.