Blemishes in the Fair Tax

Editor's Note: There are a lot of ideas on how to "fix" taxes, though many conflict with each other and most fail. From around the world, here is one of several current prescriptions.

It's a great idea—on paper: Scrap the individual income tax, the estate tax, the payroll tax, and the corporate income tax, and replace them all with a single, 23 percent national sales tax. This would boost the economy by eliminating red tape and removing loopholes that clutter the tax code. At least, that's the case made by proponents of the so-called FairTax, a group that includes about one-fourth of House Republicans.

A legislative proposal to eliminate most existing tax law and put the FairTax in its place was introduced in the House in 1999 but never moved out of committee. Now supporters, energized by Republican gains in the midterm elections, are taking another stab at making it law. "The FairTax makes it so no individual ever has to deal with the tax man again," says Representative Rob Woodall, a freshman Georgia Republican who is the lead House sponsor of a 2011 bill.

Boosters say the FairTax is elegant in its simplicity. Yet part of the reason the idea hasn't caught on beyond a core group of conservative advocates is that it's more complex than it seems. It isn't the same as a flat tax, which is based on income. It also isn't akin to the value-added taxes used around the industrialized world, which are collected at the producer and wholesale levels, as well as at the point-of-sale. The FairTax is like the sales taxes that many U.S. states charge, though critics contend that the way it is calulated makes it actually a 30 percent levy, not 23 percent.

The 23 percent rate is set at a level designed to raise the same amount of revenue as the taxes it would replace. Yet it assumes full compliance. If experience is any guide, that's too optimistic: The current tax code, even with safeguards such as W-2 forms and automatic withholding by employers, leaks roughly $300 billion a year due to avoidance and evasion.

To generate sufficient revenue, the FairTax would have to be applied to goods and services that Americans are not accustomed to paying taxes on, such as rent, new-home sales, legal fees, and health care. If a political decision were made to exempt some categories, those that remain would require a higher rate. "The notion that we'd be able to get a clean tax that taxed everything at the same rate seems fanciful," says William G. Gale, a senior fellow at the Brookings Institution in Washington. "No country in the history of the world has done that."

The higher the tax rate, the greater the incentives for consumers and retailers not to report cash transactions. That would mean the economic jolt that FairTax supporters envision wouldn't materialize, Gale says. "We stall on the question of: Is it enforceable?" he says. "I just don't think it passes the laugh test at that level."

The FairTax would weigh heavier on lower-income households, because they spend a larger proportion of what they earn. That's why Woodall's proposal calls for a "prebate," a monthly advance rebate that covers the cost of the tax up to the federal poverty level. Compared with the current system, the FairTax would be a boon to the highest earners, who spend a relatively low share of their income each year and would no longer have to pay taxes on capital gains., a nonpartisan group at the University of Pennsylvania, estimated in 2007 that the proposal would translate into a tax increase for people making between $15,000 and $200,000, compared with the current system.

Woodall has heard all these complaints before, yet he thinks the FairTax is an idea whose time has come. To fulfill his dream, he sees an opportunity to harness the energy of his fellow freshmen legislators, who aren't yet attached to particular tax breaks that would disappear if the plan were enacted. "Call me a freshman optimist," he says, "but I see those opportunities for people to say: 'You know what, there are some big ideas out there, and let's team up to make them happen.' "

Representative Patrick J. Tiberi, an Ohio Republican who chairs a crucial tax-writing subcommittee, believes the FairTax is not politically viable. Yet the U.S. tax code, he says, is too broken to delay repair. "We would be not very smart if we wait until the perfect time," says Tiberi. "We have to do something today to make our tax code fairer, simpler, and pro-growth."

The bottom line: A proposal to replace all levies with a 23 percent sales tax is unlikely to advance in Congress.

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