Bartlett brutalizes the "Fair Tax"

Bruce Bartlett, a conservative/libertarian public policy analyst of some fame, crushed the "Fair Tax" in a Wall Street Journal op-ed piece over the weekend. Proponents want the Fair Tax to replace the federal income and payroll taxes with a single federal sales tax on final goods and services. The proposal has been gaining in popularity, although like the "flat tax" before it, one would have to be an optimist to expect Congress to do anything so bold and useful as changing our ridiculous tax code on income (both income and payroll taxes).

Bartlett starts by banging on the proposed 23% tax rate:

They assert that a rate of 23% would be sufficient to replace federal individual and corporate income taxes as well as payroll and estate taxes...In reality, the FairTax rate is not 23%. Messrs. Linder and Chambliss get this figure by calculating the tax as if it were already incorporated into the price of goods and services. (This is known as the tax-inclusive rate.) Calculating it the conventional way that every other (This is called the tax-exclusive rate.) The distinction is confusing, but think of it this way. If a product costs $1 at retail, the FairTax adds 30%, for a total of $1.30. Since the 30-cent tax is 23% of $1.30, FairTax supporters say the rate is 23% rather than 30%.

This is correct as far as it goes. But it fails to note that current purchases are "after-taxes"-- after income and payroll taxes have taken their chunk. So, at worst, there would be equal percentage increases in both prices and after-tax incomes. In a word, we'd be replacing one inclusive tax with another.

Then, Bartlett makes an important point about taxes on government-bought goods and services:

The federal government would have to pay taxes to itself on all of its purchases of goods and services. Thus if the Defense Department buys a tank that now costs $1 million, the manufacturer would have to add the FairTax and send it to the Treasury Department. The tank would then cost the federal government $300,000 more than it does today, but its tax collection will also be $300,000 higher. This legerdemain is done solely to make revenues under the FairTax seem larger than they really are, so that its supporters can claim that it is revenue-neutral.

And another nice point on the political unlikelihood of such a tax applied to certain goods and services:

State sales taxes have long exempted all but a few services because of the enormous difficulty in taxing intangibles. But the FairTax would apply to 100% of services, including medical care, thus increasing their cost by 30%. No state comes close to taxing services so broadly. Consumers would also find themselves taxed on newly constructed homes. Imagine paying 30% to the federal government on top of the purchase price of your next house.

So, where does that leave us in terms of the numbers? According to Bartlett:

A 2000 estimate by Congress's Joint Committee on Taxation found the tax-inclusive rate would have to be 36% and the tax-exclusive rate would be 57%. In 2005, the U.S. Treasury Department calculated that a tax-exclusive rate of 34% would be needed just to replace the income tax, leaving the payroll tax in place. But if evasion were high then the rate might have to rise to 49%. If the FairTax were only able to cover the limited sales tax base of a typical state, then a rate of 64% would be required (89% with high evasion). I've emphasized problems with the FairTax rate because public opinion polls have long shown that support for flat-rate tax reforms is extremely sensitive to the proposed rate, with support dropping off sharply at a rate higher than 23%.

Some researchers disagree (vehemently). In any case, the broader point is that one must be careful in understanding what's being taxed the rate that goes with it. If the political process dictates that X is taken off the table, then the tax rate for what remains must increase-- for the tax to remain revenue-neutral.

Finally, one more zinger to wrap things up:

Perhaps the biggest deception in the FairTax, however, is its promise to relieve individuals from having to file income tax returns, keep extensive financial records and potentially suffer audits. Judging by the emphasis FairTax supporters place on the idea of making April 15 just another day, this seems to be a major selling point for their proposal. Yet all but six states now have state income taxes. So unless one lives in one of those states, this promise is an empty one indeed.

Maybe Federal tax reform would lead to State tax reform. But in any case, the flaws in the Fair Tax are more problematic than I had considered. And all of this misses the larger issue: that the Federal government is far too large. Expenditures-- and thus, revenues-- should be much, much smaller.