The Trouble with the FairTax

By :: May 27th, 2015

GOP Presidential candidate Mike Huckabee recently got into a spirited debate with Fox News anchor Chris Wallace about Huckabee’s  proposal to replace all federal taxes with a national retail sales tax, called the FairTax by its supporters.  Wallace pointed out that low-income people spend a much larger share of their income than high-income folks and thus a FairTax would be regressive. As evidence,  he cited TPC (although the particular statistics he used  came from  earlier research by economists Dan Feenberg, Andrew Mitrusi, and Jim Poterba).

Gov. Huckabee was dismissive:

They have it exactly wrong. In fact, it’s the bottom third of the economy who benefit the most from the Fair Tax, and the people at the top third who benefit the least. Everybody benefits some. That tax study is one that has been discredited by the people who spent over $20 million, very thoughtful economic study developing the FairTax. It’s not just some political idea.

The governor is right in one respect:  The tax is designed to protect low-income people from higher taxes via a large new cash transfer program called a “prebate.”  Every household would get a cash transfer equal to the amount of tax that a family at the poverty level would owe.  (Ironically, this would be the largest welfare program in history.)

The problem is that very high-income households spend only a fraction of their income, while low- and middle-income people spend all or most of what they make.   A sales tax, by design, exempts a large share of income at the top.  If it includes a prebate to protect people at the bottom and doesn’t add to the deficit, then it must raise taxes on people in the middle.figure 1

The latest data on spending as a share of income published by the Bureau of Labor Statistics Show that lower-income households spend more than they earn—presumably aided by tax credits and other cash transfers, gifts from family members and friends, and borrowing (see chart).  People earning over $150,000 spend only half of their income (and the share continues to fall as incomes rise, although it’s not shown in the summary statistics).  Compared with a broad-based income tax, the proposal effectively allows a 50% deduction for the average high-income household.  Because it is also a flat rate tax, it would be especially regressive, especially compared with the current income tax where rates rise with incomes.

A decade ago, President George W. Bush’s Tax Reform Panel considered a sales tax as a revenue-neutral replacement for the income tax. It rejected the idea after concluding   that the rates would have to be much higher than promised by the FairTax people. It also calculated the tax would be very regressive as the figure below shows.    figure 2

The Panel also found that the prebate would be extremely expensive, hard for taxpayers to manage, and complex for the IRS to administer.   In addition, the panel was concerned  a federal retail sales tax rate of 30 percent or more would result in widespread evasion and create real problems for states that rely heavily on their own sales taxes.

FairTax advocates counter that their proposal would also replace regressive payroll and excise taxes (as well as highly progressive estate taxes), but the bottom line is that tax burdens on middle-income households would surely rise while high-income families would get a big tax cut.

Some people might call that an UnfairTax.

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