Flat Tax vs. the Fair Tax

With the approach of April 15, there are a lot of commentators who are advocating the replacement of the income tax with a flat tax while others are promoting something called a "Fair Tax". What are the differences? Do either forms of taxation have any chance of replacing the income tax?

The flat tax is the easiest to explain. Instead of multiple, progressive tax rates that look like a stairway, there is only one tax rate. Instead of hundreds of diverse deductions, exclusions, exemptions and tax credits for different taxpayers, there is only one deduction for each taxpayer or family based on family size. But that deduction is substantial enough to eliminate the tax for lower income families. Various advocates of the flat tax disagree about what the single rate should be, but most of the proposals range from about 12% to as high as 33%. Most of the flat tax advocates seem to argue in favor of a revenue neutral rate that would produce the same amount of tax revenue as the combined revenue from the personal income tax, the corporate income tax, the social security tax, the estate and gift tax and an assortment of other taxes. But it would not require any major cuts in government spending as a pre-condition for switching to a flat tax.

Critics of the flat tax point to the 28% top income tax rate introduced by the 1986 Tax Reform Act that was pushed through by President Reagan. It was only a couple of years later that the rate was raised and has gradually gone up to 35% for individuals. Many deductions and tax incentives were removed by that law, but others have been introduced to take their place. Currently, the politically popular types of tax incentives are tax credits for various kinds of energy conservation. Critics also point to the fact that the flat tax is still a tax based on income and that it would require the continued intrusion of the IRS to verify that income had been reported truthfully.

For more on the flat tax see the CF&P video at http://www.youtube.com/watch?v=nhUOpNve1bY

and the Heritage Foundation Guide to the Flat Tax.

The fair tax is a national sales tax that would ostensibly replace the income tax. The government would send a check to each citizen that would represent the equivalent of an exemption from the tax at lower income levels, which is referred to as a "prebate" by the designers of the fair tax.

Advocates of the fair tax argue that a tax on consumption would have a stimulative effect on investment and would even draw investment from other parts of the world. The tax would be collected by businesses and could be managed by the state governments that already have a sales tax in place. In those states, the tax rate would include the amount already being charged in each state. States that do not impose a sales tax would either adopt one or the federal government would impose and enforce a sales tax in those states. One of the arguments in favor of the sales tax is that it is far more difficult for people to evade the tax.

Critics point to the fact that while the FAIR tax proposal calls for a repeal of the 16th Amendment to eliminate the income tax, that would require approval by 3/4of the state legislatures and would take a long time. Meanwhile, there is nothing to require that the proposal to amend the Constitution be submitted to the states. And there is nothing to prevent the politicians from simply adopting a national sales tax (or value added tax) in addition to the income tax. This is precisely what has happened in many European countries. Also, the politicians would be free to tinker with the amount of the prebate, and the various goods and services that would be granted an exemption from the tax. In addition, a high sales tax rate in border states with Mexico or Canada would lead to extensive smuggling of higher priced goods.

For more on the FAIR tax see the FAIRtax.org web site. and Wikipedia.

Is there a better choice?

While I favor the Fair Tax over the Flat tax, my main concern is that I see no mechanism to tie the introduction of the fair tax to the elimination of the 16th Amendment. I would favor a plan that would propose a repeal of the 16th Amendment with the stipulation that IF the income tax is repealed, then the federal government would replace it with a national sales tax. I would even favor making the repeal of the income tax (and other taxes like the Social Security tax, corporate income taxes, estate taxes, etc.) and the adoption of a sales tax part of the same Amendment. And while I have a problem with the idea of revenue neutrality, I do believe that once people are having to pay a sales tax of 15% to 30% of everything they buy, it will put a lot of heat on the politicians to reduce the rate and to not introduce a lot of exemptions. In addition, competition with other countries would help to keep the rate at a reasonable level.

Of course, there is also the "little" problem of getting a very left wing president and congress to go along either idea.

But that's just my two cents. And a lot of my professional colleagues think I'm a crackpot.

Vern