What Is the Fair Tax Act & Is It Fair?

The House recently proposed H.R. 25 “FairTax Act of 2023” on January 9th. The Fair Tax is a proposed tax reform plan that aims to simplify the US tax system. Unlike the current system, which is based on a complex landmine of income, payroll and estate taxes, the Fair Tax would impose a single national sales tax on all new goods and services purchased in the country.

This plan has been around in various forms since 1999, but it has never been given a floor vote since it doesn’t have any mainstream support amongst either political party.

What Is a “National” Sales Tax?

The national sales tax would add a tax of 23% on top of existing state and local sales tax rates. (If you think your loaf of bread is already a lot more expensive recently, add another 23% on to it.) 

In the proposed legislation, the sales tax would be administered by the existing infrastructure of the state and local governments. The idea is to slash the cost of the IRS and pass along the bill to the states. (I’m sure they won’t mind, right?)

A flat 23% additional tax sounds like a pretty easy system to manage. And it might be simpler than the byzantine mess of the income, estate and gift system. At least to start. For those of us that have to deal with sales tax filings, it’s a whole nother matter. In fact, there is an entire organization dedicated to state sales tax simplification. The ugly truth is, what is a simple sounding “sales tax” quickly attracts lobbyists seeking special carve outs and reduced rates for whomever they are working for.

Our current system of state and local sales tax largely exempts tax on sales of services. HR 25 seems to indicate the national sales tax would encompass a tax on services. Most states would not have the infrastructure needed to handle this.

Also, it is increasingly harder to determine the difference between a good or service. When you pay for software, are you paying for a tangible good or are you paying for a service? What if the purchase price includes installation? States already have difficulty defining these terms and often disagree.

What Is the Difference Between a National Sales Tax and VAT?

Europe has already experimented with a national tax on goods and services. Their version is called a “Value Added Tax” or VAT for short. A VAT taxes the increase in value generated at each stage of the supply chain. That means all businesses are subject to VAT (suppliers, manufacturers, wholesalers, etc.).

To comply with the VAT rules, you figure your gross tax on sales and then subtract “input credit” which are taxes that you paid for any goods that you are reselling. Effectively, you end up with a tax on gross margin (net profit after taking into account direct costs but not administrative costs). 

VAT taxes generally caused at least a short term contraction in GDP in the year of implementation. 

Is a Fair Tax Really “Fair”?

The main idea behind the Fair Tax is to create a more straightforward, fair and efficient tax system that eliminates the exemptions that benefit the wealthy at the expense of middle-class Americans. It is a consumption-based tax that would only tax what people spend rather than what they earn.

Under the Fair Tax proposal, all federal income and payroll taxes would be abolished. This includes personal and corporate income taxes, Social Security taxes, estate and gift taxes, and taxes on capital gains and dividends. The IRS is effectively abolished by eliminating funding for the agency in 2027 under the proposal.

The bill would still require reporting on wages to the Social Security Administration for purposes of tracking Social Security benefits. So even though payroll tax collection is out the window, W2s might not be? And somehow, self employed taxpayers would need to report earnings to receive credits. The current bill doesn’t appear to fully take this into account.

The Fair Tax would also provide a tax break for low-income families. Under the proposal, households would receive a monthly rebate from the government. This rebate would be computed using annual poverty level guidelines. For a family of 4, this monthly rebate would be computed as $532 ($27,750 poverty level income x 23% national sales tax rate / 12 months). 

In our fictional world, now that the IRS has been abolished, I wonder who is issuing the monthly rebates and keeping track of family size?

I’m unsure if the rebate mechanism is “fair.” It has been estimated that more than half of Americans pay no income tax, although many are paying Social Security and Medicare taxes at 7.65% of their income. 

What Does the Fair Tax Look Like in Action?

A middle class family making $100,000 in 2022 could expect to pay about $8,100 in federal income taxes. If they spent 75% of their income on taxable goods under a national sales tax at 23%, they could expect to pay $17,250 in additional sales tax. Their rebate of $6,384 would bring the net cost down to $10,866 which looks like a tax hike of about $2,766 in my book. 

Summary

While the Fair Tax has failed to garner any widespread support, it’s important to understand the proposed legislation and how it might impact the economy if passed. We will continue to see proposals like this popping up, especially as our income, estate and gift tax laws continue to become more complex. While accountants like job security, I think most of us would trade some security for income tax simplification.