Revision or Repeal: Tax Reform Proposals

The FairTax proposal has gotten lots of buzz lately. Simply put, the FairTax is a proposed national sales tax that would completely replace the federal individual and corporate income taxes, as well as payroll tax deductions for social welfare programs such as Social Security and Medicare. The standard version calls for the abolition of the IRS. Clearly, it's a breathtaking idea.

Interestingly, all the buzz over the FairTax has invigorated the flat tax movement in response. The flat tax is a reform of the federal income tax system — it would replace the current morass with one uniform rate for everyone, and eliminate all deductions (except for generous exemption amounts for married couples and children). The standard version of the flat tax also exempts investment income — interest, dividends, and capital gains — from taxation, eliminating the present double tax on such income.

So which is better? Before we answer that, let's take a moment to revel in the reality that Americans are increasingly aware of these two radical reform proposals, and that we may find ourselves in the position of arguing over a choice between a flat tax vs. no income tax at all. Wow!

As long as government is funded by involuntary means such as taxation, we can rate such means from two perspectives: economic and moral. We should strive for taxes that do the least economic damage and that maximize our liberty.

A flat-rate income tax with no deductions, and which exempts investment income, is far better, along both of the above dimensions, than what we have now. It would spur investment, since investment income would no longer be penalized. It would dramatically reduce the cost of compliance and free capital for more productive purposes. Lastly, it would enhance our liberty by ending the system of taxing higher income earners at higher rates — a scheme that explicitly punishes productivity.

However, the FairTax would achieve these same ends. It would not tax income at all, investment or otherwise. It would reduce the cost of compliance even more than the flat tax, since we wouldn't have to file returns at all. Since most states and municipalities already levy sales taxes, it is doubtful that retailers would shoulder much added cost of compliance. They are already setup to collect and pass on sales taxes.

Since the FairTax would replace all federal income and payroll taxes, it's estimated that the total cost of goods will not increase. The present-day cost of goods is saturated with all those income and payroll taxes built-in; when those hidden taxes are eliminated, the prices of goods should fall, although it may take a few years to see the full effect.

What's more, the FairTax offers a big win for liberty that the flat tax simply cannot: No longer would we have to report our income to the government. Since every new deduction or tax credit added to our current system compels us to divulge ever more private information as part of our returns, this is a huge gain in keeping our lives private from the state.

Lastly, there is the matter of how long the flat tax will stay flat. Political entropy will likely bust the flat tax, as politicians begin to add loopholes, deductions, and ultimately, different tax rates. A sales tax is much harder to complicate, and the impact of such complications is less damaging to the individual taxpayer.

By these measurements, the FairTax is better. It represents a radical, gusting breath of fresh air — and it puts a stake through the heart of the income tax. There are, however, problems in the way it is being marketed that may inhibit its chance of adoption. The key problem concerns the estimated national sales tax rate that would be necessary to fund today's bloated federal government. The FairTax supporters often peg it as 23%. It's actually 30%.

Every time supporters talk about the rate, they begin by explaining the difference between two methodologies: inclusive vs. exclusive. Income taxes are commonly quoted in an inclusive manner; they are deductions from the original amount of pay. For example, a 30% tax on $100,000 of income means that $30,000 will be deducted, or withheld, from the $100,000. In contrast, sales taxes are commonly quoted in an exclusive manner; they are surcharges added to the price of a good or service. For example, a 30% sales tax on a $10 item means that $3 will be added to the price, for a total of $13.

The FairTax advocates confuse the issue by trying to maintain methodological consistency in analyzing both income taxes and sales taxes. They insist on representing the FairTax the same way as the income tax, by quoting rates in an inclusive manner. For example, they will describe the above example starting with $13 as the price, instead of $10, then take the $3 out, which amounts to 23% of $13. They then claim that the tax rate is 23%, rather than 30%. In other words, they add the tax to the price, and then use that after-tax price to work backwards and calculate sales tax rate as a percentage of the total transaction amount. They do this to claim a lower rate, 23%, which they hope will make the FairTax more palatable to the public.

This kind of salesmanship will always fail because it is both counterintuitive and inconsistent with how Americans already conceptualize sales taxes. There is no point in trying to force the same methodology on two fundamentally different kinds of taxes, and the American electorate is not going to be patient with people lecturing on inclusive vs. exclusive methods of calculating sales tax rates. They will want to know at what rate a good will be taxed, and for the FairTax that rate is 30%.

It’s worth noting, however, that as a percentage of income the rate is indeed 23%. For example, if you earn $100,000 per year under a FairTax system, and spend all of it, 23% of your income will have gone towards the FairTax, not 30%. If you don’t spend all of your income, your effective tax rate will be less than 23%. The importance of this 23% rate is that it compares favorably with what many Americans pay in combined federal income, Social Security, and Medicare taxes. Here lies a better marketing approach — forget talk of inclusive vs. exclusive methodologies; just speak of percentage of income.


Since the FairTax is the best tax reform proposal, and because it would revolutionize our economy and government, we should push hard for it. Let's keep the message simple, and avoid alienating or confusing the voters with odd technical or methodological demands.

A final thought: Compromise is the reality of politics. It's important to start by asking for what you really want, even what you might not think you can get. Set the bar high. If we cannot get the FairTax passed in a few election cycles, the interim compromise we settle for might very well be the flat tax. We could do much worse.



Joe Duarte is a software quality consultant living in Arizona.