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The Recession & Corporate Finance
Taxation has always been a source of concern in the US. Income tax in particular has caused more controversy than any other type of tax levied in the history of the country. From the time the country was formed in 1776, from Alexander Hamilton’s Federalist No. 21 explaining why taxing states and individuals on the revenue they earned was by no means justifiable, people have come up with arguments against the now current system of taxation.
For a good 124 years, the US functioned with a system of taxation very similar to the proposed FairTax[1]. For the last 100 years or so, however, the country has functioned fairly well with the current income tax system too. In fact, the US has excelled in world politics and economics in the last 100 years far more than it did in the first 124 years. It has become the global economic, political and military leader during the last century. Some might argue that the revenue the government earns (via income tax) has nothing to do with it; the mere fact that the country matured over time might be enough to explain US dominance in the world today. However, for the government, or Congress, who benefit from the income tax system, the maturity is hardly relevant justification to weaken the position of the income tax system.
The FairTax plan proposes to replace the federal income tax, including capital gains taxes, all payroll taxes, the estate gift tax, and corporate and self employment taxes, with a single stage, 23 percent federal sales tax on the sale of all new goods and services at the final point of purchase. No family or individual will pay taxes on basic necessities, because of generous rebates built into the FairTax plan. Such rebates make the FairTax much more progressive than the current income tax system, refunding all taxes paid on consumption expenditures up to the poverty level for families of various sizes[2]. The FairTax is revenue neutral, that is, the 23 percent is calculated based on the expected change in consumer spending due to the change to FairTax while keeping governmental revenue the same as it is under the income tax system.
Support for FairTax has grown to a peak recently, with more than 20 members of the Congress co-sponsoring the plan introduced by Rep. John Linder of Georgia[3]. People in favour of switching to a Fair Tax have given numerous arguments against the Income Tax System that the Fair Tax solves for them. However, they all suffer from the same fallacy. From the very first argument given by Alexander Hamilton in Federalist No. 21 to any argument you can find in support of the Fair Tax today, anyone has yet to mention the advantages or benefits to Congress or the US government. Supporters of the FairTax in the enthusiasm and rush of excitement based on the advantages that FairTax will bring to them have evidently forgotten who makes the decision.
Given that in the purest form of democracy Congress and the government are supposed to do what the people that elected them want, we must understand that bureaucracy and corruption of politics make sure that none of the purities of democracy come into play. That being said, we must understand that Congress’ most powerful resource for raising revenue on a relatively short notice as well as controlling the public is the Income Tax[4]. Now, keeping in mind these factors, if we were to look at any of the arguments in favour of Fair Taxation, they give Congress no reason whatsoever to switch from the Income Tax to the Fair Tax.
The only reasonable situation under which the Congress or US government would even consider thinking of the FairTax would be when they are told exactly what they gain from it. If it is to their advantage to switch to the Fair Tax system, then there is a reasonable chance that they will do it. Think of the United States of America as a big corporation and think of the Congress as upper level management. When someone proposes something to management, they must tell them what good it will do to them. If it is to their benefit, they declare it as being beneficial to the corporation. If it is not to their benefit, the proposal hits the recycle bin. Whether a decision based on such management criterion is ethical or unethical is a different argument; the unfortunate fact of the matter is that this is how the system works. We have seen that in the business world recently (with Enron and MCI Inc.) and unfortunately the US government leads with example. The stakeholders, or in this case the general public, do not have much of a say in how anything works. Just as the shareholders do, the public elects the government and the Congress and is then at their mercy.
Having established that, we now need to see what Congress gains from the FairTax. Every year, the IRS spends millions of dollars on tax audits under the Taxpayer Compliance Measurement Program (TCMP), trying to make sure that people pay the amount of taxes they owe. The problem arises due to the extremely complex income tax system. Majority of the population is not aware of whether they should file a tax return and if they should, how they are to fill out the complicated form(s) that makes the lives of even the most qualified accountants and tax professionals miserable. In 1997, the General Accounting Office, in a tax gap report said:
“The TCMP (Taxpayer Compliance Measurement Program) data showed that an estimated 33 million of the 42 million taxpayers (82 percent) were not assessed a fraud negligence penalty, suggesting that much of their noncompliance was unintentional.”
This merely shows that the income tax system has become too complicated for people who cannot afford accountants. Research shows that even the expertise of the latter no more guarantees correct tax calculation. In the annual Money magazine surveys 50 accountants prepare a hypothetical middle class couple’s tax return and come up with at least 45 different answers each year. This is a major indication that the tax system is too complex for even the tax professional.
Due to such complexity, the IRS has to spend money auditing innocent individuals who are unaware of their tax liability. In most cases, whether penalties are assessed or not, the money spent on the audit is not recovered by the amount of tax these people end up paying. As mentioned above, 82 percent of the people’s inability to pay tax was due to their lack of knowledge about the income tax system.
The FairTax will not only make the life of the IRS simpler, but it will also mean that they do not have to spend as much money on audits as they do under the income tax system. Under the FairTax, even if we assumed that every business in America was a retailer and required to file a tax return, no more than 19 million businesses would be required to file returns compared to over 154 million returns (of all types) filed today[5]. This would mean a reduction in the amount paperwork filed to and processed by the IRS, literally hundreds and thousands of dollars in all the excessive paper that floats around (despite the IRS’ valiant efforts to encourage people to file online).
Alongside, if every business in the country were to be audited, the IRS only has to audit 19 million businesses, there by reducing amount of audits conducted by almost 55%[6]. As of 1997, the IRS spent over$ 4.5 billion on tax audits. Under the FairTax this figure would also be reduced by 55%, thereby making it $2.025 billion (in 1997). Also, since fewer returns would have to be processed, the IRS would not require half the staff it requires now. In 1997, the IRS spent a whopping $ 1.78 billion on the management of the organization itself. These costs could be cut substantially under the FairTax (due to fewer returns needing processing), giving the Congress billions of dollars to play with[7].
However, the issue of ethics comes to mind the IRS has to lay off employees. Such employees would now become part of the private sector, thereby, again saving the government money in the form of wages, pensions etc. Also, because under the FairTax, what you earn will be what you take home. Americans will be able to save more and invest more. The FairTax will, therefore, dramatically increase investment levels compared to levels that would have been achieved under the current income tax system[8]. This means that the US economy would grow, thereby producing more jobs in the private sector, creating employment for the then ex-IRS employees. Although such a transition would take time, the long term effects would benefit the Congress, at the same time helping the economy grow.
A major source of concern expressed in papers in favour of the FairTax has been the excessive amount of money spent by the private sector in complying with the IRS code. Arthur Hall, a tax Foundation economist, estimated compliance costs at $ 225 billion for the year 1996[9]. Compliance costs have become such a massive number not because that’s what it takes to follow the tax code but because due to its complexity, “holes” and problems have been created that even the IRS and writers of the IRS code are not aware of. Money is spent on locating these holes and exploiting them to minimize the tax liability of people. If the tax code were simpler, there wouldn’t be as many holes or chances of exploitation or what can sometimes be classified as unintended errors by the tax professionals themselves who proudly discover such problems in the tax code (for an hourly fee that most heart surgeons charge during surgery), thus meaning that the IRS would not have to audit people who were trying to work their way around the tax code.
The FairTax makes compliance with itself relatively simpler. A flat national retail sales tax would eliminate so much of the trouble caused by the variable income rates in the income tax system. Moreover, the simplicity of such a system would not leave much room for exploitation of the tax code, thereby reducing the amount of money wasted in the economy on compliance with the tax code (and by the IRS to assure such compliance) and making it available for the private sector to invest in and help grow the economy.
There is, however, one problem that has been brought up in discussions that is thought of to be prevalent even under the FairTax system. As of today, there are millions of businesses out there that misrepresent the amount of sales tax they owe to the government / charge to their customers. The 23 percent proposed FairTax rate has been calculated keeping in mind based the sales tax that is actually reported by such businesses. In my experience as a business owner, and as knowing others who own small businesses, about 30% of the sales are not reported[10]. This means that most businesses are actually not reporting 30% of the sales tax that they owe to the government. Opposition to the FairTax argues that the FairTax will in no way improve such misreporting of the FairTax. However, I beg to differ on that.
The amount of money the IRS spends on making individuals (not businesses) comply with the tax code is phenomenal[11]. Let’s assume that of the 154 million current tax payers, if 19 million are actually businesses that need to charge and report sales tax, there are 135 million individual income tax payers. Under the FairTax, the billions of dollars saved on making these people comply with the tax code would be saved. Since there are now only 19 million taxpayers, it is very possible for the IRS or any other tax implementing authority to track every business and all the sales via an information system that centrally holds and stores all the sales data from these businesses. This, again, will not only mean more control for the IRS over the taxpayers (which should be heavenly for Congress), but after an initial investment it would mean an extensive amount of revenue generation.
With the current technology, it is possible and very feasible for the IRS to host a database (or to outsource it to someone) whereby they keep track of Point of Sale (POS) terminals in every store. This would mean that every registered, legal business (at least retail) can only use sale terminals that are sold or authorized by the IRS, i.e., linked to their database so that they can keep track of every sale. This would greatly reduce, if not eliminate misreporting of sales tax dollars. Better yet, even if the IRS will conduct and audit of all 19 million business annually, they can make sure that these businesses are not using any unauthorized terminals. Auditing costs for the 19 million businesses stay the same as under the income tax system (saving the money spent on the other 23 million audits as per the General Accounting Office report); the question now remains of the investment required to design such a system. As mentioned earlier, the IRS would only spend about $ 2.025 billion on Tax Law enforcement with the 19 million businesses. That leaves them with another $2.5 billion as of 1996. This investment alone from 1996 should be enough to cover the cost of building such an information system.
Better yet, if the IRS out sources the productions of POS systems to manufacturers who already produce them, they can be made compatible with the new system with minor hardware and software changes. This could also include a business opportunity for the government where they could produce and sell such units; thereby generating more revenue for itself. 19 million is a traceable number; 154 million, however, is probably not. Also, this would only be a one time investment with relatively small maintenance costs in preceding years and if it is done right, a manufacturing business that would more than cover all such costs.
Lastly, a benefit to Congress; be it more political than practical, nevertheless, will exist with the acceptance and implementation of the FairTax. Today, the US claims to be the closest thing to a pure Capitalist economy in the world. One of the major determinants of a capitalist or market economy is generally consumer’s ability to use the items in demand according to his/her ability to pay for such items. Based on that very principle, consumers should be taxed on their ability to pay for consumption of goods in the economy, rather than their investment in the economy. The current income tax system, however, does not do that. Whether people use the money to reinvest it into something or to actually spend it on an end product, under the income tax system they are charged income tax on it. No matter how steeply the tax on income is graduated, it does not necessarily make an income tax progressive over the course of one’s lifetime[12].
Innocence on part of the American public, but if they were to see how the income tax system (in the American economy) violates the very basics of the (capitalist) system it claims to be best representative of, they would express such severe dissatisfaction that would make the life of Congress rather miserable (as most would think they deserve). The FairTax solves this problem just like it does the others. As suggested in a paper on http://www.fairtax.org titled “Fairness and Federal Tax Reform,” the author writes that:
“…the FairTax, far more than an income tax, is based on a taxpayer’s ability to pay precisely because it is based upon consumption. Whether or not a taxpayer can consume for personal enjoyment is a more accurate litmus test for whether or not that taxpayer has the ability to pay (for consumption of goods and services produced by/in the economy). When taxpayers do not consume for personal enjoyment, but have income, they must be saving or investing those resources. When taxpayers save and invest, they contribute to public welfare (and they should not be taxed on contributions to public welfare).”
The income tax system is known to be in violation of the US Constitution in its purest form. Although such a violation of the US Constitution does not concern the international community, the US claim to be a highly capitalistic and free society can come under some scrutiny due to the income tax system. In its purest form, the income tax system is no different from the roots of communism, which gives the governing authority the ability to control the population, take their money and distribute it as they see fit. Upon reflection of the income tax system, the US could be blamed for practicing the very idea that it has opposed over the last century; which caused it to aid other enemies of Communist Russia in its destruction. If light were shed on such issues on the international community, it could arise some very serious questions as to the validity of the political dominance (without any military intervention) of the United States in the world today. It is, therefore, to the benefit of the United States government to move away from the income tax system before the international community receives a “wake-up call.” Although such political ramifications are not the topic of this paper, their mention merely shows the advantage of switching to the FairTax (which is the goal of the paper).
True as it is, there is no guarantee as to the accuracy of the numbers proposed by the evaluators and supporters of the FairTax. However, the numbers available for 1996 and 1997 show that switching to the FairTax will not only increase the available cash to the US government, but with the predicted growth of the economy due to the increase in consumer spending, tax revenue will also increase over the years.
I believe that switching to the FairTax brings more than financial advantages to the Congress and the US government. It will validate many claims that the US makes in the international world about being fair, just and providing a free environment for its people. More than that, it might give Congress the respect and willingness to comply that it would like from the population. In that scenario, they do not need the control and power that income tax system (in the opinion of most free citizens) unnecessarily gives them.
I wrote this paper in my junior year at university. I still believe that fair tax is probably the fairest and best way to go with today. Living in the UK, you really learn to appreciate the US tax system, fair or not, it certainly is a blessing compared to this country. In the UK, the government takes approximately 57.5% of your disposable income in the form of PAYE, National Insurance and VAT. There are other additional taxes and payments that are imposed on UK residents, with the net tax for some totaling about 65% of gross income earned. Is it just me, or does that reflect on the lack of the British people to protest? You decide!
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Works Cited
[1] Origins of the Income Tax. Research and Support. Americans for FairTaxation http://www.fairtax.org/origins.asp.
[2] The FairTax and the Federal Revenue Income Tax: A Comparative Analysis. Americans for FairTaxation. http://www.fairtax.org. For further information plese see, “The FairTax Plan,” Americans for Fair Taxation.
[3] Picket, Joseph. Slay the Withholding Beast. June 5, 2003. http://www.cfif.org/htdocs/freedomline/current/guest_commentary/fairtax.htm
[4] For more information refer Dr. Scott Butterfield and his cynical lectures on Income Tax. College of Business, University of Colorado at Colorado Springs.
[5] See SOI Bulletin, Winter 1998-1999, table 12, p. 210. Note: Sole Proprietorships with less than $ 2,500 in annual receipts excluded since the de minimus rules in the FairTax would not require most of them to file returns.
[6] (42million -19 million) / 42 million x 100 as per the General Accounting Office Data.
[7] FY 1997 IRS Budger Request. IRS Fact Sheet # FS-96-06. IRS News Releases. February 03, 1996. http://www.unclefed.com/Tax-News/1996/Nrfs96-06.html. © 2002, National Tax Services, Inc.
[8] Jorgenson, Dale W. Ph.D. The Economic Impact of Taxing Consumption. Harvard University, Testimony before the Ways and Means Committee, March 27, 1996.
[8] Jorgenson, Dale W. Ph.D. The Economic Impact of Fundamental Tax Reform. Testimony before the House Ways and Means Committee, June 6, 1995.
[8] Jorgenson, Dale W. Ph.D. The Economic Impact of the National Retail Sales Tax. Harvard University, November, 1996.
[9] Federal Tax Compliance Costs Climb to $225 Billion. Tax Features, Tax Foundation, March 1996. See also, Match 20, 1996, Dr. Hall’s testimony before the House Ways and Means Committee.
[10] Personal Experience, it does not get any more authentic than this.
[11] The exact figure would be some part of the $ 4 billion spent; however, there is not enough information available to compute it.
[12]Kahn, Joseph. Examining a Change to a National Retail Sales Tax Regime: Impact on Households. Decisions and Ethics Center, Stanford University, unpublished draft position paper, November 1996.
