Why A Fair Tax Isn't Fair... And The Laws of Unintended Consequences...

Ever since Huckabee won the Republican vote in the Iowa Caucus, there has been renewed interest in what he calls a Fair Tax.

In interest of fairness, let me provide a link to those supporting a Fair Tax that allows you to read what they say.

Basically, the Fair Tax idea is to tax consumption and not income. Income taxes are to be abolished, all other taxes as well (more or less), and everything is financed via the Fair Tax, which is differentiated from a Value Added Tax by being paid not at all stations of the value chain, but rather ONLY by the end consumer.

Hence, the basic example being the $100 widget, the current state of affairs is that you pay $100 for the widget plus your local sales tax (where applicable, not every state has sales taxes). Let's postulate that you have $100 income that is taxed at 23% (their example), that means you have to earn $130 in order to spend $100. So you had income of $100, spend $100 (assuming no current sales tax: it's clothing in New Jersey, for instance, the government gets $30.

Now, under the Fair Tax, you'd have your full $130. The widget would cost you $130, of which would be $100 plus 30% Fair Tax, the government gets $30.

So what's the difference and why all the fuss?


Simple: this is not reality.

First of all, final consumer goods are not priced according to what it costs the maker to make them, but rather what the market will bear. If incomes go up, prices will follow them as manufacturers seek to maximize their profits.

Hence in the above example, the Fair Tax advocates assume that the manufacturer would drop their prices to reflect their savings on taxes.

This is, at best, a rather naive assumption that has little or no likelihood of ever occurring.

Remember, goods are priced not COGS (cost of goods and services, i.e. all possible inputs into the production process) plus profits to cover the cost of capital and investments. Goods are rather priced at what the market will bear: the MP3 player that you readily buy for $100 online ( i.e. leaving the trade chain out of the story) costs, factoring in all possible costs, at best $25 to make (in quant 200'000) and get to the final consumer. The fact that you pay $100 for it is irrelevant: the difference is the company's profits.

This is fundamental: costs are on the one side, prices on the other. The ability to not merely balance the two, but rather to create the largest possible difference between the two, determines the success or failure of a company. Companies that balance the two fail, since they lack the funds to expand and improve their products; companies that maximize the difference, despite competition, thrive and succeed.

The real world is vastly more complex than our simple and simplistic example. You don't have income of $100 that goes for a single widget: that is a construct to make the basic idea simple. This is misleading: what you really have is gross income of, say, $63,497 per year, and you spend, say, 60% of that on consumption, with another 20% being taken up in income taxes/FICA and the rest used to pay down debt or to save. To give that real-world flavor, say $38,098 in consumption, $12,699 in taxes and $12,700 in debt servicing or savings.

Now, under the Fair Tax, you'd be spending 90% of your income on consumption (your 60% + 30%), nothing on income taxes, leading to a theoretical difference of -10% in savings (40%+20%+40% without FairTax; 70%+0%+30% under Fair Tax).

That means your disposable income went from $50,767 ($38,098+$12,669) to $63,497, an increase of 25% (63497/50767=1,2508).

Now that sounds good, doesn't it?

You consumption, though, goes from $38,098 to $49,527, a 30% increase that you, as the final consumer, pay under the FairTax concept. You're left with 63497-49527, or $13,970, which compared to your previous savings of $12,700 is an increase of 10% (13970/12700=1,1000).

Now that sounds great, doesn't it?

But what happens when a FairTax is implemented? Remember, everything you buy is now 30% more expensive in terms of perceived utility, and you have "only" a 25% increase in your disposable income. That means you will perceive your real purchasing power ability as having dropped by 5%.

Your consumption patterns *will* change.

In the real world, people have spending limits, either informal or formal. Personally, I have no qualms about spending $100 for that MP3 player: for me, that is disposable income. I don't do it every week, though: once a month is what I am comfortable with. If I were to have 25% more money in my pocket, that would jump to $120: I'm fiscally conservative. However, someone else may feel comfortable spending $150 on their MP3 player when their incomes increase, i.e. are fiscally liberal.

Now, companies making that MP3 player set price points: they know how their consumers behave (and spend huge amounts of money finding that out!). If they see incomes jump, say by the 25% in the above example, then they're going to try to increase their prices accordingly. Not immediately, but rather when the next product comes out, with "new" and "improved" added to the product description along with the price increase. Knowing how your customer reacts when his income stream increases is key to commercial success, and cannot be ignored: prices will grow, and you won't be moving up in terms of quality, but rather companies will price their products according to the disposable income of their customers. That's how the real world works, folks: anything else is an academic exercise at best.

After all, the goal of the company is to charge the maximum that the market will bear: if they can get away with charging $150 for a $35 item, they will, but will be happy enough to live with a $100 price.

Now one of the fundamental tenets of the FairTax folks is that companies will charge less for their products, as their products cost them less to manufacture. This is where the FairTax falls flat on its face: for it to work, companies must reduce their prices - pass on the benefits from lowered costs - in keeping with this reduction in their costs from lower taxation. Unless this is written specifically into law and companies are forced to do so, they won't: there is no incentive for them to do so, as all companies work within the same environment. As the FairTax FAQ correctly states, company taxes are passed on in one form or another to consumers, forcing prices up. Companies don't have a choice of doing this or not: they pass on cost increases as a matter of principle. If taxes were eliminated, there is only one incentive to reduce prices.

To gain market share.

Companies reduce prices for one reason only: to gain market share, either for ongoing products by expanding the customer base in excess of losses per unit, or by attacking the markets of their competitors to hurt their earnings greater than internal losses. Companies reduce prices to increase the perceived utility of their products, not because their costs are lower: this only works for companies who can gain a price advantage over their competition, and because this applies for all companies, this doesn't play here.

To reiterate, for the FairTax to work, companies would have to drop their prices: if they do not, then the calculations don't work.

What you've really done with the FairTax is to give inflation a huge push, as companies seek to maximize their portion of increased incomes. Again: prices in the real world are not priced at the marginal return price of the last unit made, but are priced according to what the market will bear. There are some efficient markets that will tend to lead to the marginal price of the last unit made, but there are plenty of inefficient markets out there as well.

In other words, that widget isn't going to fall from $100 to $77: it is going to stay as close to $100 pre-tax as possible, since that is the point where consumers buy. What improves is profit margins. The idea that there is a 100% trade off is naive at best.

Now, I've labeled this post as what a FairTax isn't fair.

Why?

Because at the very core of it, it's a regressive tax. There is no way to get around the fact - not opinion, but absolute, inconvertible fact - that lower income people spend more of their income on consumption than those with significantly higher incomes or wealth. It's not a life-style choice, either: the rich can, past a certain life-sustaining minimum, chose to consume; the poor must consume, meaning that someone rich can adjust their lifestyles to match what they are willing to pay in taxes, but someone at the bottom of the food chain cannot make any such decisions, as 100% of their income goes to consumption.

Now, this is rejected as an argument by the FairTax advocates, who argue that by giving something called a prebate (cash before the transaction, as opposed to a rebate, cash after the transaction) you can equal out the regressive nature of the beast.

Sorry: this assumes that this will make a real difference to the low-income consumer.

Someone who is, pre-FairTax, consuming 85% of their income, paying 15% in taxes with no savings, will, after a 15% prebate, spend 85%+30% = 115% of their pre-FairTax income, which will have risen to 115% to leave them in exactly the same situation as before.

Or let's be more exact: someone who is at the bottom income levels today, according to the FairTax FAQ, would get a 19% prebate to compensate for 30% in taxes.

How is that fair?

For me that's a 11% difference, a negative difference, that low-income folks can't avoid.

How is that fair?

Ultimately, changing the admittedly arcane and bizarre current tax code with this would have major unintended effects.

1) Inflation would increase as manufacturers exploit increases in income. This adds to the regressivity of the FairTax, as inflation will always lead corrections to any sort of prebate, resulting in real purchasing power loss, rather than gain.

2) Consumption patterns would change. We have no way of knowing what the effects will be: it may be moderate, it may be severe. If new houses are included, but existing houses are not, then fewer new houses will be built and existing houses will become significantly more expensive, creating a bubble in existing house prices, as demand chases a drastically reduced supply. This is merely one aspect: while those who are timid souls and who save a significant portion of their income regardless of taxation rates would benefit, this merely postpones the problem, as their later consumption will be taxed when their incomes are least able to finance the tax.

3) Is increasing savings and reducing consumption good for the country? Or more pertinently, is it good for me? This is more complex than I want to get into right here, but suffice to say that if consumption were to be reduced by, say, 15%, that means the flow of goods and services would be reduced by that amount as well, which drives down GDP. If that is the goal of the system, then fine: it certainly does not, however, sell itself as that. This is a serious point: I do not see how using the tax system to create greater preferences for savings against consumption can improve the lives of US taxpayers, since many, if not most, define their happiness - one of the god-given rights in the US - via material and services consumption.

4) The incentive to complete the final transaction outside of the realm of this tax would increase. Black markets would be created to complete final transactions outside of the system for high value items: if I pay 20% less for an illegal transaction, the seller has 10% more money and I've got 20% more money, with the government losing 30%; the enforcement of the FairTax would have to be wide-spread and draconian if it were to succeed, and this raises more problems than it solves.


Summing up - and this has gone on way too long already - the FairTax is neither Fair nor a good idea.

If you want to make the tax system fair, a Flat Tax is the way to go, with no deductions: everyone pays their share. A billionaire with $100,000,000 income from dividends and interest pays 20%, as does the local barber or the traveling salesman. You set it by dividing total income from all sources by needed government expenditures to get the base rate: it goes up and it goes down accordingly, each and every year, and the only way to increase income is for people to earn more or increase the tax rate.