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Thursday, April 19, 2007

Flat Tax, Fair Tax - Which Is Better (Or Worse)?

Gary D. Halbert and InvestorsInsight [newsletters@investorsinsight.com]

Is An Alternative Tax System Necessary?

Whenever the subject of income tax comes up, there's usually someone who mentions tossing the Internal Revenue Code in the dumpster and starting again from scratch, followed by cheers from everyone listening. Everyone seems to be sick and tired of the complexity of the current tax code and the hassle of dealing with the dreaded April 15th deadline (April 17th this year).

The two alternatives most frequently put forth as a replacement for the current tax code are the so-called "Flat Tax" and the "Fair Tax." Both of these alternative tax systems have been extensively debated in the public media, and have even been introduced in Congress. But before going into these two alternatives in more detail, let's look at some reasons why the current tax system is deemed to be in need of repair or replacement.

I have heard politicians say that the current income tax system is broken. I don't think that is accurate, because to say something is "broken" implies that it worked at one time, and I'm not sure the tax code ever has. It's always been confusing, difficult to comply with and even difficult for the government to administer. While there have been other attempts to "fix" the tax code over the years, none have made it significantly simpler or easier to comply with. In fact, they usually have the opposite effect.

So, what do Congress and the American people see as the major problems with the current tax code? Plenty! Just a few of the most often mentioned problems are as follows:

1. The tax code is so complex that it is almost incomprehensible. And I'm not just talking hard to understand by the public, but even by the tax professionals. For a number of years, Money magazine sent a hypothetical family's income and business information to up to 50 tax professionals. Most years, they got back anywhere from 45 to 50 different answers from tax professionals using the exact same information. More recently, the USA Today newspaper did the same experiment with only 4 tax professionals, and got back 4 different answers that ranged from owing the IRS over $500 to receiving a refund of $1,754. That's quite a discrepancy.

2. Call the IRS for clarification? Good luck! A 2006 study conducted by the Treasury Inspector General showed that approximately 26% of taxpayer questions were either answered incorrectly or not answered at all by IRS staff at taxpayer assistance centers. If tax professionals and the Treasury Department's own employees can't figure the tax code out, then something is definitely wrong with the beast itself.

3. The current tax code is costly to comply with. The non-partisan Tax Foundation estimates that individual taxpayers and US companies will pay as much as $300 billion this year alone for all tax preparation and compliance costs. To put that in perspective, that's a 20% levy on top of the approximately $1.5 trillion in total taxes that will be paid.

4. The current tax code is full of loopholes designed for special interest groups. Of course, not all of these are bad things, such as deductions for mortgage interest and charitable contributions. However, not all loopholes are for such noble causes, and the mere fact that loopholes can be created makes the tax code susceptible to being a way to pay off political debts, or garner political favor.

5. The tax code can be described as the best example of what is commonly called the "law of unintended consequences." Changes enacted during one period of time may have extremely negative effects later on. The Alternative Minimum Tax and marriage penalty are just two examples of how the tax code's failure to keep up with the times has ensnared taxpayers who were not the original targets of tax legislation.

6. The tax code is so complex, both intentional and unintentional noncompliance is common. This, in turn, requires that the IRS provide for enforcement of the income tax laws, which can and does lend itself to abuses. Testimony before the Senate Finance Committee in 1998 exposed many IRS abuses, prompting lawmakers to reign in improper and sometimes illegal collection activities. Since then, the IRS has been trying to present a "kinder and gentler" side, but recent talk of closing the "tax gap" by insuring compliance could mean that this pendulum may swing back the other way.

Obviously, the above list is not exhaustive, but it does illustrate some of the major problems that exist with the current Internal Revenue Code. The existing law seems to have so many "moving parts" that it is virtually impossible to interpret, comply with or even administer. One source I read said that the current tax code and accompanying regulations account for 67,204 pages containing over 9.4 million words. Virtually no one will stand to defend it, but can it be replaced by something better?

The "Flat Tax"

When most people think of a Flat Tax, they think of a single, low tax rate for all taxpayers. In such a system, the rich, the middle class and the poor would all be taxed an equal percentage of their income without any deductions or other special allowances. However, if that's what you think of when you hear politicians talk about a Flat Tax, prepare to be disappointed.

The Flat Tax proposals as set forth by former Congressman Dick Armey, former presidential candidate Steve Forbes, and others are far from a flat tax. The only similarity is that everyone pays a single tax rate - 17% - but the level of income that rate applies to would be different depending upon an individual's overall earnings. Other proposals have other flat percentages ranging from 14% to 19%, but the basic concept is the same.

In an effort to keep from being considered regressive, all of the major Flat Tax plans I have seen have some level of personal exemptions, allowing larger families the ability to have a higher income exempt from the Flat Tax. These range from under $25,000 to over $40,000 for a family of four. Since lower-income households would have little or no income over and above the personal exemptions, the effective tax rate for them would be smaller, or possibly even zero.

As a practical matter, the final level of personal exemption as well as the tax rate percentage would be set by Congress, and would also then be subject to periodic review (read: change). Unearned income such as investment gains, pensions, Social Security, savings, etc. would not be taxed at all under some plans.

Inheritances would also pass without taxation as the estate tax would disappear under most of the Flat Tax proposals. Corporations would have a similar flat tax rate on profits.

Yet whatever proposal you want to latch onto, it's clear that the Flat Tax is not flat at all.

The personal exemptions were obviously added to the Flat Tax proposals to avoid being labeled as a regressive taxation scheme. Even with the personal exemptions, some critics still regard the flat 17% rate as being much higher for some taxpayers than the current level of personal exemptions and the 10% lowest bracket under the existing tax code.

Under the Forbes Flat Tax plan, there would be no deduction for mortgage interest, state and local taxes or charitable contributions, which some see as a major negative. However, some of the Flat Tax proposals have also incorporated child credits and earned income credits. These would allow lower-income families to pay low or no taxes, plus get a refund of the credit.

The big question to ask is whether the Flat Tax proposal meets its objective of simplifying the tax code. To that, I have to answer "maybe, for a while." The elimination of many deductions and credits would certainly make the tax form shorter, though not quote "postcard size" as some proponents suggest.

While the Flat Tax may be simpler when first passed than the existing tax code, if you look at many of the special provisions that have already been incorporated as the idea has been bantered around over the last decade or so, it's already starting to attract credits and deductions.

More importantly, who thinks that Congress will leave a Flat Tax alone once it's passed? I certainly don't. The one, single tax rate could also be changed (read: raised) by any future Congress, and eventually become just like the existing tax code it replaced. I have absolutely no confidence in Congress' ability to refrain from tinkering with a flat tax rate. They will also be able to tinker with what is exempted from the definition of income, the personal exemptions, etc.

The Flat Tax is also not likely to win many fans among the liberals, since it is often viewed as being regressive. Plus, a 17% or 19% flat tax rate could result in a massive tax cut for high-income taxpayers. In fact, Steve Forbes was criticized for touting the Flat Tax during his presidential run because he would have been one of the main beneficiaries of the tax savings. I've said before that I never met a tax cut I didn't like, but they need to be accompanied by cuts in spending as well. I don't think any Congress has the ability to do that.

Of course, any new tax system has to supply enough money to run the government. So how does the Flat Tax do in that department? We all know that revenue projections are only as good as the assumptions used.

Proponents of the Flat Tax point to the fact that, in the short-term, the Flat Tax would likely decrease tax revenues (thus increasing deficits). However, in the longer term, Forbes expects the Flat Tax to produce a stronger economy, lower interest rates and eventually result in higher tax revenues. This is consistent with supply-side economics, but tax cuts to the rich will be a very hard sell in a Democratic-controlled Congress.
As for my personal opinion, I have to say the jury is still out on the Flat Tax.

While it sounds good on its face, a detailed examination of the various proposals shows that some of the very same complexities of the current system are already embodied in the Flat Tax. Perhaps my biggest reservation comes from the knowledge that politicians will find it very hard to leave any level of flat taxation alone in the future.

The "Fair Tax"

While the Flat Tax can be described as essentially a leaner version of the current income tax system, the Fair Tax is a whole new creature. The Fair Tax is not an income tax at all, but rather a national sales tax on all retail purchases. Even more revolutionary, the Fair Tax would replace not only the personal income tax, but also the corporate income tax, gift tax, Medicare tax, Social Security tax and estate tax.

Radio talk show host, Neal Boortz and Congressman John Linder are the primary champions of the Fair Tax. Boortz's book, The FairTax Book, debuted as a No. 1 bestseller on the New York Times list, providing strong evidence of the discontent of the American public with the current tax structure. Linder's Fair Tax bill (H.R. 25) currently has 57 co-sponsors, where the Flat Tax bill (H.R. 1040) introduced by Representative Michael C. Burgess, M.D. has only four.

Here's how the plan would work. The Fair Tax is a "consumption tax," which is
a tax paid when money is spent rather than earned. Virtually all federal income taxes would be replaced with a national sales tax payable upon the purchase of most new goods and services, including medical costs, new cars, new homes, gasoline, food, Internet purchases, and electricity. Used goods would be exempt (more about that later on). Savings and investments would escape taxation, as would corporate earnings.

The Fair Tax is considered "fair" because everyone consumes goods and services, but not everyone pays income taxes. Supporters claim the Fair Tax would eliminate the failure to report cash transactions, the ability to escape taxation through the use of loopholes and any other features of the current tax code that are viewed to be "unfair" to the average taxpayer.

The tax rate is presented as being 23% of the cost of goods, but this is a bit misleading. Most of us think of sales taxes as being a percentage on top of the price of a good. For example, here in Austin we have a sales tax of 8.25%, which means that you pay $108.25 for a $100 pair of boots. In these terms, the Fair Tax is really a 30% sales tax, since that's the percentage applied to the base price of the good or service. They arrive at the 23% number through a little creative math.

Using our $100 example, the total price including the sales tax would be $130. Dividing the total tax ($30) by the total cost ($130) works out to be 23%. Since 23% is lower than 30%, that's the way the Fair Tax is being promoted. However, since the Fair Tax doesn't replace the Texas sales tax, our boots would actually cost $138.25 since the 8.25% state sales tax would have to be added to the 30% national sales tax.

Since the Fair Tax would be a sales tax collected by businesses across the country, supporters envision a world without the IRS. There would be no federal income tax filings (though state income tax filings will continue), no withholding from paychecks, and no April 15th deadline. Thus, simplification at the individual taxpayer level would be accomplished. Since businesses routinely collect state sales taxes, supporters claim that the addition of a national sales tax won't be an issue for most companies.

The biggest problem with this grand scenario is that consumption taxes are considered to be highly regressive, in that they put more tax burden on those with lower incomes than those who are wealthy. It just stands to reason that low-income families must spend a greater percentage of their earnings on the necessities of life than those with higher incomes.

To fix this inequity, proponents of the Fair Tax propose what they call a "prebate" in the form of a monthly check equal to the estimated sales tax on goods purchased for each household. Those with lower incomes would receive a full reimbursement of sales taxes, while those with higher incomes would get less of a prebate, or none at all.

This is an important point. Even without state sales tax, it's going to be tough for some individuals to pony up an additional 30% sales tax on top of the goods they purchase. The prebate is designed to offset the up-front cost, with low-income individuals getting a 100% relief from the sales tax. Supporters hope that this prebate feature will allay any concerns of the Fair Tax being viewed as regressive by the liberals among us.

Proponents also claim that the Fair Tax is voluntary, in that taxpayers can choose when to purchase certain items, and also decide to purchase used goods instead of new ones. I suppose this is true for some purchases, but good luck finding used food, services and medicine.

As for the matter of government tax revenues, supporters of the Fair Tax claim that it will be "revenue neutral," meaning that it should bring in the same amount of tax revenue as the current system. Proponents also argue that the Fair Tax should have the same beneficial effects on the economy as the Flat Tax is expected to produce, leading to greater economic output, higher incomes and ever more consumption (and thus more taxes). According to one article I read, some economists predict that a consumption tax like the Fair Tax could increase the average American's real income by as much as 9% over the long run, and result in a 10.5% growth in the US economy in the first year.

One of the more controversial provisions of this tax scheme is the premise that the prices of many goods and services would decline by as much as 20% due to the elimination of "embedded taxes." Dale Jorgenson, a Harvard Economist, noted in a now decade-old study that scrapping the tax code would result in a savings equal to the amount of taxes paid by everyone along the chain of production.

Let's apply that to our boots example noted above. Before elimination of the tax code, our boots cost $100. Once embedded taxes are eliminated, our boots will now cost only $80. Here's the good part - adding a 30% sales tax to the reduced $80 cost now produces a total out-of-pocket of $104, only $4.00 more than the previous base cost.

Sorry, folks, but this is where I have to jump off of the Fair Tax bandwagon. There's no way you can get 100% of your current gross salary (before withholding), have prices at the store stay roughly the same after adding a 30% tax, prebate all of this tax to the public, and still have the government up and running.

Well, there is one way - if you reduce wages. Jorgenson admits that to get the savings he projects, you'd have to cut wages by about 20% as well, since wages also contain part of the "embedded taxes." So, while supporters of the Fair Tax make the claim that you will get to keep 100% of your paycheck, even Boortz now admits that it's going to be a smaller paycheck.

And the potential disadvantages of the Fair Tax proposal don't stop there. There are a number of other major roadblocks to the design, implementation and administration of this new kind of taxation. These include the following:

1. The Fair Tax would apply to goods and services that many states exempt from their sales taxes. Thus, businesses in those states would be met with a confusing array of "taxable or not taxable" questions. Plus, states may balk at having yet another unfunded mandate require them to administer collection of federal government revenues.

2. Prebates would have to be calculated and administered by some federal bureaucracy. So even though the IRS would be disbanded, something would have to take its place. One idea has been to shift this duty to the Social Security Administration. That's right, just as they're being hit with 78 million Baby Boomers, let them also be responsible for sending a monthly prebate to virtually every household in the U.S. As my teenagers say, yeah right!

3. Just because the Fair Tax is a whole new kind of creature doesn't mean that our elected officials will refrain from tinkering with it. The tax rate, prebate amount, list of taxable goods, etc. can be tinkered with over time, possibly creating a monster equal to our current tax code. Individual taxpayers would not have to deal with any increased complexity caused by Congressional tinkering, but businesses will, possibly leading increased prices.

4. The Fair Tax promotes the repeal of the 16th Amendment which authorizes the income tax. However, the Linder bill does not contain the necessary constitutional amendment language, so companion legislation would have to be introduced. Conceivably, Congress could pass the Fair Tax but not repeal the 16th Amendment. Without this repeal, a future Congress would be able to impose another income tax on top of the Fair Tax if they so desired.

5. The Fair Tax proposal also results in new taxes, such as taxation on all Internet purchases and new homes (used homes are exempt). A 30% sales tax on top of the cost of a new home could be devastating to the home building industry. It would also do away with deductions that people find important, such as for charitable contributions and mortgage interest.

6. Taxpayers find ways of cheating on their taxes now, and the Fair Tax would be no different. Some economists believe that very high sales taxes promote cheating and even smuggling. Plus, the Fair Tax only applies to new goods and services, creating the possibility of black market operations and even the "recharacterization" of new goods to used status. The sheer size of the 30% Fair Tax makes noncompliance attractive.

7. Finally, the Fair Tax rate of 30%, or 23% if you prefer, is considered to be too low by many economists, and would be in addition to state sales taxes. A tax rate of 35% to 50% or more could lead to a huge decline in production. Since consumer spending now accounts for apprx. 70% of the US GDP, a Fair Tax could have a major negative effect.

There are other positive and negative aspects of the Fair Tax, but suffice it to say that it is not the cure-all some supporters suggest. Another idea based on a form of national sales tax is something known as a "Value-Added Tax, or VAT. These taxes are common in Europe and Canada, and work by taxing the "value added" during each stage of production. Of course, the VAT has its own set of pros and cons, and would also need to accompany repeal of the income tax. Unfortunately, space does not permit me to go into a discussion of the VAT, but perhaps I can cover it in a future E-Letter.

Why Congressional Action Is Unlikely

I have discussed above how both the Flat Tax and Fair Tax systems have been introduced in Congress. While each has its champions in both the House and Senate, and both garner co-signers, I think it's all for show.

After all, nobody likes the IRS or the current confusing tax code or paying taxes, so any proposal to do away with them is likely to be popular among the folks back home. So some in Congress are quick to support these new tax reform ideas, but the key is, they know such reforms will never be passed.

On another front, the current tax system has a huge constituency that depends upon its continued existence. While many accountants, attorneys and tax professionals will moan and groan about the complexity of the tax code, deep inside they know that their very jobs depend upon it. If the tax code was easy to decipher, who'd need a professional to help out?

Add to this the hundred thousand-plus federal government employees whose jobs revolve around the administration and enforcement of the current tax code, and I think you start to get the picture. Now, add in the special interest groups that exist to promote and maintain favorable tax treatment for various current deductions (charities, mortgage industry, real estate, alternative energy, farmers, etc., etc.) and you begin to get an idea of the huge headwind any proposal to change the tax system would face.

Everybody acts as if they are all for it, as long as it doesn't have a negative impact on them. Likewise, organizations and special interests that depend upon favorable tax treatment are OK with simplification, as long as they don't lose their special tax benefit.

We also can't forget the folks back home who elect the politicians. In my April 3 E-Letter, I mentioned that the bottom 50% of taxpayers account for just over 3% of the total income taxes paid. Thus, roughly half of an average politician's constituency may have no problem at all with the current tax code. This is especially true for those who are reaping an 8-to-1 return on their tax dollars, based on the Tax Foundation study that I mentioned in my April 3 issue.

Then there's the issue of the approximately 44 million people who are not currently on the tax rolls. A Flat Tax or Fair Tax system may put them back on, at least to some extent. Do you think they'll be happy with the politicians that made them pay taxes again? I don't think so.

Past Events May Be A Key To The Future

Perhaps the most compelling argument for the continuation of the current tax system is that simplification of the tax code has been tried before, and failed miserably, in my opinion. I have written previously about how the significant changes to the tax code enacted in 1986 under President Reagan had started out as a very simple, two-tiered system.

Of course, that was before the lobbyists had their way. Charitable organizations said they couldn't survive without a tax deduction for contributions. Real estate and mortgage lobbyists said that deductions for interest and taxes had to be preserved to promote home ownership. Every deduction and tax benefit had its own lobbyists, and by the time they were all finished, we wound up with a tax code at least as confusing as the one it replaced, if not more so.

So, to believe that either the Flat Tax or Fair Tax has a chance of being passed requires that you believe lobbyists are less interested in protecting their turf, or that politicians have undergone a fundamental change in their thinking. Unfortunately, I'm not buying either of these ideas, so I don't think we'll see substantial change in the tax system. Unless…

Return Of The 800 Pound Gorilla

In my
April 3 E-Letter, I discussed how Social Security and Medicare spending is the 800 pound gorilla in the room that nobody wants to talk about. Like it or not, politicians will have to address this colossal primate at some point in the future, and when they do, it will most likely be long after something should have been done. Thus, their backs will be up against the wall.

At that point in time, when politicians hear a loud and clear demand from their constituencies that they do something to fix these ailing entitlements, maybe - just maybe - they will summon the backbone necessary to take the steps needed to fix not only the entitlement programs, but the income tax system as well.


While it's entertaining to discuss alternatives to the clearly too-complex tax code, my opinion hasn't changed much since first learning of these alternatives. The Flat Tax and the Fair Tax both have their positives and negatives as discussed above. Neither is remotely as simple or easy to implement and administer as their proponents would have us believe.

While some politicians have jumped on the bandwagon for the Flat Tax, and others for the Fair Tax, the truth, in my opinion, is that few in Congress who have signed onto these proposals believe they have any chance of becoming law. I think most have only signed on to look good to the voters back home.

At the end of the day, I don't think either the Flat Tax or the Fair Tax is going anywhere. Meanwhile the Baby Boomers start retiring next year, and the number of them retiring will go up every year thereafter, leading to an entitlements financial crisis in the coming years. As I discussed in my April 3 E-Letter, that will mean higher taxes.

As a final thought, I know that this E-Letter will likely generate strong feelings in those of my readers who are sold on either the Flat or Fair Tax alternative. So, before you send your e-mail to me, know that I had fully expected to be won over by one plan or the other by the time I finished my research. Quite honestly, I was disappointed that both of these proposals have so many potential disadvantages associated with them. With a tax code so much in need of replacement, I had hoped one of these alternatives would be the "silver bullet" necessary to do the job. Unfortunately, neither program gets there for me, not to mention they have little to no hope of being enacted.

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