The Flat Tax Is Not Flat and the FairTax Is Not Fair
[This talk was given at the 2009 Austrian Scholars Conference at the Mises Institute. It is available as an MP3 audio download.]
Our current income tax system, inaugurated in 1913 with the adoption of the 16th Amendment, began with a 1 percent tax on taxable income above $3,000 ($4,000 for married couples). A series of surcharges of up to 6 percent were applied to higher incomes, with the maximum rate being 7 percent on taxable income over $500,000. Less than 0.5 percent of the population ended up paying income tax.
From these humble beginnings, the income tax soon blossomed, thanks to World War I, into a tax with a minimum rate that doubled and a maximum rate that reached 77 percent on income of over $1 million. The rates did not fall significantly until 1925. In the middle of the Great Depression, the top rate rose to 79 percent. During World War II, the tax rate for those in the highest income bracket reached an astounding 94 percent. The Internal Revenue Code of 1954 resulted in 24 brackets with rates ranging from 20 to 91 percent. The top rate remained at 91 percent until 1964. Under the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986, the top marginal tax rates were lowered to 50 and 28 percent respectively. The Economic Growth and Tax Relief Reconciliation Act of 2001 established the current tax brackets of 10, 15, 25, 28, 33, and 35 percent.
There is no question that the federal tax code is too long, too complex, too intrusive, too confusing, and too inequitable. The members of Congress responsible for the tax code would not even disagree. As a consequence, cries for tax reform can always be heard from every quarter — and especially around election time. There are even organizations dedicated solely to tax reform, such as Americans for Tax Reform, Reform AMT, Citizens for Tax Justice, and Americans for Fair Taxation. Since the federal government is always looking to increase its revenue while at the same time making Americans feel better about paying their taxes, it has also climbed aboard the tax-reform bus, most recently in 2005 when President Bush formed the President's Advisory Panel on Federal Tax Reform.
I am sorry to say that principled libertarians who welcome gradualism toward the goal of substantially reducing or abolishing the income tax while at the same time shunning any compromise of the principle that taxation is theft — like those friends and supporters of the Mises Institute — are in the minority.
Left-liberals, who want to use the tax code for their social engineering and income redistribution schemes, are not opposed to taxes on principle. Barack Obama ran campaign commercials openly boasting that no taxes would be raised on any American making under $250,000. This, of course, means that he intends to fleece any American making over this amount.
Conservatives are not generally opposed to taxes on principle either. They have no problem taxing the American people to fund bloated defense budgets, US military adventures around the world, the CIA, FBI, and anything related to law enforcement or homeland security, faith-based welfare programs, educational vouchers, abstinence-education programs, the war on drugs, and various conservative pork projects.
But what's up with libertarians?
Brink Lindsey, of the Cato Institute, supposedly a libertarian think tank, wrote in an online article for the New Republic that also appeared on the Cato website:
Tax reform also offers the possibility of win-win bargains. The basic idea is simple: Shift taxes away from things we want more of and onto things we want less of. Specifically, cut taxes on savings and investment, cut payroll taxes on labor, and make up the shortfall with increased taxation of consumption. Go ahead, tax the rich, but don't do it when they're being productive. Tax them instead when they're splurging — by capping the deductibility of home-mortgage interest and tax incentives for purchasing health insurance. And tax everybody's energy consumption. All taxes impose costs on the economy, but at least energy taxes carry the silver lining of encouraging conservation — plus, because such taxes exert downward pressure on world oil prices, foreign oil monopolies would wind up getting stuck with part of the bill.
Shift taxes? Increase taxes? Tax the rich? Impose new taxes? Use the tax code to influence public policy? What kind of libertarian tax reform plan is this? How about reduce, cut, eliminate, and abolish taxes? Not deductions, not exemptions, not credits, not shelters, not loopholes — taxes.
Two specific tax reform plans that some libertarians have fallen for are the Flat Tax and the FairTax. Both plans promise to invigorate the economy, increase employment, and raise everyone's standard of living. Neither one is true to its name; neither one is an incremental step toward overall lower taxes. Both are fraught with problems and contradictions; both are revenue-neutral plans that would fund the federal government at the same obscene level that it is now.
The Flat Tax is an income tax. It is the tax-reform idea that has been around the longest. First proposed by economist Milton Friedman in 1962, the flat tax entered the mainstream through a 1981 Wall Street Journal article by Hoover Institution economists Robert Hall and Alvin Rabushka called "A Proposal to Simplify Our Tax System." This article grew into a 1985 book published by the Hoover Institution Press called The Flat Tax. A second edition was published in 1995, and an "updated revised edition" in 2007 that can hardly be called either. Aside from this book, the Flat Tax gained national prominence when House Majority Leader Dick Armey (R-TX) pushed the idea of a Flat Tax after the Republicans gained control of Congress during the Clinton administration. A few bills based on the Hall-Rabushka plan were then introduced in Congress, but came to nothing. Other incarnations of the Flat Tax were pushed by both Democrats and Republicans. Another incarnation of the Flat Tax is that of former Republican presidential candidate Steve Forbes. His 2005 book is called Flat Tax Revolution.
Under a Flat Tax, everyone's income is taxed at the same rate (Forbes says 17 percent; Hall and Rabushka say 19 percent). And not only are there no tax brackets, there are generally no tax deductions other than personal and dependent allowances. Social Security and Medicare taxes would remain as they are now. The appeal of the Flat Tax is simplicity. You can do your taxes on a postcard-sized form says Forbes. Goodbye compliance costs.
The problem with the Flat Tax is a simple one: the Flat Tax is not flat. And furthermore, no one actually pays 17 or 19 percent. In fact, taxpayers don't even pay the same percentage. The Flat Tax is actually a highly progressive tax. It is more progressive than our current system, and effectively has more tax brackets. Who said progressivity requires graduated tax rates? Under the Forbes plan, a family of four would pay no federal income tax on its first $46,165 of income; a family of six would owe nothing until its income exceeded $65,930. And those figures are sure to have increased since they were first proposed back in 2005. But not only would many families pay no income tax, they still might get a refund anyway because the Forbes plan includes a refundable child credit and earned-income credit.
If you want an example of a real flat tax, look no further than the 2.9 percent Medicare tax. Everyone pays 2.9 percent (split between employer and employee), on every dollar earned, no matter one's marital status, number of dependents, or income level. I am in favor of neither the tax nor Medicare, but if you are looking for a genuine flat tax, then the Medicare tax is your tax.
The Fairtax is a consumption tax. It is the most radical tax reform plan, bar none. It also has the most vocal and intolerant proponents. The FairTax is the brainchild of three businessmen concerned about the crippling effects on the economy of the current federal tax code. After adopting the name "FairTax" for their tax-reform plan, they formed Americans for Fair Taxation in 1997 and enlisted Representative John Linder (R-GA) to introduce FairTax legislation in Congress. Linder first sponsored the "Fair Tax Act" in the House in July of 1999, and has reintroduced a FairTax bill at the beginning of every term of Congress since then, including the current one.
Although Linder's FairTax bill languishes in the House Committee on Ways and Means each time it is introduced, it has always had a number of cosponsors, including Tom Tancredo and Duncan Hunter — but not Ron Paul, the acknowledged taxpayers' best friend. It also has its share of supporters outside of Congress, including Mike Huckabee and Neal Boortz. The latter is the author, with Congressman Linder, of The FairTax Book, published in 2005. A paperback version of The FairTax Book was issued in 2006 with some notable changes to correct false statements made in the original hardcover release of the book. Boortz and Linder also published a sequel, FairTax: The Truth, Answering the Critics, just last year.
I am getting weary of writing about the FairTax. Every time I think I've written my last article on the subject, some new opportunity presents itself and I take the bait, as I am doing right now. I don't consider myself to be an expert on the FairTax. Although the idea of the FairTax has been around since 1997, I had never even heard of the FairTax until I wrote an article for the Mises Institute in 2005 on the evils of the withholding tax. It was only after my inbox was bombarded with mail from FairTaxers trying to sell me on the FairTax that I looked into it. If you have read any of my articles on the subject you know that I didn't like what I saw.
The FairTax is a national retail sales tax of 30 percent on the final sale of all new goods and services. All new goods — from cars and houses to prescription drugs and food; and all services — from operations and funerals to rent and haircuts. Because it would replace the personal income tax, there would also no longer be withholding tax, capital-gains tax, the alternative-minimum tax, or taxes on interest and dividends. Even your gambling winnings would no longer be taxed. Of course, there would be no tax deductions either. The FairTax would likewise eliminate corporate income tax, estate tax, gift tax, unemployment tax, Social Security tax, and Medicare tax. The appeal is obvious: no more complex tax code, no more taxes withheld from paychecks, no more 1040 forms, no more record keeping, no more compliance costs, no more IRS audits. And if that weren't enough, the FairTax also includes a monthly rebate to offset the taxes paid on basic necessities.
But for a plan that promises such a utopia, the problems with the FairTax are legion. The stated rate of the FairTax is too low to achieve the promised revenue neutrality. The amount by which it is claimed that prices would fall under a FairTax system has been grossly exaggerated. There is nothing to prevent an income tax from being reinstituted, giving us a two-headed hydra of an income tax and a consumption tax. And not only would state and local governments have to pay a national sales tax to the federal government, the federal government would have to pay sales taxes to itself on all its new purchases. Since I have already written extensively about the problems with the FairTax, I will stop with its problems here and focus on why the FairTax, like the Flat Tax, is not true to its name.
So why is the FairTax not fair? Well, first of all, what's fair about a consumption tax? Why is it that people who rightly criticize the income tax are so quick to accept a national sales tax on consumption? The FairTax perpetuates the fallacy that the government has a right to confiscate a percentage of the value of each new good sold and every service rendered. This is no different than claiming that the government has a right to the portion of each American's income. As Murray Rothbard explained,
The consumption tax, on the other hand, can only be regarded as a payment for permission-to-live. It implies that a man will not be allowed to advance or even sustain his own life, unless he pays, off the top, a fee to the State for permission to do so. The consumption tax does not strike me, in its philosophical implications, as one whit more noble, or less presumptuous, than the income tax.
The FairTax is also not fair because of the rate. What is fair about the government taking a 30 percent cut on every transaction? I know the FairTaxers claim that the rate is only 23 percent, but when I buy an item for $1.00 and end up paying $1.30, the basic math I learned in elementary school tells me that I paid a tax rate of 30 percent. But regardless of whether the rate is 23 or 30 percent, why should the bloated, pork-laden leviathan we call the US government get anywhere near this much of our income?
And finally, maintaining that the FairTax is a "fair" tax system, or one that is "fairer" than our current system, is highly subjective. Boortz himself even acknowledges this in his newest book on the FairTax: "Whether a tax system is 'fair' is a complicated economic and philosophical question, one that inevitably involves oversimplification and subjective judgment."
If you want an example of a real fair tax, then consider the equal tax. I first saw this proposed by Joe Sobran. Let every American pay the same amount — no deductions, no exemptions, and no exceptions. Sobran reasons,
The billionaire doesn't use the police or the streets any more than the pauper. Maybe less, since he presumably hires private guards to protect him and has less need of the police, and he is less likely to drive long distances than to fly.
Now, I wouldn't like paying this tax any more than I like paying income tax, but it is certainly a fair tax.
But not only is the Flat Tax not flat and the FairTax not fair, the Flat Tax is not fair and the FairTax is not flat. Let me repeat that: not only is the Flat Tax not flat and the FairTax not fair, the Flat Tax is not fair and the FairTax is not flat.
According to Hall and Rabushka, the flat-tax system they propose is both "fair and progressive — the poor pay no tax, and the amount that a family pays rises with income." They say their Flat Tax is fair because it is based on the principle that "income should be taxed exactly once, as close as possible to its source."
But how can a system that punishes success and fosters class envy be considered "fair"? And why should it be considered "fair" that income is taxed "exactly once, as close as possible to its source"? Just because every American would pay the same rate under the Flat Tax doesn't necessarily make it a fair tax. Making the tax code less progressive is not enough. As Rothbard again explains,
The flat-tax movement is part of a process by which the government and its allies have been able to split and deflect the tax protest movement from trying to lower the taxes of everyone, into trying to force everyone into paying some arbitrarily defined "fair share."
It is no consolation to a wealthy person who is stripped of his money by the federal government that a poorer person is likewise relieved of his money by the same percentage.
One of the reasons FairTax supporters claim that their tax is fair is that it has a flat rate that everyone would pay. But the FairTax is about as flat as it is fair. I already mentioned that the FairTax includes a monthly rebate to offset the taxes paid on basic necessities. This "prebate" is based on the government poverty level and family size. Thus, although everyone would pay the same rate under the FairTax, the end result would be that some Americans would pay no taxes at all, some would have most of their taxes offset, and some would get more money back than they paid in taxes. This makes the FairTax an income redistribution scheme under the guise of tax reform.
Neither the Flat Tax nor the FairTax is a step toward the libertarian goal of substantially reducing or abolishing the income tax; neither tax-reform plan is an incremental step toward lower overall taxes. They could be, however, if their promoters recognized that the problem is taxation itself, not the tax code. All they have done is shift the debate from how much of the wealth of the American people the federal government confiscates to the manner in which the wealth is confiscated.
We don't need compassionate tax reform that makes people feel better about paying their taxes; we need radical tax reform that reduces, cuts, eliminates, and abolishes taxes without replacing them with other taxes. As I have quoted Congressman Ron Paul on many occasions, "The real issue is total spending by government, not tax reform."
With the federal budget fast approaching $4 trillion, I can't think of anything that is more of a waste of time than quibbling about how the government can make the tax rates flatter or fairer while it robs us of trillions of dollars. The only fair tax is a tax low enough to flatten skyrocketing congressional spending. Like educational vouchers and the privatization of Social Security, the Flat Tax and the FairTax are gimmicks that libertarians should avoid.