45 percent of Americans pay no federal income tax

After the first time trying to prepare and file personal taxes, most Americans learn the same lesson: The American tax system is complex and difficult to understand. Many people also feel that corporations, wealthy individuals and families, and special interest groups have unfair access to loopholes and exemptions that help them avoid paying their “fair share.”

One system that has gained a following in recent years is called the Fair Tax Plan. Simply put, this plan would replace the federal income tax system with a flat national sales tax. Proponents believe this initiative would eliminate loopholes, evenly spread the tax burden, and eliminate hassle without diminishing federal tax revenues.

Opinions vary widely, however, and opponents contend that the Fair Tax Plan would require the middle class to pay the most in taxes, while the wealthy would enjoy an even lighter tax burden.

To figure out where you stand on this high-profile issue, get the facts, weigh the pros and cons, and draw your own personal conclusions.

What Is the Fair Tax Plan?

The Fair Tax Act (HR 25, S 13) legislation proposes that the federal government stop collecting many different types of income tax, including:

Instead, the government would generate tax revenue by instituting a national sales tax on most purchased items. Businesses would collect the tax at the point of sale and send the revenue to the federal government. The IRS would become obsolete, and your net income would no longer have anything to do with how many exemptions you can claim. Instead, your paycheck would simply be exactly how much money you make: tax-free.

Moreover, related legislation would repeal the Sixteenth Amendment, which means the federal government would no longer have the right to levy income taxes. States and local governments, however, would still be able to collect revenue via income and sales taxes at their discretion.

How the Sales Tax Would Work

The proposed sales tax would amount to 23% of the total payment on just about all purchases. Sounds like you’d simply pay a 23% sales tax, right? Not quite. Basically, this works out to be a 30% sales tax rate, because you wouldn’t pay the tax at the register, like you do now.

For example, an item marked $100 would already include the sales tax within it – in this case, $23. This is called an inclusive tax. In other words, the cost of the item without the tax would be $77. But $23 paid on a $77 purchase is roughly 30%, the way we’re used to calculating it. While 30% is steep, you’d be working with a much larger paycheck, because no federal tax would have been withheld.

Further, the Fair Tax plan attempts to solve the issue of double-taxation. Currently, businesses must pay sales tax on the materials they use to create the goods they sell, which then get taxed again. In effect, the same material gets taxed twice. But under the proposed legislation, items purchased directly by businesses could avoid the sales tax and thereby avoid being double-taxed. This should bring the wholesale cost of your purchase down, and, in theory, it should reduce the retail price as well.

Lastly, used items would not be subject to the federal sales tax.

The Prebate

The prebate – or “annual consumption allowance” – is designed in part to relieve poverty-level Americans by providing a monthly check that would essentially offset all of their sales tax expenditures. The amount of the allowance would be based on poverty-level guidelines and would increase for larger families.

Though the prebate is geared toward poorer families, everyone would receive monthly checks, regardless of income. The prebate brings up yet another point of contention between critics and supporters. It is the most expensive element of the entire plan, would be the largest entitlement program in American history, and would constitute a welfare payment, even for those without a need. In other words, a two-parent billionaire household with two kids would receive the same monthly prebate as a two-parent, two-child household struggling to get by on $20,000 per year.

Advantages

The Fair Tax Plan may be advantageous in the following ways:

Favoring High Income Earners. Currently, our tax system is based on tax brackets: The more you make, the more you pay in taxes. Under the Fair Tax plan, only the amount of income you spend gets taxed. Someone who makes $200,000 and spends $100,000, for example, would pay only 11.5% of their income to taxes.

Helping Investments. Because the capital gains tax would be eliminated, individuals who can afford to invest will enjoy tax-free compound growth. This would be similar to having an IRA in which you could invest as much as you want and withdraw funds at any time without taxes or penalties. (Under current legislation, you can only invest a certain amount per year and must be 59 1/2 to withdraw funds without penalty.)

Making Tax Revenues Easier to Predict. Because consumption rates have been much more stable than incomes, figuring out tax revenues will likely be simpler, and estimates will be more accurate.

Benefiting Businesses. Along with eliminating double-taxation, the proposed plan would get rid of payroll taxes and taxes on capital and investments. This change could substantially benefit businesses and buyers, because prices could fall due to increased spending power and lower production costs.

Requiring More Disciplined Spending Habits. It’s apparent from the rampant use of credit cards and the mortgage debt crisis that our country has become far too dependent on credit. The Fair Tax would put an end to this problem, since the more you spend, the more you pay. Moreover, people would likely be inclined to pay off their debt, rather than spend more, since money that goes to credit card bills won’t be taxed.

Eliminating Tax Administration and Filing. Simply put, you’d no longer need to file taxes, and the IRS would close up shop.

Providing Prebates. The monthly check would help offset some portion of every household’s sales tax payments, especially for families near and below the poverty line.

Disadvantages

Scratch the surface of this plan and it falls apart, at least for many of us. Even if forward-looking economists can argue the potential long-term benefits, they don’t appear to be big enough or sure enough to offset the near-term havoc that would be wreaked upon the middle class should such a plan go through.

Major concerns include:

Penalizing the Lower and Middle Classes. Individuals and families that are above poverty level and considered middle-class will bear the brunt of the tax burden for the country. This is a progressive tax, which means that the wealthy pay more and the poor and middle class pay less as a percentage of their income. This expectation will only come true, however, if individuals spend 100% of their incomes on taxable expenditures. Taxpayers – especially wealthier citizens – are not likely to choose to live paycheck-to-paycheck. The wealthy won’t likely trade investing for spending anytime soon, so this plan would indeed be regressive – meaning those with less money will end up paying a higher percentage of their income in taxes.

Increasing Potential for Tax Evasion. Such a high sales tax rate would undoubtedly lead many to evade the tax, possibly through trade and purchasing goods in other countries.

Decreasing Overall Spending. Under this proposal, the best way to lower your tax burden will be to spend less. Too little spending is not good for any capitalist economy. In fact, while many current tax incentives are specifically created to drive consumer spending, the large sales tax could discourage consumers from spending freely, thus hurting the economy.

Eliminating Tax Deductions and Credits. Many people derive significant benefit from common personal tax deductions, such as the home mortgage interest deduction, the child and dependent care credit, education credits and deductions, and the earned income tax credit – not to mention the ability to deduct medical bills and expenses and student loan interest. The cost of home ownership, then, could significantly rise for homeowners who currently itemize and have large interest payments. Renting would become even more appealing, and an already ailing real estate market could be devastated.

Making State Income a Bigger Burden. Though federal income tax would go away, state income tax would remain, and of course it would no longer be deductible against federal taxes. The effect would be a great burden on residents of high income tax states like California. Moreover, unless you live in a sales tax free state, like Oregon or New Hampshire, you could pay your state’s sales tax on top of the Fair Tax and on top of your state’s income tax. For a family living in Los Angeles making $100,000, this would be well over 40%!

Depending Too Much on Spending. Paradoxically, this tax is dependent on spending, but at the same time discourages it. Plus, since many wealthy individuals already invest on their own and in other businesses, they may be further motivated to do so. Those moves could benefit the economy overall, but since these activities would be non-taxable, the national burden shifts to the lower economic classes.

Increasing Costs for Immigrants. The prebate check system will not include non-citizens, significantly raising the cost of living, especially for lower-income immigrants, permanent residence (“green”) cardholders, and visa holders. It could also deter highly educated foreign workers with great careers, such as doctors, engineers, and technology sector workers, from immigrating.

The Fair Tax Act and Inclusive Taxation

The Fair Tax Act may attempt to improve the current system, which favors the wealthy with loopholes and big deductions, by replacing it with a more equitable system of taxation. However, this may not be the case. While the downsides are troubling, what is most disturbing is how advocates present the plan.

First, let’s quickly review the current sales tax and what the change would mean. Everyone in this country is accustomed to paying what’s called an “exclusive tax” on their purchases. This means we see how much an item costs and then calculate the tax on top of that price. In fact, until I read about the Fair Tax Act, I didn’t know there was any other way to pay sales tax.

Since this is the crux of the Fair Tax plan, it’s worth addressing again. If you purchase an item for $100 that has a 23% tax, you would expect to pay $123 total. This would be an exclusive tax. However, the Fair Tax plan calculates their tax as inclusive. In other words, your $100 purchase already incorporates $77 for how much the item costs and $23 for the actual tax. But a $23 tax on a $77 purchase comes out to 30% the way we currently measure it.

In explaining the plan, it seems that Fair Tax proponents call it a 23% tax so the plan sounds better. And this makes me wonder, what else are they spinning, and why do they misrepresent a crucial aspect of their plan in the first place? If the people vetting the tax plan don’t understand why it’s misleading to talk about an inclusive sales tax, then I suspect other aspects of the plan will be misleading and possibly flawed as well.

On the other hand, if the ruse is intentional (which seems like the rational explanation), what else are they trying to sneak past us, and why? As if the length of the list of cons isn’t enough, this simple bit leads me to suspect that the Fair Tax is anything but fair, and that it’s just another ploy to get the rest of us to pad the pockets of the upper and corporate classes.

What Does It Mean for You?

The Fair Tax is gaining traction because many people feel that our current system of taxation is unfair. But though it claims otherwise, this plan is no different.

Consider that many families can currently get their effective federal tax rate down far below 23%. I have a five-person family: two adults and three children. Our effective tax rate was 8.91% last year, and while we aren’t near poverty level, we are not considered remotely wealthy. Of course, we have a mortgage and private mortgage insurance, plus one child in college, two in elementary school, and plenty of student loan interest. In other words, we have a lot of deductions to lose if the Fair Tax goes through.

Take a look at your tax return to find your effective tax rate. If you use a service like TurboTax or H&R Block, it should be listed on the first page. How much more (or less) would you pay under the Fair Tax plan? If you don’t have children or a mortgage and you have a good salary, your tax rate may be fairly high. But do you ever plan to have a mortgage or children? And how do you feel about the middle class taking the brunt of this tax plan to keep the country solvent – regardless of whether or not you’re in that class yourself?

Take this into account and think about how much more or less you’d pay when deciding whether or not you think the Fair Tax is truly fair.

Final Word

A lot of us are looking for change – the kind of change that will bring our country back to its glory days, or at least give more of us a fair shake at being comfortable and successful. And because of that, it can be easy to believe whatever our favorite politician says without properly evaluating the facts. It’s happened to me and I’ve been sourly disappointed.

As responsible citizens, we need to examine the facts of the Fair Tax ourselves. One place to start is to look at who’s sponsoring the bill. What’s their history and what have they supported in the past? This can give you an idea of their motivations and who they really serve – the people or special interests. Just don’t take my word for it or anyone else’s. The best way to create a truly equitable system of taxation is to demand hard facts over catchy soundbites and empty promises.

What are your thoughts on the current system of taxation? Do you think the Fair Tax will effectively address these problems?

We often talk about income as if it's this fixed thing. Those people over there are the 1 percent. These over here live in poverty. That other group is the people in the top 20 percent. That's not the way it is.



While economic mobility hasn't increased in this country over the past few decades, there is still churn. Lots of people move up and down the income ladder over the course of a career.



What are the chances an American spends time in the top 1 percent? In the top 10 or 20 percent? How likely is it that people will live in poverty for some part of their adult lives?



Because many people may have a windfall once in their lives — think of a middle-class family selling a house they've owned for decades — we looked at how many Americans will find themselves in various income categories for at least two consecutive years.

61 out of 100 U.S. households will break into the top 20% of incomes (roughly $111,000*) for at least 2 consecutive years.

39 out of 100 U.S. households will break into the top 10% of incomes (roughly $153,000*) for at least 2 consecutive years.

5 out of 100 U.S. households will break into the top 1% of incomes (roughly $360,000*) for at least 2 consecutive years.

20 out of 100 U.S. households will fall into poverty (roughly $23,850 for a family of 4*) for at least 2 consecutive years.

The data for the graphs come from Mark Rank and Thomas Hirschl, who have analyzed over 40 years of household income data and ran the numbers on how likely each household will switch income groups.



Why is there so much churn in income? There are no real surprises here. According to Rank and Hirschl, raises, promotions, new careers, and a spouse entering or leaving the workforce can all create large swings in household income.