Homepage

Personal Finance > Taxes
    SAVE   |   EMAIL   |   PRINT   |   RSS  
Just how fair is the 'FairTax'?
The push to scrap income taxes -- and the IRS -- is gaining fans. But the plan has a lot of holes.
September 7, 2005: 12:28 PM EDT
By Pat Regnier, Money magazine
Neal Boortz
Neal Boortz

NEW YORK (Money magazine) - If you don't care much for talk radio, or you don't live in the South, the name Neal Boortz might not ring a bell.

But pay attention: Around 4 million people nationwide catch his radio show. It's No. 1 in Boortz's home market of Atlanta and ranks first or second in numerous smaller cities in red states.

His 180-page polemic for radical tax reform, The FairTax Book, made its debut at No. 1 on the New York Times' bestseller list in August.

When Boortz came to Jacksonville for a book signing at a downtown hotel on a sticky, sweltering Thursday night last month, close to 1,000 people turned out for a chance to meet him -- and to bask in his rage at the Internal Revenue Service.

"How many of you want the federal government out of your paycheck?" asks Boortz from the hotel's ballroom stage. Wooo-hooo! roars the crowd. Boortz's wife Donna, standing at the back of the room, looks on in amazement.

"This is for taxes," she says. "This is not sex and violence we're talking about."

No kidding. Everybody likes a tax cut, but fundamental tax reform is one of those issues that's generally as boring as it is important. Who wants to waste an evening thinking about marginal rates? But the plan Boortz is selling is disarmingly simple: Just eliminate most federal taxes -- income tax, Social Security tax, corporate tax, what's left of the estate tax -- and replace them with a big, fat national sales tax.

No more complex tax forms. No more IRS audits. No more long lines at the post office on April 15.

Could this actually happen? Boortz's timing certainly couldn't be better.

Right now in Washington, a group of top policy experts and former lawmakers appointed by President Bush are hammering out a proposal to overhaul the tax system. Supporters of the FairTax, backed by a grassroots network of 600,000, have worked hard to keep their plan on the panel's agenda. The panel is holding public hearings in September, and the report is due at the end of that month.

Although few tax watchers expect the panel to fully embrace the FairTax, most predict that it will call for dramatically simplifying the code and making the system far more friendly to savers -- two steps in the FairTax's direction.

If that happens, FairTaxers expect to gain even more momentum. "There's no way you can stop this train," says FairTax organizer Howard Johnson, a retired Navy jet mechanic at the Jacksonville signing who says he puts in four or five days a week for the cause.

Republican congressman John Linder of Georgia, Boortz's co-author and longtime friend, has 37 co-sponsors for his bill to make a national sales tax a reality. Even so, it may be hard to believe such radical change is possible -- especially since many tax experts say that the numbers just don't add up.

But Yale law professor Michael Graetz compares the FairTax with the campaign to kill the estate tax. He co-wrote a book about that fight, and points out that a decade ago nobody in Washington thought the estate tax was vulnerable either. Says Graetz: "You fail to take something like [the FairTax] seriously at your own risk."

Who's listening to this guy?

"I can't allow this to become the FairTax radio show," says Boortz, sitting in a Jacksonville radio studio and chatting during a break from his show. His producer, Belinda Skelton, says that whenever Boortz talks about the sales tax, her board lights up with callers. She turns most away. Clearly, Boortz has hit a nerve with his audience -- so just who are they?

They're probably a little different from the crowd that goes for Rush Limbaugh or for Boortz's pal Sean Hannity.

In person, the 60-year-old Boortz is warm and courtly, and that rubs off on the show. His on-air rapport with Skelton, a charming thirty-something who calls just about everyone "sweetie," and with associate producer Royal Marshall, who is black, leavens the Angry White Guy shtick.

Boortz presses many of the usual conservative hot buttons, and he's been getting seriously worked up about Cindy Sheehan lately. But he took the other side from Hannity on the Terri Schiavo case (he supported the husband) and refuses to let callers talk about abortion -- unless, he quips on air, "You were an aborted fetus."

During a break in the Jacksonville broadcast, Boortz and Skelton run over to another studio in the building to watch a morning duo called Lex & Terry put on a weekly act that involves, basically, getting a pretty woman drunk on the air.

This week's volunteer, a diminutive, scantily dressed blonde named Erin, smells of Crown and Coke from 10 feet away. Boortz leans over and tells her, "You know, tall men love short women." Suddenly, she leaps up and wraps her legs around Boortz's burly, six-foot-plus frame.

Not long after, Boortz is talking about this on his own show, and there's a picture of him and Erin on his website. These antics probably don't win him much favor with the more religiously minded right-wingers. And they won't do him any good with effete, blue state, mainstream media types either. (On the air, he teases me for looking appalled at the whole scene.) But if you like irreverence mixed with equal measures of patriotism and distrust of the government -- pleased to meet you, Mr. Swing Voter -- you'll like Neal.

Steve and Marci Colwell are avid Boortz listeners. They came to the book signing wearing T-shirts declaring themselves "Parishioners of the Church of the Painful Truth." (Boortz sometimes calls himself High Priest of the Church of the Painful Truth.)

The Colwells own a candy store, so a national retail sales tax would have a big impact on them. But to them, that pales beside the impact of today's tax load -- Marci says high taxes have kept them from opening a second store. Steve likes that a sales tax would collect a fair share of taxes from people who now don't pay, like "drug dealers, prostitutes, even sky caps at the airport."

They're also impressed with a key argument of the book, that ending federal income taxes would take something called "embedded taxes" out of the price of everyday goods. "When you remove that, you save a lot of money," says Marci.

The best tax plan $23 million can buy

The FairTax is not Neal Boortz's idea.

"I leave arriving at the numbers to the experts," he says, stretched out in back of an eight-seat charter plane bound for his next signing in Mobile, Ala. "I'm just selling the concept."

The FairTax was designed by Americans for Fair Taxation (AFFT), chaired by Houston businessman Leo Linbeck. The group says it has spent some $23 million coming up with a way to simplify taxes, signing up A-list economists to do the research and focus-grouping the concept. Linder says that a focus group even helped come up with the tax's nifty brand name. According to a report by American Public Media, AFFT and a related group have spent about $22,000 funding trips (mostly speaking engagements) for Linder.

Boortz, who's an amateur pilot and all-around aviation nut, says with some excitement that AFFT has discussed giving him and Hannity the use of a Gulfstream jet for a FairTax barnstorming tour.

The FairTax is what economists call a consumption tax, and the basic economic rationale for it is the same as for all such taxes. It is designed to make saving and investing more attractive to people and companies, which most economists think would spur economic growth as people plow more cash into starting businesses, building factories and so on. With the FairTax you'd get taxed only when you spend money on retail goods and services.

The trouble with a pure consumption tax is that it can put a hideous burden on poor and middle-class people, who have to spend most of what they earn to live.

So the FairTax tweaks the formula by sending a "prebate" to every American for the amount of tax they pay on spending up to the poverty line, which today is $22,400 for a couple with one kid. In effect, basic necessities are tax-free. FairTaxers propose a tax worth 23 of each $1 you spend, so a family of three earning $30,000 a year and spending that much on taxable goods would pay about 6 percent of their income in tax after the rebate. A family earning and spending $125,000, about 19 percent. (State and local taxes would be levied on top of that.)

The rebates help make the FairTax progressive -- tax jargon for "richer people pay more." For the very rich, however, that's not quite the whole story. Say you earn $2 million a year. You can live pretty well spending $1 million, and as a result pay a mere 11 percent of that year's income in taxes. If the very rich pay less, that means more of the total tax burden in any year has to fall on somebody else, most likely the middle class. Reasonable people can disagree about whether this really matters -- over time, a consumption tax looks more progressive because the rich savers or their descendants eventually spend the money and get taxed. But Boortz and Linder say that all this worry about progressivity at the top is just jealous carping anyway. "We have very few Communists left in this world, but there are some," says the congressman.

Pssst. Wanna buy some tax-free milk?

All these questions about fairness will be a political obstacle to a sales tax. But the practical problems seem even more daunting. Many mainstream economists and tax experts like the idea of some kind of consumption tax -- in fact, the superiority of consumption taxes is almost conventional wisdom these days.

But many of the same people point to serious problems with the FairTax plan. (A sales tax is just one way to levy a consumption tax. Competing plans include the European-style value-added tax, or VAT, as well as variations on the flat tax Steve Forbes made famous.)

Critics claim the FairTax has two major flaws: It wouldn't work in practice and, even if it did, it wouldn't raise enough money. The first problem has to do with the fact that people cheat on their taxes; they do it now, and they'd find ways to do it under a sales tax. With all of the taxes we'd owe being lumped into one big sales tax, lots of people might be tempted to try evading it, with black markets springing up everywhere.

Joel Slemrod of the University of Michigan's Office of Tax Policy Research says that only six countries in the world have tried to collect a sales tax north of 10 percent, and four of them eventually adopted alternatives like a VAT. Consumers might also be unpleasantly surprised by all the things that get taxed: Not just milk at the grocery store, but legal fees, rent on an apartment, even health-care expenses.

Linder says the administrative problems with a sales tax have been over-blown. Really, he asks, is your local big box store going to help you cheat on your taxes? And the FairTax frees millions from filing tax returns and gets the hated IRS out of their lives.

"I want a system that doesn't have an agency that knows more about you than you are willing to tell your own family," says Linder. This is crucial. FairTaxers seem to care as much, if not more, about getting rid of the IRS as they do about the economic and budgetary impact of reform.

Policy wonks in Washington may have a hard time appreciating how infuriating and confusing the income tax system is for many ordinary Americans. I heard plenty of that in Jacksonville. "It's the complexity of the system that drives me nuts," says Kellum Sowers, another of Boortz's self-described "parishioners."

Just a few years back, this magazine sent identical tax scenarios to 45 professional tax preparers and got 45 different answers back. None of them came up with what we believed to be the correct tax liability.

A knottier problem is what the rate would have to be.

The FairTax bill pegs it at 23 percent in order to fund the government at current levels without raising the deficit. (If you think of the FairTax like a state or local sales tax, you'd say that this is a markup of 30 percent on prices at the store. See the chart above.) But economist William Gale of the Brookings Institution says that this number is way, way too low. "They're telling kind of a big lie about tax reform," he says.

Gale calculates that a 23 percent rate would blow a $7 trillion hole in the budget over 10 years, and that a more realistic rate is 31 percent, and higher still if you allow for evasion. And if lobbyists convince lawmakers to exempt things like health care or other necessities -- a real possibility, given the culture of Washington -- the gap looks even bigger.

FairTaxers respond that Gale isn't taking into account the huge economic growth they believe would occur once the tax system started encouraging investment. And besides, they add, whatever rate you'd pay is comparable to what you now pay. Counting Social Security and payroll taxes, your marginal rate may be north of 30 percent. "To talk about [sales tax rates] independent of what we're currently facing is slightly unprofessional," says Boston University economist and FairTax supporter Laurence Kotlikoff, speaking of Gale.

So the FairTax is certainly debatable -- fiercely so. But in their book, Linder and Boortz push the argument even further. They make a very big claim that isn't debatable at all. It's just wrong.

The painful truth

Toward the end of The FairTax Book, there's a handy little box summarizing what the authors say will happen if we make the switch to a sales tax. Here are the first three points:

  • We start collecting 100 percent of our earnings in every paycheck.
  • We all get virtual raises, since payroll taxes are no longer siphoned

From our checks.

  • We all start receiving monthly prebates equal to the amount of

Consumption tax we would be expected to pay on life's basic necessities.

This sounds pretty good. Of course, we know that it isn't nearly as big a gift as it seems because we'll have to pay some of it back in taxes when we buy things at the store, right? Er, apparently not. Boortz and Linder write:

  • The prices of consumer goods and services remain essentially the same, with the removal of embedded taxes compensating for the added consumption tax.

We'll explain this bit about "embedded taxes" in a moment. But first, let's consider what Boortz and Linder appear to be saying. Prices at the store are the same. Your boss stops taking all that money out of your paycheck. Uncle Sam is sending you money instead. And, oh yeah, the government is still up and running.

This just can't happen. "It is practically and logically impossible for the government be collecting the same amount of money as before and have everyone suddenly be better off," says Daniel Shaviro, a tax law professor at New York University.

Part of the problem is the way Boortz and Linder are using the idea of embedded taxes. In an eight-year-old study paid for by AFFT, Harvard economist Dale Jorgenson noted that because the taxes paid by everyone in the chain of production are embedded in the cost of goods, prices could decline an average of 20 percent if all those taxes were scrapped. The FairTax Book devotes an entire chapter to this idea.

What The FairTax Book fails to mention is that prices can only fall this sharply if companies cut wages. I asked Jorgenson about this, and he agreed. Say your salary is $100,000 a year today, but you take home $80,000 after taxes.

Your company is still paying that extra $20,000. In a FairTax world, it will save that money, and be able to lower its prices accordingly, only if it can reduce your salary to $80,000. In other words, your take-home pay is the same as before. Sure, you'd get to "keep 100 percent of your paycheck," as Boortz and Linder repeatedly write, but it would be a smaller paycheck. That's kind of a big thing to leave out.

I pressed the point with Boortz and Linder. Boortz denies that the book intentionally overpromises. The introduction, he notes, emphasizes that "this book isn't about saving a penny in taxes." But he concedes that the book is confusing about this, and vows to correct it in later printings. Fair enough.

Meanwhile, these guys want to replace the entire tax code, they've ignited a populist movement to get it done, and tens of thousands of copies of the uncorrected book make the FairTax sound like magic.

The wages of spin

Let's separate the message from the messengers for a moment. The goof Boortz and Linder have made hardly blows apart the argument for the FairTax. A simplified tax code that reduces the costs of enforcement and compliance -- $110 billion in 2003, by Michigan Prof. Slemrod's conservative estimate -- would be an economic plus. And any tax that results in more growth would, by definition, leave you with more money in your pocket over time.

Some economists predict that a consumption tax could increase the average American's real income by 9 percent over the long run. Others say the numbers are much lower; it all depends, they say, on how you design the tax and the assumptions you make about how people's behavior will change. But few experts think our current tax code -- with its crazy quilt of deductions and exemptions, not to mention that nasty AMT -- couldn't be improved upon.

And although Boortz and Linder use the red-meat language of the right when pitching the FairTax, there are some elements of their plan that liberals ought to take a close look at.

It replaces the Social Security payroll tax, which tends to hit less affluent people harder. Rich big spenders could end up contributing more to the retirement system than they do today. And the other tax plans favored by Washington types raise their own fairness questions. Boston U.'s Kotlikoff, who recently argued for the sales tax in a cover story for the liberal New Republic, worries that other consumption-driven reforms will be a boon to the already wealthy.

These are serious ideas Americans should hear more about. What we don't need is more spinning. FairTaxers promise a world where taxes are effortless, the IRS is dead and gone, and nobody has to sacrifice a thing. But we know this:

There are complications in any tax system. Somebody's got to collect the money for the government. And there will always be losers in the tax game.  Top of page

YOUR E-MAIL ALERTS
Fair Tax
Taxation
Economy
Internal Revenue Service (IRS)
Manage alerts | What is this?