Saturday, August 19, 2006

The Fair Tax

A reader asks:

Professor: Could you shed some of your wisdom on the Boortz/Linder tax plan, the FairTax.
As I understand it, the so-called Fair Tax plan calls to raise a substantial fraction of U.S. federal tax revenue with a retail sales tax. It is one form of a consumption tax. Many economists—and I include myself among them—believe that consumption taxes are better than income taxes because they do not discourage saving. (See this previous post on the topic.)

Some tax experts tell me that a large retail sales tax, such as that envisioned by the Fair Tax, may cause problems in compliance. That is, if a retail sales tax has a high rate, retailers will find ways to evade. One solution to this problem is to collect the tax throughout the various stages of production, rather than all at once at the final sale to the consumer. This is what a value-added tax does. From an economic standpoint, a retail sales tax and a value-added tax are equivalent, but the value-added tax may raise fewer problems in compliance.

I should note that there are other ways to implement a consumption tax in addition to a retail sales tax and a value-added tax. Some of these other administrative mechanisms give policymakers more parameters to vary the degree of progressivity. Examples include the Hall-Rabushka version of the flat tax and the Bradford X-tax.

One possible complaint about a retail sales tax or a value-added tax is that these tax systems are proportional (or "flat"), rather than progressive, as a function of consumption. That "defect" can be remedied to some degree by giving people a lump-sum grant financed by the flat consumption tax. In that case, the overall system would be flat in marginal tax rates but progressive in average tax rates.