Would the FairTax help or hurt the middle class?

Question

Gary Johnson said he would ultimately try to implement the FairTax to replace the current federal tax code. After reading about the FairTax it seems like it would only benefit the rich. Would the FairTax help or hurt the middle class?

Answer 1

Well, note that the FairTax would eliminate four kinds of taxes:

1. Income tax. Current rates are 0%, 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.

2. Payroll taxes. Current rates are 15.3%, 2.9%, and 3.8%.

3. Corporate taxes. Current rates are 15% to 39%, ending up at 35% at the top.

4. Estate taxes. Rates topping out at 40% for estates over a million.

Let's take this backwards.

Estate tax

This is mostly a tax break for the wealthy, as they have most of the wealth taxable by this. The current exemption is over $5 million.

Note that this is not a major revenue raiser, as it is only levied once per lifetime. And the wealthy have more options to evade it. For example, if your charitable trust hires your children, you don't pay estate tax on that transfer (although your children would still pay income taxes, etc.).

Corporate taxes

A corporation is a legal fiction that is used to govern the relations between three groups: owners, employees, and customers. All corporate revenue derives from customer purchases. As such, all corporate taxes are paid by the customers, many of whom may be middle class.

That said, this isn't entirely clear. In perfect competition, we would expect owners to require a fair rate of return and employees to demand a fair salary. This leaves all taxes paid by the customers. But very little competition is perfect.

Some of the tax effect may be felt in a smaller market. I.e. instead of passing the cost onto the customers, taxes may force them to produce less product. Marginal producers simply go out of business. This hurts owners (often rich) a little bit. It hurts job prospects somewhat. It hurts customers a lot, since they can buy less of a product that they want.

In monopolistic sales, the price is generally demand driven. Increased costs reduce production a bit, and they decrease the money available to pay employees and owners. The general belief is that this would impact the rich more than the middle class, but both are affected. Note that the middle class owns about 20% of the stock market in aggregate (mostly in the form of pensions), and most employees would be described as middle class.

Payroll taxes

This is a regressive tax. It starts at 15.3% with no exemption, 12.4% for Social Security and 2.9% for Medicare. Then the rate goes down to 2.9% and then up to 3.8%.

In theory, half of the tax is imposed on the employer. However, it seems unlikely that employers simply eat this. From their perspective, this is part of the cost of having an employee. So it is reasonable to include the employer's share as part of the employee's income and taxes paid by the employee. Calculating this is a bit odd, since we increase the employee's income:

 15.3% / 1.0765 = 14.2% effective rate
 2.9% / 1.0145 = 2.86% effective rate
 3.8% / 1.0145 = 3.75% effective rate

The 1.0765 and 1.0145 come from the employer's share, which is normally hidden.

In any case, the bulk of this tax is paid by the middle class, as it is only levied on wages and salaries. The wealthy get more of their income from investments. And of course the Social Security portion is only levied on the first $118,500 of payroll income.

Income taxes

It is true that only about 50% pay income taxes, but most of those are middle class. Some middle class people pay no income tax, so the bulk of their taxes paid are in the form of payroll taxes. So the effective combined rate starts at 14.2% (0% income and 14.2% payroll). The Earned Income Tax Credit (EITC) effectively exempts part of the first $14,820 in income from payroll taxes.

The FairTax replaces the EITC and income tax deductions with a "rebate" that effectively exempts the first $11,770 of income per adult/taxpayer and $4160 per child/dependent. So a family of four could effectively earn $31,860 without paying any tax under the FairTax. I.e. they don't have to pay the first $7327.80 in tax.

The EITC is complicated. It doesn't apply to everyone and the formula for calculating it is non-trivial. The same family of four could claim the EITC up to an income of $49,974, but it phases out and has a hard limit of $5548 in tax avoided.

It is generally counted as an advantage that the FairTax would be easier for working class people to claim. One simple calculation that works much like the deductions do under the current system rather than multiple rate tables and arbitrary rules.

After the initial tax bracket, the next tax bracket is 10% plus the 14.2% effective payroll tax. But remember that we also increased the income, so

(10% + 15.3%) / 1.0765 = 23.5%

So once people get out of the 0% tax bracket, the combination of income and payroll taxes starts at 23.5%. So most people will get a small tax reduction even if they consume all of their income (and savings don't get taxed under the FairTax).

This continues at higher income tax rates

(15% + 15.3%) / 1.0765 = 28.1%
(25% + 15.3%) / 1.0765 = 37.4%
(28% + 15.3%) / 1.0765 = 40.2%

But now the Social Security tax phases out.

(28% + 2.9%) / 1.0145 = 30.5%
(33% + 2.9%) / 1.0145 = 35.4%

And now we add the Additional Medicare Tax.

(33% + 3.8%) / 1.0145 = 36.3%
(35% + 3.8%) / 1.0145 = 38.2%
(39.6% + 3.8%) / 1.0145 = 42.8%

This is for single filers. Married filing is more complicated. The main thing I wanted to show was that all combined payroll and income tax rates are higher under the current system than under the FairTax.

Deductions

Note that this replaces all tax deductions with the rebate. This gets rid of charitable deductions and increases the tax rate on investment income to 23% (currently tops out at 15%). As an example, Mitt Romney's published tax rate from 2011 would go up under this system. Most middle class people take close to the standard deduction. Even those who itemize usually don't get a large improvement, so this will have less effect on the middle class.

Payer

The FairTax is paid by sellers, not workers. Not much help for the self-employed in rate terms, although their tax calculation will be simpler. But for most people, this means that they only have to claim their rebate, not pay tax. The tax will only show to most people as a line item on their sales receipt. For example, if you pay $10 for an item, $2.30 of that would go to the government as tax.

So for most people, taxes become much simpler. Instead of taking a bunch of W-2 and 1099 forms and using them to fill out a 1040, most just have to fill out the rebate form. That basically just needs to ask if you are filing alone or with a spouse and how many dependents. You don't even need to do the math. The IRS can do that after you send the form and before they send you a check.

This will lower stress in April and leave people with more leisure time.

Revenue

Some studies claim that 23% will be close to revenue neutral. Rates assuming revenue neutrality and setting the rate based on that range from 23.82% to 31%.

Dynamic effects

Proponents claim that the simplicity of the FairTax will lead to higher revenue, as it encourages savings and investment. Opponents call this voodoo economics. Generally proponents overestimate such dynamic effects while opponents underestimate them. The reality is often in the middle somewhere.

Summary

If you compare the FairTax to the current income tax, it doesn't seem to offer much of an advantage for the middle class. If you instead compare it to the actual mix of taxes that people pay, it looks better. If you personally want to see how it would affect you, remember to include payroll taxes (both halves) in your tax payments currently. Also, remember to exempt part of your spending with the rebate and not include your savings.

It's unclear if they'll actually be able to meet their suggested rate of 23%. They might need either a higher rate or a supplementary tax, e.g. a 10% tax on payrolls over a certain amount. The latter solution shouldn't have much effect on the middle class.