Real Economic Stimulus

Nearly a year after Barack Obama signed the American Recovery and Reinvestment Act, an economic “stimulus package” that was supposed to jumpstart the economy and create or save 3.5 million jobs, Americans are facing double digit unemployment, a declining dollar, and a burgeoning debt. If Jimmy Carter were president, he would be giving a speech about the malaise of the American people. If we only believed in the President a little more, we’d be a lot better off. Or so he would say.

It’s time that Congress and the President back a real economic stimulus plan. No, I’m not talking about massive tax or budget cuts (though these would certainly be better than the stimulus plans proposed thus far), I’m talking about replacing our current tax system with the FairTax.

The FairTax is a national sales tax that would tax the consumption of all new goods and services in the United States at an inclusive rate of 23%. This means that if you bought $100 of beer at the Village Bottle Shop, the federal government would get $23 dollars and the VBS would keep the remaining $77.

There would be no exemptions such as for food, drugs, or medical expenses, but instead every household would receive a monthly rebate (more technically, a prebate) equal to 23% of the monthly poverty rate, a figure already calculated by the federal government. Let’s say that the annual poverty rate for a family of five is $30,000. Every family of five would then receive a monthly prebate of $575 (30,000 × 0.23 ÷ 12) to cover monthly expenses up to the poverty level. In other words, a family of five that only earns an annual income of $30,000 would not pay a single penny in federal taxes. The prebate completely un-taxes those individuals who are at or below the poverty level.

The FairTax would also eliminate the federal income tax, the payroll tax, corporate income taxes, the alternative minimum tax, the gift tax, the estate (death) tax, the self-employment tax, capital gains taxes, and the IRS. States would collect the national sales tax since most of them already have the structure in place to collect sales tax, thereby eliminating the need for the IRS.

To understand why the current system should be replaced by the FairTax, it is necessary to understand what is wrong with the current tax system and the benefits that would result from the implementation of the FairTax.

To help explain costs of the current system and the benefits of the FairTax, I spoke with former Governor of Arkansas and one of the most vocal proponents of the FairTax, Mike Huckabee. I also spoke with Purdue professor of economics, Bob Holland.

Incentives and disincentives are the forces that drive economic behavior. Governor Huckabee put it this way, “If you reward something, you get more of it. If you penalize something you get less of it.” Our current system penalizes productivity, investments, savings, and therefore economic growth. It also rewards reckless spending.

One of the biggest problems with the current system is that taxes are withheld from our paychecks. Dr. Holland noted, “When we withhold income taxes, we fixate more on our after-tax paycheck. That’s how we organized our lives. We know how much that amount will be but we don’t think about how much we actually pay in taxes.” Because most people don’t really know what they pay in taxes, it’s very easy for politicians to raise them.

Despite any disagreements with these arguments against the current tax system, there’s one thing that virtually everyone can agree on and that is the current system is unbelievably complicated. “We expend a lot of resources in the United States just for compliance of the current tax code,” Holland pointed out, “Frankly, my wife and I, we basically hire an accountant to help us with our taxes. And even then, I’m never quite sure when I’m signing my tax forms that I’m complying with the law.” It’s estimated that more than $500 billion is spent every year just to comply with the current tax code. If we could free up those resources to be used more productively than complying with tax code, imagine the economic benefits it would have.

The FairTax, on the other hand, is almost the exact opposite or our current system. It is simple, transparent, and rewards productivity, investment, and savings.

“The point of the FairTax,” according to Holland, “is to promote savings, first and foremost. Right now, the US has a very low savings rate and in part you can blame our current tax system. With increased savings, the macroeconomic impact of that would be that it would push down real interest rates that we pay on borrowed money.”

Many opponents to the FairTax would argue that home sales would plummet because the mortgage interest deduction would be eliminated. First of all, more than 65% of Americans choose to file the short tax form, and therefore cannot deduct mortgage interest. As Dr. Holland noted, the increased savings resulting from the FairTax would drive down real interest rates, thereby reducing the cost of a mortgage. Additionally, the vast majority of homes sold every year are used homes which would not be taxed at all (remember, only new goods and services are taxed).

The FairTax would nearly eliminate the underground economy. Huckabee explained, “Right now there are a lot of people who are involved in illegal activity, whether it’s drug dealing, prostitution, gambling. They don’t pay taxes. But those people buy things at retail whether it’s a car, a house, food.”

Holland added, “You don’t even need to go to illicit activities such as drugs or prostitution, all you have to do is think about the average waiter or waitress who doesn’t report their tips. There’s a lot of under-reporting of income.”

By bringing out the underground economy, the tax base is necessarily widened. This is the reason that FairTax collects as much revenue as the current system, even though the tax burden for every income level (with the exception of the extremely wealthy) is decreased. Additionally, it would collect tax from illegal immigrants and the many more millions of foreigners who visit this country legally every year.

If corporate taxes and capital gains taxes were eliminated, foreign companies would be much more willing to invest in or relocate to the United States, as it would be the largest tax haven in the world. Additionally, as Huckabee noted, “The other thing [the FairTax] does is that it brings capital back to the US. Right now there’s an estimated 13 trillion parked off shore. That’s legally moved. It’s not that people are evading taxes, it’s that they’re avoiding taxes legally, which is understandable, because multi-national companies have to make tax decisions to stay in business.” The effect of attracting foreign investment and bringing US capital back to our shores would undoubtedly be enormous.

Recent economic studies of the FairTax show that real wages would in increase by 10.3%, disposable income would increase by 1.7%, GDP would increase by 2.4%, and consumption would increase by 2.4%, all in the first year. Although there would be initial layoffs due to the transition, according to a recent study, employment has the potential to grow by 3.5% in the first year. Additionally, government revenues would increase by 0.5% in the first year. The effects of the FairTax in the long run would be even greater.

One of the biggest arguments against the FairTax (and in sales taxes in general) is that they hurt the poor. Some argue that the FairTax is regressive, that is, it would affect the poor more negatively than the rich. Although, for reasons too technical to explain here, sales taxes are neither progressive nor regressive, the FairTax would actually be more progressive than the current system. This is due to several factors. First, as mentioned above, the FairTax would completely untax the poor with the prebate. Secondly, the FairTax would eliminate the Payroll Tax, which is by far the most regressive tax in place. Removing this tax eliminates the largest tax burden of the working and middle classes. Lastly, the FairTax would tax the wealthiest Americans at the full 23% of consumption. With our current system, the extremely wealthy only pay 15% on capital gains and dividends. They pay little to no income or payroll taxes . Under the FairTax, the tax burden on the wealthiest Americans (those making well over $500,000 per year) will actually increase.

In addition to the economic benefits of the FairTax, there would also be numerous political benefits (or costs, if you believe government is not big enough). Dr. Holland noted that the FairTax is “a politician’s nightmare. As long as you can keep the current tax system sufficiently complex, then I can easily use the tax code to reward supporters and punish detractors. If it’s just a simple sales tax, I’ve lost a lot of the juice, a lot of power.” Increasing taxes and spending will be much more difficult under the FairTax because the tax burden would be completely transparent, which is not a feature (by design) of the current tax system.

At this point, you may be thinking one of two things: “the FairTax is a miracle” or “the FairTax would destroy big government.” Both are inaccurate. The FairTax only seems like a miracle because it would be so much better, in terms of economic benefits, than the current system. The FairTax would not reduce the size of government as it is designed to collect as much revenue as the current system, but it would make it more difficult to increase the size of government.

The FairTax is officially supported by 80 economists, including one Nobel laureate, and is sponsored by nearly 70 members of Congress, including Indiana Representatives Mike Pence and Dan Burton. “I think more people understand it and how it works,” Huckabee stated, “There’s growing support. Most people who say they aren’t for it are people who don’t understand it.”

Bob Holland had a slightly different take. “Personally speaking, I would prefer the FairTax over our current system, but I don’t think this proposal has a snow ball’s chance in hell of getting through Congress.”

True reform will not be easy. It will require a large grassrroots movement. If you’re interested in learning more about the FairTax, visit http://www.fairtax.org or check out the FairTax books by Neal Boortz and John Linder.