A fair tax system involves replacing all national-level taxes, including corporate and capital gains taxes, estate taxes, and payroll taxes with a national consumption tax. The tax would apply once, when a new product or service was purchased for personal consumption. It is an idea that was first introduced in Congress in 1999, though it has never come to an actual vote.
The goal of the fair tax system would be to create a level tax for everyone that is based on their consumption habits. That means households could limit the impact of this tax on their finances by not consuming new goods or services. By growing their own food or using their own labor to complete taxes, many taxes could be avoided.
It is a proposal that would tax everything, including the interest on a mortgage or food purchased at a grocery store. Here are some of the pros and cons to consider when looking at the fair tax solution.
List of the Pros of a Fair Tax System
1. It would provide a monthly rebate for an annual consumption allowance.
To ease the burden on low-income families, a monthly “prebate” is part of the fair tax system. The amount received would be based on the size of the family only. No income requirements would be listed in the tax. For a family that is a couple with 4 children, their annual consumption allowance would be $40,180. That would create an annual prebate of $9,241, paid in monthly installments of $770.
2. It would give families more control over their tax payments.
By limiting consumption, families would be able to control their finances more effectively. If the family income is lower than the annual consumption allowance, then they would essentially pay zero taxes. Although they would still be charged taxes at the point of sale, the monthly prebate checks would cover those expenses. Purchasing used items would eliminate taxation exposure. The fair tax system would also not tax business transactions or exports. Anything considered an “investment” would also be excluded from the tax.
3. It does not require a marital status.
Domestic partnerships, whether recognized or not, are recognized by the fair tax system. It only looks at the number of people who are living together within the same household over the course of a year. There is no marriage penalty or benefit because this tax system doesn’t recognize the significance of marital status.
4. It incentivizes households to earn more.
Under the fair tax system, it is only the amount that you spend on new goods and services that will get taxed. That means there is an incentive to earn more, if possible, because it would drop the effective tax rate for the household. At the same time, because investments are not taxed under the system, households could growth their wealth by compounding it without the threat of a tax or penalty.
5. It would make tax income more stable for the government.
Tax revenues from a consumption tax tend to be more reliable than other forms of income tax. That means there would be more stability in revenue for the government to plan for, making the services it provides more predictable. There is the added benefit that no one would be required to file a national-level tax return with this system too, which simplifies the taxation process.
6. It benefits all businesses.
Under the fair tax structure, business income would get rid of all payroll taxes. It would eliminate double taxation issues on certain types of business income. It would remove the taxes paid by a business for investments. That would give businesses more spending power to improve their scalability, which would likely increase job opportunities at the local level.
7. It would encourage healthier spending habits.
Because the fair tax is based on consumption, households will only pay more if they purchase more new goods or services. Some costs, such as a rental payment, would be unavoidable. That is what the prebate system is for. It helps to cover the costs of the unavoidable taxes a household would face each month. With budgetary discipline, most households could limit their tax exposure under this type of system.
8. It would increase the national GDP.
According to the Beacon Hill Institute, the fair tax system would collect over $350 billion more than the current system of income taxation on the national level. This would support a GDP increase of 7.9% in the first year it was implemented. Estimates suggest that domestic investment would increase by almost 75% in the first year, even though consumption would likely drop by about 1% for the first two years of the tax plan.
List of the Cons of a Fair Tax System
1. It would create a used product marketplace.
Because the tax would only apply to new goods or services, proponents of the fair tax suggest that households could save money by purchasing used goods. With a stronger demand in the used goods market, however, the prices of those items would also go up. There might be savings present for used goods compared to new goods when the fair tax system is implemented. Compared to today’s taxation system, every household would likely pay more in taxes than they do now.
2. It would place a greater tax burden on lower incomes.
The idea of a fair tax system would be regressive on income levels that are higher. That is because consumption, as a percentage of a household’s income, becomes lower as income levels rise. That means the lower income households would pay much more in taxes. Under the current system in the U.S., the lowest tax bracket is 10%. Under the Fair Tax system, the effective tax rate would be 30%.
3. It would be unpredictable.
The tax rate under this system would adjust every year, based on the receipts that were received by the government. That means there would be no way for households to plan for long-term expenses because they wouldn’t know what the tax rate would be. For loans and other installment purchases, the tax on their interest would never be known until the new rates were published. The only way this system becomes predictable and progressive is if every household spends all their income on taxable expenditures.
4. It would tax everything, with limited exceptions.
What qualifies as a new purchase is very liberal under this conservative idea. If you live in an apartment, your rent would become taxable. The interest on your credit card would be a taxable charge. You’d pay taxes on your groceries. It is often packaged as a sales tax, but the fair tax system is much more than that.
5. It would only apply to the national government.
In the United States, there would still be the right of each state to impose a sales tax of their own at the point of sale. That means consumers would be hit twice with a tax for each new purchase they make. Although there are incentives to invest funds for all households within this tax system, there would need to be funds available to do so. The prebate check issued each month would only cover a certain portion of a household’s tax responsibilities, which could decrease, not increase, their power to save.
6. It would encourage international purchases.
Under the fair tax system, many consumers would likely try to “game the system” by initiating international purchases. To counter this issue, the rules of taxation would apply to any international purchase for new goods as well, which would be collected by customs officials before releasing the purchase to the consumer. Since it is a monetary transaction that initiates the tax, consumers may also look to create a bartering network to initiate trades instead of transactions.
7. It would only offer prebates to U.S. citizens.
The only way to receive a prebate under the current structure of the fair tax system would be to become a citizen of the United States. Even people who are here legally on a work visa, a permanent residence card, or similar status would not qualify for the prebates. That means they’d be forced to pay the higher rate of taxation immediately, without any relief coming their way.
8. It could deter high-skill workers from coming to the country.
The benefit of the fair tax system is that it excludes some common activities from the taxation. Business owners are encouraged to invest more into their brands, which would likely improve the economics at a local level. It would also mean that needed services, such as health care, would be immediately taxed. Foreign workers would be deterred from coming to the U.S. because they’d be forced to charge the consumption tax while not receiving any tax relief themselves.
9. It would raise taxes on most families.
Under the way the U.S. currently measures tax rates, the effective tax rate of the fair tax system is 30%. Proponents say that the tax rate would be 23%, but that is an error in calculation. The example used is a $100 purchase. The purchase would include $77 for the item and $23 in taxes. That is a 30% tax. For it to be a 23% tax, the final cost would need to be $123 for it to be inclusive. Even at 23%, however, that would raise taxes on most low-income families while reducing taxes for higher income earners.
10. It would eliminate all deductions.
Many households have multiple deductions which limit their tax liabilities over the course of a year. From student loan interest to mortgage interests and charitable deductions, many households can reduce their taxable income levels to a lower effective tax rate under the current system than they would be able to do under the fair tax system. There would be no deductions in the fair tax system because the sole focus would be on consumption.
11. It would disproportionately affect seniors.
The fair tax system would force seniors, living on a fixed income, to pay the same consumption taxes as everyone else. Although they would receive a prebate check (like everyone else), their lifetime effective tax rate could be as high as 45% under such a system. Their only benefit would be a likely change to withdrawals from their savings accounts, which would eliminate potential tax burdens there. For seniors with a Roth IRA, however, that issue is already gone.
12. It would cost more to collect the tax.
Because the responsibility to collect taxes would likely fall on state-based revenue departments, the cost to do so would likely cost over $9.6 billion. The savings generated by eliminating the IRS would be $9.38 billion. That means we’d pay more to ensure our own taxes are properly collected under this system.
These fair tax pros and cons suggest that the idea of a consumption tax might be beneficial to the national economy. How that tax is structured will create a positive or negative impact on families. Under the fair tax structure, the benefits only happen if everyone is spending everything on taxable goods. It creates a paradox. Proponents say that such a system would encourage saving money, but it would create a higher effective tax rate for those who do.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.