“Changing the Tax System: Comparing the Flat Tax with the Fair Tax”
Stephen M. King, Ph.D. 

Today’s U.S. Internal Revenue Code, which underwent its last major restructuring in 1986, costs individual taxpayers alone approximately 3.18 billion hours and $75.5 billion to comply. It is highly complex and complicated, with the standard 1040 form including some 143 pages of instructions or triple the number of pages in 1975.[1] Size, cost, complexity, confusion, and inequity are many reasons why many groups[2] are calling for comprehensive tax reform.

Two reform possibilities touted recently include the Fair Tax (initiated and promoted by Americans for Fair Taxation[3]) and the Flat Tax (such as promoted by Steve Forbes, former Republican presidential candidate).[4] This TEF BRIEF accomplishes two goals: first, it briefly compares these two major tax reform proposals and, second, it raises two questions: 1) are both systems fair? And 2) how do both proposals affect the size of government and government spending?

Congress first introduced the Fair Tax in 1999. Since then, the measure has gone through several iterations and is now titled the “The Fair Tax Act of 2007.” The Fair Tax is a national retail sales tax, or what is commonly referred to by economists as a consumption tax.[5] Effectively, it is a tax on what people buy and not on what they earn. The Fair Tax proposal is comprised of three main elements. First, it taxes all new goods and services at a flat 23 percent rate. Second, it includes a rebate or more accurately a “prebate” element for all taxpayers. And third, it taxes the rich’s wealth as well as the common laborers’ wages, thus retaining a certain degree of progressivity.[6]

In addition to several procedural and systemic differences between the Fair Tax and the current tax code, the Fair Tax has substantial economic implications as well. First, the Fair Tax makes the cost of government much more visible than it currently is, simply because there are no “hidden taxes” or “embedded costs” to cover up as in the current system. The Fair Tax eliminates most current taxes, including individual income taxes and all loopholes, the Alternative Minimum Tax (AMT), all corporate and business income taxes, capital gains taxes, Social Security taxes, Medicare taxes and all other subsequent federal payroll taxes, self-employment tax, estate or “death” taxes, and finally all gift taxes.[7] Second, the Fair Tax increases the likelihood of retaining blue collar jobs from disappearing to overseas markets. Because the Fair Tax eliminates all hidden or “embedded taxes” many American-based companies that have plants in foreign countries, which by the way have tax systems, such as the flat tax, favorable to capital and labor investment, would have a greater incentive in returning to America.[8] Third, both the “shadow economy,” which is legal but unreported economic activity and is estimated to cost the U.S. economy anywhere from $650 billion to $1.5 trillion, and the “underground economy,” which is illegal economic activity such as the illicit drug trade, is in excess of $1 trillion.[9] The shadow economy, which conservatively makes up approximately ten percent of the U.S.’s Gross Domestic Product (GDP), costs the federal government about $345 billion in lost revenue.[10] This will be eliminated with implementation of a national retail sales tax, such as the Fair Tax.

The Flat Tax, which also has the effect of a consumption tax because it allows for more savings and investment which can then be designated for consumption purposes, is designed to tax all individuals at the same level. (There is currently a version sitting in Congress titled appropriately H.R. 1040. For clarity purposes we will briefly examine Forbes’ version.) According to Forbes, a Flat Tax system would tax all personal and corporate income at 17 percent. It would increase exemptions (e.g. $13,200 per adult, $4,000 per child or dependent, and a one-time $1,000 tax credit per child 16 and younger) and like the Fair Tax would reduce the capital gains tax to zero, while also eliminating both the estate tax and the Alternative Minimum Tax (AMT). It would also streamline the filing process by using a postcard-size return.[11] In addition, Flat Tax proponents trumpet other advantages such as no special tax preferences for the wealthy,[12] eliminate double taxation of savings and investment, stimulate work effort on the part of the working class, and enhance entrepreneurial efforts, from venture capitalists to small to medium size businesses.[13]

Both tax reform proposals, however, contain problematic elements. Fair Tax opponents make several claims. First, they claim that the 23 percent rate is really 30 percent.[14] Fair Tax proponents, however, claim that opponents must compare inclusive and exclusive tax rates equally. (Note: The 23 percent rate is based on an “inclusive rate,” which is a percentage of the total dollar paid out or earned, thus on a $100 item, $23 goes to Uncle Sam and $77 is the consumer’s purchasing power. The 30 percent rate, on the other hand, is based on an “exclusive rate,” which is a percentage of income left or the actual price of an item being purchased, which means if you purchase an item for $77 you pay an additional 30% (or $23) in sales tax, or $100, at checkout.)[15] Second, the rebate or “prebate” is sent to every U.S. household. The “prebate” measure is designed to protect lower- middle income to poor families from being taxed on necessities, such as food. The “prebate” program’s cost is estimated to be somewhere from $600 to $780 billion per year, representing the largest entitlement program in American history.[16] Finally, even though the legislation calls for the elimination of the IRS, the administration, oversight, and enforcement of the law would require additional bureaucratic units created within the Department of Treasury as well as de facto create “new tax collectors” (retailers) and “new taxpayers,” including governments, churches, and other non-profits, if there are no exemptions for these groups.[17]

The Flat Tax is also not without its critics and problems. Is the Flat Tax really flat? It is flat in the sense that it consists of one rate, but it is also progressive in that the more one makes, the more tax one pays. Also, even though it has features of a consumption tax the Flat Tax is still an income tax. It taxes salaries and wages, income earned, rather than consumption directly. Moreover, the Flat Tax does not call for the repeal of the 16^th Amendment or for the abolition of the IRS. Thus it would be quite feasible and possible for the federal government to raise the flat tax and return, for example, to some form of the current system.[18]

So, which of the two reforms, i.e. the Fair Tax or the Flat Tax, meets our two criteria of fairness and promotion of limited government and free-market principles? Let’s define “fairness” according to two standards: achieving administrative efficiency and pursuit of individual and social equity. Administrative efficiency requires streamlined bureaucracy, elimination of needless rules and regulations, and cost savings. For economists in particular equity is generally understood to be “equal treatment of equals.”[19] On the surface, both reform proposals appear to accomplish these requirements. While the Flat Tax greatly reduces the power and authority of the IRS, the Fair Tax eliminates it altogether.[20] In addition, both proposals appear to be somewhat equitable, at least when compared to the current tax system, because regardless of salary or wage level the same tax is applied to all. However, both reform types contain a degree of progressivity, where both shift the lion’s share of the tax burden away from the lower-middle income and poor, requiring the rich and wealthy to pay taxes on a greater share of their income or on what they purchase.  

However, both proposals largely fail to meet the second criterion: promoting limited government and free market principles. For example, both reform measures are touted as “revenue neutral,” which means they do not reduce the amount of revenue available for the federal government to spend. The Fair Tax website emphasizes this point, stating that the Fair Tax plan provides “dollar-for-dollar federal revenue neutrality.” In addition, proponents even argue the Fair Tax is not “about cutting spending or changing government benefits. It’s simply a plan to change the way Americans fund their federal government.”[21] And Forbes even argues that his version of the Flat Tax will increase federal revenue by some $11 billion, while “generating $56 billion more in new government revenue…” and “an estimated $6 trillion in additional assets would be created.”[22] Do we really want a tax reform system that either does not decrease government spending or actually even increases it?!

Although reform of the current tax system is essential, Milton Friedman advocated the need for additional steps. He argued that cutting taxes and thus reducing the amount of revenue available to the government is the critical point. Government spending accounts for nearly 50 percent of total national income, including both direct and indirect income. This is why Friedman was in favor of some type of Tax and Spending Limitation Amendment be added to the US Constitution. Such an amendment would be designed to restrict total government spending and return any revenue in excess of spending limits to the taxpayer.[23]

If the fiscal welfare of the U.S. is to be salvaged, however, simply switching to either the Fair Tax or Flat Tax system, although necessary, is not the critical issue. The critical issue is not tax reform only, but tax reform PLUS reduction in total amount of government spending. Edward Crane contends that too much dependence on “growing the economy” without “a focus on individual freedom and restoration of constitutional government” will only promote an “activist government,” regardless of which party is in control.[24]

Granted, both the Fair Tax proposal and Flat Tax reforms at least partially shrink the size of the federal government through reduction of or even elimination of the IRS and the many thousands of pages of rules and regulations that accompany the current tax code. However, if the amount of revenue remains the same or higher than current levels (e.g. the federal government budget is nearly $3 trillion dollars) and the estimated federal budget debt and future fiscal commitments amount to almost $60 trillion, then simply reforming the current tax system without attending to the critical need to reduce the size and impact of federal government is only addressing part of the problem.

Dr. Stephen M. King is Research Vice-President at Public Interest Institute.

The views expressed herein are those of the author and not necessarily those of Public Interest Institute or Tax Education Foundation.  They are brought to you in the interest of a better-informed citizenry.