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How Fair is Fair Tax?

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What the proposed tax means for you.

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Backers of the Fair Tax propose taxing consumption rather than income, eliminating the need for the Internal Revenue Service.

Here's how the proposed Fair Tax would work:

  • Replace the Federal income tax with a national sales tax of 23%
  • Repeal the 16th Amendment, which granted Congress the authority to impose an income tax
  • Provide "prebates," or government payments prior to incurring any expenses, to low income earners up to an amount equal to the poverty level. This would eliminate the regressive nature of the proposed Fair Tax
  • Eliminate all tax breaks, including corporate credits and the homeowners' deduction for interest paid on a mortgage

Because there would be no tax on savings and investment income, no loopholes and no difference in the tax rate based on income level, proponents of the Fair Tax believe it would be pro-growth.

But critics believe the Fair Tax is unworkable. Their list of grievances is long.

For starters, they believe it understates the tax rate necessary for it to be viable. Here's the basic calculation: If a product retails for $1, the Fair Tax adds 30%, boosting the total price to $1.30. The 30 cents paid in tax is 23% of $1.30, which is why the Fair Tax rate is 23%, not 30%. Clever argument say critics, but it still adds 30 cents to a $1 purchase.

But even at 30%, detractors take issue with the Fair Tax, arguing it wouldn't be high enough to raise sufficient revenue to cover current costs. Some think it would have to be set at 50% or more. Minyanville's Taken to Tax

And what of states that currently impose no sales tax, like Alaska, New Hampshire or Oregon?

Or those without income tax? What do they tell us about the feasibility of the Fair Tax? Proponents say that payroll taxes and federal taxes would no longer be folded into the retail price, therefore goods would be cheaper. But critics argue, in states that currently don't impose an income tax, they aren't.

There's more. Critics say the Fair Tax would be regressive because low income earners spend a greater portion of their income on basic necessities than high income earners. Further, "prebates" would necessitate the creation of a national welfare agency with knowledge of low wage earner's income, despite the abolition of the IRS. How else would "prebate" checks be calculated?

Those opposed are also concerned about tax evasion. They believe it could run rampant among people with access to goods at wholesale.

Black market wholesale activity could be conducted on the Internet with ease -- think eBay and PayPal -- rather than alleys or, for that matter, the United States.

The Fair Tax would apply to services, boosting the cost of a trip to the doctor. Would the medical profession willingly become tax collectors?

Then there's the problem of government purchases. If Uncle Sam buys widgets at $1 million each, the government would be required to add $300,000 in sales tax, boosting the total price to $1.3 million. On paper, that would increase revenue, but wouldn't actually make additional funds available, because the government would be paying its own tax.

The proposed tax would also apply to state and local governments, boosting costs.

Critics say a flatter income tax is a better way to eliminate inequities in the current tax code, while still raising sufficient revenue to fund the federal government.

The Fair Tax Act of 2007 (H.R. 25; S. 1025) was introduced by Representative John Linder and Senator Saxby Chambliss, both Georgia Republicans. The measure has 67 co-sponsors in the House and four in the Senate.

Translation: Don't hold your breath waiting for the Fair Tax to become law.

No positions in stocks mentioned.
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