Rejecting FairTax Part One: Why Not Tax Consumption?

In Part One, I'll cover the dangers of taxing consumption as a major source of government revenue, both to the individual and to the economy.

Part Two will cover the little-known problems in the FairTax proposal- the "fine print" FairTax advocates won't tell you about (or don't know themselves); I'll also refute some of the inconsistencies and rhetoric used by FairTax advocates.

Part Three will introduce the reader to the benefits of flat income taxation- why it's superior to consumption tax, and the economic benefits of flattening the tax code.

Part Four will introduce the reader to the Negative Income Tax Credit- an ideal solution to the the problems of our massive welfare state, which can only be implemented in conjunction with an income tax system.

Part One: Why Not Tax Consumption?

I think it's safe to say that nobody is happy with our current tax code. It burdens people who want to succeed in business, it favors the largest businesses who can afford to lobby for carve-outs; the enormity of the tax code creates a substantial compliance burden for smaller businesses; and- as already known to those of us on the small-government side of the aisle- 47% of the public pay no income tax at all, while recieving benefits funded by the other 53% who pay.

In our fervor to change the tax code, however, some people have been seduced by the idea of scrapping the tax code entirely: Eliminate income taxation and convert to a national tax on consumption. Whatever problems we currently have, I contend that this conversion would make our tax situation far worse.

Let's start with defining "consumption", because even this term creates problems. "Consumption" means the purchase of any good or service.

In a "pure", or "flat", consumption tax system, all transactions are taxed. Stated another way, every bill you recieve- your phone bill, your car insurance bill, your cable bill, your garbage removal bill, etc.- would include a consumption tax. Your grocery, fuel, medication, and clothing purchases would include a consumption tax. When you make a major purchase- such as a home or a car- the purchase price would include a consumption tax. If your washing machine or central air conditioning breaks down, the cost of parts and the bill for labor from the appliance repair service would include a consumption tax. If you hire a home health aide, consult an attorney, or visit a doctor, the bill for their services would include a consumption tax. If you own a business, all of the purchases made for your business- "business expenses"- would be subject to consumption tax. Making a deposit at the bank would include consumption tax, since the banking institution is offering a service by accepting your money.

Financial services- such as credit cards or bank loans to purchase a home or a car- would be taxed twice: Consumption tax on the goods purchased, and consumption tax on the service of financing.

Such a "pure" consumption tax would be wholly offensive to the public. Because of this, the major consumption tax schemes seen around the world today are designed to mitigate the impact of taxation on certain purchases. European-style value added tax, or VAT, is a system designed minimize the impact on businesses by allowing companies to recoup taxes paid on supplies. Most state sales taxes in the United States exempt some (but never all) purchases of food and medications. Variable rates are used in some countries to change the tax burden on various products: For example, levying a lower rate on medical devices than on clothing purchases. Certain transactions are exempted from taxation.

This illustrates the fallacy of a basic assumption about consumption taxes: That a consumption tax code would be simpler than an income tax code. As you can see above, there is just as much incentive to over-complicate a consumption tax code as with an income tax code. Most carve-outs found in the federal income tax code are also intended to mitigate the effects of taxing incomes.

It also illustrates a basic problem with consumption tax systems: They are regressive, in that the lower a person's income, the greater the share of their income is spent on consumption. A tax code can't predict whether a loaf of bread will be purchased by a well-to-do person, or a homeless person who has panhandled all day to buy it. Fair Tax proponents propose a "poverty grant", or "prebate", to alleviate this problem. I will discuss that in Part Two.

This brings us to the "47%"- the 47% of the public who currently pay no federal income tax. It's easy to think of this 47% as "freeloaders"- and while some of them are, others are clearly not. Many of this group are people whose incomes are currently tax-privileged for good reason: They are Social Security recipients, combat veterans, disabled people, and others whom society has determined should not be burdened with taxation. Also in this group are people who live on already-accumulated (and already-taxed) wealth: Persons living on accumulated retirement savings, for example. They have already paid their "fair share", and imposing consumption tax on would amount to double-taxing them.

As for the "freeloaders"- this group are problematic because they are net recipients of tax money. They pay less in taxes than they recieve in taxpayer-funded public assistance.

Imposing consumption tax on the "47%" would target precisely the wrong people: It would impose taxation on people we don't want to burden- such as retirees, veterans, and the disabled- while welfare recipients would continue to be net recipients of tax money. In other words, a consumption tax wouldn't fix the problem, it would simply add another problem. I will address the problems with our welfare system, and the overlooked solution to most of them, in Part Four.

High consumption taxes also have an effect on behavior: They provide incentive to develop a black market for untaxed goods. Consider a similar black market which already exists here in the United States: the market on tax-free cigarettes sold through Native American reservations, and one can readily see how a tax-free market on other goods could emerge and prosper quickly. And by the way: If the thought of "black market food" doesn't immediately make you think of a communist country, then I hereby revoke your "Small Government Conservative" card.

Consumptions taxes disproportionately burden businesses, too.

As stated above, in a "flat" consumption tax model, all purchases of goods and services are taxed, including purchases made by businesses; and as already known, any tax on business purchases constitutes the mother-of-all-barriers to growing a business.

With an income tax, it's relatively easy (though time-consuming) to deduct revenues spent on business expenses from taxation. With a consumption tax, this is decidedly more difficult, since tax is paid at the point-of-sale.

In countries with a VAT, for instance, businesses may recoup, from the government, the amount of taxes paid on expenses at the end of each year; however, the records-keeping burden of doing so is enormous, even more so than the records-keeping burden of our income tax system, because the purchasing business' records must match perfectly with the selling business' records.

This system also creates additional work- and additional expense- for government tax agencies: Every business in the country submits a request for reimbursement of taxes paid, every year, which means governments must compare the tax forms submitted by 'Business A' against the tax forms of every other business 'Business A' has purchased from that year.

It's no surprise, then, that some countries- Costa Rica, for example- choose to only allow certain expenses to be deducted, in order to minimize this burden of examination. In choosing to limit the types of expenses eligible for deduction, the government makes a conscious decision to tax certain business expenses- which brings us full-circle to the mother-of-all-barriers to business growth mentioned above.

The net effect of this: large businesses are favored, while small businesses remain small. The larger a business, the more easily said business may cope with the intense regulatory burden of records-keeping, or absorb the cost of taxes paid on business purchases. In fact, consumption taxes disproportionately favor vertically-integrated businesses- those companies large enough to own their suppliers- since greater integration means all records-keeping (or all business purchasing) is internal.

Stated another way: Consumption tax schemes are the cronyists' best friend, since consumption taxes favor already-large businesses and stifle potential competitors by preventing them from growing. (Note: I refuse to dignify the term "crony capitalism", since it isn't capitalism at all.)

This being the case, wealth remains generational, and the American dream of working hard, taking risks, and succeeding- and accumulating wealth in the process- becomes impossible. Consider this point: The class warfare rhetoric of socialists- "rich people stay rich, poor people stay poor"- becomes fact when a widespread consumption tax is instituted. This goes part-way to explaining how European nations (early adopters of consumption tax) accepted and embraced socialism at a faster pace than it was accepted here in the United States.

In sum: Consumption taxes as a major source of government revenue keep poor people poor, inhibit growth of small businesses, favor large businesses and ensure that wealth remains generational. Consumption tax schemes cause economies to become stagnant by stifling competition, and promote conditions which breed socialist sympathy and criminality.

If you, the reader, would like to refute these assertions, all you need to do is show me an example of a country which has had a major (i.e., a rate substantially greater than state sales taxes here) consumption tax for more than ten years, where none of these events have taken place. I can confidently issue this challenge, because I know there isn't such a place.