The Fair Tax Act explained

Key Takeaways:

• As financial professionals, your clients may have questions about The Fair Tax Act, a proposed national sales tax which aims to simplify taxes by taxing consumption, rather than income.
• The proposed rate is 23% inclusive of the tax—meaning the rate is applied to both the purchase price and the tax itself—on most purchases of goods and services.
• The Fair Tax could reduce the federal tax burden for individuals whose spending is significantly lower than their earnings; however, the tax could penalize the middle class and poor who are above poverty level who must spend most of their earnings.
• Many versions of a national sales tax have been introduced in Congress over the last 25 years, and currently the Fair Tax Act does not have the Congressional support to become law.

At this time of year, your clients may get frustrated with income taxes and think, “there must be a better way.” The Fair Tax Act aims to simplify taxes by taxing consumption, rather than income.

While members of Congress have been proposing some form of flat tax for over 20 years, the Fair Tax Act was introduced again early in 2023. It is important to note that the Fair Tax does not have broad bipartisan support and is unlikely to pass in its current form.  Since your clients may still have questions about this legislation, we’ll explore what the act is, the potential benefits and drawbacks, and the future of the Fair Tax Act in this blog.

What is the Fair Tax Act?

The Fair Tax Act proposes to eliminate the federal income and wealth transfer system and replace it with a national sales tax. Under the bill’s provisions, the Internal Revenue Service would be eliminated, and each state would administer the national tax as well as its own.

The proposed rate is 23% inclusive of the tax—meaning the rate is applied to both the purchase price and the tax itself. A 23% inclusive rate is analogous to a rate of 29.8% if the tax were applied only to the purchase. So, consumers would pay a tax of almost 30 cents (plus applicable state and local sales taxes) per $1 purchased; but no federal taxes would be paid on their earnings.

Certain expenditures would be exempt from the Fair Tax to avoid double taxation. These include business and government purchases, as well as used and intangible property.

The Fair Tax Act includes a rebate equal to the amount of national sales tax paid up to the poverty level. This is designed to offset national sales taxes, so that a household at poverty level would essentially pay no tax. The rebate would be paid to all households, regardless of income.

Finally, the bill requires the national sales tax to be terminated if the 16^th Amendment to the Constitution, authorizing income taxes, is not repealed within 7 years of the Fair Tax Act’s enactment.

Benefits of a Fair Tax System

The Fair Tax could reduce the federal tax burden for individuals whose spending is significantly lower than their earnings. Investment growth and earnings would compound tax-free, which may encourage saving and investing. Net business earnings would dramatically increase, as only sales to consumers would be taxed, which could foster domestic business growth.

Tax revenues may be easier to predict, as consumption rates are generally more stable than income. Compliance would be simpler for individuals, as tax withholdings and filings would be eliminated, as well as the IRS.

The proposed rebate would be payable monthly, in advance, providing some relief to families near the poverty line.

Drawbacks of a Fair Tax System

Since high earners typically consume less as a percentage of their total income, the tax could penalize the middle class and poor who are above poverty level. Wealthy taxpayers could save income without paying taxes and would receive the proposed rebate. The tax could encourage affluent individuals to engage in more tax-free activities, such as investing more in businesses, which could reduce the overall tax base and reduce expected tax revenues.

The Fair Tax system could facilitate tax evasion through barter and foreign purchases. Furthermore, lawmakers would no longer be able to influence public policy through deductions and credits, such as for charitable donations and home purchases.

The Fair Tax Act transfers federal tax administrative responsibilities from the IRS to the individual states. Decentralization could reduce economies of scale and create confusion for taxpayers.

Furthermore, the states would still levy their own income and sales taxes, and no federal deduction would be available.

The Future of the Fair Tax Bill

While the Fair Tax Act of 2023 has some Congressional support, it is unlikely to become law, as it would have to pass in both the House of Representatives and Senate without a Presidential veto. Some form of national sales tax has been proposed periodically since 1999 without gaining traction. While many people agree that our current tax system is too complicated, tax reform is not simple, and a complete overhaul of the federal tax system would be challenging.