The Lowest Tax Rate

The FairTax replaces all the revenue from current income and payroll taxes with a rate of just 23% on new goods and services. If you think that’s too high, you are probably in much higher tax brackets today; it’s just hidden from view. In fact, lets look at an example.

Assume you’re a average family earning $50,000 with 2 children. Your house payment is $850 a month, $700 of which is for interest. You have two cars with total payments of $400 a month. You pay $200 a month of your employer provided health insurance premium and you contribute $5,000 (10%) to your 401-k. You tithe an additional 10% ($5,000) to your church.

Your total taxes for 2003 would be $5,104. (An effective tax rate of 10.2%).

This includes your portion of federal payroll taxes but not your employers. It also does not include the hidden cost of taxes embedded in the prices of all goods and services purchased today. Adding these costs would raise your effective tax rate to over 20%!! (Assumes 10% embedded costs)

Professor Dale Jorgenson, former chair of Harvard’s Economic Department, estimates total embedded costs of the current system of taxation averages 22% to 25%.

Under the FairTax, your entire $50,000 would be free from federal taxation, your current home and car payments as well as your 401-k savings and charitable gifts would not be taxable. The prebate would prepay taxes for you up to the poverty level of $24,240. When added to the non-taxable spending detailed above, your effective tax rate would be .45%! (less than ½%).

Even if you bought 2 new cars and a newly built home subject to the FairTax, your net taxes would only be $4,897 for an effective tax rate of 9.79%!! (Assumes same payments and average implicit mortgage interest fees – May 2005).

And remember, the FairTax abolishes all hidden taxes! Other tax reform plans claim to have lower rates, but keep payroll taxes of over 15% and actually increase the federal taxes hidden in the prices of things you buy. When you count all taxes, no tax plan has a lower rate than the FairTax.

FairTax and Businesses - Basics

The FairTax is a consumption tax, i.e. a national retail sales tax on all new (not used) goods and services sold at retail. Taxes are paid only when someone purchases something (except education and charitable contributions -- education is an investment in human capital and not taxed, and contributions are not consumption but giving).

All businesses that sell goods and services at retail (whether they are sole proprietorships, S corporations or C corporations) will be required to charge sales tax on their retail sales. They will have to register as sellers and report taxable sales and sales tax collected (to the state sales tax authority who will administer the FairTax) on a monthly basis.

Business to business sales (or the purchase by business of inputs necessary to produce, render, sell etc a good or service) are not taxable. With a consumption tax, as the FairTax is, you don’t tax intermediate sales. Why? To keep taxes from being embedded in the retail price of goods and services, and then having the national sales tax be a tax on a tax. This is for the benefit of the consumer – to make sure there are no hidden taxes increasing the sales tax that they pay.

The text of the bill states:

PRODUCE, PROVIDE, RENDER, OR SELL TAXABLE PROPERTY OR SERVICES-

`(A) IN GENERAL- A taxable property or service is used to produce, provide, render, or sell a taxable property or service if such property or service is purchased by a person engaged in a trade or business for the purpose of employing or using such taxable property or service in the production, provision, rendering, or sale of other taxable property or services in the ordinary course of that trade or business.

Here are the provisions to make sure that only bonafide business purchases are exempt from tax.

1) To qualify as a purchase for business purposes the item has to be used at least 95% for business purposes (i.e. it allows for incidental nonbusiness use). If the item does not meet this criteria, then the transaction is taxable, and the provision for mixed use (business and personal use) applies. This provision allows the business to apply for a credit of the sales taxes paid on the portion of the property that is used for business purposes.

Mixed use property or services are taxable property or services purchased both for taxable use or consumption and for a business purpose. An example would include a home office or a car used for both business and personal purposes. Mixed-use property or services are subject to the FairTax unless said property or service is used more than 95 percent for business purposes during each calendar year (or portions thereof) it is owned. The purchase of the property is taxed but a registered seller is entitled to a business use conversion credit. This credit is equal to the mixed-use property amount times the business use ratio times the FairTax tax rate. Example: A sole proprietor spends $30,000 (including tax) for an automobile that he or she uses 80% for business purposes and 20% for personal purposes. This person would be entitled to a business use conversion credit of the price including FairTax times 80% times 23% ($30,000 x .8 x .23) or $5,520.

There are detailed and, unavoidably, somewhat complex rules for calculating these amounts. For example, the mixed-use amount and the business use ratio are calculated differently for real property, tangible personal property, and vehicles. A person entitled to a credit amount for mixed use on a calendar basis may file for the credit in any month following the calendar year giving rise to the credit. These rules are, however, simpler than income tax rules governing the same problem. Those who wish to avoid the application of these rules would need to not use property for both business and personal purposes.

2) There is also an anti-tax avoidance provision in the FairTax to prevent businesses from buying personal consumption items on behalf of their employees to escape taxation. If a business buys taxable property and services for its employees that would have been taxable if the employees purchased the taxable property and services directly, then the FairTax is still due. The employer/business would be responsible for remitting the tax. In addition, to prevent employers from providing huge employee discounts to avoid taxation, the FairTax treats employer provided employee discounts over 20 percent as taxable. Again, the employer would be responsible for the tax.

3) In order to qualify to purchase items tax free for business purposes, the person/business will have to be registered as a seller and will be liable for reporting taxable sales and sales taxes collected from customers each month. They will also be subject to audit by the state sales tax authority. To make tax-free purchases, they will have to have their tax-exempt certificate on file with the vendor and make the purchase through a “wholesale register”. This will be a supplier who only makes sales to other businesses or through a register at a retail outlet through which only business to business sales are conducted. For example, if a business only was to purchase a business item through Wal-mart and didn’t want to pay the tax, they would need to have their tax-exempt certificate on file at that store and make the purchase through a register set up only for wholesale transactions. Otherwise, the business would pay the tax upfront and file for a tax credit.

Keeping business sales separate from retail sales starts an easy to follow audit trail. Keep in mind that all the records the IRS uses today to verify income tax reports (purchase records, inventory reports, sales receipts, bank records, etc) will still be available for verification under the FairTax. But businesses will no longer need to file all the complex annual reports connected to the income tax system with the possibility of being penalized for making a mistake. By contrast, the FairTax is extraordinarily simple.

How about small service businesses? First, the FairTax has deminimus provisions that remove any person with sales under $1,200 from the FairTax. So we aren’t concerned with a teenager mowing lawns during the summer or baby-sitting for neighbors. The first thing to always consider is how the current system addresses a certain group. The FairTax should not be compared with an impossible ideal, but with the current system.

Currently, small service businesses are often paid in cash. The customer has no way or knowing whether or not that cash is reported as income by the business owner. Basically, it only takes one to cheat the system. With over 130 million points of collection under the current system, the audit rate is less than 1%.

Under the FairTax, even if the business owner takes cash, it will be clear to every customer whether or not the business owner is collecting the tax. Every customer becomes a potential witness against the business owner if he is cheating on the collection. Consider also that competitors will likely know if a business owner is cheating since they will not be able to compete on price. As the competitor tries to obtain business, one of the customers are very likely to mention this fact and the business owner in short order will be audited.

Whether we are looking at taxation from an individual or a business perspective, their will always be those who attempt to cheat, no matter how simple the system. Most Americans though are honest and have no problem paying their “fair” share. That is part of the problem today. The tax system is too complex. There is a sense that the “other guy” is not paying their “fair share” because the tax system has divided us into hundreds of special interest. The odds of getting audited are small and therefore the reward is worth the risk.

Under the FairTax, the system is very visible and straightforward. We will be moving from 130 million points of collection to about 14 million so the risk of audit for those collecting the tax will be much greater. There is no personal reason for a business owner not to collect the tax from their customers, as there is no personal savings to them, only to their customer…and they would be taking the risk of sanction and penalties if they did not collect it.

Will there be some who attempt to cheat the system. Absolutely! There is no perfect system, But with a greater sense of fairness, less complexity, simple audit trail, less reward for cheating and greater risk of audit, the compliance rate under the FairTax will be much greater than under any form of income tax.

FairTax and the Poor

The Fair Tax plan is the only proposal that completely untaxes the poor. Our income tax system today seeks to add progressivity by personal exemptions (which have failed to keep up with inflation), by the earned income tax credit (which is ripe with fraud), by steeply progressive rates (which punish those that have fluctuating income or who are trying to improve their lot in life). But the poor and middle class pay heavily in four ways.

· The poor and the middle class today pay regressive payroll taxes targeted solely at “wages” (sweat equity), the means by which those without personal wealth earn income. Payroll taxes are 15.3% on the first dollar of wages, up to about $90,000; thereafter, the payroll tax rate drop to 2.9 percent.

· The poor and the middle class pay significant income taxes, despite personal exemptions and standard deductions. For example, a single person will pay at least a 10% rate for each dollar earned beyond $8,200 in taxable income.

· The poor and the middle class pay hidden taxes when they buy any good or service. That is because taxes imposed upstream are buried in the price of U.S. manufactured goods and services. Dr. Dale Jorgenson, Chairman of the Harvard Economics Department, estimates these taxes at 20-25% of the price.

· The poor also pay because the tax system today stifles upward mobility. It does so by: (1) taxing wages heavily and regressively, (2) by imposing steeply progressive rates if one chooses to work harder, (3) by taxing savings and investment twice or three times, and (4) by confiscating a family’s income before they have determined whether to spend or save.

· Because programs such as the EITC are steeply phased out as incomes rise, the marginal tax rates on the poor with children can be higher (47%) than that of the richest Americans (35%)

Our tax system should be based on the “ability to pay.” One must be able to attend to their own needs before the government burdens them in taxes. The Fair Tax untaxes the poor by:

· Repealing the regressive payroll taxes.

· Repealing upstream taxes hidden in goods and services.

· Providing a monthly rebate in advance equal to 23% times the HHS poverty level so that no one pays taxes on the necessities of life.

· Giving people ultimate choice over their destiny – save and don’t pay taxes or spend and pay taxes.

· Stimulating economic growth – the poor are the first to be laid off in bad times and the last to be rehired.

The Fair Tax “rebate” allows one to consume tax free up to the poverty line. As an example, a family of four’s poverty limit is 25,660 in 2005, meaning that the annual rebate would be $5,902 under the AFFT Fair Tax plan. Only when an individual or household consumes beyond the Health and Human Services poverty limit is the tax applied.

FairTax and Home Ownership

Many people say they favor the income tax over the FairTax when it comes to home interest deductibility. This is due to a misunderstanding of the advantages under the current income tax system. There are four main components to examine in comparing the two tax systems as they pertain to home ownership: Principle payments, interest payments, capital gains when sold, and the current and future value of the home. Let’s look at each separately.

PRINCIPLE:

Income Tax: Principle is paid with after-tax dollars and is not deductible

FairTax: Principle is only taxed if it is a new structure built for non-business use

New homes are treated equally under both the income tax and the FairTax while the principal of existing housing is not taxed under the FairTax.

ADVANTAGE: FAIRTAX

INTEREST:

Income Tax: Interest is deductible, however to take the interest deduction you must itemize (only 27% of Americans take a home mortgage interest deduction). To itemize you must give up the Standard Deduction, which was $10,000 in 2005 (married couple filing jointly). This means the net gain from the mortgage deduction is the interest paid minus the Standard Deduction. Other itemized expenses may help raise the level of deductibility, but the net is always the total itemized expense minus the Standard Deduction. One must keep many records and receipts when they itemize as they increase their chances of being audited.

As an example, assume an average homeowner has a total mortgage payment of $15,000 a year ($1,250 a month). The interest portion of the payment is $11,000 and they have no other expenses they can itemize. To claim the $11,000 interest expense, they must remove the Standard Deduction of $10,000 (2005) and their net gain in deductibility is $1,000. Although some homeowners may have interest expense in excess of this, (expensive homes, multiple homes, etc.) they then start running up against the AMT. They also have accountant and record keeping fees.

FairTax: Interest is not a taxable expense, whether the home is new or “used”. Non-taxable interest payments beat tax-deductible interest, as there is no reporting necessary. The entire interest in not taxed (any implicit services charges would be taxed) and you don’t have to give up the rebate to receive the benefit.

Under the income tax, interest is only deductible if you itemize and then, only to the extent it (and other itemized items) exceeds the “standard deduction.” Interest is never taxed at any level under the FairTax and you don’t lose the rebate.

ADVANTAGE: FAIRTAX

CAPITAL GAINS ON RESALE:

Income Tax: When a home is resold, the seller may exclude up to $250,000 of the gain from the sale of their primary residence if they have lived there at least two years. The exclusion is $500,000 for a married couple. Once again, there is still the record keeping and reporting expense.

The new purchaser on the other hand must pay the principle of the home they just bought with after-tax dollars again. This essentially amounts to double taxing the same gain on the property (capital gains to the seller and income tax to the buyer). In effect, the TOTAL home value is taxed again and again on resale as the principle is always paid with after-tax dollars.

FairTax: Used property is not taxed, so regardless the amount of the gain, there will be no tax to the seller or the buyer.

Just like with the principal, under the income tax, there is a tax deduction sometimes, under certain circumstances (that are always changing), and you must report to the Government to get it. Under the FairTax, it simply is not taxed.

ADVANTAGE: FAIRTAX

MISCELLANEOUS:

Home Values: The cost of new construction will be reduced (accordingly to the research paper, up to 25%). To the point that after tax prices of new homes would increase, existing home owners will enjoy additional capital gains as the values of those homes adjust. Other changes in the economy will work to increase both home values AND home affordability simultaneously, such as:

Increased take-home pay

Economic Growth

Lowering of Home Interest Rates

Increased time and freedom (no compliance efforts)

Every study has shown increased productivity, economic growth and job opportunities under the FairTax. When combined with lowered interest rates and the removal of embedded cost, this empowers more Americans into home ownership.

ADVANTAGE: FAIRTAX

Standard Deduction vs Fairtax Exclusion:

Now consider the Standard Deduction ($10,000 for a couple filing jointly in 2005 and $5,000 for an individual) under the income tax and the personal exemption ($3,100 for 2005). I am not considering the Earned Income Tax Credit here as this discussion is on mortgage interest expense deductibility and it is unlikely that many claiming the EITC itemizes on his or her tax form. Here is a comparison of the Standard Deduction plus the Personal Exemption to the FairTax Exclusion based on family size. Keep in mind, the FairTax exclusion (rebate base) applies whether you spend money on new items or not. You don’t loose it, just because you purchase non-taxed items. For family sizes over 1, I’m assuming joint filers.

Family Size S. Deduction + Pers. Exmptn FairTax Exclusion

(Income Tax System) (FairTax System)

1 $ 8,100 $ 9,570

2 $16,200 $19,140

3 $19,300 $22,400

4 $22,400 $25,660

5 $25,500 $28,920

6 $28,600 $32,180

All filers receive a greater exemption under the FairTax. And remember, the Fairtax only taxes new items. Most items that are income tax deductible today ONLY for those keeping detailed records and reports are naturally tax free consumption under the FairTax, such as interest payments (all interest, not only housing) retirement savings and charitable giving. Unlike the current system where you must give up the standard deduction to claim many of the “tax deductible” provisions, there is no loss of the prebate in receiving this treatment. Those items are just simply not considered consumption.

ADVANTAGE: FAIRTAX

Compliance and Reporting

No tax forms! No filing! No penalties! No IRS intimidation! As a nation, we save approximately $250 billion in compliance costs and 6.1 billion hours a year in wasted effort.

The FairTax is superior on every point. Add to this the increased freedom, and privacy and it is a win all the way around. It’s time to change the initials of the IRS to INS and to send them to the borders to terrorize terrorists instead of working American citizens.

FairTax and Rent

Rental inputs will not be taxed, but rent payments will be.

As a landlord, the purchase of the rental units, the material and service for upkeep, the insurance for the units, etc. will be business inputs and will be tax free. From the business perspective, your costs will be reduced substantially and you will no longer have the complexity of the tax code to deal with.

From your personal viewpoint as a taxpayer, your own income of course will also be tax free. You will only be taxed if you buy taxable goods and services about the poverty level.

You will collect the tax on the rental payments made by the tenants (unless they are business rentals which are not taxed) and be paid 1/4 of 1% of the collected amount for your effort. This will be forwarded to the State taxing authority.

From the renter's perspective, nothing much changes from today. Rental payments today are made with after tax dollars so for someone in a 15% marginal tax bracket, they must earn $130 to have $100 left to pay towards the rent. (That includes their portion of payroll taxes, but not their employer's).

Under the FairTax, if they earn $130, they will take it all home to apply to the rent. Even if you do not pass any of your business savings to them in the form or lower pre-tax rent as a result of your reduced business cost, they will still be no worse off than today. ($100 in rent would be $130 after adding in the FairTax and they will have the full $130 from wages to pay it.) If you also decide to lower pre-tax rents to pass a little of your business tax savings to them, they will be better off.

This is only from the rental viewpoint. When you factor in the prebate, the growing economy and opportunity, and the increased personal freedom, they and everyone else are truly better off.