Taxation in pictures: Why FairTax makes sense

The New York Times made some coverage of the FairTax proposal recently. The coverage was done in a way typical of mass media trying to be "unbiased": they vaguely describe the topic being covered, and quote some people who are in favor, quote some people who are against. The arguments in favor or against are not really explained, and it is left up to the reader to perform their own research, or walk away from the issue with lingering doubts.

People who are in favor of FairTax generally say that the proposal has been designed by competent economists, and has been verified and endorsed by many more. They say that the calculations behind the proposal have been verified many times, and that the people who refute the proposal either haven't taken the time to understand it, or have vested interest in the current, horrendously complex, tax system.

People who are against FairTax generally quote some other economist who calls it "unworkable" or "a swindle" without bothering to explain why.

However, there is an easy way to comprehend why the FairTax makes sense. All it takes is a picture.

Taxation in the US

The following diagram illustrates taxation in the American economy.


When you buy a $100 product, you observe being directly taxed only by the state, assuming there's a local sales tax. What you don't observe, however, is that the remaining $90 you are paying for the product has a lot of other tax built in.

How much tax in total?

Over the past 15 years, total US government receipts - federal, state and local - have summed up to about 33% of GDP (OECD, 'Tax&Non-TaxReceipts').

According to the US GPO, based on data for the year 2000, "total Federal spending accounts for 20% of the gross domestic product, while total state and local spending account for 12%".

The federal government collects a large majority of its revenue through the personal income tax (10-35%), corporate income tax (35-39%), social security (12.4%), and payroll tax (2.9%). The states get some of their revenue from the federal government, while collecting the rest through sales taxes (0-10%) and piggybacking on the federal income tax (0-10%).

Current federal budget deficits are about $480 billion, about 3.8% of GDP. This means that the federal government spends about 20% of GDP, but collects only about 16.2% in taxes. A majority of the remaining 3.8% is borrowed from the private sector, while a minority is taken from the economy as an invisible tax, by the government simply printing the money.

You don't see these taxes when you buy a product in a retail store. But out of every $100 you spend for a product, some $29 on average are taken by the government, at some point or another in the process of the product's production. Some $16 are taken by the federal government, and some $12 are taken by the states.

Due to special interests and their lobbying, there are numerous exceptions, and the effective tax level is different for every individual product and service.

The fact that they collect this money at so many different points, and using such a complex tax code with so many special cases and exceptions, imposes a large compliance burden nationwide. The Tax Foundation estimated that this burden was $265 billion in 2005 - about 2% of GDP. This likely means that the US would experience an immediate one-time GDP growth spurt of 2% if income taxation was eliminated, just from not having to comply with the income tax alone.

There would almost certainly be another, permanent 2% or so increase in annual growth because the government would stop taxing investment to spend it on consumption.

Taxation in the EU

If you think the US has it bad, look at the following diagram for Europe.


So you thought the US rescued Europe from fascism in WWII, eh?

No such luck.

To understand, take a minute to meditate on this quote from The Big Book of Fascism by our friend Benito Mussolini:

Anti-individualistic, the fascist conception of life stresses the importance of the State and accepts the individual only insofar as his interests coincide with those of the State, which stands for the conscience and the universal will of man as a historic entity.... The fascist conception of the State is all-embracing; outside of it no human or spiritual values can exist, much less have value.... Fascism is therefore opposed to that form of democracy which equates a nation to the majority, lowering it to the level of the largest number.... We are free to believe that this is the century of authority, a century tending to the 'right', a Fascist century. If the nineteenth century was the century of the individual (liberalism implies individualism) we are free to believe that this is the 'collective' century, and therefore the century of the State.

And so it is across Europe today. Just compare this sentiment to the diagram you see above. The State is everywhere.

In addition to the personal and corporate income tax, payroll tax, and social security taxes which are present in the United States, most EU countries impose the Value Added Tax, which performs essentially the service of a sales tax. The difference, as you can see from the diagram above, is that the VAT is much more convoluted, raising compliance costs across the EU and opening opportunities for scamsters to abuse the system, forcing the EU to lash back at them by raiding and closing otherwise perfectly good offshore banks.

Additionally, EU personal and corporate tax levels are higher than in the United States, bringing total government receipts of Euro area countries to a whopping 45% of GDP. Mussolini would be pleased.

The FairTax

Finally, here is the diagram for the FairTax proposal.


Simple, eh? Instead of collecting taxes bit by bit, at every conceivable point where there is any kind of financial transaction, the FairTax government would focus its collection in a single place: where the consumer purchases a product or a service.

The FairTax rate of 23% is calculated to replace only federal taxes. Various US states have different approaches to taxation, and it is up to them to keep their existing systems or change to an additional sales tax on top of the FairTax.

However, if you recall that US federal taxes collect about 16.2% of gross domestic product (the remaining 3.8% is borrowed or printed), it should be apparent how a 23% FairTax rate is enough.

With a federal government that taxes about 16.2% of what the people of the United States produce; and with US consumption at 86% of GDP; a 23% consumption tax works out to 23% x 86% = 20%. Subtract the FairTax prebate - a sum of about $480 billion, or again about 3.8% of GDP - and the result is 16.2%, exactly the amount collected by current federal taxes.

For a more involved FairTax rate calculation, check out Taxing Sales Under the FairTax: What Rate Works? on the FairTax website. And see also the FairTax FAQ.

[Originally posted on denis bider's blog]