Government funding under the FairTax.

Government funding (under the FairTax)

The FairTax entails eliminating all direct taxes (on income, salary, dividends, etc.) and replacing them with a single tax on consumption (sales tax or VAT), set at a rate that keeps tax revenues constant (revenue neutrality).

Advantages (relating to government funding)

The FairTax approach to funding the government has several distinct advantages:

The sales tax, unlike the income tax, has a straightforward, intuitive rationale.

In a free market, a person’s earned income is a measure of how useful he/she is to society, and a person’s consumption is a measure of how useful society is to him/her. A requirement to pay taxes for being useful to society is mighty counterintuitive. In contrast, having to pay tax when society is useful to you is quite intuitive. An intuitive justification is a good thing, the sales tax has it, the income tax doesn’t.

A qualification: capital gains, dividends and interest are the expression of exploitation and should therefore be downright illegal (or at least taxed at 100%). The FairTax apparently let's exploitation walk free, but that's only because, in a global economy with free moving capitals, it's just not possible to tax capitals directly (they simply flee). Yet in fact, the FairTax indirectly deals exploitation a bigger blow than the income tax ever could, because the prebate effectively claws back some of exploitation's spoils and returns them to the likely victims.

Example

Say you need a table and I can build one. If I do it, it’s me doing you a service (not the other way around), even though I am the one making money. The more tables I manufacture, the more I'm helping you and the higher my income. The money/income represents just an acknowledgement of this, and a promise on your part to return the favor later. The thrill of making money makes people instinctively grateful and quite willing to pay society for the privilege, overlooking the fact that they are the ones who provide a service to society, not the other way around.
The sales tax is simple, with low administration and compliance costs.

For taxpayers the compliance cost is minimal: put a coin into a vending machine and... you just paid your taxes! Nothing to calculate and nothing to remember. Compare this to declaring income: one must remember and list all types of income, gather relevant documents, read extensive instructions, and fill long forms. If you sell stocks… you must figure cost basis for each. It you are a company… it gets so complicated that you need to hire accountants.

The state’s administration costs are much lower as well. No need to: deal with millions of individuals, mail forms, draft instructions, provide support, verify millions of forms, cash millions of checks or issue millions of refunds. The retailers collect the tax but their burden is also minimal: the top line (revenues) times the tax rate gives the amount to be remitted to the government.

Such simplicity frees human resources. Income tax complexity is stressful for inexperienced entrepreneurs, and acts as a distraction if not a downright deterrent. It has the same effect on individuals considering to invest in the stock market.
The sales tax ends the income tax' discrimination against domestic products (in favor of foreign ones). The income tax is basically a negative subsidy to domestic products!

The sales tax DOESN'T discriminate because it either applies to both local and foreign products (when they compete on the domestic market), or to neither of them (when they compete abroad). The income tax, on the other hand, DOES discriminate because it ALWAYS inflates only the price of domestic products, never the price of foreign ones (no matter where they compete). Therefore, unlike the sales tax, the income tax undermines the competitiveness of domestic products both internally and abroad.

This simple but staggering fact drives the most profound implication: the FairTax GREATLY diminishes the negative impact that government size has on economic competitiveness, thus allowing “big government” to be economically competitive and therefore politically viable.

In a global market with free moving capitals, using the income tax to fund “big government” is simply futile. By discriminating against domestic business (in favor of foreign ones), the income tax turns government revenues into a direct burden for the local economy preventing it from competing effectively. As a consequence capitals flee, sinking the economy further and forcing the government to scale back. The sales tax simply breaks this cycle changing the game entirely.

The bottom line is that the income tax is the very reason why social democracy is unsustainable and should be viewed as its #1 enemy. The sales does away with such nonsense allowing a country to freely implement the political choice of its people, without any extraneous pressure from the global market.

In fairness, the sales tax discriminates too, but it discriminates against domestic consumers, not producers. Consumers are much less mobile than capitals, and they don’t really compete with foreign consumers anyway. And it is plenty reasonable for a country to be financed by its own citizens (particularly the ones that are in a position to spend a lot).

An important consequence is that, in a global market where countries compete for capitals, one country adopting the FairTax will force other countries to do the same (in order to regain competitiveness and avert a capital flight). A country’s one-time, immediate increase in competitiveness upon adoption will be quickly offset by a sudden, one-time appreciation of the local currency. The exchange rate jump will get noticed, draw attention and speed up the rate of adoption.
Income taxes artificially increase capital requirements, discouraging new business formation.

The income tax applies when value is created, while the sales tax applies when value is consumed. Since value is first created and then consumed, the income tax is extracted from the economy earlier than the sales tax. Under an income tax system, this time-gap between production and consumption must be financed by the economy, hence higher capital requirements under the income tax.

Direct taxes are embedded in the price of any end product, and most new companies need such products (machinery buildings, etc.) to start operating. A startup firm’s initial capital must cover all this (plus wage taxes relating to any long initial production cycle the firm might face). This extra financing needs pose no problem to large companies with easy access to capital, but could very well prevent a cash-starved entrepreneur from turning his idea into a business.

It might seem the income tax is harmless because it’s levied only in the happy case a profit is achieved, but in fact it is much like a tax to be paid in advance by new businesses in order to be allowed to start operating. In other words… the income tax is a tax on new ideas entering the economy.

To highlight this mechanism consider an island were people fish from the shore until one gets the idea to build a canoe and fish out at sea. He has no savings but the canoe builder accepts a delayed payment. Their plan is doable under a FairTax system but not under an income tax system (click to expand this example).

The VAT implementation of the FairTax does exhibit this problem but in a significantly milder degree in most cases. The sales tax implementation is free of this obvious flaw .

Startups frequently struggle to finance initial capital requirements, while the government can easily borrow for next to nothing. What sense does it make to have startups finance this? It’s like asking startups to put down a deposit (to the tune of 23% of capital) in order to get a license to operate.
Income taxes transfer risk from the state to individual producers.

The income tax isn’t just levied in advance (as shown above), it is also non-refundable: if the venture fails the state does not return the tax paid. Thus the income tax transfers risk from the state to individual businesses. This makes no sense considering that, unlike taxpayers, the state is well diversified (since it is invested in all taxpayers, while taxpayers are only invested in themselves).

Such risk transfer adds to the downside of starting a new business (or even growing an existing one), which is a significant inconvenient. The FairTax does not transfer risk.

Continuing the previous example, even if the fisherman could finance the tax for building the canoe, an inconvenient would still remain: in case of failure (maybe the canoe sinks or fishing out at sea doesn’t work) the state does not return the tax paid, which adds to the risk of attempting to implement new ideas.
The business environment becomes very attractive, especially for foreign capital and would-be entrepreneurs.

The FairTax makes it possible for a foreign company to bring machinery, produce domestically, export to a third country, and not pay any tax at all. Not even off-shore tax heavens allow this!

Short of providing subsidies to domestic producers, the state can’t make the business environment any more attractive than the FairTax does.

Moreover the FairTax eliminates the high cost and stress of complying with a complex and opaque tax system (a significant deterrent for inexperienced, would-be entrepreneurs).
The FairTax is (likely) marginally better for economic growth, and clearly better for improving the economy.

GROWING the economy and IMPROVING it are two distinct feats.
Imagine an economy where everybody digs deep underground at high risk to their life/health to extract gems for one bored multi-trillionaire who thinks their glitter is cute. If they double their effort and dig twice as hard… that’s economic growth! If the trillionaire owns ALL the land he could spur economic growth by simply threatening to evict everybody unless they double the digging (particularly effective if no one can swim).

An economy doesn’t need to be bigger in order to be better, but rather to keep resources focused on priorities, facilitate adoption of new ideas and make it easy for everyone to participate.

How do the two systems compare relative to these two distinct objectives (bigger versus better)?

An elaborate incentive comparison (looking at marginal tax rates) would probably be inconclusive (or at least not clear cut), yielding mixed results depending on income tax brackets. Yet the FairTax is likely more conducive to growth (overall) for a variety of reasons:
- It redeploys significant human resources from tax administration to creating real value;
- It makes starting/growing a business simpler, easier (lower capital requirements) and less risky.
- It gives foreign companies a solid incentive to transfer production facilities inside the country (a later example will support this claim).
But the FairTax really shines in terms of IMPROVING the economy:
- It significantly lowers barriers to new ideas entering the economy (by making it easier for startups to form);
- It shifts economic resources toward basic priorities (away from pointless luxury);
- It makes it easier to find a job and participate in the economy.
  Through a combination of improved social cohesion (everybody gets a monthly check), trend of diminishing self-centeredness (ego-inducing luxury ad budgets get compressed), and wider availability of basic necessities (mainly enabled by the monthly check), the FairTax will lead to a more laid-back society. This in turn will blunt cut-throat competition and thus make it easier for people to participate in the economy.
The main benefit of the FairTax reform consists not in growing the economy but rather in improving it.
Tax evasion becomes significantly more challenging.

Income tax liabilities can be lawfully lowered by using offshore vehicles registered in secretive tax heavens (accepting, once in a while, a $100K charge from the offshore vehicle for some fictitious consulting would do the trick).

Unlike the income tax, the sales tax cannot be avoided using offshore vehicles. To avoid the sales tax one needs to conceal retail sales from tax authorities.

But retail activity, by nature, requires exposure and advertising, not discretion and secrecy . Therefore, hiding a retail activity is way more difficult than hiding a wholesale one.

Also, there are clear economies of scale in tax dodging, so a tax that applies to small value transactions (like the retail sales tax) is significantly harder to avoid than one that applies to big value transactions .

Besides, retailers can’t tell legitimate shoppers from tax inspectors. And even if they did, most shoppers would not accept to participate in an illegal act, and would likely report any such proposal from the retailer.
Inflation overstates income and therefore inflates the income tax (hyperinflation makes this a vicious, hard to escape cycle).

Income basically measures the increase in equity over a period of time. But, during such period, inflation decreases the value of the monetary unit. By measuring end-of-period equity with a shorter yardstick, accounting ends up overstating it, which means income and income taxes are overstated too.

If the rate of inflation is low this problem is mild. But for countries experiencing hyperinflation this can be catastrophic: even a low nominal income tax rate can in fact lead to an 100% (or more!) tax rate relative to real income. This forces companies to apply huge markups just to break even, fueling even more inflation.

The sales tax avoids this mess altogether .
The income tax puts entrepreneurs at a disadvantage relative to established corporations.

If one particular investment project fails, the established corporation can partially recover the loss by offsetting it against the profit of its other operations, thus lowering its income tax liability. But an entrepreneur who loses his life savings in a similar investment project can’t do the same, because usually he has no parallel income stream to offset the loss against.

Therefore, when evaluating an investment, the established corporation and the entrepreneur face a different risk profile for one and the same investment opportunity! This de facto uneven playing field creates a barrier to entry for would-be entrepreneurs.

The FairTax avoids this shortcoming altogether (since it applies to neither the corporation nor the entrepreneur).
The income tax dropping to zero for negative incomes is a mathematical peculiarity that: 1) transfers further risk to the economy; and 2) likely reinforces any existing economic moat.

Defining the income tax as a set percentage of income is straightforward, but making an exception for negative income is a departure from mathematical simplicity. This peculiarity transfers risk from the state to the economy and might reinforce any existing economic moat some corporations might have.
To illustrate this, consider an investment project with a simple probability distribution of outcomes under a common (peculiar) income tax definition, and operate a revenue neutral (in expectation) switch to a non-peculiar income tax.
- The required rate will be higher (to compensate for the cash outlays under negative income). This implies that companies that face a more favorable probability distribution (due to some economic moat) enjoy a lower tax rate at the expense of their competitors.
- Also, comparing the standard deviation of net profits under both tax definitions indicates the peculiarity transfers risk from the state to the economy.
Click here for a detailed numerical example
Consumption can’t be negative so the FairTax doesn’t exhibit this peculiarity and its negative consequences.

Government funding (under the FairTax)

Advantages (relating to government funding)

The sales tax, unlike the income tax, has a straightforward, intuitive rationale.

The sales tax is simple, with low administration and compliance costs.

The sales tax ends the income tax' discrimination against domestic products (in favor of foreign ones). The income tax is basically a negative subsidy to domestic products! 

Income taxes artificially increase capital requirements, discouraging new business formation. 

Income taxes transfer risk from the state to individual producers. 

The business environment becomes very attractive, especially for foreign capital and would-be entrepreneurs. 

The FairTax is (likely) marginally better for economic growth, and clearly better for improving the economy.

Tax evasion becomes significantly more challenging.

Inflation overstates income and therefore inflates the income tax (hyperinflation makes this a vicious, hard to escape cycle).

The income tax puts entrepreneurs at a disadvantage relative to established corporations.

The income tax dropping to zero for negative incomes is a mathematical peculiarity that: 1) transfers further risk to the economy; and 2) likely reinforces any existing economic moat. 

The sales tax ends the income tax' discrimination against domestic products (in favor of foreign ones). The income tax is basically a negative subsidy to domestic products!

Income taxes artificially increase capital requirements, discouraging new business formation.

Income taxes transfer risk from the state to individual producers.

The business environment becomes very attractive, especially for foreign capital and would-be entrepreneurs.

The income tax dropping to zero for negative incomes is a mathematical peculiarity that: 1) transfers further risk to the economy; and 2) likely reinforces any existing economic moat.