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Overview

State funding & social protection.


This overview contains the following sections:

Introduction


The proposed tax system (known in the USA as FairTax) is comprised of two distinct ideas:
  1. Funding the state exclusively by taxing consumption.

    This entails replacing direct taxes (such as personal & corporate income taxes, payroll taxes, etc) with a flat sales tax (at a rate that ensures revenue neutrality).
  2. Redistributing a part of tax revenues evenly to all citizens (aka Basic Income).

    The state sends to everybody (rich or poor, employed or not) a monthly check (same amount to all).
Both ideas are simple and each brings significant benefits on its own, but they complement each other and really shine together (as one system).

Basically, the sales tax makes social democracy economically competitive and therefore politically viable. This lays the foundation for 'universal basic income', social democracy's simplest yet smartest implementation.

The FairTax proposal is being promoted in the US since at least 1997. I intend to promote an almost identical variant outside the US, rebranded as ShareTax.

ShareTax vs. FairTax


FairTax is a catchy name, but, to better promote outside the US, it makes sense to rebrand. ShareTax seems a good choice, since sharing consumption is the core idea .

Two numbers define any ShareTax reform: the sales tax rate, and the percentage of revenues to be redistributed as basic income.

These numbers are a nation’s political choice . I will therefore strip them out of the discourse, and focus solely on promoting the ShareTax core logic.

I do suggest two minor (but not insignificant) changes to the FairTax:
  1. Individuals, rather than families, should be entitled to the monthly check (both for design simplicity, and to avoid mixing the concept of 'family' in a tax debate).

  2. The state should hold in trust a minor's monthly checks until his 18th birthday (to avoid an incentive to overpopulate, and to allow a better start to adult life).

  3.  

Rationale


Unlike the income tax system, the FairTax has a simple, intuitive rationale.
The income tax doesn’t have a similarly straightforward rationale.

Misconceptions


Fully understanding the FairTax implications is not easy, and misconceptions abound. The most complex issues relate to ensuring a smooth transition to the FairTax. Other issues are simpler yet often misunderstood.

A common misconception is that introducing a 23% sales tax (30% relative to net prices) will make prices jump accordingly. Since direct taxes are also embedded in the price of everything, eliminating them lowers prices and makes room for the sales tax to apply with ultimately little or no effect on price levels .

Main issues (quick overview)


The FairTax is progressive in consumption (hard on big spenders and light on the thrifty). Ultimately, the FairTax is a very clever and effective tax on luxury. To facilitate understanding I list the most important issues upfront and elaborate later:
  1. The FairTax greatly upgrades the ability of “big government” to compete in a global economy with free-moving capitals. It has the potential to make social democracy economically competitive and therefore sustainable.

  2. One country adopting the FairTax forces all other countries to do same. The jump in competitiveness will be highly visible due to a sudden currency appreciation. And the competition to attract capital will drive this “domino effect”.

  3. The FairTax will shift economic resources from pointless luxury to basic necessities. This will lower both prices and perceptions of what constitutes a “modest but decent” standard of living. Combined effect will be to stretch the prebate further and make such living standard more widely accessible.


Let’s now look at the two components of the FairTax (government funding and social protection) separately.

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:
  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5. 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.

  6. 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).

  7. 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.

  8. 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.

  9. 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 .

  10. 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).

  11. 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.


Political opposition to FairTax (quick comments)


Many economists like the FairTax but politicians (especially on the left) hesitate, because the sales tax is deemed regressive (in income) and therefore unfavorable to the poor. Such concerns are not only unfounded, but actually get in the way of society helping those in need. Showing this is not particularly difficult but not quite trivial either.

First of all, social protection is a separate objective from funding the government, and should therefore be dealt with separately .

Showing that regressivity is a misplaced concern is not particularly difficult but isn't quite trivial either. The following hints will be detailed later on: Sales tax regressivity might look like a problem, but it isn't. Yet these misunderstandings will dissipate slowly. In spite of regressivity concerns, the FairTax will prove to be a game-changer, with dramatic implications in favor of the poor.


Social protection (under the FairTax)


The FairTax entails redistributing a portion of tax revenues evenly to all citizens through a monthly check called prebate (same amount for all). Thus the FairTax' approach to social protection is essentialy to implement a universal basic income (UBI).

Advantages (relating to social protection)


The FairTax approach to social protection (essentially the same as basic income) has several distinct advantages:
  1. The system is equitable in the sense that everybody (rich or poor, employed or not) receives the exact same amount.


    The FairTax basically creates a threshold for living standards and allows no one to fall beneath it. Without it, society is nothing but a mere jungle.

    Imagine such scheme would have been agreed at time zero (when society first came into being)...

    Nobody would have said it is inequitable! But now some got rich and don’t need the check (mainly because their future is financially secure), so they refuse to fund it.

    However, in the absence of society, their financial security would go up in smoke, and wouldn’t have materialized in the first place. Since the poor are part of, and contribute to a society that makes the rich’s financial security possible... the rich should at least agree for society to provide the poor with some minimal financial security as well.

    And let’s not forget, the rich get the check too!
  2. UBI is extremely simple, and therefore easy to understand and implement.


    Unlike targeted benefits systems, this one doesn’t require any bureaucracy. The burden is minimal for both the government and the recipient:
    • Everybody is entitled to the check, so no need for time-consuming, expensive background checks.
    • Simply mail a check to every citizen, once a month, same amount for all.

  3. It does not create a disincentive to work.


    People get the monthly check no matter if they are employed or not. So there is no disincentive to seek employment, because getting a job does not trigger any loss of benefits.

    Such a disincentive is a serious problem for any targeted benefits system, such as the US “food stamp” program, and even the 'rebate' hidden inside a progressive income tax.

  4. Strengthens social cohesion.


    The monthly check will be for the recepient a tangible, recurrent, and undeniable proof that society cares.

    Such proof will make people feel they are “part of the team”, strengthening social cohesion and reducing criminality.

  5. Does not humiliate the beneficiary.


    Imagine a proud, productive member of society that gets sick, loses his job, skips a mortgage payment, and ends on the street, with no cash or credit. That’s a numbing ordeal.

    The last thing he needs on a psychological level is having to “beg” for social benefits. Filling forms characterizing one’s failure… and waiting in line with other down stricken citizens… that stuff is humiliating at the very worst time, and enough to tip many into a depression.

    The proposed system does not humiliate the recipient, because it doesn’t have to be requested (everybody gets it automatically). Moreover, since everybody receives it (rich or poor, employed or not), there will be no stigma associated with it.

  6. A progressive income tax provides no relief to the poorest (if you have no income progressivity doesn’t help at all).


    The whole point of a progressive income tax is to embed an element of social protection into the fiscal system. In this respect the progressive income tax fails miserably.

    A progressive income tax is mathematically equivalent to a flat rate income tax (the top rate) less a rebate that depends on income according to the formula: rebate = (top rate – actual rate) x income. This equivalence allows a proper comparison with the FairTax, which itself is structured in the same way, a flat rate less the prebate.

    It is immediately obvious that people with no income get no relief under the income tax, their rebate is $0 (under the FairTax they still get the prebate).

    The following numerical example shows that the benefits from progressivity flow entirely to the middle class (which is not surprising given their political clout).

    If the top rate is 40% but your actual rate is only 20% because your income is only $40K, then you get a rebate of $8K. If your actual rate is 10% because your income is a mere $10K, then you get a lower rebate ($3K). And if your income is $0K, you get no rebate at all ($0). So average incomes get higher rebates than low incomes!

    Unlike a progressive income tax, the FairTax delivers effective social protection in a simple and equitable manner.

    Moreover, being poor is not about income, it’s about consumption. Social protection needs to target people that spend little, not people that earn little. Otherwise it might end up helping someone who enjoys a lavish lifestyle, because his $1 million is stashed under the mattress so he has no income.



Shortcomings


A system can’t truly be great without a couple shortcomings (smiley face goes here) so here’s one and a half:

  1. Capital gains are a consequence of exploitation, yet the FairTax doesn’t tax them at all. That's because, in a global market where capitals move freely and countries compete to attract them, directly taxing capital gains simply does not work. So the FairTax wisely avoids picking up a fight it cannot win. Exploitation is a distinct issue and requires a distinct solution.

  2. Any change in the economic framework (even a dramatic simplification such as the FairTax) entails costs and risks: taxpayers might fail to fully comprehend and consequently act in unpredictable ways; producers might use the opportunity to collude to raise prices; and switching to a new system requires a significant one-time effort.

The first shortcoming is diluted by the fact that the prebate effectively claws back some of the exploitation spoils, redistributing them to the likely victims. The prebate deals exploitation a harder blow than a progressive income tax ever could. As of now, basic income appears the most promising mechanism for dealing with exploitation.

The second one is also debatable. The switching costs cannot really be blamed on the FairTax itself, but rather on having to switch from a tax system that was flawed to begin with. Many intricacies fall in this category as the FairTax gets the ungrateful burden of undoing a complex, unintelligent income tax system.

The following example helps clarify the above point.
Two travelers wanting to reach their hometown arrive at a crossroads. The road on the left is short, comfortable and safe. The road on the right is long, difficult and dangerous. They might debate but the smart choice is clear: take the road on the left. Now let’s say the travelers choose to go right and after a couple hours realize their mistake. They now face a different choice: continue or return to the crossroads? Returning might still be best but it now entails two extra hours of backtracking. It’s obviously unreasonable to blame the original smart choice for the need to backtrack (those extra hours are entirely due to the dumb choice made in the first place).

Similarly, it is unfair to blame the FairTax for the costs, risks and complexities of switching from the income tax. The income tax system shouldn’t have been implemented to begin with, and the switching costs are now necessary to set things properly, as they should have been from the beginning.


Switching to the FairTax


A smooth transition to the FairTax is theoretically possible but somewhat unlikely in practice. This raises issues of significant complexity, beyond the scope of this overview. This section will briefly mention the main ones.

What would happen after switching to the FairTax? If properly managed, a plausible, baseline ‘prediction’ is that:
The following issues must be considered/evaluated:
Untangling the income tax’s intricacies to smoothly replace them with FairTax’ simplicity will be a challenge. Click here for a simple, baseline model of such transition.

Main issues (revisited)


Switching to the FairTax is a complex and extensive topic. But three main issues about this reasonable, clever and morally superior tax system should stand out:
  1. The sales tax ends the income tax’ discrimination against its own economy, which is what denies social democracy the economic competitiveness it needs to be politically viable.


    The FairTax is a silver bullet against wild capitalism. It will enable social democracy by allowing it to smoothly navigate a global, hypercompetitive economy, whithout having to constantly swim against its current.

    In a global market with free moving capitals, the income tax determines a race to the bottom with countries competing for capital with ever lower tax rates. In other words, the income tax is the very reason why social democracy is not sustainable.

    Here’s the supporting logic in five steps.
    1. Domestic products compete with foreign ones both locally and abroad. A country’s income tax is always a cost for domestic products but never for foreign ones, no matter where these compete. In other words, it discriminates against its own economy (much like a negative subsidy would)!

    2. Such discrimination translates government size into a direct burden for the local economy, undermining its competitiveness. This link plays a crucial role in stifling social democracy's economic viability.

    3. Seeking extra revenues to fund some social program makes the economy less competitive. This determines a capital flight that sinks the economy and forces the government to scale back. Basically the income tax generates a race to the bottom with countries competing for capitals with ever lower tax rates.

    4. Enter the sales tax. The sales tax ends all this because it doesn't discriminate. It either applies to both domestic and foreign products (when they compete internally) or to neither (if they compete abroad).

    5. By breaking the link (between government revenues and economic competitiveness), the sales tax ends the market pressure on ‘big government’, giving social democracy 'room to breathe'.

    If social democracy is a nation’s political choice, the global market must not be in the way. The income tax is a tool against democracy, and the FairTax is the clever way to set this straight.

  2. One country adopting the FairTax will force all others to do the same, as the only way to stem an outflow of capitals towards the new FairTax jurisdiction.


    The FairTax allows companies to produce and export without ever being subject to any tax. Not even ‘tax havens’ currently allow this! Adopting it gives any country a significant, one-time boost in economic competitiveness.

    The free-market constantly pressures corporations to minimize costs, and therefore capitals will flow into the new FairTax jurisdiction at a brisk pace. This will put overwhelming pressure on other countries to adopt the system as well, in order to stem the flight of capitals.

    All this will be highly visible due to a dramatic and sudden, one-time appreciation of the local currency. Such appreciation should, by the way, completely undo the gain in competitiveness .

    The strength and visibility of this economic mechanism will ensure a fast rate of adoption, potentially making the FairTax a worldwide standard in a short period of time .

  3. The monthly check will shift economic resources away from pointless luxury, ultimately making basic necessities more widely accessible.


    The FairTax is ultimately a very clever tax on luxury, with its progressivity hidden in plain sight: everybody contributes the same percentage (of consumption) and everybody receives the same monthly check (basically a flat sales tax plus basic income).

    Such redistribution from big spenders to the thrifty will make basic necessities more accessible in two ways.
    1. Directly, by endowing the poorest with money to buy basic necessities;
    2. Indirectly, by getting the free market to lower prices with efficiency and innovation.
    Also, perceptions will gradually change about what 'basic necessities' should actually entail. At the very least, this will make people happier about whatever their level of spending is .

    For many people, all these benefits (some immediate, some gradual) will relieve to some extent the stress of making ends meet.


Other socio-political implications


Apart from making 'big government' economically competitive (and therefore sustainable) in the global market, the FairTax will exert overwhelming influence on both politics and society:


Summary


The FairTax system has a fiscal component and a social one: Both ideas are simple and have an intuitive rationale, and each has clear benefits that greatly complement the other.

The FairTax increases the economy’s competitiveness simply because the sales tax (unlike the income tax) does not discriminate against domestic producers .

Such discrimination creates a direct link between tax revenues and economic competitiveness, which keeps capitals away from 'big government' .

The FairTax breaks this link, allowing social democracy to be economically competitive, and therefore politically viable. This will prove a milestone in the evolution of politics and society.

Although the jump in competitiveness will be promptly offset by a one-time appreciation of the local currency , a significant inflow of capitals will still follow, putting overwhelming pressure on other countries to follow suit.

The basic income will help the poorest cover their basic necessities. In time, the shift in economic resources away from luxury will also result in such necessities becoming cheaper, stretching the check further.

Democracy makes it highly unlikely the monthly check will ever be reversed. And since a majority of people benefit from its increase, the political pressure should be there to gradually increase it .

The end result of basic income will be a more relaxed workforce, less likely to engage in cut-throat competition, which in turn will make it easier for people to participate in the economy.

The FairTax will affect society in other ways as well . All these effects will converge into creating a better society for everyone (including the rich).

Whatever the political choice of a nation (whether a 'nanny state' or a 'survival-of-the-fittest' type of capitalism), the FairTax represents the optimal system for its realization.



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Example to illustrate the higher capital requirements and risk under the income tax.


The income tax system makes starting a new business both riskier and more difficult to finance (relative to the FairTax). This likely acts against growing the economy but for sure acts against improving it. In other words, it acts as a deterrent to new ideas entering the economy.

To illustrate this point, consider two fishermen on an island. Fishing one full day usually yields five fish. They can go without eating for a while, but to be able to work they need to eat at least 2 fish/day each.

Under an income tax system they would give one fifth of their catch (20% income tax) to the state. Under a sales tax system they would give one fifth of their meal (25% sales tax) to the state. If the entire catch is always eaten the same day, then the two systems are basically equivalent. But if some of the catch is dried for later consumption then, under the FairTax, the tax payment gets postponed.

Now let’s say one of them (fisherman 1) has the idea to build a canoe and fish out at sea to double the daily catch. The other fisherman (fisherman 2) can build a canoe in 5 days, but he doesn’t believe this will work. So fisherman 1 (the entrepreneur) hires fisherman 2 to build the canoe, for an appropriate daily salary, let’s say 5 fish/day.

Fisherman 1 has no fish saved so he can only pay sometime in the future, but that’s OK with fisherman 2 (he’s willing to get paid at a later date). During the canoe building process, fisherman 1 plans to fish and share the catch with fisherman 2 so they can both work. If the catch is 5 fish/day, then (after taxes) they get to eat 2 fish/day each (just enough to be able to work). This will basically constitute a partial payment on the builder’s 5 fish/day salary, with the balance to be paid in the future (tentatively after the first successful fishing expedition out at sea). This is the plan, and it could improve livelihoods.

At this point the two tax systems have dramatically different consequences:

– A direct tax system would simply prevent this business attempt from happening. Because, at the end of each day, the state would demand both the tax on the builder’s daily salary (5 fish * 20% = 1 fish) and the tax on the entrepreneur’s daily catch (5 fish * 20% = 1 fish). This adds up to a total of 2 fish/day in income tax. The only available source for this tax payment is the entrepreneur’s 5 fish daily catch, but that would leave the two fisherman with just 3 fish/day for consumption, which is below the assumed limit of 2 fish/day/person they need in order to be able to work. Basically the income tax makes it impossible for this venture to go forward!

– The FairTax on the other hand would not be in the way of this venture at all. Because the FairTax doesn’t require the canoe builder to pay any tax on his 5 fish daily salary, until he eventually receives and gets to consume the fish. All they need to pay is the 25% tax on the fish they consume. Therefore the entrepreneur’s 5 fish daily catch is sufficient to cover both their minimum 2 fish daily diet (total of 4 fish) and the corresponding 25% consumption tax (4 fish * 25% = 1 fish). Under the FairTax the entrepreneur has the ability to attempt his project.

The bottom line is that, under the direct tax system the fishermen would be forever constrained to fish from the shore, while under the FairTax the fishermen would not be restrained from attempting a potentially better way to fish. The difference between the two stems from the increased capital requirements under the income tax.

If the fishermen actually have enough fish dried/saved so they can afford to pay the income tax related to building the canoe, a serious inconvenience still remains: if the attempt fails (maybe the canoe sinks, or fishing out at sea yields little) then the state does not return the fish paid as income tax (on salary) to build the canoe. This adds to the overall risk of any business venture.

It should be noted that the income tax system does extract taxes earlier, which means there is a time-gap between state funding under the FairTax and state funding under the income tax system, and this could be viewed as a relative advantage of the income tax. But considering that generally borrowing is much easier for the state than for entrepreneurs (such as the fisherman in the above example), it cannot be reasonably argued that this compensates in any meaningful way for the seriously negative effects on new business formation.

This example clearly shows that the income tax system determines both higher capital requirements and higher risk levels (relative to the FairTax), slowing new business formation and the adoption of new ideas.

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Example to illustrate a plausible, baseline prediction of FairTax’s effects.


As explained before, the FairTax will not determine a jump in consumer prices simply because a sales tax is being introduced. A new 30% sales tax will not produce a 30% jump in consumer prices by any means, because eliminating direct taxes allows prices to drop just about enough to make room for the new sales tax to apply with little or no effect on price levels.

The easiest way to see this is to imagine a closed economy (no foreign trade), with no inventories, where everybody lives paycheck-to-paycheck (paychecks are spent as soon as they are earned). In such oversimplified model a flat 20% income tax rate and a 25% sales tax (with no prebate) are mathematically equivalent, which means that switching from one to the other is not really a change at all and therefore it cannot possibly make any difference.

So what is reasonable to expect upon switching to the FairTax? The following model gives a good idea.

Imagine the US has a flat 20% income tax rate. An entrepreneur has a machinery that one skilled employee can use to manufacture some product (assume for simplicity no materials involved and the machinery lasts forever). The employee needs a few hours to manufacture one piece and for this effort the entrepreneur pays him 10$. After a 2$ income tax the employee earns 8$ net. The entrepreneur sells the product for 15$, makes a 5$ gross profit and pays 1$ income tax, for a net income of 4$. In this economy basically for every product manufactured the employee gets 8$ (about 53% of the value created), the entrepreneur gets 4$ (about 27%), and the state gets 3$ (20%).

The local product competes with basically identical foreign products, both on the domestic market and abroad. The foreign products sell for 15€, which is equivalent to 15$ since the exchange rate is 1.00€/$.

Now let’s say the government switches to a 25% consumption tax (25% applies to the net price). Assume for simplicity there are no inventories. And let’s for a moment further assume that, after the switch, all stakeholders in the US economy jointly agree to reduce all prices by 20% (big assumption but let’s go with it). What happens? Well, the employee’s wage goes down 20% to 8$, but there is no income tax anymore so the net wage is the same as before 8$. The entrepreneur’s revenues drop by 20% to 12$, but the worker’s wage is down to 8$, and there is no income tax anymore, so the net income is still 4$. The consumer price is unchanged since the new 25% sales tax brings the price back up from 12$ to 15$. Finally, when the product is consumed the state gets a 25% tax, which amounts to 3$, same as before.

What about the competition with foreign products? Well, the FairTax slaps a 25% sales tax on imports so their price on the domestic market becomes 18.75€. On the other hand, the price of US products on foreign markets drops to just 12$ (since the sales tax does not apply to exports). All of a sudden the foreign products are no match for US products on either market (domestic or foreign). This one-time jump in US competitiveness is likely to be promptly offset by a one-time, 25% appreciation of the local currency, from 1.00€/$ to 1.25€/$. Following such appreciation the previous equilibrium is reestablished: the foreign product sells for 15$ on the domestic market (18.75€ at the new 1.25€/$ rate) and the domestic products sells abroad for 15€ (12$ at the new 1.25€/$).

But why would US stakeholders jointly agree to reduce all prices by 20%? Well, an argument can be made that, between the two tax systems, there is a correspondence of outcomes: net wages and incomes under the FairTax at 80% prices levels are the same as net wages and incomes under the direct tax system at 100% price levels. If this holds true, then the price level that maximizes wages/incomes under the FairTax is always 80% of the corresponding optimal price under the direct tax system. In other words, if it’s optimal for workers to demand a 10$/product wage under the income tax system, then it is optimal for them to demand 8$/product (80%) under the FairTax. Similarly, if it’s optimal for the entrepreneur to sell at 15$ under the income tax, then it is optimal for him to sell for 12$ (80%) under the FairTax.

The above reasoning does not claim to prove much, this is an oversimplified model and reality is much more complex: employees and entrepreneurs might not realize the above mechanism; many other taxes come into play; the income tax is progressive instead of flat and the sales tax comes with a prebate; the US holds foreign currency and debt denominated in foreign currency, while foreign countries hold US currency and $ denominated debt; etc. However, the above reasoning makes the previous predictions plausible.

The bottom line is that, by switching to the FairTax, consumer prices should not change and neither should incomes/wages, so the purchasing power should be unaffected. The US economy gets a step-up in competitiveness, which should be immediately offset by a corresponding appreciation of the local currency.

In a previous section, a claim has been made that “foreign companies get a solid incentive to transfer production facilities inside the country”. In light of the above model, it is now easy to see that, although net incomes for US corporations remain the same in $ terms (following the adoption of the FairTax), they actually increase when expressed in foreign currency. This fact supports the claim.

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Example to illustrate the negative effects of the income tax rate dropping to 0% for negative incomes.


This example includes 4 steps: 1) consider a simple investment under the common income tax definition and compute the expected value of the income tax; 2) switch to a tax definition without the tax peculiarity and recompute the expected value of the income tax (which will be lower); 3) adjust upward the tax rate to make the switch revenue-neutral (in expectation); 4) compute the investment’s standard deviation of net payoffs and compare with value in step 1. The common tax definition will exhibit a higher standard deviation of net payoffs (compared to a tax definition without the peculiarity).

Step 1

Consider a 1,000$ investment with two possible outcomes. The negative one entails a 0$ payoff and has a probability of 40%. The positive one entails a 3,000$ payoff and has a probability of 60%. This might describe growing vegetables on a small lot. Assume the income tax is a flat 20% but drops to zero for negative income (the common definition, which includes the “mathematical peculiarity”).
The income tax has an expected value of 240$ with a standard deviation of 196$.
The net investment payoff has an expected value of 1,560$ with a standard deviation of 1,398$.

Step 2

We now redefine the income tax by keeping the rate steady at 20% for negative incomes too (we eliminate the peculiarity). Under the negative outcome there is now a 200$ payoff from the state (a negative tax equal to 20% of the loss), the positive outcome is unchanged. The expected value of the income tax drops to 160$ (from 240$ in step 1).

Step 3

We raise the tax rate to 30% in order to make the switch revenue-neutral in expectation. The higher rate brings the expected value of the income tax back up to 240$, with a standard deviation of 441$.
The net investment payoff has an expected value of 1,560$ (obviously unchanged from step 1), with a standard deviation of 1,029$.

Step 4

We compare the standard deviation of the investment’s net payoff under the two definitions and find it is higher under the common income tax definition: 1,391$ versus 1,029$ (a reflection of the lower income tax variability). This means the “mathematical peculiarity” of the income tax (rate dropping to zero for negative incomes) transfers risk from the state to the economy which is an undesirable consequence.
Moreover, under the common definition, the tax rate for positive incomes is lower (more favorable to the taxpayer) than under the normal tax definition (and less favorable for negative incomes). This makes it more likely for players that enjoy some kind of economic moat to benefit from the more favorable rate. In other words it reinforces any such economic moat, which is also undesirable.

The sales tax doesn’t exhibit any of these flaws, as consumption, unlike income, is always a positive value.

The above computations are included in the Excel file risk_transfer.xls

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