This presentation is intended to review and raise issues with respect to Federal legislative proposal H.R. 25 (109^th): Fair Tax Act of 2007, the “Fair Tax”. Because the title of the proposed legislation prejudices the discussion, this presentation refers to this proposed legislation as H.R. 25.

Summary of H.R 25:

*       Elimination of all Federal individual and corporate income taxes, payroll taxes, and the Federal estate and gift taxes

*       Implementation of a tax exclusive flat rate national sales tax of 30% on all goods and services sold at retail (ensuring that goods and services are only taxed a single time).[1] Exports would be exempted from the national sales tax. Property purchased for investment would be exempted from the sales tax. Retail purchases of goods and services by government would be subject to the 30% sales tax.

*       The flat rate national sales tax would be administered by agencies organized in the individual states, sales tax administrating authorities. If a state or states choose not to administer the flat rate national sales tax, the Federal Department of the Treasury would become the sales tax administrating authority in such states. In all events, Treasury would have general rule making responsibilities.

*       All lawful residents would receive a monthly “prebate” intended to be equal to the sales tax on cumulative expected monthly purchases at the poverty level. Unlawful residents would not receive the prebate. The prebate would be paid by the Social Security Administration acting upon information provided by sales tax administrating authorities.

*       H.R. 25 significantly revises the definition of self employment income for social security benefit calculation purposes.

H.R. 25 – Conclusions

• With all of its complexity, the current Internal Revenue Code is a more evenhanded approach to collecting necessary Federal revenues than H.R. 25. This is not to say that the author believes the current Internal Revenue Code is the right long term answer for the United States; it is to say that H.R. 25 is not the right long term answer.

Impacts on Taxpayers

• H.R. 25 eliminates any differential in the rate of taxation between the first dollar purchase over the poverty line by low income Americans and the last dollar purchase by the richest Americans.
• In any state where there is a decision to eliminate their state income tax, the combined Federal, State, and local flat sales tax rate could easily exceed 43%.
• H.R. 25 would result in an immediate reduction in purchasing power upon implementation for existing savings which have previously been subject to U.S. income taxes (double taxation).
• H.R. 25 would result in a very significant competitive purchase price advantage given to an investor purchasing a new residence over a couple wishing to purchase the same property as a home.
• H.R. 25 would result in an on-going and significant reduction in purchasing power for many social security recipients with other sources of income or savings.
• H.R. 25 would result in the elimination of the safety net provided by the Internal Revenue Code in reducing Federal taxes for victims of disease and disaster, the elimination of incentives to save through pension plans or investment retirement, and the elimination of credits and deductions for child care.
• H.R. 25 would result in an increase in purchasing and investing power for very high wage earners and the ability of the wealthy to earn profits from investments and reinvest without taxation while low income Americans are paying an H.R. 25 designated 30% Federal sales tax on food. The ability of the wealthy to pass along exceptional levels of never taxed wealth, tax-free, generation to generation, seems a prescription for a feudal system.
• Under H.R. 25, while there could be a reduction of compliance requirements for wage earners and retirees, compliance activity for the self-employed and service providers would increase. If a state did not eliminate their state income tax, there would be no compliance reductions for wage earners or retirees.

Impacts on Social Security Benefits – Self Employed

• H.R. 25’s proposed change in the definition of self employment income for the ultimate receipt of social security benefits is bizarre, unfair and unworkable. Under the language of H.R. 25, many self employed individuals currently earning social security benefits would no longer be earning any social security benefits.

Administrative Decisions & Impacts

• H.R. 25 anticipates that virtually every state will willingly agree to become a sales tax administrating authority.  Given the proposed fee for this administrative task and the political risk that would accompany this decision, it is possible that not a single state would decide to become a sales tax administrating authority.
• The administration required to implement and thereafter continuously administer H.R. 25 might be beyond the capability of Federal and state government. It may also be far more expensive than administration of the current Internal Revenue Code. (The proposed collection fees alone under H.R. 25 approximate the total annual budget for the Internal Revenue Service.)

The very notion of initially and annually registering 300,000,000 lawful citizens, providing a monthly check to each and believing this can be accomplished confidentially, efficiently and without fraud has at least a touch of unreality to it.

H.R. 25 could not be implemented until (1) a sales tax administrating authority was established and successfully organized and staffed in every state, (2) every lawful resident given a legitimate social security card, (3) every lawful resident registered confidentially and without fraud, and (4) this information transferred to the Social Security Administration and reviewed for duplicate social security numbers and general fraud issues.

Economic Certainty & Likely Economic Impacts

• The economic risks, particularly in the immediate aftermath of implementation, are far too significant to the overall economy to chance.
• There are conflicting studies projecting the necessary tax rate required to achieve neutral tax revenues under H.R. 25.
• There have been no micro-economic studies with respect to the impact of H.R. 25. The lack of study with respect to the prices of high volume, low margin products (food) is especially worrisome.
• Taxing state and local governments on their purchases and providing no interest rate advantage to state borrowings must result in significant tax increases at the state level.
• Basic tax planning that would occur in the final year of the Internal Revenue Code and the first year of H.R. 25 would reduce Federal revenues by a very significant amount.

Legal Uncertainty

• H.R. 25 is fraught with legal uncertainty. There are constitutional arguments that H.R. 25 would be unconstitutional with respect to constitutional limits of Federal taxing power.
• There would be state and local challenges with respect to the exclusion of unlawful residents from the receipt of the prebate.
• The World Court could probably weigh in with respect to trading issues.

Other

• With every major conceptual change, there will be thousands of different interpretations of the rules. It would take years to sort these interpretations out. During that period, Treasury would issue volumes of rules and regulations.
• The opportunity for Social Security fraud would increase with respect to actual employment.
• Should U.S. products begin to appear in the world market place at prices significantly lower after the removal of Federal income taxes, tariff responses could be expected.
• With exports untaxed, U.S. goods could be 30% more expensive for Americans than the remainder of the world.

H.R. 25 – Intended Results & Apparent Philosophy of H.R. 25

H.R. 25 would replace the Federal income tax, payroll taxes and the estate and gift taxes with a flat rate national sales tax. After reimbursing (in advance) lawful citizens for the estimated sales taxes levied upon the dollar value of estimated necessary retail expenditures at the estimated national poverty level, all lawful citizens would pay a flat rate national sales tax on all purchases of retail goods and services. Unlawful citizens would not receive a prebate.

H.R. 25 represents a philosophy of tax collection without any attendant social or economic policies.

H.R. 25 – Purchasing Power vs. the Tax Rate

There has been a significant amount of discussion regarding the proposed sales tax rate in H.R. 25.

H.R. 25 proposes a 23% “tax inclusive” sales tax rate. Sales taxes are not traditionally described in a “tax inclusive” manner. Sales taxes are traditionally described in a “tax exclusive” manner. A “tax inclusive” sales tax rate is a percentage of the total register price. A “tax exclusive” sales tax is a tax calculated on the purchase price before the tax is added. As shown below, a 23% “tax inclusive” sales tax rate is equal to a traditionally described “tax exclusive” sales rate of 29.87013%.

This paper refers to the tax rate as proposed in H.R. 25 as 30% (rounding 29.87013% to 30%) so that the tax rate may be more accurately compared and contrasted with other sales tax rates which are traditionally described on a tax exclusive basis. Using the traditional “tax exclusive” rate of 30% will neither increase nor decrease the tax shown for any transaction; it provides only clarity in presentation.

The important point of this discussion is not to dwell on the appropriate description of the tax rate, but to understand the impact of H.R. 25 on purchasing power. The following chart contrasts the purchasing power to the individual buyer of his or her purchasing dollars of (1) H.R. 25 on income previously taxed under the current Internal Revenue Code, (2) the current Internal Revenue Code using three separate average tax rates, and (3) H.R. 25 on income after the implementation of H.R. 25:

                                               Purchasing Power                   Purchasing Power             Purchasing Power

                                                     Of Dollars                              Of Dollars Earned               Of Dollars Earned

                                                Earned & Saved                              Under The                             Under

                                           Before Implementation               Internal Revenue Code                H.R. 25

Calculating the impact on an individual’s purchasing power is difficult because every Federal income tax return is different and average rates of tax can be difficult to calculate. To determine relative purchasing power of future income and receipts one needs determine the gross income of the individual and actual purchases at retail. Individual calculations for the impact of H.R. 25 would require the following analysis:

                Total Gross Income From All Sources                              Total Gross Income From All Sources

                Including Social Security, Insurance                                Including Social Security, Insurance

Reimbursements, Tax Exempt Income, etc.                      Reimbursements, Tax Exempt Income, etc.

                Less:                                                                                       Less:

Federal Income Taxes & Federal Withholding                H.R. 25 taxes on Retail Purchases of Goods

Taxes                                                                        & Services (calculated with either a tax   inclusive rate of 23% or a tax exclusive rate
of 30%)                                            

                Purchasing Power - Current Law                                       Purchasing Power - Under H.R. 25                                   

The concept of purchasing power vs. raw data clearly confuses the strongest supporters of H.R. 25. The following is copied from the Fairtax.org website:

The FairTax benefits retirees who depend mostly on Social Security.

For older, low-income households, the FairTax generates a major reduction in remaining lifetime taxes. Again, the reason is that the elderly not only continue, under the FairTax, to receive the same real Social Security benefits, they also receive the FairTax prebate. The average Social Security benefits for a retired couple living solely on Social Security are $18,776. The FairTax prebate for this couple is $4,697 which is $381 more than the FairTaxes the couple would have to pay if they spent the entire $18,776 on taxable consumption.

Every word of the above paragraph is accurate. However, the inference that the result is good for this retired couple is incorrect. Under H.R. 25, the purchasing power of the retired couple referred to in the example is actually decreased under H.R. 25 from $18,776 to $18,704.

Note that if this retiree is also spending funds from savings, the reduction in purchasing power is enhanced under H.R. 25.

H.R. 25 - Impacts

Impacts on Taxpayers

• Analysis of the comparative impact at and after the implementation of H.R. 25:

*       At implementation, existing savings will have diminished purchasing power of 30%.

*       At implementation, high earning citizens with deferred income from such items as pension plans and stock options would have immediate increases in purchasing power.

*       At implementation, investors would have the ability to sell investment assets without Federal taxes. The proceeds of such gains would be immediately available for reinvestment without any Federal tax consequence.

*       At implementation, citizens would be able to make unlimited gifts without tax consequences and estates of any size would be able to be passed from one generation to the next without Federal taxation.

*       At implementation, all of the social and business incentives, benefits and disincentives included in the Internal Revenue Code disappear:

*        Incentives

•       Home interest deduction – encouraging home ownership
•       Individual retirement plans, self employed pension plans, pension plans for businesses – encouraging saving for retirement
•       Contribution deductions - encouraging contributions to charity
•       Adoption credits – encouraging adoption
•       Lower tax rate on capital gains - encouraging investment
•       Lower tax rate on dividends - encouraging investment
•       Energy credits – encouraging protection of the environment
•       Research & development credits – encouraging research & development

*        Benefits

•       Deduction – casualty losses – lessening taxes after calamity
•       Deduction – medical expenses – lessening taxes during serious illness
•       Deductions & credits – child care costs – making it possible for parents to earn a living and feed their families
•       Credits – foreign tax credit – ensuring that Americans working abroad are not double taxed on their income
•       Reduced tax rate - social security income – lessening taxes for elderly

*        Disincentives

•       Loss of deduction – excess corporate compensation

*       At implementation, those individuals who have deferred income from Federal income taxes and who would be subject to estate taxes upon receipt of those funds or death, would permanently avoid those taxes

*       Ongoing, many, if not most, retired individuals receiving social security and currently paying Federal income taxes or spending cash savings would have diminished purchasing power.

*       Ongoing, for high income earners and the very wealthy, it would be virtually impossible for there not to be a reduction in Federal taxes  

*       Ongoing, the purchase of a home built after implementation of H.R. 25 would cost 30% more for a family than an investor.

*       Ongoing, existing alimony agreements would become a serious problem. Such agreements contemplate increased buying power for the payor of alimony through tax deduction and decreased purchasing power for the recipient through the payment being taxable income.

• For many individuals, the compliance requirements of H.R. 25 would be significantly increased. Service providers, investors owning property, and people performing part time jobs would be required to file monthly sales tax reports with the sales tax administrating authority.

Impacts on Social Security – Benefits Calculation For Self Employed Individuals

·         H.R. 25 modifies the definition of self-employment income:

Gross payments received for taxable property or services

Less: Gross payments made for taxable property or services (without regard to whether tax was paid pursuant to section 101 on such taxable property or services)

Less: Wages paid by the self employed person to employees of the self-employed person

Self Employment Income

*       Self employment benefits would be calculated differently for the self-employed following implementation of H.R.25. Income calculated in a traditional manner would no longer be the basis for social security benefits for the self employed.

*       Self-employment income for social security purposes would exclude all self-employed individuals who are selling non-taxable products or delivering non-taxable services, resulting in a total loss of social security benefits

*       Self employment benefits would decline should a self-employed individual purchase equipment for the underlying business, thus discouraging the self-employed from investing in their businesses, a concept clearly at odds with any steps designed to expand the economy

Administrative Decisions & Impacts

• Analysis of Administrative & Political Issues At the State Level

*       Each State would be faced with a series of difficult decisions with respect to whether it chooses to become a sales tax administrative authority and/or makes changes to its own method of taxation. Each of these decisions would include both political and financial implications. There is no assurance that a single state would determine to become a sales tax administrating authority. Where a state determines not to become a sales tax administrating authority, the Federal government would assume that role.

*       In states that determine to eliminate their existing income taxes and piggyback these revenue requirements on the new national sales tax, sales tax rates could exceed 43%. (In a California city with a current sales tax of eight percent, if California terminated its income tax and substituted a new flat rate state sales tax of 6%, the combined local, state and H.R. 25 rate would approximate 44%.)

*       In states that determine to maintain their existing state income taxes, there would be no reduction in compliance activities regarding the income tax and there would be increased compliance requirements under H.R. 25. The administrative costs of maintaining an income tax at the state level without the existence of a Federal income tax would be very substantial.

*       Because H.R. 25 requires state and local governments to pay the national sales tax and because the states would lose their ability to borrow funds at favorable tax exempt rates, it is possible that state legislators would have no interest in doing anything to make the process of implementing H.R 25 easy.

Economic Certainty & Likely Economic Impacts

• The Federal government will lose its ability to influence the economy or individual behavior through modest or significant changes in the Internal Revenue Code.
• The application of H.R. 25 to purchases by state and local governments would increase the costs of state and local governments and require an increase in state and local taxes.
• The loss of the rate advantage available to state and local government in issuing tax-exempt bonds would increase the costs of state and local government and would require increases in state and local taxes.
• At implementation, there would be immediate impacts on pricing and disintermediation in certain markets. Prices on high volume, low margin items, such as food, would likely increase dramatically.
• At implementation, foreign buyers of American retail products would have a 30% competitive price advantage over Americans.
• Tax planners would legally, easily, successfully and materially reduce Federal income tax revenues in the year precedent to implementation of H.R. 25 and successfully reduce Federal national sales tax revenues in the year following implementation.
• With H.R. 25 eliminating the Internal Revenue Service two years after implementation of H.R. 25, it can be projected that auditing of tax returns for the final year of the current Federal income tax would be very low. Therefore, it can be projected that fraud by both non-filing and enhanced fraudulent deductions or unreported income would be greatly enhanced.
• That a national sales tax rate of 30% would produce revenues equal to the revenues produced by the existing income, payroll, estate and gift taxes is unproven.
• Ongoing, there will be a significant incentive to spend money in other countries; there would also be a significant incentive to leave retail purchases in other countries. There would be a significant incentive for individuals buying second homes to locate those homes outside the United States and avoid the 30% national sales tax on that purchase. There would be a significant incentive to make retail purchases in other countries and not report their use upon bringing them into the United States.
• Large retailers would be required to post bonds of 1.5 times their average monthly sales tax liability, amounts well beyond the financial capabilities of some businesses.

Legal Uncertainty

·         Proceeding with a new form of Federal taxation without a constitutional amendment to assure that the methodology is constitutional would be foolhardy. Without a constitutional amendment, surely to be challenged under the Constitution is the ability of the national government to tax purchases by the states. Challenges might also be offered on constitutional grounds with respect to the ability of the national government to impose a national sales tax and the exclusion of illegal residents from receiving the prebate.

·         State & local legal issues could be raised including the relationship of taxing authorities with Immigration Customs & Enforcement. Would the state sales tax authorities attempt or be required to inform Immigration Customs and Enforcement of the location of families which included unlawful residents.  Challenges might arise with an interpretation of the law to be effectively requiring national identity cards.

·         State and local legal issues might be raised as to the propriety of providing prebate benefits to legal residents who are not citizens.

·         There could be a plethora of international legal issues including treaty enforcement and unfair trade issues.

Other

·         Charging a sales tax on purchases by the Federal government and subsequently paying two levels of administrative fees to collect this tax would increase the cost of Federal purchases by the ½% fees.

·         With the elimination of payroll taxes and income taxes, adding employees to payroll lists for purposes of increasing individual social security benefits would come without cost to employers. The Social Security Administration is neither staffed nor sufficiently experienced to audit for such issues.

Immediate Loss of Buying Power – The current purchasing power of after-tax savings would immediately decline by 30%. Cash that would have purchased $1000 of goods and services would now only provide for $770 in purchases of retail goods and services.

Loss of assets – Any current holder of long term tax exempt debt would immediately sustain a dramatic decrease in the value of their assets. Without the tax-free advantages of state and local debt, new investors would dramatically discount the value of existing long term state and local debt.

Immediate Increases in Buying Power - For taxpayers with deferred ordinary income (various types of pensions, deferred salary plans, stock options etc.), there would be an immediate increase in purchasing power. Upon implementation, a corporate executive who is the holder of qualified stock options with a value of $2,000,000 would see an increase in purchasing power of over $200,000 after exercise of the options. Should that person choose to reinvest those funds, the increase in investing power would be $700,000.  (Under current Federal income tax law, the executive received the options without any taxation and with the expectation that upon exercise of the options, he or she would pay income taxes at ordinary income tax rates.)

For individuals with pension plans or investment retirement accounts, under the existing Internal Revenue Code, there are penalties as well as Federal income taxes if they take access to those assets before age 55. These penalties would disappear as the funds could be immediately accessed without Federal tax.  For individuals who receive the funds after age 55, the funds are currently subject to income taxes at the time of receipt. With implementation of H.R. 25, these individuals would be able to receive these funds, for which they had previously received a reduction in federal income taxes, tax-free. These taxpayers would also receive the earnings that these funds had previously generated without taxation.

Generational Wealth Increase – Accumulated wealth is currently taxed in the United States through the estate tax upon death and via the capital gains tax when assets are sold at a profit. With the current estate tax, there is no estate tax on net assets of $1,500,000 or less. The estate tax rate on net assets over $1,500,000 begins at 18% and rises to 45% until the taxable estate reaches $2,000,000. The estate tax rate increases to 46% on net assets over $2,000,000. With basic estate tax planning, a couple with assets of $3,000,000 escapes all Federal estate taxes. H.R. 25 would eliminate the estate tax in its entirety. The ability to move money from generation to generation is an issue

That should be more deeply considered.

For individuals that have invested in real estate for their entire lives, because of existing Federal income tax rules, many have never paid Federal income taxes on the appreciation of their assets. For these individuals, the only tax to which they would currently be subject is the inevitable estate tax.  Their increase in both buying power, investment power and the ability to pass wealth tax-free through generations explodes with the end of gift and estate tax.

For those with untaxed gains in investment assets, there would be an instant ability to generate gains and pay no Federal taxes prior to reinvestment of the proceeds. For example, assume a taxpayer purchased a stock in 1980 for $100,000 and that stock is now worth $500,000. Today, if that individual sold that investment, he would pay a Federal capital gains tax of 15%, $60,000. If the income tax were repealed, that person would have the entire $500,000 to reinvest. Continued...