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.

None of these benefits would accrue to America’s low income taxpayers. 

Impacts of H.R. 25 - Ongoing

Prebate - H.R. 25 provides that all lawful residents receive a monthly check, a prebate equal to the Federal income taxes imposed on the expected retail purchases of an individual at the poverty level.

The prebate provides a national sales tax exemption at precisely the poverty level. H.R. 25 provides this prebate to all lawful residents regardless of income or wealth. No amount is provided for unlawful residents. Wealthy would receive exactly the same prebate as America’s poorest legal residents.

H.R. 25’s flat rate national sales tax rate, for a two adult household, would indirectly exclude taxation on $1700 of monthly retail purchases and services by delivering a monthly prebate check or making an electronic deposit of $391. For each additional member of the household, an additional $287 of retail purchases would be excluded resulting in an additional $67 monthly rebate amount.

All purchases of retail goods and services would be taxed at the national flat-tax sales rate of 30% with the expectation that the prebate amounts would be used for the purchase of necessities. There is no mechanism to ensure that the prebate would be spent on sales taxes for the necessities of the individual or his family. There would be no assurance that a child would not go hungry and the funds spent on books, drugs, alcohol or chocolate bars.

Impact on recipients of Social Security - Under current law, social security benefits for married couples are untaxed until the sum of their other taxable income (interest and other pensions) plus one-half of social security equals $32,000.  As income grows, up to 85% of social security can be taxed.

The purchasing power of a couple, totally dependent upon Social Security, receiving $18,776 of social security income decreases by 3.74% under H.R. 25. If that couple has other income, the impact of H.R. 25 is a further diminution of their purchasing power. Middle income retirees would see their purchasing power reduced significantly from their income and by a further reduction of 30% on any of their savings that are expended for retail goods and services. With respect to the taxes on their pre-H.R. 25 savings, these taxpayers would be subjected to double taxation at the Federal level. For many social security recipients, H.R. 25 decreases purchasing power.

Impact on High Wage Earners - At the highest income levels, current Federal income taxes approximate thirty percent (after deductions for state income taxes). If a hypothetical athlete or actor earns $50,000,000 from salary and endorsements, his or her approximate Federal income taxes would approximate $15,000,000. (Contrary to urban legend, it is virtually impossible to avoid this tax unless the athlete or actor is donating significant amounts to charity.) To pay the same amount of taxes with a national sales tax, the professional athlete or actor would need to make, after H.R. 25 sales taxes, retail purchases of over $38,000,000. It is axiomatic that an individual who already owns his home and a few favorite toys is unlikely to annually have this amount of retail purchases of goods and services. As a result, the high wage earner is going to have a dramatic reduction in Federal taxes paid and will have funds far in addition than under the current Internal Revenue Code to invest.

Impact of H.R. 25 on Relative Position of Home Buyer and Rental Residence Investor – H.R. 25 provides that the purchase of a new home by a buyer with the intent of occupying the home for his or her family is subject to the flat rate national sales tax. H.R. 25 provides that an investor purchaser of that same residence would not be subject to the flat rate national sales tax. That taxpayer would charge his renters the flat rate national sales tax. The result is that the investor buyer would have a 30% price advantage in competing with the home buyer for new residential property. The purchase price for the investor would be $300,000; the young couple would pay $390,000.

Impact of H.R. 25 on Personal Tragedy – The current Federal income tax allows a deduction for casualty losses in excess of 10% of income and medical expenses in excess of 7.5% of income. Through these deductions, the taxpayer who has a casualty (Katrina / San Diego fire) effectively receives a deduction in his or her Federal taxes. Under H.R. 25, there is not a reduction in taxes and the citizen must pay an additional 30% sales tax on the lumber to re-build his home after a major fire and/or the wonder pill that is keeping his child alive. This is contrary to the historical spirit of America.

Tax Planning for H.R. 25 (and before)

Tax planners will be attracted to H.R. 25 like bees to honey.

In the initial planning to decrease taxable income in the final year of the current income tax system and in making retail purchases proceeding the first year of the national sales tax, tax planners would puncture expected Federal revenues in both years.

Final year of the Federal Income Tax - Every taxpayer in the Untied States would be attempting to do the maximum tax planning possible in the final year of the Federal income tax. Such efforts would include completely legitimate actions such as:

*       Prepayment of state and property taxes

*       Prepayment of contributions for the next year

*       Prepayment of medical expenses

*       Acceleration of any business expenses that might be deductible – maintenance, repairs etc.

*       Deferral of all sales of property where there would be a taxable gain. Anyone contemplating the sale of any property at a gain (including securities) would, if at all possible, wait until the Federal income tax was eliminated before executing the transaction. Transactions where the purchase would occur for the purchaser and the income would be deferred for the seller would be the item of the day

*       Deferral of salary and other income through the use of any device possible including Rabbi trusts, late payments of bonuses etc.

*       Maximization of depreciation methods

*       One particularly elegant tax planning device would be the legal payment to a self employed retirement plan. This payment is due on April 15^th, at the time of filing the personal tax return. A taxpayer in the 34% tax bracket could make this payment, a maximum of $40,000 on April 15^th and reduce his or her taxes by $13,600. On April 16^th, that person could retrieve the money from their retirement plan tax-free.

*       Corporations would defer their dividends to avoid the income tax on their shareholders in the final year of the Internal Revenue Code.

*       The list, while not endless, would be very extensive and totally legal.

With the expectation of the demise of the Internal Revenue Service and a unique reduction in the number of audits by the Internal Revenue Service, there would be the expectation of increased fraud in the final year of the Internal Revenue Code.

After Adoption of H.R. 25 - For wealthy U.S. individuals, H.R. 25 would encourage them to purchase and keep assets overseas. There would be a 30% price advantage to a villa in Mexico or a castle in Ireland versus a second home in the United States. Other big ticket assets such as yachts etc. would also be best kept and purchased offshore.

Every possible ambiguity would be resultant in plans to avoid a national sales tax. The Treasury would need to continue to propose laws and write regulations to insure that the intended Federal revenues were collected. Tax lawyers and accountants would be there every step of the way to attempt to reduce, legally, their clients’ taxes.

Impacts on Social Security – Self Employed

Self employed individuals currently receive social security benefits based upon their self employment income. Self employment income for social security purposes is currently calculated in a manner identical to the calculation of taxable income for Federal income tax purposes. H.R. 25 calculates self employment income as gross payments for taxable property or services less the sum of gross payments for taxable property or services and wages.

This appears to be a mistake of significant proportion.

The application of H.R. 25, as proposed, would eliminate any consistency between the historical calculation of earnings from self employment and that required under H.R. 25. The proposed change in the rules could be viewed as inappropriate by both retirees and current self employed individuals. Any business that was selling products for re-sale would have no gross payments received for taxable property and therefore no self employment income, regardless of the business’s actual income. In a growing business, where the profits are poured back into the business to buy more equipment, the self employed owner would be garnering no social security benefits.

If self employment income was calculated in the traditional manner, the taxpayer would be required to calculate taxable income under the current Internal Revenue Code after implementation of H.R. 25. This would require the continuance of the Internal Revenue Code and the continuing requirement of a calculation of taxable income for the self employed. It would result in the promise of lesser compliance costs and the elimination of the Internal Revenue Code being inaccurate.

Administration Decisions & Impacts

The Administrative Processes - Requirements

It is uncertain whether the administrative tasks required by the Federal government including the Social Security Administration and the participating states can be accomplished in a timely and fraud free manner. It is uncertain whether the costs of implementing and administrating H.R. 25 would be less than, equal to, or greater than the current costs of the Federal government and the states of administrating the current Federal income tax. The costs of collecting the Federal taxes under H.R. 25 (1/2 of one percent) would approximate the entire 2008 budget of the Internal Revenue Service. With increased costs for the Social Security Administration along with the possibility of states attempting to preserve their state income tax codes, administrative costs of implementing the tax system could easily grow under H.R. 25.

There will be both increased and decreased compliance costs for individuals dependent upon their specific circumstances.

Sales Tax Administrating Authority

1. The first administrative step in the process of implementing H.R. 25 is for the Federal government to enter into an agreement with interested states for the creation of individual sales tax administrating authorities. Included in these agreements with the states would be requirements including confidentiality, collection of the tax, and remittance of the tax. The collection fee paid to the sales tax administrating authority for the tax would be one-quarter of one percent of the amount remitted.
2. Where a state agrees to become a sales tax administrating authority, the state would need to create a staff, develop software and find locations around their state to register lawful residents. The staffing for the original and continuing registration of all lawful residents would include significant numbers of one time and seasonal employees. Where the state did not determine to participate in the process, the Federal government would also need to go through the process of creating a staff, developing software and finding locations around the state to register lawful residents. The sales tax administrating authority would be responsible for collecting the tax and transmitting to the Federal government.
3. The sales tax administrating authority would be responsible for auditing the payors, registrants and administrating the law.
4. The Treasury would be responsible for creating the underlying paperwork for the sales tax payors and providing rules and regulations.

Social Security Administration

Social Security Numbers – The first step in the process of receiving the prebate is the receipt of a social security card. Social security cards are legally produced only by the Social Security Administration. The processing under H.R. 25 would be exceptional in that every lawful child of every illegal resident would be eligible for the prebate. The requirement of an unlawful resident applying for a social security card for his or her lawful children (born in the United States) is problematic. The relationship between the Social Security Administration and the Immigration and Customs Enforcement (ICE) would need to be vetted and clarified. The relationship between ICE and the sales tax administrating authorities would need to be vetted and clarified. As at least two of these entities would be Federal agencies, there could be enforcement opportunities with respect to immigration matters. This would be a serious issue in the United States Congress and many cities and states.

Social Security Administration – State sales tax authorities – information, systems, costs etc. – The system requirements of integrating information systems with fifty separate sales tax administrating authorities would be daunting and expensive. Each state would need to have a system that was integrated with the Social Security Administration and the Social Security Administration would need to be able to move payments from state to state as citizens moved from state to state.

The Social Security Administration relies upon the Internal Revenue Service to audit for fraud in the self employment context. The Social Security Administration relies on the requirement of payroll taxes to insure that extra individuals are not added to payrolls for the purpose of collecting social security benefits. Without the Internal Revenue Service and without payroll withholding, this dynamic of ensuring a fraud free social security system would be lost. An entire system of auditing and enforcement would therefore need to be developed and implemented by the Social Security Administration.

Prebate Administration – Annual Registration and payments to 300,000,000 lawful residents

1. After obtaining a social security number, every lawful resident would have to submit social security numbers and their family information to the sales tax administrating authority for the purpose of the sales tax administrating authority transmitting the information to the Social Security Administration for monthly payment of the prebate. The sales tax administrating authority would be responsible for ensuring that the applicants were legal citizens, signed various assertations about residence, and that there was sufficient information for the Social Security Administration to mail or electronically deposit the monthly prebate to the lawful resident.
2. The Social Security Administration would be responsible for receiving the information from the sales tax administrating authority, ensuring the accuracy of the information (duplicate social security numbers etc.)  and timely sending the monthly prebate checks or making the electronic deposit.
3. Each sales tax administrating authority would receive and transmit to the Social Security Administration changes to the residency, filings including family additions and subtractions, as well as changes of address etc. The information would be updated in perpetuity for births, deaths, changes in address, and marriages.
4. Every lawful resident will be required to annually re-register with the sales tax administrating authority. Assurance that only lawful residents are registered and that no fraud was taking place would be very difficult to achieve. The very nature of large groups of one time and part time employees, which initial and annual registration would require, would exacerbate all levels of risk with respect to fraud and abuse. No state agreeing to be a sales tax administrating authority would have any reason to be concerned with the issue of unlawful residents. State sales tax authorities would have no incentive for accurately performing the registration task as for each unlawful resident considered lawful under H.R. 25, more funds would flow into the state economy.
5. The initial and on-going costs of registering 300,000,000 citizens would be staggering. 

H.R. 25 Sales Tax Collection Administration

Collections – State sales tax authority

The sales tax administrating authority would be required to register each seller in the state using federally produced forms, collect the funds from each seller each month and transfer the money less a one quarter of one percent fee  to the Federal government. The sales tax administrating authority would be charged with insuring that all sales taxes are paid and with auditing the payors. As discussed previously, the auditing task would include determining who owed use tax on items such as houses being converted from investment to personal use and whether houses were rented at fair market value to family members.

Administrative requirements – Taxpayers

Sellers of taxable goods and services would be required to report their sales and pay taxes at least monthly. These reports and payments would be made to the state sales tax administrating authorities. These reports would be required from sellers, including service providers and the self employed. There have to be serious issues with any expectations that small and individual, part-time service providers will comply with these rules. At the lowest income levels, there would be little hope for compliance and a belief that services provided by unlawful residents would result in payments under H.R. 25 would seem to be incorrect.

Wage earners – Each wage earner would be responsible for attaining social security cards for all legal residents of his or her home and annually registering the family with the sales tax administrating authority. These individuals would have a significant reduction in paperwork.

Self employed lawful citizens -

1. Each lawful self employed resident would be responsible for attaining social security cards for all legal residents of his or her home and annually registering the family with the sales tax administrating authority.
2. Before selling a product or delivering a product, every person liable to collect and remit taxes pursuant to H.R. 25 would be required to register with the sales tax administrating authority. This would include sellers of products and services for retail and investors owning property for rent.
3. Annually, a filing would be required with the Social Security Administration with respect to self-employment income. A filing would also be required with respect to self employment income with respect to wages paid to third parties.

The Administrative Processes – The political decision making process

Would a State Agree to become a sales tax administrating authority?

The implementation of H.R. 25 in each state would require each state to make very significant and politically charged decisions. The timeliness of these decisions would determine the time line for possible implementation of H.R. 25. The delay of a single state in making its determination and entering or not entering into an agreement with the Federal government to be a sales tax administrating authority would slow the implementation date of the program. A national sales tax with only forty-nine states ready to begin operation is a non-starter. The implementation of H.R. 25 could only begin on a January 1^st.

H.R. 25 assumes that each state would desire to administer the national sales tax (inclusive of its requirement to annually register every lawful resident). H.R. 25 assumes that the Federal and state governments are capable of registering every legal resident and delivering a monthly check or deposit to each legal resident with competence and fraud-free.

If this author were asked for a recommendation by any state as to whether that state should become a sales tax administrating authority, my opinion would be that there is dramatic downside and absolutely no upside to a decision to become a sales tax administrating authority. There is not a single compelling reason for any state to accept the responsibility of being a sales tax administrating authority. There is  no significant profit to be made by the state, and there is the possibility of a significant loss as the result of the initial and annual registration of lawful residents. There is the possibility of failure to accomplish a confidential and fraud free registration and the accompanying political and legal fallout there from. There is the possibility that simple participation in this process would have significant negative state-wide political consequences.

Would a state repeal its existing income tax?

Regardless of whether a state determined to be a sales tax administrating authority, the state would be required to consider whether it should or could continue to administer its own income tax. Without a state eliminating its own income tax, the promise of a reduction in compliance costs and activities for the residents of that state are lost. In states which continued their income tax, the residents would be required to complete state individual and corporate tax returns nearly identical to the current Federal income tax return along with beginning to comply with the requirements of H.R. 25.

Forty-five states and the District of Columbia have state income taxes. Virtually every state relies on the Federal income tax system in some major part to administer their state income tax system. Most state individual and corporate tax returns begin with the Federal taxable income of the individual or entity filing the state tax return. Most states refer directly and indirectly to the Internal Revenue Code, and Regulations and case law to provide much, if not all of their legal underpinnings for their law. All states with an income tax have arrangements with the Internal Revenue Service to share audit information and individuals and corporations audited by the Internal Revenue Service generally receive a state billing at the end of the Federal audit process be that with appeal to the courts or through negotiation and billing. Not all, but substantially all individual and corporate audits conducted in the United States are conducted by the Internal Revenue Service. State taxing authorities tend to audit only for state residency and state specific income tax laws.

Most states neither have the resources nor the tax expertise to adequately review complex transactions, multi-state or multi-national corporations or complex tax returns. To continue a state income tax system, each State would be required to administer their own law without Federal assistance. This would require recreating all of the elements of Congress, Treasury, Federal courts and the Internal Revenue Service to administer their state tax. If all forty-five states maintained their state income tax systems, the current costs of law, regulation and audit may be multiplied by as much as forty-five times. Further, as time ebbed, undoubtedly, each state would pass laws and rulings not consistent with other states and business and state courts would begin to adjudicate matters differently making the entire issue of complexity an entirely new matter for multi-state businesses. The costs of this would be dramatic.

Should a state abandon its income tax and add a new state sales tax to the sales under H.R. 25, sales tax rates would explode. Total sales taxes collected in some states on every retail transaction could easily exceed 43%. A hotel room in New York City with combined hotel tax, national sales tax, state sales tax and local sales taxes could have a total sales and hotel tax rate exceeding 50%.

Would a state change its state sales tax to conform to H.R. 25?

Currently, most states impose sales taxes, exempting particular items such as food. Today, many or most local governments also impose sales taxes, also exempting particular items such as food. H.R. 25 presents a cascading of issues for every legislature and local government body.

If a state sales tax currently exists, does the state or local government determine to tax everything as provided in H.R. 25 or will the state or local sales tax exempt items currently exempted? Continuing any differences would seriously impact the technology costs of all sellers of both Federal taxable and state non-taxable items. If the state elects to follow H.R. 25, that state could need or feel compelled to initiate its own prebate to ensure that the poor are not suddenly incurring a substantial unreimbursed increase in taxes on food etc. Perhaps, the Federal government would increase its prebate and surcharge the states in some manner for a state prebate. (This would result in different prebates in different states, opening the door to a plethora of issues surrounding equality of value as opposed to equality of prebate payment.)

If a state collects its disability and unemployment taxes from withholding, either it would have to require withholding on salaries, perhaps as the only withhold if Federal and state income taxes disappear, or determine a new methodology to collect such taxes.

Political Issues:

Economics for the State - Each state would need to determine whether one-quarter of one percent is a sufficient payment to administer H.R. 25. The dynamics of the decision are fairly robust. First, is there a profit to be made? If not, why would a state be interested in participating? (If the Federal government will come into the state, hire state residents, lease property in the state and buy local products, unless there is a significant profit to the state from becoming a sales tax administrating authority, there would be no compelling financial reason to become a sales tax administrating authority.) The decision with respect to whether a profit can be made for the state in deciding to become a sales tax administrating authority would include a full analysis of implementation costs. As the intial costs would be expended before the first dollar of tax collections, there might be a significant cash drain on the state from the implementation process. Politically, does the state wish to manage and deal with all of the issues of becoming the Internal Revenue Service in a much more visible way than their current state taxing activities?

Where a state determines to become a sales tax administrating authority and does not abandon their existing income tax, that state should have no interest in its requirement to provide and/or implement the auditing and enforcement provisions of H.R. 25. When an audit produces one quarter of one percent of any collections to the Federal government, the costs of virtually all audits will exceed the revenues to the sales tax administrating authority. With respect to determining the lawful status of a resident, there would be no revenues resulting from the audit process and therefore no benefit to the state from actively pursuing such audits.

Where a state determines to abolish its income tax and adopt the H.R. 25 methodology of taxing everything, there is an argument to be made to stay out of the Federal government’s business and simply consolidate its current tax authorities into one state agency and begin its new sales tax form with: Federal Taxable Retail Sales and Services. There are ample savings available to the state in this scenario.

State Decisions – unlawful residents - Lawful / Unlawful Citizens – One of the most contentious issues in the current political arena is the issue of the unlawful resident immigrant. H.R. 25 proposes to exclude unlawful residents from the “prebate”. In certain states and within certain areas of those states, the number and percentage of individuals who are unlawful residents is very significant. The number of families with both lawful and unlawful residents is also very significant and the resulting increased taxation of food and the basic necessities of life would be a serious issue to be confronted by these individuals and these individual states. There would be significant political pressure to have no part of a system that would increase taxes on the poor, lawful residents or unlawful residents.

While not politically correct to state, there is the possibility of social instability if prices are raised to the poor, regardless of a prebate or not. Certain areas of the country are populated by significant percentages of unlawful residents along with less economically advantaged lawful residents. This is a formula for isolated civil unrest issues following the implementation of new and significant sales taxes on food.

It is of interest that the prebate is intended for any lawful resident. As a result of this notion, all legal alien residents will receive the monthly prebate.

Undoing a state sales tax authority agreement – Based on the statutory language, it would be very difficult for the Federal government to “fire” a state that was not doing an adequate job as a sales tax administrating authority. Beyond that, the Federal government would be totally unprepared to take over the work for a sales tax administrating authority if it won such a battle.

Economic Certainty & Likely Economic Impacts

Macro-economics

This paper does not address the long term macro-economic impacts that would accompany the adoption of H.R. 25. Supply side economists argue that lower tax rates generally increase economic activity and therefore are good for everyone. As the express goal of H.R. 25 is to achieve a tax neutral result, the supply side economists should argue that the impact of H.R. 25 is neutral. This excludes the issues of increased state taxes resulting from H.R. 25 requiring the taxation of state government purchases and the loss of the advantage from tax exempt borrowing.

The impact of disintermediation of the short term macro-economic impacts should be deeply studied before there is any serious consideration of H.R. 25. Further data needs to be collected with respect to the volatility of the securities markets that H.R. 25 could create. The elimination of all Federal taxation of securities transactions would eliminate any potential for an investor to wait out a sudden drop in the marketplace because of income recognition and tax payment issues. This might or might not cause some level of instability in the securities markets.

One of the abilities lost in H.R. 25 is the ability of Congress to stimulate the economy through tax reductions in times of economic decline or malaise. This tool would be permanently lost with a passage of H.R. 25.

Tax Rate

There are conflicting studies with respect to the tax rate that would be required to achieve revenue neutrality with a flat rate national sales tax. The Arduin, Laffer & Moore Econometrics study supporting H.R. 25’s  “23% sales tax on all final consumption expenditures on new purchases” shows as follows:

                                        Revenues Raised in 2004 from Taxes Replaced by the FairTax Proposal

*Individual Income tax receipts include: Personal income taxes, Capital gains taxes, taxes on dividend income, and the Alternative minimum tax.

Source: Congressional Budget Office, Historical Budget Data, http://www.cbo.gov.

                                                           Estimated 2004 Revenues if the FairTax Proposal were in Effect

Issues that should be raised here include: If the government is both paying and receiving the $1,843,400,000,000 of sales taxes on government consumption, should this amount be removed from the schedule? With the advantage being provided to investor-buyers of new residential housing (exemption from the 30% national sales tax), can the taxes being projected from the purchase of new homes be accurate? Are collection costs considered in the analysis? Many other questions need raising and discussion.  

The President’s Advisory Panel on Federal Tax Reform predicted that a national sales tax of 30% would result in more substantial tax evasion than occurs in the current Federal income tax system. This evasion could only be enhanced where states abolish their income tax structure and add their tax collection amount as an additional sales taxes to the 30% proposed under H.R. 25.

Cost of State Government

H.R. 25 would cause an immediate increase in the cost of state government. The 30% sales tax added to the cost of state purchases would increase state government costs by the amount of retail purchases, 30%.

H.R. 25 would result in the loss of economic advantage for state bonds which are issued tax free under the current Internal Revenue Code. There currently are approximately $1,800,000,000,000  in outstanding tax-free state and local debt. Assuming a 2% differential between the tax-free rate and other investment rates, this represents, over time, an increase of $36,000,000,000  in annual costs of local and state governments. There is also the concomitant impact to the value of existing bonds. This impact would be the immediate reduction in value of these bonds which in some cases could destroy the economics of many bondholders.

Exports

If a foreign buyer, not subject to paying U.S. taxes on U.S. exports, has a 30% price advantage over a U.S. purchaser, that buyer can afford to outbid the U.S. buyer and continue to pay a lower price. This is a problem for U.S. buyers.

Imports/Use Taxes

It is notoriously hard to collect use taxes. Taxpayers often consider use taxes as “for someone else”. Collection would prove very difficult.

Microeconomics

Empirically, high volume products with traditionally low margins would have resultant and instant price increases under H.R.25.

Safeway Corporation currently pays approximately 1% of its sales for its products in Federal income taxes. Without study of any other factors and assuming that there is very little in the way of U.S. income taxes paid by its suppliers in its costs (farmers do not generally earn dramatic profits from their products), to achieve the same after-tax profit with the elimination of the Federal income tax and the implementation of H.R. 25, Safeway would have to increase prices by about $ 11.5 billion dollars a year. This equates to an approximate 27% increase in the price of food. There are cascading impacts to this issue. At the poverty level, the rebate would be recalculated only annually resulting in any immediate disintermediation in prices of low margin, high volume items being born by purchasers for the first year. Beyond the poverty level, the increasing taxes on food would impact other purchasing decisions.

Legal Uncertainty

The likelihood of legal challenges in the court system to H.R. 25 is significant. These challenges could result in restraining orders with respect to the initially required administrative steps of implementation. A successful attack on H.R. 25 after elimination of the Federal income tax would be a national disaster. If there is any question as to its constitutionality, a constitutional amendment should be the form of this legislative change.

Constitutionality

Before enactment, at a minimum, a formal finding, available for public review and response by private legal counsel and special interest counsels, by the appropriate legal counsel representing the United States government should be released confirming the constitutionality of H.R. 25. Both the general concept of a national sales tax and the concept of a prebate limited to lawful residents and its enforcement plan should be fully vetted. The language of the sixteenth amendment to the constitution allowing taxation by income tax appears to have been written to provide explicit protection from Article One, sections 4 and 5 of the Constitution.

The recent Ninth Circuit of Appeals ruling disallowing the Federal government from using social security numbers as a methodology of policing immigration should cause anyone to give pause to the entire concept of the prebate being limited to lawful residents and the government’s ability to enforce such a provision.

Unlawful Residents

Courts could intervene on the issue of lawful residents being the only individuals being able to receive the prebate.

The sales tax collection requirement for an unlawful resident represents a significant dilemma. If the registration form asks for a social security number, the unlawful resident will be unable to obtain the correct paperwork to implement the national sales tax under H.R. 25. Those willing and desiring to obey this law, but who remain in the United States illegally would be unable to comply with H.R.25.

Other

Withholding - H.R. 25 eliminates withholding, the most effective manner of tax collection in the world. The current system of withholding would be lost to the Federal government by enacting H.R. 25

Fraud – There is ample academic research that tax fraud expands as sales tax rates go up. Tax fraud also logically expands as opportunities increase. Both are a concern under H.R. 25. For states that abandon their state income taxes, combined Federal, state and local sales tax rates could exceed 43%. This is sufficiently high for sales tax fraud to become rampant. The issue of performing a task as a local maintenance person etc. with a price of $500 cash or $650 with a credit card or check cannot be overlooked.

As there would be no requirement to pay payroll taxes, there would be incentive for fraud with respect to social security filings. Unless the Social Security Administration dramatically increased staffing, there would be little opportunity for the Social Security Administration to review payrolls from businesses which include family members who actually performed no work. These individuals would be added to the social security benefit lists. Adding a sister, daughter etc would be far too easy.

Elimination of the IRS – The plan to eliminate the IRS two years after passage of H.R. 25 would be a mistake. The IRS would need years to complete current audits and a full compliment of auditors would need to be available to audit the last year of the Internal Revenue Code or taxpayers would assume they could get away with anything. Completing their work would take about six years after the passage of H.R. 25.

General claims by H.R. 25  advocates & responses thereto

Proponents of H.R. 25 make the following claims (with responses in italics by the author):

• H.R. 25 eliminates the Internal Revenue Service. – H.R. 25 replaces the Internal Revenue Service with fifty separate sales tax administrating authorities. The Treasury will create a new agency to administer the laws of H.R. 25. It is the tax collecting agency that people have hated for centuries, not the name thereof.
• Closes all loopholes and brings fairness to taxation – In the Internal Revenue Code, one person’s loophole is another person’s definition of fairness. Both the deduction for home interest and a specific credit to encourage research and development can be loopholes for one and intelligent social incentives for another. As people become knowledgeable about H.R. 25, tax planning strategies will develop and loopholes will be identified.
• Ensures Social Security and Medicare Funding – H.R. 25 no more assures funding for social security and Medicare than the current Internal Revenue Code. H.R. 25 would collect the same revenue as the current payroll tax. Adequate funding for social security and Medicare remains dependent upon actions by Congress.
• Brings transparency and accountability to tax policy – H.R. eliminates tax policy.
• Allows American products to compete fairly – Trade policies are by their very nature, very fluid. To the extent that U.S. products begin to arrive in nations where they will ultimately be untaxed, it is safe to assume that trade barriers will be erected to restore the current balance of trade.
• Reimburses the tax on purchases of basic necessities
• Enables retirees to keep their entire pension check – This claim is disingenuous. While the pension check will not be subject to income taxes, the purchase of goods and services will be subject to a flat rate national sales tax on all purchases of retail goods and services. For individuals spending their pension check of good and services, this claim is without meaning.
• Enables workers to keep their entire paycheck - This claim is also  disingenuous. While the pension check will not be subject to income taxes, the purchase of goods and services will be subject to a flat rate national sales tax. For individuals spending their pension check on goods and services, this claim is without meaning.