This is a long wonky read, with a fair amount of math. If you're not into that, cool.
Now, on to the wonkiness!
On paper and at first glance, as with many schemes designed to simplify the U.S. tax code, the Fair Tax has some appeal. We look back in time, calculate roughly how much money the country needs to fulfill its obligations, foreign and domestic, and then apply a simple formula so that we can raise the needed funds by taxing only consumption. The tax code is simplified, everyone pays the same rate (more on that later), and there is much more money left in the economy where it presumably will do the most good for the most people.
This is an oversimplification in some ways, but that's the gist of it. We would shift our primary focus from the taxation of income to the taxation of consumer spending. Based on calculations done by those who have studied the numbers and developed the policy proposals, the Fair Tax rate on consumption would be 23%, functioning as a point-of-sale tax included in the price of the good or service. It's sort of like a sales tax, but not really, and there are certain exceptions, and everyone would get an annual "prebate" based on their individual and family situations... anyway, it's complicated and the purpose of this post is not an exhaustive review of how it works; there are plenty of resources for that online (FairTax.org).
One of my main pet peeves with supporters of the Fair Tax is the way in which its proponents sometimes misuse terminology in an effort to gain support. I'm not accusing them of being insidious - they have every right to advocate for those policies they think are best. However, when widely understood terms with longstanding definitions are conscripted into service in a way which can mislead, I feel I should do my part to help correct the situation.
The purpose of this post is to lodge a basic complaint about messaging: we live in a world in which the tax system is entirely focused and calculated on the income of a person or corporation, not its consumption. Taxable income can be reduced by many things, including certain expenditures, but tax rates themselves are applied to income-after-deductions, known officially as adjusted gross income or AGI.
In the most recent election, and during the so-called fiscal cliff debate which followed, we heard a great deal about two particular tax-related terms: effective tax rate and marginal tax rate. I will define them in a moment, but in the meantime a brief primer on adjusted gross income (AGI) will be very helpful.
Under our current system, AGI is defined as an individual's total income minus qualified deductions such as student loan interest, mortgage interest, healthcare expenses, various credits, and so forth. Every taxpayer has the ability to access a set of deductions & credits based on their personal situations, and they must qualify in order to take them. Some of them reduce taxable income, and others can reduce taxes owed. To keep things simple, again keep in mind that AGI is post-deductions income. Also, for now, let's ignore capital gains and tax-free instruments such as municipal bonds. We'll only be talking about income from wages, since that is the only type of income received by the vast majority of Americans.
Your "marginal tax rate" commonly refers to the highest advertised tax bracket that applies to a given income level, but since our system is progressive, that isn't the percentage you'll actually owe. You're taxed at 10% of the first $8,700 and then 15% of the next ~$27,000 and so forth. For simple numbers, if you are single or married filing separately, if your 2012 AGI is $100,000 your top tax BRACKET will be 28%, but your marginal tax RATE is 21.4%. See the 2012 IRS tax tables for reference.
Your "effective tax rate" is a reflection of the actual percentage of your GROSS income which wound up going to taxes. The formula is: [total tax owed] / [total gross income]. Again, we're keeping the numbers simple.
Thus, let's say our single person above had gross earnings of $150,000. His or her "effective" tax rate would be 14.3%: he or she was able to itemize $50,000 worth of deductions, resulting in an AGI of $100,000 and therefore a tax obligation of $21,400. [$21,4000] / [$150,000] = 14.3%.
Make sense? Again, this is keeping the numbers fairly simple. I'm intentionally leaving out state taxes of various kinds, or this post would quickly grow to encyclopedic proportions.
Now, here's my complaint about Fair Tax proponents using the term "effective tax rate": ignoring a taxpayer's income, they'll take a given level of spending (i.e., consumption), multiply it by their 23% and come up with the total tax paid. Next, they subtract the "prebate" from the total tax paid, arriving at the actual tax paid. Then, they take THAT number, divide it by the total money spent, and triumphantly announce a figure which they call the "effective" tax rate.
Here's what it looks like:
“@TXFairTaxer: Effective #FairTax rate for AN UPPER-CLASS SINGLE PARENT w/ 1 CHILD (after prebate): Spend $75K/yr = 17.56%”
23% tax on spending of $75,000: $17250.
Prebate is ~$4000.
Total net tax paid therefore is $13250.
Tada!! Effective tax rate is 17.6%, since [$13250] / [$75,000] = 17.6%.
Thus, the focus is entirely on consumption and not income, but the use of the term "effective" tax rate is misleading because you're comparing apples and oranges. We have no clue how much income that "single parent with 1 child" earned, because the Fair Tax neither cares nor keeps track; all we know is that their total spending subject to the Fair Tax was $75,000 in a given year.
Therefore, comparing what we currently understand as an "effective" tax rate to the FairTax notion of an "effective" tax rate is meaningless at best, and misleading at worst. Tax policy debates focus on income, because that's what constituents focus on. They want to know whether they'll be paying more or less as the result of a given proposal.
Since consumption isn't always proportionally related to income, and since there are several types of goods which aren't subject to the Fair Tax in their strategy, this hypothetical person's income could easily be all over the place. Here are some basic calculations. Note that I am changing only their hypothetical income; their spending amount (and therefore their net Fair Tax paid) is unchanged:
Assuming $75,000 total Fair Taxable consumption and a ~$4,000 prebate:
Gross income: effective tax rate
$100,000: 13.25%
$150,000: 8.8%
$200,000: 6.6%
$300,000: 4.4%
It gets worse, though. In an effort to combat the perception that the Fair Tax would represent a huge giveaway to top earners, Fair Tax proponents regularly claim that it is actually a progressive system because people who spend more will pay a higher rate because their prebate as a percentage of Fair Taxes paid is increasingly small. They'll say that someone who spends $1,000,000 has an "effective" rate of 22.6% [$230,000tax - $4,000prebate] / [$1,000,000spent] = 22.6%.
Again, though, we don't know how much this millionaire actually earned. If they earned (via wages) $2,200,000, and had an AGI of $2,000,000 their marginal tax rate would be 33.8%: [$676,761] / [$2,000,000]. Their true effective rate would be 30.76%: [$676,761] / [$2,200,000].
Under the Fair Tax system, their true effective rate would be only 10.27%: [$226,000] / [$2,200,000].
Thus, in our current system, a single millionaire filer will have a true "effective" rate of ~30% pretty much regardless of how much they spend. In the Fair Tax system, at a similar 50%-of-income spending level, their true effective rate would be closer to ~10%.
As for our single $150,000 earner: in our current system, pretty much regardless of what they spend, their rate would be ~14%. In the Fair Tax system, at that $75,000 spending level, their true effective rate would be 8.8%.
My point in all this is that the terms "marginal tax rate" and "effective tax rate" should be reserved for calculations which take income into account. I would propose that the Fair Tax folks consider developing new terms for what they're trying to do. For one thing, "marginal tax rate" is meaningless in the context of the Fair Tax, because there are no brackets and therefore no margins: the tax is level at the point of sale. For example, in a state with a 5% sales tax, I'll pay a nickel of tax if I buy a $1 candy bar, whether I make $20,000 or $2,000,000 per year, and whether that nickel is already included in the sticker price or not.
As for the "effective tax rate," using it in an attempt to persuade knowledgeable people will fail from the start, because they will understand that the Fair Taxers' equation is meaningless. Furthermore, calling the Fair Tax system progressive is only slightly true: it is for the first $100,000 or so of hypothetical income & spending, after which it is anything but progressive. It quickly becomes embarrassingly regressive. I understand that the prebate prevents the Fair Tax from being truly regressive at the lowest income levels, but it certainly LOOKS like a high-earner giveaway.
Based on what I have read, I believe that this central problem is one of the main reasons the Fair Tax Act has languished in Congress for years: it is politically impossible to propose this as a viable system and sell it to the American people because its inherent inequality would make it a laughingstock, especially since it is billed as the "fair" tax system (businesses are exempt?!?!). People were irked enough that Mitt Romney's 2011 effective rate was only ~14%, and even more so when they learned that it would have been closer to ~12% if he hadn't monkeyed around with his charitable giving in order to inflate his rate.
On top of that, removing all capital gains and dividend taxes definitely makes the Fair Tax a non-starter: Romney would have had to be spending an astounding $1,000,000 per MONTH on Fair Taxable goods and services in order to get close to that ~14% true effective rate. I realize that the Fair Tax is as much a philosophical argument as a fiscal one, but given the recent high emotions surrounding the increase of a single tax bracket just a few percentage points, something tells me that a proposal that would drop the top 1%'s effective tax rates to nearly single digits just isn't going to fly.
I do have numerous concerns about Fair Tax implementation, forecasting, maintenance, design, and so forth, but this post is not designed to address those. Nonetheless, I do hope this post proves useful. Please let me know if you have comments, questions, or corrections. My intention here was to make an argument about terminology; it was not to mischaracterize or mislead. I welcome all civilized debate.
Thank you for your time.
