01.07.08

Implications of a “Fair” Tax?

Posted in Finance at 4:41 pm by Valentine

A few years ago, Steve Forbes ran for president on a “flat tax” platform, promising a greatly simplified income tax schedule with a 17% tax assessed on all earned income (with an initial exemption).  Mike Huckabee is pushing an even more radical reform, replacing not only the income tax but also the payroll taxes for Social Security and Medicare with a 30% national sales tax on all new goods and services.  The government would then rebate an amount equal to the tax on a poverty-level income, greatly reducing the burden on lower-income households.

There is no such thing as a free lunch.  If this tax is to support our current level of spending, it must withdraw the same amount of money from the economy.  Who might win under this proposal?  What economic choices might be affected?

  • Imported goods and services would be taxed, eliminating one of the major economic incentives for outsourcing (the avoidance of paying US taxes).
  • Those who have been saving in Roth IRAs would be penalized.  They paid income tax on that money up front in the expectation that it would be tax free when withdrawn for retirement.  Existing savings in taxable accounts would be similarly reduced in value.  If this idea catches on, spend your money quick!
  • The distinction between tax-deferred accounts (e.g. 401k plans) and conventional investment accounts would disappear.  Since taxation would be on consumption, all savings would be tax-deferred.  In theory this should stimulate savings, however the elimination of tax-deferred accounts would also eliminate the penalties triggered by an early withdrawal of those funds.  It could become very tempting for people to “borrow” against their retirement savings, just as many borrowed against their home equity in recent years.
  • FICA taxes are effectively regressive, taxing wage income (up to a limit) but not investment income.  The tax burden on low-income workers would likely be reduced under this proposal.  At the other end of the scale, the wealthiest individuals generally spend only a small portion of their income. Thus their tax burden would also be reduced, with the remainder growing tax-deferred until it is ultimately spent.  This suggests to me that “middle America” would likely bear the brunt of the costs of this plan.

Am I missing any major implications?