Why the Fair Tax Won't Work

Lots of people are convinced that we need to migrate from the income/payroll-based tax system that we have today to a consumption-based tax system. The incentives to do so make some sense in that the consumption-based tax would collect taxes from individuals who otherwise are not paying taxes now. The consumption-based tax is therefore considered a regressive system because tax rates would go down with an increase in the tax base. The tax base would expand to include individuals who make too little money to pay income taxes and it would also include individuals who are otherwise getting some big tax breaks. Everybody has to eat, so everybody would pay tax on money they spend to survive.

The consumption-based system could be designed to be a "fair" tax, but so could the one we have now. I think the name is a complete misnomer in that respect. But I believe the concept is flawed in another way. The income/payroll based system has small and large businesses collecting taxes from their employees and remitting it to the government. There is a reporting system for both income (1099s) and for wages paid (W-2s). If an employer fails to provide an employee with a W-2, the employee can't file his taxes and get his refund and he will squall to IRS. It happens. Likewise if a sole proprietor fails to file his taxes, the 1099s will catch up with him and the IRS will come calling. The system we have is sort of designed to audit itself. IRS would rather audit through computers tracking these forms than calling people to come in with their shoeboxes of receipts.

So if we transition to a consumption-based tax system, small and large businesses will be collecting taxes not from the employees, but from the customers. We have some of that going on with state sales tax and some excise taxes, but not on the scale we would need with a consumption tax. Small businesses can get into financial trouble and fail to remit the sales tax. There is no reporting system to alert the government when this is happening. The government may find that a business has stopped sending the sales tax reports and payments in, or that the amounts have fallen off so that they don't appear to be sufficient, but then the government needs to send out an auditor to check it out. They really don't have a way to know for sure if there is anything broken without sending out a warm body.

As an aside, you may be assured that with the downturn in the economy and state coffers getting low, there is a lot more sales tax audit activity. We are hearing about some aggressive tactics on the part of state governments to replace lost revenues through audit assessment.

My point is that the automated audit system employed by IRS would need to be replaced by a great number of sales tax auditors and tax collectors. And these would be the old style IRS tax collectors with guns on their hips. I don't picture this as being the type of system that fair tax advocates have in mind.