Chris Berry On The Net

Every few years a proposal is put forward to abolish the Internal Revenue Service, or to scrap the entire federal tax code and start from scratch. The plans that have received the most consideration in recent memory were the Flat Tax proposal put forth by Steve Forbes, and more recently, the Fair Tax, which was an essential element of Mike Huckabee’s quest for the Republican presidential nomination in 2008. While supporters of the Flat Tax never gained much traction, a number of Fair Tax supporters are still working quietly to advance their cause.

Both of these plans appeal to the basic sense of fairness held by many Americans that we should all share equally in the responsibility of supporting our government, and that no one should be required to carry a disproportionate share of the burden based on their income. There is also a strong belief among these people that the purpose of taxation is only to provide the revenue necessary for legitimate government functions, and not for social engineering through redistribution of wealth.

The Fair Tax would essentially eliminate all federal income and payroll taxes, and in their place we would have a national consumption tax. In order to compensate for the inherently regressive nature of sales taxes, a “prebate” mechanism would provide quarterly refund checks to everyone for the tax on purchases of essential items representing a poverty level income. Critics of the plan point out the cumbersome nature of this prebate mechanism, and also express doubts about the market turmoil created by the sudden increase in the price of big-ticket items like automobiles and houses. These are legitimate concerns, but they are not the most significant problem with the Fair Tax.

One of the major selling points of the plan is that it eliminates the complexity of our current system which poses an undue burden on taxpayers. The current tax code is complex for two reasons. Politicians are to blame for a major share of the complication due to their inability to resist the tinkering urge, and to constantly build in measures designed to reward favored voting blocs or punish others. The other reason for the complexity is that the law is attempting to establish fair standards for determining what is and isn’t income subject to taxation. This is a complex issue that requires a complex solution, and this is where the logic behind the Fair Tax fails.

Let’s look at two taxpayers who both have incomes of $50,000. Everything about their situations is the same except that one also suffers a loss of $50,000 when his home is destroyed by a natural disaster and his insurance does not cover the entire cost of rebuilding. The current tax code allows him to recoup a portion of this by using the capital loss to offset future taxable income. Under the so called Fair Tax, there is no mechanism to offset his loss, and he would in fact pay a 23% penalty on the cost of rebuilding his home.

Losses are more common in business than for individual taxpayers. At any given time, for every business that is operating profitably, another one is likely to be losing money. This holds true whether you are looking at major corporations or mom & pop enterprises. Entrepreneurial risk is the life blood of our economy, and we depend heavily on small businesses for job creation and continued economic growth. The reality, however, is that the majority of new small businesses fail, resulting in significant financial losses for their owners. By cushioning the impact of potential losses, the current tax code encourages investment and risk that might not take place otherwise. The Fair Tax would discourage entrepreneurial risk taking by failing to provide any sort of safety net for capital losses.