This week, we take on the criticism that the FAIRtax will create a huge evasion problem because the rate is so high.
It’s true that the FAIRtax rate of 23% tax-inclusive is higher than the sales tax rates that most of us are used to. But many countries’ Value Added Tax (“VAT”) rates come close. Germany’s standard rate, for example, is 19%. The VAT rates in the Scandinavian countries are actually higher, 24-25%. These rates, however, are tax-exclusive. They would be lower if quoted on a tax-inclusive basis as the FAIRtax is.
Despite what seems like a really high rate, there are several reasons why evasion and non-compliance under the FAIRtax will drop dramatically. First, it takes two people working together to cheat the FAIRtax—a willing seller and a willing buyer. Under the income tax, it only takes one. A taxpayer who does not have his regular wages reported to the IRS by his employer can easily understate income or overstate deductions and avoid detection.
The FAIRtax is simple. Because it’s simple, it is perceived as fair, and voluntary compliance rises.
The number of collection points under the FAIRtax drops from 155 million to 20 million. There will be plenty of “formerly employed” IRS agents available for hire to enforce the tax.
Most retail sales in the United States are made by major chains and big-box stores. The clerk at the cash register there will have neither the incentive, nor the ability, nor the authority, to help someone evade the tax.
What about those small, independent businesses such as your plumber, your lawn maintenance guy or your local garage mechanic? What’s to stop them from offering under the table, tax free deals for cash? As it turns out, plenty.
First, even if they don’t make retail sales themselves, suppliers to these businesses must register. Registration provides tax auditors with a trail. When your local garage mechanic buys parts, bulk oil or even shop rags, the mechanic will have to show the supplier his registration certificate in order for the supplier not to charge the mechanic tax.
The state tax authorities who will be enforcing the FAIRtax have a number of ways to detect cheating. Through years of experience, they’ve gotten pretty good at knowing what your mechanic’s sales should be based on the amount of supplies he has purchased. They also have computers that let them compare a particular business’s reported sales with other businesses of similar size. If the sales numbers fall outside the expected norms, you can bet that the authorities will swoop in with an audit, and if you’re caught cheating, the penalties are severe.
What is the non-compliance rate of a typical sales tax? David Duran (“Addressing the Tax Gap …,” California State Board of Equalization 2014) once analyzed evasion and non-compliance of California’s state sales tax. He estimated that the sales tax gap for California at about 5%. However, most of the problem came from California’s Use Tax, that is part of the sales tax.
Use Tax is owed on sales that originate from out-of-state. If we subtract the Use Tax evasion rate from the overall rate of 5%, the remaining evasion rate from in-state sales in California is 2.45%. California did not have the ability to control out-of-state sales. This opened a window of opportunity for cheaters to evade the Use Tax.
However, with the FAIRtax, goods and services from outside the country will be controlled at the border. That means that the FAIRtax will not have the same problem with out-of-country sales that California had with out-of-state sales. There will be no such window of opportunity to evade the FAIRtax like there was with California’s Use Tax.
Compare the California non-compliance rate of 2.45% with today’s evasion of the income tax. In 2017, Professor Richard J. Cebula of Jacksonville University undertook a study which concluded that the Federal tax gap will exceed $9 trillion over ten years. The tax gap is the difference between what is owed and what is actually collected.
Professor Cebula estimated the tax gap for 2017 at $489 billion. According to the Congressional Budget Office, the government took in $1.6 trillion in income taxes in 2017. Therefore, Professor Cebula’s figures indicate a tax gap of nearly 31% for 2017. In other words, 31% of income taxes that were owed were not paid, either through inadvertence or intentional evasion, and that’s projected to be even higher in future years.
Again, compare that to the 2.45% non-compliance rate for California’s sales tax and it’s clear that evasion under the FAIRtax will be significantly less than the evasion we’re seeing with the income tax.
Our board member, Jade Walle, CPA and partner in a Big Four public accounting firm, perhaps explains it best. Jade describes a fraud triangle as a three-legged stool. The legs are opportunity, rationalization, and pressures or motivation. If any leg of the three-legged stool is eliminated,
then the fraud stool falls down and fraud generally cannot occur.
With the FAIRtax, all three legs come off the stool. First, the dramatic drop in collection points greatly reduces opportunity. Rationalization drops because more people perceive the tax system as fair because everyone pays tax. Pressures and motivation drop because the FAIRtax gives everyone a chance to earn a living legitimately.
Despite the fall of the three-legged stool, there will still be some fraud with the FAIRtax. It’s just a fact of life that wherever there are taxes, there are people who will find ways to get around them. But compared to the income tax, fraud under the FAIRtax will be miniscule.
I would love to hear from you about how to squeeze this explanation into a soundbite.
AFFT Grassroots Coordinator & Secretary
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