Comparing Average And Marginal Tax Rates Under The FAIRtax And The Current System Of Federal Taxation

The FAIRtax is a proposal to replace these federal taxes with a federal retail sales tax, assessed at a single rate.

*  Personal income tax
*  Corporate income tax
*  Payroll (FICA) tax
*  Estate tax
*  Gift tax
*  Generation-skipping tax

The FAIRtax also provides a rebate to each household based on its demographic composition.   The rebate is set to ensure that households living at or below the poverty line pay no taxes on net.

This paper compares average and marginal labor income and saving tax rates under the current federal tax system and The FAIRtax.  As specified in H.R. 25/S. 25, the legislation that would implement the reform, The FAIRtax’s tax rate is 23 percent and is measured on a tax- inclusive basis, meaning that a dollar’s expenditure would yield 77 cents in consumption after payment of the retail sales tax.

Although Gale (2005) questions whether a 23 percent tax-inclusive rate would suffice to maintain real federal spending and also cover The FAIRtax rebate, a recent analysis by Bachman, Haughton, Kotlikoff, Sanchez-Penalver, and Tuerck (2006) based on CBO 2007 projections indicates that less than a 3 percent scale-back of non-Social Security real federal expenditures would be needed to accommodate a 23 percent FairTax rate.  As a share of GDP, these expenditures have risen by over 20 percent since 2000.

In asserting that a real revenue-neutral 23 percent FairTax is feasible, Bachman, et al. (2006) assume that the revenue losses due to evasion and avoidance under The FAIRtax will be no greater than those already incumbent in NIPA measures of household consumption.  In so doing, Bachman, et al. (2006) may overstate The FAIRtax revenue base.   On the other hand, Bachman, et al. (2006) likely understate the revenue base in ignoring The FAIRtax’s general equilibrium, macroeconomic feedback effects.

Indeed, as discussed in Kotlikoff (2005), introducing The FAIRtax would likely raise real wages by 19 percent over the course of the century relative to what technological improvements would otherwise generate.  On the other hand, Kotlikoff’s paper shows that the aging of society, interacting with our Social Security and government health care systems, will place significant stresses on the nation’s finances.  And the ability of the government under a FairTax to maintain the tax system’s tax rate at 23 percent or, indeed, even lower, will depend critically on reforming these major entitlement programs.

Households finance their current and future expenditures on consumption based on their current wealth and their current and future labor earnings.  Hence, taxing consumption expenditures is effectively equivalent to taxing existing wealth and labor income.  Given its 23 percent rate, The FAIRtax would effectively tax both existing wealth and current and future labor earnings at a 23 percent rate.

As shown here, current total effective federal marginal tax rates on labor supply appear to be either higher or much higher for almost all American households than they would be under The FAIRtax.  The current system’s marginal wage tax rate exceeded The FAIRtax’s 23 percent marginal rate for all of the 42 single and married stylized households we considered.

To read the entire report, download the file.