FairTax, the ‘Fair’ Tax Code Reform

Last updated on June 10, 2022

The debate over the complications in the tax code has turned into discussions over FairTax, the tax reform proposal from Congress that proposed to overhaul the present tax system. The proposal is for the replacement of federal income taxes, payroll taxes, estate taxes and gift taxes for a single tax: consumption tax on retail sales.

In FairTax, all current federal taxes are replaced by a 23% tax on the final sale of all goods and services. Intermediate sales will not be taxed. Income tax is replaced by consumption tax.

Consumption tax is not new to the U.S. Taxes were levied on consumption in the early history of the country, but consumption tax has its own weaknesses, which must be carefully considered to achieve long-term gains. Some of the difficulties of having consumption tax are correctly explained by Investors:

“Supporters (of FairTax) argue that in addition to raising revenue, the tax would act as a “speed limit” that reduces volatility in the markets. Opponents counter with studies showing that the revenue estimates are overstated, and that the tax could actually increase volatility.”

Additional concerns include the indirect impact on middle-class investors — the tax would hit trades done by mutual funds and retirement plans, such as 401(k) accounts — and the competitive effects on particular jurisdictions, as the tax creates incentives for such transactions to move across borders.

Given these concerns, one would think that the U.S. Congress would carefully debate the merits of a financial transaction tax, not rush to approve it. Yet the U.S. Senate just passed a bill that may enable states to impose their own financial transaction taxes — a recipe for increasing economic uncertainty.

Supporters of the Marketplace Fairness Act (MFA), which the U.S. Senate passed on May 6 on a 69-27 vote, claim that online retailers enjoy an unfair advantage over their brick-and-mortar competitors. The bill, they maintain, addresses this imbalance by allowing states and localities to require “remote sellers” to collect taxes for “sales” to their residents.

However, the bill is silent on the particular products and services of “sellers” and “sales” it covers. Thus, it could open the door for state and local governments to tax financial transactions they deem as “sales” on businesses throughout the country.

Financial industry trade groups, including the Financial Services Roundtable and the Securities Industry and Financial Markets Association (SIFMA), have expressed concern. “The bill could lead to unexpected costs being passed on to consumers of financial services, including sales taxes on services or state-level stock transaction taxes,” SIFMA says in a statement.”

Implementation of FairTax, that suggests fairness in taxes by its name, cannot guarantee it. Investors illustrate how state-level financial transaction tax can fail, and has failed previously.

“From 1905 to 1981, the state imposed a transfer tax on securities transactions (in New York). After a 50% increase was proposed in the 1960s, the president of the New York Stock Exchange threatened to build a second trading floor in Trenton, N.J., to bypass the New York tax.

New York settled on a 25% increase instead, but even that caused many investors and financial firms to flee. A NYSE analysis from the late 1960s noted that, “New York securities markets have experienced increasing competitive problems in recent years from regional stock exchanges located in San Francisco, Los Angeles, Chicago, Detroit, Philadelphia and Boston. . . . From 1965 through 1967, the volume of trading on the regional exchanges increased by 73.2%.”

This competition prompted New York to phase out the tax starting in the 1970s. The state still collects a nominal tax, but since 1981, the proceeds have simply been returned to traders.”

The good news is that the proposal for FairTax is just a proposal. It will need much thought to transform the current tax code into an effective system that can be beneficial to all.