the Tax System:
Comparing the Flat Tax with the Fair Tax”
U.S. Internal Revenue Code, which underwent its last major
restructuring in 1986, costs individual taxpayers alone
approximately 3.18 billion hours and $75.5 billion to comply. It
is highly complex and complicated, with the standard 1040 form
including some 143 pages of instructions or triple the number of
pages in 1975.
Size, cost, complexity, confusion, and inequity are many reasons
why many groups
are calling for comprehensive tax reform.
possibilities touted recently include the Fair Tax (initiated
and promoted by Americans for Fair Taxation)
and the Flat Tax (such as promoted by Steve Forbes, former
Republican presidential candidate).
This TEF BRIEF accomplishes two goals: first, it briefly
compares these two major tax reform proposals and, second, it
raises two questions: 1) are both systems fair? And 2) how do
both proposals affect the size of government and government
first introduced the Fair Tax in 1999. Since then, the measure
has gone through several iterations and is now titled the “The
Fair Tax Act of 2007.” The Fair Tax is a national retail sales
tax, or what is commonly referred to by economists as a
Effectively, it is a tax on what people buy and not on what they
earn. The Fair Tax proposal is comprised of three main elements.
First, it taxes all new goods and services at a flat 23 percent
rate. Second, it includes a rebate or more accurately a
“prebate” element for all taxpayers. And third, it taxes the
rich’s wealth as well as the common laborers’ wages, thus
retaining a certain degree of progressivity.
addition to several procedural and systemic differences between
the Fair Tax and the current tax code, the Fair Tax has
substantial economic implications as well. First, the Fair Tax
makes the cost of government much more visible than it currently
is, simply because there are no “hidden taxes” or “embedded
costs” to cover up as in the current system. The Fair Tax
eliminates most current taxes, including individual income taxes
and all loopholes, the Alternative Minimum Tax (AMT), all
corporate and business income taxes, capital gains taxes, Social
Security taxes, Medicare taxes and all other subsequent federal
payroll taxes, self-employment tax, estate or “death” taxes, and
finally all gift taxes.
Second, the Fair Tax increases the likelihood of retaining blue
collar jobs from disappearing to overseas markets. Because the
Fair Tax eliminates all hidden or “embedded taxes” many
American-based companies that have plants in foreign countries,
which by the way have tax systems, such as the flat tax,
favorable to capital and labor investment, would have a greater
incentive in returning to America.
Third, both the “shadow economy,” which is legal but unreported
economic activity and is estimated to cost the U.S. economy
anywhere from $650 billion to $1.5 trillion, and the
“underground economy,” which is illegal economic activity such
as the illicit drug trade, is in excess of $1 trillion.
The shadow economy, which conservatively makes up approximately
ten percent of the U.S.’s Gross Domestic Product (GDP), costs
the federal government about $345 billion in lost revenue.
This will be eliminated with implementation of a national retail
sales tax, such as the Fair Tax.
Tax, which also has the effect of a consumption tax because it
allows for more savings and investment which can then be
designated for consumption purposes, is designed to tax all
individuals at the same level. (There is currently a version
sitting in Congress titled appropriately H.R. 1040. For clarity
purposes we will briefly examine Forbes’ version.) According to
Forbes, a Flat Tax system would tax all personal and corporate
income at 17 percent. It would increase exemptions (e.g. $13,200
per adult, $4,000 per child or dependent, and a one-time $1,000
tax credit per child 16 and younger) and like the Fair Tax would
reduce the capital gains tax to zero, while also eliminating
both the estate tax and the Alternative Minimum Tax (AMT). It
would also streamline the filing process by using a
In addition, Flat Tax proponents trumpet other advantages such
as no special tax preferences for the wealthy,
eliminate double taxation of savings and investment, stimulate
work effort on the part of the working class, and enhance
entrepreneurial efforts, from venture capitalists to small to
medium size businesses.
reform proposals, however, contain problematic elements. Fair
Tax opponents make several claims. First, they claim that the 23
percent rate is really 30 percent.
Fair Tax proponents, however, claim that opponents must compare
inclusive and exclusive tax rates equally. (Note: The 23 percent
rate is based on an “inclusive rate,” which is a percentage of
the total dollar paid out or earned, thus on a $100 item, $23
goes to Uncle Sam and $77 is the consumer’s purchasing power.
The 30 percent rate, on the other hand, is based on an
“exclusive rate,” which is a percentage of income left or the
actual price of an item being purchased, which means if you
purchase an item for $77 you pay an additional 30% (or $23) in
sales tax, or $100, at checkout.)
Second, the rebate or “prebate” is sent to every U.S. household.
The “prebate” measure is designed to protect lower- middle
income to poor families from being taxed on necessities, such as
food. The “prebate” program’s cost is estimated to be somewhere
from $600 to $780 billion per year, representing the largest
entitlement program in American history.
Finally, even though the legislation calls for the elimination
of the IRS, the administration, oversight, and enforcement of
the law would require additional bureaucratic units created
within the Department of Treasury as well as de facto
create “new tax collectors” (retailers) and “new taxpayers,”
including governments, churches, and other non-profits, if there
are no exemptions for these groups.
Tax is also not without its critics and problems. Is the Flat
Tax really flat? It is flat in the sense that it consists of one
rate, but it is also progressive in that the more one makes, the
more tax one pays. Also, even though it has features of a
consumption tax the Flat Tax is still an income tax. It taxes
salaries and wages, income earned, rather than consumption
directly. Moreover, the Flat Tax does not call for the repeal of
the 16th Amendment or for the abolition of the IRS.
Thus it would be quite feasible and possible for the federal
government to raise the flat tax and return, for example, to
some form of the current system.
of the two reforms, i.e. the Fair Tax or the Flat Tax, meets our
two criteria of fairness and promotion of limited government and
free-market principles? Let’s define “fairness” according to two
standards: achieving administrative efficiency and pursuit of
individual and social equity. Administrative efficiency requires
streamlined bureaucracy, elimination of needless rules and
regulations, and cost savings. For economists in particular
equity is generally understood to be “equal treatment of
On the surface, both reform proposals appear to accomplish these
requirements. While the Flat Tax greatly reduces the power and
authority of the IRS, the Fair Tax eliminates it altogether.
In addition, both proposals appear to be somewhat equitable, at
least when compared to the current tax system, because
regardless of salary or wage level the same tax is applied to
all. However, both reform types contain a degree of
progressivity, where both shift the lion’s share of the tax
burden away from the lower-middle income and poor, requiring the
rich and wealthy to pay taxes on a greater share of their income
or on what they purchase.
both proposals largely fail to meet the second criterion:
promoting limited government and free market principles. For
example, both reform measures are touted as “revenue neutral,”
which means they do not reduce the amount of revenue available
for the federal government to spend. The Fair Tax website
emphasizes this point, stating that the Fair Tax plan provides
“dollar-for-dollar federal revenue neutrality.” In addition,
proponents even argue the Fair Tax is not “about cutting
spending or changing government benefits. It’s simply a plan to
change the way Americans fund their federal government.”
And Forbes even argues that his version of the Flat Tax will
increase federal revenue by some $11 billion, while “generating
$56 billion more in new government revenue…” and “an estimated
$6 trillion in additional assets would be created.”
Do we really want a tax reform system that either does not
decrease government spending or actually even increases it?!
reform of the current tax system is essential, Milton Friedman
advocated the need for additional steps. He argued that cutting
taxes and thus reducing the amount of revenue available to the
government is the critical point. Government spending accounts
for nearly 50 percent of total national income, including both
direct and indirect income. This is why Friedman was in favor of
some type of Tax and Spending Limitation Amendment be added to
the US Constitution. Such an amendment would be designed to
restrict total government spending and return any revenue in
excess of spending limits to the taxpayer.
fiscal welfare of the U.S. is to be salvaged, however, simply
switching to either the Fair Tax or Flat Tax system, although
necessary, is not the critical issue. The critical issue is not
tax reform only, but tax reform PLUS reduction in total amount
of government spending. Edward Crane contends that too much
dependence on “growing the economy” without “a focus on
individual freedom and restoration of constitutional government”
will only promote an “activist government,” regardless of which
party is in control.
both the Fair Tax proposal and Flat Tax reforms at least
partially shrink the size of the federal government through
reduction of or even elimination of the IRS and the many
thousands of pages of rules and regulations that accompany the
current tax code. However, if the amount of revenue remains the
same or higher than current levels (e.g. the federal government
budget is nearly $3 trillion dollars) and the estimated federal
budget debt and future fiscal commitments amount to almost $60
trillion, then simply reforming the current tax system without
attending to the critical need to reduce the size and impact of
federal government is only addressing part of the problem.
Stephen M. King is Research Vice-President at Public Interest
expressed herein are those of the author and not necessarily
those of Public Interest Institute or Tax Education Foundation.
They are brought to you in the interest of a better-informed
Several working papers detail NTU’s position on tax
reform. See Ryan Kool, “The Flat Tax: A Worthy
Competitor in the Global Economic Game,” NTUF Policy
Paper #157, 13 September 2005, accessed at
11 July 2008; Erica J. Pagel, “Revolutionary Reform: The
Transition to a National Retail Sales Tax,” NTUF Policy
Paper #120, 10 September 1999, accessed at
11 July 2008 ; Eric V. Schlecht and Jared Adams, “Tax
Reform: Challenges and Possibilities,” NTUF Policy Paper
#107, 3 February 1999, accessed at
11 July 2008.
“One Simple Rate,” The Wall Street Journal, 21
August 2005, accessed at
www.opinionjournal.com/forms, on 7 July 2008. See
also his book Flat Tax Revolution: Using a Postcard
to Abolish the IRS (Washington, DC: Regnery Press,
Consumption taxes are not new. Alexander Hamilton
referred to them in The Federalist Papers, #21.
Value-added tax, or VAT, which is popular in many
European countries and has been in existence for several
years, is also a form of consumption tax. See Al Ehrbar,
“Consumption Tax,” The Concise Encyclopedia of
Economics, accessed at
8 July 2008. See Alan Greenspan’s favorable opinion for
consumption tax replacing the current tax system in
“Greenspan: Consumption Tax Could Help Economy,” 3 March
2005, accessed at
www.foxnews.com on 7 July 2008.
For an overview of the FairTax proposal see the
Americans For Fair Taxation website (www.fairtax.org).
See also Laurence J. Kotlikoff, “Why the FairTax Will
Work: A Response to Bartlett,” Tax Notes, 4
February 2008: 1-7, for a detailed defense of the
Neal Boortz and John Linder, The FairTax Book: Saying
Goodbye to the Income Tax and the IRS (New York, NY:
Harper Collins, 2005): 74, 75.
Forbes, “One Simple Rate,” 21 August 2005.
Daniel J. Mitchell, “A Brief Guide to the Flat Tax,”
Backgrounder, 7 July 2005 (Washington, DC: The
Heritage Foundation): 1-7.
Robert E. Hall and Alvin Rabushka, The Flat Tax,
2nd edition (Stanford, CA: Stanford
University Press, 1995): 84, 87.
“Simple, Fair, and Pro-Growth,” 5 November 2005: 208.
Laurence M. Vance, “Flat Tax Folly,” accessed at
http://mises.org/story/2112 on 8 July 2008. Sheldon
D. Pollack, The Failure of U.S. Tax Policy: Revenue
and Politics (University Park, PA: The Pennsylvania
State University Press, 1996): 279-288.
Hall and Rabushka, p. 26.
See table titled “How does the FairTax compare?”
www.fairtax.org on 7 July 2008.
Boortz and Linder, 2005, p. 76.
See Forbes, The Wall Street Journal, 21 August
“The Republican Congress in Historical Context,” The
Republican Revolution Ten Years Later: Smaller
Government or Business as Usual? Edited by Chris
Edwards and John Samples (Washington, DC: CATO
Institute, 2005): 17-22.