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THE 'FAIR TAX' AND THE 'REAL' RATE

August 28, 2007

Advocates of the "Fair Tax" national retail sales tax plan say they can eliminate all federal income and payroll taxes with a "23%" national retail sales tax. Even a cursory look at the plan shows that it really has a 30% rate, as we typically understand sales tax rates. Neal Boortz and other Fair Tax fans insist that it really is a 23% rate, properly understood.

Part of the reason Mr. Boortz & Co. are so insistent that it really is a 23% rate is marketing. Just as "Fair Tax" sounds better than "Big Honking National Retail Sales Tax," 23% sounds better than 30%.

Yet Mr. Boortz is also trying to draw a comparison between income tax rates and sales tax rates. Income tax rates are computed on a base out of which the tax is drawn, while sales taxes are computed on a base to which the tax is added. For example, a 33.33% income tax takes $33.33 out of $100 of income, where a 10% sales tax is added to a $100 sale, making for a total cost of $110. The income tax is about 50% of the $66.67 that the income tax-payer has left after taxes, while the tax remitted by the retailer is 10% of what he charged.

Mr. Boortz says that if the income tax rate above is measured based on pre-tax income, out of which the tax is paid, a sales tax rate should be measured based on the whole transaction, including the tax itself.

While this has a superficial logic, it fails at the computational level. The reason that income taxes are conventionally measured "tax inclusive" and sales taxes are measured "tax exclusive" is because in each case the conventional method is the shortest way home.

COMPUTING THE FAIR TAX

A "tax inclusive" sales tax requires the following computations:

Where X is the gross sales price including taxes,
T is the tax, and
P is the pre-tax price,

the tax computation is as follows:

T=.23X
and X-T=P

Then X-.23X = P
and .77X = P
and X=1.298701P.

This computation would have created hopeless supermarket checkout lines in the era of mechanical cash registers, so sales taxes have always been computed by skipping the intermediate steps. In this case, you would just add 29.89701% to the sales price. In real life, a legislature would round it to 30%, because decimals are hard.

Computing income taxes on a "tax exclusive" basis would similarly require an extra computation that is mathematically equivalent to a single-step computation at a different rate; not surprisingly, the single-step rate is what has traditionally been used.

So while Mr. Boortz thinks we're just being thick when we say the "real" rate under the Fair Tax is 30%, the 30% rate is just a shorter way of saying "T=.23X and P=X-T".

Related:

Tax Update coverage of the FAIR TAX KERFUFFLE

Reason Magazine blog: Bruce Bartlett Isn't Fair

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