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January 08, 2008

One of the more odd assertions about the "Fair Tax" 30% national retail sales tax proposal is that it will not increase after-tax retail prices because retail prices will fall by an "embedded 22% income tax cost."

If we assume that, say, 5% of the cost of a retail sale is income tax compliance (and it's not, or I would be living in a nice beachfront mansion somewhere), that means 17% of the cost of a retail product is income tax. Assuming an average effective rate of 30%, that would require a fully-loaded profit margin of 56% through the supply chain (30% rate x 56% net income = 17% tax on 100% of the sales price). That's preposterous. Even if you assume that 4% of the 17% is attributable to the payroll taxes that the Fair Tax is supposed to replace, you still need a net margin of 43%.

The numbers get even worse when you consider how much of the cost of retail items are never subject to U.S. income tax in the first place because they are made overseas. It's hard to see how the U.S. income tax is embedded in the cost of a DVD player imported from China, or how the Fair Tax makes that price fall 22%.

Finally, even if you believe that removing an "embedded" income tax makes prices fall, why would that only affect retail prices? That same tax should be embedded in wages and salaries; why wouldn't they also fall, under the same logic?

My longer take on the Fair Tax is here, and my discussion of why the real rate is 30%, rather than 23%, is here. A lengthy pro-Fair Tax argument can be found in our comments here. Marginal Revolution has a sensible take here.

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