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FairTax - Income Taxes vs. Sales Taxes

FairTax - Effect on the Economy and Consumer Spending


One of the largest effects a change to a national sales tax system such as FairTax would have is to change people's working and consumption behavior. People respond to incentives, and tax policies change the incentives people have to work and to consume. It is unclear if replacing an income tax with a sales tax would cause consumption within the United States to rise or fall. There will be two opposing forces at play:
  1. The Effect on Income

    Because income is no longer taxed, the incentives to work have changed. Many workers can choose the amount of overtime they work. Take the example of someone who would make an extra $25.00 if he worked an hour of overtime. If his marginal income tax rate for that extra hour of work is 40%, he would only earn $15.00 and pay $10.00 in income taxes. If income taxes have been eliminated, he would get to keep the whole $25.00. If an hour of free time is worth $20.00, then he would work the extra hour under the sales tax plan, but not work it under the income tax plan. So a change to a sales tax plan reduces the disincentives to work, so workers as a whole will end up earning more. If workers earn more, they'll spend more. So the effect on income suggests that the FairTax plan will cause consumption to increase.
  2. Changes in spending patterns

    It goes without saying that people don't like paying taxes if they don't have to. If there is a large sales tax on purchasing goods we should expect people to spend less money on those goods. This could be accomplished in several ways:

    • Spending less and saving more. Of course, today's savings are likely to be used for tomorrow's consumption, so consumers may just be delaying the inevitable. They still may wish to save more, as they may believe the sales tax will not last forever or they may plan on finding other ways to avoid the tax in the future.

    • Spending money outside of the United States. Currently if consumers wish to spend their money cross-border shopping in Canada or on a vacation in the Caribbean, they have already been taxed by the Federal government on that money at the income level. Under a sales tax scheme, they can spend their earnings outside the country and not be taxed on any of it, unless they bring enough goods back into the United States. So we should expect to see more money spent on vacations and outside of the United States, and less money spent within the United States.

    • Spending in a manner which evades taxes. If there is an easy way to evade taxes, it is likely that a large number of people will participate in it. One easy way to evade sales taxes is to claim your spending as a "business expense", even if it is a purchase for personal use. Goods which are used in production, known as intermediate goods, are not subject to a regular sales tax. The government could close this loophole by making the sales tax a "Value Added Tax" (VAT) such as the Canadian Goods and Services Tax (GST). VATs and GSTs are rather unpopular with the business community, as they raise the costs of production, so it is unlikely the U.S. would want to embark on this path. With a high sales tax rate, tax evasion will be prevalent, so this effect will cause a decrease in spending on "taxed" goods.

Overall it is not clear whether consumer spending will increase or decrease. But there are still conclusions we can draw on what effect this will have on different parts of the economy.

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