I Just Couldn’t Make Myself Like the FairTax

by Brian Stanley
by Brian Stanley
Recently by Brian Stanley: The Government Is Just a Referee? Hardly.

There are times, for various reasons, that I try to make myself like something. Ballet, for instance. I really wanted to like it. My wife and I have some good friends who are very active in the local ballet company, and attending the ballet would not only have allowed us to do more with them but also to have access to the best tickets, some fine parties and excellent free food. But I failed. My public school tastes came to the forefront and prevented me from appreciating the fine art of the toe dance.

Golf is another example. I’ve played off and on since I was a kid, but I’m still trying to force myself to enjoy it, or at least tolerate it. It’s a great way to experience the camaraderie and male bonding you see in those prostate medicine ads on TV, and it allows one to get (a little) exercise. Besides, I’ve always liked driving those little cars. So far, however, I’ve spent lots of money and still can’t convince myself that the game is anything other than drudgery periodically interrupted by alternating bouts of anger and embarrassment. My golf spending appears to fall in the category of a personal type of malinvestment.

Another example, of a different kind, is the FairTax. Introduced in the U.S. House in 2005 as HR 25, this bill, as most people reading this know, would eliminate the federal income tax and many other taxes and replace them with what is essentially a national sales tax with a rate of either 23% or 30%, depending on how one calculates it. When I first heard of the FairTax three or four years ago, I was excited – as excited as one can get about the subject of tax, that is. I went on line and printed out the entire bill, and, from time to time over the next couple of days, I read it. It seems I have time to do this kind of thing because I don’t go to the ballet or play golf.

My first reading left me underwhelmed, but reading any kind of tax code will leave you that way. I didn’t like the fact that the FairTax was to be revenue neutral, but I realized that revenue neutrality was required for it to have any chance of passage. I’m not a strict ideologue; I’m willing to achieve goals incrementally. Incrementally is how we became a welfare state, after all. If the FairTax would simplify the tax code, I saw that as an improvement worth supporting. If I have to pay the federal government a bunch of money, I might as well do it as quickly and with as little paperwork as possible. The issue of tax reduction could come later.

But, try as I might, I couldn’t make myself become a supporter of the FairTax. I don’t hate it. But neither do I support it.

What are my reasons? They are essentially those set out by Laurence M. Vance, an accounting professor in Florida, in a series of articles for the Ludwig von Mises Institute, so I refer you to those articles. See "There’s Still No Such Thing As a Fair Tax," Mises Daily (May 15, 2008); "The Fraudulent Tax," Mises Daily (Oct. 9, 2006); "There Is No Such Thing As a Fair Tax," Mises Daily (Dec. 12, 2005); and "The Fair Tax Fraud," Mises Daily (May 18, 2005). Instead of restating all Vance’s arguments and again delving into the many details of the FairTax, which I couldn’t do as well as Vance did anyway, I’d like to look at the fundamental structure of the FairTax from what I believe is the viewpoint of the Austrian school of economics, particularly as represented by Ludwig von Mises and Murray Rothbard, as that examination was sufficient to allow me to make my decision, though I did also look at the details of the plan and various economic analyses for and against the FairTax.

Mises, with his praxeological method of economics (logical, deductive reasoning based on the fact that humans act and use means to achieve subjectively chosen ends), warned us again and again not to be fooled by the false precision offered by the mathematical economists; and it’s safe to say that it is such economists who purport to give us accurate predictions about how the FairTax will affect consumers, businesses and the economy as a whole.

"Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action[,]" Mises wrote. "But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding." Human Action, Scholar’s Edition (Auburn, AL: Ludwig von Mises Institute, 2008), pp. 118–119.

"We can predict…that, other things being equal, a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop[,]" he added. As to why quantitative economists tend to overestimate the accuracy of their formulas, Mises said: "The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure." Id., at p. 118.

We know, then, that the FairTax will cause changes, and we have some kind of idea of the kind of changes it will bring about; but we’re fooling ourselves if we say that we can quantify with any meaningful degree of accuracy precisely how much behaviors will change. The FairTax, after all, will be a wholesale change of the entire scheme of taxation in the massive United States economy. No nation on earth relies completely on a retail sales tax for its primary source of revenue. How can we predict precisely how such a change will affect the behavior of consumers and businesses, as well as governments, which are also subject to the FairTax?

"Economics is not, as ignorant positivists repeat again and again, backward because it is not ‘quantitative.’ It is not quantitative and does not measure because there are no constants[,]" Mises wrote, adding: "Statistical figures referring to economic events are historical data. They tell us what happened in a nonrepeatable historical case." Id., at p. 56.

Rothbard, of course, agreed with his mentor’s opinion about mathematical economics. And critics of the Austrian aversion to using mathematics in economic analysis shouldn’t assume that these economists eschewed math because they didn’t understand it. Mises was, by all accounts, a competent mathematician, and Rothbard earned a double undergraduate major at Columbia University – economics and mathematics. So these two understood mathematics well enough to recognize its limitations in economic forecasting. See William L. Anderson, "Mathematics and Economic Analysis," Mises Daily (April 2, 2002).

Rothbard wrote in his magnum opus, Man, Economy and State, that in economics one is dealing not with "‘functional’ quantitative relations among variables, but with human reason and will causing certain action, which is not ‘determinable’ or reducible to outside forces." Man, Economy and State, with Power and Market, Scholar’s Edition, 2d Edition (Auburn, AL: Ludwig von Mises Institute, 2009), at p. 324. He added: "The only ‘natural laws’ (if we may use such an old-fashioned but perfectly legitimate label for such constant regularities) in human action are qualitative rather than quantitative. They are, for example, precisely the laws educed in praxeology and economics – the fact of action, the use of means to achieve ends, time preference, diminishing marginal utility, etc." Id. (Italics and parentheses in original. Footnote omitted.)

Though Rothbard, like Mises, died before the FairTax came into being, Rothbard did address the issue of the consumption tax, specifically the retail sales tax, in Man, Economy and State. And he disagreed with the contention that a retailer could easily pass on a sales tax to the consumer.

"The most popular example of a tax supposedly shifted forward is the general sales tax[,]" Rothbard wrote. ""In fact, however, there is no way for prices to increase at all!... Stocks of goods or factors have not yet changed, and neither have the demand schedules. How then could prices rise?" Man, Economy and State, at p. 930 (Italics in original.). Basically, Rothbard said that if sellers could have raised prices they would have done so before the imposition of the tax. But, as most sellers have their goods priced at or near their maximum levels (considering the existing demand schedule), it is not as easy as many say it is to increase prices to accommodate sales taxes. Therefore, sellers tend to experience reduced revenue, which means that they have to lower their costs. It follows, then, he continued, that the seller’s losses are "imputed backward to interest income by capitalists and to wages and rents earned by owners of original factors – labor and ground rent." Id., at p. 932.

Because general sales taxes reduce "not just consumption, but the incomes of original factors[,]" it turns out, Rothbard contended: "The general sales tax is therefore an income tax, albeit a rather haphazard one." Id., at p. 934. He then concludes his discussion of the sales tax by noting that "we reach the paradoxical and important conclusion that a tax on consumption will fall more heavily on savings-investment than on consumption in its ultimate incidence." Id. (All italics in original.) In footnote 47 on p. 934, Rothbard says that, despite what some economists say about the sales tax, "…there are few taxes indeed that will not be as bad as the income tax from the point of view of the free market. Certainly sales or excise taxation will not fit the bill."

In fairness to the FairTax proponents, we must remember that Rothbard was not commenting directly on the FairTax. The FairTax would replace the personal and corporate income tax, the estate and gift tax, unemployment taxes, alternative minimum taxes, capital gains taxes and Social Security and Medicare taxes; so it is possible that the elimination of these taxes could have changed Rothbard’s analysis of the general sales tax. Perhaps he would have believed it more likely that sellers could raise their prices if consumers were freed of the obligation to pay these other taxes. That does make sense. Still, Rothbard’s distaste for the general sales tax allows for the inference that he would not believe it would be as easy to pass along taxes as many FairTax proponents contend. Further, it isn’t likely that his opinion would have been dramatically different even if he had been dealing with a sales tax that was replacing an income tax. In footnote 47 he was comparing an income tax with a sales tax and an excise tax as to how each alone would disrupt a market economy. He was not doing his analysis of the sales tax under the assumption that the sales tax would be imposed in addition to an income tax.

Even if sellers can raise their prices to pass along the FairTax, we have no idea how consumers will react, especially during the transition period, to significant price increases. And the price increases would be about 30% if sellers can’t reduce the costs of their inputs (discussed below). Why 30% if the tax is 23%? If the price of an item is $100 and the tax on it is 23%, for the seller to still receive the $100 of revenue, he must make sure that $100 is 77% of the total price including the tax. Why 77%? Because 100% minus 23% = 77%. So we divide $100 by .77 and the answer is $129.87. If the seller can raise the price $29.87 to a total tax inclusive price of $129.87, he can still get his $100 of revenue. If he can’t, then the tax will eat into his revenues and lower his gross profit margin. (This is where the 23% v. 30% debate comes in. As you see, the tax of $29.87 is 23% of $129.87, but it is 29.87% of $100.)

If the seller can indeed lower his costs to maintain his gross margin – in part because he no longer has to pay income tax – perhaps it won’t matter if his gross revenue falls. Also, FairTax proponents assure us that because of embedded taxes – taxes on the inputs that raise the price of the final consumer product – the cost of goods sold will drop, perhaps by as much as 22%.

In that case, costs would not increase for consumers and profit wouldn’t fall for sellers (or for any sellers of higher order goods). For example, say a seller sells a widget for $100 and has costs of goods sold of $90. His gross profit margin is 10%. If his COGS drops 22%, the COGS becomes $70.20. If he sells his widget for $100 and remits 23% ($23) for taxes, that leaves the seller $77 in revenue. His gross profit of $77 minus the $70.20 COGS leaves him $6.80 and is a gross profit margin of 6.80/77 or about 9%. That’s close enough to say that the seller’s gross profit margin would stay at 10%.

If the COGS does drop by 22% that would avoid Rothbard’s argument concerning sellers’ inability to pass along sales taxes to buyers. But it doesn’t avoid Mises’ and Rothbard’s conclusions that one cannot accurately quantify the behavior of human actions in a complex economy. For example, how do we know that the cost of inputs will drop 22%? Will sellers of higher order goods resist price reductions? Will consumers, knowing that sellers’ costs have dropped, demand additional price reductions? Might the disruption of the terrible but familiar tax regimen cause anxiety among consumers and bring about a reduction in consumer spending? How will the collection of the new taxes by sellers of consumer goods affect their overhead and therefore their net profits? Will consumers react to paying taxes on services and transactions on which they have never paid taxes (like purchases of new homes and doctors’ bills) by reducing consumption? Given that sellers of services don’t have COGS, will they still be able to lower prices because of the absence of income taxes so they can get the same gross revenue they have been getting?

No one really knows the answer to these and many more questions. At least, no one can quantify them with any comforting level of assurance. We might then end up with, among other results, a significant drop in revenue to the federal government.

Normally libertarians wouldn’t care whether a tax proposal might fail and end up reducing revenue to the federal government. In fact, lowering – even eliminating – federal revenue is the goal for most of us. But if the FairTax fails to provide sufficient revenue to the feds, Congress could and would use that as an excuse to pass various (unread) panic-induced bills raising revenue by all sorts of diabolical means.

Even if it does bring in the same amount of revenue, when will Congress see fit to raise rates or make additional transactions taxable? A constitutional amendment would prevent the re-imposition of an income tax, but it wouldn’t prevent Congress from taking other actions to increase the revenue from the tax or make it more complicated. Does anyone remember the Tax Reform Act of 1986? Obviously Congress can also raise taxes and increase complexity through the current code, too; but the unknowns about the FairTax coupled with the possibility – no, certainty – of amendments to it in the future give the FairTax, in my subjective opinion, too much downside with not enough upside. Sometimes the devil you know is preferable to the devil you don’t know.

I’d be willing to incur virtually any amount of risk and disruption to get passed a law or constitutional amendment, as the case may be, that would significantly reduce or eliminate taxes, or allow secession, or recognize the restrictions on federal power contained in the Tenth Amendment, or recognize that the states are laboratories and should be given a maximum amount of independence, or renounce the USA’s role as self-appointed policeman of the world, or make any such substantive, permanent change in the political landscape. But the FairTax doesn’t offer enough to justify the risks that it would fail and invite new taxing schemes and, in addition, prevent the serious consideration of any other tax reform for decades.

Finally, as a bit of an aside, even if the use of mathematics in economic forecasting is legitimate, the analyses provided by FairTax proponents don’t provide us with sufficient evidence to believe that the FairTax will work as promised. There are some impressive studies supporting the FairTax, but there are also impressive studies demonstrating why the FairTax won’t work. Both sides can offer mathematical evaluations done by competent, respected mathematical economists. All this tells us is that numbers dealing with a vast, complex economy can often be made to support many different and even conflicting arguments.

March 19, 2010

Brian Stanley [send him mail] is vice president and general counsel of The Hefner Company, Inc., an oil and gas and investment company in Oklahoma City, OK. He also maintains a private law practice.

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