Many people view sales taxes as a “regressive” form of taxation and have conerns about its impact on the poor and middle class. Fortunately, these issues have been thought through very carefully by the creators of the FairTax plan.
Still, it’s often useful to read an independent analysis of the same issues, to see what other researchers have come up with.
In that vein, I found the following information very useful. It is an excerpt from the Cato Institute’s policy analysis titled “Emancipating America from the Income Tax: How a National Sales Tax Would Work.”
A common assumption about the NST is that it is naturally regressive, since lower income individuals spend a greater percentage of their income in any given year on consumption of necessities. Because a sales tax is an altogether different paradigm of taxation, any judgment on the equity of the tax must be accompanied by a different analysis of regressivity.
To examine how a national sales tax could address such concerns, a number of issues should be broached. First and foremost, taxing income at a graduated rate is not the only means of making a tax system progressive. Moreover, a tax on income, no matter how steeply graduated, does not necessarily make an income tax progressive. Even if progressivity is measured by the common standard of “ability to pay,” the income tax is imposed only on productive labor and the return to capital and not on wealth. An income tax does not tax consumption of older accumulated capital, whereas a sales tax does.
Equally important, using taxable income as the basis to determine progressivity is necessarily based on a year-to-year analysis where the ability to pay is measured as a function of income per unit of time. Consumption over the life of a taxpayer is in many respects a better measurement of the ability to pay taxes. Because people’s incomes fluctuate throughout their lives, the lifetime application of a sales tax is much less regressive than it would appear to be when examining a cross-section of taxpayers in any given year. [40] Since all income is earned for the purpose of eventual consumption, under a national sales tax, the taxpayer can defer taxation by saving his income. But he cannot forever avoid the tax.
In any case, an NST plan can be made progressive through a rebate mechanism that would shelter low-income people from paying the tax. One manner in which the NST could be made less regressive would be to exempt certain necessities–such as food and clothing–from the tax. That approach would exempt, however, the most expensive food (lobster and caviar) and the most expensive clothing ($1,000 designer suits). It is a very inefficient means of providing tax relief to lower and middle income Americans and would necessitate a much higher overall rate. [41] A more neutral and less distortive approach is to simply provide each family a level of consumption free of tax by providing a rebate of the tax on expenditures up to the poverty level. That is the device we recommend and the approach chosen by Representatives Schaefer and Tauzin in H.R. 3039. [42]
The rebate could work as follows: A family consumption refund would be established for each household at an amount equal to the sales tax rate times the poverty level. The poverty level is defined by the Department of Health and Human Services guidelines and should be raised by the sales tax rate. [43] For a family of four, the HHS poverty level for 1996 is $15,800, so the sales tax poverty level would be $18,588. The annualized rebate, which would be refundable for households with earnings below the poverty level, would therefore be $2,788. Assuming the head of household was paid 26 times per year, the rebate amount included in each paycheck would be $107.23. Earnings would be reported to the Social Security Administration. Employers would pay less payroll tax, and the Treasury would reimburse the SSA for the rebate amounts provided to families in order to ensure that the balance in the trust funds was unchanged. [44] Only the source of the payments to the trust funds would change. [45]
Families with no annual wages and salaries would apply directly to the Social Security Administration for a rebate check. Table 4 indicates the applicable poverty thresholds and maximum rebates for 1996 assuming a 15 percent national sales tax rate. [46]
All workers would receive a rebate up to the maximum rebate amount shown in the table. Thus, the average tax rate for a family of four earning and spending $37,176 would be 7.5 percent. The average tax rate for a family of four earning and spending $74,352 would be 11.25 percent. Figure 1 illustrates how the average tax rate increases with spending. This assumes that the sales tax falls on the consumer. The view that it falls on the factors of production is commonly, though by no means universally, held by economists.
The family consumption allowance approach has several effects. First, it makes the sales tax applicable only to consumption beyond the necessities of life. Second, it makes the tax in effect progressive, not only because it is based on consumption, a better index of true ability to pay, but because–if one wants to continue to view progressivity through an income tax lens–it entirely exempts lower income workers. Third, unlike most state taxes, it does not undertake the complex and politicized task of determining what to tax and what to exempt, thereby minimizing administrative and compliance questions and economic distortions.
See their full analysis for much more information about how Cato’s version of a national retail sales tax would work.
Bear in mind that there are some differences between this version and the FairTax plan (for example, Cato’s sales tax does not remove or replace payroll or Social Security taxes). Still, the approaches have much in common, and reading Cato’s analysis is very educational.