The FAIRtax improves upon major factors that bear upon compliance.
To understand how it does so, policy makers need to look at the several factors that bear upon compliance – both fraud and non-fraud – from the scholarly research. The five most important of these are as follows:
- the number of taxpayers in relation to enforcement resources;
- the marginal tax rates;
- transparency or the risk of detection/ability to hide defalcation;
- the magnitude of punishment if caught; and
- perceptions of unfairness.
Number of taxpayers in relation to enforcement resources.
The 2014 IRS Data Book gives the number of tax filers under the current system as a whopping 158.1 million. The FAIRtax removes approximately 134 million taxpayers entirely from the tax system, reducing the number of filers by 85 percent to about 24 million. Thus, enforcement authorities can catch cheats by monitoring far fewer taxpayers. Because the number of collection points is so much lower under the Fair Tax, if enforcement funding is held equal then the audit rate for potential evaders increases considerably and the likelihood of apprehension is correspondingly higher. The perception of risk as a deterrent should also increase commensurately. In other words, the risk of detection increases and the risk-adjusted cost of evasion increases.
Marginal tax rates.
A taxpayer’s marginal tax rate is the tax rate that applies to the taxpayer’s last dollar of taxable income. It is the marginal tax rate that affects his or her decision regarding whether to work more. The higher the marginal tax rate, the greater disincentive to increase work or to find a higher paying job. Likewise, a high marginal tax rate affects a taxpayer’s incentive to cheat.
Because the FAIRtax has the broadest tax base, marginal rates are the lowest they can be under any sound tax system. With a lower marginal tax rate, cheaters profit less from cheating. All other things being equal, the motto that “every man has his price” applies to encourage more attempted evasions as the reward from cheating increases. Lower marginal rates, if the risk and motivation are the same, imply lower evasion rates because the benefit from evasion declines while the cost of evasion remains comparable. However, precisely because of the larger tax base and lower marginal tax rates, the benefit from lawful tax avoidance or illegal tax evasion under the FAIRtax is much less at the margin relative to either the current system or competing alternative tax systems that have higher marginal tax rates.
The graph below shows the marginal rates under the FAIRtax and the current federal tax system (income and payroll taxes) for 42 stylized married households divided into seven income categories. The marginal tax rate for the FAIRtax is 23%. Each additional dollar spent includes 23 cents of taxes. Across all income categories, the marginal tax rate under the current system is higher than the FAIRtax.*
How can low income persons have high marginal rates? For example, it is not uncommon for married couples earning $30,000 per year with two children to face high marginal tax rates. Given the level of their federal marginal tax bracket, and their loss of the Earned Income Tax Credit from earning extra income and their exposure to marginal Social Security/Medicare taxation, their current total marginal effective tax on earning an extra dollar can be over 35 percent, and possibly over 45 percent.
To see the study on which these rates are based click here.
Transparency or the risk of detection/ability to hide cheating.
Visibility was specifically mentioned by the Government Accountability Office as affecting compliance. The transparency of the FAIRtax increases the likelihood that tax evasion is uncovered and leaves little room to hide between honesty and outright fraud (to say nothing of the well-established efficiency of current state sales tax authorities, well experienced in detecting such infractions). When an individual claims exemption, he has to do so in a very visible way at the cash register.
Magnitude of punishment if caught.
The severity of applicable penalties is also a factor, but this would be expected to increase. This is not to say that the FAIRtax adds to the impressive array of penalties now in the code; but rather, that it becomes quite transparent when someone is cheating as opposed to “gaming” the system. When a retailer fails to pay over trust funds, he does so at great peril and with the knowledge that he is violating the law (i.e., committing evasion). Few excuses apply.
Perception of unfairness.
Perception of the fairness of the tax system is increasingly regarded as an important consideration. Studies have persuasively shown that attitudes are important determinants of compliance. Having both a negative attitude towards the tax system and perceiving other taxpayers as dishonest significantly increases the likelihood a person will evade taxes. Today, cheating is encouraged by the perception that one’s neighbor is not paying his or her fair share. Under the FAIRtax, as the costs of compliance shrink and the perceived fairness of the tax system increases, some of the hostility to the tax system will decline.
State tax administrators can focus enforcement resources on far fewer taxpayers, using consistent and vastly simpler forms, with far fewer opportunities to cheat, diminished incentives to do so, and a far greater chance of getting caught if they do.
Karen Walby, Ph.D. is the Director of Research for Americans For Fair Taxation. See more here.