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As I was surfing the internet tonight I came across an issue that I had briefly read about earlier in the election system. What I came across was the official website for the “Fair Tax.” If my memory is correct, I recall a president candidate or two running with a major part of their platform being the “Fair Tax” system. According to the site, John Cox, Alan Keyes, Ron Paul and Mike Gravel all supported the Fair Tax. John McCain did not support the Fair Tax. Barack Obama and Hillary Clinton did not give and official answer one way or another. The official website can be found here.

Here is my official view of this proposed tax policy.

Under the Fair Tax system, there is no income tax. If you make $10/hour and work 80 hours during your pay period you will get a paycheck for $800, instead of the tax adjusted amount. The government has to get their money from somewhere though, and the Fair Tax system suggests that they should get it from sales taxes. The Fair Tax systems is actually entirely consumption based. Those who like to spend a lot of money will pay the most in taxes. Those who are savers will be rewarded by paying less in taxes. Compared to the current income tax based system, the Fair Tax would be the equivalent of a 23% income tax. Compared to a sales tax, the Fair Tax system would have a 30% sales tax.

Fairtax.org makes some compelling arguments for why a switch to this kind of system would be a good idea. Their main arguments are:

• Enables workers to keep entire paychecks
• Enables retirees to keep entire pensions
• Refunds in advance the tax on purchases of basic necessities
• Allows American products to compete fairly
• Brings transparency and accountability to tax policy
• Ensures Medicare and Social Security funding
• Closes all loopholes and brings fairness to taxation
• Abolishes the IRS

The people in favor of the Fair Tax feel that too much time money and confusion is spent each year attempting to file taxes. With a flat rate sales tax, this would cover all government expenses without all the confusion.

Some critics argue that the Fair Tax system would eliminate the deduction that is taken on interest payments on a home. Fairtax.org argues that since you will have more take home income this would offset the deduction that you would normally take. They also claim that “With the fair tax, mortgage interest rates fall by about 25 percent (about 1.75 points) as bank overhead falls.” Homes also become more affordable since “first-time buyers save for that down payment much faster, as savings are not taxed.”

The Fair Tax system has created what they call a “prebate.” This is essentially a prepayment by the government to offset the estimated amount of taxes that one would pay on essential goods and services. For example, a household with two adults and two children would receive a prebate of $537/month. This is based on the assumption that they will spend $28,000 on essential goods and services. Hawaii and Alaska oddly enough have a different prebate table, which actually result them receiving a greater amount in prebate money.

Some people argue that the prebate is pointless, and food and medicine items should just not be taxed. FairTax.org responds to this by saying, “the wealthy spend much more on unprepared food, clothing, housing, and medical care than do the poor. Exempting these goods, as many state sales taxes do, actually gives the wealthy a disproportionate benefit.” They also feel that “exempting one product or service, but not another, opens the door to the army of lobbyists and special interest groups that plague and distort our taxation system today.”

Although the system was designed to be free of loopholes, there is one that really stands out to me. The Fair Tax only taxes new goods. The theory behind this is that the item was taxed already when it was first purchased and should not be taxed a second time as a used item. Therefore, people who purchase used goods will not have to pay the tax. This could could have a couple of benefits/drawbacks. Poor people are more likely to buy used than the rich, and therefore will be saving 30% automatically on all used goods. At the same token, used goods could be sold at a 30% premium because it is common knowledge that these items aren’t going to be taxed, and therefore the missing tax gets passed on to the business owner in the form of higher profits. Having no tax on used items is something that would make any environmentalist happy. With a automatic 30% markdown on all used items, it would encourage people to buy used rather that new and would help to reduce consumption and encourage reusing old items.

Having no tax on used goods could have a major negative impact on companies though. Imagine a car manufacturer like Ford. Why would someone want to pay a 30% tax on a new $30,000 car ($9000 in taxes added on). The $30,000 car would actually cost $39,000 after taxes. It is a common theory that vehicles lose 20-25% of their value as soon as you drive them off the lot. At 20% we could conservatively say that the $30,000 car would be worth $24,000 not long after it was first purchased. Let’s say that the value drops by 20% by the end of the first year of ownership. Why would someone want to pay a $15,000 premium for a car that is a year newer? Remember that the slightly used car would not be taxed and the new one would. This would not make any sense at all from a consumer’s standpoint. I think that this Fair Tax system would have a very negative impact on big ticket item manufacturers.

I think one major advantage of the Fair Tax system is that it would help to reduce tax evasion and illegal immigrants. People can definitely evade taxes in this system by buying used goods, but there are times when you have to buy new goods. Food, medicine, motor oil and gasoline are some major items that quickly come to mind. The Fair Tax system would increase the amount of money that is put into the tax system by illegal immigrants. The system would also give a large incentive for illegal immigrants to become citizens. The prebate is given out to “all valid Social Security cardholders who are U.S. residents.” Illegal immigrants would not fall into this category and would not qualify for the prebate. They would be forced to either qualify for citizenship, or pay the 30% tax for food without a prebate.

Overall I think that the Fair Tax system has the potential to be an effective system. It has a few issues with it that could use a little more ironing out, but as our current tax system becomes more an more confusing I could see an increasing movement towards this type of system. For those who are interested in reading more about the Fair Tax, there is a book dedicated to the subject written by Neal Boortz and John Linder.

For a link to the official Fair Tax Act of 2007 – HR 25/S 1025 plain English summary, click here.

An IRA (Traditional or Roth) is a great way to start saving for retirement. The beauty of the two IRAs is the tax benefits that each program offers.

With the Traditional IRA, your contributions are tax deferred, meaning you can deduct contributions from your earned income for the year. Your deposits also grow tax free until withdrawal. The only downside with a traditional is that withdrawals are taxed at the current rate. This may benefit you if you are in a high tax bracket now and expect to be in a lower bracket upon retirement.

With a Roth IRA your contributions are not tax deductible. Your funds grow tax free, and any earnings withdrawn after a certain age are not subject to income taxes. One advantage to the Roth is that you can withdraw your contributions without penalty. This can be great if you need funds for an emergency and don’t want to have the added burden of additional fees. A drawback is that you cannot deduct your contributions from your taxes.

As you can see, each has its own unique set of advantages and disadvantages. To read the official IRS rules and regulations for each type of account, click here.

One important thing that you should be aware of though is that you are only allowed to contribute a certain amount each year. If you are under 50, the 2007 contribution is $4,000 and the 2008 contribution limit is $5000. If you are 50 or older you can contribute up to $5,000 in 2007 and $6,000 in 2008. I included the 2007 tax values because you can actually make contributions to your IRA for the previous tax year all the way up until taxes are due on April 15th, 2008. By making a 2007 contribution you are giving yourself the opportunity to maximize your total allowable contributions.

Sometime in May the government will be sending out checks worth up to $600 per individual or $1200 per household. The government feels that by doing this they will be able to stimulate our currently stagnant economy. It seems like a fairly good idea and all, but will people really spend the money? I think that for the most part people will spend it. People will look at the money as an unexpected gift and by spending it they won’t be deviating from their budget because they were never expecting this money in the first place. Sure, this may give a temporary boost to the economy, but it won’t be anything long lasting or long term.

Here is what I project people will do with their money:

50% will go out and blow it all within the first few weeks on something that they been wanting but not able to afford. These are the people who probably need this money the most to go towards paying off debt, but that isn’t going to happen.

20% will save the money. These people have always been good savers, and they most likely see this as a golden opportunity to increase their savings without doing any extra work.

10% will put the money towards their credit cards or other sort of loan product in order to pay it off earlier. These people have made an excellent choice for their personal finances. Any opportunity to pay off more debt should be taken advantage of. This is a golden opportunity to do so.

20% will do some combination of the above three things. It will likely be more spending than saving though.

Here is one thing that I don’t like about this rebate. Americans are drowning under piles of debt, but with this free money, most people aren’t going to put it towards paying off their debt. I think that the government should automatically put at least half if not all of this so called “relief” money towards their current debt. They would put half of the funds towards the debt and half as a refund check to the citizen. For those who were in collections or had late debts, all of the refund check would be put towards the creditors. This would encourage people to get up to date with their accounts so that they could get the majority of their check.

All this credit checking would theoretically create a high cost for the government, but the relief act would require creditors to submit a petition for funds if their debtors met a certain criteria. If they did not submit the petition they would not receive a portion of their refund.

I know that this is most definitely a fantasy idea, but I believe that if something like this were to take place, the American citizens would be much better off than they would be with just a straight refund check. I do agree that the government should not be one to tell people what to do with their money, but I do believe that if there was a financial incentive to do the right thing with it, people would be more receptive.

I am really curious to hear what others think about this idea. Do we need to encourage people to pay off their debts? Should the the government have a say or an influence in this? And last but not least, what will you be doing with your relief check come May?

This weekend my girlfriend and I went down to Portland, Oregon to visit some friends. It is always nice getting away from all the hustle and bustle of Seattle and going somewhere different. Portland is a nice city that seems to be quite a bit smaller than Seattle, but is not lacking in any of the amenities of a larger city. One of the main draws for people to the Portland area is the fact that Oregon does not have a sales tax. According to Taxadmin.gov, there were only five states that had no sales tax as of 1/1/2007. Those states were: Alaska, Delaware, Montana, New Hampshire and Oregon.

The sales tax in Seattle is roughly 9%. When we go down to Portland, we like to take advantage of the fact that there is no sales tax. I got to thinking on the way down that there is probably a decent population that drives from Seattle to Portland and back in one day just for shopping. These people have no other reason to visit the city (ie: visiting friends/family, sightseeing etc.) They only make the trek to save some money. I started to think about how much money a person would need to spend in Portland so that their tax savings would equal what they spent on gas to get there.

The trip from Seattle to Portland is roughly 175 miles. This would make the round trip (175 x 2 = 350 miles). Let’s also assume that the car being used is fairly economical and gets 30 miles to the gallon and gas is $3.10 a gallon for regular (which it currently is in our neck of the woods). It would take the car (350 miles/30 mpg) 11.67 gallons of gas to make the whole trip. At $3.10/gallon, it would cost (11.67 x $3.10) $36.16 to make the trip. In order to save $36.16 in taxes, one would have to spend ($36.16/.09) $401.77. At this spending level, you would be no better off than shopping in Seattle. Anything spent over this amount, and your trip would be a success. If you spent any less than this amount, then it would actually cost you more to shop in this tax free environment. If you decided to carpool with a friend, then you would only have to spend half as much to break even.

Let’s take a look at a chart that shows how much you would need to spend based on the mileage of your car in order to break even.

Obviously, the worse the gas mileage, the more you would have to spend on goods to break even. Here is something else to think about. The lower the differential between tax rates, the more you would have to spend to break even. Lets go back to the 30 MPG example. Imagine if the tax rate in Seattle was only 6%. Here is how much you would have to spend. 350/30 = 11.67 gallons of gas x $3.10/gallon = $36.16 to make the trip. Now, we divide $36.06 by .06 rather than .09, and we get $601. With a change of only 3 percentage points, a consumer must spend almost 50% more to break even!

The lesson learned in this story is that although tax free purchases may sound good on the surface, you must spend a lot to make the trip worth it.

I have attached to this post a graph I created in Excel that shows how as MPGs decrease, one must increase their spending to make the tax free savings worth it.