In the course of my vacation I was reading the actual FairTax bill when I stumbled across a massive loophole in sections 301 and 302, the sections dealing with the prebate.I wasn't looking for anything of the kind. In fact, I was looking at the section to see if the rules were overly strict on family composition. But while I was trying to figure out if the wording excluded counting spouses of children, it struck me that there was a much larger problem.

Now I have been critical of the prebate as have many others, and we have often brought up the topic of fraud. However, the problem I have found is not fraud per se, but a perfectly legal means to receive multiple benefits for the same individual. And, thanks to the wording of the act, it doesn't even qualify as a crime.

Allow me to show through an example.

Suppose a household is made up of Al and Alice, a married couple. With them lives Bob, their son, and his wife Betty. They also have two children, Charles and Cindy. Now the prebate is based on the concept of qualifying households. Section 302 gives a number of rules for how households may be composed, who may be included or excluded, and how to handle children in joint custody cases¹.

Starting form these rules, let us assume Al files as the head of household. He can claim his spouse, Alice, and his son Bob. He cannot claim Betty as she is not a lineal descendant, but he can claim Charles and Cindy, so he gets a prebate for five people.

As she was not in Al's household, Betty can set up her own household. She can claim Bob, as he spouse, and Charles and Cindy, as her children, so she can get a prebate for four people.

"Wait a minute," I hear you saying, "those three were already claimed!" And you would be right. However, in all the definition of who can be claimed in a household, there was one small oversight. I can find nowhere in the law that states a person cannot be claimed if they were part of another household. Nothing².

So, if we really want to max out the prebate, Charles can set up a household for all six, as they are all qualifying for him, and Alice can set up one identical to Al's, with five people. Which means that six people can receive twenty individuals worth of prebate³.

Now, obviously in practice this would never work. Someone would amend the statute to include the simple rule that to qualify in a household  the person must not be claimed in another. But, at the moment, the bill says nothing of the kind, and such overlapping households are legal.

So, if this won't make it into the final law, why am I mentioning it?

The reason is simple. So much of the FairTax argument is based on faith, that I felt I had to point this out. The argument always goes "experts say the 23% will cover costs", "experts say there are 22% embedded taxes", "experts say it is revenue neutral" and so on. My point is that those experts drafted a bill which allows double, or more, counting of individuals. These experts are as fallible as the next man. So I refuse to accept their say so for any arguments.

As I have said over and over, I want someone to audit this plan who is not a true believer. I am not about to accept the word of experts. Experts make mistakes. And just a few little errors in assumptions turn the FairTax from economic nirvana to a massive failure.

Which is my entire point. Instead of taking this on faith, let's have a bit of rationality, and ask, if the assumptions are wrong, if the economics are not so rosey, what then? What happens in the worst case scenario? Are we still better off? Or do we need to rely on the predictions of experts, need to hope for the best, as any other outcome makes the FairTax a lot less pleasant an alternative?

I don't have the answers. I may have some in the future, but right now I don't. I know the FairTax folks published a lot of their rationale, but they seem to rely on a lot of aggregate numbers which mask a lot of important details⁴. I am looking for better figures to examine, but for now I just can't say what the worst outcome is.

What disturbs me is that no one on the FairTax side thought to tell us about it either. All is sunshine and candy and rainbows and unicorns. Not a word about what happens if things go south. Which actually makes me a little more uneasy. Never trust anyone who tells you everything will be fine.

The fellow wearing belt and suspenders may look a little silly, but at least you know he has considered the possible alternate outcomes.

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1. It is a minor complaint, but the joint custody provision says that a child, to be counted, can be claimed only by the parent who has the child more than 50% of the time. If there is a true 50/50 joint custody, from the wording of the law, it appears NEITHER parent can claim them. Also, if there is no formal custody agreement, the law is quite silent. But these are trifling complaints compared to the one I raise in the essay proper.

2. That is not entirely true. In children with divorced parents it is specified they can only be claimed by one parent, but that is the only place where double counting is prohibited.

3. Some will argue that the law says all family members in a residence will make up a household, meaning that a single residence can have no more than one household. But I would argue that as Betty was excluded, she is not a family member, and thus must be allowed to form her separate 4 person household. It may be arguable if Alice or Charles can set up third and fourth households, but  we clearly have to allow Betty's with its three person overlap.

4. The Arden, Laffer and Moore document is the best source, but it still relies on "macroeconomic" aggregates, which hide a lot of distinctions by using national figures. For example, just to name one, the removal of tariffs will destroy the US sugar industry. Whether that is desirable or not, it is not considered when we use "aggregates", as the differing impact of tariffs is hidden in an overall number. What we need is a more detailed analysis, taking into account the variable distribution of taxes and their impacts, not the broad overview which seems to be the bulk of the FairTax economic analysis.

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POSTSCRIPT

Now, it is possible I am wrong, and somewhere in that 133 page monstrosity there is a prohibition against double counting, but I didn't see it. Though I must admit I did suffer some of that "legislation hypnosis" I recall from law school, the version of highway hypnosis that strikes when trying to wade through Munn v. Illinois at two in the morning, so I can't claim I recall every word.

The one counter argument I foresee, and I mentioned in the footnotes is the wording that says every member of a family living in a residence will be part of a household. However, as I showed, if we assume Al as the person around whom the household centers, then Betty is excluded, so we have to allow a second household. Of course, we could start with Bob and include everyone, but nothing in the law defines who we must use to define what is a family, so my structure seems perfectly acceptable. From the wording, it sounds as if the person filing can choose how the family is defined, or at least who is used to define a single family.

I am sure some FairTax advocates will dispute with me, but the fact is the simple addition of the rule "and shall not have been included in another household" would have saved all these headaches, yet the supposed experts just forgot it.

Which, as I said, was my point. These are humans, and their plans are human plans. As von Moltke said about war, "no plan survives contact with enemy", and I would say of taxes, "no plan survives contact with reality". Despite all the assurances of experts, things will go wrong, and assumptions will prove too optimistic. We need to look at what happens in a worst case scenario, and as far as I see, no one even thought to do so. All is based on the belief that their assumptions are absolutely correct. And that frightens me.

UPDATED 06/02/2008

If anyone questions my construction above, then I offer an alternative. The law is quite detailed on whether or not a household can claim a child living away from home in some contexts, but not in others.

Let us say that my spouse and I separated and she lived three weeks with her parents and then one week with me. From my reading of the law, there are provisions for students and minors in joint custody, but nothing covering adult children. Logically, only one of us can claim her, but nothing in the law says we cannot both claim her, meaning she will be claimed on both her parents' household and mine.

Well, as I said, I am sure the final version would add the simple text that a person cannot have been claimed in another household, but for the moment it really does appear that there is no rule against double counting. It goes against the intent of the prebate, but there is nothing in the letter of the law which prevents it.

After all the effort that went into drafting the bill, it is a glaring oversight. And one that does make me worry about the existence of other possibilities for prebate fraud that I have overlooked.