The FairTax and Tax Evasion
Opponents of the FairTax like to assert that a federal sales tax would increase tax evasion. It is more likely, however, that the FairTax would increase tax compliance while reducing compliance costs at the same time. It is impossible to argue in good faith that the current approach is doing its job since the problem is getting worse with the passage of time despite major and ever more intrusive attempts to address the problem.

Some of the problems regarding the underground economy that exist under the income tax would remain under the FairTax, particularly those involving cash transactions made in the illegal economy or with the explicit intent of evading taxation. However, 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. People who are in noncompliance because they perceive the present system as unfair or illegitimate may choose to comply with the FairTax. Most importantly, because of lower marginal tax rates, the benefit from lawful tax avoidance or illegal tax evasion will be much less at the margin relative to either the present system[15] or competing alternative tax systems, such as the USA Tax or flat tax[16], that have higher marginal tax rates, particularly on wages or self-employment income.[17] Research has confirmed the intuitive relationship between higher marginal tax rates and higher rates of evasion.[18] Lower rates, all other things being equal, imply lower evasion because the benefits from evasion decline while the costs of evasion remain comparable.

Much is made from the fact that a federal sales tax would place the responsibility for tax collection with the retailer, a sector of the economy in which small businesses are better represented. Small businesses are viewed as more likely to evade taxes since the owner, and beneficiary of tax evasion, is more likely to also be responsible for keeping the books and filing the tax returns. While there is, of course, some truth to the proposition that evasion rates among small businesses are higher, it is highly implausible to suggest that evasion would increase under the FairTax. First, those small businesspersons that are inclined to cheat on their sales tax are probably already cheating on their income tax and would be inclined to do so under any tax system. Second, the economic importance of small firms in the retail sector is usually grossly overstated According to the Joint Committee on Taxation (JCT), small firms only account for 14.9 percent of gross receipts by all retailers, wholesalers and service providers.[19] Since the gross receipts of wholesalers would not typically be subject to tax, the true scope of the small "problem" companies is smaller still. However, sole proprietorships, perhaps the most likely to evade tax under the present system and under the FairTax, are not included in the JCT figures.

Third, the necessary corollary of the tax collection point being concentrated at retail establishments, rather than with individuals or other businesses, is that there are fewer points where revenue agents must concentrate their enforcement efforts. The collection points in the FairTax system would be perhaps 10 percent of those under the current income tax system or other alternative tax systems.[21] Because the number of collection points is so much lower, if enforcement funding is held equal then the audit rate for potential evaders would increase considerably, and the likelihood of them being apprehended is correspondingly higher. In other words, the risk of detection would increase and risk-adjusted cost of evasion would increase. Increased evasion due to the greater concentration of small businesses in the retail sector would be outweighed by greater compliance due to greater simplicity and perceived legitimacy of the tax system, from reduced temptation due to lower marginal tax rates, and from higher risk of detection due to a smaller taxpayer population. Fourth, some small business owners evade taxes because they feel the present system is unfair or overly complex and burdensome, or that they have been wronged by the system.  They are much less likely to feel that way about the FairTax. Fifth, and perhaps most importantly, the marginal benefit from evasion will decline under the FairTax since the marginal tax will decline. Thus, the incentive to cheat will decline markedly.

Any one of the 118 million income tax filers can cheat the income tax system today, and a great many do so. Under the FairTax, however, only retailers (about 14 million-tax filers altogether) would be in a position to cheat In addition, the vast majority of retail sales, 90 percent, are made by large firms that are less likely or find it more difficult to cheat. A retailer who cheats under the income tax system has very similar, if not the same financial gain, as a retailer who cheats under the FairTax system. If a retailer under the FairTax system, failed to report taxable sales, the government would lose and the evader would gain by an amount equal to the sales tax on the good or service purchased. In an income tax system, the government loses and the evader gains by an amount equal to the marginal income tax rate times the amount not reported. An income tax evader will see his taxable income go down dollar for dollar, for every dollar of income not reported. Typically, failing to report a small fraction of a business' gross income will be sufficient to drive its reported profit to zero.

Even if, however, we were to make the unlikely assumption that evasion rates would be higher under the FairTax system than under an income tax system, they would have to be much higher to justify the income tax's huge compliance costs (estimated to be over $225 billion in 1996), many of which are incurred by businesses and are deductible as a business expense. Moreover, if compliance proved to be a problem, information reporting along the lines of present law (1099's) could be implemented to facilitate cross-checking by government auditors. These 1099s would reflect the quantity of product sold to retailers. An auditor could then ensure that the retailer's books either reflected a sale of these products or that the products were in inventory. The FairTax requires all businesses (including non-retailers) to keep business records kept in the ordinary course of business that would aid cross checking by government auditors.[22]

Conclusion
Tax evasion will undoubtedly be a problem under any tax system. It is a major and growing problem under the current tax system, despite very substantial efforts and increasingly harsh treatment of the taxpaying public. Almost 40 percent of the public, according to the IRS, is out of compliance with the present tax system, mostly unintentionally due to the enormous complexity of the present system. This breeds disrespect for the tax system and the law, and makes a system based on taxpayer self-assessment less and less viable.

The FairTax is likely to reduce rather than exacerbate the problem of tax evasion. The increased fairness, transparency, and legitimacy of the system will induce more compliance. The roughly 85 to 90 percent reduction in filers will enable tax administrators to address instances of noncompliance more effectively, and increase the likelihood that tax evasion will be discovered. The relative simplicity of the FairTax will promote compliance. Businesses will need to answer one question to determine the tax due: how much was sold to consumers? Finally, the dramatic reduction in marginal tax rates will reduce the gains from tax evasion. If the cost of noncompliance remains comparable (or even increases due to the increased likelihood of getting caught caused by the much smaller number of filers), then both the expected profit from and frequency of tax evasion will decline.