Question: How does the "transition inventory credit work"?
The effective date of the FairTax is January 1 with the income tax repealed on Dec. 31st (the day before). The “items for sale” on retailer’s shelves will still have the cost of embedded taxes in them. That is why the FairTax has a “transition inventory credit”. The purpose of the inventory credit is to initially drive down prices for these goods by exactly the amount of the FairTax. All goods held in inventory or various stages of production on the implementation date of the FairTax (January 1) will not be taxed again to avoid the double taxation you mentioned.
The vendor is eligible for an inventory credit equal to 23% times the value of the inventory (items in stock). The credit is available for up to 2 years giving the vendor plenty of time to move the “pre-FairTax” inventory. As the vendor sells these items, the vendor can claim the FairTax inventory credit against the amount of FairTax he has collected from the customer and is required to remit to the state sales tax authority. This will enable the vendor to lower prices so that the retail price + the FairTax will be approximately the same as before the FairTax. Here is an example of how the inventory credit works.
Lets look at the purchase of a new car on January 2nd right after the FairTax goes into effect:
Assume the inventory cost of a new car (including taxes already paid under the Income Tax system) is $20,000 and the car dearlership expects to make a 10% profit.
1) In December, before the FairTax, the car sold for $22,000.
2) When the FairTax takes effect in January, the inventory value has associated with it a tax credit for 23%, or $4,600.
3) Since the car dealer knows that the public knows they get a tax credit for all cars in inventory, they will be forced (by competition and public opinion) to lower their price accordingly.
4) The car dealer prices the car for the same selling price (including the FairTax). This means the car is sold for $16,923 plus 30% FairTax (tax-exclusive rate) of $5,077 for a total cost of $22,000.
5) The seller completes a monthly sales tax return reporting the sale and remits the FairTax collected.
6) On his sales tax return, the seller would also claim the transition inventory credit of $4,600 which lowers the seller's net cost to $15,400.
7) The seller's profit is now $1,523 (9.9% of net cost, or approximately 10%) which is the same profit the dealer made before the FairTax).
Note that the inventory credit is transferable and lasts for two years. This means new cars built before and after the FairTax will have comparable costs. There is also an incentive to sell all inventory within two years, when the credit terminates.
The above car bought new in December (or before) can be re-sold used for $22,000 without FairTax.
The above car bought new in January can be sold new for $22,000, including the FairTax.
The above car bought new in January can be re-sold used for $22,000, without any additional FairTax.
Thus after-FairTax sales prices are competitive between new and used cars bought before or after the FairTax.
An awareness of the inventory credit will cause consumers to be wary of any net cost increases at the FairTax transition. Over time, prices will adjust to new levels that reflect the actual lower post-FairTax cost of capital and production.
Karen Walby, Ph.D., Director of Research, FairTax.org