What Immediately Happens to Prices?
Dale, at QandO, has brought up again what he feels to be a problem with the way the FairTax is being sold. As I desire to be fair, I’d like to answer his claims. In truth, he is right, but at the same time, I think that the benefits will far outweigh this problem.
He first cites relevant statements by economist Alan Garner:
An important question from the standpoint of short-run macroeconomic adjustment is how the increase in consumer prices relative to wages occurs. One possibility is that the after-tax consumer price level would rise by the full amount of the consumption tax while wages remain constant. Another possibility is that the after-tax consumer price level would be constant while wages decrease. Most discussions of transitional tax-reform issues assume the first case. When a VAT has been introduced abroad, authorities typically permitted an upward adjustment in the after-tax consumer price level, although efforts were generally undertaken to ensure that this one-time adjustment did not become a sustained inflationary process (Tait).
Dale follows this by saying:
What Fair Tax people are promising is a free lunch. They promise that a) tax revenues will be neutral, b) prices will fall, and c) wages will rise.
In all honesty, this is a fair criticism. The idea that when embedded taxes are gone as a cost to business, prices will drop, is true. Competition will force the prices down to an equilibrium level that reflects these cost decreases. However, the immediate reaction to the FairTax will not remove all of the embedded taxes as a cost to business. The reason is that when politicians offer to end withholding, most workers are not going to allow their salaries to be cut. This means personal income taxes and the “employee contribution” to payroll taxes will not disappear. They will be paid to employees rather than to the government.
This means that prices cannot immediately drop 22%
I hate to have to concede this fact, because it makes the FairTax sound worse. The pre-tax price of products will, of course, fall. Removing the employer contribution to payroll taxes, removing corporate income taxes (and income taxes for self-owned businesses), and doing this across all levels of the supply chain will drop prices. But unless workers take salary cuts at the same time, the drop will not be 22%.
Prices of goods will immediately rise, by 10-20% (rough estimate)
I should point out that I don’t see any way that prices will increase by the full rate of the FairTax (23% inclusive, 30% exclusive). This has typically been the response to sales or VAT taxes in Europe, but those taxes were never used as a complete replacement for other taxes. Since this will replace so many taxes, competition will force the price down, but we will still see an increase at the retail level once the tax is implemented.
This being conceded, we have to ask what effect will occur as a result of this increase?
First, for almost all workers, who will see their paycheck increase by much more than the rise in prices, and who will also receive the prebate, this will certainly be a net positive. Taken as a class, very little needs to be said, as their wages will definitely increase by a large factor.
However, that leaves the poor workers, who pay no actual income tax, and the elderly, who are often on fixed incomes.
For poor workers, the prebate will ensure that they are not harmed. For a family at the poverty line, the prebate will provide enough additional income to offset any tax that would be paid. Typically these families are also buying many goods (cars, etc) used, rather than new, so they will be getting a net increase in spendable income. Considering they will get a minimum of 7.65% raise, based upon the end of payroll tax withholding, plus the prebate, they should be helped. The biggest problem for many of these families is that they rent, which is taxed. But the prebate should be large enough to solve this. For poor(er) families above the poverty line, it is harder to judge. Many of these families are paying income taxes, so they will see their incomes rise by more than 7.65%. Many of them also own their homes, which will be a largely-untaxed portion of their income. But there must exist a tipping point where the prebate ceases to be much of a help, and where their wage increase due to withholding is not extremely large. There is a possibility that families right at this margin could be harmed.
For the elderly, it again is an issue. For the very poor elderly, the people who are surviving solely on Social Security benefits, it is likely to be a positive change. The prebate will likely raise their income by more than the immediate increase in prices, making it a net benefit. As their income increases, though, there is a point at which they will not be seeing any benifit from the end of income, payroll, and interest tax repeal. There may be a point at the margins where they are harmed. For many of the more wealthy elderly, since much of their fixed income will be subject to income, interest, or capital gains taxation anyway, they will be a case much like workers, where they definitely see a benefit under the FairTax.
In the long term, wages will reach an equilibrium point as well. This may take several years, as it is unlikely that most workers will see their wages ever drop. Thus, my prediction is that wages will hold constant or increase at a very low rate, while economic growth catches up. In the long term, prices will drop by 22% relative to their current level, as wages come in line with a new market. But in the short term, unfortunately a rise in prices at the retail level must occur.
The question still exists whether the FairTax is worth it, even with this knowledge. And I think the answer, from an economic standpoint, is yes. For most people in this country, the new tax structure will be an immediate benefit. For a small few, and certainly not the very poor, it might be a harm. But the economic growth spurred on by this system will be incredible. When you compare that to our current tax system, which harms everyone except the very rich and large corporations, who can structure their affairs in such a way as to avoid it, I think it is a net benefit. Considering the drag our current tax structure places on our economy, and it tips the scales heavily for the FairTax.