What Immediately Happens to Prices?

September 3, 2005  ·  Filed under: Criticisms, Education

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.

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23 Responses to “What Immediately Happens to Prices?”
  1. Very interesting Annalysis. I believe the pretax rent will drop. Rents are very market driven and can easily fall. If a tenant’s rent is currently $1000 per month and is going to $1300 with Fair Tax the current $1000 has embedded income taxes. Most rents are offset by interest expense and building depreciation expense,so there is not a large embeded tax, but if fair tax passes and rents are taxed rents will fall. The market cannot bear that 30% increase. Rents are directly related to incomes. I bet we end up aroung $1150 as the new after tax rent.

    Mark Giraudo  ·  Sep 5, 2005 at 4:24 pm  ·  Permalink
  2. Good point. I hadn’t thought about the specific economic analysis as far as how rents would be impacted. I’m not sure how heavily the market can take them being driven down, but you’re right that they’ll undoubtedly come down some (pretax).

    Brad Warbiany  ·  Sep 5, 2005 at 6:11 pm  ·  Permalink
  3. Of course, because an apartment complex is a long-term asset, all the construction costs are history. There are some current costs such as maintenance and management fees. Income and payroll taxes will be eliminated for these items, providing some cost relief to the complex owner. The amount of profits set aside to pay corporate taxes will also be eliminated.

    New complexes could be built at lower rates with imbedded taxes removed from the construction supplies. The prices offered by these new companies will drive down prices on all rental properties.

    Bill Rook  ·  Sep 5, 2005 at 7:45 pm  ·  Permalink
  4. […] In recent weeks, a number of people (including Brad Warbiany and Pat Regnier) have raised the question, “How much of their gross income will employees keep under the FairTax plan?” […]

  5. As a residential rental landlord with small holdings, this whole “Fair Tax” idea scares me silly. I am not wealthy, and my eight duplexes (16 units) are meant to get me through my retirement years since my employers have never had any type of pension plan.
    The problem as I see it is that should rents fall, my property value falls with them. Most loans are tied to the appraised value of a property and all of them have a clause which states that should a property’s value fall below the principal of the loan, the loan can be “called” and the entire principal balance is immediately due.
    Many rental properties are highly leveraged because the owners use the equity built up in one property to purchase another property. Should my loans be called by the lenders, I am facing bankruptcy and extreme poverty in my old age, not to mention I will have nothing to leave my children. Is this really what you had in mind?

    Lynn Robb  ·  Nov 21, 2005 at 9:52 am  ·  Permalink
  6. Lynn,
    Property values, I suspect, are more dependent on the expected profit than the expected rent.

    Here’s what you can probably expect to see:

    1. Interest rates might decline slightly because with banks having less of a tax burden, they do not need to build that tax into their profits. So your mortgage might go down.

    2. Any maintenance that you need to do will not have a FairTax component to it, because it is a business input. So that cost will decrease to you.

    3. Most rentals are not profitable immediately, but as time (inflation, property values) goes by, the rents grow independently of the mortgages. So 4-5 years after buying a place, the property value won’t matter too much, as the rent you’re earning is enough to cover your obligations with profit on top. I wouldn’t suggest buying a new rental property within 1-2 years of the FairTax being implemented, but properties you currently own should be above water enough by the time the FairTax was implemented to be okay.

    Last, the point you bring up is purely a matter of transition costs. FairTaxers have never said that the transition will be absolutely smooth for everybody. At the very least, it will put H&R Block out of business. My biggest worry about the FairTax will be the immediate transition period. But once that transition period completes, these things will balance themselves out, as markets always do.

    Brad Warbiany  ·  Nov 21, 2005 at 10:54 am  ·  Permalink
  7. Please allow me to disagree with you point by point:
    1. You state that interest rates will go down. How does this affect me since I already have my loans at 5.5% courtesy of the last recession? If my property value declines and the lender calls my loan, I will have to come up with additional money and get a new loan at a HIGHER interest rate because of the property value decline or let the property be foreclosed.
    2. Are you guaranteeing me that prices are going to fall on building supplies? That flies in the face of all the rules of supply and demand I learned in my economics classes. Plywood etc. has never been higher thanks to Katrina, Rita and whatever disaster comes next.
    3. As someone who spends nights, weekends and holidays renovating and working on my units, I need to see a turnaround much sooner than 4-5 years. If that is what we can expect, there is no future in owning rental property and the market will certainly tank. Or–landlords will hunker down and RAISE rents just to protect their investments. How does this help the middle and lower class renter?
    4. I am obviously one of the people your proposal was intended to harm. Contrary to popular belief, not all landlords are plutocrats battening on the downtrodden and disadvantaged. Most of us are just middle class baby boomers trying not to starve when we retire.

    I would love to see income tax simplified, but your proposal would irreprably harm the economy in the process. Sorry-I can’t support your “Fair to Some Tax.”

    Lynn Robb  ·  Nov 21, 2005 at 11:33 am  ·  Permalink
  8. Lynn,
    I should be more clear. Rents can only drop by the amount that the market bears. The drop will be caused by the removal of embedded taxes in the cost of owning rental property. This means that rents will drop by the amount of taxation removed from the rental process.

    My point is that your balance sheet likely won’t change much. Unless something specific to your personal situation makes it different from the majority of landlords, there is no reason why you or other landlords would lower your rent to the point you’re losing money or putting your loans in jeopardy. Assuming you’re making a decent income from rental property now, there’s no reason to think that will change, and you’ll no longer have to pay any income taxes on that income.

    But to answer the specific concerns.

    1) If the situation is bad as you say it is, banks calling in the loans would only worsen their situation. And if landlord all of a sudden start looking to refinance, banks will compete with their rates to get that business. There’s no reason to think that you won’t do better than your current 5.5%.

    2) Yes, prices will decline. Every building supply you use has some component of tax built into its price now due to embedded taxes. Those components will disappear, and since you won’t be paying the FairTax on those goods, your price will decline. Likewise, contracting services to a plumber, electrician, etc won’t incur the FairTax, and since you won’t be paying that workman’s income tax, his prices will decline as well. Supply and demand will force these prices down.

    3) If you’re making money on your investments now, I would expect you to still be able to make money once the FairTax goes into effect. My point about the 4-5 year thing is that people often lose money early in the lifespan of rental property due to paying more for it than rents will bring in, in the knowledge that appreciation of the property and future rents will make it worthwhile. That’s irrespective of the FairTax and any effect it will have. And if renters don’t lower their rents, the lower class renters may have to rely on some of the help the prebate gives them to make ends meet. But considering that those lower-class workers may be bringing home more take-home pay, they’ll be in better shape to pay that increase.

    4) The proposal was not intended to harm anyone except people who profit from a confusing, inefficient tax code. The goal is to make the tax fair to all. As I mention, the transition effects will not be felt equally, and to some extent, that can’t be helped. But the important point is that the long-term positive effects of the FairTax make it worth finding ways to minimize the short-term negative effects of the transition.

    The FairTax is fundamentally better than the income tax, but the question of how to get from here to there is not as easy. You mention that the FairTax would irreparably harm the economy, but the income tax is already a huge drag on the economy. It’s a question of how hard we want to try to make things better instead of keeping the flawed system we already have.

    Brad Warbiany  ·  Nov 21, 2005 at 12:49 pm  ·  Permalink
  9. I have had the same qualms about the FairTax and how it would affect renters. Why wouldn’t you charge tax on rent just like on a new house? Problem is, there is nothing said about rent in H.R. 25. As far as I can tell, under the FairTax there would be no tax on rent.

    I brought this up with my father (also a FairTax supporter), and he sees rent as return on capital income and therefore not taxed.

    This issue does need to be discussed because I think it would be absolutely unfair to tax someone buying a new home but not taxing someone who is renting a new home. Also, what about the landscape maintenance, repairs, minor improvements etc. that really amount to services that a homeowner would have to pay tax on?

    So now that I have found a forum that is talking about it, here’s my solution:

    A landlord is doing two things by renting property to a consumer.

    One, he is investing in capital that will have appreciation in value as well as return on investment (just like if you put the money in a long-term mortgage but getting instead of receiving the interest). This should not be taxed because it is pure income from capital. Period.

    Two, she is providing maintenance services, marketing services, etc. in order to make the apartment attractive, livable, fully rented (higher occupancy equals lower needed rent) and profitable beyond its pure investment. This sure sounds like services that should be taxed under FairTax.

    Now the math:

    Rental Income MINUS Mortgage costs (actual or appraised at current competitive interest rates) = Taxable Rental Income (@ the 23% inclusive rate). This would effectively tax (at the FairTax’s 29.9% external rate) all of the income from rent that does not represent pure return on investment (at mortgage rates).

    This does add complexity to the system, but I don’t think it’s all that difficult. After all, any landlord can easily tell you how much his mortgage on the property costs and he can also tell you what his rents were. After improving a rental unit, the landlord could get re-appraised and recalculate his ‘consumption tax capital return reduction’ to get additional tax advantage which also provides a better product to the consumer.

    Controls would need to be in place to prevent someone from getting a high interest mortgage and making the taxpayers pay for his additional deduction. The accepted rate would have to have a reasonable maximum presumably changed as interest rates change.

    Also, lest we consider throwing in exemptions for all sorts of other things, this reduction that is given is variable based on capital value + resonable current interest. For this reason, and because you CAN continue to use and sell and provide value from property, you should continue to get this reduction as long as you own the property. This is not a mortgage interest reduction, this is not a one-time deal that only hits income. This tax is meant to hit the service portion of the rent and unless you believe the property is worthless on the day that the mortgage is paid on it, then the reduction would need to still be there ad infinitum.

    FairTax Thinker  ·  Nov 26, 2005 at 11:43 pm  ·  Permalink
  10. One major revision to my earlier post. H.R. 25 does mention rents (all over the place) and they specify them as taxable.

    This needs to be changed for my support to be 100%.

    Even as is, I’d vote for it but I feel for our landlord friend in this forum. How can you say that someone should pay tax on their investment? I thought we all agreed, no more income tax and why are we taxing property? If you don’t give a reduction for the appraisal value and reasonable interest return of a given property, what you begin taxing is the landlord’s investment income and his property’s value on top. What should be taxed is the services he provides and his profit above the normal investment profit. After all, that’s all we’re making all other forms of business pay with the FairTax.

    FairTax Thinker  ·  Nov 27, 2005 at 12:00 am  ·  Permalink
  11. Thanks. I was looking for a candid assessment of the rebalancing of wages and prices as a result of the transition and agree with most of your conclusions.

    I would add that middle income seniors who’s wealth is maintained in tax deferred (401k / IRA) or especially tax exempt (Roth) accounts would see little benefit on the income side yet be hit with the brunt of price rises. Be sure to hurry and recharacterize your Roth back to a traditional IRA if this goes through.

    Also with the discussion on interest rates… It is my understanding that interest paid would be subject to the Fair Tax — perhaps negating any drop in rates.

    Scott Dysart  ·  Oct 10, 2007 at 3:13 pm  ·  Permalink
  12. 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.

    There is also a horizontal equity issue, which drives me – as a renter with no hope of buying a home – up a wall.

    A poor (e.g. retired) homeowner, enjoying the tax preferences of homeownership, gets the prebate, and winds up with “free” money. (e.g. X prebate minus .7X tax = .3X free money)

    A poor renter, paying tax on every dollar of his rent (and typically more than the homeowner, who has either a low mortgage payment or no mortgage payment at all.

    So at equal incomes, a homeowner will have greater purchasing power before taxes are considered) AND will pay less tax than a renter.

    Minimum Wage  ·  Jan 28, 2008 at 5:18 am  ·  Permalink
  13. Also, I cannot see any way in which rents fall under the FairTax.

    The tax breaks enjoyed by landlords (e.g. writeoff for “depreciation” on an appreciating asset) in the existing tax code go away under FairTax.

    Perhaps more foreboding, the historical record indicates that landlord cost reductions – small and large – such as California’s huge Proposition 13 property tax cut – NEVER have resulted in rent reductions. Add a little FairTax and a lot of renters are going to take a big hit.

    Minimum Wage  ·  Jan 28, 2008 at 5:29 am  ·  Permalink
  14. Why do you think Landlords costs will be reduced under Fair Tax? Because we don’t pay fair tax on maintenance items? We write this off now.

    Right now due to interest expense and depreciation I don’t pay any taxes on my rental units. Like most small landlords, I am counting on them being paid off in retirement and generating income then or selling them at a higher value and making my money off appreciation. Like most small landlords, I do not get current income from my rentals so I pay no income tax.

    I am currently a landlord and if Fair Tax takes effect, I will have to raise my rents to cover the costs. Since I rent to low income tenants who cannot afford a raise in rent they will now be homeless. I will be unlikely to find somebody else to fill these units at the higher rental rates I need to make my payment and pay the Fair tax. So if I cannot find a new tenant, I will put my units up for Sale. My single family units will likely sell but what about my multi-family units? They will take a huge loss in value because their value is based on the rent multiplier. Since I bought them and have a mortgage on them, they will likely be worth less than my outstanding mortgage with a 30% price reduction.

    Without tenants paying rent, I will not be able to make my payments and will very quickly find myself in bankruptcy and homeless along with my former tenants.

    Simply exempting rents like mortgages are exempted from the fair tax would fix this problem for both landlords and tenants.

    The tax as it is proposed doesn’t sound very fair to me.

    A Landlord  ·  Apr 4, 2008 at 12:31 pm  ·  Permalink
  15. Under the current tax system, when landlords sell their depreciated property they have to pay a capital gains tax on all that depreciation they get back. Am I right in assuming that once the fairtax takes effect they will no longer have any tax burden for that depreciated value? That could help ease some of the pain that landlords might face under the fair tax.

    Andrew Martin  ·  Apr 4, 2008 at 4:41 pm  ·  Permalink
  16. Andrew —

    Actually, there is a loophole available under the current tax law for landlords and other real estate investors where they can exchange property on a tax-free (tax deferred) basis to enable them to defer capital gains essentially indefinitely.

    There are billions and billions of deferred capital gains out there that theoretically would not be taxed until someone dies and the estate tax comes due. But under the FairTax the estate tax is eliminated so those deferred capital gains would presumably never be taxed.

    Since I’ve got investment real estate, I certainly appreciate the ability to exchange it tax free, but I’ve always thought that was probably a loophole that should have been closed a long time ago.

    Hayden Kepner  ·  Apr 4, 2008 at 5:04 pm  ·  Permalink
  17. I thank you for the warning. I will definitely recharacterize my Roth IRA to prevent that from happening.

    roth ira rates  ·  Dec 10, 2008 at 9:43 am  ·  Permalink
  18. No doubt the Fair Tax will be somewhat disruptive to the rental housing industry, and I can see why it would alarm property owners that are highly leveraged, with little room for error.

    I think that if the “pre-bate” contains enough of an allowance for basic housing expenses, it could offset the fair tax on rents for basic housing.

    I do have some concern that “basic” housing costs are very, very different across the USA, (where other consumer costs are more or less equal) and that “pre-bates” might need to be adjusted upward in areas with very expensive housing costs and property values… to be fair to both renters and their landlords.

    Doug Prop Mgr  ·  Jan 1, 2011 at 11:15 am  ·  Permalink
  19. Doug,

    I am not a property manager, but I have a son-in-law who owns 24 rental units in Virginia. His worry about the Fairtax is that if nominal rent increases by 18% as we have estimated, his renters may decide to buy a used house instead of renting? What do you think?

    Hank Van Gieson  ·  Jan 1, 2011 at 3:51 pm  ·  Permalink
  20. Well, I own rental property. For short-term rentals in Tennessee (e.g. cabins), we must charge 12.75% for gross receipts tax. Although that supposedly is paid by our guests, it really comes out of my pocket because the guests look at the gross (i.e., tax included) price before deciding whether it’s worth it to rent our cabin.

    If the FairTax were enacted, even assuming the tax-exclusive rate were only 30% (a big if!), then the total tax I’d need to charge would be 42.75%. Essentially, it would become economically impossible to rent the cabin. Now, I might just decide not to rent the cabin and survive because I’ve got alternative sources of income, but people who are dependent on rental cabins (or hotels, motels or campgrounds) to earn a living would all be bankrupted.

    Hayden Kepner  ·  Jan 2, 2011 at 6:22 pm  ·  Permalink
  21. Contrary to popular belief (of fairtax opponents), the rental market won’t be destroyed. If it does shrink compared to current law, it is because current law is geared to help rental properties. But why should it be? That’s what actually makes the fairtax fair. It doesn’t play favorites (except with education, but maybe we can get that changed).

    And remember, these extraordinarily rough estimates of 18% prices increases are in nominal dollars. On average, real prices stay the same. An 18% price increase means the Fed allowed an 18% inflation over a limited time period. I wouldn’t put it past them, but some opponents of the fairtax thinks the Fed are “heroes” and saved us from financial collapse. It’s really anyone’s guess, but I can’t imagine them have 18% as their goal (currently they have a 2% annual inflation goal).

    Andrew Martin  ·  Jan 2, 2011 at 7:11 pm  ·  Permalink
  22. In the fair tax bill there is a $200/monthly administration deduction for businesses/individuals who have to pay the fair tax. If the tax amount if less then $200 for the month you are not required to file.

    In other words I pay a friend $400 to cut some trees in my yard, under the fair tax this would be $520. If he has a job and is just doing this side job for a little extra cash he does not have to file this under the fair tax because $120 is less then $200. I would just pay him the $400 end of story. It would be inefficient for the government to tax millions of people who may do a job here and there.

    If you take an apartment you rent for $1,000 a month you don’t have to raise the rent if the fairtax is implemented. 23% of the $1000 is $230 that goes to the fair tax. Once you subtract the $200 you know are only paying $30 in taxes and the owner of the house gets $970 income tax free.

    If you own a 100 apartments chances are you are going to need employees to maintain the apartments. Accountants, maintenance workers and so forth. By law you would have to pay 7.5% payroll taxes (social security and medicare) for each employee then you have pay taxes on the money you make collecting rent. This is where the hiding taxes come into play under the current system, both are eliminated under the fair tax, so you simply pay the 23% tax on the rent that you collect minus $200.

    Even if rent goes up slightly remember the renters are now paying no income tax. Rent may go up slightly at first in the case for someone with 16 apartments who may not have employees but it won’t be 30%

    tony  ·  Feb 20, 2011 at 2:50 pm  ·  Permalink
  23. Actually, the FairTax does play favorites, it picks winners (homeowners) and losers (renters).

    Since rent is fully taxed, and at least part of a homeowner’s housing consumption is untaxed, a renter will always pay more tax than a homeowner at equal consumption.

    Also, rents cannot possibly fall as much as the FairTax costs renters. The largest tax embedded in rent is the property tax – not the income tax – and the property tax is not affected by the FairTax.

    If free markets existed in housing – if renting were a voluntary choice for all renters – then paying FairTax on rent would be voluntary.

    But millions of Americans are involuntary renters, and the Fairtax redistributes their income upward.

    Terry Pratt  ·  Mar 25, 2011 at 1:19 am  ·  Permalink