FairTax Debate Between Kotlikoff and Gale, at AEI
A news tip from FairTax critic Hayden Kepner: the American Enterprise Institute has published the video of their debate between William Gale and Larry Kotlikoff. You can view the video by going here and clicking on “video.”
20 Responses to “FairTax Debate Between Kotlikoff and Gale, at AEI”
Joshua — One can also pull up the underlying studies and power-point presentations at the same web site.
As background for your readers, a couple of years ago William Gale, an economist at the Brookings Institution had published an analysis of the FairTax that concluded that the revenue-neutral rate over the next ten years would, at best, be 44% at the tax exclusive rate (which I think translated into something like 31% at the tax-inclusive rate, but I’m not sure.) Last year, the Beacon Hill Institute, together with Laurence Kotlikoff, published a report that concluded that the revenue-neutral rate for 2007 would be 31.2% (tax excusive; 23.8% tax inclusive). So, the main topic of the AEI conference was which rate was correct.
Below is my attempt at a summary of the main points made. (However, as the speakers were pressed for time they needed to rush through some points, so I’m sure I missed plenty.) Also, I do not necessarily agree with these points, but I’m trying to give a relatively accurate rendition of what was said.
Kotlikoff’s Points
1. Gale’s methodology was basically sound; however, Gale severely undercounted the revenue that would be generated by taxing state and local governments.
2. The Beacon Hill study probably undercounted tax-evasion by a small degree, so the real revenue-neutral rate would be slightly higher (i.e. 32% tax exclusive; 24.3% tax inclusive).
3. Tax evasion will be kept down because the IRS or some similar agency will still be around to enforce the FairTax and there should be innovative ways to detect cheating.
4. The economy should expand by at least 10% over time with the FairTax, which is not counted in any of the models.
5. Prices will probably rise 30% under the FairTax; which Kotlikoff says some liberals might think is a good thing because (a) the rise in prices would indirectly “tax” wealth because the savings of wealthy folks would immediately be worth less in real terms, and (b) the U.S. government will see the real cost of its temendous public debt decrease by this one-time inflation.
6. Democrats should like the FairTax because it is a tax on wealth. Although in the short term high-income folks will see a decrease in their taxes, over the long run, their wealth will be taxed as they and their decendants spend that wealth. This tax on wealth helps keep the rate low.
Gale’s Reponse:
1. Gale says that his study did not undercount revenue from taxing state and local governments; he cannot understand why Kotlikoff would think that.
2. The Beacon Hill study used essentially the same methology as the Gale study, so Gale does not know why the Beacon Hill study came to such a different result (not only from Gale’s study, but from every other independant study).
3. The difference between the studies is NOT due to different assumptions about tax evasion or excluding certain items from taxation (e.g., health care, new homes.) Each of the studies used the same favorable assumptions.
4. Gale assumes that the differences between the results of the studies must be “in the weeds,” in other words, one will need to look very closely at each of the at myriad of individual assumptions/data/calculations made in each of the studies to figure out the difference.
5. Gale did not agree that the economy would grow under the FairTax to the extent Kotlikoff did. He believes realistically any growth would be much lower, in the 0-3% range.
6. Gale did not necessarily agree that reducing the federal debt through a 30% rise in the price level was a good thing (or that other nations that we owe money to would not retaliate somehow).
7. Gale believes that a “vicious cycle” would emerge as lobbying groups and politicians would try to exempt certain items from the FairTax (e.g., credit card interest; health care), which would force the rate up even higher.
Jane Gravelle (of the Congressional Research Service)
1. Tax evasion will probably be much higher under the FairTax than anticipated.
2. Other nations with lower sales tax/VAT rates than proposed under the FairTax have experienced high rates of non-compliance.
3. Many opportunties to game the system under the FairTax, with under-reporting, setting up shell businesses; collusion, etc.
4. Consumption of taxable goods and services will decrease under the FairTax (thus driving up rates).
Incidentally, one thing they all seemed to agree upon was that the argument that the “underground economy” would suddenly be taxed (and thus generate new revenue) under the FairTax was bogus.
THIS IS GETTING VERY CONFUSING! ONE MUST DO AN ALMOST IMPOSSIBLE AMOUNT OF INVESTIGATING TO FIND OUT THE REAL STORY...WHEN ONE PERSON ON THIS BLOG SAYS SOMETHING YOU HAVE TO EITHER BELIEVE IT OR DISCOUNT IT OR SPEND LOTS OF TIME TRYING TO PROVE OR DISPROVE IT.
WE NEED PAUL HARVEY TO TELL US THE REST OF THE STORY!
Why One Should Follow Beacon Hill
During the American Enterprise Institute’s February 28, 2007 program on “Taxing Sales Under the Fair Tax: What Rate Works?” one development demonstrated that the conclusion of the Beacon Hill Institute and Kotlikoff is to be adopted to the exclusion of Gale’s. The background is as follows.
William Gale had published a paper in Tax Notes on May 16, 2005 contending that the replacement rate necessary for a national sales tax along the lines of a Fair Tax would be 31% tax-inclusive, 44% tax-exclusive. Before coming to the seminar, Gale had reduced his rate requirement to 28.2% tax-inclusive, 39.3% tax-exclusive.
The Beacon Hill Institute of Suffolk University Team, in collaboration with Boston University’s Laurence J. Kotlikoff, using Gale’s methodology, published its own paper in Tax Notes over one year following the Gale paper on November 13, 2006. In their paper Beacon Hill concluded that the Fair Tax revenue replacement rate would be 23.82% tax-inclusive, 31.27% tax-exclusive. With minimal spending reductions on the non-Social Security side of the government spending ledger, the 23% tax-inclusive rate would put the government in the same surplus-deficit position as it is today.
Kotlikoff, who with David G. Tuerck argued his and Beacon Hill’s position at the seminar, presented a detailed reconciliation of how their analysis resulted in a lower rate than Gale’s, using the same methodology. The presentation showed, item-by-item, where Gale’s revenue base was understated, and where Gale’s required revenue was overstated.
In the discourse that followed, Gale admitted that he could not account for the difference between his rate and Beacon Hill’s. After some perfunctory remarks rejecting certain possibilities, Gale dismissed the problem with the statement that the “difference must be in the weeds.”
Gale should have combed through the Kotlikoff-Beacon Hill “weeds” before coming to the seminar. Gale had at least three months before the seminar to do so, and he knew that his own thesis had been challenged and would be challenged further. The analysis that would have been required from an economist such as Gale would not have been difficult because the Kotlikoff paper used Gale’s methodology. The data was government data, to which Gale had ready access.
As of today, Gale still has not explained why his figures differ from Kotlikoff’s and Beacon Hill’s. I submit that he has not done so because he cannot.
~Jim Bennett
Summit, NJ
Jim, it appears BHI included federal spending in the FairTax base where Gale did not so I can’t see how they can say they used Gale’s method.
Also, I haven’t been able to determine how (or if) BHI adjust the required revenue to keep real federal spending level. They say they keep real spending level - so they must have. I just can’t figure it out.
Fred,
I passed your questions on to David G. Tuerck, Executive Director, The Beacon Hill Institute, Professor and Chairman, Department of Economics, Suffolk University. I can do no better than to pass his responses back to you verbatim. Professor Tuerck’s responses are as follows:
AS TO FEDERAL SPENDING IN THE FAIR TAX BASE
“We used Gale’s method, insofar as the underlying algebra is the same. The difference is in measuring certain terms in his equations and ours. Perhaps this reader sees a difference in that Gale computes the tax rate as te = G/(C - B), where we compute it as ti = G/(C + G - B).
“Let C =personal consumption, G = federal government spending and B = the prebate base. Ignore everything else.
“The answer is that the two calculations are equivalent. te is the tax-exclusive rate, which Gale computes, and ti is the tax-inclusive rate, which we compute.
“Suppose we start with our calculation of ti and reduce it to te: te = 1/(1 - ti), so that te =(G/(C + G - B))/(1 - (G/(C + G - B))) = (G/(C + G - B))/((C + G - B -G)/(C + G - B)) = G/(C - B). Presto! The G disappears from the base, but nothing substantive has changed.”
AS TO REAL FEDERAL SPENDING LEVEL
“We keep real federal spending level by allowing for the possibility that price might rise by as much as te. Thus we inflate both nominal spending and nominal revenues by the same fraction.”
Best regards,
~Jim Bennett
Summit, NJ
Fred,
I know that Joshua considers this blog to be “Fairtax 401″, not “Fairtax 101″, but this input from the Boston professor really muddies the water, and doesn’t answer the real question, imho. You asked how they kept real spending level as claimed. This answer seems to say that they assumed that prices would rise by the amount of the exclusive tax rate (30%), and that revenues from the tax on the higher prices would also rise by the same fraction. Duh!
But, the real question ought to be “Who pays?” Governments don’t pay taxes out of some hidden cash drawer, in the end they get their revenue from us, the taxpayers. This answer doesn’t make it clear just how revenue is increasing. If it’s federal revenue raised by the federal government taxing itself, then what that means is that they continue to believe that moving cash from pocket to pocket at the federal Treasury level makes sense, which it doesn’t. If they mean overall revenues will rise, then they are confirming that the state and local taxes will also have to rise. Either way, the Fairtax 30% rate still does not account for the revenue needed to offset the tax on government consumption.
Hank,
If the question is: why not let the US government buy tax-free and lower the federal budget correspondingly, there are two policy reasons. First, making the government pay market prices for goods and services, at least in the first instance, damps government spending. Second, making the federal government pay market prices discourages questionable shifting of services to sham government functions and all the associated dispute.
States, and the fed too, will pay slightly more on their purchases of goods and services (not 30%), but there are two moderating factors. First, states will not pay employer taxes to the fed that they pay today for their employees today (I know that fact because I am a state government employee). State costs are more concentrated in personal services than procurement. Furthermore, state borrowing costs will drop significantly, which for a state like New Jersey is considerable.
The feared run up of state and local taxes simply will not materialize under the Fair Tax.
~Jim Bennett
Summit, NJ
Jim,
I admire your enthusiasm for the Fairtax on this and other blogs, but in this case I believe that you are quite mistaken in your belief about the run up of state and local taxes.
I have done a paper on the subject that I’d be happy to email to you upon request. (vanlinda@comcast.net).
First, according to the Kotlikoff/BHI study report, 68% of federal consumption is for goods and 32% for personnel services (payroll). Similarly, 59% of state/local consumption is for goods, and 41% for payroll. Either they are wrong or you are? (or perhaps NJ is a little strange?)
My study assumes a 10% pretax cost decrease due to eliminating business income/payroll tax costs as well as compliance costs, and an after tax retail price increase of 17%. It also assumes that the taxable burdened cost of government payrolls is 150% of the basic payroll.
The added costs to the federal government amount to $104 billion for goods, and $108 billion for personnel services after taking credit for $22 billion in SS payroll tax savings. The added costs to the states would be $110 billion for goods, and $169 billion for personnel services.
The AFFT argument for taxing governments is, as you say, to prevent government competition with the private sector. But, it seems to me that by untaxing private businesses, the level playing field is fully restored, and adding a tax on governments is surely overkill? There are much simpler legislative means to keep governments out of the private sector, for instance, check out HJR23.
Finally, I’m not sure just what state and local borrowing costs you have in mind, but I’m aware that state and local governments frequently use bond issues to raise money for capital projects. And those bond issues are already tax advantaged. The AFFT estimated 100 -200 basis point drop in rates is based on experience with those muni bond offerings. Contrary to your belief that government rates might drop, I’d suggest that rates will have to rise in order to compete with non government investment opportunities. As I understand it, people invest in municipal bonds largely because the interest is non taxable, even though the risk may be greater. Take away the tax advantage, and it may get much tougher to float a government bond issue without raising the rate of return. If I missed your point, please tell me just what borrowing you were referring to. Thanks.
If prices do drop by the 22% embedded tax rate and federal/state/local goverments no longer have to pay the tax, won’t all these goverments be receiving a huge boost in tax revenue, i.e. costs drop while revenue stays the same means purchasing power increases?
Jim, I’m afraid that doesn’t answer my question. I’m still not seeing where they kept real federal spending level in their calculations. He claims that they inflated nominal spending and nominal revenues by the same fraction but this is only to account for a price level change and since it’s on both sides of the equation, it factors out. If federal government spending is in the base, to keep federal expenditures level in real terms, you must increase the nominal revenue required by the amount of FairTax the federal government would pay.
To quote Gale [t1 is the required tax-exclusive national sales tax rate]:
“To maintain the real size of the federal government and its programs, any nominal federal outlays that are subject to the sales tax must rise in nominal terms by t1 percent to cover the tax payments that are due on that spending. Thus, nominal taxable federal spending must rise from GS in the pre-sales-tax economy to GS1 = (1+t1)GS.”
Let’s look at the BHI study. Equation (27) is where the 23.82% rate is determined. It shows:
2,228 / (9,189 - 0.01 + 913 + 1,089 + 276 - 2,112) = 23.82%
Equation (26) shows the the 913 in the denominator to be “taxable federal government spending on goods and services” adjusted for the administrative fee. So they include taxable federal government spending in the base.
The 2,228 that is the numerator in equation (27) is shown in equation (26) to be the 2007 “revenue from taxes to be eliminated under the FairTax” minus the savings from closing the IRS. It appears to me they never adjusted the required revenue by the amount of the FairTax as Gale did.
I don’t see how this paper shows the 23.82% rate allows the federal government to “maintain their real spending level after the switch to the FairTax.” It seems to me they repeat the mistake Gale was criticizing.
With all due respect to Jim, I too watched that “debate” and I certainly did not get the impression Jim got.
In the first place, Beacon Hill/Kotlikoff were paid by AFFT for their study and, presumably, to participate in the debate. Gale is not being paid by anybody to oppose the FairTax, so there’s no incentive (other than intellectual curiosity) for him to spend too much time debating the “weeds” of different studies.
Second, the “debate” was really an hour-plus presentation by Kotlikoff, with about ten minutes for Gale to respond, then about twenty minutes of back and forth between two or three other economists. So it was not a real debate in any sense.
Third, Gale’s study was over a ten year period. Beacon Hill/Kotlikoff study was for 2007 only, in which they buried the fact that they were assuming a deficit of $476 billion as their “revenue neutral” figure.
Fourth, during the presentation, Kotlikoff admitted that their study had underestimated tax evasion and that the required rates from their study would be (slightly) higher than in the paper.
Fifth, the study completely ignored any decrease in consumption (or shift to non-taxable consumption) that would result from taxing goods and services, as well as any other tax-avoidance strategies in their analysis. Even a 10% decrease in taxable consumption would radically raise their required rate.
Sixth, as others in this forum have argued, it appears that Beacon Hill included government spending in their formula. Frankly, their response to your email from above seems to be a continuation of their obfuscation. It’s been my experience that when an economist cannot answer a question in plain English, it’s often because they don’t want the answer to be understood.
Seventh, I will also point out that in the “debate” even the FairTax advocates conceded that (a) the FairTax won’t bring in any additional revenue from the “underground economy,” and (b) that prices will need to rise by the tax-exclusive rate of the FairTax. Most FairTax advocates will fight to the death on these points.
If you are going to claim the “debate” somehow proves the FairTax will work, then you’ve also got to concede that we won’t be getting any additional tax revenue from illegal aliens and drug dealers, and that prices will rise by the amount of the FairTax. You can’t cherry-pick what you like and ignore the rest. Unfortunately, that’s something far to many FairTax advocates have done and often continue to do.
Regards,
Hayden
Hayden, it’s interesting that if you remove taxable federal spending from BHI’s denominator (i.e., remove it from the base as Gale does) you get a 26.39% inclusive rate (35.85% exclusive). Gale found the rate for 2005 would have been 26.7% inclusive.
It seem obvious to me that BHI’s 23.82% rate does not use the “Gale Method” in that it keeps taxable federal spending in the base without increasing the revenue required by the same amount. This raises serious questions as to the validity of the 23.82% rate and some of the claims they have made (e.g., they used Gale’s method, maintains real federal spending level). I believe BHI/Kotlikoff need to address these issues and explain their calculations (they are complex so it is possible that we are just misunderstanding them - but I’ve looked over the paper pretty carefully). I hope those on this forum that have contacts with BHI are asking these question and will post responses here.
BHI recognizes that if the government taxes its own purchases from itself, this is a wash. In other words, whether the government taxes itself or not is irrelevant for the determination of the “real spending neutral” FairTax rate. They start with nominal government expenditures G (on the right-hand side of the equation) of goods and services. Those expenditures must buy the same real goods and services under the FairTax as they would under current law, except for IRS services that would no longer be needed because of the removal of different taxes valid under current law.
Morphh, if government spending is in the base, to be “real spending neutral” you must adjust the revenue required by the amount of tax that would be paid (see Gale). The 23.83% rate calculation in BHI’s study does included taxable federal spending in the base - it does not adjust the revenue required. It repeats the mistake Gale was criticizing.
Morphh,
Color me dense if you wish, but your statement that “whether or not the government taxes itself irrelevant” is incredible. If you really believe that, try taking the $2 trillion in government consumption out of the BHI base/rate study calculations, and you will see that the rate goes up to 30% inclusive. It can only be irrelevant if the revenue side of the equation also goes down by a like amount, and I fail to see how that can happen. The only tax savings available to governments is the 7.65% payroll tax all governments pay for their employees.
Where is the rest of the government cost savings. Hint: Under the Fairtax, Government consumption generates around $460 billion, while the current government share of payroll taxes amounts to $56 billion.
Please identify the $404 billion you say is irrelevant.
If you take the $2 trillion out of the tax base, aren’t you in effect saying the government’s tax burden of $460 billion is gone. Therefore, government consumption is now $1, 540 billion. Of course, this all relies on the assertion that pre-tax consumption is 22% cheaper.
To me, “whether the government taxes itself or not is irrelevant” makes sense based on how one would define the rate, but only if deficit spending is ignored.
Here’s why: Assume R[rate] = T[tax collected]/(T + D[deficit spending] + O[everything else in the consumption base]), or R=T/(T+D+O). I believe it’s suggested that the government no longer tax itself. Then you get R=T(1-R)/O which solving for R yields R=T/(T+O). I assumed the amount of tax collected needed to be reduced by the rate. Without the deficit, the two rates are equal.
I e-mailed BHI and they are working on a response, which I expect is part of their overall Bartlett rebuttal.
I see that Laurence J. Kotlikoff’s January 15, 2008 rebuttal to the Bartlett piece of December 2, 2007 in Tax Notes has appeared on this FairTaxBlog.com site, and it addresses the above points about government spending.
With respect to the federal government, Kotlikoff makes it clear that his and Beacon Hill’s September, 2006 paper that appeared in Tax Notes aleady took into account that the federal government’s nominal spending would be higher under the Fair Tax than its 2007 spending without the Fair Tax. See Formula No. 12 in the 2006 paper. The Fair Tax rate caclulated by Kotlikoff-Beacon Hill puts the federal government in the same real spending positon - not nominal spending position - it would have found itself in 2007. See also pages 12-13 of the rebuttal paper on the treatment of government.
Kotlikoff also acknowledges in both papers that nominal state and local government spending will be higher. He allows that the point is difficult to sort out and subtle, but in effect the increase required in state income taxes offsets - but only partially - the benefit from the Fair Tax. Rebuttal at pages 13-14. State governments do not need to be compensated by the federal government when the Fair Tax is implemented.
Having acknowledged that state and local government nominal expenses will rise under the Fair Tax, one must consider that there are several offsetting conservative assumptions that Kotlikoff and Beacon Hill have made. First, they assume there will be no dynamic benefit to the economy from the Fair Tax. This we know is not true. Second, the economists assume there will be no monetary accommodation by the Fed, which they contend is irrelevant. The third assumption, which they do not express, is that they do not consider any offsetting price reductions resulting from the removal of taxes from the cost of production. These are three overly conservative assumptions.
The fourth observation comes from me. Kotlikoff and Beacon Hill did not express the offsetting effect on state and local spending (and on federal spending) of un-taxing education under the Fair Tax. In my state, New Jersey, the school district portion - before a dime of state aid is received - of my property tax bill that funds the municipality, the school district and the county, is over 50%. This does not yet consider the portion of the county budget that funds education, such as Union County College and special education. At the state level the New Jersey State budget for education is $10.975 billion, which is over one third of the entire state budget. None of this is taxed under the Fair Tax.
In view of the foregoing, the Fair Tax will not materialize in the spending and tax hikes that will drive seniors and others into penury.
~Jim Bennett
Summit, NJ
I’ve discovered two obvious errors in BHI/Kotlikoff’s paper in regards to the Family Consumption Allowance (prebate). First, in Appendix B they claim “The number of households was inflated using the U.S. Census Bureau estimate of population growth from 2004 to 2007 (2.77 percent)” but the numbers they used are 2004’s data (2004 Current Population Survey: Table H1 — census.gov/population/www/socdemo/hh-fam/cps2004.html) inflated by 0.92%, not 2.77% as they claim. I’m not sure where they got 0.92% but that’s typical of a one year increase, not three years - so essentially they are using 2005’s population, not 2007’s as they claim.
The second error is one Gale made also. The Census data (as shown in Table H1) breaks down households into “Family Households” and “Nonfamily Households.” BHI/Kotlikoff and Gale assumed that the prebate was based on households in that if there were two or more people in a nonfamily house, only one would get the full amount of the prebate for a single person and the rest would get the amount for a “lineal ancestors and descendants.” This is incorrect. The prebate is based on families, not households. Nonfamily households in the Census data are unrelated people living in the same dwelling, e.g., roommates. Under the FairTax, if there are two more unrelated people living in the same household (nonfamily households) they are considered separate “families,” would file for the prebate separately, and they would each get the full amount of the prebate for single people. The annual consumption allowance for a single adult is $10,210 vs. $3,480 for a linial ancestor or descendant, so this error is not insignificant.
If you correct these two errors in BHI/Kotlikoff’s calculations the “prebate base” goes from $2,112 billion to $2,205 billion. Plugging this corrected number into their rate calculation results in the inclusive rate going from 23.82% to 24.06%.
[BTW, I found this error while plugging in as many actual 2007 numbers into BHI/Kotlikoff’s calculation as I could. A quick run through shows his estimates were pretty far off and most were in favor of lower FairTax rate. I’ll post my results when I’m done.]
Gentlemen, please read the United States Constitution. They already made a tax and economic system. Let’s use that one.