Jay Bookman Decries “Faith in the FairTax”
April 23, 2007 · Filed under: Criticisms
FairTax critic Hayden Kepner sent me a link to Jay Bookman’s new column “Fervent faith in the FairTax defies reason.”
I tired of the ad hominem attacks after the first few paragraphs, but perhaps others here would like to wade through the whole article and share their thoughts.
68 Responses to “Jay Bookman Decries “Faith in the FairTax””
What Bookman (not Brookman; I got his name wrong) did was go to the FairTax.org website and plug various income scenarios into the FairTax calculator to compare the taxes that would be paid under the FairTax versus how much is currently paid in federal income tax. In almost every case, the amount paid under the FairTax was significantly less than what is paid under our current system.
So Bookman then asked the obvious question: If everyone pays less in taxes under the FairTax system than they do today, how can the FairTax possibly be revenue neutral?
Many FairTax proponents say that this is so because “the tax base will be expanded” under the FairTax system. Or, to be specific, foreign tourists, illegal immigrants and the “underground economy” will be taxed under the FairTax, thus bringing down the required tax rates for us honest taxpayers. Oh, if it were only so!
Unfortunately, this argument fails when examined, as I shall show below.
1. Tourists. Obviously, for every dollar in tax revenue the government would get when a foreign tourist spends money in the U.S. under the FairTax system, the government would LOSE tax revenue when American tourists spend money overseas. So, at best, its a wash. But since prices in America would go UP under the FairTax, the reality is that we would have fewer foreign tourists coming to America and more American tourists traveling abroad. So we would LOSE tax revenue in the tourist trade.
2. Illegal Aliens. In the first place, many if not most illegal aliens currently pay taxes, because most have regular jobs (though they might use fake social security numbers). Thus, they currently have social security, Medicare and, often, state and federal income taxes already withheld from their paychecks. All of that tax revenue will be lost under the FairTax.
Second, the FairTax only taxes the purchase of NEW goods and services. I don’t know too many illegal aliens who buy new houses or new cars. And few purchase health insurance or auto insurance. So those expenditures will not be taxed. In fact, most illegal immigrants live very frugally and send money back to their families back home, so the odds of balancing the budget off of their purchases is pretty remote.
Third, as discussed below, the purchases of illegal aliens are currently taxed in the same way they would be under the FairTax system.
3. Underground economy. The argument that the FairTax will tax the underground economy goes like this: Under the FairTax, the drug dealer will not collect or remit the FairTax when he sells illegal drugs to his customer. But when he buys a new Cadillac with the proceeds, the Cadillic dealer will need to collect and remit the FairTax on the sale of the Cadillac. Thus, the drug dealer will be taxed when he spends his ill-gotten gains.
OK. Fair enough. But let’s see what happens under our current system. When the drug dealer sells his drugs, he doesn’t report or pay taxes on his income. But when he buys the Cadillac, the Cadillac dealer must report and pay taxes on its income from the sale. (Similarly, the salesperson must pay income taxes on his commission, the manufacturer must pay income taxes on the sale of the car to the dealer, etc. This is the so-called “embedded taxes” we are currently paying.)
So, the result is that the drug dealer is causing a taxable event to occur when he spends his money, which is exactly what would happen under the FairTax. So no net gain to the government. This is why no economist (including FairTax supporters such as Kotlikoff) give much credence to the notion that the FairTax will result in a windfall by taxing the “underground economy.”
Sorry to pop anyone’s balloon, but I gotta call it as I see it.
Corrected spelling of his name. Thanks.
Hayden,
Here is the basic tax base argument (the links in the post point to the detailed info on the tax base).
You will note that my argument involves neither tourists, illegal aliens, or the underground economy.
There is also a notion of degrees that this train of thought handily ignores.
If the drug dealer buys the car for $50,000, then the business is going to be taxed on the PROFIT of the car only, which may be less than $10,000. There would certainly be a difference in the amount of revenue resulting from this event, than if the entire $50,000 price was taxed, would it not?
So while saying the ‘underground’ economy would result in brand new revenues might not be completely true, consumption taxes would do a better job of extracting FAR MORE revenues from it, and that shouldn’t be in dispute. Same goes for illegal aliens, and perhaps for tourism as well.
My point is that this argument presents no numbers to back up its assumptions. A perceived loss is treated in same degree as a perceived gain, but economics doesn’t work like that. Things have costs and gains. The FairTax should be a large net gain in virtually all of these areas according to economists who have done good research using dynamic models that attempt to predict for changes in price.
James –
What you are implictly saying is that the FairTax rate will be far higher than the embedded taxes we are currently paying. I happen to agree with you, but that is NOT what Boortz, Linder and AFFT claim.
As you know, they claim that the embedded taxes we currently pay are about 22% and that the FairTax rate would be 23%. If that were true, that would mean that the drug dealer’s purchase of a Cadillac under our current system would generate almost as much tax revenue as the same purchase under the FairTax system. Since you say that can’t be right, what you are really saying — finally! — is that the FairTax rate must be much higher than the embedded tax rate in order for the FairTax to be revenue neutral. That’s the same thing William Gale, Dale Jorgenson, the Joint Committee on Taxation, the President’s Tax Reform Commission and we other critics have been saying all along.
Thank you for finally seeing the light and joining the Reality Based Community.
Hayden,
Bookman says that if current tax payers are all paying less, then it can’t be revenue neutral. But he’s ignoring the expanded tax base. Some people — those who currently pay little or no income tax, who you described above — will pay more taxes under the FairTax.
If I understand you correctly, you are have successfully argued that the 23%/30% FairTax rate will not raise more revenue than the current system.
Yet no one is claiming it will necessarily raise more revenue; it is specifically designed to be revenue-neutral overall. (I think even James, above, will have to qualify his phrasing some about where it will and won’t raise more revenue.)
Rather, we are claiming that it will shift the source of revenue, broadening the tax base, so that more people are paying taxes, at an average rate lower than that which the earlier group of taxpayers had been paying.
Customary tax-paying citizens like you and me will pay less, while others who currently succeed in paying less income taxes (immigrants, tourists, retirees, drug dealers, etc.) will pay more. In the end, it evens out and the government gets the revenue it needs.
Quadrupole’s calculations, linked above, show this revenue neutrality very clearly.
So where is the problem?
Joshua
Josh said it better than I did, but I’ll try to make my point better.
Most of us believe that the embedded taxes that will actually come out of price with the FairTax won’t be 22%, but will instead be more like 10-15% depending on industry. This means we should see price increases on the things we buy on the order of around 10-13%. So yes, there will be a difference in these two rates, and Boortz has even referred to it in the revision of his book.
Virtually any serious student of the proposal anymore assumes there will be price increases since it came out that the Dale Jorgensen study included tax estimates on employee payrolls. I will cede that until recently the salesmanship was this zero-sum game business, but not for the past year or so.
But here’s the REAL kicker: You use the logic of embedded taxes to say that our drug dealer buddy is simply going to be taxed the same 22% embedded price with the FairTax as he is today: no difference.
Here’s the difference: us real taxpayers are paying our income taxes PLUS embedded taxes to the tune of a total marginal rate of 40+%. The nontaxpayer is only paying 22%. Sucks don’t it? And the ‘embedded’ part is purely regressive as well, with no relief (often we are paying off business tax burdens at very high corporate rates).
Under the FairTax, we’ll see the nontaxpayers and the taxpayers paying roughly the same thing. Prices will go up (taxes for nontaxpayers and taxpayers alike), and income taxes will go away (but just for taxpayers).
But don’t just focus on percentages either. Focus on dollars.
Let’s assume a $20,000 car today represents about $4400 in taxes that eventually go to the Feds due to embedded taxes and that taxpayers likely paid an additional $2500-4000 in taxes in income taxes to purchase the car in the first place. A nontaxpayer only paid the original $4400. After the FairTax, the car will cost $23,000, $5290 of which is tax money for the Feds. Now the nontaxpayer is paying more dollars in tax, and the taxpayer is paying less than before. It begins to level out.
Joshua –
I must have not made myself clear, so I’ll try again.
1. FairTaxers claim that we currently pay 22% in embedded taxes in our purchases.
2. If that is true, then that means that drug dealers, illegal aliens. foreign tourists, etc. are also currently paying 22% of embedded taxes on their purchases.
3. So, drug dealers, illegal aliens, foreign tourists are currently being taxed, albeit indirectly, at a rate of 22% of their purchases.
4. Under the FairTax, the embedded taxes are supposed to disappear, to be replaced by a 23% consumption tax.
5. Thus, drug dealers, illegal aliens and foreign tourists will begin paying taxes at a rate of 23% of their spending, which is almost equal to the embedded taxes they are currently paying indirectly through their spending.
6. Ergo, no material difference in the taxing of the underground economy, illegals and foreigners under the FairTax versus our current system.
7. James says that the FairTax will extract FAR more revenue from the underground economy, illegals, etc. than does our current system.
8. If this is true, that means that the FairTax rate will need to be FAR greater than the embedded tax rate of 22%.
9. This argument has nothing to do with the size of the tax base.
10. I am simply saying that the FairTaxers can’t have it both ways. They can’t claim that we honest taxpayers are currently paying embedded taxes at a 22% rate, and then turn around and claim that drug dealers, etc. are not currently paying the same embedded taxes at the same 22% rate.
11. So if drug dealers are currently paying embedded taxes on their Cadillac purchases at a 22% rate, we won’t be gaining any appreciable new revenue by replacing the 22% embedded taxes with the 23% FairTax.
12. Thus, in order for the FairTax to extract FAR more revenue from the underground economy than our current system does, then that means that the FairTax rate will need to be FAR greater than the 22% embedded tax rate.
I realize I am starting to repeat myself, so I will stop here. I hope I am being clear. I am not trying to pick on James, I am simply trying to point out some of the many inconsistencies in the claims of the FairTaxers.
James — I did not see your response when I drafted my earlier post, so I apologize for not responding to it. I think you are genuinely trying to be honest about some of the issues with the FairTax. You recognize that it’s not a perfect system; no tax system can be. There’s going to be good points and bad. Once some of those good and bad points are identified (they can’t all be known at this time), then folks can start having rational discussions about the merits of the plan. So, kudos for Joshua for facilitating some honest discussion here.
Anyway, I agree with you. The FairTax (or any consumption tax) would probably capture more tax revenue from the underground economy than our current system does. Although we would probably disagree on just how much net gain would really be realized (due, in part, because we don’t know just what sort of black market would develop under the FairTax.)
I’m still pretty certain that there would be minimal, if any, net gain from illegal aliens for the reasons set forth in my earlier post. But, hey, our respective postions are at least moving somewhat closer than what they had been. Not how did that happen?
Regards,
Hayden
Hayden,
Our difference of perspective lies here:
“6. Ergo, no material difference in the taxing of the underground economy, illegals and foreigners under the FairTax versus our current system.”
On the contrary. Right now when the drug dealer buys his car, the 22% (or whatever) in embedded taxes is being paid by a wide range of individuals: the dealership, its employees, its vendors, its manufacturers, etc. That’s why it’s called an embedded tax — someone else is paying it!
In contrast, under the FairTax, the 23% consumption tax is paid once, at the end, by the consumer — in this instance, the drug dealer.
That means the FairTax has shifted the tax burden from a handful of “innocent bystanders” to the person we’re wanting to tax, which in this case is someone who has so-far avoided directly paying much at all in federal taxes.
Yes, the cost of his purchases was already about the same, and yes some of the money he pays already would wind its way back to the federal government through a circuitous path … but now it’s being paid directly by the drug dealer, without placing myriad burdens on the legal, financial, and accounting systems of other parties.
Seems cleaner to me, and more advantageous, this way. Now the drug dealer carries his own full tax burden rather than having two dozen other parties helping shoulder it for him.
Joshua
Joshua, Joshua, Josua –
You and I will never agree on any of this stuff, yet at least you are fun to spar with!
According to the FairTaxers, the embedded tax is currently included in the price you pay for the good. Likewise, according to the FairTaxers, the FairTax will be included in the price you pay for the good. Either way, the tax is collected by the seller. The buyer doesn’t write a check for the taxes and send them to the government. Ergo, no material difference.
Yes, under our income tax system, we honest citizens must pay income taxes in addition to the embedded taxes. Drug dealer won’t pay any income taxes on the sale of his drugs. But under the FairTax, we honest merchants will need to collect and remit the FairTax on the goods we sell and the services we provide. The drug dealer won’t collect and remit the FairTax on the drugs he sells. Ergo, . . .
Legalizing drugs so that we can tax drug dealers or their customers directly is a completely different debate than the one we should be having here.
Your original post is one that I think has been refuted quite well once you take into account that the realistic estimate of embedded taxes that can come out of price is roughly 10-15% rather than 22% and that is roughly half the FairTax rate.
My example was only for a drug dealer, but the math works out the same on a percentage basis for any non-taxpayer buying any good or service in the United States.
To further the point:
Tourism to the United States will continue to be popular as long as the new price is not too dear. 15% is a bit high, and will likely reduce tourism somewhat, but I doubt it would reduce the overall level of tourism by 15%. Like gas prices, actual reduction in activity due to price comes with sensitivity thresholds. I think the tourism industry might begin to see the effects at around 10%, rather than on dollar one. So we’ll see, but I still believe this is a net gain.
Illegal aliens may not contribute much, but they’ll contribute. As many people argue, there is virtually no way to completely live without paying the FairTax (unless you’re a farmer or something). But if they are illegal, they’ll almost certainly get no prebate money, so every time they buy groceries, they’ll get taxed. For those illegals who have snagged bogus SS numbers, they’ll pay roughly the equivalent of poverty-rate taxation, the same as today. Only the FairTax should offer less of a chance at a negative tax burden than the current system.
But I am glad you at least ceded the point that a consumption tax will do a better job of pulling more revenue from the ‘underground economy’ than income taxes. Now maybe you should relay this to Mr. Bookman.
Regardless of the opinion of Bookman, the fact is that he works for the AJC because he has the correct political attitude. Just as has C. Tucker, B. Lukovitch et.al. He would be elated if the only citizens required to pay income taxes were the “richest 1%”!
Hell, Steve, I’d also be elated if the only citizens required to pay income taxes were the richest 1%.
I’ve been out of pocket while moving, and missed out on all this good exchange on the Bookman article. I think you all missed out on the obvious answer to the original question- “If everyone pays less, how can the Fairtax be revenue neutral?” One of you came close when offering that the consumption base is expanded. But the specific answer seems to be that the Fairtax treats governments as consumers and taxes governments at all levels. Approximately 23% of the revenue generated under HR25 comes from governments, and, as far as I know, they don’t pay income taxes under the current law!
As for tourists, illegals, and the underground economy, only tourists consumption was included in the Kotlikoff/BHI study base, and more than half of the tourist consumption was offset by spending abroad by US citizens. The net tourist spending ($53 billion) accounted for just 1/2 of 1% of the Fairtax base they used in arriving at the 31.2% sales tax rate.
How firm is the 31.2% rate? Not very, IMHO. Factors that might lower the rate do include the consumption by illegals and the underground economy, depending on which side of the arguments you come down on. The basic conservatism (under reporting) in the NIPA tables used in the study might also increase the base and lower the rate. And the biggy is the dynamic forecasts by Kotlikoff regarding economic growth and increased revenue.
But the factors that could increase the rate include the whole issue of evasion as well as the propensity for our government to use tax systems to accomplish “social engineering”. I think the authors of HR25 made a very bad mistake when they exempted education tuition and job training. This allowed the camel’s nose to get under the tent flap so to speak, and it won’t be long before some Senator, who thinks health care or home ownership is more important than education, proposes to exempt health care costs and mortgage costs. And the race is on, all of which will raise the rate.
Finally, only a rate increase seems to be practical in view of the need to extinguish the annual budget deficit and the $9 trillion national debt. I wouldn’t expect the rate to fall in my lifetime.
Criticisms over the projected rate aren’t deal breakers for me. They seem to be more a criticism of the projections and the intended execution rather than the model itself.
The need to get the projections correct and the transition smooth is definitely important. But at the end of the day, as long as revenue neutral is the fixed design goal (and is achieved), then what does it matter what the rate turns out to be? So what if it is 80%? If we are revenue neutral and the costs of compliance and collection are the same, then that is what we are paying now anyway. We are just paying it in 10 different places, many of which are covered up by things like taxing business. If the cost of compliance and collection are less, then we have a better system.
If anything, claims that the rate will be higher are a preview of the shock that will come when the veil is lifted from the nickel and diming and indirect approach that is in place now.
It seems to me that when it comes to the rate, the FairTax is just the messenger – its not the problem.
To determine the required Fair Tax rate, look at government statistics for total taxes collected from payroll taxes (employee and employer share), income taxes (corporate and personal) and estate taxes. Add in the amount of the prebate. Total tax plus prebate for 2006 is $2.724 trillion. Next look at the total consumption and adjust for Fair Tax provisions; total tax base $11.05 trillion. The rate comes to 24.6% for revenue neutrality. If the economy grows 10% as some economists predict, the needed rate would be 22.8%.
Following the same proces for 2004, the rate would have been 22.8%. Why the difference? In 2004, the government collected 14.7% of GDP in taxes; in 2006 16.8%. If the government increases tax collections beyond the growth of the economy, the Fair Tax rate will increase. That isn’t the fault of the Fair Tax but the uncontrolled spending by congress. Likewise if the economy grows beyond normal levels tax rates will fall.
How far will prices fall under the Fair Tax? Eliminating corporate income taxes and employer share of payroll taxes would eliminate $773 billion of business costs. Business compliance costs would have been reduced by $170 billion.
The 22% embedded costs that economists have calculated included corporate payroll and income taxes as well as personal income taxes and payroll taxes. Estate taxes ($28 billion) were not included.
Assuming that the 22% embedded in product costs results from the $2.236 trillion of taxes collected, The $773 billion of business taxes would be 35% of the total taxes collected. 35 percent of 22% is 7.7 percent impact on product costs. $170 billion of compliance costs adds another 1.7% to product costs. When costs go down, competition will force prices down. Thus from direct cost reductions, it is reasonable to see an immediate reduction of at least 9% in prices.
The implementation of the Fair Tax will at the same time put all of the payroll tax and income tax withholding along with all other income and estate taxes into the pockets of individuals. The taxes plus prebate will add $1.951 trillion to disposable income of individuals. That is 72% of the total Fair Tax.
Over time some or all of the $1.9 trillion may result in slower wage increases and reduced costs for business. How much, how soon is pure speculation. The important thing is that the individual consumer will have more money net of taxes under the Fair Tax for consumption or saving.
Marvin, an excellent analysis! The analysts at AFFT projected a more optimistic 12% reduction in production costs over a year ago, but gave no rationale. Your 9% makes good sense.
You wrote:
“Thus from direct cost reductions, it is reasonable to see an immediate reduction of at least 9% in prices.”
I think (hope?) you meant “a 9% reduction in pretax prices”? Readers might think that retail prices are going down and that is just not true. Using your 9% reduction in production costs, prices at the cash register will rise by 18% on average—(1.00 x .91 x 1.30 = 1.18). Actually, this price increase only applies immediately to services. Prices for new goods will see a more gradual rise due to the inventory tax credit effects during the first year of implementation.
I might also quibble with your use of the word “immediately” Competition works well in some business sectors and geographical locations. But, while petroleum and airline tickets might respond rapidly, I would guess that the price of public transportation, for instance, would be very sticky downward. And prices in rural areas might not move down as quickly due to less competition? With all the foreign made products on our shelves, I wonder how big boxes such as WalMart will handle prices? Chinese costs of production aren’t going to change if/when HR25 becomes law?
I also think that if, as you said, everyone will have a lot more cash to spend , then there might be upward pressures on prices? And added savings might help reduce interest costs.
Marvin — You seem to be knowledgealbe about some of the FairTax calculations. Does you calculation of $11 Trillion tax base include spending by the federal government? If so, you might be overestimating revenue generated by the FairTax. Both Gale and Kotlikoff agree that taxing the spending of the federal government will not result in any net revenue to the federal government (i.e., it will be like taking money from your right pocket and putting it in your left pocket). If you back out federal spending from the tax base, you will probably end up with a much higher tax rate necessary to be revenue neutral.
Hank — Although I know have spent a lot of thought on this, I think the simple answer is that prices will go up directly in proportion to any increase in the money supply. For example, if the FairTax is imposed by there is no increase in the money supply, prices won’t rise but the size of our paychecks will decline. But if the Fed increases the money supply sufficiently, then prices will rise by the full amount of the FairTax rate (and we’ll keep 100% of our paychecks). That is what Kotlikoff seems to think will happen. I suppose there could be a middle ground where prices only rise 9%-12%, and our salaries drop by a lesser amount, but it will depend on the money supply.
Hank wrote:
‘I also think that if, as you said, everyone will have a lot more cash to spend , then there might be upward pressures on prices? And added savings might help reduce interest costs.’
This depends on each industry. Indeed added disposable income generally equals some added savings and some added consumption. Depending on what items get added consumption, there may or may not be upward pressures on prices. Certainly added savings will reduce interest rates somewhat.
The reason I say upward pressures on price may or may not happen is because if there is added demand for a product, it typically gets a short-term price increase, quickly followed by an increase in supply which brings price down. iPods are a good example. They are still relatively expensive, but now the top model is 30% less expensive than it was in the past, and there are new low-end models that are very cheap, all because of customer demand for more iPods.
So on macroeconomic levels I don’t believe increased consumption will necessarily contribute to higher prices over time. In small areas perhaps, but not overall.
Hayden, why would the Fed need to increase the money supply at all?
Our employers already have this money and give it to us out of their pockets, not from the Treasury. Why would the Federal Reserve need to add money just for us to get our full paychecks?
That makes no sense to me.
If you instead wish to argue that a lot of money will be ‘freed up’ from the transition to the FairTax and that might have similar effects to adding to the money supply, that is a more realistic argument.
Well, we are fast approaching the point where we need the services of an Economics professor. Monetary accomodation is a concept that escapes me, but what Hayden is saying is in line with Kotlikoff’s study–sort of. Normally, if prices went up 18%, we could blame it on a loose Fed monetary policy–too much cash chasing too few products. As I understand it, the Fed tries to restrain inflation by tightening or loosening the federal funds rate–i.e., the money supply. But in the event of a revolutionary change in our tax system such as the Fairtax, I fail to see how the Fed could fail to increase the money supply? Otherwise, businesses would go broke (they can’t lower prices below their cost level), and/or our wages would fall–which isn’t going to happen! So, I suspect that there will be a full monetary accomodation policy by the Fed to support the Fairtax.
Hayden is also right to raise the subject of the impact of the federal government paying taxes –to itself. This sham, under the guise of trying to keep the federal government out of the private sector, is a way to lower the Fairtax rate–but it makes no sense. As I have said previously, if it’s such a good idea, maybe we ought to tax the government consumption at a 100% rate, and none of us would have to pay any taxes?? Absurd!!! Just for the record, if AFFT removed federal government consumption from the base, the rate would go to 26.4%, (using the Kotlikoff/BHI study numbers).
OK lookit, the ONLY reason to increase the money supply is to add more money to an economy that needs it.
If prices go up because of the Fair Tax, monetary policy is NOT needed to correct it. It is happening BY DESIGN, to tax consumption, rather than income. So just allow prices to go up, give people their full checks and prebate and let the market sort it out.
Inflating the currency simply is NOT necessary.
The FairTax may create a temporary phenomenon similar to inflation for a short period of time, but we won’t need more money to accomodate anything, because the money was already there, it’s just being collected in a different way.
In other words too: if we take the same amount of revenue in taxes from the economy after the FairTax as before (i.e. revenue neutral) , there is no need to inflate currency is there?
James, where is the business going to get money to pay the FairTax?
The business doesn’t pay any money. It collects the money from consumers. In fact, an average business should pay NO federal taxes at all. They can purchase labor tax-free (no employer’s share taxes) and business expenses are tax-free via business registration. And the business itself pays no income taxes or corporate income taxes.
So the next question would be if the consumers pay the tax, where do THEY get the money? The answer is that the consumers get the extra money for items & services by NOT having to pay income taxes and getting a monthly prebate on taxes up to the poverty level spending for their respective household sizes.
Another way to look at it is that individuals are paying all taxes now – and they will be paying all taxes under the FairTax.
The only source of tax is wealth and the only entity capable of having wealth is an individual. Businesses never have, and never will pay tax because they cannot have wealth.
With income tax, wealth is recognized by an individual’s abiltity to collect money. With consumption tax, wealth is recognized by a individual’s desire to spend money.
James, the business pays a sales tax (“remit” may be a more accurate term). That is the legal incidence of the tax. You are talking about the economic incidence of the tax. You are assuming that a business can shift the entire economic burden to the consumer. I don’t think you can make that assumption. It could be that the business isn’t able to raise the price of the item by the full amount of the sales tax requiring either the owners to take less profit or to reduce their labor costs.
But this isn’t really what we were talking about. You might find “Monetary Implications of Tax Reforms” useful.
While this paper is very complex, it might be worth your time to take note that their consumption tax model includes no rebate system and also replaces far more taxes than the FairTax does, hence its high rate (66%).
It also does not include any dynamic economic analysis of interest rates or increased savings (admittedly ignored by the author).
Also, many of the monetary policy suggestions in the paper assume a tax change with no transition rules for inventory (the FairTax has a good one) to mitigate the transition flux period.
In short, the paper is in my opinion a good one, but I don’t think it is wholly applicable. I think the best monetary policy in this instance would be to just stay hands-off and let the plan work out, but perhaps provide solid information during the transition to maintain cool heads on the stock markets.
I do indeed assume that a business can shift their entire tax burden to the purchaser, because the bill does not hold them liable for any taxes whatsoever. Price competition might be heightened but the going rate for labor might conceivably be a bit lower after the FairTax, so I have a hard time believing businesses will be put in much of a pinch.
I tend to believe that if purchasing power stays roughly the same even if prices go up, that consumption won’t necessarily go down, and that profits won’t be devalued if they aren’t taxed at all. So in my mind, a one-time price increase should be allowed without deflating currency or inflating currency arbitrarily. The government choosing to try to regulate this kind of transition with monetary policy is likely to have very negative side-effects in the long-term.
I also tend to believe that the Federal Reserve isn’t really a necessary invention either, so forgive my skepticism.
I agree with Hank that I am getting out on the edge when I (a humble lawyer) start talking about monetary policy, but from my vague recollection of Macro-economics 101, the price level in an economy is directly related to money supply. So, all things being equal, when the money suppy increases, prices must increase. (I readily acknowledge that the “all things being equal” is the great unknown here.) On the other hand, if money supply does not increase, the overall price level cannot rise.
So, under the FairTax, assume a fixed money supply and three general holders of money: consumers, businesses and the government. If we consumers have MORE money (because of the elimination of income taxes plus the rebate), then either business or the government MUST have LESS money. Which means, the country either goes into a recession or deeper into debt.
The second alternative is, under a fixed money supply, that government, business and consumers have the SAME amount of money under the FairTax system than under our current system. But, since income and payroll taxes will be eliminated, that implies that our salaries must DECREASE by the amount of income and payroll taxes we are currently paying. That will net us the same amount of money as we currently have.
The third alternative is that we consumers will end up with more money under the FairTax and that business and the government will have the same amount of money as they currently do (or even more if, as FairTaxers believe, the economy grows). In order for that to happen, the money supply MUST be INCREASED. If the money supply is increased, the the over-all price of goods MUST also INCREASE.
I’m sure Milton Friedman would roll over in his grave if he saw this, but I think that’s basically how it would work. However, I do not claim to have any specialized knowlege in economics so I am certainly willing to be corrected by those who know more on the subject.
Your third scenario is the correct one, and the one I keep mentioning. However it comes with caveats. One, consumers end up with only very slightly more money. Two, businesses may end up with better access to capital, but in the short term will likely break even. Third, the government should probably be very close to breaking even, but might come up 1% short if all the latest go-round with studies is to be believed. Please remember to argue with degrees.
Yes, the price of goods will increase.
BUT you are incorrect that the money supply has to increase in that scenario.
The prices of goods only change due to the tax, not the money supply, as the changes are minor and should level out.
The argument that inflation of prices ONLY occurs when money supply increases is an oversimplification of pricing phenomenon, and one that assumes that there is no major tax overhaul going on.
Now the Fed might attempt to counteract price increases with monetary policy, which I think is unwise. I believe they should stick to the Greenspan method of allowing slow monetary growth in pace with the economy at large to allow sufficient currency to circulate and no more. The Fed should merely try to keep up, and not control the economy for the short term as the changes work out.
This is how Kotlikoff explains it in “Taxing Sales Under the FairTax – What Rate Works?“:
At a macroeconomic level, prices depend on how the monetary authorities react to changes in tax policy, macroeconomic conditions, and other variables affecting prices. In simple terms, the overall price level must be consistent with the “quantity theory” equation, whereby MV = PY. Here M is the money supply, V is the velocity at which money circulates, P is the price level, and Y is real income. For the purpose of this analysis, we assume that under the FairTax, V and Y would remain unchanged. Therefore, a rise in the price level would be possible only if accommodated by an increase in the money supply.18 Put another way, without monetary accommodation, prices faced by consumers under the FairTax would not rise. Any changes to the level of monetary accommodation — that is, increase in the money supply — would cause prices to increase in the same proportion.
18 In fact, Y would not remain constant, but would rise, owing to the “dynamic” effects that would arise from replacing the existing tax system with the FairTax. We discuss this further below in connection with the evasion issue.
We aren’t discussing potential dynamic effects, so the footnote is not relevant.
This is still within the bounds of what I discussed earlier.
I see no reason to change monetary policy beyond allowing for whatever growth is needed (I suppose this would be full accommodation if I understand these articles correctly). However I see that prices in Kotlikoff’s article only go up about 1.3 which is far less than I would expect. If Kotlikoff is correct, only marginal increases in money supply (i.e. no significant change in real money supply growth rate from today’s growth rate) is necessary.
I will cede that.
However I believe we won’t need a 15% increase in money supply for 15% increase in prices. The ratio described in MV=PY is highly dependent on velocity of money which is not described and may increase (more consumption). All other things being equal, this may hold the money supply down to low growth (M being outpaced by V) at a particular price level.
Edit: I reserve the right to be completely and utterly off-base on my previous post. I THINK i understand the definition of velocity of money…
Most of the debate over any issue probably hinges on the interpretation of words. Party A uses a term not very precisely and party B interprets the meaning differently. In an earlier post, I said, immediately there would be a 9% reduction in prices. Of course price reductions forced by competition will take some amount of time. I have no way of proving how much time but believe it would be short term i.e. less than a year. A 9% reduction in prices meant before application of the 23% Fair Tax.
I also used a Fair Tax base of $11,050 billion in my analysis. This comes from taking personal consumption of $9,422 billion and government consumption (federal and state) of $2,573 billion. The total consumption of $11,995 billion is adjusted for various factors as outlined in calculations by Kotlikoff to reach the Fair Tax base of $11.050 billion.
The issue of the impact of the Fair Tax on government should be analyzed more carefully. The first reaction of many people is to say this will increase government cost by 30%. But remember, that product and service costs purchased by this sector will fall at least 9% (before the Fair Tax). The elimination of the payroll tax will save government entities 7.65% of gross wages (employer share of payroll tax). Does this imply an overall 8% reduction in costs before the Fair tax and a 15-18% increase after? 15% of $2,000 billion would be $300 billion. Where will this money come from? increased fair tax rate? Higher state and local taxes? I would like to better understand this.
I am a CPA but not a monetary expert by any means. Logic tells me that an expansion of the money supply would only be necessary if there was a “real” rise in prices. I don’t think that happens with Fair Tax enactment. Individuals will have extra money in their pockets when they do not have to pay income, payroll and estate taxes. They will also have the $460 billion prebate. That coupled with the 9% average reduction in prices will be spent paying the Fair Tax bill. There will be a about $200 billion of extra cash in the hands of individuals that results from reductions in tax compliance costs of business and individuals. This will be offset by the same $200 billion being lost by tax related services. Will there be any substantial impact on real prices and monetary growth in this situation? It doesn’t seem to me that this is the classic inflationary “too much money chasing too few goods.”
Marv, excellent comments and interesting questions.
You wrote in the first paragraph: “A 9% reduction in prices meant before application of the 23% Fair Tax.” If you meant a generic Fairtax, that’s O.K., but I wish you had said “before application of the 30% Fairtax.” Retailers will apply 30% to the pretax price of goods and services, not 23%. In your later discussion about government impact, you seem to used the 30% correctly, so please pardon the “idiot lesson”, it’s just that too many Fairtaxers continue to write about a 23% sales tax, which it isn’t. 23% of every dollar spent is fine, or better yet, a 30% sales tax.
As for government impact, your $300 billion is a bit low if you meant both federal and state/local government entities. I used Kotlikoff’s study assumptions that the breakout of spending for goods/services is 68%/32% for the federal government, and 59%/41% for the state/local governments. This is important because the treatment of government costs is different for goods versus services(payroll). Using the $900 billion federal and $1.1 trillion state local consumption, and applying the breakout percentages, you can see that the added costs for goods would be $92 billion for the federal government and $97 billion for state/local.
When doing the payroll calculations, there is an added consideration. HR25 defines wages and salaries as including all compensation including cash, employee benefits, disability or wage replacement insurance, unemployment compensation insurance, workers comp insurance, and the fair market value of any other consideration paid for services rendered. In short, the burdened cost of labor? I use a 50% add on to the basic cost of wages, because I couldn’t find any authoritative source with more accurate data. Therefore, the added costs of payrolls, using Kotlikoff’s 31% sales tax figure, would be $176 billion for state/local and $112 billion for the federal government after adjusting for the 7.65% FICA savings.
A second issue is whether or not the state/local governments will be allowed to cascade their taxes–i.e., tax the federal tax. HR25 has as a goal the elimination of multiple or cascading taxes. It state/local governments can’t tax the tax, but can only tax the pretax price of goods and services, then there could be an added $39 billion cost impact on state/local governments assuming that sales taxes currently make up about 30% of state/local revenue.
Bottom line: the impact on governments looks more like $500 billion to me, and I have the same questions about where the money will come from? Is the Fairtax really revenue neutral, or does it simply shift taxes to the state/local level?
As a CPA, do you have any better data on burdened costs of payrolls, or is my 50% good enough for government work? Also, is it even practical for employers to calculate the burdened costs on a monthly basis and apply the tax? Or should HR25 be changed to indicate that the tax would only apply to basic payrolls?
Appreciate your comments!
You number crunchers are scaring me. I’m just a liberal arts major.
But I can tell you that I’d get a 90% tax cut if the FairTax is implemented as written. (In large part because I already own my own house, as do most other Americans, and I sure as hell wouldn’t buy a brand new house if I needed to pay a 30% tax or higher on the purchase price. I don’t think Kotlikoff or anybody else has factored in a projected drop in sales of new homes and new cars in their analysis.) Most other upper-middle class and high income families would see similar tax decreases.
If I get a windfall that large, that means that my good friend Hank’s going to take it in the shorts, since he’s retired and will face the full burden of the price increases without the off-setting benefit of income tax reduction. Unless, of course, his pension is way up there, which wouldn’t surprise me.) The truth, of course, is that the numbers can’t possibly work, but I’ll let you number-crunchers figure that out.
Hank – I don’t have the data and haven’t seen any reports that address the impact on government. I haven’t studied this area carefully as yet and only asked the question to see if anyone had solid analysis to shed light on this issue. Before I am willing to endorse my back-of-the-envelope estimate of $300 billion or your $500 billion, I need more facts. I first heard of the Fair Tax less than 5 months ago. At first, I was very skeptical. Solid easy to believe info was hard to find. But through diligent study, I have figured out that the 23% rate works, how the 22% embedded costs were determined and how initial year prices would be effected. This issue of impact on government expenses needs more study before a conclusion can be reached. I was hoping someone had already done the work for me.
What individual states do with their taxes is up to them. The Fair Tax puts no restrictions on the states. Because, state income taxes are based on the federal tax code with minor adjustments, I think most states will totally eliminate their income tax. This would probably be replaced by a broader based sales tax at lower rate than today. Some states are looking at replacing a part of their property taxes with a broad based sales tax. Whatever each state decides, it will be completly up to the state. Conformity with the Fair Tax would make life simpler for the states but isn’t mandatory.
I use the 23% rate always understanding that it is tax inclusive. If you look at the rate the way we do income and payroll tax rates, then 23% is correct. If you look at the Fair Tax the way we look at sales taxes today, then 30% is right. As the Fair Tax replaces taxes that are calculated on a tax inclusive basis, I think it is more comparable to also refer to the Fair Tax in the same way. If you pay $20,000 of taxes on $100,000 of income, you say I paid 20% in taxes. However if you calculate your taxes based on the $80,000 that you had left, your tax rate is 25%. In my mind, 23% equals 30%. It is the total tax collected that is important. I don’t believe Fair Tax supporters are trying to decieve anyone by stating the rate as 23%.
Hayden- sorry to burden you with so many numbers but this is the only way I know to show people how the Fair Tax will work. I realize that my background with taxes and accounting makes it a little easier to understand all of this. But, as you can see from my previous response to Hank, I haven’t gotten everything figured out either.
I want two things to happen concerning the Fair Tax. Everyone should know about this plan and understand it. This is the most important legislation to be proposed in at least 70 years. The potential impact on Americans and the economy is enormous. Secondly, this plan should be thoroughly debated to determine that it is best for America. It should be decided by the people, not by lobbyists who influence congress.
I know nothing about either you or Hank and your financial situations. I too am a retiree and do not fear the Fair Tax. I haven’t calculated what the total impact will be on my financial situation but don’t expect a big difference plus or minus. This should be about what is best for America as a whole. In that way, we will be making a big gift to our children and grandchildren.
You say your taxes will be cut by 90% under the Fair Tax. For this to happen, you must be working and earning a fairly low salary or you earn a significant amount and are saving a huge portion of your income. In either case, I applaud your 90% cut. The poor shouldn’t pay any taxes until the basic necessities of life are taken care of. That is why the prebate was made a part of the program. The high earner who doesn’t spend what he earns isn’t using the products and services available. He is also investing his savings in his business and is creating jobs and making more products and services available to consumers. If puts the money in the bank, it is available for others to use to build the economy. Everyone is better off.
Don’t worry about Hank. He will be fine under the Fair Tax no matter what his income level when compared to where he is at under the current system. It would take a lot more numbers to show you this and I know that I have already used more numbers than you would like.
New housing costs wont go up 30%. There is more labor in housing than in the average product and therefor higher payroll tax costs. Prices of new houses will fall at least 10% before the Fair Tax. Initially this will increase the price of a $100,000 new house to $117,000. How much of a premium are people willing to pay for new over used? There is a constant need for more new housing. Buyers are going to push up the price of used houses until the gap between new and used is narrowed to the point where perceived value of the two houses is equal.
Remember, the buyer is going to have a lot more money in his pocket with removal of the individual income, payroll and estate taxes. Also, the home buyer will be find it easier to save for the new house without income taxes and interest rates on mortgages will be lower.
Most people make buying decisions on big ticket items based on the affordability of the payments. The housing industry will do very well under the Fair Tax.
The same arguments can be made for autos except imports. Imports do not have many U.S. taxes included in their costs. There will be little cost savings for importers to pass on to their customers and they will have the same Fair Tax rate. This will cause more foreign companies to build their cars in the U.S.A.
Kotlikoff and other economists have included all of this in their studies. No one has shown me as yet where the Fair Tax is bad for America as a whole. But, my mind is open and I will consider any information that anyone comes up with. One of the beauties of the Fair Tax is that it is good for every political persuasion; liberal, conservative, Democrat, Republican, Libertarian, independent or whatever.
Actually, Kotlikoff and the Beacon Hill study specifically did NOT include any analysis of ways people might alter their behavior to avoid paying the FairTax (i.e., by buying used cars and homes instead of brand new ones) and the impact of such behavior on tax revenue. Nor did they include any estimate of revenue loss by people illegally evading the FairTax (i.e., by setting up network marketing business and buying a new car as a business expense.) In fairness, however, neither do the studies make any provision for the economic benefits they believe will result from the FairTax. They sort of assume that the revenue loss from tax avoidance and tax evasion will more or less equal the revenue gained by increased economic activity (which is a proposition that William Gale, for one, emphatically disputes). They then make some reference that those issues will need to be studied further.
Marvin, you wrote: “But through diligent study, I have figured out that the 23% rate works, how the 22% embedded costs were determined and how initial year prices would be effected.”
Your previous posts show that you do indeed have a good understanding of the embedded costs and the price issues. However, for you to say that the 23% rate works assumes that you agree that (1) Federal taxation of State/Local government operations will not be found to be unconstitutional under the doctrine of intergovernmental tax immunity;(2) a taxable consumption base of 81% of GDP makes sense (no precedent can be found); and (3) evasion will not be an issue. I haven’t seen any data to refute these concerns, so will continue to believe that the rate issue is still up in the air. Probably not that important in the larger scheme of things.
You also wrote: “Don’t worry about Hank. He will be fine under the Fair Tax no matter what his income level when compared to where he is at under the current system.”
Actually, Hayden’s concern for my “shorts” is well placed. I, along with most single seniors with annual incomes under $60,000 and married seniors with annual incomes under $100,000 would have lower effective tax rates under current law. My analysis used the 2005 IRS software and a Fairtax calculation worksheet provided by AFFT. I would be happy to forward a copy to you upon request to:vanlinda@comcast.net.
As for the Fairtax impact on governments, you won’t find any previous studies done in my opinion. Kotlikoff/BHI were supposed to address that issue but took a pass. Their report concluded that there would be no impact provided that state and local taxes were raised? Didn’t speculate about how much taxes would have to go up? I have a five page analysis I’ll send along at your request.
When James gets through blogging HR25, I’ll have a revised Fairtax proposal that I could support, and which would have a far better chance of Congressional acceptance than the current version. Stay tuned!
Hank – I have restricted my analysis to the Fair Tax as written. Constitutionality has not been considered. I make no judgement of whether 81% of GDP as a base makes sense. Evasion I have thought some about and I don’t believe that it will be anywhere near the level that is found in our current system. That is a hard one to prove with indisputable evidence one way or the other. I only rely on my former experiences as an auditor to know that it will be much easier to police and catch the significant Fair Tax cheaters than under the current system. 85% of all taxable sales will come through large retailers. Engaging in material cheating would be extremely dangerous on their part.
As I said, my analysis has not gone deeply into how specific individuals including myself would fare. I am certain there will be individual situations of income and spending patterns where some will be better off and others will be worse off. Would be happy to review the data that you mentioned. Send to marvin.ammentorp@dcranch.com.
Could not find through google search any articles that addressed the specific question of Fair Tax impact on government. But, I did some thinking and recognize that both of us were missing a lot when we estimated a shortfall of $300-$500 billion as the result of government entities paying the tax on specified expenditures. We did not consider how much would be saved by the 9% reduction in the cost of goods and service. We also may have ignored the savings from government entities not paying the employer share of payroll taxes. Also, the Federal government would save about $10 billion off the IRS budget and many billions when interest expenses on the huge national debt are reduced under the Fair Tax.
But it is probably easier to look at this from a macro standpoint. We showed in an earlier post that price reductions plus tax savings plus the prebate would put enough money in the pockets of individuals to pay the Fair Tax. Leaving compliance cost savings as a bonus of a couple hundred billion dollars. But, the total revenue collected includes the amounts paid by state, local and federal government. That means that individuals still hold the same amount of money in their hands. This will be used to pay the added taxes needed to make governments “whole.” I believe the state portion of this will be collected when state and local sales taxes are collected on the 17% rise in prices after applying the Fair Tax. Also the impact of significant economic growth resulting from the Fair Tax has been ignored.
Government entities like business don’t pay taxes. They only serve as a conduit from the individual whether under an income or consumption system.
Am certain that the Fair Tax can be improved. That is why everyone needs to understand this program and weigh the pros and cons. Everyone needs to enter this debate and come up with a program that will provide maximum benefit to all Americans.
Hank – no one will ever confuse me with Chief Justice Roberts in a discussion about the constitution. However, this is the internet and everyone can have an opinion, whether it makes sense or not.
Taxing government entities would only apply to state and local entities from a constitutional perspective Education salaries have already been removed from the Fair Tax base. Government entities wouldn’t pay the Fair Tax directly on goods and services. Retailers would collect and pay the tax as part of the price of the product purchased. Is this any different than the taxes that are now embedded in the cost of the products purchased by government?
There is one area where government entities would be required to file and pay the fair tax; for government services such as police, fire, garbage collection etc. If these services are nopt taxed, they would have an unfair advantage over private competition. many smaller government units contract with private companies for fire and garbage collection as an exmple.
Even if it were determined that state/local entities could not be taxed, then the increased rate would come out of the pockets of individuals. Remember, the individual will have extra money in his pocket until he either pays it directly as part of the Fair Tax or pays it through a government entity. There is no change in the total tax collected and there is no change in the total amount of tax paid by the individual.
The net impact of including government in the Fair Tax base is zero.
Economics 101:
TAXES
1. Taxes are the enemy of economic growth.
2. Taxation is the process by which productive members within an economy are required to provide funding to non-productive members in an economy.
3. Taxes are on “profits” or funds that would have gone into development of new ideas, hiring of new employees, purchasing of new capital equipment, or investing in other ventures.
4. The higher the taxes, the higher the underemployment and unemployment rates as companies attempt to do more with less.
5. Tax money is wasted because it is money removed from the market to provide services for which people would not willingly pay.
SPENDING
1. Government spending does not spur economic growth. It creates the illusion of economic growth as it pumps either directly taxed dollars, or newly fabricated dollars into the economy.
2. Government expenditures regularly outpace returns, hence more dollars are manufactured, direct taxes are raised, or both.
3. Government projects are simply wealth redistribution programs. The contractor on a highway project is no more a creator of wealth than the welfare recipient.
4. The idea that a broken window due to vandalism, war spending, or other non-market prescribed expenditure.
MONETARY POLICY
1. A subjective standard for currency backing cannot defeat inflation.
2. The purpose of a central fiat bank is to allow for “elasticity” of the money supply. Elasticity equals inflation.
3. As a “need” emerges, the Federal Reserve begins Xeroxing more money, or coding more bits and bytes into bank accounts, buying government bonds to cover government checks.
4. The initial recipients of the new money benefit from enhanced spending power and, if wise, proceed to spend while the value is still reflecting the old dollar to goods ratio.
5. As the freshly photocopied dollars flood into the marketplace there are more dollars chasing fewer goods – this is called inflation.
6. Even in cases where the “price” of items remains steady, it is still inflation; the market is simply capable of outrunning (typically over short distances) the proliferation of fiat currency.
IN THE END
The solution isn’t a “Fair” tax, regardless of its aim and rate. The solution is the eradication of government spending, thus eliminating the “need” for income or profit taxes, and stopping the Federal Reserve and its Parker Bros. operation.
–M
“Most of us believe that the embedded taxes that will actually come out of price with the FairTax won’t be 22%, but will instead be more like 10-15% depending on industry. This means we should see price increases on the things we buy on the order of around 10-13%. So yes, there will be a difference in these two rates, and Boortz has even referred to it in the revision of his book.”
It is ALSO the case that there is a nearly $1 trillion in imports that will be taxed at a higher rate, and that most of the economic activity now taxed at a low rate that will be taxed at a higher rate is imports. That average should consider the two distinct cases.
Hence, there will be a large shift that favors American production as compared with the current system. Who would be the losers? Foriegn producers who will have profits and/or costs squeezed to compete.
this is the missing $1trillion (ie $200-$300 billion in tax revenues) that the columnist ignores and that makes the FAIR tax (and an even better idea, the BTT) a great deal.
WSJ: “We wonder if there isn’t a left-right deal to be made here: broaden the base by eliminating special-interest preferences, but lower the rate to make America’s companies that do not pay taxes more competitive. ”
Great idea!
“I’d also be elated if the only citizens required to pay income taxes were the richest 1%.”
A liberal/conservative compromise would be to have only the ‘rich’ ie top 10% pay income taxes, while the remainder of the taxes is consumption based.
The top 10% pay about 67% in taxes, and a flat tax of 15% on the top earners could yield almost half of current income tax revenues.
disadvantage:
- income tax is around to possibly grow like crabgrass
advantages:
- opposition to excellent FAIR tax is stymied by angst about the high rate
and issue of fairness, alleviates it
both pro and con: Is a partial step in the right direction.
Patrick,
In your post #45, you wrote: “It is ALSO the case that there is a nearly $1 trillion in imports that will be taxed at a higher rate”.
You may have missed the discussion of HR25, Sec. 905 which took place on this site in June. Check the Archives for June, with particular attention paid to the Walby clarification.
Your $trillion in imports which you suggest might raise $200-$300 billion in higher taxes is not correct. Based on the wording in Sec. 905, the majority of our trading partners (some 55-60 countries) will continue to pay whatever reciprocal import tax is specified under existing trade treaties. There will be little or no windfall import tax money.
Check it out!
Actually that is not correct, Hank. Section 905 specifically addresses taxes on the income of foreign persons and corporations, not tariffs or duties. Direct imports will bear the FairTax for American consumers and not a tax treaty-based figure. The tax treaties only apply to withholding of taxes on the incomes of foreigners and their businesses.
Actually, you are right, James. Sorry, must be getting senile?!
Let’s try something different that has been bothering me. I continually read that the reason for expressing the Fairtax rate in inclusive terms is so that proper comparisons to the income tax (also an inclusive tax) can be made.
I’m having trouble taking the next step in this logic. How does one compare the Fairtax to the income tax using the 23% inclusive rate? I explained the Fairtax to my son, and his immediate reaction was “That’s great! I’m paying 25% now under the income tax. Where do I sign up for the Fairtax”
Is that the hoped for reaction? Comparing the Fairtax rate to the marginal income tax rate? Doesn’t make sense to me! So, can one of you math experts walk me through exactly how to compare the income tax to the Fairtax??? (I’m assuming the bottom line is expressed in terms of dollars paid for taxes.)
Thanks
23% is also the marginal rate for the FairTax. So yes – if you want to use marginal rates for both you can. Of course, both can be expressed in some form of an effective rate, which may be more appropriate. Don’t forget in your comparison to add in payroll taxes (15%) and embedded corp taxes & compliance (10% estimate). So you have a 50% inclusive tax compared to a 23% FairTax. Exclusively, this would be 100% or the 30% FairTax.
Ok, I’ve just started reading about this, but the first thing that hit me was using the federal government’s spending as part of the tax base was was off. I thought the right hand, left hand analogy was accurate above, and if you take that into account then I got a inclusive tax rate of 28-29% and a 41% exclusive rate using the adjusted base.
Secondly the next issue I had was that some how this would remove the need for the IRS, but I fear that tax evasion would be pretty insane here and while it may not be higher than today, it still has to be accounted for (something the current tax rates have accounted for). It took me all of 30 seconds to come up with a strategy for tax evasion under the fair tax system. Company A sells a product to Company B as a new good at a lower cost while Company B sells the product used at a higher cost eliminating much of the taxation. So an IRS would still have to exist to prevent this kind of cheating.
Additionally someone brought up another point above that there would be a likely increase in B-to-B sales. What is to prevent the large-scale creation of B-to-B product and services providers from popping up to deal with a large number of new single-person businesses which are just mechanisms for tax-evasion?
On the trade-relations front, my fear is that our trade partners will complain as the fair tax, as described, is a de facto tariff which may violate treaties we have with various countries.
My next concern has to do with the fact that the tax base more than doubles (using the 4.2 billion and the 9.2 billion dollar figures from the Fair Tax Blog mentioned above) when going from income taxes to PCE. To me that makes no sense. Essentially we’re saying taxable income is less than expenditures by a large factor. Also I didn’t see any mention of the cost of the pre-bate which is rather large; nor when pre-bate checks start coming. If they start coming as soon as the individual reaches working age, then you may be paying out much more than you’re taking in for that segment of the population. If not then you’re over-taxing children between the ages of 13 and 18 (though I can live with that). I figure 13-year olds can have babysitting and lawn care jobs.
I also have some remaining points that haven’t been addressed as far as I can tell, but I’m probably missing something.
Where is the discussion of the remaining embedded taxes that result from B-to-B retail purchases. Small businesses don’t usually use direct B-to-B systems, but rather they shop at Office Max and other retail outlets. Shouldn’t this remaining embedded tax, which disproportionately affects small business be taken into consideration? Is it, am I’m just not seeing it?
Is the cost of the pre-bate calculated into the fair tax rate as this large expense has to be accounted for as it doesn’t exist in the current system.
How does the fair tax address the issue with middle class families being hit hardest? The point made in the linked article is valid. Being a regressive tax at its heart, it has a near inverse linear relationship between income and taxation as a percentage of income. The pre-bate knocks off one end, but then you end up with a hump in the middle of the highest tax burden as a percentage of income. Wouldn’t this put pressure on the middle class further squeezing it out?
What’s prevents a company from finding a location with cheap labor, low corporate taxes and simply declaring all sales as international sales while maintaining distribution centers here in the U.S.? Labor is a much higher cost than taxes for a company and would remain the deciding factor for off-shoring. How would this tax help significantly change that?
—
As I see it, though I would love correction, it seems like this tax moves some of the tax burden to the middle class from the upper class and gains some ground by taxing the underground. Illegal immigrants and tourists would not have a significant impact as they already have an offset (American tourists abroad and Immigrants actually pay income tax).
Mind-boggling, magical, math, Morphh!! But not entirely accurate? First, the Fairtax is a statutory flat tax and I don’t see how you can describe the 23% rate as a marginal rate? The 23% applies to the very first dollar spent on consumption of goods or services as well as the last. My 25% marginal income tax rate only applies to a very small part of my gross income. Marginal rates and flat tax rates can’t be sucessfully compared IMHO.
Next, as usual, my retired status doesn’t seem to get any respect. You said to be sure to add in the 15% payroll taxes when calculating my effective tax rate. I’m retired and don’t pay any payroll taxes. Also, it seems to me that you double counted the employer share of payroll taxes when you advise me to add the 15% and then add 10% for the employer embedded costs of the income tax. Part of the 10% in employer embedded costs is the employer share of the payroll tax, is it not?? And surely you don’t believe that the 10% would apply to my gross income? Only to what I spend for goods and services perhaps? So it can’t just be added to other tax rates, can it?
As for your bottom line comparison stuff, I can’t believe that you would be telling anyone that their taxes under the Fairtax would be only a third of their income tax burden (30% vs. 100%)? Incredible!!!
I’m still looking for a reasonable comparison tool and I don’t think your explanation helps much, but I appreciate your interest in discussing this issue.
Orion,
Well, you have a good grasp of the not-so-obvious it seems to me. Several comments for your consideration follow:
(1) Spend another 30 seconds and get used to the idea that a product isn’t “used” until the sales tax is paid. Your company A/Company B scam won’t work.
(2) I agree that, initially, there may be a rush to incorporate in order to game the system. However, the penalties for fraud are pretty stiff, there will be a far greater chance of an audit, and if your “business” purchases somehow wind up in your home, big trouble!!
(3) The tax base doubling from $4.2 Trillion to $9.2 Trillion can be partially explained by the fact that there is currently about $1 Trillion in untaxed income due to exemptions and deductions, there is $2 Trillion added for taxable consumption by governments at all levels, and there is $1 Trillion in FICA taxes to consider.
(4) As for the prebate, you need to reread the book or the info on the fairtaxgroups site. The cost of the prebate is included in the 23% rate (it added around 4%-5% to the rate). The checks start coming when you are born–that is, the checks are based on family size. Add a child, get a bigger check. You have to be 18 or older to be eligible to have the check sent specifically to yourself.
(5) Your concern about pressure on the middle class isn’t necessarily valid. Almost everyone will pay less tax under the Fairtax, although it’s possible that the tax burden on senior retirees will be greater under the Fairtax at some gross income levels. It isn’t a zero sum game by any means. Yes, the rich will see a reduction in their tax burden, which might not sit well with some liberal members of Congress. And I might add that completely untaxing all businesses, no matter how sensible, won’t sit well with the same members of Congress.
(6) My major concern is that the authors of HR25 may have badly overreached when they included payroll taxes in the mix of taxes to be replaced by the Fairtax. One unintended consequence may be that, with the prebate, 30 million workers might pay no net federal tax, yet will still qualify for full Social Security retirement and health care benefits. Meanwhile, us retirees, who paid into the trust funds for 45 years, will have to resume paying through our sales tax dollars. Not fair, IMHO!
Hank, et al
I assume the 30 million that will pay no tax is related to those below the poverty line. Does the number include just adults, just working people or is this everyone? If it is everyone, many of those 30 million don’t pay any tax today. How much does the non tax paying group increase under the Fair Tax?
If people living below the poverty level pay taxes, aren’t they being deprived of the necessities of life? When you lower the tax bill for people below the poverty line, don’t you then reduce the amount of welfare payments necessary to ensure everyone has the necessities of life? Isn’t the net effect on government then zero?
The payroll tax on individuals is really a tax on business. Without the payroll tax, business costs would be lower and the prices you pay would be lower. Every consumer pays the “payroll tax” when they buy any product. What is the difference if you pay it in the price of the product or pay it as a designated portion of the Fair Tax?
People will still earn their social security benefits just as they do today. Benefits will be based on earnings reported to the social security administration. Funding will come from a tax on consumption instead of a tax on production. The tax on production really becomes a tax on consumption in the end.
Forcing higher prices onto products makes American products less competitive with foreign produced items. Foreign countries can not complain about the Fair tax being unfair to them. They already remit the VAT on exports. Taking corporate taxes out of U.S. products is the same thing. Foreign countries charge the VAT on imports. The fair tax is added to the cost of products imported into the U.S. Yes, many (most) countries also have corporate taxes and an overall higher tax rate which is currently included in the price of their exports. These countries will be free to eliminate those taxes and increase there VAT to replace the revenue. This would be good for their economies and everyone would benefit.
As a follow up to Orions suggestion that companies will artificially create used goods to avoid the FairTax, I have a question regarding the purchase of used goods overseas.
As I understand it, if one buys a brand new yacht in the Bahamas and tries to import it into the United States, he will be required to pay the FairTax when he does so. (I don’t know for sure, I’m just repeating one of Boortz’s claims.) Would that also apply if he bought a used yacht in the Bahamas and tried to import that?
If not, I can see an obvious loophole. An entrepreneur sets up a Cayman Island corporation to buy new yachts in the Bahamas. He saisl them around for a couple of months, so that they are now “used.” Then hes sellsl the used yachts to wealthy Americans seeking to avoid paying the FairTax.
Any way to prevent that? As far as I can tell, that would not be illegal under the FairTax system, so the entrepreneur wouldn’t even need to go to the trouble of setting up a Cayman Island corporation. If it would be illegal, it seems to me that it would be very difficult to police unless all imported goods, whether new or used, would be subject to the FairTax.
James — You’re the FairTax blogger/guru, what do you think?
Marvin,
The 30 million are workers that filed individual returns in 2004 and had gross incomes at or below the poverty level for their particular family size. This cursory analysis started with an estimate of the net Fairtax paid by various family units at various gross incomes. Basically, singles with $10,000 gross, married with $20,000 gross, and married with two children withb $35,000 gross will pay no net federal tax under HR25.
Using 2004 tax data, of the 132 million individual returns, 37%(48 million) had incomes less than $20,000. Another 14% (18 million)had incomes between $20k to $30k. By removing the retiree returns, it is possible to estimate that 30 million workers would pay no net federal tax under the Fairtax.
Under current law, the only way workers can pay no net federal tax is to first reduce their taxable income to near zero through deductions, exemptions, and credits; then use the refundable EITC and refundable Additional Tax Credits in the amount needed to totally offset the 7.65% payroll tax. Again, using 2004 income tax data, it appears that less than 1 million workers pay no net federal tax. A far cry from the 30 million estimate discussed earlier.
I’ll be the first to admit that this is a very cursory look at the issue. But, numbers aside, is it really fair to create a class of workers that pay no net federal tax, yet qualify for full SS retirement and healthcare benefits? While at the same time, making current retirees resume paying into the trust funds through our sales tax dollars. I paid for my SS benefits for over 45 years, and I think this would be a major break in faith by the government.
Others have pointed out that workers surely will increase their gross incomes to a level where they would start paying a net federal tax. For some, that is true. However, all workers that are getting just a cost of living increase each year will never pay any net tax. The prebate amount actually increases at a slightly faster rate–the two diverge.
I won’t disagree with your comment that businesses don’t really pay the payroll tax. We the consumers pay the tab through higher prices. Ideally we all should be paying our SS premiums directly through payroll deductions and get the employers out of the picture. But we are where we are, and I still believe it’s a bad idea to let 30 million workers completely off the hook.
Hank,
I wasn’t being completely serious.. it was sort of a joking answer. It was directed at your son (so payroll taxes would apply – unless your son is retired as well). You are correct that the statutory rate is 23%; however, the marginal rate is 0% up to the poverty level and then 23% thereafter. This is shown in the Kotlikoff studies. You are correct on the 10% – I forgot to remove employer payroll, so this would be less. However, my point was you have to look at the overall tax burden placed on an individual. When comparing the FairTax to the current system, you have to consider all the taxes it replaces. If the FairTax were to only replace the income tax it would be half the rate. So to compare it to only the income tax is to leave out a large part of the burden (particularly when 80% of Americans pay more in payroll taxes then income taxes). I don’t think people would pay one third less – it was more of a joke post with some things to consider… stirring up some discussion. ;-p
Hank,
First, *Standard Disclaimer that I may totally be off, so be kind*
The idea behind the scam is that company B pays the tax, but on a retail product that only costs 1/10th its actual value.
Company A makes Yachts and sells them exclusively to Company B for 10K and Company B pays 23% on that 10K. Now Company B then resells them to the public for 100K tax free as the tax has already been paid on them when it bought them at 10K. They avoid 90% of their tax liabilities this way. And according to what little I’ve seen this isn’t illegal. Company A funnels the difference into investments into Company A to counteract the loss.
Ok, I work writing financial forecasting software. And something occurred to me in that this should work much like a balance sheet. If it’s revenue neutral and you assume no economic benefit then for every dollar someone no longer has to pay, someone else does.
Now assuming that people buy products with embedded taxes in them, drug dealers, illegal immigrants and tourists already pay for some of them. The only thing we’re not getting out of them is income tax, but that’s only a real issue for the drug dealers (and other black marketeers). So for every dollar we get that we wouldn’t have normally gotten from them, is a dollar that someone else doesn’t have to pay. Illegal Immigrants pay taxes when they pay above the table, but the ones who don’t fall under the black market category above. And of course people who’ve paid into the system who would then get taxed again at an effectively higher rate will also pay more into the system.
So the only gains for currently paying are coming from the black market, people who get paid off the books, and retirees, then even given all that I would like to see how much taxation would be happening if there were a way to do that. That, to me, is the only real thing you can claim.
So let’s say that in terms of income you could actually get taxes on all these people. My guess is that spread over the U.S. population it would result in a less than $10B additional tax dollars which is basically $50 / adult / year on average (using the assumption that adults make up 2/3s of the U.S. population, but that’s only a guess). Now $10B in tax income would represent some 28.5B in revenue being taxed (at 35%) since these guys are the big runners. But even if it were 3 times that you’re only looking at $150/person/year.
Overall I’m reminded of the riddle:
3 men go into a hotel and pay $10 each. After the men return to their rooms, the hotel manager sends a busboy to give them back $5 making the total bill $25. When he arrives at the room, he gives the gentleman the $5 to which the gentleman gives him back $2.
Now each of the gentleman as paid $9 each for the room and 3×9 = $27 and the busboy has $2.
Where did the remaining dollar go?
—–
That’s how I feel when I start seeing these discussions. It seems like people keep trying to compare things and mix and match them and it just turns out ugly. You can’t really mix methodologies here and get a good result I feel.
So my last question is how does one deal with someone taking a product they bought retail, adding something to it and then reselling it retail? Is the tax on the retail sub-part deducted from the new part or is there a double taxation? If the internal part is more valuable than the combination, but you can only sell the combination for 50% of what the raw parts costs, do you pay a second time on the internal part at its original sale price or do you pay for the combined price (50% as above)? Though this one also reeks of potential scams. Give me a day and I’ll find it.
I have some questions about how certain things will work.
A) Leases: ownership doesn’t transfer and an owner can lease things multiple times;
B) Liceneses for use: ownership doesn’t transfer and it may be a complicated set of rules as it gets to a traditional end-user;
C) Subscriptions: this seems like it would get taxed, but it could get complicated.
All sorts of things fall under A. Does the tax get covered only on the first lease (which isn’t for the full value of the product) or does it cover subsequent leases as well (which may cover more than the full value).
Leasing may become very popular simply because of the avoided tax burden (if tax is paid only once) or very unpopular (if tax is paid each time). Is this not a case of picking winners and losers? Of course any system of leasing is basically just renting? If renters do pay each time, then it’s the former; if they don’t its the latter.
All sorts of thing fall under B as well. Software, music, movies, and books. When I buy much of this software, I’m only buying a license to use it. Now it’s not a product or a service, but I’m fairly certain he meant to include them.
Orion,
Leases are a service. You get taxed on your lease payments. If someone leases me a car, I pay FairTax on my lease payments for the duration of the lease. If they then lease it to someone else, that second person pays FairTax on their lease payments. If they then sell it to a third person, that person pays FairTax on the remaining portion of the value of the car that they are paying for. It has to be this way, because otherwise you could use a lease as a tax avoidance vehicle.
Leasing is not picking winners and loosers, it’s important to realize that your lease is basically a financing mechanism, and it’s just another way of fractionally buying the value of the car.
Licenses for use: In all the examples I can think of (which are basically software licenses) you would pay FairTax on the price of purchasing that license. If the license is transferable and you then sold it to someone else, that would make it a *used* license and it woudn’t be taxed.
Subscriptions: Simple payment for goods or services. If I subscribe to the Wall Street Journal for $100 a year, that $100 is FairTaxed.
Ok my next thoughts.
It feels like there isn’t a clear distinction between B-to-B and B-to-C in terms of taxation.
If I buy something for the purpose of retailing it to the public I don’t pay taxes on it, but if I buy something without the purpose of reselling it then I do pay taxes on it, but how does one make that distinction legally in such a way that companies can’t simply declare the intention for it to be a component?
My initial thought on licenses which I didn’t explain at all really was that if a company like Dell purchases a license for Windows does Dell pay or do I pay the tax on that license? This is a product I can purchase on my own without the computer.
How let’s instead say I’m an artist and I buy raw materials from a store because I don’t have a B-to-B account. I’m now paying B-to-C taxes on something I plan on reselling, but now the person buying the product is paying twice. Once on the raw materials and again on the final product. Doesn’t this constitute a hardship on small business which tends to buy their products using the same avenues as the general public? Do we give business people a card saying I get my business stuff tax free like the big guys? If we do wouldn’t that make it really easy to cheat the system and add complexity as retailers now have to have two prices for each item in their systems?
No, it’s not that hard. If you can’t get supplies from a wholesaler and you end up paying tax on the items you buy, you can apply for the rebate on the taxes yourself. You do need to be a registered seller of your artwork to qualify though. But any business can be a registered seller, large or small.
It does not make it especially easy to ‘cheat the system’ as retailers don’t HAVE to provide tax-free items to registered sellers if they don’t wish. Checking the business certificates and everything is potentially difficult for retailers so they aren’t forced to do it. They will likely provide tax-free B2B transactions for their back-end supplier arrangements, and leave standard sales to the ‘manual’ rebate process. Otherwise they’d have to keep EVERYONE on file, and that’s not practical.
There does exist the opportunity for small business to cheat fairly easily by claiming all manner of personal expenses as business inputs, but they will have increased scrutiny upon them since only businesses will be targeted and not every household in America. These businesses routinely cheat today (itemizing personal purchases as business expenses) so there’s unlikely to be much difference with the FairTax.
James/Joshua,
This might belong elsewhere, but I don’t know how to start a new thread?
I recently came across a CBO report published in December 2006 entitled “Historical Effective Federal Tax Rates. 1972 to 2004″
Here is a quote that caught my attention. “CBO assumes – as do most economists – that the employers share of payroll taxes is passed on to employees in the form of lower wages than would otherwise be paid. Therefore, the amount of these taxes is included in the employees income, and the taxes are counted as part of the employees tax burden.”
If this is the case, then Marvin’s analysis of potential price increases under the Fairtax would seem to be shot to hell! If the only savings available to businesses are limited to income taxes and compliance costs, then the total savings which would be available for pretax price reductions would be 2% for income taxes and 2% for compliance costs, or a total of 4%. If this is accurate, then prices can be expected to rise by 25% under the Fairtax. (1.00 – .04 x 1.30 =1.248.)
I don’t happen to agree with “most economists” or the CBO. They may be excellent economists but I doubt that any of them own a business and have to make a payroll? So, here is a little quiz that some of the business owners on this blog might want to respond to?
Assuming your business is operating in a competitive environment, if the payroll tax was eliminated, which option would you choose?
A. Use the 7.65% windfall to increase your profit margins.
B. Use the 7.65% windfall to lower your prices in order to try to increase your market share.
C. Use the 7.65% windfall to increase your employees paycheck.
There are all sorts of varients to these three choices, but try to focus on just these, please. What do you think?
Eh? Where are you getting 2% from?
Businesses drop their own corporate income tax (15-35%). Self-Employed sole proprieterships now become less burdened (they pay 15% in payroll taxes straight up, the employer’s share & the emplOyee’s share).
Their payroll budget drops 7.65% right off the bat, as they are no longer required to pay extra for payroll taxes on their employees.
Then on top of that, they pay no taxes on business inputs at all.
Any of these numbers should be more than 4% of the cost budget of a business.
Now I do not own a business but I worked in a small Mom & Pop computer store and I have also talked about this with my boss at work.
He basically said he would probably windfall it for the first year, keeping it in the business, reinvesting some of it. But he also said that with payroll taxes out of the way, that it basically became less expensive to hire employees and that gave him extra money to play with to give out raises or to try to snag exceptional hires.
So I guess the point is, he planned on doing a little of each.
James,
My point was to show what would happen if the payroll taxes were not counted as potential business savings, but were treated as an employee “payraise” as seemed to be the premise by the CBO and “most economists”.
Perhaps my 2% is incorrect? I used the Kotlikoff/BHI data and figured that the $290 billion in corporate income taxes was 2% of the $13959 billion in 2007 consumption (sales). Similarly, the compliance costs of $300 billion (pick a number) added the other 2%. So, 4% of sales seemed to me to be the max possible business savings? And therefore, prices will incrfease by 25%. Am I guilty of fuzzy math???
If one of you more gifted math majors want to correct me, I’ll not object. After all, that’s why we pay you the big bucks?!?
Orion —
I believe that ownership does transfer on a lease. It transfers to the finance company.
Just a point, if a employer pays an employee $100, they pay an additional $7.65 for the employer portion of FICA which makes their total cost of employment $107.65. If you remove the FICA, they save $7.65 of that $107.65, or 7.1% – not 7.65%.