Putting Revenue Neutrality in Context
This is a reply from Quadrupole to Hayden, picking up from their discussion here. I’m promoting this to its own thread to provide some front-page coverage for Quad’s valuable observations. Happy Independence Day, everyone!
Hayden,
A couple of quick responses. First, to your point 2, the FairTax never promised you a fully funded government, we just promised you revenue neutrality: ie, we’d bring in no less money that the current system. A fully funded government would require massive tax increases, and the question of how much funding the government should receive is a totally separate argument. That’s why I would generally disagree with your point 4. Of course taxes would have to be raised massively to go beyond revenue neutrality.
Second, in response to your point 3, frankly, it’s getting harder to do revenue neutral. Why? Because revenues have surged in the last 3 years. If you go back to the historic CBO numbers I cited earlier you’ll see that federal revenue as a percentage of GDP has gone up by 2% of GDP since 2004, and will likely be higher still in 2007. A 31.25% exclusive FairTax translates to about a 24% inclusive rate. That the FairTax rate would have drifted up a percentage point while government revenues have surged does not surprise me.
On your point 7. Political difficulties with taxing things like imputed financial services on credit card interest, sure. Practical difficulties, no way 
On the scale of everything else the financial service industry does, the FairTax provisions are quite trivial.
On your point 9 about state and local taxes. I used to have a link to a nice exhaustive study of what the rate would have to be in each state to replace their current tax systems with the FairTax, but all I can find now is this paper for Michigan, which shows the FairTax rate to replace their sales tax is 3.76% (and Michigan is considered a high tax state) (that number is inclusive, but exclusive it would be 3.9%, so not that different). Please note I’ve not vetted these guys numbers, so it should be considered merely illustrative. However, I find your 15% exclusive estimate to be overblown.
One other point I would like to make. I think part of the sticker shock on the FairTax has to do with the fact that people don’t really realize how much they are paying in taxes to begin with. For example, the lowest marginal income tax rate is 10%, the payroll taxes are 15.3%, so the lowest marginal tax rate is 25.3% inclusive. Since you are fond of talking about the FairTax in exclusive terms, that’s 34% exclusive. So 34% exclusive is the lowest marginal federal rate going right now.
Now look at the states, lets take North Carolina for an example. North Carolina’s lowest marginal income tax rate is 6%. So state plus federal would be 31.3% inclusive. Exclusive that’s 45.5%. Then add in North Carolina’s 7.5% sales tax (exclusive) and you start to really feel the pain. And don’t get me started about property taxes
Please note, all of the above are examples using the lowest possible marginal rate.
It’s important to remember that the FairTax isn’t magic, it just endevors to do the following things:
1) Broadens the taxbase
2) Reduces compliance costs
3) Untaxes dollars invested in productive purposes (but *not* the profits of those investments that are consumed).
It’s fair game in my mind to argue against the desirability of any of these goals. I find them laudable, but you are not required to agree with me.
It’s fair game to argue that these are the wrong goals, or that additional goals should be added.
It’s fair game to argue that the FairTax does not acheive any one or combination of these goals. I’m pretty convinced that as proposed it will acheive these goals, but my conviction doesn’t make me right.
My sense however is that bickering back and forth about the revenue neutral FairTax rate is probably a less productive line of discussion at this point than discussion of what goals are appropriate and whether or not the FairTax meets them. Your thoughts?
Quadrupole
Quad –
OK, even though Joshua has named this thread “Putting Revenue Neutrality in Context,”, I agree that there’s really no point in arguing about the revenue neutral rate. We’ve hashed that over to death time and time again.
So let’s look at some of your goals/benefits of the FairTax.
1. Broaden the tax base. I’ve heard that over and over again from FairTax supporters, but honestly I don’t REALLY know what that means. Sure, I’ve seen your macro-numbers, but on a micro-level, can you explain to me (a) exactly what the tax base is, and (b) exactly how it is broadened. Maybe if we can go over some specific examples I’ll have a better understanding of how it really works.
2. Reduces compliance costs. I’m not so sure about this one, becasue compliance costs for most individuals of the income tax is nil. I mean, for most people, their taxes are taken out of their paychecks, they get a W-2 form at the end of the year, some forms from their bank and/or brokerage house, and then they send in a 1040-A or a 1040-EZ form, and that’s it. The income tax (for individuals) doesn’t start getting complicated and time consuming until people start having more complicated investments, such as rental properties, and their own businesses, and start trying to maximize deductions for these investments/businesses. The same thing will happen under the FairTax. Compliance for small real estate investors and small business owners will be expensive, time-consuming, and complicated as they allocate their expenses to (taxable) personal expenses and (non-taxable) business expenses, and either pay taxes or seek rebates on a month-by-month basis. Vacation homes that are rented out (something I’m familiar with) will be very, very complicated on a tax basis under the FairTax.
3. Untaxes dollars used for productive purposes. Well, that’s sort of another way of saying the wealthy, who have the most money to save and invest, see their taxes reduced, while the middle class, who must consume most of their incomes, bear the brunt of the tax. So, we’re back to the fairness argument here. And, of course, there’s nothing to keep investments in this country as opposed to, say, China or India. Nevertheless, I do agree that it is important that taxes be minimized from investment decisions; that is, investment decisions should be made on their own merits, rather than for tax consequences.
A couple of other good things about the FairTax:
1. It eliminates the corporate income tax, which I’m sure we all agree is redundant, burdensome to our industries, unproductive, and makes our companies less efficient and competitive.
2. Eliminates the multiple tax systems (social security, medicare, income, alternative minimum, etc.) so that (a) people can see and understand just how much government is costing them, and (b) politicians can’t play the shell game of lowering taxes over here while raising taxes over there.
3. Increased efficiency. In theory, at least, a consumption tax will general more economic efficiency than an income tax, though I believe this is tempered by the required tax rate and the effect on certain industries (i.e. homebuilding) if people alter their consumption habits to minimize their taxes.
I think these are all laudable goals, I just don’t particularly think the FairTax is the best way to achieve these goals. I think a simplified income tax, together with the elimination of other taxes, would the a better way to achieve these goals while maintaining, or even enhancing, a progressive tax system.
By the way, on another note, a good book to read on the problems with our current tax system is called Perfectly Legal by David Cay Johnston of the NYT. I you regularly listened to the Al Franken radio show, you would be familiar with him. (For some reason, I doubt if most folks on this blog were regular listeners to Al Franken, which is a shame.) Johnsto’s general thesis is that the upper middle class get screwed with our current system, because we don’t have enough money to take advantage of the real tax breaks for the weathy, yet we don’t have the numbers to get the tax breals the politcians spread on the masses to keep them compliant. But, I can assure you, his preferred solution would not be the FairTax.
OK, enough for today, time to start up the Bar-B-Q.
I used to listen to Al Franken sometimes, I have one of his Audiobooks. However, I just don’t agree with him on virtually any of his opinions on tax or economic policy. I sometimes do agree with him on his characterizations of certain people on Fox news, but I digress.
I will leave most of this response to Quad, but I specifically wanted to get into the bit on reducing compliance costs. Compliance costs are, I would agree on a per-person level, relatively low, but it is not zero. My mom worked for H&R Block for a number of years and nearly every customer they had was going in to get Earned Income Credit (i.e. they were poor). They simply didn’t feel confident in getting through the paperwork required to apply for things like the Earned Income Credit or other education credits.
For myself, I use online services and thy aren’t expensive, but they aren’t free, either. I usually pay about $30 to use those services and e-file.
But then if you are a small business person, making typically $40-70K per year in profits, itemizing in order to minimize tax burdens, you might literally spend thousands a year on accountants, special bookkeeping, and professional tax preparation. Now that’s not a poor person, but it’s not a rich person either, and small businesspeople are a large number of citizens.
We should not discount the cost of compliance if it simply doesn’t fall on the lowest common denominator of society. It won’t affect them much, either way. But for those of us with more complicated financial situations, the FairTax could really be a boon.
James,
I certainly agree that compliance costs fall mainly on businesses and the wealthy(?). But with all respect to H&R Block, there is no need for the average worker to pay for their tax service. AARP has thousands of trained tax experts that will do returns for anyone for free. Millions used that service last year and the numbers are growing each year. They just don’t do complicated or business returns.
Furthermore, it is my understanding that anyone can use the IRS online software and e-file for free.
The 20 million businesses in the US make up an estimated 13% of all returns filed. Add in the wealthy and I still believe that three out of four filers don’t have any real compliance costs. What makes me want to gag is statements such as I read recently that “every family in the US pays an average of $900 per year in tax return compliance costs”. Very misleading IMHO!!
The Fairtax will indeed be a boon for businesses! After all, the legislation was written by business people for businesses. Makes me wonder where all the public business support for the Fairtax is??
Well it is not only the businesses that would benefit, but nearly anyone with something more complicated than simple wage income to report. I don’t know how many people that represents, but it’s got to be more than the 20 million businesses alone.
Last I checked the IRS did not provide free online software but rather farmed it out to private services, but many of those services did provide their services for free if you had a simple 1040EZ type of return or if you were in some age group (seemed arbitrary to me, varied from outfit to outfit).
If you had to do anything more complex than that, it was about $30 to file both state and federal returns.
But just as we should not overstate with broad averages that ‘each family has $900 in compliance costs,’ neither should we understate anecdotally and with the same broad brush that the ‘average worker has zero costs.’ Each argument is extreme and is a manipulation of facts.
My old boss who owned a small computer shop was making between $60-80K per year from his business and was paying some $3000 per year on tax preparation with his accountant and on filing his expenses to itemize. I now make money within that range but my expenses are about $50 per year, tops (but I am comfortable with doing my own taxes, others aren’t). The H&R block crowd can be $50-$150 depending on type of return and situation.
There are virtually infinite variations on this, so I would propose that we use language such as:
“Reduced compliance costs under the FairTax would represent significant savings (hundreds and perhaps thousands of dollars) for taxpayers who have significant compliance costs under the income tax system (perhaps a third of all taxpayers).”
James, sounds reasonable to me!!
Quad: I finally got your Fairtax/Income Tax comparison study to come up and I have a question. Why did you include the employers share of the payroll tax when computing an individuals income tax burden? I don’t see that as anything but an employers cost of doing business. Under the Fairtax, do you believe that the employer has any reason to then include those dollars as part of an employees gross wages? I’ve never seen an employment contract yet that said I would be paid x dollars and the employer would pay half of my SS benefits tax? Those tax dollars are the employers responsibility and are not part of my wages IMHO.
I’m asking because I did the same type of study last year and came up with very different results, so I’m trying to understand why.
By the way, you seem to have overlooked a major portion of the population in your study in that you didn’t examine the comparisons for retired families. As the “senior retired representative” on this blog, (I’m older than Marvin), I feel the need to point out that us retirees drawing Social Security will generally have a lower effective tax rate under current law. Check it out!
As I have read about the FairTax, whenever the topic of compliance costs came up, it never occured to me that it meant cost to individuals to file their own returns. Of course, that is included, but I thought the references were alway aimed at compliance costs within businesses – especially big business. Of course $900 is way to high if we are talking about individuals filing – but it sounds low when you consider the embedded cost in everything those individuals buy from businesses.
Remember too that the cost of compliance doesn’t end with filling out forms and filing returns. Businesses expend an enormous amount of strategic effort and attention molding themselves to fit efficiently in the context of the current tax system. From where they locate to where they manufacture to what kind of products they make and when, etc., etc.
I doubt that the burden can really be calculated. But there is one thing for sure – consumer’s pay every cent of it now, and it is not trivial.
The more important question is, if the FairTax happened, what would happen to all of the attorneys, accountants, consultants and financial planners that make 100% of their living from working the existing tax code?
Mark,
I asked my accountant, a CPA, about the FairTax expecting opposition. He was actually in favor of the FairTax and the loss of tax preparation revenue didn’t bother him. He said, “I can make more money helping companies make money than I can by helping them avoid taxes.”
Hank, I think it was appropriate for Quad to include the employer portion of payroll taxes. Most economists agree that virtually all of the payroll tax burden is borne by workers, even that portion that is legally paid by the employer. Even with Quad’s comparison using the minimum marginal rates, he excluded corporate tax burdens that are passed to individuals. If you wanted to make a more direct comparison, we could remove the percentage of the FairTax that collects income for taxes that are not directly compared.
For example – 2007 estimates: Income taxes 1,101 billion (48%), Corporate taxes 290 billion (13%), Payroll 871 billion (38%), Gift/Estate 26 billion (1%) – Total 2,288 billion.
So if you wanted to only compare income taxes, half of payroll taxes, and not include corporate taxes (17.6% inclusive using figures above), you should reduce the FairTax marginal rate minus prebate by 33% (so a FairTax rate of 16.3%). While I understand the comparison above, it seems unfair to compare half the tax burden of one system to the full tax burden of another. In addition, your taking the lowest marginal rate of one system and comparing it to the maximum rate of another. It seems the main point that Quad was trying to make – people just don’t understand their current tax burden as the cost of government is spread out among many different avenues and not fully visible to individual citizens. Thus the sticker shock.
Also with regard to compliance, the cost of preparing and filing all business and personal income tax returns is estimated to be $250-$300 billion each year. Approximately the same amount of money was estimated for calculating the tax implications of business decisions for a total of $500 to 600 billion. According to a 2005 report from the U.S. Government Accountability Office, the efficiency cost of the current tax system — the output that is lost over and above the tax itself — is between $240 billion and $600 billion every year. These costs are ultimately borne by individuals and in many cases the cost of goods and services, as this is the income used to offset a business expense. $900 dollars per person may be an average based on the total cost. I don’t think we can look at only what this or that person expended (including the cost of time), without also considering the effect on business and prices that are also paid by that consumer.
Keep in mind that the FairTax, unlike the current system, includes a method to pay for its own compliance to the state and the business. This is something that is not factored into the current tax structure at all – an invisible compliance tax burden of $500 billion. Perhaps that’s another thing that could be removed from the FairTax rate when doing a direct comparison.
So many good thoughts in the above comments. If only everyone understood the Fair Tax this well, real progress could be made in developing a workable system that is a vast improvement over what we have today.
No one that files a tax return can get by totally free. Even if you are close to the zero tax line, you have to collect your income and deductible expense information. You may even go to a tax preparer to find out that you owe no tax. As pointed out above, most people have to get help to file for refunds or child/earned income credits. AARP is a great help to many people in the preparation and filing of returns. However, you still have to collect your information and make at least one and probably two trips to the AARP office in the process.
The estimate of $65 billion as the cost to individuals to prepare their tax returns includes accountant fees, tax software and the time individuals spend getting their information together, keeping records and reading the tax literature necessary to prepare your return. I believe these estimates calculate the time at $10 per hour and estimate 6 billion hours are spent on these activities. Many people would rather pay the professional preparer that money than suffer the frustration of trying to do their oiwn returns. What happens to that 6 billion saved hours? It could be spent on leisure or some would engage in productive activities for pay or as volunteers. Society benefits more from either choice than from applying those hours to forced wasteful activities.
Morph is right on target with his comments on compliance costs.
Hayden has it exactlyy right with the comments on business taxes being inefficient and an unnecessary burden on the economy.
It will be very difficult to actually reduce wages in the short term to eliminate the employee share of payroll taxes from gross wages. Many union contracts specify gross wage rates. Government and business pay schedules are well established. People would revolt at a visible reduction in their gross pay. Over several years, market forces might cause this to occur, but it is not practical in the short term.