Cascading Embedded Costs of the Income Tax
From Hank Van Gieson:
There is a fairly lively discussion on the fairtaxgroups site concerning just how much income tax costs can be removed if the Fairtax was approved. I have long been puzzled by this question, particularly because it seems to make sense that at each step of production, there would be cost savings if the income tax went away. That logic would make one believe that the cost savings accumulate or cascade at each step of production.
However, back in 2005, this issue was debated at length on another blog, and data was presented which claimed that the savings don’t cascade. I contacted the writer, but he/she seems to have little patience with fools, so I never was able to have a decent exchange. Here is his/her paper, for which I apologise in advance for it’s length, but not it’s content.
Does anyone on this blog understand this issue and would be willing comment on the paper? Clearly, the outcome would impact positions taken by Marvin and others regarding initial price increases?
“To: pigdog
I see you’re back. Perhaps you missed this from another thread: Since it has come up again in this thread, let’s take in indepth look at this “cascading taxes” assertion.
Here’s the way one really calculates embedded (cascading, hidden, pick-your-favorite-term) taxes.
Levels 1 2 3 4 5 6
Initial Cost Revenue $2.01 $4.05 $8.15 $16.40 $32.99 $66.39
$1.00 Cost $1.00 $2.01 $4.05 $8.15 $16.40 $32.99
Tax Rate PBT $1.01 $2.04 $4.10 $8.25 $16.60 $33.40
34.40% Tax $0.35 $0.70 $1.41 $2.84 $5.71 $11.49
NetProfit $0.66 $1.34 $2.69 $5.41 $10.89 $21.91
Net Profit % 33.00% 33.00% 33.00% 33.00% 33.00% 33.00%
Accumulated Tax Paid $0.35 $1.05 $2.46 $5.30 $11.01 $22.49
Tax cost as a % of Revenue 17.30% 25.90% 30.18% 32.30% 33.36% 33.88%
Intial Cost: Initial cost to the first level for the widget ($1.00)
Tax Rate: The Percentage of Profit Before Taxes owed as Tax
Revenue: The amount received by a business from the sale of a widget to the next level (sale price)
Cost: The amount the business paid to the previous level for the widget
PBT: Profit before Taxes: The amount of Revenue in excess of Cost at each level
Tax: The amount of PBT that is Tax (@ the Tax Rate of 34.4% of PBT)
Net Profit: The amount of PBT that remains after taxes are removed
Net Profit %: Net Profit expressed as a percentage of Revenue
Accumulated Tax Paid: The cumulative amount of tax paid by the current and all previous levels
Tax Cost as a % of Revenue: The Accumulated Tax Paid expressed as a percentage of current-level Revenue
So, using pigdog’s inputs (since we’re after the MECHANISM!, not the VALUES!), after the 6th level, “Accumulated Tax Paid” grows to a whopping $22.49. Even more eggregious is the “Tax Cost as a % of Revenue” which grows 33.88%!!. Compared to the original table offered by pigdog, these numbers are even worse...
...or are they?
Let see what happen when a new retailer jumps into the frey, except, he is smart enough to buy the widget at the Initial Cost of $1.00 and sell it at the 6th level sale price to generate revenue of $66.39:
Levels 1
Initial Cost Revenue $66.39
$1.00 Cost $1.00
Tax Rate PBT $65.39
34.40% Tax $22.49
NetProfit $42.90
Net Profit % 64.61%
Accumulated Tax Paid $22.49
Tax cost as a % of Revenue 33.88%
It turns out that after only ONE level, the “Accumulated Tax Paid” is exactly the same as it was when SIX levels handled the widget before! Even more amazingly, “Tax Cost as a % of Revenue” is also EXACLY the same as the six level example. How could that be? I thought taxes “cascaded”!
Well, it turns out that the amout of Accumulated Tax is proportional ONLY to the amount of accumulated PBT. Whether you take all the profit at one level or chunk it up and divide it among many levels, you wind up paying the same cumulative amount of tax: a percentage of cumulative PBT.
So pigdog is right: the numbers don’t matter, its the MECHANISM that is of interest, BUT since pigdog got the MECANISM wrong, he drew the wrong conclusion.
As you can see Taxes don’t multiply, they add. And they only add up to an amout proportional to cumulative profit: accumulate less profit, pay less tax. And it doesn’t matter how many levels of accumulation there are, the tax is only proportional to the accumulated profit.
Now let’s say that the last three levels of the chain extract NO profit. If pigdog is right, all that “Cascading” tax from levels 1, 2, and 3, should keep on growing.
Let’s see:
Levels 1 2 3 4 5 6
Initial Cost Revenue $2.01 $4.05 $8.15 $8.15 $8.15 $8.15
$1.00 Cost $1.00 $2.01 $4.05 $8.15 $8.15 $8.15
Tax Rate PBT $1.01 $2.04 $4.10 $0.00 $0.00 $0.00
34.40% Tax $0.35 $0.70 $1.41 $0.00 $0.00 $0.00
NetProfit $0.66 $1.34 $2.69 $0.00 $0.00 $0.00
Net Profit % 33.00% 33.00% 33.00% 0.00% 0.00% 0.00%
Accumulated Tax Paid $0.35 $1.05 $2.46 $2.46 $2.46 $2.46
Tax cost as a % of Revenue 17.30% 25.90% 30.18% 30.18% 30.18% 30.18%
Hmmm.... Everything stopped growing. Why? Because there is no additional profit to tax. The tax is levied only on the new profit at each level; NOT on ANY portion of the tax embedded in the Cost from prior levels.
Now, of course, if you want to argue that 33.88% is way too high a level of tax embeddes in price, then the numbers DO matter. You see, as you lower your profit expectation by reducing your price, far less profit (and tax) accumulate. Let’s see what happens when the chain lowers its Net Profit % expectations from 33% to 10%:
Levels 1 2 3 4 5 6
Initial Cost Revenue $1.18 $1.39 $1.64 $1.94 $2.29 $2.70
$1.00 Cost $1.00 $1.18 $1.39 $1.64 $1.94 $2.29
Tax Rate PBT $0.18 $0.21 $0.25 $0.30 $0.35 $0.41
34.40% Tax $0.06 $0.07 $0.09 $0.10 $0.12 $0.14
NetProfit $0.12 $0.14 $0.16 $0.19 $0.23 $0.27
Net Profit % 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
Accumulated Tax Paid $0.06 $0.13 $0.22 $0.32 $0.44 $0.58
Tax cost as a % of Revenue 5.24% 9.69% 13.46% 16.65% 19.35% 21.65%
Profit and Tax still accumulate, but at a much slower rate. The accumulated tax after six levels is far less than was accumulated after TWO levels in the 33% NPAT% example.
Conclusion: Taxes are indeed embedded in price BUT they only accumulate in proportion to PROFIT. Extract no incremental Profit, pay no additional tax. So, regardless of Cost, regardless of the number of levels, regardless of the tax rate, regardless of how much was already paid by prior levels in a chain of transactions:
the tax paid at any level is only proportional to the profit extracted at that level
the cumulative tax paid is only proportional to the cumulative profit extracted
the tax from prior levels is not taxed in subsequent levels
The “magic of compound interest” (called “cascading” by pigdog and others) does not apply here.
Please feel free to repost this anywhere you may encounter the infamous “cascading taxes” table posted by pigdog
Mein eyes, the goggles do nothing!
Seriously, can we get a little formatting on those tables?
Yeah, sorry about that. Just showing what was sent to me. If anyone wants to create the HTML for the tables and e-mail it to me at jzader at fairtaxblog dot com, I’d be happy to insert it into the post.
I’m very sorry about the transmission problems. Being sort of a “neanderthal” when it comes to computers, I can only direct you to the source as follows: Search for “Dale Jorgenson”, go to the 41st entry entitled “Jorgenson Explodes Fairtax Myth”, then work your way to the 609th response where you will find the post and the tables that got so garbaged up in my post.
I might add that the initial post contains very interesting emails with Jorgenson that are good background in case anyone is confused about Jorgenson’s “embedded taxes”.
seems to me this is as complicated to the ordinary person as our current tax system. I have an open mind - but please - is there anything out there that will talk down to an average citizen with only 4 years of college in order to clarify the mumbo jumbo?
From the Editor: This isn’t meant to be an introduction, Diana. Far from it! You’ve poked into the graduate seminar. Sounds like you’re looking for FairTax 101. Perhaps the FairTax entry at Wikipedia is a good place to start. That also contains links to additional information.
Just scroll down to post 609 and you can see the tables Hank was talking about.
Now I am still trying to verify what these guys are actually talking about, but at least the tables look nice.
The thrust of the conversation, if I could follow it, on the blog you mention, seems to be that pigdog asserted that taxes cascaded upward to a point higher than that of the original tax placed upon them. His detractors, and the poster of this table, above, decry that view and instead claim that embedded taxes instead approach a limit based on a percentage of profit.
The latter is indeed the correct view, as multiple levels of taxation based upon an income tax or VAT both only tax the difference from one level to the next (i.e. the Value Added for a VAT or the profit from one stage to the next for an income tax). This creates a series of diminishing returns, approaching zero at some point.
What relevance does this have to us on this blog? I am unsure. If Hank’s original question of how much embedded tax costs can be removed is the question we are going to answer, my answer would be:
It depends a lot on the industry what the specific numbers will be, of course, but ultimately there are limits to what we can remove. Multiple stages of taxation do provide more savings, but not much, as only a fraction of the tax burden increases at each stage, not a cascading effect as pigdog mentioned. Multiple taxes that do not cascade but are additive could represent more savings still, but the FairTax does not aim to remove many of these kinds of taxes (excise taxes for example).
This is why most of us here on this blog have generally come to the conclusion that a 15% increase in prices after business savings come into play is probably our best estimate. ‘Cascading’ tax savings would seem to indicate that more savings are possible, making say, 5% price increases available within a year, which I sincerely doubt. Plus, most of the larger studies that account for revenues don’t have ‘cascading’ tax revenue estimates for a very good reason, and don’t mention them (at least none that I have read top-to-bottom, which is only three of them).
It is far more interesting to try to calculate the costs of working around the tax system instead, and compare them to the FairTax. Differing compensation plans, withholding, dealing with a variety of tax-deferred compensation schemes, etc all cost a lot of time, effort and moolah, and those are the things I think will begin changing quite rapidly if we pass the FairTax.
I am just a simple man and can not figure out this complex theory of cascading taxes. To me it seems that all of the discussion is meaniingless.
All of the materials and services purchased by a producer at any level include on AVERAGE 22% of embedded taxes. The producer adds his value to the product and marks up the price. 22% of his markup on AVERAGE is because of taxes he pays. The price of the resulting product is now higher but still includes 22% total embedded taxes. It remains that way throughout the production/distraibution/retail cycle. There is no cascading of taxes.
If you look at the books of any business, you wont find an account that accumulates all of these taxes that total to 22% Most of the total will be in hidden in materials purchased and wages paid. Only employer share of payroll taxes and business taxes on income can be identified in separate accounts.
Marvin,
I may be simpler yet, but I still have a simple question: Under the Fairtax, if there are six levels in the production cycle of a widget, and at each level the business saves 10% due to the elimination if the employer costs of the income tax system, and there are no sales taxes on BTB transactions, and assuming the magic of competition works at all levels, why isn’t the cost (before tax) of the final widget 60% lower/cheaper?
Why don’t the cost savings cascade?
Example
1. $10 initial cost - 10% - $9
2. $1 value add - 10% - $.90
3. $1 value add - 10% - $.90
4. $1 value add - 10% - $.90
5. $1 value add - 10% - $.90
6. $1 value add - 10% - $.90
Total - $15 normal cost, $13.5 savings cascade
Total percentage reduced 10%
Morph, thank you!!! Light dawns on marblehead! I now understand that the savings at each step of production can only apply to the value added at that step, and if the average savings is 10%, then the final savings (or price reduction) will be 10%, period. And it doesn’t matter how many production steps, or what value added is involved at each step, the result will be the same.
If I’m correct, then you have managed to greatly simplify “Dimples” complicated charts and explanation, for which I, and possibly others, are grateful.
Morph
Thank you for explaining what I was trying to communicate.
How do I access “Jorgenson Explodes FairTax Myth”?
Bubba, See #3 above.