Comparing Average and Marginal Tax Rates under the FairTax and the Current System
Morphh just pointed out the Oct 2006 study “Comparing Average and Marginal Tax Rates under the FairTax and the Current System of Federal Taxation” by Kotlikoff and Rapson, which is available at that link in PDF format.
Here is the executive summary for easy perusal:
Comparing Average and Marginal Tax Rates under the FairTax and the Current System of Federal Taxation
EXECUTIVE SUMMARY
The FairTax is a proposal to replace the federal personal income tax, the federal corporate income tax, the federal payroll (FICA) tax, the federal estate tax, the federal gift tax, and the federal generation-skipping tax with a federal retail sales tax, assessed at a single rate. The FairTax also provides a rebate to each household based on its demographic composition. The rebate is set to ensure that households living at or below the poverty line pay no taxes on net.
This paper compares average and marginal labor income and saving tax rates under the current federal tax system and the FairTax. As specified in H.R. 25/S. 25, the legislation that would implement the reform, the FairTax’s tax rate is 23 percent. This tax rate is measured on a taxinclusive basis, meaning that a dollar’s expenditure would yield 77 cents in consumption after payment of the retail sales tax.
Although Gale (2005) questions whether a 23 percent tax-inclusive rate would suffice to maintain real federal spending and also cover the FairTax rebate, a recent analysis by Bachman, Haughton, Kotlikoff, Sanchez-Penalver, and Tuerck (2006) based on CBO 2007 projections indicates that less than a 3 percent scale-back of non-Social Security real federal expenditures would be needed to accommodate a 23 percent FairTax rate. As a share of GDP, these expenditures have risen by over 20 percent since 2000.
In asserting that a real revenue-neutral 23 percent FairTax is feasible, Bachman, et al. (2006) assume that the revenue losses due to evasion and avoidance under the FairTax will be no greater than those already incumbent in NIPA measures of household consumption. In so doing, Bachman, et al. (2006) may overstate the FairTax revenue base. On the other hand, Bachman, et al. (2006) likely understate the revenue base in ignoring the FairTax’s general equilibrium, macroeconomic feedback effects. Indeed, as discussed in Kotlikoff (2005), introducing the FairTax would likely raise real wages by 19 percent over the course of the century relative to what technological improvements would otherwise generate. On the other hand, Kotlikoff’s paper shows that the aging of society, interacting with our Social Security and government health care systems, will place significant stresses on the nation’s finances. And the ability of the government under a FairTax to maintain the tax system’s tax rate at 23 percent or, indeed, even lower, will depend critically on reforming these major entitlement programs.
Households finance their current and future expenditures on consumption based on their current wealth and their current and future labor earnings. Hence, taxing consumption expenditures is effectively equivalent to taxing existing wealth and labor income. Given its 23 percent rate, the FairTax would effectively tax both existing wealth and current and future labor earnings at a 23 percent rate.As shown here, current total effective federal marginal tax rates on labor supply appear to be either higher or much higher for almost all American households than they would be under the FairTax. The current system’s marginal wage tax rate exceeded the FairTax’s 23 percent marginal rate for all of the 42 single and married stylized households we considered.
For some low- and middle-income households, the marginal tax on working under our current tax system is more than twice the 23 percent FairTax rate! Take, as an example, a middle-aged married couple earning $30,000 per year with two children. Given the level of their federal marginal tax bracket, their loss, at the margin, of the Earned Income Tax Credit from earning extra income, and their exposure to marginal FICA taxation, their current total marginal effective tax on earning an extra dollar is 47.6 percent!
Since the FairTax taxes consumption at the same rate no matter when it occurs, it imparts no incentive to consume now as opposed to later and, thus, no disincentive to save. In economic terms, the FairTax’s marginal effective tax rate on saving is zero. In contrast, the existing federal tax system imposes very high marginal effective tax rates on saving. For the 42 households considered here, marginal effective tax rates on saving range from 22.6 percent to 54.2 percent. In addition to imposing, in almost all cases, much lower marginal taxes on working and, in all cases, dramatically lower marginal taxes on saving, the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.
Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax.
The FairTax not only lowers remaining average lifetime net tax rates. It also maintains and, indeed, enhances overall progressivity in the tax system. Consider middle-aged married households. The FairTax average lifetime tax rate is very low – only 1.5 percent – for the couple with $20,000 in annual earnings, and much higher – 20.5 percent – for the couple with $500,000 in annual earnings. The reduction in the tax rate at low earnings is proportionately much greater at the low end of the earnings distribution than at the high end. In switching to the FairTax, the $20,000-earning couple experiences an 86 percent cut in its average tax rate, whereas the $500,000-earning couple experiences a 42 percent cut.
The current federal fiscal system is highly complex. Understanding its work and saving incentives for any given household requires very sophisticated software – software that deals with (a) all major provisions of the federal income tax, including the Earned Income Tax Credit, the child tax credit, the alternative minimum tax, Social Security benefit taxation, the decision to itemize deductions, the indexation of tax brackets, exemptions, and standard deductions, and the interaction of the federal income tax with each state’s personal income tax, (b) the complex determination of Social Security benefits, which includes the calculation of primary insurance amounts, early retirement benefit reductions, delayed retirement credits, the recomputation of benefits associated with earnings after benefits have begun, the earnings test, family benefit maxima, and the scheduled rise in the age of normal retirement, (c) the payroll tax, including its separate employer and employee components, its interaction with federal income taxation, and the projected increase in the covered earnings ceiling, and (d) the reduction in after-tax returns arising from the U.S. corporate income tax.
Following Gokhale, Kotlikoff, and Sluchynsky (2002), the method used here to study average and marginal taxes under the existing federal tax system is to run a set of stylized households through ESPlannerTM (Economic Security PlannerTM), a personal financial planning software program. The program, which was co-developed by myself and Dr. Jagadeesh Gokhale, determines a household’s highest sustainable living standard and the amount of saving, spending, and life insurance needed to preserve that living standard through time. In “smoothing” a household’s living standard, the software ensures that the household never exceeds its borrowing limit (which is typically zero).
In forming its recommendations, ESPlanner makes highly detailed, year-by-year federal and state income tax and Social Security benefit calculations, which take into account all the aforementioned tax and benefit provisions as well as a host of others. Because it focuses on lifetime planning, ESPlanner considers how current work and saving decisions affect not just current taxes and Social Security benefits, but also all future taxes and Social Security benefits. This life-cycle/dynamic element is critical to understanding the size of effective marginal taxes. The reason is simple. Earning or saving another dollar this year alters not just this year’s taxes and, potentially, Social Security benefits, but also, potentially, all future taxes and Social Security benefits. Ignoring any of those future tax and benefit provisions can seriously distort the measurement of the true gain from extra work or saving.
Economists measure the gain from extra work or saving in terms of consumption. The gain from extra work is typically measured in terms of its maximum impact on current consumption. Thus, if a worker earns an extra $100 this year permitting this year’s consumption to rise, at most, by $50, we say the worker faces a 50 percent marginal tax on his or her labor supply.
The gain from extra saving is typically measured in terms of the impact on future consumption of forgoing a fixed amount of current consumption. In the absence of any effective marginal tax on saving, reducing current consumption by, say, $100 would lead to an increase in future consumption, measured in present value, of $100. If future consumption, measured in present value, rises by only $50, we say that the saver faces a 50 percent marginal tax on saving.
ESPlanner is ideally suited to measuring these tax rates on working and saving thanks to its underlying consumption-smoothing algorithm and its standard of living index. These features allow users to specify if and how they’d like their living standard to change in the future. The program can, in effect, be told to spend on current consumption and only on current consumption all the net proceeds arising from additional current earnings. (Net proceeds references the additional current earnings themselves less any increase in current and future taxes plus any increase in current and future Social Security benefits, where changes in future taxes and Social Security benefits are measured in present value.) And in measuring the marginal effective tax on saving, the program can, in effect, be told to spend the proceeds of additional current saving so as to uniformly raise consumption in all future periods.
See the full PDF document for additional details and the accompanying charts.
A few flaws in your analysis. First your math above assumes that these taxpayers do not own a house and itemize their deductions. Many Americans do own their house and this should be mentioned. Second, and relatedly, with the Fair Tax, we as Americans (and I became a Citizen last year) lose the mortgage interest deduction. Will this not have a detrimental affect on the already fragile housing market. Third, the FAIR tax does not allow for charitable contributions - ie, a tax deduction. Therefore in your math above this assumes (again) these taxpayers do not itemize and do not have charitable contributions which many Americans do (inluding myself).
Additionally, your first example above about the family of 4 which earns $30,000 a year and for one dollar over would be a 47.5%. Which calculator are you using because my math shows that their effective rate (with FICA) is 9.8%.
In addition, if we implement the FLAT tax, what will be the hit on the economy for the 100,000+ accountants that are now out of work.
Finally, the FAIR tax is terribly regressive (how many low income taxpayers have a bank account to which they can cash their refund check?) and its impact on the economy (charity, housing market, accountants, underground sales tax transactions to avoid the tax) could be detrimental