“No Such Thing” as an Embedded Tax?
UPDATE: This person (who posted under the name “Gus James”) contacted me after I made this post. He revealed his real name and explained why his comments were posted more than once (it wasn’t a case of spamming, as I had concluded). I apologize for leaping to an incorrect conclusion. For historical purposes, however, I’m leaving my original post below.
A reader posting under the name “Gus James” has spammed multiple posts with his missive below. I’m adding him to our spam list (to discard future comments unceremoniously), but I’m posting his missive below for dissection.
He ignores basic principles of economics, aside from his bone-headed mantra of “supply and demand,” of course.
I wouldn’t expect anyone with a background in free market economics — anybody else here read Thomas Sowell, Henry Hazlitt, and the like? — to have difficulty knocking this one out of the park.
Without further ado:
I have some bad news for you. There’s no such thing as an embedded tax. Sure, a business can pull its income statement at the end of the year and divide taxes paid by gross sales to come up with a false “embedded tax” figure. But when it comes to setting prices, that figure is entirely useless for two reasons. First, prices are based on supply and demand, not internal costs of any kind (including taxes). Second, income taxes (a major element of the so-called embedded tax) are only incurred if and when a business makes a profit, and therefore, could not be incorporated into pricing decisions.
Let’s talk about the basic economic law of supply and demand first. As most of us know, housing is struggling in many, if not most, parts of the country right now. Developers and home owners alike are finding that homes are selling for less than they cost to build (or the purchase price). If the theory of embedded taxes were true, then prices could never fall below cost. But in the real world of supply and demand, they often do. In fact, many businesses have the means to operate at a loss for years and many profitable businesses sell some of their products at a loss to encourage customers to buy other profitable products (i.e. loss leaders). Again, embedded taxes are not factored into pricing decisions.
Let me give you another example on the topic of supply and demand. I had a buddy who worked for Baxter, a company that sells hospital supplies. My friend (a salesman, not an accountant) was responsible for establishing prices for his customers. Each year, he sat down at his desk at home, and raised prices for every item in his catalog based on one question and one question only...how high could he raise them before his customers would squeal? Pretty high, it turned out. Overall, the profit margins on his book were in the neighborhood of 500 percent at the time. He didn’t consider embedded taxes in his pricing decisions, and of course, would not lower prices if payroll taxes or any other form of business tax went away. No business would.
Now, specifically referring to one component of a business’ tax burden, income taxes could not be factored into the price of a product or service since they’re only incurred if and when a business makes a profit. To increase prices specifically to reduce income taxes would be to increase prices specifically to reduce profits (also keep in mind that, in any given year, more than half of all businesses either operate at a loss or barely break even). So, assuming just for a second that prices were actually established based upon internal costs such as “embedded taxes”, the 22 percent figure (generally accepted by FairTax proponents) would be seriously overstated since income taxes are not factored into pricing decisions under any circumstances
Now, back in the real world, prices are based on supply and demand, not internal costs or embedded taxes. If supply and demand suggests that prices must come down, then they will—regardless of taxes paid. On the other hand, if supply and demand suggests that prices can be increased, then prices will rise—regardless of taxes paid.
In conclusion, the “embedded tax” concept has no basis in reality. This concept was created by FairTax marketers specifically to disguise the truth that under this consumption tax proposal, prices would rise by the amount of the tax imposed (see page 26 of the study linked to from Neil Boortz Nuze page on his website)
Have at it, folks.
Well, without even reading the guy’s full post I can already tell it is ludicrous. There’s no such thing as embedded taxes? That’s like saying there’s no such thing as trees... yet most of us can look out the window and see trees - likewise, most of us can look at our paycheck and see that our employer is taking away money for social security and medicare... and we know that our employer has to match those contributions. That’s money going to a government program, a tax. Now if the employer didn’t have to match that social security contribution, their cost of production wouldn’t be so high and they have the option of either paying the employee more, lowering the cost of their products/services, or hiring more employees.
GM had an adjusted loss of $1.5 billion for the last quarter. How much embedded taxes are there in the price of a GM car? Answer: None. They got exactly what the market would bear for their product and that price would have been the same whether they paid no taxes or $10billion. It happens the price they were able to get was below their costs to produce the car. Their costs didn’t determine the price, the market did.
What is their solution? Raise prices to cover their costs? That would be suicide. Their problem isn’t their costs - it’s fundamental supply and demand. They are supplying more cars than are being demanded at the price that covers their costs. The only solution is to reduce the supply of their cars and hope this will bring the market price above their costs.
[From the Editor: You could also say, “GM had an adjusted loss of $1.5 billion for the last quarter. How much steel costs are there in the price of a GM car? Answer: None. They got exactly what the market would bear for their product and that price would have been the same whether they paid nothing for steel or $10billion.” All you have succeeded in asserting, Fred, is that the final price of a product bears no relationship to the costs of producing that product. Oh really? This is a good way to end up bankrupt, but is not a good way to run a business or to understand the role of taxes in an economy. –Joshua]
At the micro level, prices are determined by profit maximization. While supply and demand are factors in this, so are costs. When costs of production increase, in general, it will be to the advantage of the business to raise prices to cover at least part of that cost increase. Hence, any tax that strikes a corporation in the form of an increase in the cost of production is actually transferred, at least in part, to the cost of the goods sold.
When a tax is levied industry-wide, the cost of production increases for all players in the market, and the amount by which producers can raise their prices is dependent in part upon price elasticity of demand. For inelastic goods (gas and groceries, for example), more of the production cost increase is transferred into consumer prices.
Barry, do you consider corporate income taxes a cost of production?
Joshua, most businesses that start do end up bankrupt. How is this possible if prices are determined by costs?
Fred,
It is the very threat of bankruptcy which places a strong incentive on business owners (and entire industries) to keep prices higher than costs.
Your example of companies going bankrupt proves that prices are not determined solely by costs. But you mistakenly adduce it as evidence that prices are not determined at all (or to a significant degree) by costs.
Any business not covering its costs through product sales over the long term must either (a) raise its prices, (b) lower its costs, or (c) stop selling the product.
This is equally true of industries as a whole — although there is a certain flexibility in how much different companies can trim costs to keep their expenses lower than their income.
If this does not prove to you that prices are significantly influenced by costs, I don’t know what would.
When we say “costs influence prices,” that doesn’t mean that whatever costs you have, you can just tack on a premium and that’s your new price. It means: If you can’t keep prices higher than your costs, then you either find a way to trim costs or you stop selling the product altogether.
Have you ever owned a business, Fred? I can’t imagine any business owner thinking that costs don’t influence prices.
Joshua
Gus James writes above that “prices are based on supply and demand, not internal costs of any kind (including taxes).”
This sentence is self-contradictory and reveals that Gus does not understand what “supply and demand” even means.
Why? Because one of the single largest determinants of the “supply” of a thing is the cost of creating it.
As cost goes up, “supply” tends (other things being equal) to go down — because it requires more resources to create the thing.
Therefore, as the costs of providing a product or service go up, this tends to lower the supply of that product relative to the demand for that product ... causing prices to rise.
(Economists have developed far more detailed ways of describing this phenomenon, but the general principle still holds true.)
Joshua,
I don’t want to claim any special expertise in business affairs, but there is a group of 3.5 million American businesses with less than 2 shareholders per corporation that lose money year after year, yet they stay in business. They are called S Corporations, and I know what they are all about because I was one. I believe it is likely that the majority of S Corps with few employees are set up to specifically lose money in order to shield other income from federal taxes.
My prices for my service were in no way determined by my costs, but strictly by the market and the competition. So, it isn’t entirely correct for you to assert that businesses have to include costs in their pricing strategy.
[As you imply, they’re not real businesses; they’re a means of sheltering income. Such “corporations” are an anomaly, a deliberate distortion of economics inspired by and maintained by the income tax system. Is it not rather ironic and inappropriate then to use them as an example against a consumption tax? The elimination of the need for such distortions is a major advantage of the FairTax. –Joshua]
I’ve always thought that the supply curve is expressed in price as a way of normalizing it with the demand curve. However, while demand is basically driven by price, supply is actually driven by profit. I think this may be where people have some confusion.
If the FairTax were to be implemented, then savings arising out of the elimination of personal income taxes and, essentially, half of all payroll taxes would accrue to the employee since it’s the employee that pays these taxes. Gross pay after the FairTax would be the same as gross pay before the FairTax, but take-home pay would increase accordingly.
Employers, on the other hand, primarily pay two components of federal taxes a) payroll taxes amounting to 7.65 percent of payroll and b) corporate income taxes. It’s accurate to say that corporate income taxes are not embedded into the price of any product or service for reasons already indicated.
However, one can argue that, technically speaking, payroll taxes could be embedded into prices. Remember though that payroll taxes make up 7.65 percent of payroll, not 7.65 percent of all costs. Depending on the industry, payroll expenses can vary from a very small portion of overall costs to a very large portion. If on average, payroll makes up half of company costs, then payroll taxes would average 3.825 percent of overall costs.
As Joshua said, anybody with any familiarity with micro-economics knows that prices are influenced by cost, or more specifically, variable costs. Fixed costs are considered sunk and are not factored into pricing. So, if on average, half of payroll expenses are considered a variable expense that rises or falls with production, then 1.9 percent of the price of a product purchased or sold could, in theory, be a factor in determining the price to maximize profits. Mathematically, that doesn’t mean that prices would increase by 1.9 percent, just that a higher number is used as the basis for calculating the price point at which profits would be maximized (or losses minimized, as in the GM example). Of course in the real world, most businesses price their products mostly by observing the competition and a lot of trial and error, further reducing the impact of limited savings in payroll taxes.
On the other side of the cost equation, fixed costs, overall startup costs would fall by approximately 1.9 percent in this scenario, theoretically, encouraging others to get into the market, increasing supply (i.e. competition) and driving down prices. However, this savings is also not very high and such increased competition would be limited to relatively profitable industries where barriers to entry are already low (mature industries, by definition, already operate with low profit margins not leaving much room for price adjustments and increased supplies to the market).
The bottom line with the supply side of the equation is that, on a macro level, the elimination of the corporate income taxes would have no effect on prices while the impact of the elimination of the employer’s share of payroll taxes could be relatively insignificant. As a result, downward pressure on prices from the supply side is likely to be limited if the FairTax were to be implemented.
The other side of the coin is demand. As I stated earlier, take home pay would increase signficantly if the FairTax were to be eliminated, putting upward pressure on prices. Given the size of such pay increases (7.65 percent plus personal income taxes) such pressure from the demand side would almost certainly overwhelm any limited downward pressure on prices coming from the supply side.
Would the Fed allow prices to increase? The Beacon Hill study says that it “seems likely” that the Federal Reserve would fully accomodate the introduction of the FairTax and “permit consumer prices to rise by roughly 30%”, the proposed tax-exclusive FairTax rate.
In short, prices are likely to rise with the implementation of the FairTax due to increased demand and Federal Reserve policy.
I’d like to make a correction to my previous comment. When I indicated that corporate income taxes aren’t embedded into prices, I was speaking strictly on a micro level.
On the macro level, Joshua is right again. To the extent that returns on investment would increase with the elimination of the corporate income taxes, our economy could see an increase in competition/supply putting downward pressure on prices. But keep in mind that most businesses operate at a loss or with very thin profit margins. In such cases, increased investment returns would either be non-existent or small.
Still, as the Beacon Hill study confirms, upward pressure on prices from the demand side is more likely to overwhelm downward pressure that would result from the elimination of embedded taxes.
Assuming that prices rise as the Beacon Hill study predicts, one might be able to argue that, mathematically, the economy could absorb a 30 percent sales tax on all goods and services with the savings realized from the elimination of existing personal taxes. However, the psychological impact of such dramatic after-tax price increases on consumer behavior might have negative consequences. For example, tax avoidance/tax evasion activities could grow.
I’m sorry to dominate the discussion. I was hoping others would jump in...perhaps I’ve bored everyone to sleep.
So, let me throw out a bombshell, and say that I think that the Beacon Hill study, distributed by Neal Boortz and others as a document intended to provide support for the FairTax proposal, actually vindicates Gus James’ assertion that there’s no such thing as an “embedded tax”.
Page 57 of The FairTax Books says “...if the tax burdens of all the corporations, businesses, and individuals in the manufacture, marketing, and sale of [the goods and services we purchase] were to be removed–these businesses would experience an immediate increase in their profit margins that would roughly equal that 22 percent [level of embedded federal taxes]”.
Let’s unpack this statement a bit. One can infer from it that an “embedded tax” is defined by FairTax proponents as a federal tax that:
1. equates to 22 percent of the price consumer goods and service under our current federal tax structure,
2. in relative terms has a direct one-to-one relationship with prices (in other words, if such taxes fall by 10 percent...aggregate consumer prices fall by 10 percent, and vice versa),
3. has an “immediate” impact on consumer prices as it increases or decreases, and
4. operates in a vacuum such that other variables affecting supply and demand would never overcome the impact of either increasing or decreasing such federal taxes.
If these items make up the criteria for an “embedded tax”, then as Mr. James suggests, there’s no such thing. Why? Because every detail of this assertion is patently false. The 22 percent figure is overstated, any impact that lower taxes on business might have on retail prices would be indirect (not direct), the relationship between falling taxes and falling prices are not anywhere close to one-to-one, any impact that decreasing business taxes could have on retail prices would not be “immediate”, and as the General Motors and Baxter examples demonstrate, the forces of supply and demand are affected by countless other variables that could either increase, reduce, counter or overwhelm any pressure put on prices by specific aspects of our tax code (other such variables might include oil prices, war, drought, natural disasters, trade agreements, peace agreements, elections, the Fed, demographics, cultural norms and on and on).
The economists at Beacon Hill, a conservative-leaning organization, predict that prices will rise by “roughly 30%” if the FairTax is enacted. This prognostication directly contradicts the assertion that prices will fall by 22 percent (or stay the same when you include the retail tax) because of so-called embedded taxes.
In the final analysis, as Gus James wrote, prices are determined by the larger forces of supply and demand (of which business taxes are only one factor).
Do business taxes impact consumer prices? Yes...indirectly, subtly, over time and in congruence with countless other factors affecting supply and demand. Is there such thing as an “embedded tax”...i.e. an existing federal tax that has a direct, immediate, one-to-one impact on retail prices? Definitely not.
Is there such thing as an “embedded tax”...i.e. an existing federal tax that has a direct, immediate, one-to-one impact on retail prices? Definitely not.
I haven’t seen anyone suggest that such a creature exists, on the contrary.
Still, companies will see their actual tax-related costs go down with the passage of the FairTax. Currently those costs are passed on (ultimately) to the consumer in the form of higher prices.
I have been saying all along that there is no such thing as an “embedded tax”, and it seems like there is growing agreement.
The problem as I see it is that shorthand terminology causes misunderstanding and confusion. What Jorgenson concluded back in 1997 was that there were “embedded costs of the income tax system”, not embedded taxes. But the rank and file Fairtaxers seem to believe that there are embedded taxes which can be removed and replaced by the sales tax, essentially one for one. This just isn’t true. If we all get used to saying that there are embedded costs, then it follows that those costs can be removed with some impact on retail prices. Certainly not one for one as Helena points out in the example case of payroll taxes, but, depending on the market forces, all things being equal, pretax costs will go down. How much depends on resolution of the employee gross versus net discussion, and the probable use of the employer cost savings for price reduction versus a myriad of other applications such as pay increases, shareholder payments, increased profit margins, business expansion, etc. etc.
If we call it by the proper name, I think a lot of the confusion goes away?
Hank,
The name “embedded taxes” doesn’t seem misleading to me at all. If some people treat it as a fixed figure that is the same across all industries, then they’re simply not paying attention.
If we agree that there are “embedded costs of the income tax system,” as Jorgenson says, then it seems much more misleading to say “there are no embedded taxes in the prices we pay today” than to say “there are embedded taxes in the prices we pay today.”
If anything, it seems you are saying that “embedded taxes” should really be “tax costs embedded”? Seems like trivial semantics to me.
Joshua
There is some element of truth in most of the above statements but there is also some poor logic and misunderstanding displayed in the comments.
All business taxes like all other costs become a consideration in setting prices.
In that sense, taxes are embedded in product costs. No, cost isn’t the only consideration in setting prices, especially in the short run. Anecdotal evidence of what happened in one situation has no bearing on how prices in total are set and proves nothing.
A business determines what return on investment they need in the long run to make it worthwhile to continue to invest in a given business, a segment of the business or a particular product. Competitors will take volume away from any company that charges a premium for their product unless there is some real or perceived additional value.
Pricing alone will not effect supply and demand. Supply is elastic and will increase to meet demand unless there are constraints that prevent increased production. Demand is based on how much money the consumer has to spend on a given want or need.
On a macro basis, prices will rise or fall based on the cost of production. After the fair tax is implemented, business costs will drop by the employer share of payroll taxes and corporate income taxes. Yes,corporate income taxes effect prices. A business must earn a certain level of return on investment after taxes over the long run or a smart businessman will take his investment elsewhere. He will invest where he can earn the best return on his investment. Return is after taxes and all other expenses. Individuals will have more money in their pockets because payroll taxes wont be deducted and they wont have to pay income taxes. Price reductions plus extra money in the consumer’s pocket will exactly offset the amount of the fair tax. The government by definition is taking the same amount of money from the private sector as before.
The real question is what will be the overall effect on the U.S. economy. If business has lower costs and can better compete with foreign suppliers and offshore money returns to the U.S., the American economy will boom and most people will be much better off. The fair tax makes a lot of sense on a macro basis but it will not leave every individual in exactly the same financial position as today. If that is what the objective is,then why make a change?
FYI, The Dept. of the Treasury just released a paper entitled “A Review of the Evidence on the Incidence of the Corporate Income Tax.” The studies reviewed “suggest that labor may bear a substantial burden from the corporate income tax.” The assumption is that the owners of capital bear the rest of the burden.
The abstract:
Who ultimately bears the burden of the corporate income tax plays an important role in the distributional analysis of tax policy. Distributional tables often assume that the incidence of the corporate income tax falls on the owners of capital but there is considerable uncertainty amongst economists about who bears the burden of the corporate income tax. This paper reviews the evidence on the incidence of the corporate income tax, especially in light of recent empirical studies that focus on the relationship between the corporate income tax and wages. While further research is necessary to draw definitive conclusions, these studies suggest that labor may bear a substantial burden from the corporate income tax. These empirical results are consistent with computable general equilibrium models based on an open economy in which a single country sets its tax policy independently of other countries; in these models, assumptions that capital is mobile and consumers are willing to substitute tradable goods produced in different countries imply that labor can bear more of the incidence of the corporate tax than capital bears. Evidence on the degree of capital mobility across countries and the sensitivity of corporate investment to changes in tax policy also corroborate the possibility that the corporate income tax lowers wages by reducing the productivity of the work force. In addition to changes in productivity associated with changes in capital intensity, labor may also bear part of the corporate income tax if wages are determined in a bargaining framework since the corporate income tax may change the equilibrium wage bargain. Overall, the recent empirical evidence, the open economy computable general equilibrium models of tax incidence, and the sensitivity of the amount of capital investment within a country suggest reconsidering the assumption that the corporate income tax falls on the owners of capital; labor may bear a substantial portion of the burden from the corporate income tax.
I didn’t see compliance costs mentioned in this thread. Ifound a paper that suggests the 265 billion or so compliance costs used in AFFT calculations could be a very low, but reliable, quantity. This paper suggests that if one adds up other good “guestimates” the actual savings in compliance costs could be 1 trillion or more.
I don’t see anyone mention the supply chain and how all the embedded costs will add up and most likely reduce the price of the final retail product. Keep in mind too the entire supply chain is FairTax free because it’s business to business.
What I see is that every item or service in the supply chain has it’s own market and supply and demand curves. I believe there will be a profound effect when all those supply and demand curves are free to reach equilibrium without all the negative effects of federal taxation.
Never underestimate the power of freedom.
To Anyone,
My Congressman asked for specific data on embedded costs in housing production.
I find it disturbing that he didn’t already know this since the government continually use the mantra “own your own home.”
Please give me a source or email me with reliable information so I can inform my Congressman of the added virtues of the FairTax.
With Appreciation,
Tom
tmorrison002@comcast.net
I think Dr. Dale Jorgenson put the figure on housing at 25%.
Tom,
Actually, the Jorgenson study put the embedded costs of construction at 24%. There is no specific data on housing. However, if you go to the AFFT website, and select Research, then select the real estate and home ownership block, you will find on page 4 of the first White Paper the following statement:
“It is estimated that the removal of these embedded costs could reduce the purchase price of a new home by as little as 12% and as much as 20% in normal markets”
A final note of caution. As most of us on this site are aware, the embedded costs stated as a percentage of producer prices is a constant no matter how many levels of production there may be. There are many levels of production in the construction of a new house, but percentage wise, it’s the same as if there was only one level. Embedded cost percentages do not cascade upward. Perhaps Morphh can elaborate?
Hank,
In the businesses that I deal with, mostly resturaunts and bars the embedded taxes are much higher, the 24% would be a good average. You are correct that costs do not cascade up and down the supply line but there is two sides of the ledger, costs and profit. Both sides have embedded taxes that are added to the prices we pay and the government has had over 95 years experience at hiding them from us. Businesses have been forced to add taxes into the price we pay.
Tom — Without opening up a can of worms here, you need to realize that the “embedded taxes” including the taxes paid by employees and construction workers. That means in order for the “embedded taxes” to disappear in the price of a home, the employees’ wages must be reduced by the amount they are currently paying in taxes. (I.e., if an employee currently makes $50,000 per year, but pays $15,000 in taxes, his wages under the FairTax would need to be reduced to $35,000 in order for the “embedded taxes” to be eliminated from the cost of construction.
Tom, To clarify Hayden’s comment, for “all” the embedded costs to be removed would require employees to recieve net wages. You can still have partial reduction in costs and recieve gross pay. We’ve been estimating around 10% on average.
As the final comment here, let’s just say that the “embedded taxes” and what would happen to them under the FairTax are a complicated things.
It’s not as simple as saying, “If we switch to the FairTax, construction prices will drop by 25%.”
Hayden wrote, As the final comment here, let’s just say that the “embedded taxes” and what would happen to them under the FairTax are a complicated things.
I can agree with you there. No one business or one industry will be the same, some will have price increases and some will even be able to reduce price.
But at the very least, we will no longer end up paying for the lobbyists hired to game the current system with the Fair Tax. I don’t even think it would be possible to quantify how much we now pay so that the fat cats can get breaks for their business interests. Even-though, lobbyists fees would fall under compliance cost and not really as an embedded tax, I still believe that it has a larger impact on the price we pay than some of the more visible embedded taxes. There are over 32,000 registered lobbyists in Washington, making billions of dollars a year. This is one thing that I believe needs to be stopped now.