TIME: FairTax has its “moment in the sun”
From a recent post by “Curious Capitalist” Justin Fox on the TIME blog:
Mike Huckabee’s victory in Iowa Thursday was a big victory also for the “Fair Tax,” the radical revamping of the federal tax code that he endorses. And while Huckabee’s Iowa win may be a one-off, one gets the feeling that the Fair Tax campaign will be with us for a while. The resurgent John McCain is mildly supportive of it as well. And the legions of Fair Tax fanatics aren’t going anywhere.
And later, this interesting story:
Anyway, on the occasion of Huckabee triumph, I called up Leo Linbeck Jr., the Houston businessman who together with two friends launched the Fair Tax movement just over a decade ago. I’m not sure what I expected from the conversation–maybe a little gloating over the Iowa results, I guess. What I got was two hours of mostly fascinating discourse, ranging from tax theory to feudal nature of modern Washington D.C. to the ideas of philosopher/theologian Michael Novak.
The Fair Tax got started like this, Linbeck told me: Three old rich men in Houston talked over lunch in 1995 about what they could do to leave the country better off before they died. They hit on reforming the tax system, and in particular simplifying it, as a worthy goal. “I’ve been a beneficiary of the complexity of the tax code,” is how Linbeck puts it.
Linbeck set out to find economists who had done work on what an optimal tax system might look like and ask them to put together a plan. He ended up with eight, among them such prominences as Harvard’s Marty Feldstein and Dale Jorgenson and Boston University’s Larry Kotlikoff. Economists who care a lot about optimal taxation tend to lean to the political right, and Feldstein is of course a Republican Party eminence. But the plan was to be nonpartisan. Kotlikoff, in fact, has been advising Democratic presidential hopeful Mike Gravel, another Fair Taxer–albeit a far less successful one than Huckabee.
What they came up with, mainly out of their economic studies but with feedback from market research that Ogilvy & Mather was conducting at the behest of Linbeck’s Gang of Three (they ended up spending $23 million on the overall effort) was the national retail sales tax, with rebates for all ($2,348 per adult last year if the tax had been in effect) so that the poor would end up paying little or nothing.
The main idea behind shifting taxation in this direction is to remove the burden on investment and production and place it all on consumption, thereby presumably stimulating long-run growth and exports. Lindbeck also argues that with the payroll tax gone, low-income workers would stand a much better chance of saving up money and rising out of poverty.
One big catch is that the Fair Tax would dramatically lower tax rates on those with the highest incomes. Linbeck had an interesting if not entirely convincing (to me, at least) response when I brought that up. “I don’t know many poor people that buy a G5, and I don’t know that many that buy a Bentley. The best indicator of people’s well-being is what they spend and how they spend it.” This was a reference to the work of W. Michael Cox, chief economist of the Federal Reserve Bank of Dallas. Consumption is wealth, the argument goes, which makes a consumption tax the fairest kind of tax.
Fox links to a post here the Fair Tax Blog early in the article. Nice!
(Thanks to AFFT’s Aaron Schutte for the tip.)
I’m not clear on assumption behind the statement — “The main idea behind shifting taxation in this direction is to remove the burden on investment and production and place it all on consumption, thereby presumably stimulating long-run growth and exports.”
Given the fact that consumer spending accounts for approximately two-thirds of our gross domestic product, one would think that consumption is at least as important to our economy as investment. However, the idea that taxes should be imposed entirely on consumption while investment (including short-term or speculative investments) should not be taxed at all would seem to imply that consumption is less important.
In addition, the Beacon Hill study of the FairTax proposal appears to have concluded that consumer prices are “likely” to rise by the full amount of the tax-exclusive rate (i.e. “roughly 30%”). If they’re correct, then wouldn’t the FairTax tend to reduce demand, and therefore impede long-run growth rather than stimulate it?
If prices did rise by that much, which is very unlikely considering the removal of the corporate income tax, employer payroll tax, reduced compliance, plus funded FairTax compliance (.25% of collected tax) - it would be equally offset by an increase in purchasing power. Any changes in prices will likely be followed by a similar change in purchasing power. BHI shows that it would not matter whether prices fall or rise—the relative tax burden remains the same because if prices increased with the addition of the FairTax, wages would also rise accordingly; or if the Federal Reserve did not decide to accommodate (does not increase the money supply), then prices would fall and wages would remain at their net rates. Purchasing power for buying consumer goods and services in either situation would remain essentially the same, and the FairTax rate would be the same.
Take a look at the economic studies by BHI “The Economic Effects of the FairTax: Results from the Beacon Hill Institute CGE Model” http://www.beaconhill.org/FairTax2007/EconomicEffectsFTBHICGEModel4-30-07.pdf and Arduin, Laffer & Moore Econometrics “A Macroeconomic Analysis of the FairTax Proposal” http://www.fairtax.org/PDF/MacroeconomicAnalysisofFairTax.pdf
I thought I had previously posted a reply this, but it didn’t get posted for some reason.
Anyway, my point was that FairTax proponents (such as Mr. Linbeck in this article) often throw out the name of Harvard economist Dale Jorgenson as being one of the pioneers behind the FairTax, yet they fail to note that Dr. Jorgenson does not support the FairTax. Although he, like many economists, has written that a consumption tax at a relatively modest level is more efficient than an income tax, he has also written that the FairTax is too ambitious to accomplish its goals.
That is, by trying to replace all federal taxation with one consumption tax, the tax rate would need to be too high. At that point you start losing efficiency, get more tax avoidance and distrotions to the economy, and the regressivity of a consumption-based tax gets more pronounced. Dr. Jorgenson was recently quoted in a NYT article on the FairTax where he again stated that it was too ambitious to accomplish its goals.
I have never seen Marty Feldstein comment on the FairTax one way or the other. But I know that AFFT had also hired Jim Poterba of MIT in its initial studies, and Dr. Poterba sat on the President’s tax reform commission that was very critical of the FairTax.
In fact, it appears that of all the economists that AFFT initially retained to study/develop the FairTax, Dr. Kotlikoff of BU is the only one who actively supports it (and even he believes that there would need to be serious revisions to it to deal with tax avoidance and regressivity issues.)
Morphh,
Thanks for the links.
I understand and agree with your assessment that the “relative” tax burden remains the same if prices increased under the FairTax since wages are likely to rise accordingly (”relative” meaning that the tax burden for some would rise while the tax burden for others would fall). As you said, this would mean that relative purchasing power would essentially remain steady (neither rise nor fall).
But your reporting seems to contradict AFFT. It’s my understanding that AFFT argues that a major benefit of the FairTax would be that relative purchasing power would actually rise (in other words, prices would remain flat after the FairTax replaces embedded taxes while profits and take home pay increases). So, the folks at Beacon Hill seem to contradict AFFT when they conclude in their report that prices are “likely” to rise by about 30 percent under the FairTax.
I also remain confused about the idea that the entire burden of taxation should be placed on consumption and none on investment. It’s clear how this approach would tend to encourage investment, but wouldn’t it also tend to discourage the approximately two-thirds of our economy that is consumer spending (ultimately harming returns on such investment)?
I’m sorry to remain skeptical, but for me, these arguments are not easily absorbed.
Thanks again!
Helena, I don’t think any of the documents on AFFT state that prices will stay the same and people will get their gross. They might have back in 2005 and earlier but they have since corrected that. Boortz/Linder made this mistake in the first edition (hardcover) of the FairTax book, corrected in the paperback. They “misunderstood” the Jorgenson data. You still have some people that state that prices will remain the same and others that say that you’ll get your gross income. They could both be correct statements as this is dependent on if the fed expands the money supply to accommodate the FairTax. Usually you will not hear both (gross pay and same prices) unless the person is misinformed or being deceptive. They do have a study titled ” Simulating the Dynamic Macroeconomic and Microeconomic Effects of the FairTax” that concludes the long term effects of the FairTax would reward low-income households with 26.3% more purchasing power, middle-income households with 12.4% more purchasing power, and high-income households with 5% more purchasing power. So they do claim it will increase purchasing power, but it is not because of a double gain through gross income and consistent prices.
Just so everyone understands - when Morphh talks about the long-term effects of the FairTax he means loooong-term effects. Those simulated gains are for people who won’t be born until 2030!
Morphh,
The “free lunch” Fairtax myth is still alive and well based on everything I read on other blogs. I try to correct the myth every day, but it seems to live on, and on, and on!
And, I don’t agree that Boortz/Linder ‘corrected” the paperback. On page 58, Boortz writes: “one of the beauties of the Fairtax is that the price of American consumer goods and services relative to your take-home pay will decline by roughly the same amount as the proposed Fairtax rate of 23%. This very nearly makes everything a wash.” On page 60 it says: “Once the Fairtax takes effect, you will be in complete control of your paycheck as nothing will be withheld.” To me, that says that you will get all your pay and prices will somehow remain about the same?
This is a total obfuscation of the real facts. If Boortz had simply written that “real” purchasing power would initially be about the same, I’d agree 100%. The most likely outcome is that you will get your whole gross pay and retail prices will rise by 15%-20%. Everyone’s standard of living will be relatively unchanged. But the paper-back only makes things worse, IMHO!
Morphh,
The AFFT site currently states in their FAQ section: “...When the FairTax removes income, capital gains, payroll, and estate and gift taxes, the pre-FairTax prices of these goods and services will fall. The removal of these hidden taxes may also allow wages to rise. Exactly how much prices will fall and wages will rise depends on market forces...” One can find similar such statements/implications throughout the site.
http://www.fairtax.org/site/PageServer?pagename=about_faq_answers#17
Also, responding to Jay Bookman, an Atlanta Journal-Constitution editorial writer, Boortz writes, “Bookman says that Congressman Linder has claimed that the FairTax would force prices down by as much as 30%. Wrong again. That figure is closer to 22%.”
http://boortz.com/nuze/200704/04232007.html
At the risk of beating a dead horse, such statements contradict the Beacon Hill study which concludes that consumer prices will increase by about 30 percent (Beacon Hill reasonably assumes that, under the FairTax, today’s gross pay would be tomorrow’s take-home pay).
Again, I agree with you that relative purchasing power would remain flat under either scenario. But I strongly suspect that most FairTax supporters continue to operate under the impression that they would benefit from the “double gain” you referenced since these proponents continue to insist that consumer prices will fall while remaining vague, at best, about what would happen to wages.
Helena, your confusing production cost (pre-FairTax prices) with final retail price (post-FairTax prices). AFFT says that production costs will decrease, not final prices. This is a true statement - be it 22% (by employees receiving their net pay) or 10-13% (by employees receiving their gross pay). This is dependent on if the fed expands the money supply. I can not see how prices could rise by the full amount of the FairTax. This would assume that the removal of the corporate income tax (15-39%), employer half of payroll taxes (7.65% of wages), income tax compliance costs ($250 billion), and the gain of .25% of FairTax collection to retailers ($5 billion) would have no effect on the producers price. If someone says prices will fall, they’re talking about production prices, not final prices. Even with a full decrease of 22%, the FairTax adds 23% right back so prices are remaining the same under that scenario, not decreasing. What Linder probably said and has said was that the FairTax would eliminate almost all federal taxation costs from the supply chain, which could lower production costs by up to 30%. 22% is an average from the Jorgenson study, but some types of business have more embedded tax cost then others. For example, the cost estimated for housing construction was 25%, above the average of 22%.
Morphh,
This may sound nit picky, but I wish you would say that “the Fairtax adds 30% right back so prices remain about the same”. In your example, you said that even if the 22% in embedded costs were removed, the Fairtax adds right back 23% and prices remain the same. Not true. If you take out 22% and add 23%, prices go down 4%. (1.00 x .78 x 1.23 = .96). The correct way would look like this. (1.00 x .78 x 1.3 = 1.015.) A 1.5% rise in prices on average, but still about the same.
The reason I raise this nit is to be sure everyone understands that if producer costs only fall by 10%, retail prices will rise by 17%, a not insignificant increase.
I’d also like to suggest that all this stuff about prices is kind of irrelevent for individuals, because we will probably be getting a large increase in take home pay, so “real” prices will remain about the same. Our standard of living will not suffer. But, the reason I continue to flog this issue is the impact it has on government finances. Retail prices will rise, but the governments won’t have any offsets other than the 7.65% payroll share costs. Governments don’t pay income taxes, nor do they get a prebate. State and local taxes will have to go up by an estimated 10%-15% in order to pay the federal sales tax. And that is basically what the BHI studies say after you strip away all the confusing economic jargon they tend to use.
I’m not certain just what question you asked BHI on January 4th, but I look forward to any further explanation of just how governments can tax themselves into prosperity?
Morphh · Jan 14, 2008 at 8:41 am
If someone says prices will fall, they’re talking about production prices, not final prices.
———–
Yes, but when production prices fall in a free competitive market businesses looking for market share will lower retail prices. I believe most businesses want increased market share.
I also found 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 have faith in the free market. I suspect prices will fall at least as much as the FairTax if not more.
Morphh,
You wrote, “AFFT says that production costs will decrease, not final prices...If someone says prices will fall, they’re talking about production prices, not final prices. ” The AFFT quote I gave was from the their website in response to the question “How does the FairTax affect wages and prices?” With all due respect, you are the one who is confused. This question and it’s response does not refer to “production costs/prices”, it refers to RETAIL prices. Their answer again...”pre-FairTax prices of these goods and services will fall.” (Boortz/Linder are also referring to pre-FairTax retail prices.)
You also wrote, “I can not see how prices could rise by the full amount of the FairTax.” I suspect that’s because you’re looking exclusively at the supply-side of the equation. You have to consider the law of demand as well.
Yes, lower production costs would increase competition and put downward pressure on prices. But from the demand side, remember that more money for both households and businesses to spend (Beacon Hill correctly assumes that pre-FairTax gross pay would be post-FairTax take-home pay) would put upward pressure on prices. Therefore, the law of demand will offset the law of supply. The result being that retail prices (excluding sales tax) would remain unchanged after the FairTax kicks in.
So, as Beacon Hill concludes, once the FairTax kicks in, prices would increase by the amount of the tax (current retail price plus “roughly 30%”).