Questions about the FairTax from a Landlord
From a reader named Chris, who is a landlord:
I have tried to read several posts about how the fair tax will affect landlords and tenants. I have read the Fair Tax book, and also read the article on the blog here this blog in particular very casually skirts around the real issue at heart of the post…
“So, you need to figure out how you can send the 23% off to the State, maintain your profit margin, and still be competitive in your local rental market. Not an easy task and the transition period might be a little rocky?”
Here is my question. Lets assume that my average rental payment from each tenant is $1,000 per month and also assume that my PITI mortgage payment is $750 per month so my properties cash flow nicely at $250 per month. Once the fair tax is implemented I have a choice of how to charge the tax. On the one hand I can take a hit and just pay the tax out of my pocket by changing the rent to $770 per month and charging the 30% on top of that to keep my tenants rent the same at $1,000 per month. Most, if not all, landlords will find this route appalling and ridiculous to even consider.
The other choice is to keep my monthly cash flow the same and charge the tenant the tax. This is the purpose of the fair tax system right? That’s to charge the consumer a tax for what they consume. Since my tenants are consuming the housing, they should pay the tax. This would make my tenants per month charge for his housing go from $1,000 per month to $1,300 per month, which is a HUGE increase. Since monthly housing is most people’s single largest expense, this is an extremely sensitive matter that needs to be analyzed. (As a side note, i would assume that most american rent rather than buy, does anyone have any data on that?) Everybody’s argument for the tax at the register is that you get all of your paycheck so the increase is tax is really a wash. But see the problem is that my mortgage payment will not go down once the fair tax is implemented. Interest rates may go down, but no mortgage company on the planet is going to recast a loan to a lower interest rate in the middle of a loan just because their embedded cost of doing business gets lower because they don’t pay payroll or taxes on income. It would be great if it were going to be that easy. As a matter of fact, since I am consuming the benefit of a debt, I will have to pay tax on my mortgage interest that will cause my payment to actually go UP after the fair tax is implemented.
I have to pray really hard that my tenant will eat the extra tax, otherwise no matter what happens my monthly cash flow, and my income will actually go down as a result of the FairTax! It either goes down because I have to adjust the rent to be competitive, or it goes down because my tenant has to move out to find cheaper housing.
Here are the facts, most landlords make much less that $250 per month per house. For most landlords the reality is they make 25-75 per month after all the repairs and maintenance and vacancy costs are accounted for. For these landlords to take less cash per month in for the rent than they do now will cause people to go into negative cash flow situations on multiple houses at nearly the same time. And this will apply to hundreds of thousand of landlords across the country, so please don’t try to marginalize this issue as a “bump in the road to transition.” Has anyone done any studies or reports on how this will actually effect the bottom line of those of us who have developed a significant portfolio of rental property? Or even for the mom and pop who have 1 duplex? Where can I find more in depth analysis of this problem or discussion on the topic?
Specifically, I’d be looking for an analysis of the average income for a person who paid X dollars per month in rent, what their expected increase in take home pay would be after the fair tax is implemented, and what their expected monthly prebate check might be, and what the actual difference would be to the persons bank account if the rent were to remain the same and the 30% tax were charged on top of it. Please do not get into a discussion of 23% vs. 30%. It is a 30% tax charged at the point of sale I can either say the rent is $1,000 plus tax or $1,300 tax included. Either way it is an increase of 30% over and above what I now charge for rent. Thanks for your great website and all the time you’ve spent already answering so many of my questions in the form of answers to other posts.
There are two things to mention here that were not considered in the reader’s letter:
1) The person who owns the property will no longer have to pay income taxes on any rental income or other income, so they will have more money in pocket.
2) The person renting the property will no longer have to pay income tax so they will have more money in pocket.
I’m sure there are other angles to take here as well, but my solution is just to sit down with the tenant and work on a deal with those two things in mind. Yes, you’ll have to raise the price a little bit to keep making a profit, but you can come up with something that works for both parties.
The blog i had already searched through can be found here.
There are a couple other factors to consider that you’re neglecting.
1) What happens to the money you make via a rental? In your hypothetical scenario, you’re going to pay income tax on any profit you make. This goes away under the FairTax.
2) Each and every expense you have now with your property has hidden, embedded tax costs. The plumber you pay has to pay income taxes, self-employment taxes, embedded taxes on supplies, etc. Under the FairTax, all of that goes away, so every contractor you hire and supplies you purchase would be cheaper, with no tax component at all. You could probably look at your prior maintenance costs, and figure that anywhere from 10-20% of those costs reflect embedded tax costs.
3) Even if you are losing money by having to pay more on your p+i payment than you’re getting in rent, consider this: with no income tax, no payments on principal OR interest are taxed, and this is true whether it’s your 1st or 2nd home, or whether you’re an individual or a business. Further, there will be no taxes on the gain of the value of the home when you resell it — so the full appreciation of the value of the property will still be yours instead of sending some of it to the government. Basically, as a landlord, you are in this both for the rent and for the investment. Under the FairTax, the investment side of that deal is much sweeter, so the rent side of the deal can be more competitive.
The combination of these things means this - what it costs you to provide a rental property to a tenant is free of *any* and *all* federal tax components. (Property tax would still be an issue, of course.) The investment opportunity is also higher. This means that the overall cost of the rent should be lower (before tax).
4) The FairTax prebate is designed to reimburse an individual or family for the sales tax applied up to the poverty level. So in your case, if the person renting the house currently for $1000/mo was a family of four, their prebate would be $525 a month, more than enough to cover the increased cost of rent, which would increase to something less than $1300 (because of competition, you’ll pass along your tax savings), as well as still have a good about of the prebate left to cover much of the increase of other basic consumption items.
Derek, thanks for your reply. I’ll respond to your points as you made them...
1) Because of depreciation, my income tax liability is basically reduced to zero on my rental property anyway. I don’t pay taxes on my rental income, and most landlords do the same thing.
2) Okay i see your point here, but reducing the cost of those goods and services may save me $10-40 per month, a drop in the bucket compared to the 30% tax increase of $300.
3)”Even if you are losing money by having to pay more on your p+i payment than you’re getting in rent, consider this...” Ok if this is the case then i instantly loose the ability to support my business or my family on my rental income. This is totally ridiculous to expect someone to be able to run a business sustaining loses every month.
I don’t pay any gains on the appreciation of the rental property anyway. It’s called a 1031 Tax Deferred exchange. If i sell a property and realize a $500,000 gain on it but put that money into a 1031 account, i can buy another property with that money and delay the payment of taxes indefinitely. But under your suggestion, i should just be okay with losing money each month? No business can support that!
There is no way to get the the “sweeter” investment side of the equation you posed when the rent side of the equation sandbags you from the start. You have to be able to support the property from day one. Ever heard the expression Equity Rich but Cash Poor?
4) This is where i want more people to chime in with actual data. The prebate was designed to reimburse for taxes spent on the necessities of life, but nowhere in the book or on any post have i seen states that the prebate included a calculation for the tax you would pay on your housing expenses. The fact is that renters have a far greater tax liability than homeowners. I don’t want to debate the homeowner vs. renter thing under the fair tax, what i want is to see if my tenant will still be able to afford my rent PLUS the additional income tax when this thing finally passes. The fact is that my per month expenses as a landlord will not go down on each property i own, so there is no was for me to reduce the rent. The rent has to stay the same, i can’t go into a negative cash flow situation.
The questions asked raise a basic issue: there are many unknowns. The FairTax rate computation makes no assumptions about downward prices. In fact, the paper “Taxing Sales Under the FairTax: What Rate Works?” assumes price increases of the full 30%. Data in that report also show that corporate and social insurance taxes, as a percent of expenditures, are about 10%.There is no known answer to what “new take home” pay will be. It appears benefits (insurance, employee discounts) provided by employers to employees will be taxable and I haven’t seen that analyzed anywhere. It’s premature to assume current gross will become the new take home pay.
The actual impact on a person who pays $xx in rent will depend on what portion of their actual income is used to cover necessities and what their real taxes are today. In the example used, a family of four takes $26,300 off their income taxes today: $10700 in standard deduction, $13600 in personal exemptions and $2000 child care credit. Their actual income tax burden might be quite small. If $1000 rent comprises 1/2 of a persons non-discretionary spending and prices stay the same, the $525 prebate won’t cover a FairTax of $600 monthly. If rent comprises 1/3 of non-discretionary spending, the FairTax will be $900. Tables from the Bureau of Economic Analysis show that medical care, housing and food are the largest consumption areas, in that order, and are relatively equal in dollars spent. Without knowing what portion of current salary is allocated to taxes and to non-discretionary spending, your question is unanswerable in actual dollar impact. It’s reasonable to say that the greater the precentage of discretionary spending, the less the impact on the bank account.
The other unknown is whether states that don’t currently tax basic necessities will conform their systems to the FairTax base. In the proposed law, there is an incentive for them to do that. If that happened, you’d be collecting and remitting sales tax as well - if you don’t already.
Chris forgot to mention he would keep all the federal taxes he now pays. If he’s in the highest tax bracket which seems reasonable if he owns apartment buildings then he’s going to be making roughly 50% more profit. Lots of room there to lower rents and still be ahead.
I find it hard to believe that’s a real example of cash flow. Is he trying to finance the entire amount without any down payment?
dculling,
Have you ever run a rental business? My son-in-law has rental property so,
here is his business plan in brief. Let’s see what the Fairtax would do to his plan?
He bought 24 rental units in Virginia for $2.2 million, financed $1.7 million for 20 years with annual mortgage payments of $174,000. His annual rental income is $233,000 at an average of $900/unit and 90% occupancy. His expenses other than the mortgage are roughly 20% of revenue or $46,000 annually. Depreciation allowance is $73,000 per year.
As you can see, he pays no federal income tax with income of $233K and expenses plus depreciation of $293K.
His cash flow is a very small positive 5% or $13,000 per year.
Under the Fairtax, some of his expenses may drop a bit, but his local property taxes are going up, and his mortgage payments may also rise due to the implicit tax provisions of HR25. If expenses are a wash, his rent would have to rise to $1170, a 30% increase. And that doesn’t begin to be offset by the single prebate, and uses up most of the married prebate. Not a pretty picture for the folks renting his units.
He might be forced by competitive pressures to use up his small profit to reduce the rent somewhat. Even going to zero profit, his rent will still have to be at least $1120.
The only saving grace in all of this is that if he can stay in business, when he does sell the properties, there won’t be any tax owed. And I agree that that is no small consideration.
Dculling –
I see that you are not a landlord. Most landlords don’t pay taxes on much, if any, of the rent they receive because depreciation, interest expense and other costs related to the property generally create a tax loss. When they sell the property, they either pay long-term capital gains rate of 15% or do a tax-free exchange.
Under the Fairtax, landlords would need to pay 23% (or more) of their revenue in federal taxes, so, in order to keep the same income stream, they would need to raise rents by at least that amount.
dculling,
Would you agree that how the FairTax will impact Chris is based on his individual circumstances? Isn’t he the only one who has the information needed to determine what his additional profit, if any, would be? I don’t know where his rental properties are located or whether he has a base of possible tenants able to absorb a price increase, should that occur. I also don’t know what portion of his profit would be needed for personal taxable expenses of his own versus non-taxable business expenses. I certainly don’t know his current federal tax burden.
He brought up some important questions that aren’t easily answered with generalities. In theory, consumption is consumption. But, in practice, consumption is discretionary or it’s not. And some non-discretionary consumption can’t be bought “used” to save tax: insurance, healthcare, food,rent etc. This is a fact the FairTax, as proposed, is unable to address with a universal Prebate based on household size and makeup. Although, to be accurate, there isn’t a universal Prebate schedule - Alaska and Hawaii have different schedules.
I would agree that the specific details of how the FairTax will affect Chris depends on his individual circumstances, but I’m convinced that overall he will be far better off.
Economic growth is good for everyone which is the main promise of the FairTax.
Eliminating all the unnecessary wastes of time and money inherent in the current code can do nothing but good for everyone. While the AFFT says we will have equal or better buying power, they are not counting the effect of eliminating all the wastes. To me this suggests we will certainly have better buying power after the FairTax passes.
Opponents always look for some detail to hypothesize into some horrific outcome. I suppose they just can’t get passed their fear of change.
I’m not a landlord, but my father was. I believe he put a significant down payment on the property so the rent he charged was twice his payment. Half of the profit was held for maintenance.
The FairTax will not overcome bad business decisions.
It’s a good thing that people look for details in the FairTax that could result in some “horrific outcome”. There’s no doubt some will benefit greatly from a national sales tax, others will struggle to maintain their current living standards. The research papers I’ve read hypothosize that those in the middle income ranges will reap their benefits in anywhere from 5-10+ years.
The uncritical proponents of the FairTax ought to take a more realistic look at the facts and figures. Start with the Prebate itself: without that universal giveaway, the FairTax rate would be 20.3%. How is it efficient to charge a higher rate just so the government has the money to send out monthly “tax free spending” checks to every household? To me, the Prebate program is a huge red flag that indicates an underlying issue not fully addressed.
I’m not arguing the current tax system has much going for it. I do think the FairTax, as proposed, has some basic flaws and shouldn’t be touted as having nothing but positive impacts on everyone regardless of their economic circumstances.
A post script to #7. I spoke with my son in law last night, and his rental business is in trouble. The local property taxes doubled this year, and his cash flow is seriously negative. He is trying to refinance his mortgage to an interest only, five year loan at 6% in order to solve the cash flow problem. Property taxes are a very large expense and, under the Fairtax, can be expected to increase significantly.
He raised another issue with the Fairtax that I haven’t seen discussed. His clients are on the edge of buying rather than renting. If his rents increase 23% as mentioned, and interest rates drop, many of his renters would choose to become first time buyers, and there goes the business. So, don’t look for a lot of Fairtax support from the “landlord society”.
Hank,
That postscript sounds like a rotten case of wearing gray-colored glasses.
As a (relatively new) member of “the landlord society,” I embrace the FairTax wholly. Will there be bumps and readjustments? Surely.
But any self-respecting landlord lives and dies by investments — the very area that will experience dramatic boons by the untaxing of investment income.
Also, while I haven’t been following this discussion closely, I don’t recall anyone mentioning that tenants will each have prebates that offset — and in the case of lower-income tenants, will more than completely offset — any necessary rent increases. Higher-income tenants, whose prebate will be smaller relative to their monthly rent, will further benefit from having to pay no income taxes.
Sorry, but I can’t muster much sympathy for your son, here. There are lots of reasons why property investors around the country are experiencing serious problems, but a prospective FairTax isn’t one of them.
An economy-slugging income tax is one of them.
Joshua
Joshua,
It’s not my gray colored glasses that are involved here, it is the concerns of a 52 year old, highly successful vice president for a major medical equipment manufacturer who went into the rental business in Virginia as I described. By comparing his situation to those of Chris, whose post started this discussion, I think they have some pretty good insights on what could happen to their rental businesses under the Fairtax.
From Joshua: Great, let’s look at them. I agree this is interesting stuff, I just don’t see why you’d ignore the significant benefits of switching to a consumption tax — especially for investors — over the relatively minor issues you manage to scrape together here.
In rereading all the responses, I noticed several misstatements:
(1) There are three erroneous claims about the supposed benefits to landlords from not having to pay income tax on their rents. Be advised that they probably don’t pay income tax today under current law due to the depreciation allowance as Hayden noted earlier. Good point, and may be relevant for some investors. But even those who don’t pay income on their rent, still pay income taxes on their investment earnings, any other income they receive, and the income-tax-inflated prices of goods they buy. Anybody in a position to be an investor, stands to gain significantly by the elimination of an income tax.
(2) Renters may have more money as noted, but they are going to have to have more $ in their pocket to pay the higher rents. Not sure what the point is, here, unless you’re acknowledging that renters are unlikely to be hurt overall.
(3) Contrary to the claim, the mortgage could be taxed under the implicit tax provisions of HR25. This is speculative, so it’s hard to say either way. I would certainly agree that it’s a potential concern.
(4) While some expenses may go down, others will go up, such as local property taxes and mortgage debt payments. The expense part of the business plan may just be a wash. Sure, and if some see their overall expenses go up, that’s not catastrophic, as we’re dealing with a dynamic system, here. In any event, there is no way to make significant changes to a tax system without having negative effects somewhere.
(5) The only way an investment in rental property can work in the long run is if property values rise over time. Ask some landlords in Florida just how their business plans look now, after a 30%-40% drop in property values. This has absolutely nothing to do with the FairTax, so why throw it in as an argument against?
(6) As for the prebate covering the potential rent increases, not true for singles, and almost not true for couples at the lower income levels. And those folks are the vast majority of renters. It most certainly is true for anyone living at the poverty level. And for those above the poverty level, their increased rent will be additionally offset by the elimination of income taxes and greater economic opportunities. Again, I believe all you’ve proven, here, is that there are some interesting dynamics to look at.
Landlord concerns may be valid, and handing them a pair of rose colored glasses won’t help!
I’m not advocating rosy glasses; I’m advocating clear glasses. Many economists have noted the economic benefits of switching to a consumption tax vs. an income tax; you don’t need rosy glasses to acknowledge those very significant benefits, especially for people who are in a position to invest in large pieces of real estate.
In particular it’s your “[all the renters will buy homes] and there goes the [rental] business” comment that seems incredibly naive about how markets respond to new dynamics. Don’t you think home prices will be going up in response to any increased demand? You seem driven to portray at the negatives without the positives, and I find it unproductive in this context.
“The FairTax will not overcome bad business decisions.”
Amen to that. I’m not a landlord so I can’t speak to all the intricate issues. But look, if the entire basis of making money as a landlord is that you’re able to deduct the depreciation of the property, then you’re staking your economic future on a tax policy that is most likely to change in one form or another. If your business approach is based soley on the current tax structure, of course you stand to lose if the tax structure is overhauled.
The reality is, what you can charge for rent has absolutely nothing to do with your mortgage payment, how much it costs to maintain the property, or the cost of the property taxes. What you can charge for rent is almost completely based on market conditions - the supply of available units, the number of people looking to rent units, and the competitive forces of those people considering buying a home.
So if you’re worried about rising property taxes? Guess what, that’ll affect people considering buying a house as well. If you’re worried about rent going up? Guess what, that’ll be the same issue for everyone else trying to rent out units.
Funny how some of these posts have popped up between others.
Anyway, the whole rental thing is an interesting topic. It let’s the opponents start off with the disadvantage of having paid all the embedded taxes before the FairTax and then claim how hard it is to make a profit afterwards. A better example would be purchasing the property after the FairTax and since it’s for a business not having to pay any tax.
Could it be that rental properties are treated like existing inventory and thus there will be credit for those? I don’t know and don’t feel like looking it up.
Also there are several reasons to own rental properties. One of them is for a tax write off and another is for the future capital gains taxed at 15% instead of for income. Something a highly successful vice president for a major medical equipment manufacturer might be inclined to do.
I can only imagine how well the economy will run when people start making real business decisions instead of tax dodging decisions.
Ellen,
I disagree for the many cases where opponents appear to be intentionally fear mongering. Bartlett is a good example of this. He starts with the worst possible assumption to the point of “invention,” ignores the effects of a dynamic and growing economy then extrapolates to a horrific outcome. He is one that should know better so I assume he’s acting out of self-interest.
If you search you can find he is a supporter of either a flat tax and/or a VAT. Once a famous supporter and part architect of Reagan’s successful tax cuts he has since fallen from grace to the point of getting fired for speaking out against President Bush. I won’t give any credence to him because I think he has some kind of agenda other than what’s best for this country.
Then there are those who can’t accept the FairTax is a non-partisan tax reform proposal. Clearly many think it’s some kind of assault on their ideology. Ideologues can be quite creative in their fanaticism. I think they are easy to spot because most use Bartlett’s work and emotionally charged rhetoric to try and coerce the reader. I’m not accusing anyone here of course.
Then there are those that honestly think they have something to be worried about. Some of these even have just enough math skills to be dangerous. However, at some point they should realize they are not experts in economics, at least not as credentialed as the small army of economists supporting the FairTax; funny how egos so often keep that from happening.
So what I’m getting at is, no, it’s probably not a good idea in most cases for people to look at the details of the FairTax. It’s too easy to find misinformation and/or something to get hysterical about if one doesn’t have a good understanding of certain principles and concepts. As Dirty Harry would say, “a man’s got to know his limitations.” This won’t stop anyone of course.
I believe the FairTax will help everyone. Sure there will be a period of adjustment which may affect some people worst than others like those that make a big profit gaming the system. I don’t think we should worry about very low percentages of the population, whatever happens, eventually they will have a much better standard of living than without the FairTax. History shows us that economic growth really is a tide that lifts all boats.
I suspect the research papers you read were not counting the effect of economic growth which is the main promise of the FairTax. Many problems arise from people trying to do static analysis of the FairTax. Also I’ve seen the AFFT likes to give very conservative estimates, so much so I’d call their numbers a worst case scenario. I should probably go through all the documents I’ve read and make a list of where they are playing it safe and why it looks that way to me.
I’ve looked at the facts and figures and think it’s realistic to be optimistic. This is based on my own areas of study much of which was independent because so little of what I needed to know was taught to me in public high school. A couple of college economics classes don’t hurt either. On a related note, it was during the second class while thinking of something to write a term paper about I independently re-invented the Laffer Curve.
The prebate is what makes the FairTax progressive. This is necessary to appeal to the Democrats which is necessary to get the FairTax passed. It also happens to be a lot like the reverse income tax idea of Milton Freedman. The prebate only requires a simple application filed once a year not the kind of in depth info required of other programs. There also is no point where one’s income will suddenly lowers one’s benefit which is a problem with other assistance programs. We don’t need any more people purposely making less so they don’t lose a benefit. It’s simple and simple is better I think. I’m sure there any many people that won’t file for it because they are wealthy or just proud. Who knows, this could add up to billions saved off of the projected cost.
Whatever flaws the FairTax has I’m sure we’ll be able to fix it as we go. I really doubt there are any significant flaws that the free market and economic growth won’t fix.
Hank,
I’d tell your son-in-law to invest that $2.2 million into an index fund which have returned a little over 12% a year in the last 5 years. That $2.2 million would earn $264,000 then subtract the payments and he’d have $90,000 left over with no property taxes or headaches. Index funds are also tax efficient in that their returns are typically capital gains which of course wouldn’t matter after the FairTax.
Your son-in-law is clearly investing for other purposes than yearly income. Nice try Hank.
Property taxes are not related to the FairTax. In fact, there are a couple of states looking into replacing their property taxes with a FairTax. The one I saw would add 3% to the rest of that state’s FairTax. I’ll do what I can to get Nebraska to replace property taxes with a FairTax so we’ll look really good to all those foreign businesses that will relocate here.
Hayden,
You’re talking about landlords like Hank’s son-in-law since you’re talking about a no or low income business. You’re just trying to stock the lake with red herrings with Hank.
Actually, the question you raise can be generalized further. After the FairTax is enacted, if you buy a new property for the purpose of renting it out, do you pay tax on it? I would assume not, but that makes it quite inconsistent with purchasing a used property for the purpose of renting it out.
As far as I can remember, there are no provisions for converting an item that has already been taxed into an item used for business purposes, and get any kind of credit on that. A used item is a used item. I think doing any kind of conversion back and forth would be too complicated.
Dsculling,
Just one comment: the research papers I’ve read have all included the promised economic growth under the FairTax. Given the fact that people have ongoing financial obligations just to live, it’s important that potential impacts be understood, as much as possible. To me, the FairTax, as currently proposed, is not the best solution. Perhaps my opinion is colored by the uncritical selling of the plan by those who think it’s a magic bullet. It’s simply a fact that it will take some people years to make up the ground they’ll lose. The good news: we’re too much of a debt driven economy so anything that curtails more debt has some merit.
Ellen,
Of all the research I’ve seen none of them include the savings of the hidden costs of compliance, tax gap, lost efficiency, disincentive, and uncertainty costs. I’ve linked 2 different sources in other threads that suggest these could be as high as 2 trillion today. While these are just estimates there’s no reason not to expect something positive from eliminating most of these wastes. For instance, Hank’s son-in-law is not making as much money as he could if he wasn’t dodging taxes. How often does that happen now across the US?
Then there’s the trillions of American dollars hidden in offshore accounts. I don’t think the effect of those coming back to America is included in any of research either.
I believe I’ve seen a bunch of instances where the AFFT is playing it safe with very conservative estimates. I suppose the thought of 300 million angry Americans might have something to do with it.
You can keep looking at the details if you want, but at some point I think it’s best to rely on fundamental principles. I would suggest reading up on the works of Milton Friedman. It’s pretty interesting how he evolved from a belief in Keynesian economics and the New Deal to a firm belief in Laissez-faire. Along the way he proved that government monetary policy turned a mild correction in the market into the Great Depression and the New Deal just prolonged it.
Milton’s favorite example of Laissez-faire economics is Hong Kong. Pretty amazing how that little bitty overcrowded country with basically no natural resources managed what is probably the greatest economic growth in history. They did this with an income tax, albeit considerably less than ours. One has to wonder about the possibilities of no taxes on income, productivity or investment.
dsculling, I agree that looking at fundamental principles is important and that’s one reason I’ve concluded the FairTax would have unintended negative consequences. It is fundamentally based on the concepts of the lifetime utility of money and consumers “smoothing” their expenditures based on lifetime earnings. That principle assumes all consumers are relatively equal in their savings and spending rates - as a proportion of income. We know that’s not true. At the same time, debt is at record levels as many consumers have borrowed against tomorrow to buy “wants”, not needs, today. The difference between discretionary and non-discretionary spending is an important un-addressed factor. While the FairTax might well depress that discretionary over-spending, it doesn’t adequately address the issue of non-discretionary spending. That, of course, is one reason many states do not apply sales taxes to housing, food, medical care etc. The Prebate is an unnecessarily expensive shotgun approach to resolve the predicted initial (5-10 years +)negative impact on what is often called the middle class. The middle class drives this economy and the government would have to step in with whatever brilliant solutions they pulled out of a hat.
Ellen,
Any change may have unintended consequences. What you apparently are forgetting is we are currently living with the unintended consequences of the income tax which the FairTax is designed to fix. The unintended consequences of the income tax probably affects every single person in America today. I suspect one could easily argue, since our income tax affects trade and policy, that the entire world has suffered negative unintended consequences because of it.
Let’s look at a few of these unintended consequences of the income tax. It originally started out as a simple flat tax only on the rich. Then it was raised by any handy excuse like war. Soon it was perverted by politicians seeking to give one group of people some benefit presumable at the expense of some other group. However, lobbyists representing powerful special interests soon learned how to game the system for their benefit and politicians learned this was a great way to generate campaign funds and other perks.
If you look at corporate taxes as a percent of total revenues, they have gone down consistently over time independently of the official rate. This stands in evidence of the fact that powerful people use the income tax to gain advantage over others. Is the success of Wal-Mart due entirely to competing successfully and fairly in the free market or is it due to being able to hire lobbyists or at least smart tax accountants and being able to take advantage of all the loopholes and such? Wal-Mart is often accused of destroying Mom and Pop businesses wherever they’ve built stores. Was it really Wal-Mart or the inability of small business to take advantage of the loopholes?
Speaking of small businesses, the income tax is clearly more of a burden on them. Small businesses are often the source of true innovation. Google, YouTube and eBay are three innovative and highly successful companies I can think of right now that were once small businesses. Since this disproportional burden on small business stands as a barrier to entry and growth, one has to ask themselves how many innovative products or services have been stopped or put out of business by the income tax. You can find many letters here to the President’s Advisory Panel on Federal Tax Reform from small business owners pleading for relief or saying how taxes forced them out of business.
Then there’s the wealthy that make investments as a tax dodge and not to maximize income like Hank’s son-in-law. How do you or the AFFT measure the total effects of something like that; no one can. Without looking up lobbying firms, it would be safe to assume there are lobbyists for the wealthy and powerful property owners giving them advantages where probably none exists for the benefit of individual home owners. Thus, mostly likely there is a disproportionably high amount of rental properties and a correspondingly lower amount of affordable homes. This would keep many from home ownership, the single most important investment and cost of living reducer for most Americans.
How about the effect of taxing investments? The wealthy are typically not stupid powerless people. Acting out of self-interest is perfectly normal so instead of being robbed by the government the wealthy have learned how to hide their wealth in offshore accounts and other means. How has this affected America with unintended consequences? Well it surely deprived many American businesses of capital. Increased capital is directly related to increased productivity which is directly related to lower prices and higher wages. One can only imagine where we’d be today if we had never adopted an income tax, but instead a proportioned indirect tax, like the FairTax, just like our founding fathers intended.
I could go on and on about the unintended consequences of the income tax. To worry about the unintended consequences of the FairTax while ignoring the far reaching effects of the income tax that ripples throughout the free market, compounding and multiplying undesirable effects that can not be easily measured, shows to me a lack of understanding of the power of a free people participating in a free market. I would suggest watching Milton Friedman’s video series “Free to Choose” to help restore your belief in free markets or to deprogram you from incessant manipulations of those that wish to deprive you of freedom.
Quote from Milton Friedman:
Ellen said:
Are you suggesting that people don’t plan ahead? I would suggest the present income tax combined with certain government programs interferes with people planning ahead and the FairTax will encourage it instead.
Ellen said:
I don’t think it assumes that at all. Can you show me such an assumption from AFFT?
Ellen said:
Well yes, debt is encouraged by the current system. The FairTax will encourage savings and investment for all income levels, thus aiding people to plan ahead.
Ellen said:
No, it’s accounted for with the prebate. The lower percentage of income spent for non-discretionary spending of the wealthy is accounted for. The wealthy tend to be able to choose how much income they receive and hide the rest typically as future capital gains. I suspect when there are no taxes on investment they will go for maximum income, making more and spending more and paying more FairTax.
Ellen said:
The reason is political, not economic. There is no good economic reason to subsidize certain areas of consumption, certainly not with the tax code anyway. Interfering with the natural balance of the free market is what causes those unintended consequences you’re concerned about. Remember the founding fathers preferred apportioned indirect taxes, like consumption taxes, and made un-apportioned direct taxes, like the income tax, unconstitutional.
When America experienced the Great Depression, many Americans gave up on capitalism thinking it had failed when in reality it was the Fed that failed. Many Americans began a “love affair” with the Communism, Socialism and Fascism of Europe thinking we should emulate them and ended up overturning the wisdom of our founding fathers by passing the 16th amendment and implementing income taxes. Since those European ideologies have clearly failed, why do we hang on to any of their failed ideas? We need policies based on good economics, not good intentions that always fail.
Personally I think implementing the reverse income tax idea of Milton Friedman, where we could combine the prebate and all other government aid into one monthly cash payment, would be a far better idea. This would require filing more personal information than the FairTax though. However, I recognize that the FairTax has a limited scope and it’s not supposed to be the FairSpend proposal. In defense of the prebate, it does costs less than half of current tax refund schemes.
After showing you many reasons the middle class will probably do better than the AFFT allows themselves to predict, you’re still insisting the middle class will be worse off. I must insist the positive benefits of the FairTax are far reaching and profound of which there are many that can not be quantified. Again, one has to have a belief in the power of a free people participating in the free market, among other things, to see how everyone will be better off.
If you watch Milton Friedman’s series “Free to Choose” I believe you’ll see the power of freedom and thus the benefits of the FairTax. If not then I’m afraid the political indoctrination of the Left or just fear of change has been too powerful.
This is to the best of my understanding of the FairTax, and is not necessarily the case:
I believe the most likely outcome is that rental properties will qualify for the business use conversion credit/inventory credit. Thus, if you bought a house for investment purposes pre-FairTax, you could apply and receive an Inventory Credit for that house; so if the value of that house was $200k, you would get a $46k credit (23% of $200k). Likewise, if you live in a house and then decide to switch it over for rental, you would apply for the Business Use Conversion credit. You could then use this credit to offset future FairTax payments, or more likely, monetize the credit (by selling it off, as specified in the FairTax bill) and use it to refinance the mortgage on the house, dropping the house’s mortgage payments.
Once the house has been converted to an (untaxed) investment, you would have to pay the FairTax on rent recieved, but since the mortgage payments will have dropped due to the refinancing, the whole excercise should be a wash. (This doesn’t even include the expected 25% drop in mortgage interest rates, though I don’t know how much of an effect that would have; I don’t know if there are different rates for investment properties.) If you then sell the house, unless you sell it to another investor/landlord, you would have to collect and remit the FairTax on that house.
The same basic case can be made for all rental businesses. This is the case which makes the most sense to me, but I’m not certain that it’s correct.
The short answer is:
You’d raise your prices by 30%, and hope that your tenants take-home (including the prebate) increases by an equal amount. If they are at the poverty line, their income should increase by AT LEAST the prebate, which is 30% of their current salary.
And everyone (up to the Social Security limit) would be getting at least a 8.5% raise due to elimination of FICA. (i.e. currently they take home 92.2% of their salary.)
Everyone’s take-home is 30% higher, and everyone’s rent goes up by 30%, and it is a wash. (If you own a home, your mortgage suddenly is 30% cheaper, except you don’t get an interest tax deduction, so maybe it is a wash too.)
Your take-home, however, will stay the same. So your personal purchasing power will drop by 30% assuming all of your net income is going to personal consumption. This is because your profits are currently tax advantaged (deferred indefinitely) under the income tax system, and will be subject to the same tax as everyone else under the Fair Tax.
Some people will win under the Fair Tax, and some won’t. Landlords, taking advantage of all kinds of arcane rules under the Income tax, will probably not be immediate winners.
Chris,
Actually there is one fuzzy area that still needs to be considered. Under Article II, Chapter 2, Section 202 of the bill there is a business use conversion credit that would apply to a landlord who buys real property from a private party. The credit is the amount of the Fair Tax. Applying this credit effectively reduces the landlord’s captial costs immediately for that particular real property to 77% of the landlord’s purchase price.
This savings is in addition to reduction in real interest rates. [See “Simulating the Dynamic Macroeconomic and Microeconomic Effects of the FairTax” Jokisch and Kotlikoff 2005, sic.: “In transforming the economy’s prospects from one of a capital shortage to one of capital deepening, the FairTax also reduces real interest rates, with the 2100 real interest rate ending up 160 basis points lower than in the base case.”]
I will be submitting a proposal to Congressman Linder, when he re-introduces the bill in 2009, to clarify that the inventory credit, Title II, Subtitle A, Chapter 9, Section 902, which is the equivalent of the business use conversion credit for a trade or business with pre-Fair Tax inventory, includes real property in the hands of a real estate investor. With this clarification, a landlord’s capital costs, regardless of when he acquired the property or from whom, will be at least 23% lower than they are today - before one considers the added benefit from the landlord’s lower interest costs.
The point is that, while the landlord still must charge tax on the rent, the combination of the foregoing two effects plus the landlord’s reduced embedded costs of about 10% will enable the landlord to reduce the rent before collecting the tax - probably more than offsetting the effect of the tax itself.
~Jim Bennett
Summit, NJ
Chris,
PS re Note 7 (Hank Van Gieson): Because the cost of education is not taxed under the Fair Tax, the increase in state and local taxes will be more moderate than critics predict. From my own property tax bill, over 50% goes to the School District. Then, of the 26% component of my property tax bill going to the County, there are embedded education expenses. Finally, about one third of the New Jersey State budget is earmarked for education. Any “recapture” taxes that state and local governments will need to collect in order to maintain real purchasing power will be more than offset by the benefits of the Fair Tax.
~Jim Bennett
Summit, NJ
Great points Jim.
Jim/Morphh,
Not so good points when you both begin to understand that my concern about rising state and local taxes is based on the data base used by Kotlokoff and BHI in their September 2005 base/rate study. The $1.1 trillion in the state and local taxable base already had $403 billion in education related expenses removed. I estimate that the net Fairtax cost to state and local governments will be $279 billion, which is roughly 21% of all state and local consumption. Taxes will have to rise by 21% or services cut by an appropriate amount to rebalance their budgets. Them’s the facts, and they can’t be swept under the table by speculating about Fairtax benefits.
I’d be happy to send anyone a copy of my “Fairtax Financial Impact on Governments” study upon request to vanlinda@comcast.net.
Jim, the only portion of the school district’s budget that would not be taxable would be wages and salary paid to “employees directly providing education and training,” i.e. teachers. Everything else (e.g., books, buildings, administrative employees, etc.) would be taxed under the FairTax.
Fred, please read the FairTax Bill sec 70. It looks to me that educational institutions are treated just like any other non-profit entity in that they pay no taxes on taxable property or services.
Hank, did you figure educational institutions paid taxes on taxable property or services for your calculations?
Dculling,
First, non-profits would pay the FairTax on their purchases unless they were for export or resale. Kotlikoff has non-profits paying ~$36 billion in FairTax for 2007.
Second, a school district is “political subdivision” of a government, not a non-profit organization. As a part of the government their purchases of taxable property and services is subject to the FairTax. They are also considered a “taxable employer” which means the wages they pay their employees are taxable (in the bill, “service” provided by their employees is considered a “taxable service”). But specifically exempt from being considered a taxable service is “any service performed by an employee for which the employee is paid wages or a salary... by taxable employers to employees directly providing education and training.”
Kotlikoff included government consumption - which includes school districts - in the base but specifically removed “wages paid to government employees who provide education and training.”
That was sec 706. Dang, I wish we could edit after posting.
Re Post #29 (Fred Johnson)
Fred,
Your interpretation is overly restrictive. The portion of the school district’s budget that would not be taxable includes school district administration and state departments of education, and here’s why. Below is the excerpted language from four separate parts of the bill that discuss education and training. Title II, Subtitle A, Chapter 1, Section 2(a)(14) exempts “employees directly providing education and training” from the term [taxable] service.
Administrators at the Board of Education are providing education and training just as directly as the teacher in the classroom. The reason for the administrators’ economic existence is none other than education and training. Other portions of the bill assist in the construction of the word “directly.”
The definition of the word “education” includes primary and secondary education, which is predominantly the domain of public school districts. Taxable employers, except for households, are almost exclusively governments, and the presumption is that the legislator intended the exemption of employees who directly provide education for a purpose. Otherwise the exemption would be without meaning. Definition 8(d) supports this interpretation when it sates that education and training shall be treated as services used to produce, provide, render, or sell taxable property or services. These services are not taxable.
Finally, including administration personnel among “employees providing education and training,” and state education departments, puts public schools on the same footing with institutions that provide post-secondary education, and independent schools. This argument is buttressed by the definition of a not-for-profit organization which includes an organization organized and operated exclusively for educational purposes. Those organizations do not pay tax on their employees’s wages and salary, and they do not pay tax on tuition. The only distinction between this kind of an organization and a public school district is the public school district does not charge tuition.
Thus, the tax-free status is not limited to teachers in the classroom.
~Jim Bennett
Summit, NJ
——————
Title II Sales Tax Enacted
Subtitle A-Sales Tax
Chapter 1 Interpretations, Definitions, Imposition of Tax, Etc.
Section 2 Definitions
...
(4) Education and Training
—The term ‘education and training’ means tuition for primary, secondary, or postsecondary level education, and job related training courses. Such term does not include room, board, sports activities, recreational activities, hobbies, games, arts or crafts or cultural activities.
...
(8) PRODUCE, PROVIDE, RENDER, OR SELL TAXABLE PROPERTY OR SERVICES.—
...
(D) EDUCATION AND TRAINING.—Education and training shall be treated as services used to produce, provide, render, or sell taxable property or services.
...
(14) Taxable Property or Service
...
(B) Service For the purposes of subparagraph (A) the term ‘service’
...
(ii) shall not include any service performed by an employee for which the employee is paid wages or a salary
...
(IV) by taxable employers to employees directly providing education and training
...
Chapter 7 - Special Rules
...
Section 706 Not-For-Profit Organizations
...
(b) DEFINITION.—For purposes of this section, the term ‘qualified not-for-profit organization’ means a not for-profit organization organized and operated exclusively—
(i)... for religious, charitable, scientific, testing for public safety, literary, or educational purposes.
...
Jim, all that research you did is right on target. No argument from me about your interpretation. But it doesn’t change the fact that state and local taxes are going to rise by 21%, or services are going to have to be curtailed by a like amount in order to balance the state and local budgets.
In case you missed my point made earlier, the Kotlikoff/BHI study from 2005 removed all those education related expenses when they calculated the Fairtax base/rate for state and local consumption. Over $400 billion in education expenses was recognized and removed from the base. So, I find it difficult to understand just what benefits of the Fairtax you envision would offset the “recapture” taxes needed to maintain real purchasing power. Can you please explain just what you mean?
Re Post #28 (Hank Van Gieson)
Hank,
The rise in state and local taxes appears to be your strongest criticism of the Fair Tax. Even if we were to accept your estimated tax-increase of 21% for state and local governments without any question at all, this increase would not be a deal-breaker in my mind. I say this as one who lives in the state with the nation’s highest property taxes and who struggles to pay them, together with state income and sales taxes. The increase is one-time, and the dynamic benefit of the Fair Tax to the economy would more than offset this tax rise.
Landlord Chris should be able to pass on the 21% local property tax blow because his tenants, in most cases, will take home 26% more in pay,* and presumably they will not spend their entire income on rent.
~Jim Bennett
Summit, NJ
*Assume, reasonably, they save, as a result of the Fair Tax, 13% in income tax and 7.655% in payroll tax (employee portion), i.e., 20.655%. This is the most likely consequence of the Fair Tax. Therefore the tenants take home 26% more from their employment (tax-exclusive).
Jim, under your loose definition, what employee of a school district would not be directly providing education and training?
dsculling, a school district would not be considered a non-profit. Under the bill it would be a “political subdivision” of a government.
(I posted a similar reply but it seems to have gotten lost in the ether.)
All employees of a school district would be exempt from tax on their salaries.
I to understand that a school district is different from a not-for-profit organization. My point in citing that part of the bill was only to use it as an aid in interpreting statutory language concerning school-district employees.
Regards,
~Jim
So it’s your opinion that the word “directly” in the language of the bill is superfluous and that there is no one working for a school district who is “indirectly” providing education and training?
I do not think the work “directly” is superfluous at all. Everybody in the school district is directly providing education and training. The teacher in the classroom could not provide education and training if there were no payroll clerk in the back office at the board of education to pay his or her salary. Both are providing education and training directly.
The Mayor, Fire Chief and Police Chief are examples of people who work for a taxable employer who do not directly provide education and training. Another example is the municipal tax collector who collects the property tax, part of which ultimately goes to the school district. The tax collector remits to the municipal treasurer, who remits a portion to the school district. Although these two are involved peripherally in the education process, they do not directly provide education and training. Their salaries are taxable.
Best regards,
~Jim
Then it is superfluous.
Frankly, I think you are stretching the meaning of “directly providing education and training” to the point of breaking. The pertinent definition of “directly” is “without anyone or anything intervening.” The only people in a school district “providing education and training” “without anyone or anything intervening” are teachers.
I think my position is quite reasonable, but we’ll have to agree to disagree. Perhaps I can get Congressman Linder to opine on that passage and give it some legislative history as an aid in interpretation.
Regards,
~Jim
I have to agree with Jim on this one, such would include both teachers and the support staff involved with providing the service of education. The function of their daily job is to contribute directly to the service of education and thus would not be taxable.
Then a school district can avoid all FairTax on outside services by “hiring” the service providers as employees and then firing them when they are done.
“Contributing directly” is significantly different from “directly providing.” Y’all seem to think the lunch lady should be considered an educator.
All right, already. Enough of the semantics discussion. If you really want to know how Dr Walby and Kotlikoff/BHI treated education expenses, someone should just email Kotlikoff or Teurck at BHI and ask the question. All I know is that over $400 billion in state and local education expenses was removed from state and local consumption when they did the base/rate study back in 2005. Did it include janitors and food service employees? Beats me, but $400 billion pays for a lot of education services.
Back to the purpose of this thread. I don’t know anything about the tenants in Chris’s rental units, but I can tell you that the 24 families in my son-in- law’s Richmond, Virginia units are paying $800 monthly, and they aren’t paying much if any income tax.
Jim, in your #35, you speculate that renters will take home 26% more pay, so an increase in state taxes won’t be a problem. As I stated, the only increase in pay for the typical low income Richmond renter would be the return of the 7.65% payroll tax, supplemented by the prebate. No net income taxes paid. So, on one side of the ledger, spendable income is up by the amount of the prebate and the payroll tax recapture, and on the other side, rents are up a minimum of 17%, and state and local taxes are up 21%. And, in the case of senior retirees, it’s just the prebate trying to offset higher prices and higher state and local taxes.
I might add that, contrary to your belief, rising state and local taxes are not my major criticisms of the Fairtax. As a retiree, I think I object mostly to having to resume paying for my pension and health care benefits, while an estimated 30 million workers pay no net federal tax, yet still qualify for full SS benefits.
I also object to having my savings double taxed, and I object to having a higher effective tax rate. On a less personal level, related to higher state and local taxes, all of us should be concerned about the constitutionality of governments at all levels taxing each other’s operations. Have we forgotten that under our republican form of government, there are two sovereign powers, state and federal, both acting on the same citizens but with different duties and responsibilities? Under the doctrine of intergovernmental tax immunity, I am reasonably convinced that that portion of HR25 will be thrown out by the Supreme Court, and the Fairtax rate will have to be increased.
Regards,
Fred,
I suppose there indeed would be an incentive for school districts to bring certain labor-intensive functions in house that otherwise might be contracted out, such as the lunch lady.
So far we have been discussing only salary and wage expenses, which I say are tax-free to a school district. The school district still would pay tax on non-wage and non-salary expenses, such as supplies and capital improvements. Two observations on these items. First, the school district would benefit from the offsetting effect from un-taxing, by the Fair Tax, of tax costs that are embedded in the prices of such items today, making the added cost to taxpayers for these items less than the tax-exclusive amount of the Fair Tax.
Second, a public school would still be at a slight disadvantage as to these items vis-a-vis a private school, which would not pay tax on these items (or wages and salaries) as long as the items are used for the educational purposes of the private school. Maybe public schools would start to become privatized and run on vouchers. That development could improve educational quality, but I’m drifting into another subject.
Regards,
~Jim
Hank, you’re comparing a marginal rate with an effective rate. Since we’re talking about low income households, factoring the prebate would reduce the effective rate to something that is similar or lower then the current system.
– start rant
Since you’re talking about double taxation, SS, and medicare objections. Let me object to your generation primarily voting for and increasing social programs that are paid for by your children. Over your lifetime, you paid for government service provided to your parents, and we’re paying for you... but it’s not quite the same thing now is it. Your generation says “we’ve paid our taxes”.. “don’t tax us again”... Baloney You haven’t paid for squat. You have debt through the roof with 60 trillion in unfunded liabilities.
With the medicare and social security explosion, there is no way your children can pay this much - it is a pyramid scheme that is going to collapse. Generational robbery! Given this, why shouldn’t you pay more for your own social programs? Why should you break my back with 60 trillion in additional taxation? This is your unfunded burden - not mine. This is the tax you didn’t pay. You should be double taxed, triple taxed, quadruple taxed, until we either decrease the programs or pay for them.
If we pay for them, I prefer the option to grow the economy like crazy to make up the losses. Hmmm, what tax system is an economic machine. oh ya, the FairTax!
Perhaps this is a discussion for another thread. The fiscal gap and generation wealth transfer.
–end rant
Hank, I’m not directing this personally at you... You may not have voted for any such programs. I’m speaking generally and I’m making an extreme point to stir up some discussion.. So I hope you don’t take this the wrong way. I hooked onto a couple of key words and you just happen to be the line of fire - I’m in frisky mood. Sorry
Hank, (Post #45)
Unfortunately the semantics discussion is unavoidable because the scope of the education exception is controlled by the language of the bill, and not by the economists. However you are right that the economists’ interpretation of that language is part of how they came up with the rate, and input from them would be helpful. The ultimate impact of state and local taxes will depend on what the economists assumed about the bill and whether their assumptions were legally correct.
Let me address the other thread that you and Morph raised. As one who will turn 60 next month, and who is probably a decade away from retirement, I would have to say I agree with Morph. Our generation, and the generations before us, are collectively guilty of child abuse. If we have to contribute towards Social Security from our consumption (which will be paid partly from untaxed interest, dividends and capital gains), that in my mind is a small price to pay to give our children and grandchildren a secure future.
Regards,
~Jim