Downward Pressure on Sales of New Items?
From reader George:
Since only new item would be taxed, there will be downward pressure on their sales as well as downward pressure on the wages of those producing new items.
So has there been any serious analysis of the consequence of this?
14 Responses to “Downward Pressure on Sales of New Items?”
George,
Great point...It’d be interesting to see how that approx. 22% embedded tax affect the used markets?
Yes you are absolutely correct and I for one think that’s a very good thing. I remember when made in America meant quality but now we have become a through away society. The concept of durable goods has become a joke. When something breaks or falls out of style it goes to the landfill. There will be new pressures on businesses to produce high quality items that will last for years, that are designed to be repairable not simply discarded so another sale can be made. There will again be a need for artisans to repair and refurbish used items revitalizing industries that have been in decline for the last couple decades. Parts and supply businesses will pick up more market share. The smaller local business with the shorter supply lines will again have an advantage. Remember it was not so long ago when over 80% of America was employed by businesses with less than one hundred employee’s. Yes, trends will change and it will be better than the mess we are in now.
That (questionable) downward pressure on the price of new items would be offset by upward pressure on the price of used items. The free market, as usual, would take care of this issue.
I’m also trying to imagine what I would buy used that would be a significant portion of my budget. A house and a car are the only things that come to mind - but these are good examples of the equilibrium in the market. Right now, a used house cost basically what comparable new house cost (there is probably a slight “it’s brand new” premium). Under the FairTax, a used house will cost basically what a comparable new house costs with the FairTax. I don’t believe there would be a significant difference from the current situation in the savings of buying new versus used. My “new vs. used” choice is about the same.
Remember, the person selling the home is going to be spending that money in the market where prices now include the FairTax. If the person selling the used home doesn’t increase the sell price by the basic FairTax rate, the “real” value of the money they receive is reduced.
There is also an issue that isn’t discussed much - mainly because it is a regulatory, not legislative, issue. That is that some used items would be partially taxed under the FairTax - specifically used items bought and sold by businesses. For example, suppose a car dealer bought a used car in San Diego for $10,000, transported it to Los Angeles, fixed it up, added a warranty and sold it for $12,000. $2,000 of that price is actually a fee for the acquisition, transportation, reconditioning, and warranty services and would be taxable. The basic rule would be a business will charge FairTax on the difference between what they paid for a used item and what they sell it for. That difference is actually the cost of whatever service they added.
This regulation would be necessary for several reasons. First, it just makes logical sense and fulfills the stated objectives of the bill. Second, it would eliminate an obvious way to legally avoid the FairTax on a lot of services. Example: need your house painted? “Sell” your house to the painting company and “buy” it back when they are done and, unless they have to charge FairTax on the difference, you have legally avoided the FairTax on the painting.
I agree with Fred regarding the downward pressure of new goods in relation to upward pressure on used goods. The pressure would also not be working a margin equal to the FairTax, so I’m not sure how much pressure would be applied based on the cost of used goods. Like the income tax system that contains embedded tax cost, used goods would contain the embedded FairTax cost. While the FairTax would not be applied to the retail sales of used goods, the inherent value of a used good includes the taxes paid when the good was sold at retail. The value is determined by the supply and demand in relation to new goods. The price differential / margins between used and new goods should stay consistent, as the cost and value of used goods are in direct relationship to the cost and value of the new goods.
Misunderstanding the margins between used and new goods generally leads to an argument for an environmental shift to re-use and re-sale of used goods, which I don’t buy. But don’t despair tree-huggers, the significant reduction of paperwork for IRS compliance and tax forms is estimated to save about 300,000 trees a year.
There is also a good argument for environmental economics. If the FairTax promotes an increase of business and manufacturing movement to the U.S., more goods consumed domestically will be produced domestically. This may reduce international shipping and consequent environmental impact, as well as production in countries with less stringent pollution controls.
I’m glad that Fred and Morph agree with Kotlikoff that prices of both new and used houses and goods will rise significantly under the FairTax, which will in turn cause an immediatly devaluation of all savings.
This will particularly hurt those retired folks who have some savings and/or have pension income but do not own much in the way of real assets.
Also, folks who are currently too poor to own a home, and are forced to rent, will see the prices of both new and used homes jump by 30%-60% (depending on what the tax-exclusive rate winds up being). So they are just up the creek.
Remember the inventory credit at the dawn of the Fair Tax. If a car dealer wants to make the same profit, as a percentage of his pre-fair tax inventory costs, he can do so without raising the price a dime. If the same car dealer wants to make the same absolute dollar profit, the price of a new car rises by only 2.7%. Hardly a reason to rush to the used car market in my mind. That’s not even considering disappearance of embedded tax costs and lower real interest rates.
As pre-Fair Tax inventory works its way out of the system and is replaced by inventory that does not receive the credit (albeit remains untaxed), the foregoing two factors kick in, together with increased efficiency due to investment and disappearance of tax compliance costs. The delta under the Fair Tax between used and new items remains insignificant. As the previous two commentators also have observed, each set of goods, new and used, eventually finds its equilibrium in the market, and the transition from property that has borne the incidents of the income tax to property subject to sales tax at retail fades.
~Jim Bennett
Summit, NJ
Treehugger? I guess I’ve been called worse. I was only suggesting that after the Fair Tax was in full effect that many would opt to repair rather than replace big ticket items. If you have a nice couch with a tear that was actually made well, it would be worth repairing. This would increase the need for local artisans and help the local economy.
I do not agree that prices will go up substantially. The difference between the FairTax and the present hidden taxes (payroll taxes, FICA and Medicare taxes, Corporate Taxes and so on) is only a few percentage points. This implies that prices for new stuff should remain the same.
At the same time, there is going to be some market adjustments as the FairTax is implemented. Good thing we operate in a “free” economy. The market place will define how much of an impact this all has.
The safe bet, in my mind, is that people will have more disposable income and the power to chose how much tax they pay. That alone is a powerful market control device. Companies will have less overhead (payroll taxes, reporting, tax accounting, and so on) so they have the opportunity to become more efficient.
I expect the economy to pick up and the volume of trade increase. That’s good.
Let the market decide.
Casey,
You are right when you say the market will sort it out. But, before the market works that magic, you seem to be saying that you would be willing to give up your current income tax and payroll tax withholding amounts to your employer, in the hopes that retail prices will remain about the same. Do you understand that 2/3rd’s of those embedded costs are your withholding? Are you really willing to take a gross pay cut down to your current net? I don’t think so! Business costs may fall by 10%-12% at best, and that means that retail prices will rise by 14%-17%. Prices for new stuff cannot remain about the same. Sorry!
Hank, I think you misunderstand “withholding.” That term covers both FICA (social security) and income tax. Under the FAIR TAX, neither of these items would be withheld from your paycheck because both programs would disappear. You have never in your legal working career taken home a paycheck without all the taxes deducted.
Your employer would benefit to the extent that he no longer would match the FICA tax withheld from each employee, no longer be saddled with the bookkeeping of deducting, reporting and transmitting these deductions, and no longer pay an income tax on any profit he might make. Since his suppliers would be similarly blessed, I forsee a dramtic drop in prices of supplies which will eventually work through the magic of competition down to the final sales price of the finished product to you and me. How brilliant!
Howard
Howard,
Not so brilliant, my friend. You seem to believe that the percentage of business cost savings accumulate or cascade through the production chain. Not true!!! It doesn’t matter if there is one or ten levels of production, the percentage cost savings remain the same. (Check out the July 2007 Archives, item #6, Cascading embedded costs)
My position is based on Jorgenson’s 1997 embedded cost study which concluded that there was an average of 22% in embedded costs of the income tax system. Two thirds of his embedded costs consisted of employee income tax and payroll tax withholding. I believe that employees will keep all their gross pay, resulting in business cost savings, including compliance costs, of 10%-12%. This means that retail prices will rise on average by 14%-17%. (1.00 x .9 x 1.30 = 1.17)
But, not to worry. Your take home pay will be increased by the amount of current withholding plus the prebate. Your standard of living should be relatively unchanged.
Hank, how can you ignore the income tax the employer pays? Your 10%-12% benefit surely recognizes only the employer portion of FICA plus compliance costs relative to employee’s withholding. I’m confident studies can be found to support any position. How about just some logic.
The FAIR TAX eliminates so much waste, only a small portion that you recognize. (1) Payroll tax collection and payment to IRS, including returns, research of errors, etc. 10%-12% (2) Business income tax 0%-35% of income (3) Costs related to dumb economic moves to reduce taxes, like buying electric autos, etc. (4) Lobbying and trade organization costs relative to income tax avoidance. As a former CPA, I can assure you these tax avoidance costs are sometimes substantial but profitable if they work. If they don’t work, the legal fees, penalties and interest really take a toll.
These costs are much greater than your 10%-12% estimate, and are eliminated without cost. It is not a trade off; it’s pure profit to society. You and I benefit enormously if all these costs are eliminated. Consider the competitive advantage U. S. companies gain in the world market place when these costs disappear.
Howard,
You may be a CPA, which I certainly am not, but I think businesses pay income tax on profits, not income as you claimed. And I certainly didn’t ignore business income taxes. But that aside, there has never been a Fairtax price impact study done to my knowledge, but here are some extracts from my price impact study for you to consider in your search for logic.
“Discussion: A simple estimate of cost reductions, which can be anticipated by removing the employer income tax, employer 7.65% share of payroll taxes, plus any employer income tax compliance costs, can be made as follows:
Using the 2007 federal revenue data from the Kotlikoff/BHI base/rate study published in September, 2006, individual income tax receipts were $1101 billion, corporate income tax receipts were $290 billion, and Social Insurance and Retirement (Social Security) receipts were $871 billion. By splitting the SS receipts, it is possible to estimate that individual taxes paid in 2007 were $1536 billion, and corporate/business taxes were $726 billion. Rounding off the percentages, two thirds of the embedded costs of the income tax system can be attributed to the employees, and one third to the businesses.
So, if there is an average of 22% in embedded costs of the income tax system per Dr. Jorgenson’s 1997 study, then only one-third or 7.3% can be used by employers for possible cost reductions, again assuming that employees keep their whole gross pay. The 7.3% estimate does not include compliance costs.
A quick “sanity check” on Jorgenson’s embedded costs of employers income tax and payroll share can be made as follows: Using the 2005 CBO estimates for federal revenue, corporate income taxes amounted to $284 billion, and the corporate share of payroll taxes was $402 billion. CBO estimates of personal and government consumption expenditures for 2005 were $10709 billion, and after adjusting consumption for assumed average profits of 10%, business costs can be estimated at $9.7 trillion. Therefore, in 2005, payroll taxes were 4.2% of business costs, and income taxes were 2.9% of business costs for a total cost impact of the income and payroll tax of 7.1% of costs. This seems to be reasonably consistent with Jorgenson’s calculations.
Compliance costs can be roughly estimated by assuming $9.7 trillion in total business costs, of which, $250 billion is compliance costs. This results in a compliance cost of 2.6% of costs on average across 20 million businesses. (available studies show that compliance costs as a percent of costs fall more heavily on small businesses.)”
Put it all together and perhaps you can see why I maintain that the most likely scenario is a 10% reduction in business costs and a 17% increase in retail prices. (1.00 x .9 x 1.30 = 1.17) That also assumes that all business cost savings are passed on to consumers in the form of lower retail prices. But that’s probably not a realistic assumption in view of competing demands to use the business cost savings to increase shareholder dividends, business expansion, employee pay increases, increased profit margins, etc. etc.
I’m not a business owner, so any comments you might have would be appreciated. Oh, I almost forgot–Arduin, Laffer, and Moore did do a cost study and they concluded that business costs could be reduced by 11.55% as I recall. Not that much difference from my 10%, but only time will tell.
Time will never tell us what the actually savings would be if we can’t get the congress to even discuss the FAIR TAX.