Purchasing Power - The Forgotten Factor
In many recent posts, I’ve noticed that purchasing power is often forgotten about in tax comparisons between the FairTax and the current tax system. Since many discussions assume employees get gross wages, we also need to factor for production cost changes. In this post, I lay out the effect that purchasing power has on tax comparisons and why I believe factoring is necessary.
Summary - When comparing tax systems, we need to consider changes in purchasing power and standard of living. If the value of the dollar changes between two systems, stating that $1 in tax from one system is equal to $1 in tax in the other system is incorrect if the first dollar can buy more goods. If I pay the same amount of taxes, but my standard of living increases - how does that compare? We need to hold standard of living consistent in a comparison, which means adjusting the dollar figures based on changes in purchasing power. In this example, I show purchasing power for a family earning $50,000 is increased by $7,900, dropping their effective rate from 19% to 3.3% comparatively. When computing comparisons in purchasing power, the taxable spending should be multiplied by .855, which is equal to 1.0 minus the tax inclusive value (14.5%) of a 17% price increase. Effective tax rates can also be adjusted to account for purchasing power changes (base income - taxable spending * .855 / base income).
Variables - I will use a base income of $50,000 for the discussion ($48,201 was median for 2006), with an income tax burden of $6,697 (13.4% effective - married filing jointly 2008), a payroll tax burden of $3,825 (7.65%), and a $1000 child tax credit, for a personal tax burden of $9,522 (19%). I’ll use 10% for the decrease in production cost (which is the removal of corporate income taxes, employer payroll taxes, and compliance costs) and a 17% increase in prices after the FairTax is added. Median family size is 3.5, so I’ve used 3 (married w/ 1 child) for child tax credit and prebate allowance. The 2008 base prebate for this family is $5,612, which would be indexed to price increases (17%) making the prebate $6,566. I will assume 100% (including the prebate) is spent on taxable goods and services.
Part I - Purchasing Power
Let’s take a $100 widget under the current tax system
$50,000 - $9,522 = $40,478 under the income tax gets you 404 widgets at $100 each.
FairTax goes into effect - employees receive gross wages, and production cost reduce by 10%. Widgets cost $90 (10% reduction) * 30% (FairTax) = $117 (17% increase in price)
$50,000 + $6,566 prebate = $56,566 under the FairTax gets you 483 widgets at $117 each.
You get 79 more widgets under the FairTax, which is equal to $7,900 under the current system. We’ll come back to this number as this is the increase in purchasing power over the current system. To buy the same 404 widgets under the FairTax would cost $47,268 after taxes, paying $10,872 of it in FairTax, but leaving you with $9,298. The $9,298 can be counted as either a reduction in taxes (bringing you to $1,574) or an increase in spending (buying 79 more widgets).
If we look at the base of purchasing power:
$50,000 - $9,522 = $40,478 for the current system
$56,566 - $13,010 = $43,556 for the FairTax
This seems to be where most people stop. We have a difference of $3,078 (good for the FairTax in this example), but that doesn’t buy 79 more widgets!? The above base of purchasing power does not take into account that production costs have reduced by 10%, allowing you to buy more with less after taxes. So in terms of todays dollars, the cost of 404 widgets is $36,360 ($90 * 404) under the FairTax, which is equal to $40,400 under the current system because it produces the same amount of widgets. To factor this in a comparison, we can multiply $36,360 by an exclusive 11.11% (which represents an inclusive 10% decrease in production cost), making $36,360 equal to $40,400 ($36,360 * 1.1111) in today’s dollars.
So for a proper comparison between the tax systems, we should show the dollar value of the additional widgets gained as an increase in purchasing power. Therefore, when using a partial accommodation model in which production cost decrease by 10% and prices increase by 17%, we need to multiply the total income by 1.1111 (substitute your preferred values as needed). To show the purchasing power, we should have (Income + Prebate * 1.1111) * .77 = Purchasing Power. In this example, (56,566 * 1.1111) * .77 = $48,395, which is $7,917 more than the current system. The $7,917 increase in purchasing power buys the additional 79 widgets in the current system, which is the difference between 404 and 483. For simplification, this is essentially the same thing as multiplying $56,566 by the inclusive value of the price increase. 17% exclusive would be about 14.5% inclusive, which is factored $56,566 * .855 = $48,364.
By making this adjustment, we can show the purchasing power in todays dollars in a comparison, revealing the real changes in tax burden with a consistent standard of living.
Part II - Effective tax rate
I think the standard of living and purchasing power are the real measures of tax burden in a comparison, and a proper effective tax rate calculation should reflect the relative increase or decrease. Let’s consider the effective tax rate using these examples.
If we did nothing to factor purchasing power, our effective tax rate would also be affected. Example: $50,000 * .23 = $11,500 - $6,566 = $4,934 or 9.9%. When including prebate as taxable, we would have $56,566 * .23 = $13,010 leaving $43,556 or $6,434 in tax on $50,000, for a rate of 12.9%. Using the income tax example above, we have an effective tax rate of 19% ($9,522 / $50,000) leaving $40,478 in purchasing power. As shown in the last post, the FairTax increases purchasing power by $7,917 to $48,395 in today’s dollars, leaving this family only $1,605 under $50,000 comparatively. What’s missing here?
While it is correct to say a 12.9% tax rate (as well as paying $6,434 in tax) - is this a proper comparison based on the relative burden? 12.9% under the FairTax includes the removed corporate taxes (income and payroll), but the 19% in personal taxes under the current system does not. We have the same issue as above where there is no factoring for the increase in purchasing power. Going from an effective tax rate of 19% to 12.9% implies that the burden is less, but we know from above that the change should be significantly less comparatively. Using the same base of income reference of $50,000, the $48,395 purchasing power adjustment shows a comparable effective tax rate of 3.3%. 19% to 3.3% better compares the relationship based on the consistent standard of living.
To factor the changes in purchasing power on the effective tax rate, we multiply the amount spent by the tax inclusive value of price increases (14.5% or .855). Using the math above (that resulted in the 12.9% rate), we make the purchasing power adjustment: $56,566 * .855 = $48,364. Therefore, $50,000 - $48,364 = $1,636 for a comparable effective rate on $50,000 of 3.3%.
A more complete measure requires solving for all the main variables in the economy using a complex model but purchasing power is key. The study “A Macroeconomic Analysis of the FairTax Proposal” makes the assumption that only the employer portion of payroll taxes is used to reduce prices (a 5 -6% reduction in pre-tax prices) and roughly a 24 - 25% increase in after tax prices. Given this, the study finds that disposable personal income (adjusted for changes in the price level) increases by 1.7% under the FairTax the first year over what it would be for the current system. This goes up to 8.7% increase in disposable income (same as purchasing power) by the fifth year and to almost 12% after ten years.
You’ve certainly put a lot of numbers out there! But an initial question is stuck in my mind: if the prebate is adjusted for the tax increase, does the 23% rate still generate the required replacement revenue? I don’t know the 2008 revenue or consumption bases; but, adding 17% to the 2007 prebate cost would have reduced the consumption base by 359b. That’s based on the most recent “what rate works” research paper. Using the numbers in that paper, the shortfall would go from 2.7% to 15.6% with the 23% tax rate.
From what I can tell it’s not a given that the tax would be included in the CPI measure. HR25 does state, in the section on Social Security COLA calculations, that IF the tax is included no adjustment would be needed for benefits. Are you aware of some other explanations of how it would be incorporated across the board since not all prices would be impacted the same? I’m not sure insurance premium widgets and grocery widgets will both increase 17%. That’s one inherent difficulty in attempting to apply a specific example to a complex universe of possibilities.
For such an index to occur, it would require the tax base itself to increase by 17%. So, we’re not talking about a static expense without a corresponding increase in revenue, but it certainly is something to consider in rate calculations. You are correct regarding different effects depending on the items. As I noted at the end, a complete analysis would require many more variables. My point was not to show some large contrast for tax burden sake. I just wanted to show how this often ignored factor can make a difference in how tax systems are compared, and these just happen to be the numbers. The tax rate, or prebate can be adjusted to fit whatever figures you choose to plug in.
Morphh,
I’m off to the NC mountains for the summer, so will be kind of out of touch for a while. I can see that you spent a lot of time and thought on the issues of effective tax rates and purchasing power. But, I don’t think you could easily explain your results to the “man on the street”, nor could the results be easily compressed to an “elevator card”. With all due respect, this seems to be another example of creating definitions to make the Fairtax case, kind of like redefining regressive taxes, used goods, sales tax rates, and other examples.
Morphh, in plain english, effective tax rates are taxes paid divided by taxable income. And contrary to your definition of taxable income which seems to equate to line 43 on the 1040, I consider taxable income as any income or wealth that is eligible to be taxed. It’s easier to list what is not taxable so,
here are the types of income the IRS can’t touch:
• Black lung disease benefits.
• Dependent care assistance paid by the military to miltary personnel.
• Disaster relief grants.
• Casualty insurance and other reimbursements.
• Child support payments.
• Compensatory damages awarded for physical injury or physical sickness.
• Damages for emotional distress due to a physical injury or physical sickness.
• Disability payments if you paid the premiums on the policy with already taxed dollars.
• Foster care payments when the care is for youngsters.
• Interest on certain state or local government obligations.
• Supplemental Security Income (SSI).
• Veterans’ benefits.
• Welfare benefits.
• Workers’ compensation.
Everything else is income and can be used to determine effective tax rates.
As for purchasing power, I’d argue that under the current tax system, income less taxes equals purchasing power. Under the Fairtax, income plus the prebate minus 17% should approximate purchasing power. And for most if not all workers, purchasing power should be greater under the Fairtax. Not necessarily so for retirees, but there isn’t much difference, imho.
I would hope that support for a national sales tax wouldn’t come down to arcane discussions of tax details. There are many other more compelling reasons to support getting rid of the IRS, which can be readily explained.
Cheers!!
Hank, I’m not sure what your point is regarding income. Consider the rate lowered by whatever value you choose, that wasn’t my point. It was already a complex issue and I wasn’t going to make it more complex by adding benefits of black lung disease. It’s certainly not easily to explain to someone on the street, but I think we’re beyond “elevator cards” and street talk on this blog. I’m not trying to create new definitions or redefine what effective tax rates are. There is an effective tax rate in the current system and one under the FairTax system, neither require adjustments when considered independently. We’re talking about comparisons and like I said in the summary, if $1 doesn’t equal $1 in a comparison, then you need to make adjustments (hold standard of living constant) so one can be adjusted to look like the other (apples to apples). I agree with your definition of purchasing power - it is what I described above. My only clarification is that the 17% has to be converted to an inclusive value (14.5%).
Morphh,
Just to clarify, your definition of taxable income seems to be that which is listed on line 43 of the 1040. Line 43 is called taxable income, and is the amount to be taxed after making all adjustments, and removing income amounts allowed for exemptions and deductions, etc. etc. My definition is simply gross income before any adjustments other than the non taxable income from the sources I listed. My effective tax rate will always be lower than yours. My point was that it isn’t a matter of who is right, but more along the lines of what does the general public believe.
Sorry about the confusion.
Morph,
Great post. I agree purchasing power is the best way to compare the two systems (I believe that’s what you were saying.) Trying to define a uniform calculation of effective tax rate between the two systems seems to be problematic. I think I’ve seen examples on this blog of the fair tax having a higher effective tax rate, but more purchasing power given certain conditions. When that situation occurs, it kind of shows how useless the effective tax rate calculation becomes. I’d gladly pay a higher tax rate for more purchasing power.
I also think that it should be pointed out that sometimes on this blog while it is correctly stated that prices will be 30% or 17% higher, it is not always clear that this is not a statement of purchasing power, but an indication of the increase in nominal dollars needed to purchase goods. In my opinion, this is an extremely important distinction.
I think this discussion validates Kotlikoff’s often-repeated point that the correct way to analyze the effect of each tax system is to use average remaining lifetime resources - discounted to present value. Otherwise we end up with apples-to-oranges comparisons.
The way the government measures income, for example, Bill Gates could qualify for the low-income allowance by foregoing interest and dividend income and livng the entire year from a checking account. He may have to get a job at MacDonald’s at the end of the year flipping burgers to show he is earning a low income. The result wouldn’t change if Bill’s Microsoft stock doubled.
A man who earns $20,000 per year, on the other hand, and who has $30,000 in paper losses on his house and securities, but hasn’t sold anything, still has to pay income tax on his $20,000. Thus, the government’s way of deeming income or losses as “realized” is inaccurate and causes distortions. Changing it, however, would make the income tax too unwieldy.
When a poor family receives welfare, free housing and the low income allowance, these must be counted as resources. Without these resources the family would starve. However, the effective income tax penalty on the poor can be high if earning the next dollar disqualifies the poor family from receiving the LIA.
Morph’s approach to measuring effects and changes on standards of living is closer to the Kotlikoff approach and therefore more useful.
~Jim
Hank, I understand what you’re saying. I tried to keep it simple and a more expanded example would include such additional variables. Note that I also tax the FairTax side at 100%, which would also likely include some amount of non-taxable spending. I’m open to suggestions on how I should present such examples in the future and keep them simple. How would you have computed the burden on the income tax side? Thanks
Morphh, Jim, Andrew,
First of all, I don’t disagree with your opinions that purchasing power would be a better measure to compare the income tax to the Fairtax. But that isn’t what AFFT has been preaching. It seems to me that all their stuff about inclusive/exclusive was aimed at doing an effective tax rate comparison, i.e. apples to apples, etc. (I won’t try to speculate why AFFT chose inclusive rates, but it’s clear that such rates are always lower.)
The problem with using purchasing power as I see it is that there are too many variables in play for the average man on the street to ever make the comparison? And the Fairtax calculator is so badly flawed as to be pretty much useless, particularly for retirees such as myself. That is why I would prefer to simply use gross taxable income and taxes paid to determine both purchasing power and effective tax rate for the current system, and gross income plus prebate plus any government pension adjustments minus 17% to account for the Fairtax price increase. I’m sure that the Fairtax will come out ahead in purchasing power, not necessarily so for effective tax rates.
My suggestion is that you all jump on AFFT and get them to iron out the errors in their calculator. I’ve worn out my welcome with Ken Hoagland, but maybe you can make a difference. Otherwise, we would all be dependent on LK’s computer model aptly named ESP which claims to look out 100 years. I wouldn’t count on a lot of enthusiasm for that approach from the rank and file!
Hank,
I never liked the FairTax Calculator on the official site. There is one on the Pennsylvania site, www.pafairtax.org that I think is not perfect but still simpler and easier to use.
~Jim
Morphh,
I think using after-tax figures consistently would make future comparisons less cumbersome. That’s possible using your thorough analysis:
$50,000 - $6657 = $43,343 current system. (Income tax is $2832 on a base
of $28600)
($56,566 * .77) * 1.111 = $48391 FairTax = 11.65% higher PP.
A second example for parent/child earnings of $35,000:
$35,000 - $2678 +$311 = $32,633 current system.
(($35,000 + $3767) * .77) *1.111 = $33164 FairTax = 1.63% higher PP.
This format allows you to factor in non-taxable purchases at real dollar cost. If your $50k family has $14,000 in real estate or state income taxes, 401k savings, mortgage, etc., here’s a way to look at those results:
$50,000 - $5808 = $44,192 current system.
(($56,566 - $14,000) *.77) * 1.111 = $36,414;
$36,414 + $14,000 = $50,414 FairTax = 14% higher PP.
One often overlooked factor is the impact of state sales taxes. If states apply them to FairTax inclusive prices and eliminate existing exclusions, real purchasing power is reduced. Prices in a state with a 6% sales tax could become $90 * 1.3 * 1.06 = $124. The true PP value of $100 would be $72.6 rather than $77. Using the $35,000 family:
(($35,000 + $3767) * .726) * 1.111 = $31,269. Whether that would be an increase or decrease in PP from today ($32,633) depends on current spending on taxable versus untaxed purchases. Imposing state sales taxes that way would reduce true purchasing power for some unknown number of families. I refuse to think about local/city sales taxes.
Your approach has merit and could be used by individuals to get a general sense of the possible change in their personal finances. There are too many variables and unknowns to draw absolute or universal conclusions.