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 $4,795, dropping their effective rate from 12.6% 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 gross income of $50,000 for the discussion ($48,201 was median for 2006), with an income tax burden of $3,487 ($10,900 married filing jointly standard deduction, $10,500 personal exemption (3 * $3,500), 12.19% effective rate on taxable income), a payroll tax burden of $3,825 (7.65%), and a $1000 child tax credit, for a personal tax burden of $6,312 (12.6%). 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, personal exemption, 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 – $6,312 = $43,688 under the income tax gets you 436 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 47 more widgets under the FairTax, which is equal to $4,700 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 436 widgets under the FairTax would cost $51,012 after taxes, paying $11,732 of it in FairTax, but leaving you with $5,554. The $5,554 can be counted as either a reduction in taxes (bringing you to $6,178) or an increase in spending (buying 47 more widgets).
If we look at the base of purchasing power:
$50,000 – $6,312 = $43,688 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 $132 in favor of the current system, but how does that buy 47 more widgets under the FairTax!? 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 today’s dollars, the cost of 436 widgets is $39,240 ($90 * 436) under the FairTax, which is equal to $43,600 under the current system because it produces the same amount of widgets. To factor this in a comparison, we can multiply $39,240 by an exclusive 11.11% (which represents an inclusive 10% decrease in production cost), making $39,240 equal to $43,600 ($39,240 * 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 $4,795 more than the current system. The $4,795 increase in purchasing power buys the additional 47 widgets in the current system, which is the difference between 434 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 today’s 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 12.6% ($6,312 / $50,000) leaving $43,688 in purchasing power. As shown in the last post, the FairTax increases purchasing power by $4,795 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 12.6% 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 12.4% to 12.9% implies that the burden is more, 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%. 12.6% 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, http://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.
Morph,
I came across this post by way of your post on the Fair Tax Nation web site. I like how you approached this. However, I may be missing something. Are you using a gross income of $50,000? If so, how did you arrive at a federal income tax burden of $6697? If you start with $50000 as gross income and then adjust with the standard deduction (for 2009 it’s 10300 (?) and subtract personal exemptions of $10200 (3*$3400/person – 2009?), you end up with a taxable income of $29500. Even if you don’t use the 2009 standard deduction and personal exemption values, you will end up with a taxable income far less than $50000, which reduces tax liability considerably. I arrive at total tax liability (Income tax + SS + medicare) to be $6415 for an effective tax rate of 12.83% and purchasing power of 436 Widgets.
While the results still favor the Fair Tax regarding purchasing power, it does not look as favorable regarding effective tax rates. I hope I have overlooked something as I prefer your results compared to mine.
J Bailey, the post is from 2008, so you should use those married filing jointly figures to arrive at the same values. In 2008, 0-$16,050 was taxed at 10% ($1,605) and $16,051-$50,000 was taxed at 15% ($5,092), for a total of $6,697. In the example (for simplicity), I presented it as simply multiplying $50,000 by the 13.4% effective rate. Keep in mind though that this was more of an exercise in explaining how purchasing power can be calculated, the effects, and why it is important to do so. Both sides may have additional exemptions and such that could change the comparison one way or another.
Morphh,
I don’t think you answered his question. Your data applies to “taxable income”, not what they made in your example. If you intended that the $50,000 was taxable income, then your figures are correct. But your scenario seems to indicate that the $50,000 was gross income? In which case, Bailey is correct. Taxable income would be $29,000 or so, and the tax would be much less–or you could purchase more widgets. Whatever, it needs clarification, doesn’t it?
You may be right there… got to love our complex tax code. $0 – $16,050 doesn’t really mean $0. That’s only a taxable $0.. you first got to exempt this and that. This is the reason I use H&R block. I’ll change it to taxable income, as on the FairTax side we’re also only talking about taxable spending.
Morphh,
I’ve been doing my own taxes for 60 years, and do not find that the code is all that complex for the average family. Unless you are another Hayden, doing your own taxes is pretty easy. But if you are “tax challenged”, may I suggest that you dial up the nearest AARP organization and find out if they offer volunteer tax assistance each year. My wife has been doing taxes for AARP for ten years, and everyone, regardless of age is welcome to use their free service. Paying H&R Block $150 is the wrong way to go!
Your comments reinforce my firm belief that every high school student should be given a class in tax preparation. I don’t know what we are teaching our kids anymore, but how to file a tax return sure isn’t on the list. Amazing!!!
As for Fairtax taxable spending, how do you plan to go about that? Each family is different and it’s hard to generalize. At one time, I did a comparison study and decided to apply a sliding scale percentage to income under the Fairtax. That is, the lower the gross income, the higher the percentage is spent on taxable consumption. Comparing effective tax rates and purchasing power under the two tax plans is not an easy task, and requires a bunch of assumptions.
Good luck!
Sorry… I was sort of kidding about the H&R block. My wife usually does the taxes (finance major) and she usually uses software like TurboTax. I think we took it to a place last year (or the year before that) as we had purchased / sold a bit of property.
My belief is that it should not take additional training for the average person understand their tax burden. If you have to give a class, it’s too complex.
As far as taxable spending, I’m defining the family in the variables. I don’t have multiple families for them to be different. It’s only there to guide the points discussed, not as a full burden analysis across different families.
I’ll try to take some time and update it with the proper standard deductions and personal exemptions. I admit that I forgot to consider those (even when pointed out, I missed it) – thanks for the correction J Bailey (and Hank for the clue stick beating).
Ok, I’ve updated it with the 2008 standard deduction for married filing jointly and a 3x personal exemption. Please take a look and let me know if I’m missing anything significant. I used 2008 as this is what I had used in the example before and I didn’t want to have to rework all the numbers – the point was the logic. I think the updated figures may illustrate the point even better, as the current system has the advantage before the proper conversion.
According to this article, http://moneycentral.msn.com/content/Taxes/Preparationtips/P105690.asp, the IRS’s own helpline got 65% of answers right in 2004 and 2005. Simple? It also talks about an identical tax situation sent to 22 different IRS help centers. Guess what? 22 different answers. And that was 20 years ago when the code was simplified.
If you don’t think it’s complicated ask Tim Geitner, our Treasury Secretary. Or our never to be HHS Secretary, former Senate Majority Leader, Dick Gephart. His failure to get it right cost him his final grand political accomplishment. Poetic justice?
And I have to agree with Morph that if you are required to take a class, it’s too complicated. Doesn’t it at all seem wrong that we should require citizens to waste their brainpower trying to figure out some convoluted taxation system created for no other reason than for some politician to gain political power?
Morph and Hank,
Thanks. Makes a lot more sense to me now. I was more concerned with whether the $50,000 was taxable income or gross income than what rates were being used (2006, 2007, 2008) as the adjustments to income (going from gross to taxable income) I believe make a bigger difference in amount of tax is owed. By the way, using 2009 tax tables I arrive at $6415 of tax owed compared to $6312 using 2008 tax tables, so close enough. Although, the standard deduction I’m using is $10300 and personal exemption is $3400 per person, so I’m not sure where I got those numbers from as I expected them to be higher than 2008. Regardless, makes the number of widgets much closer and a sounder arguement (even if not as extreme as before).
John
Regarding tax complexity:
I have always done my own taxes and since 1999 with the assistance of Turbo Tax. While I’m confident they are done correctly, I do have to say they are much complicated than what I believe they should be. I’m not sure that using the ability of the average person to do their own taxes is the best measure of being simple enough or not. Since the late 80s the tax code has gotten rediculously complex with the capacity of the average person declining (meaning schools turning out graduates that are less capable). Considering that high profile individuals who fail to pay taxes they can afford mean they are either cheats (which is hard to believe since they should know better than to cheat on their taxes as they are in the cross hairs of their opponents) or the system is too complex.
I think one of the aspects of the Fair Tax is it’s simplicity relative to what we have now. The current tax code is so convoluted in an attempt (or guise) to be progressive. I do not trust our elected officials enough to think they are writing tax legislation to do the right thing for this country. I think they are doing it to stay in power (even if they don’t realize it). Too much specialization and taxes on specific groups. If every congressman (person) was truly altruistic, then I might think differently, but they are human, so all the more reason to restrict what they can do.
John
Morphh, an assumption in your calculation is that state tax rates wouldn’t increase after the FairTax. Given the increase in tax paid by the states under the FairTax, I don’t think that’s a good assumption. State and local taxes would almost certainly increase thus affecting the post-FairTax purchasing power.
Fred, I dont think their will be much increase in real dollars, in fact, I argue that the real cost of the state would decrease, since education is untaxed (see FairTax Fantasy – important points around #39, #42, #45, #79-81). I’ll have to think how the nominal increase, due to accommodation, would effect this example. Keeping real costs the same, it may be that we multiply state tax cost on the family by 1.17 to reflect the inflation.
Morphh,
I have never been sure that I understood real versus nominal dollars, but a few years ago, I did a cost impact study using the data from the 2006 Kotlikoff/BHI study. They assumed that State and Local spending could be broken down to 59% for goods and 41% for services. Total S/L consumption was $1.1 trillion (rounded) after removing education spending of $403B. In addition, I estimated that the burdened payroll costs were 150% of the basic payroll amount. Here is the section on State/Local:
“State/Local discussion: HR25 proposes to tax all state/local government purchases in order to ensure that the elimination of the income tax would not create an unfair government competitive advantage over the private sector. Assuming employee wages remain at the current gross, pretax prices are estimated to fall 10% and after sales tax prices will initially rise 17%. This price increase means that the increased net cost to state/local governments for the purchase of new goods and private sector services would be $110 billion. ($1100B x .59 x .17 = $110B)
HR25 also mandates that all governments pay the national sales tax on the wages and salaries of all employees as representing the value of their services provided. HR25 further defines wages and salaries as “all compensation including cash, benefits, disability insurance, unemployment compensation, workers compensation, and the fair market value of any other considerations for employment services renderedâ€. This is known as the burdened cost.
The burdened cost of state/local wages and salaries is therefore assumed to be $676 billion, and the 30% sales tax would cost state/local governments $203 billion. This amount would be somewhat offset by the 7.65% FICA contribution savings amounting to $34 billion. The estimated net tax cost to state/local governments for personnel services would therefore be $169 billion. ($1100 x .41 x 1.5 x .3 – $34B = $169B)
The total financial impact on State and Local governments can be estimated at $279 billion. ($110B + $169B = $279B)”
Please notice that I used the burdened payroll costs, an issue which I have raised a number of times but no one has commented on. The definitions in HR25 seem very clear to me.
$279B would be a huge increase in S/L revenue required, and if you assume that the State/Local budgets must be balanced, and total consumption (taxes levied) in 2007 was $1333B according to the BHI study, then adding $279B would be an increase of 21%. And that’s a lot, imho!
A simple example of nominal vs real would be yearly inflation. Let’s say we had inflation of 3% last year. The nominal cost of government went up by 3%, but the real cost stayed the same. They don’t have to raise tax rates by 3% this year if the gov size is consistent (we won’t have a 15% rate increase every 5 years or a 100% tax rate in 30 years due to inflation). This is why taxes are often a percentage, so as the tax base is effected by inflation, the revenue keeps up. Some taxes like income and sales taxes do this fairly easily, others like land taxes have value reassessments. Taxes as a percentage of GDP and your tax base stay the same.
So in your example, I expect the nominal cost may be a 21% increase, but with 17% inflation, the real cost would be a 4% increase. So the state would have to raise tax rates to achieve a 4% increase in real revenue (a 5% sales tax would become 5.2%). However, I’m not seeing the calculation for purchasing power (a 10% reduction on spending for goods and services) that is the topic of this thread. Those nominal dollars would buy more for the government, so you need less of them to maintain the same level of government. So even in this example, you may end up with a decrease in real cost.
I’ll have to research burdened payroll costs. I’m not familiar with that yet.
A very large portion of state and local government’s education expenses are taxed under the FairTax. The only thing that is exempt is “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” which means teacher salaries. The cost of buildings, books, utilities, maintenance, security, administration, support staff, etc. are all taxed.
A quick look at my school district’s budget shows teacher’s salaries and “instructional staff development” (some of that may be taxable, but for this discussion I’ll say it’s all non-taxable) to be ~48% of their budget – so let’s say 50% is taxable. The majority of Texas teachers don’t participate in Social Security’s retirement plan – they use the Teacher’s Retirement System – but they do pay Medicare. So let’s say they could possibly save 5% of that 50% in teacher’s salaries (2.5% of total budget). The other 50% is going to increase 30% or 15% of total budget. So that’s a 12.5% increase in their budget.
And that’s only the school district. The vast majority of the rest of my state and local governments expenses are still tax under the FairTax.
BTW, the Texas Teacher’s Retirement System brings up an interesting problem with the FairTax. State and local governments only participate in Social Security if they’ve voluntarily entered into a “Section 218 Agreement” with the SSA. Some have, some haven’t. The employees of those that haven’t would be paying Social Security under the FairTax, but not receiving the benefits.
On the purchasing power issue, I think everyone needs to realize that, if the FairTax is truly revenue neutral, that — on a microeconomic level — overall purchasing power under the FairTax can not change. Any price reduction by one entity can only be achieved through a decline in income of another entity. A cost for one is income for another.
Fred, I don’t disagree that only a portion of education is exempt and I did not mean to imply otherwise. I was referencing the thread where I specifically state what was exempted in the rate studies, which amounts to at least 300 billion.
Taxes could be defined as a loss of purchasing power to the citizens and you are correct that this should be consistent under each system. This thread is not a matter of changing purchasing power, but properly calculating the effects and placement under each system, so that you are doing exactly what you state (properly adjusting the purchasing power so that it is equally calculated on both ends). If you do not make this adjustment, you’re not comparing the change in business taxes. We could say that these business taxes create a reduction in purchasing power under the current system. We have to calculate the effect of that removal, as it is being added back and included in the FairTax rate. To not adjust it, would be to count that loss twice, which as you stated, is improper as they should be equal.
Morphh,
Thanks for clarifying “nominal” and “real” prices. If I understand you correctly, although it might require a 21% increase in State and Local taxes in order to pay the federal Fairtax, 17% of that would be handled by the inflationary aspect of a partial accommodation model scenario, leaving only 4% needed to balance the books?
The problem I have with your explanation is you assume that all States will “tax the tax”. One of the goals of HR25 is to avoid cascading or double taxation. While that goal doesn’t necessarily apply to the States, the issue of where the State/Local tax burden will appear on the sales receipt is certainly not clear. Your outcome depends on taxing the federal tax, but an equally plausible scenario would be that the States would only tax the cost, which we both agree would be reduced around 10%. This would increase the tax rate needed to raise the same revenue, wouldn’t it?
I don’t happen to think it would be fair to allow the States to tax the federal tax, but others may disagree?
Hank, I don’t assume that they would tax the tax, but that would be one of many ways to handle it. How the state chooses to collect the same amount of revenue is up to each state. As you stated, another way would be to raise their rate, but this is not a tax burden increase on the citizens. It’s not a tax hike (if you did nothing, it would be a tax cut) – it’s an adjustment to get the same amount of tax, since the tax base has been altered. In this case, the transition to a higher rate does not translate into a higher burden, it translates into the same burden by collecting the same real revenue as before.
Morphh,
Sorry, I shouldn’t have assumed that you were advocating “taxing the tax”. Your example which helped to explain nominal and real numbers was based on taxing the tax and I jumped to the wrong conclusion. My best guess at this time is that the Fairtax sales receipt will show both the federal and State/Local tax rates applied to the product or service cost. The average State rate could rise from 6.5% to almost 9% in that scenario.
I’m not sure I understand why you keep saying that raising the rate is not an added tax burden on the citizens. It seems to me that if you add a new federal sales tax, the burden must be greater? Can you discuss further?
We’re not adding a tax Hank, we’re replacing a tax. I don’t understand where you get 9%. A 10% reduction in base would place the rate at 7.22%. However, while your tax base is decreasing by 10%, so is the government costs for purchasing goods and services. You will only increase the tax burden on citizens if the real cost of government increases. Section V of the BHI/Kotlikoff study repeats what I’m saying – perhaps in a way that may be easier to understand.
I’m going to try and give a good explanation of this, complete with examples, by the end of the weekend. I’ll try to keep it simple and will probably post it as a new thread, so look for it.
Morphh,
While you are working on an understandable explanation, let me repeat my position, and show you where I get my 9% forecast.
From any State Treasurers perspective, the Fairtax is not simply replacing one tax with another as you wrote. The Fairtax would replace the 7.65% State share of FICA payments for their employees, but they would be required to pay a 30% sales tax on all purchases of goods and services, except for some education expenditures. That can’t be a wash. State taxes are going to go up, or States will have to add their tax on top of the federal tax (tax the tax), or spending would have to be reduced in order to balance the budget. I don’t see any other viable options?
In #24 above, I think I demonstrated that State Treasurers will be looking for a 21% increase in revenue. Your response was that only 4% of that was a real revenue increase because prices would rise by 17%–in effect growing the way out of the deficit. The option I am trying to clarify is the one where the States don’t “tax the tax”, which means that the State consumption base declines by 10%. (In fact, Kotlikoff wrote that taxes are not included in GDP, so the national GDP can be expected to decline by 10%.)
Adding the 10% decline in the taxable consumption base to the 21% increase in revenue required results in a 31% problem for the State Treasurer. Assuming that the average sales tax is 6.5% today, it would have to be 8.52% under the scenario I developed. Not quite 9%, but it might be rounded up?
Please explain why the States won’t have to raise their sales tax rates? Or are you just claiming that the citizens won’t care because they have higher take home pay under the Fairtax? Adding a 9% State sales tax to the BHI 31.8% federal sales tax means that the cash register receipt will show over 40% in sales taxes. Is Joe six pack’s take home pay really going to be increased by 41%?
Remember, if the fairtax is revenue neutral and the states are paying more to the federal government, then everyone else is paying less.
Andrew,
For once I sort of agree with you! Senility must be overtaking me??? Your statement simply means that the more revenue that is raised by taxing the States, the lower the Fairtax rate needs to be. Of course, the States have to get their revenue from all of us, so, in the end, we are paying the whole tab regardless of who we pay it to.
You have now confirmed my belief that by taxing the State/Local consumption, a significant portion of the needed federal revenue is effectively hidden in higher State and Local taxes. Do you really think that is transparent?
Hank,
“Do you really think that is transparent?” To the ignorant? No. To those that have been told state/local governments are required to pay the fairtax for the services they provide? Yes. 1000 times more transparent than trying to explain how state/local governments already do this via the income tax, payroll tax, and embedded taxes? Absolutely.
Andrew,
O.K, and as one of the “informed”, will you please explain in as few words as possible just why “State and Local governments are required to pay the Fairtax for the services they provide”?
Because they pay taxes today…
My few words
I should be posting the new thread soon. Almost finished..
Hank, couple thoughts / questions on your post 24, since I’ve been using it as a reference. You multiplied wages by 30%, which I don’t think is correct in this case. It’s 23% of gross wages, the math behaving like an income tax in this case. Second, I looked at the burdened payroll, which you multiplied by 150%, and can only conclude that any additional payroll burden would come out of the other 59%. It’s not an additional burden, it’s part of their overall consumption and thus must come out of one of the two areas. Since I don’t know if the 41% includes it or not, and there’s not much sense in arbitrarily shifting from one group to the other (since they’re both taxed anyway), I plan on leaving it out. Am I missing anything on these?
Hank,
Competition.
The wage paid by a taxable employer to an employee for taxable services are payments for a service like any other under the FairTax and are taxed on the gross payment, which includes the tax.
Section 2 (a)(14)(A) states “The term ‘taxable property or service’ means … any service.” Section 2 (a)(14)(B) states “For purposes of subparagraph (A), the term ‘service’ shall include any service performed by an employee for which the employee is paid wages or a salary by a taxable employer.” So the services performed by these employees are taxable services and their wages are payment for that service.
Section 101 (b)(1) states “In the calendar year 2011, the rate of tax is 23 percent of the gross payments for the taxable property or service.” The tax is 23 percent of the gross payment for the taxable service.
Section 2 (a)(5) states “The term ‘gross payments’ means payments for taxable property or services, including Federal taxes imposed by this title.” Gross payments include the tax.
Section 103 (b)(2) states “In the case of wages or salary paid by a taxable employer which are taxable services, the employer shall remit the tax imposed by section 101.” A specific exemption to the requirement that the seller of a taxable service remit the tax, the employer is responsible for remitting the tax for the taxable service performed by the employee.
Thanks Fred, I’ll adjust the new thread for 30%.
Morphh,
Fred beat me to it, but you can’t add 23% to the current payroll cost and get a 23% inclusive tax rate. If my payroll cost is $100, and I add $23, then the inclusive tax rate would be only 18%. I agree with Fred- use 30% and the sun will continue to shine on you.
As for the burdened costs, they are part of the 41% and can’t be included in the other 59% fraction which is for the purchase of goods. Actually, I may have misspoke. I doubt that Kotlikoff et al figured in burdened costs in their 41% split. That is the issue we need to discuss. The Fairtax rate might have been lower if they had read the legislation?
The HR25 definition of wages and salaries clearly includes the burdened costs. Just google “burdened payroll and read through the first entry as to what might be included and how to calculate it. I also tried to get an estimate of the average overall burden, but found numbers ranging from 20% to 80%. I used 50% until proven otherwise. It might be higher, particularly for government employees who retire at 50% of base wages after only 20 years of service. That is a pretty huge burden, imho.
Andrew wins the test for brevity, but I don’t agree with either response as to the reason to tax government consumption. You seem to want to keep the cost of government as high as possible, while Andrew is still hung up over the competitive element which I thought we put to rest when we discussed to language in HR25 which treats any government that sells $2500 per quarter in goods or services as a government enterprise which must add the Fairtax to their price. The competition looks fair to me unless you want to natter about the probability of a government agency giving away goods and services. That gets handled at the ballot box it seems to me.
Of course I didn’t expect either of you to admit that the primary reason to tax government consumption was to keep the rate as low as possible?
I guess in and as much as the current system uses it to keep its rates lower. Not sure why the FairTax should inflate its rates when the current system doesn’t, nor any other federal tax reform for that matter. I guess the FairTax is just special like that.
Hank,
I’m not sure what you believe got “put to rest” with regard to public/private competition, but unless you can see how government provided services/products that can be generated without the fairtax have a huge advantage, the issue is alive and well. It’s awesome that the $2500 clause forces the government to add the fairtax to particular products/services, but what on Earth does that have to do with exempting the other taxpayer provided services. “Free” trash collection collects exactly $0/quarter from recipients of the service. You don’t think a 23% discount over what the private sector can provide is unfair. And does deciding at the ballot box have to do with it? You’ll be giving the voter a choice, have it done privately for X or publicly for 0.77X. I am small government libertarian and have to think hard about whether a 23% discount might be worth it. Is the government so bad that they can’t take advantage of a 23% percent discount when it comes to collecting trash? Probably, but I still have to think about. The average voter will probably be swayed by the discount. That is the advantage.
And for anyone that realizes how embedded taxes work, the reason after public/private competition for taxing state and local governments would be to stop them from getting a huge revenue windfall under the fairtax. If the labor and products they use were suddenly less expensive (as they would be once the embedded taxes are removed), I guarantee you that most governments will not be giving the money back. After those two reasons, maybe I’ll concede that the lower rate might be the reason.
Andrew,
Well, at least the real reason made your top three list. Let me try to persuade you that your list is upside down!
I think we agree that as far as government agencies selling goods and services to the public, HR25 guarantees a level playing field by mandating that those agencies must charge the Fairtax.
That leaves you with your concern that government agencies might horn in on private sector businesses by offering “free” services which might cost less without the sales tax. Under current tax law, businesses pay a hefty income tax, as much as 35%, but the government does not. I haven’t noticed any rush by governments to put private enterprise out of business, and I don’t see that happening with the Fairtax. Remember, there are no “free” government services, so any attempt by the town council, city admin, or county agencies or State government would require a vote by the citizens as to whether or not they would agree to pay higher taxes in order to support a government provided “free” service. I can’t believe that governments, particularly with the budget deficits we are seeing today, want to increase their scope of activities, nor do I think the voting public would approve.
As for government windfalls if they didn’t have to pay the tax, why are you advocating increasing the cost of government due to imposing a sales tax? Surely you understand that if the Fairtax is successful, there would be a huge government windfall, but I don’t hear anyone complaining about that?
Trying to keep the rate as low as possible is certainly good marketing, but the rationale cooked up to support that proposal seems to be a bit weak. In the end, it will probably be found to be inappropriate for the federal government to tax State and Local government consumption, so this discussion would be moot. You can continue to worry about government competition, but it isn’t on my list.
Hank,
Businesses pay a 35% tax on profit, not on revenue. But the very fact that government doesn’t get “a profit” should give them an advantage. The government’s bureaucratic ineptitude levels the playing field for private enterprise. If governments don’t pay the fairtax, now in addition to the profit disadvantage private enterprise has, it also has a 30% additional cost it has to pay.
“why are you advocating increasing the cost of government due to imposing a sales tax?” I have advocated no such thing. The windfall comes from lowering the cost of government by letting that government get an approximate 23% discount on the goods/services it consumes, but taking in the same revenue. Yes. This is because of embedded taxes. A quite common point of departure for us in these discussions. I’m not surprised this is where you and I have an issue.
“I can’t believe that governments, …, want to increase their scope of activities” Hank, Hank, Hank. We’ll never agree on this. But, from what I’ve seen in my young life, all governments want to increase their scope of activities. They’ll use any excuse. Haven’t you been paying attention to the Obama administration?