Hauser’s Law: Why You Can’t Soak the Rich
Over the past 60 years, no matter how much federal tax RATES have been raised or lowered, tax REVENUES have remained at about 19% of GDP:
The chart nearby, updating the evidence to 2007, confirms Hauser’s Law. The federal tax “yield” (revenues divided by GDP) has remained close to 19.5%, even as the top tax bracket was brought down from 91% to the present 35%. This is what scientists call an “independence theorem,” and it cuts the Gordian Knot of tax policy debate.
The data show that the tax yield has been independent of marginal tax rates over this period, but tax revenue is directly proportional to GDP. So if we want to increase tax revenue, we need to increase GDP.
What happens if we instead raise tax rates? Economists of all persuasions accept that a tax rate hike will reduce GDP, in which case Hauser’s Law says it will also lower tax revenue. That’s a highly inconvenient truth for redistributive tax policy, and it flies in the face of deeply felt beliefs about social justice. It would surely be unpopular today with those presidential candidates who plan to raise tax rates on the rich — if they knew about it.
Read the full article in the Wall Street Journal for more.
I find this to be interesting research. I have no idea about the validity of this research, but taking it at face value it seems pretty compelling. In my mind this is compelling against plans of Democrats like Barack Obama to simply increase the tax rate on the upper 1% and/or the windfall profits tax on big oil. This type of increase would yield little in the way of government revenue.
This does however seem to be almost an indirect endorsement of the FairTax Act. Looking at the final paragraph, “Presidential candidates, instead of disputing how much more tax to impose on whom, would be better advised to come up with plans for increasing GDP while ridding the tax system of it’s wearying complexity.” Isn’t this exactly what the FairTax promises to do?
I know that some on this board are skeptical at best of the FairTax, but even the most skeptical among us seem to agree that the FairTax would grow the GDP and dramatically reduce complexity. The economic growth argument seems to be won in favor of the FairTax, and I don’t think anyone without an alternate agenda will argue this. The removal of the income tax and corporate taxes, etc. will lead to increased economic growth which means increased GDP (please correct me if I’m wrong here). The other part is, even if the FairTax is not as simple as the authors like to claim, it is vastly more simple than our current system.
Dramatic simplification of our tax system coupled with increased GDP seems to be the recipe for increased Federal revenues, according to this economic research company. Since there is no mention of the FairTax anywhere in this article, I would guess that this is an independent study and therefore would carry some weight with FairTax opponents. Now to see what these opponents have to say on this.
I think there is a point the article did not make. As the top rate declined from 90% to 35%, the percentage of the tax revenue contributed by the upper-income echelon rose – and the percentage contributed by the lower echelon diminished. The reason is transparent. When the top bracket was high, wealthy people were able to use sophisticated techniques to time and influence the realization of income. As the top bracket dropped, the need for such tax planning dropped correspondingly. The Fair Tax eliminates the need for tax planning entirely.
If you want the wealthy to pay their fair share, lower the top bracket – or even better – pass the Fair Tax.
~Jim
Joshua said: “Economists of all persuasions accept that a tax rate hike will reduce GDP,…”
[Actually, Joshua did not say that. That is a direct quote from the article.]
After taxes were increased in the fiscal 1993-94 federal budget (advertised at the time as the largest tax increase in American history), this country enjoyed the longest and largest economic expansion in its history plus a continual increase in tax revenues throughout this expansion.
On the other hand, subsequent to the 2001 and 2003 tax cuts, federal tax revenues first dropped, bottomed out and then did not reach their 2000 peek again until 2006, five years after the first tax cuts were enacted. Despite the 2001 and 2003 tax cuts and 2008 $600 per family “rebates”, our economy is either in or teetering on the edge of a recession.
It’s simply not accurate to say that “economists of all persuasions accept that a tax rate hike will reduce GDP.” To the contrary. Many economists believe that to the extent that we increase taxes to reduce the national debt and the corresponding interest expense, second only to defense expenditures in discretionary spending, plus invest in our physical (i.e. economic) infrastructure (e.g. roads, bridges, dams, ports, railways), we will reinforce our foundation for long-term economic growth. There’s lots of evidence to support this belief.
Actually, the chart appears to support your assertions here. My guess is that this is still within a percent or so of the 19.5% GDP theory here. Additionally, I think that the more likely cause of this trend is the dot com bubble and subsequent burst. I’m by no means an economist, but I would be much more inclined to believe the GDP variances thru those years was much more related to the dot com bubble’s effect on the market than the change in tax rates.
Of course, the other factor that weighs into this specific time is 9/11. The event definitely had an impact on our nation and the economy. Couple that with the recent burst of the dot com bubble and I think that explains your drop in 2001.
Great! Now we have something to argue about other than the FairTax!
I saw the article when it was first published a month or so ago. Being a WSJ editorial, which never saw a tax cut it didn’t like (except for the FairTax), I was immediately skeptical. And with good reason.
The chart is graphed in such a way as to make the line look flat. But if you look at the chart closely (or you see a blow up of the chart), you will see that tax revenue as a portion of GNP rose significantly under Clinton (to around 21%, if I recall), then dropped significantly under Bush (to around 16% or so, but then climbed back up some.) So, yes, it is AROUND 19%, but those few percentage points in a $11 Trillion economy really add up. In fact, the difference from 21% (under Clinton) and 16% (under Bush) is something like $550 billion in just one year.
You will also note that revenues as a percentage of GNP dropped during the Reagan years as well. So, if anything, a close reading of the chart reveals that tax cuts do not increase revenue to the government, but rather decreases it.
Also, while the article trumpets that tax cuts during the Reagan and Bush II years, it fails to mention the tremendous deficit spending each of those administrations. Deficit spending (temporarily) boosts the economy because the government pumps more money into the economy than the private economy would otherwise generate. This increases employment, wages, and tax revenue. Of course, the downside is that we eventually need to pay the paper (i.e., the holders of government bonds), which sucks money out of the economy.
So it’s really amazing that Clinton was able raise taxes, end deficit spending and keep the economy humming all at the same time. Of course, all of that has been squandered by our current President, and I’m afraid the next President (whoever he is) is going to in for a tough time economically.
Why would they plot the top income tax rate against all tax revenue (payroll, estate, excise, etc.)? Why not look at the income tax revenue generated by those in the top bracket? And why did they make the scale of the revenue so small? It actually looks like there are some changes in revenue due to the top rate, but it’s difficult to tell with this scale (and remember, there are usually changes in other rates at the same time). According to the IRS, in 2005 the top marginal rate applied to only 953,005 returns and but ~$565 billion in modified taxable income was subject to this rate. This bracket alone generated ~$197 billion in revenue (those in the top bracket paid a total of ~$315 billion).
And as far as economic stimulus, remember long-term capital gains aren’t subject to this top marginal rate. So we are mainly looking at a labor supply response and small sliver of the labor pool at that. Is the marginal rate applied to less than a million returns really going to affect our over $13 trillion economy?
Frankly, I find the WSJ’s analysis to be severely lacking.
Come on Hayden… You aren’t seriously going to try and give the economic performance of the ’90s to Bill Clinton are you? This is the decade of the dot com, not to mention the IPO frenzy. I think I have already made a case for the dot com bubble being a huge factor in both the boon of the ’90s and the slump during the first half of this decade. Take a look at some of the IPOs that went along with this in the ’90s… Cisco, AOL, JDS, Qualcomm, Veritas… These are all hugely successful long term investments that absolutely helped to contribute to the enormous growth of the ’90s.
Your Clinton tax hike increased government revenues not because of the tax hike itself, but more due to the economic growth during this period due to the market itself. Similarly, the Bush tax cuts in 2001 and 2003 can also be read as putting the brakes on our economy that was in rapid decline. Let’s face it, something as large and complex as our nation’s economy is going to be influenced by numerous factors. I’m not saying that the tax cuts and hikes have nothing to do with Federal revenue, I’m only saying that there were much more significant forces in play during these periods.
I will absolutely agree with you however that the rampant deficit spending is a serious problem. This is something that our government needs to get serious about, and fast. I’ll also agree with you that a larger, more detailed chart would be much more informative here.
Once more, let me point back to 9/11 and the burst of the dot com bubble as to your 5% plummet in government revenue. Individually, these events would have pushed the revenue back down below 10%, in my opinion, and together these have a much greater impact. I could be wrong here, but I don’t believe that the burst of the bubble had anything to do with Bush or Clinton. The bubble burst was simply the market at large finally realizing they were pumping up companies WAY beyond their values, and this realization resulted in a precipitous fall of the market.
Anyway, while the chart and analysis are somewhat lacking, I still find this rather thought provoking.
As Scott stated, you can not draw a direct correlation between tax policy and GDP changes without looking at additional economic factors. Taxes are only one piece, and I think the point is that lower taxes contributes to increasing GDP in that particular area. If all things were equal, reduced taxes (putting more money back into the private economy), would increase GDP. This is not cause / effect, but cause, cause, cause, cause / effect – taxes are only one cause.
To Hayden’s point, I don’t think this means that tax cuts will automatically increase government revenue. The subsequent revenue related to increased GDP by the tax reduction would have to be enough to cover the loss of revenue from the tax cut. So I agree with the article’s statement that “a tax rate hike will reduce GDP” (to what it otherwise would have been), but don’t necessarily follow that it will lower tax revenue (depends on the cut and to what degree it increases GDP).
We have to consider that different tax cuts result in different effects. I believe a cut to corporate taxes would increase GDP more than a cut to individual taxes. There is also the factor of tax policy changes that differs from broad tax cuts, like in the case of the FairTax, the Kepner Tax, Van’s FairTax Lite, Competitive Tax Plan, Efficient Taxation of Income, etc. Not all plans have the same potential. Changes in what is taxed and how can greatly effect GDP.
In regard to the example given (Bush administration), the revenue reduction was more so due to economic changes, rather than tax policy. If the economy kept humming along, we’d be debt free today. This was not the falt of tax policy, on the contrary, the tax policy likely reduced economic impact (to the loss of the government). This can be applied to the other examples as well.
Here is a good link explaining what happened in the 90′s relative to tax policy and economic growth, http://www.heritage.org/Research/Taxes/wm1835.cfm. In synopsis, it makes the point that economic growth was more after the 97′ tax cut than it was after the 93′ tax hike.
Scott is right to deny Clinton credit for the surplus. The credit belongs partly to a cyclical upswing in the economy, but just as much to the Contract with America, which Clinton fought. Under the Contract with America Congress, for the first and only time, worked hard to reduce government spending.
The Fair Tax will help get Congress back on track because it will remove hidden taxes and make the tax burden glaringly visible. Think of the Fair Tax as a new Contract With America – as to the Contract’s economic facets.
~Jim
Jim,
Do you have any evidence that non-defense discretionary spending dropped significantly after the Republicans took control of Congress? I think if you are looking at the expenditures side of the budget to explain the surplus, the end of the Cold War and the subsequent reduction in defense spending was much more significant.
Sure.
For example, Congress slowed the rate of growth in Medicare and Medicaid spending. Clinton fought it tooth and nail and demagogued it, saying the Congress was going to throw seniors out on the street.
Another example. Welfare reform, limiting AFDC (as it was called then) to three years per claim and five years lifetime max. Clinton buckled under and signed it.
These are examples of the kinds of spending cuts that the Fair Tax would force.
~Jim
But do you have any real evidence that overall non-defense discretionary expenditures went down significantly (BTW, I seem to recall Clinton winning the budget battle of 1995)? I don’t see that there was that much of a dip in the numbers I can find.
Now we’ve got some lively debates going! OK, now time to jump in!
Scott — I agree with you whole-heartedly that the dot-com boom and the IPO craze probably had more to do with the tax revenue increases in the 90′s than the Clinton tax hikes. (I believe that even Clinton was surpised at the surplus, which exceeded their projections.) However, according to orthodox right-wing conservative economic doctrine (as espoused by the WSJ editorial page), the dot-com boom should have been impossible under Clinton precisely because the tax hikes (on the highest income earners) would have sucked the entrepreneurial spirit out of the country. I’m not sure how old you are, but the conservative firebrands of the day were bemoaning the tax hikes as sure to ruin the economy. The fact that they didn’t (and the economy roared inspite of, or maybe due to, the tax hikes) should have driven a stake through the supply-siders’ argument that all tax increases are bad and all tax reductions are good.
I also agree with you that 911 led to a (temporary) reduction in GNP and a reduction of tax revenue, but why would that lead to a reduction of tax revenue as a PERCENTAGE of GNP? If both GNP and tax revenue decline, then it doesn’t follow that the tax revenues as a percentage of GNP would also fall. (You might be correct in your analysis, I’m just not following it.)
By the way, for those of you who want to ascribe most of the econonic boom under Clinton to the dot-com bubble, in order to be consistent you would also need to ascribe most of the economic blip under Bush to the real estate bubble brought about by super-aggressive Fed policy, the multi-trillion dollar carry-trade (which produced the funds to invest in mortgage backed securities), and the mortgage lenders’ eliminating any lending standards. So, I think we would tend to agree that both Clinton and Bush got lucky on economic issues. I doubt if the next President is going to get that lucky.
Jim — I agree that the surplus under Clinton was not entirely due to the tax hikes, but was also due to spending reductions (of which Clinton was very much a proponent, much to the chagrin of the more liberal wing of the Democratic party). The Republicans, of course, branded Clinton a tax-and-spend liberal, but you might recall that he was actually aligned with the Democrat Leadership Council and pledged to “end Welfare as we know it.” It’s not that “Clinton buckled;” on the contrary, it took the Republican Congress three tries to pass a bill that Clinton wanted in the first place. )But I suppose this isn’t the forum to debate politics, per se. I’m sure there are plenty of other forums for that.)
But I am not sure I agree with you that the FairTax wouldl cause spending cuts, even if you are of the “starve the beast” philosophy. Congress and Bush certainly “starved the beast” over the last seven years, but spending continued to rise.
One last thing, the “Contract with America” was quickly ignored by the Repulican Congress it helped elect. If I recall, they only passed one of it’s ten resolutions. As an aside, the original Congressional proponent of the FairTax — Bill Archer of Houston — actually took the Contract with America seriously and retired after three terms in the majority, which is that the Contract has specified. None of the other Republicans who endorsed the Contract– including, notably, John Linder — seemed to think the Contract applied to them.
Fred — You make a good point that those who advocate lower tax rates usually ignore other taxes, particularly Social Security and Medicare taxes. Conservatives love to point to the Reagan tax cuts (which were passed by a Democratic Congress, primarily because they closed tax loopholes in addition to lowering rates), but they always forget to mention that Reagan presided over the largest tax increases in history in Social Security and Medicare taxes. Today, most people pay more in those taxes than they do in personal income taxes. In fact, over the last tweny years, workers have been OVERPAYING into Social Security in the myth that those overpayments would be kept in trust to pay future benefits. This, of course, has caused the budget deficits seem smaller than they actually were.
By the way, all this back-and-forth over the effect of this tax cut or that tax increase is one of the strongest arguments in favor of having a single, greatly-simplified federal tax system, which, of course, is that the FairTax proposes to do.
Get rid of all this complicated nonsense where politicians can make a grand showing of cutting taxes over here while (wink, wink) letting taxes rise over here.
Alas, I just don’t think a consumption tax (at least, not solely a consumption tax) is the way to go.
Jim,
I sort of think you and Fred are missing each other? Fred is looking for examples of non-defense discretionary cuts and your examples are entitlement cuts. Your examples are encouraging in that cutting entitlements is very difficult politically, but there has to be a way to drastically reduce entitlements before they (plus interest on the national debt) gobble up the entire federal budget. That is the “train wreck” I have been concerned about, and is why I oppose the all in Fairtax prebate. The $500-600B prebate will certainly accelerate the budget train wreck. A targeted prebate would have much less impact.
Who is this person posting as Hayden…
“By the way, all this back-and-forth over the effect of this tax cut or that tax increase is one of the strongest arguments in favor of having a single, greatly-simplified federal tax system, which, of course, is that the FairTax proposes to do.”
Go Hayden… I think you are finally beginning to get the idea.
Hayden again…
“Get rid of all this complicated nonsense where politicians can make a grand showing of cutting taxes over here while (wink, wink) letting taxes rise over here.”
Yeah Hayden!!! I think we’ve done it!!! I think we have him!!!
Once more from Hayden…
“Alas, I just don’t think a consumption tax (at least, not solely a consumption tax) is the way to go.”
DOH!!! Missed it by that much!
Sorry, I just couldn’t resist.
Hayden,
I think your recollection of the 90′s is a little off. Most importantly the majority of the boom occured after the republican led tax CUT. Not after the democratic tax increase. In fact, GDP grew on average 30% faster the four years after the tax cut (many provisions, one main thing cut long term capital gains from 28% to 20%) than the four after the tax increase (I believe the major provision was the creation of an effective 39.6% bracket and lifting the cap on Medicare). It is argued that this is so incredible because the economy is expected to grow faster coming out of a recession. It is also worth noting that after the tax cut in 97, 98 produced the first budget surplus even though the administration predicted as late as 96 that under current law the deficit would go at least past the end of Clinton’s second term. Don’t get me wrong. Some of the growth was a by product of the government restricting the flow of capital and then releasing it. But why restrict it?
As far as welfare reform, I defy you to tell me what major change to that third bill made Clinton sign it. I’ll give you a hint. It had to with proximity to the next election. I believe he even said after he signed it that he didn’t like it. Probably trying to appease his very angry base. But, he did sign it.
The congress voted on all aspects of the contract, but not all passed. Some were enacted as law and some were vetoed. If I remember right, term limits were voted on and didn’t pass, but at least they were brought to the floor. In fact, the contract, imho, was an astounding success and a similar tactic may help bring the Republicans back in the majority. In 2012 maybe.
This is off the thread topic, but these tax related videos were so funny I had to post. Often our topics get serious and some times we just need to laugh. The Turbo tax one had me ROTFLMAO.
* Takin’ on the Tax Code!
* TurboTax: The Rap (Extended Version)
I just looked up the Contract with America in Wikipedia and I’m reminded by why I USED to be a Republican. They asserted some very good and common sense ideas (although I certainly didn’t agree with all of them). Alas, when they got power, they abandoned all of their common sense ideas and instead started pandering to various special interest groups in an effort to preserve power, rather that use it wisely.
Regarding the Contract with America, the very first provision was to be fiscally responsible and require a balanced budget! Whatever happened with that?
I do agree with Andrew that if the Republicans, or the Democrats, for that matter, would list the specific bills they would seek to pass, and then actually work to pass them, they would get a lot more trust from the American people.
And you might be right re welfare reform. I can’t recal the specifics of Clinton’s plan versus the Republican plan. The actual cost of welfare in dollars is quite small in terms of the federal budget, but I believe there were a lot of indirect costs to society in how welfare was abused. So it was definitely in need of serious reform.
In my idealistic days I did some pro bono work for a young woman who really needed public assistance. I tried to help guide her through the maze (AFDC, housing assistance, food stamps) and was disgusted at how many people were clearly scamming the system (and ruining their lives in the meantime.) I’m not a religous zeaot by any means, but faith-based assistance is probably something like a gazillion times more effective than the mindless bureaucracy of government welfare programs.
Scott — I am fairly certain that you and I and most of the other folks on this board probably agree on most things. Fiscal responsibility and addressing the coming financial problems of Medicare and Social Security are probably high on all our lists. Now, if we could only get our respective political parties to address them.
After reading Alan Greenspan’s book, I was pretty impressed by Clinton’s fiscal responsibility. I wish the republicans, who claim such, would walk the talk. I was also supprised to see Greenspan was a big follower and friend of Ayn Rand. To you Rand fans, was a young Greenspan a basis for “Non-Absolute”? Maybe Josh can provided us some insight.
Post 16
Hank,
Your probably right that my comment was not entirely responsive to Fred Johnson’s post 13, and it intentionally not so because, in my mind, spending is spending, whether it is so-called “discretionary spending” or so-called “entitlement spending.” To follow the argument further, cuts are cuts, regardless of where they fall. Limiting the discussion to so-called “discretionary [non-defense] spending” makes no sense at all.
In my mind, slowing the rate of growth in any spending also represents progress over the status quo. With the cost of government becoming glaringly visible, the Fair Tax should help the effort.
~Jim
Jim,
You may want to look up the definition of “discretionary” and think about how it applies to the budget process.
Jim,
Of the $3 trillion federal budget, Congress gets to discuss and vote on less than $1 trillion, the amount of discretionary spending. The rest of the budget is basically on auto pilot until the enabling legislation is changed. Any tinkering with entitlements is pretty much limited to revising the inflationary increases that are built in. Slowing the rate of increase doesn’t qualify as a cut in my mind!! And of course, interest payments are what they are, and heaven help us if the Fed loses control of inflation and interest rates!
Congress is rapidly running out of wiggle room, and a budget train wreck is coming down the track. From the CBO data I’ve seen, adding the $600 billion Fairtax prebate to the list of entitlements could cause the wreck as soon as 2010 if the Fairtax were to be implemented this year.
I don’t happen to agree with the Fairtax claims that a sales tax would be more visable and would cause Congress to somehow reduce spending. I’d bet that none of you can tell me just how much you paid in state sales taxes last year. What is different about a federal sales tax?
Hank, I don’t see how it is proper to not count all the refunds, credits, and deductions under the current system as an expense, yet then turn around and count it under the FairTax. The IRS already sends out $270 billion in refund checks. Does this add as an expense to the Government of $270 billion that will increase the train wreck? No – it wasn’t theirs to begin with and it’s not counted. It’s a larger refund program (since it removes loopholes, deductions, etc). I’m fine to call it an expense but don’t do it to one side and not the other and then claim it is some additional liability.
Hank,
Who has the power to change enabling legislation for so-called “entitlement spending?” Answer: Congress (and the President generally has to sign the bill). I am sure Social Security, for example, will become means-tested if we continue on the path we’re on.
You’re correct that I don’t know how much I spent in state sales tax last year, but I do know how much I spend on items I buy routinely. When Governor Jim Florio, and later Governor John Corzine, raised the sales tax, I remember the increase in the cost of morning coffee. I remember making a joke about the “Florio penny.” Christine Todd Whitman, who followed Florio, rolled back the increase in the sales tax. I remember that, too.
~Jim
Re: 24
Fred
My understanding is that the terms “discretionary spending” and “entitlement spending” were coined by the media, who got people to buy into the terminology. The terms at times may be useful. As you can see however, I never bought in. Viewed substantively, spending is spending, no matter where it falls. Since the Fair Tax brings costs out into plain view, it can’t help but curb spending.
~Jim
Your understanding is wrong.
Then you haven’t bought into the budget process.
But we were discussing how a particular session of Congress changed the budget. In that discussion, the portion of the budget that they have the discretion to change should be discussed.
Uh huh. Sure.
What were we discussing? I thought it was the Gingrich Congress. Did they reform entitlement spending?
Hank,
To be more accurate, the congress gets to discuss all $3T every day they are in session. It is at their “discretion†to discuss and vote on legislation, including the alternation of mandatory spending. It is just the $1T that they are required to appropriate for the fiscal year. And I believe that even that can be considered on automatic pilot because if legislation fails to pass, the previous year’s spending is automatically assumed.
Fred,
Here, http://www.heritage.org/Research/budget/tst021606a.cfm, are some charts on overall discretionary spending, defense and non-defense. As you can see, the first Republican budget, 96’, cut overall non-defense discretionary by 1.7%. Then, of course, it started growing again and by 99’ they were back to being Democrats. That is when we should have voted out the Republicans. You can also see that the deficit reduction, 92’ and 93’ by Bush and then by Clinton, was done basically by large reductions in military spending.
And yes. The Gingrich Congress did reform entitlement spending. Welfare to be exact. I thought that is what you and Jim were discussing in posts 12 and 13.
Sidenote: Here, http://www.heritage.org/Research/SocialSecurity/wm1958.cfm, is an example of a congressman actually trying to do something to reform entitlements, Medicare, today.
Going back to the original post on this thread, I would guess that we need tax revenue to be around 20% of GNP in order to fully fund the government (that is, without continued and unsustainable deficits). Looking at the chart, it appears that revenue was around 21% of GNP during the final Clinton years when we had a surplus.
Query: What percentage of GNP is the FairTax expected to yield? I’m just curious.
Morphh,
I’m not sure just what your point is in #26? I hope you are not suggesting that the Fairtax prebate is simply a tax refund and therefore is not really a budget expense. I think we all know that just isn’t the case no matter what Fairtax advocates like to call it. The prebate will be scored as an entitlement by OMB, it will be adjusted for inflation each year, and will stay in effect until HR25 is changed. Income tax refunds aren’t included in the budget–as you said, they are just overpayments. but the prebate is a real expense and will increase the entitlement share of the federal budget significantly.
Andrew,
The ’96 budget did reduce discretionary spending by about $4.6 billion, but the Republican’s welfare reform didn’t pass until the summer of 1996 so I don’t think we could attribute that reduction to welfare reform. If you look at mandatory “means tested entitlements” in the budget numbers your link refers to there isn’t a reduction in the amount spent. The growth is lower than the average, but it still grows.
I think we need to remember that welfare reform (which I supported, btw) wasn’t a money saving endeavor – it was more about personal responsibility. In fact, the bill was called the “Personal Responsibility and Work Opportunity Act.” I think the “personal responsibility” part of the Contract with America was a success – the “fiscal responsibility” part, not so much. And then Bush took over and even more fiscal irresponsibility took over.
Hayden (In response to 32),
That is one way to look at it, but that makes the assumption that our current spending level is based on something other than politicians desire to wield as much power through appropriations as possible. Under the current paradigm, the most likely reaction to a sustained 21% GNP revenue stream would be a 23% GNP spending “need”.
I live in California. During the late 90′s, we had an incredible revenue increase. Unfortunately, we had an even more incredible spending increase. I believe the reasoning was, in good times the government needs to invest. Of course, in bad times they need to help. So in any time, they need to spend.
In order to get a sustained surplus, I believe we need to cut spending to 18% of GDP. Once that occurs, we can start re-examing what the federal government’s role in our society is vs. state, local, and personal sovereignty. Start cutting spending based on that. Of course, this would all take a huge paradigm shift.
Hayden/Andrew,
Andrew is absolutely right that the current problem is federal spending, not how the government collects revenue.
One simplistic way to answer Hayden’s question about what percent of GDP the Fairtax would yield is as follows. Using the 2006 BHI study data, they claim that the Fairtax will tax 81% of GDP. Using the 23.8% inclusive rate, then the Fairtax will raise revenue equal to 19.3% of GDP. (23.8 x 81 = 19.3).
However, using the exclusive rate of 31.2% (which is the rate the retail merchants will actually use), then the Fairtax will raise an amount of revenue equal to 25.2% of GDP. And that should be enough to balance the budget, pay for the prebate, pay for the inventory tax credit in year one, and start reducing the federal deficit in the following years. Sounds too good to be true, and it isn’t imho.
Despite Morphh’s best efforts, neither BHI, nor Kotlikoff, nor Walby have responded to any of our questions about their 2006 base/rate study. My criticisms are unchanged and include:
(1) The study assumed spending neutrality in addition to revenue neutrality although nothing in HR25 suggests that spending neutrality is a goal.
(2) The study included federal government consumption in the base, but failed to add the necessary revenue offset. Had they done so, the inclusive rate would have been 26.2%, not 23.8%.
(3) When calculating the rate, they divided the revenue neutral goal of $2228B by the consumption base of $9355B, but described the result as an inclusive rate of 23.8%. I believe that calculation provides an exclusive rate, and the inclusive rate should have been 19.2%. This would have been consistent with the 2003 base/rate study done by Dr Walby. All of which explains the rosy picture I discussed above. If the retailers use 31.8% at the cash register, then the revenue raised by taxing 81% of the GDP($11500B) would amount to $3682B, which as I pointed out, would pay for the prebate, extinguish the federal budget deficit of $486B (which is a continuing concern of Hayden), and offset the inventory tax credit in year one. But if the goal was to simply raise the $2228B which the current income/payroll taxes raise, then the Fairtax sure as shooting isn’t revenue neutral. Something doesn’t add up, and we can’t seem to get any answers from the study authors.
Hank — Thanks for the response to my question. You have made point (3) several times over the last year. It has confused me for a long time, and in fact the calculations give me a headache, but I think I have finally figured out what you are saying and beg to differ with your conclusion.
The 23.8% is, in fact, an inclusive rate. It assumes that prices will not rise, all of the “embedded taxes” are squeezed out, government spending will not increase, and that the revenue required under the FairTax will be the same amount required today. Thus, $9366B x 23.8% = $2228B. That’s a tax-inclusive calculation (i.e. 23.8% of taxable spending yields the tax revenue).
If the rate were “tax exclusive,” that would imply that prices would all rise by the tax exclusive rate, which means that government spending would need to rise by that much, which means that revenue needs would also increase by the same amount. But that’s not what the calculations assume.
It seems to me that this is just one of the many inconsistencies in the BHI study. One one hand, they state at the end of the study that prices (and thus government spending) will probably rise by the tax-exclusive rate, but their actual calculations assume that prices (and government spending) do not rise.
So, I’m afraid the 23.8% tax-inclusive rate would not, in fact, pay for the prebate, extinguish the $486B projected deficit, or offset the $600B inventory tax credit. And, as you know, the 23.8% rate does not account for tax avoidance/evasion; nor does it account for the increase in state and local taxes the FairTax will require.
And, as I’ve pointed out before, our current budget is $3.1 Trillion, which would rise to $3.7 Trillion when the pre-bate is factored in. So even if the FairTax did, in fact, raise $2228 B, we’d be so far in the hole that we’d never be able to dig ourselves out.
Hank, forgive me as I’m a little short on time this morning, but a quick thought on your post. Let me start by saying I don’t think this assumption is correct. This is pure speculation…
Could it be that the rosy picture you have come up with is by design? Could this actually be designed to cover the prebate, as well as handling the inventory tax credit, and provide a surplus to offset price increases in government spending? Even if it is by design for these reasons though, if your arguments are accurate, this does seem a bit shady. If this is by design, why not come right out and say it? I suppose the roughly 60% tax increase would be the answer here.
It would definitely be nice to have some clarification by the study authors as to your concerns. Maybe these exist and we simply aren’t aware of them. All that said, though I still have concerns about the FairTax, I’m still a supporter.
Scott,
I don’t know if the BHI study results are “by design” or not. But I do know that if the goal was to raise $2228B in 2007 dollars, (the amount raised by the taxes being replaced), and the Fairtax extracts $3682B from all of us taxpayers, it certainly isn’t revenue neutral!!!! Of course, some of the revenue will be redistributed back to us in the form of the prebatge, but there is still arond $850B unaccounted for?
My major issue is with the calculation of the exclusive tax rate. All the online dictionaries support my contention that dividing the numerator(2228) by the denominator(9355) results in an exclusive percentage (23.8%). Then, the numerator must be added to the denominator(9355 +2228 = 11583) and then divided into the numerator (2228) in order to get the inclusive rate (19.2%). If someone can show me how the 2228 is already in the denominator, then BHI would have it right. But since the denominator is 81% of the national GDP, and GDP does not include taxes per Dr. Kotlikoff, then I just don’t believe they got it right.
Fred tried at one time to show how some of the $2228 might be included in the denominator, but I don’t recall what his argument might have been???Perhaps he will contribute his thoughts??
Hayden,
Now, put your conclusions to the acid test. If the inclusive rate is 23.8%, and the exclusive rate is 31.3% as you say, what percentage will the retailers use at the cash register? I think we all, (including AFFT), agree that the answer is 31.3%. So, multiply 31.3% times your $9366B public and private consumption and you will get revenue of $2931B, not the $2228B which was the revenue neutral goal.
And to be more accurate, your $9366B base has already been adjusted downward to pay for the prebate. The actual consumption base in the study was described as 81% of GDP, or around $11,600B. Multiply that by 31.3% and the revenue generated would be $3630B. Which I propose would be enough to pay for the prebate(487B), balance the budget (486B), and offset all of the inventory tax credit (365B), in addition to meeting the $2228B revenue neutral goal. (And enough left over for you to retire in style?!)
I certainly agree with you that there is no allowance for evasion/avoidance, nor is the fact that some of the revenue needed to fund the federal government is hidden in higher state/local taxes. But, leaving those important criticisms aside, I’m simply trying to understand how Karen Walby came up mathematically with her 19%/23% rates back in her 2003 study. And why BHI talked her out of it?
As for your final comment about the rise in government spending, you have to understand that the GDP will also rise by 3%-4%, an estimated 1/2 trillion annually. So the 31.3% rate might remain fairly constant as long as federal government spending doesn’t exceed the 19% of GDP, which has been the average over such a long period of time according to the Hauser data?
I freely admit I don’t understand the implications of the BHI assumption of spending neutrality, nor do I think the study ever addressed the impact of the Fairtax on prices. There are a lot of conflicting statements which are nothing but pure speculation about prices staying the same or rising by the full amount of the tax. But BHI took a pass on discussing prices, imho.
Just apply the acid test and tell me what you think? Is the Fairtax revenue neutral or not??
Once again, I’m in the office this morning and don’t have the time to look into the numbers again myself… However, assuming that the authors of the FairTax really want to get this passed to realize the benefits advertised in the proposal it seems that keeping the tax rate as low as possible is in their best interest. I understand that Congress would absolutely love to have still more money to play with, but my thought is that hiding a 60% tax hike in the FairTax is more than a bit excessive.
I find it very odd that the vast majority of arguments I hear are of the type that the FairTax rate would have to be MUCH higher. Here comes Hank arguing that it seems the rate should actually be significantly lower. Personally, I am OK with the 23.8% rate assuming that the research and math is indeed accurate in setting that rate. I would even be OK if this rate yielded an increase in government revenue only so long as that increase were targeted specifically at reducing the national debt. However, Congress would most likely view this simply as a windfall to be spent on various earmarks, etc.
In looking up at Hayden’s post on 37 I find it interesting that Hayden comes with with a Federal budget of $3.7 trillion and by your calculations you are coming up with a revenue of $3682B. Hmm… I believe that you two are discussing the math here in different ways, and I’m not going to pretend to understand all the nuances of the economics involved but these two calculations sure seem to line up pretty well to me. Could it be that you two have taken different paths to come to the conclusion the authors of the FairTax have come to?
Hank,
Here, imho, is the issue with your math. Retailers will use the 31.3% rate, but it won’t be applied against the 9.3T base. That 9.3T includes the cost of the federal government (2T using the 22% embedded tax estimate). So you need to apply the 31.3% to 7.3T which yields about 2.2T. In other words, the embedded taxes are part of GDP.
When Dr. Kotlikoff says taxes are not included in GDP, I am assuming he means when I send $100 to the Federal Government, the GDP is not increased. However, when I purchase a stereo for $100, the GDP is increased by $100 versus say $78 (which would be minus the $22 embedded tax). I could be misinterpreting what is meant by taxes not in the GDP, but this is what makes sense to me. Now imagine that the cost to administer the federal government magically went to zero and the long term price equilibrium occurred instantaneously. If you believe in the 22% embedded tax, the current price of $9.3T in annual consumption would go to $7.3T.
I don’t think BHI took a pass on discussing prices; they just made a simplifying assumption in their calculation. To reiterate, if prices increase by 17% (just a number off the top of my head) that is an increase in the amount of nominal dollars needed to purchase the good now. It is not an increase in the amount of real dollars needed to purchase the good now. The fairtax does NOT make things more expensive (increase in needed real dollars) on average, but it may have an inflationary effect (increase in needed nominal dollars). The fairtax will change prices based on current market distortions created by our current tax system.
With all that said, I hope I am missing something (which is entirely possible). As an advocate of the fairtax, there is nothing I’d rather do more than find an error in the calculations that would lower the rate, making it more marketable.
Andrew,
Good comments and you may well be right. However, let’s start with the legal definition of “tax exclusive”: “A tax-exclusive tax rate refers to the amount of tax paid as a proportion of the pretax value of whatever is taxed; sales tax rates are typically expressed in tax-exclusive terms. A tax-inclusive rate, conversely, refers to the amount of tax paid as a proportion of the after-tax value; income tax rates are often expressed in tax-inclusive terms. Thus the difference between the two definitions is whether or not the tax paid is included in the denominator when calculating the tax rate.”
So, my case would seem to rest on whether or not the BHI denominator of $9355 contains any taxes. The $9355 represents private and public consumption in 2007 (adjusted for the prebate), and there are no taxes in that number according to Dr. Kotlikoff. No state or local sales taxes and, as you point out, no income taxes. I continue to assert that the simple exclusive calculation would be an exclusive rate of 23.8%. In order to arrive at a tax inclusive rate, the numerator of $2228 must be added to the denominator, and the resulting rate is around 19.2% or whatever.
As for prices, that is a different issue. I like your 17% increase example because that reflects my estimated 10% reduction in costs. But a 10% reduction in pretax costs will reduce the GDP by 10% it seems to me. So, the 23.8% exclusive rate I’m clinging to will have to go up by 10% to 26.2%, won’t it?
You used a couple of terms that I’m not comfortable with. What is the meaning of “real” and “nominal” dollars? Is the Fairtax revenue neutral goal measured in real or nominal dollars, or doesn’t it matter?
Nice response Andrew. It definitely makes sense to me that you would have to remove the embedded taxes component of price to arrive at the same numbers that the study arrives at. I’ll agree with Hank though that it appears the BHI study definitely took a pass on the price issue. I think everyone here will agree that the FairTax is NOT going to result in a “free lunch” for everyone. By this, I mean that the full embedded tax rate of 22% is NOT going to come out of the prices of goods and services. A purely gut-feeling guesstimate would be that maybe 10% of these embedded taxes will actually come out of the price since I think most employers will simply remit employees their full paychecks. This would result in a price increase of about 13% and that is probably an absolute best case scenario. I think the 15-17% estimate I’ve heard thrown about it probably more realistic.
I think the above discussion is the reason for the lack of discussion on the price increase by the study. Much of the study focuses on real numbers from various economic data and reports. The price change however is much less of a science and more of a crap shoot. Unless the FairTax act were to specify how employers handle the tax component of employee salaries, it’s really a matter of speculation as to how companies will actually implement the change. This obviously makes nailing down the impact on the prices of final goods and services highly speculative and as such not what you would want to include in an economic study, imho.
Regardless of the resulting price change, I think the analysis of nominal vs. real dollars is accurate. Prices will definitely change, but I think that on average Americans will retain roughly the same buying power post-FairTax as they have now, in year one. The economic benefits of the FairTax however should be a benefit to the buying power of all Americans as these benefits are more fully realized and reflected in the market in subsequent years.
My last two points in support of my argument come pretty much directly from the second Boortz/Linder book. In discussing price increases, the authors are quick to point out that the 22% embedded taxes do NOT include compliance costs which can be significant. The 22% only includes the actual taxes themselves not the billions spent annually complying with these taxes. The other piece is the reference to a study indicating a 24.8% increase in prices, but also indicates a 27.4% rise in wages in year one. Yes, prices will increase, but wages will increase slightly more than prices which keeps buying power roughly the same.
Now is the time for me to ask a question that I’m afraid will demonstrate my economic stupidity. If prices suddenly increase by 15, 20, or 25%, doesn’t this have a significant impact on the value of the American dollar? Wouldn’t this weaken the American dollar significantly? I’m fully aware of my complete lack of understanding when it comes to international currency exchange rates but I think the current oil situation speaks heavily to the problems of a weak US dollar. Now, please tell me how I’m wrong and the US dollar will be safe and even grow stronger.
Andrew –
You asked what would happen to the value of the dollar under the FairTax. I can’t tell you what would actually, happen, but THEORETICALLY the following would occur:
1. The Fed would need to increase the money supply to account for the fact that employees would now keep 100% of their paychecks. (This is the “accomodation” model.)
2. Prices would rise in nominal terms as the FairTax is applied to retail prices and there are more dollars in circulation due to the Fed’s accomodation.
3. The value of the dollar would drop due to the increase in dollars vis-a-via other currencies. (If you think of a supply-demand graph, an increase in supply decreases the price. So an increase in the supply of dollars would lead to a decrease in their value vis-a-vis other currency.)
So, from the view of a foreigner, the price of goods and services sold in the US would not increase (because the nominal price increase would be offset by the decline in the value of the dollar). But the price of US exports (which would not be subject to the FairTax) would be lower.
From the standpoint of US citizens, prices of US products would increase (which would be offset by the fact that employees had more dollars in their pockets and Social Security payments would increase.) The cost of imported goods and foreign travel would increase due to the drop in the value of the dollar.
I used to teach International Financial Transactions in law school, so hopefully I’m correct and this makes some degree sense. I tried to force myself to understand exchange rate economics, but it gets quited confusing. Also, what should happen in theory does not necessarily correspond to what actually happens in reality, as least in the short term.
Hank,
I am assuming you don’t agree that the $9.3T contains the embedded taxes. That is the key to why I believe the 23% is the correct inclusive rate.
I believe the fairtax goal of revenue neutrality is completely based on “real†dollars. This means that if all of a sudden the money supplied doubled $4.4T would be the revenue neutral amount of dollars required. Why? Because $4.4T can now buy the same as $2.2T could before the doubling of the money supply. That is why I often argue that either the full accommodation model or no accommodation model will mostly affect those with fixed dollar assets, like lenders or people with cash in the bank. In the full accommodation model, those assets will have less “real†value. Owners of things like real estate or gold will be okay in either model because if the value of the dollar goes down, it just takes more dollars to buy those. That’s why I don’t think they took a pass when it comes to the rate calculation.
Scott,
I am definitely no expert in the strong/weak dollar situation, but I always thought it was more tied to our trade imbalance than to our rate of inflation. I thought I read somewhere that we have been moving to a weaker dollar for the past 20 years, but inflation has remained relatively stable.
Hayden,
I don’t believe full accommodation needs to occur for employees to get 100% of their paycheck. Employers today have that full 100%. They transfer part to government accounts and part to employee accounts. I guess I need clarification on how you see the Feds and employers interacting in this situation.
And maybe this ties in to what I was saying to Scott, but is the value of the dollar more dependent on other currencies or what we produce as a nation? For instance, if the number of dollars in the money supply doubled at the same time the number of products and services the US produced doubled, would the dollar be worth less if the number euros stayed the same? My answer is no. The dollar would contain the exact same value. However, if the number of dollars in the money supply doubled at the same time the number of products and services the US produced stayed the same, the dollar would be worth half of what it was worth regardless of what happened to the euro. Again, I’m not an expert, so let me know if I am way off base or just slightly inaccurate.
Sorry I’ve missed all the action – I’ve been on vacation. I’ll try to catch up and post some comments. Quickly to Andrew’s point – for an employee to get 100% of their paycheck is a partial accommodation (not full). Full accommodation would have them getting a 30% increase (100% plus the employer portion of payroll taxes and windfall from the corporate income tax). So for prices to rise by 30% would require a 30% increase in wages, which would result in an increase in government revenue to cover the additional government expense. Of course, many of us think a more accurate price increase is somewhere around 15-17%, using partial accommodation – 100% paycheck and the rest goes to price reduction. In either case, the BHI and Gale study state that no, partial, or full accommodation do not effect the tax rate.
Andrew,
Turns out that between you and Hayden, I have to wave the white flag. I now understand that BHI assumed the no accommodation model, which as Hayden pointed out, allows prices to remain unchanged and federal revenue needs to stay constant with the $2228 used in the study. So you seem to be saying that the so-called embedded taxes are already in the denominator which makes the calculation inclusive.
Of course, that scenario is not very likely. As Morphh wrote, we tend to like a partial accommodation model, which means that the GDP will fall 10% due to manufacturer cost savings, and prices will rise by 17%. As I wrote earlier, doesn’t that mean that the inclusive rate will need to be 10% higher? If the base is lower, the rate needs to go up, imho. BHI doesn’t agree, it seems
Finally, I still believe that BHI mishandled the addition of federal consumption to the Fairtax base. Here, Dr. Gale agrees with me I think. Adding the $916B in federal consumption should have also added around $200B in revenue to balance the equation. The Fairtax rate should have been 26.2%, not 23.8%. I’d still like to see a rebuttal from BHI, but I guess their study is now ancient history, not worthy of further comments, in their view?
Morph and Hank –
I went back and reviewed the Kotlikoff presentation at AEI (available at the aei.org website; put “fairtax” in the search box). He reiterated that the most likely outcome was “accomodation by the Fed,” in which he stated that retail prices would rise by 30%. He didn’t say anything about wages or salaries rising, which — since he’s a staunch supporter of the FairTax — he undoubtedly would have if he had believed that to be the case. So, I’m not sure it’s accurate to say that wages and salaries will rise under the “full accomodation mode” or that prices will rise only 17% under the FairTax.
In addition, I also reviewed with interest the presentation by Jane Gravelle of the Congressional Research Service at the AEI event. Dr. Gravelle had reviewed a number of studies of non-compliance rates under various sales tax rates and VATs. The bottom line is that even relatively modest tax rates lead to significant tax evasion rates.
The UK has a VAT of around 15% (which Gravele says is far more difficult to avoid than sales taxes), and has a non-compliance rate of around 14.6%. The FairTax, together with state sales taxes, will obviously be far higher, thus it is fair to assume that non-compliance will be higher as well. Yet if the FairTax had a non-compliance rate only equal to the UK’s, the tax-exclusive rate of the FairTax would need to shoot up to 39% (in addition to state and local taxes) in order to make up for the revenue lost from such non-compliance. This will STILL yield a budget deficit of $500 billion.
Thus, once again, I would argue that under any realistic scenario there’s simply no way that the FairTax could possibly work.
Hayden, if you’re trying to suggest that prices will go up by 30% and employees will get no increase in take home, you’re as bad (worse – since you know better) as those that believe prices will stay the same along with full take home. Both are absolutely ridiculous. You can read in a number of Kotlikoff & BHI papers (and likely Gale) regarding accommodation. He probably didn’t mention it as it was known and assumed by that group – it’s an either or scenario. The reason they often choose no accommodation in rate calculation is that it is easier to present the math that way (according to BHI). After speaking with BHI, they believe a partial accommodation or full accommodation are likely outcomes but say that purchasing power will be similar in either case (they show this as does Gale). Let’s not make this any more or less than what it is – we’re replacing taxes on one side with taxes on the other; it’s nothing mysterious.
I think the evasion point has been sufficiently discussed elsewhere, so I wont rehash. (yawn)
Morph –
I see you are getting cranky in your old age, or maybe it’s because you’ve had to return to the grindstone from your vacation.
In my post no. 49, I was responding to your assertion in post no. 47 that a “full accomodation” would lead to workers’ keeping 130% of their gross paychecks. I had never heard anyone make that claim before, so I went back and listened to Kotlikoff (and reviewed the BHI/Kotlikoff study), and unless I am mistaken none of them said anything about workers’ gettin 130% of their paychecks. That was my point.
I did not suggest that worker’s would keep only their net paychecks while prices rose 30%. (However, if I’m correct that the fairtax rate would need to be 55% or higher, then it is certainly possible that workers would experience the double-wammy of their paychecks dropping (due to the erosion of the “embedded taxes”) at the same time prices rise due to the addition of the FairTax.
Regarding evasion, the reason I brought it up was the Gravelle discussion was a part of the AEI event. Boortz and Linder claim in their latest book that critics of the FairTax claim that tax rates higher than 10% are not sustainable because they lead to too much tax avoidance, but that neither Boortz nor Linder could find any study to back up that claim. I am merely pointing out that studies have been done showing significat tax evasion levels at relatively low rates. If Jane Gravelle could locate six or so, and Boortz couldn’t find any, then he’s not trying very hard.
I thought the accommodation models were as follows:
No Accommodation: Pre-tax prices drop by the full 22% embedded tax. Employees get their net pay, i.e. they lose their income and payroll taxes. Employers maintain their same profit, i.e. they give up their corporate and payroll tax. Yields a 0% increase in nominal dollars.
Full Accommodation: Pre-tax prices stay the same. Employees get their gross pay. Employers keep previously paid corporate and payroll tax as profit. Yields a 31% increase in nominal dollars.
Partial Accommodation: Somewhere between the full and no accommodation models. For Example, Van Gieson Accommodation: Pre-tax prices drop by 10%. Employees get their gross pay. Employers maintain their same profit, i.e. they give up their corporate and payroll tax. Yields a 17% increase in nominal dollars.
My confusion comes from the fact that the Fed is the entity doing the accommodation and employers are the ones determining what happens with the dollars originally slated for taxation. If the Feds left the money supply constant, is it possible (or at least reasonably probable) that prices could increase by 31% nominally, or would the market force prices back to pre fairtax equilibrium (minus old tax regime distortions)? If the answer is market force to equilibrium, what positive purpose could any accommodation have? In fact, isn’t the Feds reaction to such inflationary price increases actually a tightening of the money supply?
Hayden, I guess it depends on what you define as 100% in your 130% conclusion. In this case, 100% would be net (not gross), and something like 120% would be gross, and 130% would be gross plus a windfall from corporate and employer payroll tax passed to employees as higher wages.
Andrew, regarding full accommodation, I don’t see how business could gain a 10% windfall in profit margin. I can see the accommodation allowing them to increase their profit margin to the point of maintaining the same profit (which may be something like a 1% increase). The rest I feel would be forced into further price reductions through market forces.
From what I’ve read, full accommodation would suggest prices and wages rise by the exclusive rate (i.e. 30%)—embedded taxes become windfall gains. So be it wages to business or employees, I expect it would have similar effects.
As I see it, if tax gains go to business, we’ll see it in price reduction (to the point of no price change) and if it goes to employees, we’ll see it in increased wages.
Regarding price changes, David Tuerck expressed to me “Given the identity, MV = PY, P = MV/Y. As long as M, V and Y don’t change, P remains the same. So suppose the existing taxes go away. Price remains constant. Now impose the FairTax. Price stays the same, rises by 30% or rises by some fraction between 0 and 30%. I don’t agree that price necessarily rises by 30%. I expect that there’d be some degree of accommodation, say 15%. But the price rise would be in the 0-30% range, at least insofar as the FairTax had anything to do with it.”
Morph — That explains it. Before, when you had said 130 percent, I thought you meant gross wages would rise to that amount.
By the way, I emailed Jane Gravelle regarding the evasion issue. She replied to me with the stipulation being that these are her personal thoughts and do NOT reflect the views of the Congressional Research Service. Below is the essential part of her response, which is pretty consistent with what we’ve been discussing here.
“The work we have done here indicates that the numbers in the Fair tax bill are about right assuming no evasion or base erosion, which would be 23% tax inclusive, 30% tax exclusion. Even if you put in Treasury’s low non-compliance rate [of 15%], you get 30% and 37%. If you put in their high compliance rate [of 30%], you get 33% and 49%. So I would, relying on Treasury as the most reasonable estimates around, set the tax exclusive rate somewhere in between 37% and 49%. It would be higher if exclusions are ultimately granted.
Another factor is that revenues are not sufficient to fund the government right now, so if you wanted to replace spending, as opposed to revenues you would have a higher rate. Or if you wanted to replace permanent revenues (assuming expiration of the 2001-2004 tax cuts) that would also be higher. The spending adjustment would add 9%, the tax adjustment 7%, according to CBO. This increase would add a couple of percentage points to the tax inclusive rate, and about 4 to the tax exclusive rate.
Taking all of this into account, it seems we are talking about rates in excess of 40%. I don’t think its possible to know with much precision.
I think there are several factors to consider with regard to evasion and deficits. The rate studies implicitly incorporate some degree of tax evasion in their calculations simply by using National Income and Product Account based figures that presumably understate total household consumption. Moreover, the studies did not account for the expected capital gains that would result from a reduction in the real nominal value of U.S. government debt from monetary accommodation and the increased economic growth that economists believe would occur under a consumption tax. These factors (more along the lines of a dynamic anaysis) counteract some of the errosion and deficit issues.
Both simplicity and the amount of collection points have been shown to effect compliance. The number of tax collection points would be significantly reduce by about 80% (from 100 million to 14 million) and reduce the filing complexity to a simplified state sales tax form. Larger state enforcement budgets due to the refund (.25% of tax) would be able to audit more business.
I also have a difficult time believing that a significant amount of errosion would occur based on the retail market distribution and state enforcement. Economic Census figures show that 48.5% of merchandise sales are made by just 688 businesses (“Big-Box” retailers). 85.7% of all sales are made by 92,334 businesses, which is 3.6% of American companies. In the service sector, approximately 80% of sales are made by 1.2% of U.S. businesses. These larger companies are not likely going to risk loosing their business and face federal prison. So considering 30% evasion on the other 96.4% of businesses, we’re talking 30% of 14.3% of the tax base or 4.3% erosion. Even with something crazy like 50% evasion on 96% of business, we’re still talking about a base errosion of less than 10%.
Kotlikoff has stated that a simple form could provide the same level of reporting as a VAT, so I don’t see much of a difference there. Then add that the FairTax allows for citizens to turn in tax cheats for a reward. I just don’t see it as a big issue but I know we’ll just agree to disagree on this one.
Who has shown the amount of collection points affects compliance? I’ve looked and never found anything. I see where you added the following sentence to Wikipedia’s “FairTax” entry:
And referenced the BHI “Fiscal Federalism” paper, but if you look at the paper it says:
You appeared to originally have had it as “compliance costs” in the Wikipedia entry and then changed it. Why? There’s a big difference between the meaning of “compliance costs” and “compliance.”
Fred, I can’t quite remember why that was removed – I think to avoid confusion with business compliance costs (discussed earlier in the article) for complying with the tax. I likely thought it an error (due to the frequent use of the term) and didn’t think about the difference too much and thought of costs as evasion costs. The BHI paper does make the point that such would make detecting tax evaders easier, but in either case, you are correct and the statement will be corrected. If you find the GAO study or the “other’s” referenced, I’d like to read it myself as well, although it seems like a common sense statement. Thanks for point out the error. I think “government compliance costs” may reduce confusion or perhaps “government enforcement costs” – is this how you interpret the meaning?
Morph — As always, you make good points on compliance. But here are some counter-arguments:
1. According to Gravelle’s research, Minnesota, with a 6% sales tax, has non-compliance of between 10-15%. England, with a 15% VAT, has non-compliance of 14.6%. Is is really realistic to assume that a much-higher FairTax (in addition to state sales taxes) would have lower rates of non-compliance?
2. The overwhelming majority of tax evasion in this country today occurs in small businesses, cash-based transactions, capital gains, and other transactions where there is no double-reporting. The estimated non-compliance rates in these instances are very high, something like 50%.
On the other hand, in cases where there IS double-reporting, such as with wage income where both the employer and employee are required to report the amount of the wages and the amount of tax withheld to the government, there is something like 99% compliance.
Under the FairTax, there will be NO double-reporting of taxable purchases. (Purchasers are theoretically required to keep receipts to show they paid the FairTax, but they are not required to report that to the government.) Thus, the likelihood of substantial non-compliance is not as low as one might otherwise believe.
3. Non-compliance does not only include tax evasion, which is illegal It also includes tax avoidance, which would include legal tax planning or modifications to one’s actions to avoid paying taxes. As we’ve discussed many times before, the FairTax makes legal tax avoidance strategies extremely easy to pursue.
As you’ve noted, we’ll probably never agree on this, but I am increasingly convinced that non-compliance rates under the FairTax would have to be at least 15%, and probably much higher.
Morphh, I read BHI’s quote as meaning the costs businesses incur “when complying with the computational, reporting, and recordkeeping requirements of the tax system.” [source] But I think it’s important to point out that virtually all businesses will have “computational, reporting, and recordkeeping requirements” under the FairTax. From the FairTax FAQ: “The certificate enables the business to purchase tax free from wholesale vendors, but the vendor must retain a copy of the registration certificate to justify not having collected tax on the sale. When a business purchases items for business use from a retail vendor, they have to pay the tax on the purchase and take a credit against the tax due on their monthly sales tax return. They must keep invoices/receipts to document what they purchased and the amount of the purchase. They might also make note of the purpose of the purchase on the invoice.”
This means any business that purchases from a “retail” vendor (e.g., travel, lunches, gas, Home Depot) will have to pay the tax and then file for a credit. This sound very time consuming and means any business can cheat the system by filing false credit claims. And who is going to investigate them? The states have no interest in pursuing these types of false claims.
A new study on the FairTax has just been published by two Rice University professors.
http://www.bakerinstitute.org/publications/ImpactofHR25-TEPP.pdf
The study is 75 pages long, but the relevant results are in the table at the end of the paper. Bottom line, using actual 2006 data, and assumining no tax evasion/avoidance, not correcting for transition costs, and allowing for the actual 2006 deficit (which I believe was between $250-$300 billion), they came up with a tax-exclusive rate of 38.9% (28% on a tax-inclusive basis.). They also made it clear that the general consensus is that retail prices would need to rise by 100% of the tax-exclusive rate.
What should be even more depressing for the FairTax crowd is that these guys are SUPPORTERS of the FairTax.
It doesn’t work . . . it doesn’t work . . . it doesn’t work . . . .
I just called The Herman Cain Show. Cain is a big supporter of the FairTax and the main substitue for Neal Boortz, though usually a little more rational. My point was to inform Cain of this new study and to suggest that if he really wanted his listeners to understand the pros and cons of the FairTax, he should link to the various studies on his website.
But as soon as I mentioned that this new study concluded that the rate would have to be higer than 23%, he interrupted me and kept repeating the same mantra of Boortz/Linder. Namely, that all the studies that don’t support the 23% rate must “change the FairTax” and exclude housing, medicine, drugs, etc. He then hung up on me and said (after he’d cut me off) that if I ever found an actual study of the FairTax, he’d look at it. (A year earlier he had said the same thing when I told him of the William Gale study. I sent it to him and he never mentioned it.)
The reason I bring this up is because, other than this board, there is simply no place to get an alternative hearing on the FairTax. Linder will avoid all debates on it, as will Boortz and Cain. Yet they can say whatever they want over the air, regardless of whether it is true or not, knowing that 99% of their listeners will not bother to read any of this stuff for themselves. It’s quite frustrating to those of us who want an honest debate on the subject.
Having said that, I’ve been invited to appear on a panel discussion on CNN to discuss the FairTax in August. Boortz and Linder have also been invited and CNN is being flexible with the date to accomodate their schedules. If they agree to appear, this will be (to my knowledge, at least) the first televised discussion ever on the pros and cons of the FairTax. Something tells me neither of them will agree to it and the whole thing will get cancelled.
I’ll keep you posted either way.
Fred, that is not how I read it, but I may be in error. The paragraph states “This drop in the population of tax filers would make compliance audits much easier for tax administrators. The compliance benefits attributed to reducing the number of tax filers would also be available to states that adopt a state FairTax. Therefore, state governments that adopt the FairTax would likely find the task of detecting tax evaders easier.” This appears to be directed at the government, not business. I did not see in the GAO source link the statement regarding collection points.
With regard to the FairTax compliance, I don’t think anyone suggested that it was cost free. However, the business is paid .25% of the collection for administration – a degree of compliance is factored into the FairTax rate, unlike the current system that adds 500 billion on top. Most of the paperwork that the FairTax requires is very similar if not the same as most state sales taxes. The majority of states already audit for this stuff and have a sales history. But we’re getting way off topic…
New study.. I haven’t read it yet.. will do when I get the chance. Just took a quick glance though. Why do they have Kotlikoff’s rate at 26.5%? Perhaps I’ll figure it out as I read it. Thanks for the link. I’ll try to add it as a new post tomorrow.
Morphh,
Haven’t read it all yet, but on page 6, the study report states that the 26.5% corrects the failure of BHI to add enough revenue to offset the inclusion of federal consumption in the base. In short, governments can’t tax themselves!!! Interestingly, the report also claims that LK agrees with the correction? Might make it very difficult for Boortz/Cain to claim that this new report doesn’t really address HR25 as written?
I created a new thread for the study but I can’t figure out how to move these last few posts over to that thread without copy/delete. I’ll have time to read the study this weekend I expect. Thanks for the link Hayden
Fred @ 59… The record keeping on the part of businesses would be similar to that today. I know that when I travel for work, I am required to keep all expense receipts. Filing for the tax credit on these receipts would not be a huge overhead for most businesses and would simply be a shift in some of the accounting staff functions away from income tax related responsibilities to new sales tax related responsibilities.
As for the evasion… Again, any system devised is going to have evasion and that is something that we must accept. However, the federal government will still have a collection and investigation/enforcement mechanism in place and since the states are going to be contributing greatly to the sales tax collection enforcement that should leave the fed more resources to catch the type of evasion that you describe here. Also, we come back yet again to the nature of retail sales in this country. It is not going to be worth the risk to Wal-Mart, Best Buy, etc. to cheat in this manner. These businesses account for about 80% (I think this is correct, I didn’t look it up again) of all retail sales.
The final point here… I think this type of evasion is much less of a concern. The reason for my belief is that an offender in the case you presented is creating a specific paper trail to get caught. He will be filing a document with the government detailing specific receipts for which he is claiming this tax credit. This type of cheating should be relatively easy for the fed to catch by simply comparing tax credit filings from similar business types. Most of this comparison could be automated and then simply flag the suspicious ones for follow-up.
Evasion / avoidance issues are one reason why I would support a phased implementation so that we could understand the real figures involved and adjust course as needed.
Whether the rate needs to be 23.8% or 26.5% begs the question. If the revenue-neutral rate hypothetically needs to be 60%, that means nothing more than that is how much the government is extracting from its citizens today – just in a different form. The only change the Fair Tax signifies is that the Fair Tax brings the cost of the federal government out into the sun from the shadows and does so in a way that stops the punishment of behaviors that lead to economic growth.
~Jim
That was kind of my point. There would be no compliance costs savings – even for businesses not collecting the FairTax.