The Cost on State and Local Government
Sometimes we discuss the debating point that a portion of the federal revenue is supposedly hidden in higher State and Local taxes. As we know, tax rates and even nominal dollars can be misleading. The true measure of a tax burden is the effect on your standard of living — the transfer of purchasing power from the individual to the government. I’ll argue here that State and Local governments will see little change in their real cost, making it no more hidden than today. Let’s go over some definitions first:
Real versus nominal value - In economics, nominal value refers to any price or value expressed in money of the day, as opposed to real value, which adjusts for the effect of inflation. Real values convert the nominal values as if prices were constant in each year. Any differences in real values are then attributed to the differences in the amount of goods that the money could buy in each year. Thus, the real values index the purchasing power of the money for each year.
Example (not compounded for simplicity and brevity):
Government collects $100 from a citizen earning $1000, taking 10%.
Now let’s consider 3 years of inflation at 3% a year, 9% total.
Government collects $109 from a citizen earning $1090, taking 10%.The nominal cost increase was $9, while the real cost increase was $0.
The real cost is $0 because the burden has remained consistent — no additional loss of purchasing power has occurred to the citizen and no gain in purchasing power has occurred to the government. Revenue was consistent with inflation and the real cost of government was unchanged. The government can’t buy more goods with the extra $9, and the citizen can’t buy less because he paid it — the inflation leaves both parties whole.
Income and sales taxes usually require no change to maintain real value as the tax base adjusts with the inflationary effects. However, some taxes do require periodic adjustment, such as land taxes. In that case, either the tax base is increased (reassessment of land value) or the tax rate is increased. Under a FairTax implementation, the States would need to do a one time readjustment of their tax base(s) or tax rate(s), convert to the FairTax system, or otherwise adjust their tax system in order to maintain the same real revenues (and real burden) due to the inflation (from accommodation).
FairTax - Now let’s consider putting the FairTax into effect with a partial accommodation model assuming employees get gross pay and the rest is used for a 10% reduction in product cost, leaving a 17% exclusive price increase. The FairTax, like the current system, imposes a tax cost on government, which it does by taxing government purchases and payroll. Using the data from the BHI / Kotlikoff study, State and Local government consumption and investment is $1,659 billion. They also state that taxable spending is broken down to 59% for nonwages and 41% for wages. Given 17% inflation, $1,941 billion would maintain the same state and local burden on the citizens and collect the same real revenue. Less than $1,941 billion is a shift of purchasing power to the people (tax cut), more is a shift of purchasing power to the state (tax increase). The nominal increase of $282 billion would result in no change in real cost.
- $1,659 - $403 (tax free wages and salaries on education) is $1,256
- $403 * .9235 (-7.65% employer payroll) is $372 (tax free wages)
- $1,256 - $163 (capital) is $1,093, leaving $163 (tax free capital)
- $1,093 * .59 (nonwages) is $645 , with the remaining 41% (wages) being $448
- $645 * 1.17 (17% price increase) is $755 (taxed nonwage consumption)
- $448 * .9235 (-7.65% employer payroll) is $414
- $414 * 1.3 (30% on gross wages) is $538 (taxed wages)
- $4 * 1.17 (17% price increase) is $5 (administration fee reduction)
- $372 + $163 + $755 + $538 - $5 = $1,823 billion
The real cost has decreased by $118 billion (6%) of almost 1.95 trillion, making the State and Local burden less than before.
This does not necessarily mean that the combined burden on the citizen is less — purchasing power changes should equal out under revenue neutrality. The offset would be reflected in the federal burden. Rate studies by William Gale and Diamond & Zodrow reflect this as they reduce the tax base on state and local education by an additional $300 billion, creating a higher FairTax rate and further reducing the real State and Local burden by $51 billion to $169 billion (8.7%).
So what does that mean for State and Local taxes?
The main tax bases used by State and Local government will not factor the inflationary effects from accommodation, resulting in a loss equal to the nominal cost increase - thus shifting purchasing power to the people from state and local government. In order to maintain real revenues, the state and local government will have to make adjustments to their tax system. State income taxes are applied on gross wages, which will not change. State sales taxes are applied on pre-tax retail prices, which will decrease by 10%. Unlike normal inflation, states and local governments will have to make a one time adjustment to their systems for the accommodation, which may include: raising tax rates, modifying the tax base, taxing the FairTax, conforming to the FairTax, land value reassessment, accepting some loss of real revenue, etc.
When the real value of the tax based is decrease by inflation, an adjustment needs to be made to collect the same real revenue in order to maintain the purchasing power of both the government and the citizen. The rate may be higher, the base broader, or the system changed altogether, but it comes down to the simple question of whether you have more, less, or the same dollar value in your pocket and the impact on your family. The state and local government should continue to impose approximately the same burden on you before and after the FairTax.
A more detailed economic analysis can be found in the BHI/Kotlikoff rate study. Section V discusses the State and Local government and the need to maintain real revenues.
Morph,
Nice post. One minor correct (I believe) in the inflation example you give. If the inflation rate is 3% per year, then after 3 years of inflation shouldn’t the amount collected by the government in taxes be $109.27 and the nominal cost increase $9.27? Each year the original $1000 increases by 10% over the previous year, so:
Year Amount Tax
0 $1000 $100
1 $1030 (1000.00+3%) $103
2 $1060.90 (1030.00+3%) $106.09
3 $1092.73 (1060.90+3%) $109.27
Doesn’t change your arguement. If you rounded to the nearest $ then ignore this comment.
John
Yes John, I did consider that and thought about putting non-compounded in there to clarify, I left it out for simplicity and space. Glad you picked up on it though.. you guys are paying attention.
I’ll add the clarification and I also have a correction that I need to add - made an error with government wages on education, so stay tuned.. I’ll update it in a couple hours.
Wouldn’t it be smarter to simply tax the land value — collect a significant share of the economic rent on land, whether it be owned by individuals, corporations, foreign investors, pension funds or REITS, and use THAT steady revenue stream to fund our common spending.
It would be fair. It would be simple. It would be efficient. It would be equitable. It would not be easily evaded. It would also have very desirable incentive effects: well-located land would not sit waiting for the speculator to be good and ready to sell; rather, it would be put to use now to meet human needs. Land on the fringe would not be prematurely developed (which we call sprawl and long commutes and new infrastructure needs).
And wouldn’t it be nice not to pay a tax on your wages OR on every penny you spend to meet your needs?
Every dollar we spend on good schools raises land values. It increases the amount that tenants pay landlords and which landlords mostly get to pocket. It increases the amount that buyers pay sellers, and which sellers mostly get to keep. It increases the amount that buyers must borrow from lenders, and must pay back, with interest, for 30 working years of their too-short lives.
There is a better way. Fund that from land rent. Recycle the land rent, rather than letting it be someone’s private treasure and then taxing wages or/and sales.
This is not a new idea. But it is a wise and just one.
Ok, I updated it. I had excluded education wages since they are untaxed, but forgot about their reduction of employer payroll taxes. So I had to add that back in to show the reduction. I also clarified, to John’s point above, that the first example is not compounded for simplicity and brevity. I also color coded the second example to try and make it easier to follow.
Updated again... similar to education, added capital.
Morphh,
It doesn’t seem conceivable that two fair minded, unbiased Fairtax observers such as you and I could come to two such differing conclusions about the impact of the Fairtax on State and Local governments???
But, we have, so I’m going to try to explain why. My simply analysis assumed a 17% price increase and applied that increase to S/L purchases of goods and private services, and then calculated the net increase in payroll costs assuming burdened payroll amounts. My conclusion was that there would be a nominal increase in S/L consumption costs which would require the current S/L average sales tax of 6.5% to be increased to 8.5%.
You assumed a 17% inflation rate, and then proceeded to show that in real terms, the cost increases would be less than 17%, resulting in a tax cut for everyone. That result should not have been a surprise because you added over half a trillion in untaxed wages and capital to your equation. You also did not include the burdened amount of wages per the definition in HR25. Had you done so, the result would have been an increase in real costs which would have required a tax increase for everyone? Confusing?
I don’t believe we are dealing with the classic inflation here, but a unique, never before experienced retail price increase caused by a new federal government tax system. After all, producer costs would be lower and, according to LK, taxes are not included in the GDP so the GDP will contract by 10%, not the usual signs of inflation?
This might be a good time to also mention that the whole monetary accommodation thing probably doesn’t apply in the Fairtax case. Over $2 trillion in cash will flood the markets annually due to the elimination of income tax and payroll contributions as well as the $600 billion prebate. Am I to believe that the business checks currently sent to the federal Treasury to pay for the withholding is somehow not money. Why does Ben Bernanke have to worry about the money supply? It seems to me that the necessary cash/money to support a price increase is already in existence? Please explain why the Fed needs to get involved?
It seems to me that raising the State/Local tax rate would be a burden on all citizens. I don’t think you have adequately explained just how inflation factors would actually result in a tax rate reduction. Sorry, but it makes no sense to me.
I have written John Linder a letter asking him to clarify the burdened payroll language in HR25, and I hope he responds promptly?
Hank, My thought on burdened payroll is that regardless of whether it is wages, benefits, insurance, unemployment or workers compensation, it has to come out of the government’s base consumption today. It’s not an increase in consumption - it’s part of the current 100% (they pay these things today). So is it in the 41% or the 59%? Does it matter?... they’re both taxed - perhaps it matters a little bit as they have different offsets. If you want to increase the 41% and decrease the 59%, I don’t have an issue with that if you can give some figures for the difference.
Of course I included the tax free wages in the equation as it has to be included in a comparison with the real cost of today. They’re not tax free today, so we have to show this reduction to S/L cost.
I did not state that tax rates would reduce - I said the real tax cost/burden would reduce. Getting gross pay is not a windfall — you don’t get to keep it. FairTax people seem to get excited about gross wages, but it really doesn’t matter — it shouldn’t give you any more money. Net wages, gross wages, some other amount doesn’t matter - the government is still going to take the same real amount from you. If you get gross wages, that just means they’re going to take more nominal dollars from you. In this case, S/L government would have to raise their tax rate to do it (since their tax base wouldn’t auto-adjust), but no one is getting away with anything. The citizen is not going to get more money before/after and neither is the State. A windfall gain from gross wages is a illusion. The government is going to get its piece of pie. The slice of State/Local pie in relation to the whole pie is less, but the slice is bigger than before as the whole pie got 17% bigger.
If GDP does not include taxes, how can it decrease by 10%? The 10% reduction is mainly from the removal of taxes. I don’t know the reasoning for why the Fed would need to get involved.
Hank,
I think you’re misunderstanding what Kotlikoff stated. He said “raise tax rates” not raise taxes, there’s a difference as he states it is to “recapture the lost revenue” because “purchasing power is fully transferred to state and local taxpayers from state and local government”. “Despite suggestions to the contrary, implementation of the FairTax, including the requirement that state and local government pay the FairTax on their purchases, entails no reduction in state and local real spending, provided those governments adjust their revenue collection so as to continue to collect the same real revenues.”
Let’s step through it...
1) Do you understand and agree with the small example in the beginning of the post regarding a 10% tax?
2) Do you agree that it would be a tax decrease if the government received less than $109 and the individual kept more after the three years, likewise a tax increase if the government collected more than $109 and the individual had less?
3) A tax is primarily two parts: tax rate and tax base (tax base * tax rate = tax). Do you agree that changing either the tax base, the tax rate, or both can result in a increase or decrease in tax?
Morphh,
OK, you may be making progress in my continuing education. I’ve read and reread the Kotlikoff/BHI chapter 5 until I’m going blind. I can read, but I still can’t understand why raising the tax rate isn’t the same as raising taxes.
Tell you what, how about completing the following sentence in 20 words or less with no equations, no charts, just plain old English.
The Fairtax transfers purchasing power from State and Local governments to State and Local taxpayers by:—–
Another question that I was reminded of in researching the history of this issue is one that deals with monetary accommodation. Why does the Fed have to do anything about monetary accommodation when literally $trillions are dumped into the economy due to the increase in take home pay? That additional pay seems to me to be adequate to support the inflationary rise in prices?
Hank,
Completing the sentence: The Fairtax transfers purchasing power from State and Local governments to State and Local taxpayers by reducing the cost of production and thus decreasing the state and local sales tax base. Decreasing the tax base decreases taxes paid and increases taxpayer purchasing power.
You stated “I can read, but I still can’t understand why raising the tax rate isn’t the same as raising taxes.” It’s because the tax rate is only half of the equation (tax base * tax rate = taxes). Raising the tax rate doesn’t raise taxes if the tax base decreases to offset the change in the rate. Example ($10 * 10% = $1) or ($9 * 11% = $1)
Consider your property taxes when the county reassess your tax home value by 15%, raising your taxes but not your tax rate. They changed the tax base (home value) and you have less money in your pocket because of it. The FairTax decreases the sales tax base for state and local government (10% for example - reduction on product cost). So if they reassessed your home value for 10% less, it would be a tax decrease - you would have more money in your pocket. What if they decreased your home value by 10%, but raised your tax rate by 1% - giving you no more and no less $, giving the government no more and no less $?
This is what happens with the FairTax. The state sales tax base decreases from the reduction of production cost, meaning that the citizen now has more money (just like the home reassessment decreasing by 10%). For the state to collect the same amount of revenue, they have to raise tax rates (11%) or change their tax laws to restore the purchasing power. So the state is collecting the same amount and the individual is paying the same amount. The rest is just inflation as described in the first example based on the accommodation level.
As far as the monetary accommodation, I can’t say I fully understand those principles and why they would need to make an accommodation for the tax.
OK, Morphh,
I think I’ve got it, but let m,e play it back using some actual numbers.
The Fairtax lowers producer costs by 10% which results in a 10% revenue shortfall for the State/Local governments. If the States take no action, not only will my take home pay rise by the amount of my income tax withholding. payroll contributions, and the Family Consumption Allowance, but I would get an added benefit from lower State taxes. So, holding their tax base constant, States raise their tax rates by 10% , taxpayers lose that added benefit, and everyone is whole. In Florida, assuming the base is average, then the current 6% sales tax would rise to 6.6%. Am I correct so far?
But, Morphh, what does any of this have to do with raising the dollars needed by the States to pay for the 17% increase in retail prices? Won’t the State of Florida have to tack on an additional 17% to their 6.6% rate, making the final rate 7.7%? Isn’t that what I have been claiming all along? States will have to raise their rates-or tax the tax, or reduce services in order to balance their budget. Where is the money???
Yes, Hank you’ve almost got it. Consider a non-accommodation, instead of a 10% reduction, you have a full reduction and the State would have to adjust. The same thing is happening with the 17% but it’s on the other side - inflation. You’re correct that they would have to tack on an additional 17% to their 6.6% rate (7.7%) or tax the tax (@ 6%).
Where I think you go astray is that this does not result in a tax increase by the State. Again we look at the tax base. A tax base needs to adjust for inflation, otherwise it will collect less real dollars each year. This normally happens automatically as retail prices and incomes increase and sometimes it doesn’t (home value reassessment). With the transition to the FairTax, the sales tax base of state and local government would not automatically adjust for the 17% increase in incomes and prices. This increases the purchasing power of the individual, and decreases the purchasing power of the state. Therefor, to retain real revenue, they have to make a one time adjustment to account for the inflation.
This goes back to the first example in the post. Both the individual and the state need to remain whole - with neither party gaining purchasing power via the other. To do this, the State and Local government have to adjust their tax to the new tax base in order to collect the same real revenue. In the post, I show that using the full adjustments results in the State and Local government taking 6% more, so the increase would not have to be the full amount but an adjustment would have to be made (maybe 7.2% for Florida), which would result in a real tax burden decrease by the State and local government.
Your last question “Where is the money???” is certainly valid. While the state does not increase taxes, there is certainly a transfer of purchasing power that has to take place from the individual to the state to maintain real revenue. Meaning, the State needs to take a piece of your income windfall. So this should be computed in your ultimate tax burden and purchasing power.
Morphh,
You have done an admirable job of trying to explain why the States won’t have to raise taxes in order to pay the federal sales tax on their consumption.
But, your statement that “the State needs to take a piece of your income windfall” is just the same as saying the States will have to raise taxes. You have made the case that I’m not going to get 100% of my gross pay as advertised by AFFT, but when State costs are added to the hopper, some of my “windfall” will go to the State through higher tax rates in order to pay the federal tax tab.
I guess we can move on, but I’m going to continue to claim that unless the Supreme Court finds federal taxation of State and Local consumption inappropriate or unconstitutional, then the State and Local governments will have to raise tax rates in order to pay the federal tax. Alternatively, the States could tax the tax, increase the tax base, or reduce services in order to balance their budget.
Hank,
You state “You have made the case that I’m not going to get 100% of my gross pay as advertised by AFFT, but when State costs are added to the hopper, some of my “windfall” will go to the State through higher tax rates in order to pay the federal tax tab”.
You do still get 100% of your gross (no taxes are withheld). You then spend your money and when you spend it on taxable goods, you pay taxes. As Morph explained the actual dollars you are paying to the Florida will change, but purchasing power should not.
John,
In 45 of the 50 States, you never were going to get 100% of your gross pay. But I think we all understood that State income taxes would likely still be withheld. The point I was trying to make was that after tax purchasing power is going to be further reduced due to higher State/Local sales tax rates. The issue we are addressing is the impact on S/L governments, and I still claim there is one. The price of almost everything S/L governments purchase is going up, and the money to pay the federal tax causing the higher prices will most likely be raised by higher taxes, although there are other options.
Sorry about the sloppy writing on my part!
Hank, I think you may be missing the bigger picture. You don’t get to keep any of the windfall. 100% of your paycheck is an illusion, an advertising gimmick. We know that it doesn’t matter if you get gross pay or net pay, it’s the same burden. You’re not 17% richer, and not poorer based on State adjustments. The only thing getting gross pay does is increase costs by 17%, including government - negating the entire thing. It goes right back to the government (Federal, State, and Local). It’s a matter of shifting purchasing power and the tax bases. But it should be computed to understand and compare.
Increasing the tax rate is not in order to pay the federal tax tab, not anymore than it is today. They’re not paying any more to the Fed under the FairTax, in fact, they’re paying less. As described in the post, it’s a tax decrease at the state level, even though they have to raise the tax rate because of the base change. So it would be incorrect in my view to suggest the States have to raise tax rates in order to pay the federal tax. This implies an additional FairTax cost at that level that doesn’t exist - the cost already exists and we have to adjust to maintain it.
Morphh,
O.K, although I don’t agree with some of your comments, I think I now have the “big picture”. Some or all of the “windfall pay increase” caused by eliminating the individual tax withholding will have to be recaptured by the States by raising rates sufficient to cover both the lost revenue from the producer price decline and the increased purchasing power needed to pay the federal tax on State consumption.
You are going to have to explain why you think the States would pay less, not more, under the Fairtax. The only federal tax the States pay now is the 7.65% payroll tax. Under the Fairtax, the States would have to pay for a 17% increase in the price of their consumption. How is that less?
All of which leads to a question about just how much of the “windfall” is going to be eaten up by higher retail prices and the increased State tax rate? Is the transfer of wealth from individuals to the States really a wash?
Using data from the Kotlikoff/BHI study, the Fox -Murray study and the Diamond- Jadrow study, (an approach that might cause any competent analyst gas pains?), the individual windfall including income tax, payroll tax, estate tax, and the Fairtax Family Consumption Allowance add to $2262 billion. (that is why I don’t think monetary accommodation matters?).
A 17% increase in the $9235B private consumption comes to $10804B, an increase of $1570B. Fox-Murray estimates that the added cost to the States of the Fairtax would be $346B. Total added costs would be $1916B, leaving $346 billion on the plus side of the “windfall”. Distributed over the 115 million family units, that comes to $3000 per family, and would support AFFT statements such as the Fairtax would be good for everyone, (on average).
However, what if the Diamond Jadrow study is correct and the exclusive rate turns out to be 38%, and retail prices rise by 24%.? Redoing the above estimates results in a net loss in individual purchasing power of $300 billion, or a net burden of $2600 per year per family. That wouldn’t support AFFT marketing claims.
Hank, I show in my original post line by line what the cost is to the state and how they would pay less by $118 billion in real dollars. One large factor is that over $500 billion is tax free. A nominal calculation is meaningless.
Morphh,
I’ve spent more than a little time trying to understand your analysis (again), and I have some disagreements.
Your total current State/Local spending of $1659 B looks to be too large by $163B. You added in a capital consumption allowance(?) which maybe shouldn’t be included? Next, you inflated the $1659 by 17% to $1941, calculated the increases and decreases for each sub item of education, investment, goods, services and the fee, and concluded that since the total of $1823B was less than the inflated cost of $1941B, the tax burden on S/L was $118B less under the Fairtax. I don’t agree!
By inflating the entire consumption and then determining the actual increased costs, what did you expect to find? Because the actuals included tax free spending, the actual cost had to be less than the inflated estimate.
My study of some years ago had identical cost increases for each of the sub items except I forgot the fee. I’m in agreement that the after tax consumption by S/L governments would be $1823B. However, I compared that number to my baseline current estimate of $1496B, ($1333 + $163), and found that the total increase in S/L spending would be $327B. That is almost identical to the increase reported in the Fox-Murray report.
I have been writing that there would be an impact on S/L governments which would require increased tax rates or other possible solutions. You have been correcting me by insisting that not only would the S/L tax burden be less, but the solution would be simply to shift some of the windfall from taxpayers to the government, thus leaving everyone whole. Frankly, I think what we have here is a typical distinction without a difference? And it does lead to another question as to whether or not taxpayers would have sufficient added income to handle the increased retail costs.
You may have noticed the latest Fairtax Friday survey question about the importance of taking home 100% of gross pay? I think it’s very important but for reasons AFFT may not agree with. AFFT has been saying that the increased pay would save homeowners from bankruptcy, increase savings, etc. etc. I think the increased pay would not even offset the retail price increase, and if it were not for the FCA, everyone would be in deep trouble economically.
Hank, I’ll double check what I included in the math, but we do have to compare the real value, not the nominal value. I completely agree that the nominal value will increase, but that doesn’t tell your the impact on purchasing power. It may be easier if we used a non-accommodation model for the calculation. What you were writing was that S/L government taxes would increase, not tax rates, which I think we’ve clarified the distinction. Also, my premise was that the State’s tax base decreased, so people would be paying less even in nominal dollars. Inflation is another matter and completely dependent on the accommodation.. either the tax base includes inflation or it doesn’t. Not adjusting for it would be giving a windfall to the individual from the S/L government. It may take me a little time to reread the Kotlikoff and Murry/Fox papers - then I’ll comment on the accuracy of figures.
Morphh, Good idea. While you are rechecking the data, lets try to agree on what “real” means. For instance, I expect retail prices to rise by a nominal 17%, but if income rises by at least that much, then real prices would be unchanged. (We need to take care to understand what happens to those lower income workers that don’t get as large a pay raise due to not paying any income tax currently.)
Now as to State revenues, the reduction in the tax base by 10% due to eliminating business tax costs means that nominal tax collections are reduced by 10%, but by raising the State tax rates, real revenue can remain the same. The same result could be accomplished by widening the tax base or taxing the tax.
Have I got it about right?
Hank, that all sounds correct to me. I’ll add that inflation through accommodation measures will affect retired seniors more than workers, as inflation decreases the value of savings.