Taxation of Government Consumption

May 6, 2013  ·  Filed under: Criticisms

Taxing of State and Local consumption and non-education salaries is approximately 9% of the FairTax base, but is it proper and constitutional?  Jim Bennett and Hank Van Gieson go for Round 2 in the debate (see Round 1 from 2010).  On this topic, AFFT’s Karen Walby submitted this to the Congressional record:

Public finance economists realize that the current system imposes taxes on government, albeit indirectly through the higher wages government must pay its employees, the payroll taxes it must pay, and the higher payments it makes to government contractors, than would otherwise be the case if there were no federal income tax system. They further realize that when you shift from an income tax to a consumption tax you must maintain the same “tax wedge” in government. Not doing so would distort the private marketplace, creating an incentive to consume through the medium of government. Federal taxation of units of government has already been upheld by the Supreme Court when it affirmed that the federal government could require all units of government to pay payroll taxes on wages paid to its employees. acknowledges that increased revenue from taxing federal government consumption is exactly canceled by increased costs in the federal budget (as pointed out by the tax panel). What the tax panel neglected to point out is that this accounting method is used today by the Office of Management and Budget and Congressional Budget Office.

The FairTax taxes all consumption, including government consumption, once. Today, the income tax and payroll tax are imposed on government consumption by taxing government employees and government contractors, making government pay more than it would in the absence of these taxes. This tax revenue appears in the receipts column in the federal budget, and the added expense is counted in the federal budget as spending (exactly canceling each other out). Fortunately, at least in this respect, the federal budget is honestly presented.

This tax revenue currently “paid” by the federal government is part of the tax revenue that the FairTax replaces. The federal government could artificially reduce both spending and tax revenues by exempting its workers and contractors from both income and payroll taxes and lowering wages paid to employees and amounts paid to contractors accordingly. Similarly, the FairTax taxes government consumption and, like today, the expense and revenue would be reflected on the federal budget as such. If the FairTax were to exempt government from tax and if federal spending were held constant, then the purchasing power and size of the federal government as a share of the economy would be dramatically increased. Further, not taxing government consumption would artificially make government consumption appear cheaper and promote increased consumption via government. So, though a wash, there would be negative economic consequences if the FairTax did not continue the practice of taxing government consumption.

Hank has argued that taxing consumption is unnecessary to prevent government competition with the private sector due to Sec 704 and questions the constitutionality of it.

HR25, Sec. 704 took care of that problem by treating government agencies at any level that sell at least $2500 per quarter of goods or services as Government Enterprises. All Government Enterprises must collect and remit the 23% sales tax. There was no need to tax all government consumption. The playing field with the private sector was already level.

Furthermore, federal taxation of State and Local government consumption is unconstitutional. Sovereign powers do not tax each other, and the Supreme Court will throw out this feature under the long held doctrine of “intergovernmental tax immunity.” Your precedent for such taxation was also incorrect. The Supreme Court approved the Social Security plan because it allowed State and Local government employees a choice of whether or not to join the federal Social Security system. Many S/L government agencies decided to set up their own plan. HR25 wisely gives States a choice as to whether or not to act as the federal tax collector. A constitutional issue was thereby avoided. No such choice exists regarding the taxation of S/L government consumption.

Does Sec 704 make it unnecessary?  What about the tax wedge?  Should state and local government reflect the comparable costs of private providers, even if they’re not directly competing (applicable for outsourcing)?  Would shifting that cost away from the state present a more accurate picture of state / local cost vs federal cost, or a less accurate one?  No ear biting – Ding Ding Ding… Fight!

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12 Responses to “Taxation of Government Consumption”
  1. Morphh,

    A great job on the introductory set up, and thanks for digging up the 2010 thread with 41 comments which are still applicable. My request to renew this discussion was based on Jim Bennett and I discussing a VAT on another forum, a discussion that somehow spilled over to the subject of State sovereign rights and the inappropriateness of the federal government taxing State and Local government consumption. The subject is broader than that, it seems to me, so Morphh kindly expanded the issue to the overall question of taxing governments.

    In rereading all 41 comments from the 2010 thread, I need to make one significant correction. I used the term “unconstitutional” which is incorrect. Nothing in the constitution precludes the federal government from taxing S/L government consumption per se. The correct term, as used in the 2005 Bush tax commission report, is “inappropriate, not unconstitutional. I firmly believe that it would be inappropriate for such taxation as promoted in HR25 because our constitutional republic consists of two sovereign government powers, Federal and State, and sovereign powers can not and should not tax each other. We can discuss this further as we go along.

    While not applicable to this discussion, I also want to add to the previous comments my current take on the need for Federal monetary policy as it pertains to retail price increases under the Fairtax. AFFT and BHI have maintained that the economic formula, MV=PQ applies, and they assumed that V and Q were constant, therefore, Prices can only go up if the Money supply is increased by the Fed. Upon further research, I now believe that V is not a constant, and will greatly increase under the Fairtax. Think about it this way. The velocity of money has to be much greater when comparing income tax and payroll contribution withholding which is sent directly to the Treasury versus giving those funds to all of us to spend as we see fit. No comparison, imho. Retail prices can rise without any action by the Fed. imho.

    As for the Walby submission to the Congressional Record, I believe she was incorrect in her claim that the Supreme Court upheld federal taxation of other government units by approving FICA. Not true! The court approved the FICA plan only because it gave the States an option to either join the Federal plan or set up one of their own. Many government units did not join the federal plan. Where is the option for States to pay the tax directed in HR25? It isn’t there.

    My simplified argument is that it is inappropriate for the federal government to directly tax State and Local government consumption. The “tax wedge” is taken care of by Sec. 704 of HR25. And, the total cost of all governments can be reduced by an estimated 10% if their consumption is not taxed. Such a deal!!!

    I hope we get some comments from what used to be a very lively and informed group on this blog.

    Hank Van Gieson  ·  May 6, 2013 at 5:44 pm  ·  Permalink
  2. Hank,
    I applaud you for going from “unconstitutional” to “inappropriate.” That is a far more realistic and defensible position to take – and deserving of a more carefully crafted position for me to formulate.

    I’m out of pocket for the next few weeks, but I look forward to returning to this forum with a contribution.

    Jim Bennett  ·  May 15, 2013 at 4:58 pm  ·  Permalink
  3. Jim,

    Thanks for checking in–I had about given up on any substantive comments from what used to be the education center blog for unbiased Fairtax observers.

    Your assignment, if you choose to accept it, is to make a case for the appropriateness of the federal government directly taxing State and Local government consumption as directed in HR25. It seems to me that you will have to prove that the USofA is not a constitutional republic, or that sovereign powers can and should tax each other. A single precedent for such taxation will be necessary to make your case, imho.

    More generally, wouldn’t you have an easier task of selling the Fairtax if you could claim that the cost of governments at all levels would be reduced by 10% or so? That would be a one time saving of over $700 billion which is not chump change!



    Hank Van Gieson  ·  May 16, 2013 at 11:37 am  ·  Permalink
  4. While we wait eagerly for Lawyer Bennett’s take on sovereign powers, I can’t avoid raising an issue that is directly related. On May 16th, Cindy Canevaro, the AFFT marketing chief, released a press release in an effort to take Fairtax advantage of the current IRS scandal. What is interesting is her quote from Dan Mastromarco, the co-author of HR25. Here it is:

    ” These types of abuses of are nothing new,” said Dan Mastromarco, tax attorney and co-author of HR 25 / S 122. He added, “In 1819, Former Chief Justice John Marshall warned in McCulloch v. Maryland that, ‘An unlimited power to tax involves, necessarily, a power to destroy.’ The FairTax Act is the only way in which Congress can once and for all eliminate the harassment, political exploitation and selective enforcement against perceived dissidents. It levels the playing field and redistributes power to the citizens who pay the taxes.”

    It appears that Mastromarco, a noted tax lawyer, fails to recognize that the Marshall quote could be the death knell of the very Fairtax scheme Dan fathered. If the “power to tax is the power to destroy”, then isn’t the Fairtax proposal to let the Federal government tax State and Local government consumption, the end of our republic? Should the Fairtax be approved, won’t that make Ben Franklin clairvoyant when he responded to a question from a lady “Sir, what have you created?” with the historic answer-” A republic, madam, if you can keep it!”

    Folks, our Republic consists of two sovereign government powers, Federal and State. Sovereign government powers can not and should not tax each other. The Supreme Court doctrine of “intergovernmental tax immunity” has been chipped away at over the years, but never has there been a precedent for the sort of government taxation as proposed in HR25. Stay tuned.

    Hank Van Gieson  ·  May 18, 2013 at 1:54 am  ·  Permalink
  5. Seems Governments tax each other all the time. Everything they buy contains tons of taxes from all sorts of levels and layers, far and wide, directly and indirectly. Foreign states sell us their goods tax free? Seems the rule that sovereign states tax each other, not the exception. In any case, the tax power is broad, so it’s not like they’re just taxing them at that rate. It’s not like our current redistribution scheme that is really Federal extortion. That is a much more significant issue then a government paying taxes on the good and services they buy, just like everyone else. Heck, maybe it will keep them in check.. no special “this applies to you but not us” nonsense.

    Morphh  ·  May 18, 2013 at 2:21 am  ·  Permalink
  6. Morphh,

    Perhaps if I insert the word “direct”, you would get a better understanding of the issue. You seem to be leaning on the embedded tax concept, which was discredited long ago as a source of direct taxation. Embedded taxes impact only one thing, and that is retail prices you and I pay. Embedded taxes do not add one dime to our direct tax burden. And, it is impossible to calculate anyone’s embedded tax burden.

    There is no precedent for one government to tax another. However, if you want to nominate a candidate or two, go right ahead. Not an easy task, imho.

    Hank Van Gieson  ·  May 18, 2013 at 3:33 am  ·  Permalink
  7. It is not quite correct to say that “the FairTax taxes all consumption…” since homeowners get to enjoy untaxed housing consumption, greater than $1 trillion annually, according to the website.

    Terry Pratt  ·  Aug 29, 2013 at 7:22 pm  ·  Permalink
  8. Where can the state and local governments ever possibly get the money to pay the FairTax? Might they have to raise taxes on their citizens to cover the FairTax?

    And, they don’t now pay income tax on the tax money they get, so they will be newcomers to the federal tax system.

    It seem reasonable to not tax American state and local governments with the FairTax. These taxes will only be passed on to the people with the added expenses of administration through increased state and local taxation. It is far better and cheaper to simply raise the FairTax percentage than to use the S/L taxation scheme.

    At best, the HR 25 state and local government taxation is just another deception, like the inclusive/exclusive deception, to make the total tax look smaller than it really is.

    HR 25 is not a good start, and even a destructive beginning to a much needed real Fair Tax sales tax system to replace the income tax.

    Thanks, Phelbers

    Phelbers  ·  Oct 9, 2013 at 3:59 am  ·  Permalink
  9. Phelbers,

    Nice to have you check in again, and I certainly agree with your comments. However, if HR25 is revised to eliminate the very bad idea of governments taxing governments, the exclusive sales tax rate would jump to 43% based on the same data used in the 2006 Fairtax rate study done by BHI. I sorta don’t think that the Fairtax advocates are going to support such a revision? They will continue to lean on the very weak rationale for taxing governments which was built around the need to ensure that government agencies should not gain a competitive advantage over private sector businesses. The problem with that argument is Section 704 of HR25, which states that any government agency at any level which sells goods or services on the private market would be classified as a “government enterprise”, and would have to collect and remit the sales tax. No competitive advantage there, is there?

    Hank Van Gieson  ·  Oct 10, 2013 at 11:22 am  ·  Permalink
  10. I’d note that while excluding the local / state government from the FairTax base would make the FairTax rate go up, it would lower the cost of local / state government, thus reducing their tax rate. An increase in the FairTax rate would see an equal and opposite rate decrease at the state / local level (if they don’t try to keep the revenue windfall). Of course, there is no gain / loss by taxing the Federal Government as it pays itself. Both these effects are visible in the Gale and BHI models.

    Morphh  ·  Oct 10, 2013 at 12:50 pm  ·  Permalink
  11. Fairtaxing state and local governments is simply an AFFT/HR 25 way of hiding and secretly embedding taxes to make rates appear lower than they really are, ironically, just as the income tax now does. Elimination of hidden taxes/costs is a bulwark of the Fair Tax. It is contradictory of an underlying Fair Tax principle.

    As a strong advocate for a sales tax to replace the income tax, I would gladly accept a higher ate along with honest openness in the sales tax plan. Hank is absolutely correct, the present AFFT Fair Tax cabal would not accept higher rates over S/L exemption – they clearly have their own interests, not the nation’s, at heart. Or maybe they just think presenting an artificially low 23% will sell the plan.

    But even that total higher rate would be less than the total effective hidden rate with S/L taxation, because the added accounting and processing costs of passing the tax on to the citizens would necessarily be greater than simply including it in the base rate in the first place. Again, just where does AFFT believe the local governments will get the money to pay the FairTax?

    And, Morphh, I’d disagree with you on the federal no gain/loss point in one respect. These same handling, processing, and accounting costs in collecting and managing the sales tax would drive up tax consumption at the federal level as well. Just how much that would be I can’t say, but if the “As seen on TV” S/H rates are any clue, they won’t be cheap. The whole idea of FairTaxing government’s purchases is not well reasoned.

    And, I’m not too worried about government competition with the privater sector. I’ll take a Ford over a Trabant any day. And, as Hank suggests, wouldn’t the state government have to charge federal sales tax to the Trabant buyer anyway? Maybe I’m missing something on the AFFT competitiveness argument.

    FairTax opponents have valid disagreements with the HR 25 plan. And, the government tax is one of the strongest. Still, all of the HR 25 errors are readily fixable, but even with such remedies, the opponents summarily still reject a sales tax for other undisclosed reasons, perhaps such as being tax preparers, accountants, attorneys, IRS employees, and so on. Combined with the damaging hidden agendas of AFFT, and their very weak HR 25, the hope for replacing the income tax with a fair tax based plan is sadly still bleak.

    Thanks, Phelbers

    Phelbers  ·  Oct 10, 2013 at 2:50 pm  ·  Permalink
  12. It is not quite correct to say that “the FairTax taxes all consumption…” since homeowners get to enjoy untaxed housing consumption, greater than $1 trillion annually, according to the website.

    tony pepper  ·  Feb 5, 2015 at 10:54 pm  ·  Permalink