Kotlikoff study 23 fairtax revenue neutral

Kotlikoff Study: 23% FairTax = Revenue Neutral

October 2, 2006 · Filed under: Education

Thanks to (FairTax critic) Hayden Kepner for pointing out that Boston University Economics Professor Laurence Kotlikoff’s much-anticipated study of the necessary revenue-neutral rate for the FairTax has been published and released.

Actually, the study was conducted by several economists in the Beacon Hill Institute at Suffolk University, including Paul Bachman and Jonathan Haughton, with help from Kotlikoff.

The full study is available on Kotlikoff’s web site at Boston University and I’m making it available here on our site as well.

Here is the abstract:

Abstract

As specified in Congressional bill H.R. 25/S. 25, the FairTax is a proposal to replace the federal personal income tax, corporate income tax, payroll (FICA) tax, capital gains, alternative minimum, self-employment, and estate and gifts taxes with a single-rate federal retail sales tax. The FairTax also provides a prebate to each household based on its demographic composition. The prebate is set to ensure that households pay no taxes net on spending up to the poverty level.

Bill Gale (2005) and the President’s Advisory Panel on Federal Tax Reform (2005) suggest that the effective (tax inclusive) tax rate needed to implement H.R. 25 is far higher than the proposed 23% rate. This study, which builds on Gale’s (2005) analysis, shows that a 23% rate is eminently feasible and suggests why Gale and the Tax Panel reached the opposite conclusion.

This paper begins by projecting the FairTax’s 2007 tax base net of its rebate. Next it calculates the tax rate needed to maintain the real levels of federal and state spending under the FairTax. It then determines if an effective rate of 23% would be sufficient to fund 2007 estimated spending or if not, the amount by which non-Social Security federal expenditures would need to be reduced. Finally, it shows that the FairTax imposes no additional real fiscal burdens on state and local government, notwithstanding the requirement that such governments pay the FairTax when they purchase goods and services.

Implementing the FairTax rate of 23% would produce $2,586 billion in federal tax revenues which is $358 billion more than the $2,228 billion in tax revenues generated by the taxes it repeals. Adjusting the base for the prebate and the administrative credit paid to businesses and states for collecting the tax results in a net tax base of $9,355 billion. In 2007, spending at current levels is projected to be $3,285 billion. Revenues from the FairTax at a 23% tax rate, plus other federal revenues, are estimated to yield $3,209 billion which is $76 billion less than current CBO spending projections for 2007. The $76 billion amounts to only 2.73% of non-Social Security spending ($2,177 – $2,101). This is a remarkably small adjustment when set against the more than 30% rise in the real value of these expenditures since 2000.

Ensuring real revenue neutrality at the federal level, given the net base of $9,355 billion, implies a rate of 23.82% on a tax-inclusive basis and 31.27% on a tax-exclusive basis. These and other calculations presented here ignore a) general equilibrium feedback (supply-side and demand-side) effects that could significantly raise the FairTax base (see, for example, Kotlikoff and Jokisch, 2005), b) the possibility that tax evasion would exceed the considerable amount automatically incorporated here via the use of NIPA data, which undercount consumption expenditures due to evasion under the current tax system, and c) the roughly $1 trillion real capital gain the federal government would secure on its outstanding nominal debt, were consumer prices to rise by the full amount of the FairTax.

The FairTax redistributes real purchasing power from state and local governments to their state and local income-tax taxpayers. It does so by reducing factor prices relative to consumer prices and, thereby, reducing the real value (measured at consumer prices) of state and local income tax payments, which are assessed on factor incomes (namely, factor supplies times factor prices).

Gale (2005) and the Tax Panel (2005) recognized this loss in real state and local government revenues in claiming that these governments need to be compensated for having to pay the FairTax. But what they apparently missed is that this loss to these governments is exactly offset by a gain to their taxpayers.

Were state and local governments to maintain their real income tax collections – the assumption made here – by increasing their tax rates appropriately, their taxpayers’ real tax burdens would remain unchanged and there would be no need for the federal government to compensate state and local governments for having to pay the FairTax on their purchases. The second is that H.R. 25 does not preclude state and local governments from levying their sales taxes on the FairTax-inclusive price of consumer goods and services. This produces significantly more revenue compared to levying their sales taxes on producer prices.

Moreover, Gale (2005) and the Tax Panel (2005) arrived at a higher tax rate because they did not estimate the Fairtax rate, but instead estimated a sales tax of their own design which had a substantially narrower base.

Hayden promises to send us his best criticism after he’s finished reading the study, so we’d better all be reading it ourselves, too.

Posted by Joshua Zader  ·  Trackback URL  ·  Link

35 Responses to “Kotlikoff Study: 23% FairTax = Revenue Neutral”

[…] But, as we shall see, there is yet again another major study that has been conducted that definitively illustrates the merit of the Fair Tax. As has been reported by The Fair Tax Blog, Boston University Economics Professor Laurence Kotlikoff’s much-anticipated study of the necessary revenue-neutral rate for the FairTax has been published and released. Terry and I will refrain from reproducing the entire study, but peruse through the abstract below to see just how much the supporters already know! […]

Publius Rendezvous » FairTax Blogburst  · Oct 3, 2006 at 7:19 pm ·  Permalink

FairTax Blogburst

by Jonathan Garner of Publius Rendezvous It has been interesting lately to observe just what the critics of the Fair Tax have to say. Lately, much of what has been said has centered around percentages. Clever as it may be…

Hold The Mayo  · Oct 3, 2006 at 7:53 pm ·  Permalink

OK, Joshua.

Riddle me this: Isn’t a good libertarian like you somewhat concerned about the chart on page 20 of the study, which indicates that even with an inclusive tax rate of 23.85%, the federal deficit in 2007 would be approximately $476 billion. (Which means that at 23%, the deficit would be over $550 billion.)

Doesn’t this prove that the FairTax DOESN’T work?

Hayden Kepner  · Oct 5, 2006 at 9:49 am ·  Permalink

Hayden,

Whoa, is that really the best criticism you’ve got? This must be a good study!

The deficit is influenced by many things — Congressional spending, etc. — over which the FairTax has little or no control. So, no, deficit levels are not particularly concerning to me, by themselves.

I’d be interest in quadrupole’s take on this subject, if he cares to comment.

Joshua

Joshua Zader  · Oct 5, 2006 at 10:07 am ·  Permalink

Hayden

The FairTax seeks to be revenue neutral. What that means is that the deficit would have been $476 billion either under the existing system or under the FairTax. The reason for this is quite simple. The FairTax is *only* about replacing the tax *system*. The question of how to reduce the deficit can be approached two ways:

1) Increase revenue

2) Decrease spending

How one balances the choices involved in deficit reduction is a very contentious issue, and frankly one that has NOTHING to do with the FairTax. If you believe increased revenue is the solution *and* you believe that tax rates do not effect economic growth, then you can crank up the tax rate (either traditional or FairTax). If you believe reducing spending is the solution (or actually, just holding the line on spending would do, but I show my own biases there), the you can do that. The choice of tax system is orthogonal to the deficit reduction question. Making the FairTax revenue neutral makes that orthogonality explicite.

quadrupole  · Oct 5, 2006 at 8:12 pm ·  Permalink

Keep up the good work!

James A. Hodges  · Oct 8, 2006 at 12:55 pm ·  Permalink

I can’t let Hayden take all the heat for any criticisms of the new base/rate study. After waiting over one year for it’s arrival, I, too, was disappointed in the study methodology. No real quarrel with the numbers, although one might wonder why 40% of state sales taxes was left in the consumption base, (page 8, line 16)? Items in the base are supposed to be subject to the Fairtax, but state sales taxes won’t raise one dime in Federal revenue it seems to me?? Higher base equals lower rate!!!???

Although the study claims to have addressed the important issue of the impact of taxing government consumption at all levels, BHI really took a pass on that one. By assuming real spending neutrality, (a new constraint), in addition to revenue neutrality, the study group was able to determine the sales tax rate of 31.2% without having to deal with any estimates of what will most likely happen to wages, prices, etc. The report concludes that states can simply raise other taxes to offset any revenue shortfall caused by the Fairtax, or even tax the Fairtax inclusive price which clearly violates one of the main goals of HR25–avoiding double, multiple or cascading taxation. As for how the Federal government might offset their net cost of the Fairtax, nothing is offered, although spending neutrality seems to imply reducing other discretionary spending to offset any revenue shortfall? In short, the impact on governments is still a mystery and awaits furthur study!

(I estimate that states will need over $300 billion annually to pay for the Fairtax, and the Federal government will need to find $200 billion in offsets. I have a short two pager which backs up my claims if anyone wants to see it.)

As for the annual deficit which is described as $487 billion, I believe it’s much higher–closer to $1 trillion in the first year. That estimate consists of the CBO forecast of $350 billion for 2007, $354 billion in inventory credits, and $200 billion in net costs to the Federal government as discussed above. Not a pretty picture during transition.

Finally, the study emphasis on 23% inclusive rates is clearly misleading. What was the point of the study effort to show how little government spending would have to be reduced to hit the magic 23% on the nose? Or show what the rate would be without the prebate?? This is a national sales tax, and no one cares what the inclusive rate is! 20 million retailers simply want to know what the sales tax rate is in order to come up with the final price at the register. That rate is 31.2% and efforts to cover up that number are just plain wrong!

Hank Van Gieson  · Oct 17, 2006 at 4:45 am ·  Permalink

To change tax structures, yet remain tax neutral, some people will have to pay effectively higher taxes while some people will pay lower effective taxes. Who will be the winners and losers?

Steve  · Oct 31, 2006 at 1:54 pm ·  Permalink

Steve,

You left no e-mail address or last name, and you’re asking a well-worn question — all of which suggests you’re probably a practiced troll who won’t bother to actually participate in conversation. But here’s an answer anyway, for anyone who cares to listen.

The Winners: People overpaying taxes now, including most law-abiding lower- and middle-class American citizens, as well as any high-income citizens who save or invest a relatively larger percentage of their income than they spend.

The Losers: People underpaying taxes now, including 20 million illegal immigrants, 48 million tourists who pay no income taxes, trust fund babies who make little money of their own but spend like there’s no tomorrow, and an incalculable number of “underground economy” criminals who will never pay income tax but spend their booty on consumer goods like the rest of us.

Joshua

Joshua Zader  · Oct 31, 2006 at 3:29 pm ·  Permalink

OK, let’s try again with this:

If you increase the number of people paying taxes, then EVERYONE can pay less.

The FairTax increases the number of taxpayers by reducing the number of people who can cheat on taxes, removing the myriad numbers of exemptions from taxes, and by taxing consumption rather than income.

This means that more people will be paying, and will have fewer means or opportunities to reduce or avoid taxation. In the end, EVERYONE will be able to have a lower tax rate because of this.

James Kidd  · Oct 31, 2006 at 3:51 pm ·  Permalink

First, thanks for posting my response and responding. Sorry if I appeared as a troll, but I really was just asking an honest question. Someone just brought this tax alternative to my attention and I’m really on the fence about this whole issue. I want to be as well informed as possible so I might have a few more questions, and I will try to make them as neutral as possible.

I am currently working on my budget right now and I want to compare my current income tax with what I would be paying in fairtax. (I am aware that fairtax will change some other economic variables. If anyone has an income tax to fairtax calculator that includes estimated changes to those variables, it would be great.) I was hoping to share my findings with you (and others) if you are interested. That’s why I didn’t want to use an actual email address because I will be sharing some of my spending habits. I did use my real first name though.

So that you know where I am coming from. I am in my mid-twenties, married, recently bought a small house, no kids, just finished college a few years ago, and work full-time. Both my wife and I make over the median income for our area and almost exactly the median income for the nation. I invest 5% of my income in a 401k, but have not been able to save/invest much more quite yet while we pay down our debt.

Steve  · Nov 1, 2006 at 3:00 pm ·  Permalink

Well here is how it would likely break down:

Assuming you each make ~$45,000 per year, you probably are getting close to 25% of your collective pay withheld each check. This is around $10,800 per year from each check or close to $22,000.

So let’s run with that $22,000.

Starting off the bat, with the FairTax, you would likely be getting your gross pay, rather than net pay. So you would immediately be getting around $1833 more a month in take home pay (estimates here obviously, sorry if my math isn’t quite perfect).

In addition to that, you would register yourself and your wife for the prebate, which would be an additional $376 per month to account for taxes on the necessities.

Your 401k plan would still be available to you, but since there would no longer be an income tax penalty (no more income tax) for pulling money out early, you might consider a more traditional brokerage account, since a 401k will no longer have a real tax advantage.

Then there is the sales tax.

You will probably see many things have price increases of as much as 15%. However, over the first couple of years, prices will likely fall to remove much of the price increases. You should expect in the short term, that cost of living will go up, but you’ll have (in your case) roughly 25% more take-home pay and the prebate, which will more than cover that.

What will cost more and what will cost less greatly depends on the individual business situations of each producer, so some things may be significantly more expensive, and others will not (it depends on how much tax component exists in their prices today).

Your house note may see a small increase in interest from a sales tax on a fraction of the interest (interest rate minus treasury note rate). This would be very small, but over a couple of years, interest rates are forecasted to go down with the FairTax plan, so you might want to look into refinancing to get a better rate (even after tax). Your school loans will be in the same boat.

James Kidd  · Nov 2, 2006 at 10:00 am ·  Perma

James,

You write: “Starting off the bat, with the FairTax, you would likely be getting your gross pay, rather than net pay. So you would immediately be getting around $1833 more a month in take home pay.”

This isn’t actually true. It’s more likely that your old net income will become your new gross income, or something close to it.

Boortz described this incorrectly in the first edition of The FairTax Book, and corrected it later, to set the record straight.

There are many, many benefits to the FairTax, but getting a large, instantaneous raise from your boss (or the government or whomever) isn’t one of them.

The money you had been paying in income tax could end up in your pocket, but it’s more likely that you’d only receive a small portion of the money, and the rest of it would get distributed in ways that are dictated by market forces.

As Boortz says: “It is certainly true that after the FairTax becomes law there will be no more withholding from your paycheck for any federal taxes. What you earn is what you get. This is not to say that your gross pay will equal what it was before the FairTax. This will depend on what your employer does when the embedded costs represented by the tax burden you have passed on to your employer disappear.”

See Boortz’s full explanation for additional information on this topic.

Joshua

Joshua Zader  · Nov 2, 2006 at 11:08 am ·  Permalink

I fully understand that, and have been aware of this element of the bill for some time (I had the audiobook, which includes the correction you mention).

However, I disagree that wages would have that much impetus to drop. Dropping wages is a difficult thing for an employer to do even under very profitable circumstances, because it usually makes employees flee in droves. Reducing benefits is far easier, for example.

This is a reverse economic pressure, that employees will almost NEVER ‘negotiate’ or ‘accept’ less pay. Only very high-paid employees (like airline pilots for an example) usually will accept a pay cut ‘for the good of the company,’ and that requires legal work, talking to unions, etc.

It is true that if an employer does NOT lower the wages of his employees, his prices will be higher than they are today, to the tune of perhaps 10-20%. But this will create a very fluid situation.

The pressure to drop prices for consumers will also be countered to some degree by a pressure to keep gross wages at their previous levels. For a businessman, this may be a difficult choice, but I believe it to be very likely that prices will suffer before wages will, simply because it is easier (short-term) to charge a high price than to attempt to reduce gross wages for employees. Some compromise might be acceptable, some loss of gross wages but not a complete drop to your previous take-home level, but these solutions will vary from industry to industry, and again will have to take into account the legal agreements between employers and employees.

The bottom line is the FairTax bill does nothing to alter your wages. Nor does it alter your contracts or agreements for employment. If you are salaried or contracted, I would think your pay would be well-protected from being reduced, since you are likely held to contract with your employer.

On another note, there is the minimum wage. Do you think the gross minimum wage would get lowered in order to help prices out? Not likely. And the FairTax does not try to.

I DO believe that employers will try to hire new employees for reduced gross wages after the FairTax is passed, as wages will not need to be inflated as much to account for a particular standard of living, but working out the new cost of living after the FairTax may require a few years to settle on.

However, thank you for adding clarity to the fact that there is no such thing as a free lunch. Wages may go down a bit, prices may go up a bit, and in the grand scheme of things it will all work out. We should all be paying a bit less, and keeping a bit more, and that’s the important thing for most of us.

James Kidd  · Nov 2, 2006 at 12:37 pm ·  Permalink

James is correct on this. People should get their gross pay and prices will increase. However, production costs will still decrease by embedded compliance costs, corporate taxes, and employer portion of payroll taxes. Social Security payments are also indexed to any price increase. Employees have a contract and will end up paying the gross pay. This implied by Kotlikoff and studied in the Arduin, Laffer & Moore Econometrics analysis http://www.fairtax.org/PDF/MacroeconomicAnalysisofFairTax.pdf

Steve, I know this is a bit of reading but take a look at Kotlikoff’s paper (charts at the end) “Comparing Average and Marginal Tax Rates under the FairTax and the Current System of Federal Taxation” http://people.bu.edu/kotlikoff/Comparing%20Average%20and%20Marginal%20Tax%20Rates%2010-17-06.pdf Another one of his studies also discusses the purchasing power increase “Simulating the Dynamic Macroeconomic and Microeconomic Effects of the Fairtax” http://people.bu.edu/kotlikoff/Simulating%20the%20Dynamic%20Macroeconomic,%20October%204,%202006.pdf

I’m glad to see you looking at the FairTax and know you will find it to be the only solution that addresses many of the impending economic issues facing our country.

Jeff  · Nov 2, 2006 at 2:15 pm ·  Permalink

A little belated but in case Joshua still believes current net pay will be the future gross, here are a couple of more thoughts to help understand that that is not going to happen. First, the fairness issue regarding withholding. Everyone withholds differently depending on how you fill out the W-4. Some underwithhold and write a check in April, and others overwithhold, perhaps because they like to see a Treasury check in April. (Personally, interest free loans to Uncle Sam in the latter case seem very unappealing, but forced savings may have it’s merits?)

So, it would be very unfair to simply reduce everyone’s pay check by the withheld amount. And imagine the rush to submit revised W-4′s if this bill ever passed.

And now, the perspective from a retirees view point. If you believe that workers pay will be reduced in order to avoid a price increase, there are two outcomes for retirees. First, we keep all of our pensions, and enjoy the lower prices that you workers have ensured by taking a pay cut. Very noble of you, but unlikely. Or, perhaps you are suggesting that all retirees pension checks should also be reduced somehow. AARP doesn’t favor the Fairtax as is, let alone if you continue to insist that all pensions need to be reduced in the hopes that retailers will also lower prices at the cash register. Come on, Josh, there won’t be any pay reductions as you claim, and prices will rise, at least initially. So, it’s really not a free lunch, is it”. But it’s fair!

Hank Van Gieson  · Nov 3, 2006 at 9:36 am ·  Permalink

Regarding the BHI/Kotlikoff study, I have a question. Bear with me, the question background takes longer than the question. The study says that the federal consumption for 2007 is $900 billion, of which 38% is for payroll, ($342 billion). HR25 says that the national sales tax will be applied to the burdened cost of payrolls. Assuming that the burdened cost is 150% of the actual payroll cost, the burdened cost would be $513 billion. (Note: Researching burdened costs, I found estimates ranging from 40% to 80%. If anyone has a better number than my assumed 50%, I’d welcome it.) Taxing the burdened payroll at 31% results in a tax of $159 billion. This amount can be somewhat offset by the savings resulting from the government no longer having to pay the employer share of FICA (7.65%), a savings of $26 billion. The net cost of taxing burdened payrolls is therefore $133 billion annually.

I believe the Fairtax rate was increased from 19% to 23% to pay for the prebate. My question is-why wasn’t the rate also increased to 25.2% to pay for the net cost of taxing payrolls? As written, it seems to me that the 23% rate in HR25 is not revenue neutral. What am I missing?

Hank Van Gieson  · Nov 20, 2006 at 9:46 am ·  Permalink

OK I am confused. Please point me to the section of HR25 that you are talking about before I answer, because you are using terms I have not seen anywhere in the bill. I am also running on little sleep today, bear with me.

Specifically, what do you mean by ‘HR25 says that the national sales tax will be applied to the burdened cost of payrolls’? What section of the bill are you referencing here?

James Kidd  · Nov 20, 2006 at 10:23 am ·  Permalink

O.K., have another cup of coffee and look up in HR25: Title ll, Subtitle A, Chapter 1, Sec. 2(17). In case I screwed up the reference, here is the thing verbatim. “(17) WAGES AND SALARY- The terms `wage’ and `salary’ mean all compensation paid for employment service including cash compensation, employee benefits, disability insurance, or wage replacement insurance payments, unemployment compensation insurance, workers’ compensation insurance, and the fair market value of any other consideration paid by an employer to an employee in consideration for employment services rendered.”

This is my basis for using “burdened” payrolls to calculate the sales tax. What do you think?

Hank Van Gieson  · Nov 20, 2006 at 10:43 am ·  Permalink

That section simply defines what the terms wages and salary mean for the rest of the document. The definition itself does not state that anything will or will not be taxed under the bill. Is there something else you saw that made you think the government would tax its own payrolls? Or am I still misunderstanding you?

James Kidd  · Nov 20, 2006 at 11:26 am ·  Permalink

No misunderstanding. I thought it was pretty well settled that governments at all levels would pay the tax on the services provided by employees, valued by the payroll amount. My problem this afternoon is that I can’t point to a specific cite confirming my position. The Boortz bible simply says that all government purchases will be taxed. The BHI base/rate study includes government wages and salaries in their government consumption base, with the exception of salaries spent for education purposes. The Presidents Tax Reform Commission report notes that state/local governments must pay a tax on the value of their payrolls. I certainly could be mistaken and I’m still looking for something that I have previously seen, but maybe other bloggers could weigh in with information and opinions?

Hank Van Gieson  · Nov 20, 2006 at 12:57 pm ·  Permalink

I believe Hank is correct on this.

Chapter 9 (12)(ii) defines “any government except for government enterprises” (government enterprise being like the post office) as a taxable employer. Section 103(b)(2) states “In the case of wages or salary paid by a taxable employer which are taxable services, the employer shall remit the tax imposed by section 101″.

So I believe the government will pay 23% on salary paid as it is a taxable employer. This is required to keep government and private industry on equal ground, so that government does not have a tax advantage in providing services. For example, private industry has to remit 23% on services provided – this puts their cost of doing business at $10.00. The government does the same service but does not collect any income from the public – It offers these services for “free” and because they don’t have to remit taxes, they can do the job for $8.00. For this reason, the FairTax makes government pay 23% on payrolls to put their cost of business equal to private indusry. So now it cost the government $10.00 as well and they remit 23%.

Jeff  · Nov 20, 2006 at 3:06 pm ·  Permalink

Hank, why don’t you e-mail Kotlikoff if you have a question with regard to the neutral rate. He is quite friendly and should answer your question. I’m sure the factoring is somewhere in the math and I expect Beacon Hill did not forget these $$.

Jeff  · Nov 20, 2006 at 3:19 pm ·  Permalink

OK now I see what everyone’s talking about. ALL government employees are treated sort of like contract labor that the government consumes. All governments (state, local, and federal) have to pay 23% of the salaries and wages as FairTax.

This is a portion of the bill I knew about but had glossed over. It doesn’t impair the Fed because they get their own tax money back. For the states, they send their money straight to the Fed. This is still essentially similar to the position they are in now because of income taxes, but keeps the governments from gaining any real monetary benefit from the FairTax (unless they are a government enterprise like the USPS).

Thanks Jeff for pointing out what Hank was speaking about.

James Kidd  · Nov 20, 2006 at 3:27 pm ·  Permalink

Thanks, guys. Light just dawned on marblehead (me)! As far as the Fed goes, you are saying that they pay the tax out of one pocket and put it back in the Treasury out of the other pocket. No net change. Kind of a stupid concept if you ask me, but by adding government consumption to the base, the rate was kept at 23/30% or whatever. Very clever of those Houston tax lawyers that wrote HR25. Thanks for the input. I need to reconsider the impact on state/local governments, but I suspect there may be a very different result. Stay tuned.

P.S. I’ve been in contact with Larry K-he is very helpful as you suggest.

Hank Van Gieson  · Nov 20, 2006 at 3:57 pm ·  Permalink

I don’t know if it’s all that stupid. Federal employees (agents, soldiers, officials, etc) today pay income taxes, and isn’t that kind of the government paying itself with its own funds? Why don’t they get tax-free incomes or something if it’s all the same to the Fed?

James Kidd  · Nov 21, 2006 at 3:17 pm ·  Permalink

I don’t think it’s quite the same at all. And your comment makes me think you believe that if HR25 becomes law, everyone will have their pay cut back to the current take home level? That isn’t going to happen for fairness and contractual reasons, but if you don’t agree, perhaps a separate discussion would be useful?

My comment about stupid relates to the absolute fact that governments can’t tax themselves into prosperity. That’s the stupid idea. To illustrate: I’ve got a great plan!!! Why not simply tax governments at a 100% rate and the rest of us citizens won’t have to pay any tax at all?!? Government consumption is around $2 trillion, taxed at a 100% rate will yield $2 trillion which is just about revenue neutral for 2007. Do you think that would work? Doesn’t anyone else understand the economic stupidity of governments taxing themselves?

Hank Van Gieson  · Nov 22, 2006 at 4:57 am ·  Permalink

I understand what you are saying, but let me clarify my point: I am NOT advocating the fact the governments should tax themselves as being a wonderful idea. I was just being facetious. And if you had read much of my earlier posts, you would know I don’t think that pay would scale back to current net levels.

What this element of HR25 does is prevent government from having an unfair economic advantage over private businesses.

For example, today the government hires a mix of government servants and contractors to perform its various and sundry jobs. If under the FairTax, the government was treated as a business, then it would be to its economic advantage to only use government servants, rather than contractors, who would be charging increased prices due to the FairTax. Now again, this is more of an issue for state governments than for the Federal government, but the principle remains. Each Federal agency doing any hiring still has a budget to conform to and will be constrained by prices in a real way, even if revenues might play out as zero-sum.

To illustrate, to fill a 40K-per-year slot with a contractor would cost $52,000 if the contractor expects to keep $40,000 for his year’s work. His company would charge the $52,000 over the year and remit $12,000 as taxes. A government employee, if the government wasn’t taxed, would be a simple $40,000 wage. This is an unfair advantage for any government, and would discourage government consumption from the private sector (something we don’t want since the private sector is generally much more efficient). The bill simply taxes government consumption of employees services at the same rate it would were they outside contractors. This should help nudge the government towards minimizing its use of government servants and using private industry for more things.

James Kidd  · Nov 22, 2006 at 9:43 am ·  Permalink

One added thing to Hank’s point…

If we removed all income taxes paid today by government employees and officials to the government itself, and considered this ‘self-taxation’ money NOT to be part of the revenue we were replacing, then I think that taxing the government’s employees’ wages might not be necessary to keep the rate the same. I was just illustrating that as silly as it sounds for the government to tax itself, it does this already.

James Kidd  · Nov 22, 2006 at 9:46 am ·  Permalink

O.K., you’ve convinced me that taxing the Federal government is really just a shell game to keep the Fairtax rate lower. But I don’t agree with the other reasons you give for taxing governments. I’m no personnel expert, but your $40,000 employee which you say would cost $52,000 if hired from a contractor, would really cost the government $60,000 if they hired in-house. The burdened cost of government employees is one of the major reasons governments use contract labor today. It’s competitive, no worries about pensions, sick days, vacations, firing for cause, etc. etc., and it is a lot cheaper. Other than prisoners making license plates, can you give me some examples of governments competing successfully with the private sector? I think that whole line of reasoning is a red herring, and the real reason to tax governments is to broaden the tax base and reduce the rate. If taxing governments was such a good idea, why don’t the states like Florida do it now? (In Florida, all government agencies are exempt from the 6% sales tax.)

Now, what is the economic impact of taxing state and local governments. Using the data provided in the Kotlikoff/BHI report, it is clear that there would be a net $300 billion tax cost. Unlike the federal shell game, that $300 billion is real dollars that have to be sent off to Washington, D.C. Where will the additional revenue come from? You guessed it—all of us, in the form of higher taxes on income, real estate, or sales taxes. Or, it has been suggested that the states could simply adopt a state Fairtax. Don’t hold your breath! State, county, and local municipality taxes number in the tens of thousands across the country, all presumably voted in by the local constituency based on local conditions. Now comes Uncle Sam with a “one tax fits all” approach. I’d expect quite a bit of resistance to this proposition. Oh, and by the way, again using the BHI data, the non federal “Fairtax” would be on the order of 15% exclusive, spread across the taxing agencies. Add that to the Federal 31% and you can see that the register price will be almost doubled due to sales taxes. And we haven’t even begun to talk about the cost of prebates at all levels of government to provide progressivity. Talk about a nightmare scenario.

All of which leads me to my final thought. The impact on state/local governments is of such magnitude that a constitutional challenge on the basis of intergovernmental tax immunity is all but assured. The BHI report states that the burden imposed by the Fairtax would not differ materially from the burden imposed under current law. What that refers to according to the Fairtax staff is that the states are required to pay a share of FICA as well as collect and forward the SS tax revenue, and they say that has been found to be constitutional. Anyone who thinks that equates to taxing the state/local governments out of $300 billion annually should now raise their hand??? I’m still trying to get in touch with General Schmitz who wrote the 2000 article about the constitutionality issue. His article assumes there would be no negative impact of the Fairtax on states and concluded it would not create any constitutional issues. He might want to reconsider that conclusion based on $300 billion reasons.

Hank Van Gieson  · Nov 23, 2006 at 10:02 am ·  Permalink

I appreciate the point you are trying to make here, and it is smart to point out that the cost of local and state government will increase.

It could indeed mean local and state tax hikes. However, most state and local taxes are minor components of most individual’s tax burdens. So let’s get some perspective on the numbers. In general, Federal taxes are at least three-fifths of an individuals tax burden and state taxes only two-fifths and sometimes a great deal less. For an article detailing this for Nebraska, see this link (other states data are available at the same site):

http://www.taxfoundation.org/taxdata/show/466.html

A proportional increase in state taxation across the board of 30% (a worst case scenario that many people would not face) exclusively would only increase the overall effective tax rate of most people by roughly 12%, an amount generally considered to be more than offset in virtually every income category by cutting their Federal effective tax rate with the FairTax by one-half or more in many cases.

I would use myself as an example. I live in Nebraska, ranked #6 in the nation when it comes to local tax burdens (high property taxes here, yeesh, and they tax your automobiles too), so I have a bit of a stake in this. Our tax burden from local and state is 11.6%, so a straight increase of 30% on my local taxes would only be a 3.48% increase in effective tax burdens, if I get hit with all three barrels of state and local taxation (property, income, and sales taxes) at the full 30% proportional increase. Now I don’t know about you, but I could handle that in my town, since my effective Federal rate would be at least 12% lower.

So let’s not panic just yet.

James Kidd  · Nov 24, 2006 at 9:16 pm ·  Permalink

I need to make a bit of a clarification here. In one of my previous paragraphs I said effective tax rates could be increased by 12%.

I should have added ’12% of their previous levels’. So if you had a 30% effective rate before, it would be 3.6% increase. Don’t want to seem to be contradicting my own numbers.

James Kidd  · Nov 24, 2006 at 9:21 pm ·  Permalink

[…] But, as we shall see, there is yet again another major study that has been conducted that definitively illustrates the merit of the Fair Tax. As has been reported by The Fair Tax Blog (http://www.fairtaxblog.com/20061002/kotlikoff-study-23-fairtax-revenue-neutral/), Boston University Economics Professor Laurence Kotlikoff’s much-anticipated study of the necessary revenue-neutral rate for the FairTax has been published and released. Terry and I will refrain from reproducing the entire study, but peruse through the abstract below to see just how much the supporters already know! […]

Liberally Conservative » Blog Archive » FairTax Blogburst  · Nov 30, 2006 at 3:19 pm ·  Permalink

Time to get moving on this legislation!!!

http://edgemedia.info/2007/03/25/lets-abolish-the-irs/

Edge  · Mar 25, 2007 at 4:16 pm ·  Permalink

Kotlikoff Study: 23% FairTax = Revenue Neutral

Bill Gale (2005) and the President’s Advisory Panel on Federal Tax Reform (2005) suggest that the effective (tax inclusive) …

The Saloon dot net  · Mar 25, 2007 at 10:15 pm ·