Hot damn!
A chance to discuss policy with someone who won't start attacking and insulting me if I criticize someone's pet tax system!
Did someone say “let's be civil”? Ok, I'll play.
I haven't read everything about the Fair Tax, but from what I can gather it's a proposal to replace all federal income taxes on individuals and corporations with a flat national sales tax of 23%. (It's actually 30% -- see below) If I mischaracterize anything, I am sure COG will correct me (in a civil way) since he is (or was) the biggest proponent of the idea. See (1)
Here's how a professional economist would evaluate the proposal. To judge whether it is "revenue-neutral" as claimed, we need to compare the revenues it would raise versus the revenues it would replace. For a quick and dirty estimate, let's start with the fact that the US economy is currently around $18 trillion in GNP. Personal consumption accounts for 70% or $12.6 trillion of this. So taxing all consumption at 23% would generate $2.9 trillion. Now adjust this number downward for two things – 1) deduct sales that are exempt under the Fair Tax and 2) deduct “leakage” from transactions going off the books to evade the tax. See (2)
If switching to the Fair Tax is expected to boost revenues by unleashing faster economic growth, as its advocates claim, then we need to quantify this impact. Assuming it would expand GNP by an extra 1% a year (which would be huge) would mean extra annual revenues of $29 billion in the above illustration – BEFORE any adjustments/deductions for exemptions and leakage. See (3)
Now what about the revenues that are replaced by the Fair Tax? That's easy to look up. Federal tax revenues are running at $3.2 trillion a year. Nearly all of that would go away if we switch to a Fair Tax.
So using my crude methodology, even under the most favorable assumptions (zero exemptions, zero leakage, and faster economic growth of 1% a year) the Fair Tax would not be revenue-neutral but would cut federal tax receipts by at least $270 billion a year. If we relax the favorable assumptions, the negative impact on revenues would be much higher. See (4)
Now let's consider the impact on prices. Start with the fact that everything subject to the new tax would immediately cost 23% more at the cash register. Fair Tax proponents say this could be fully offset if producers pass along their full savings from no longer having to pay taxes on wages and profits – costs that were previously “embedded” in their prices. A good economist would evaluate this claim by measuring the embedded tax savings.
Start with payroll costs. They vary widely, depending on business. In the restaurant business, payroll costs typically account for 30-35% of sales. In retailing, the percentage is only 10-15%. And taxes are just a fraction of total payroll costs. If we assume they are one-fourth of payroll, then even a labor-intensive business such as a restaurant would save at most 9% (¼ of 35%). And since most of these taxes are deducted from employee pay, the only way for a restaurant owner to realize the savings (and pass them along in the form of lower menu prices) would be to reduce gross employee wages by the amount that used to be withheld from their paychecks. I doubt if this would happen, at least not in full.
Embedded taxes on profits are even smaller – no more than 3% of sales, assuming a 10% gross profit margin and a 30% corporate tax rate. So even under the most favorable scenario, removing embedded taxes would only offset about half (9 + 3 = 12%) of the amount that a 23% Fair Tax would add to prices at the cash register. And if we relax the favorable assumptions I made in the above illustration, the savings are far less. See (5)
So I would have to say my cursory look at the Fair Tax suggests it wouldn't live up to the hype. This doesn't mean it isn't a good idea to start taxing consumption more and income less. It just means we need to be realistic and measure the cost/benefits as objectively as possible.
Any comments? What am I missing? Be civil. I certainly will, unless COG resumes his shit-slinging!
Originally Posted by lustylad
1) If presented honestly, the tax rate is actually about 30%, not 23%. The reason is that, in order to make it sound better, FairTax promoters decided to pitch the plan by disingenuously presenting the
tax-inclusive rate, unlike the manner in which sales taxes are normally described. Let's say that something with no sales tax would cost you $100. The FairTax is designed to make it the case that AFTER you add the sales tax, the percentage of the after-tax price is 23%. Adding about $30 to the $100 pretax price does just that. To anyone else, that sounds like a 30% tax. But to a FairTax advocate, it's 23%!
2) All of the studies I've seen on broad-based consumption taxes seem to suggest that revenue expectations fall far short of the back-of-the-envelope number you get if you simply figure the product of what is purported to be personal consumption expenditures and the tax rate applied to that base. I recall, for instance, that the aforementioned Robert Barro has written several times that a well-designed, broad-based consumption tax in the US could be expected to raise 0.5% of GDP for each percentage point of the tax rate. European experience with the portion of the VAT that's not exempted for necessities indicates the same thing after adjusting, of course, for Europe's lower levels of consumer spending relative to the US.
Also, when the Bush Treasury Department hired some consultants to look into this idea and similar consumption tax plans back around 2005 (at more or less the same time they tried to promote Social Security privatization), they gave up on it after concluding that the tax-exclusive rate would have to be a little more than 30% just to replace the income tax, and to make it revenue-neutral, you would have to leave the payroll tax in place. The only economists I've seen dispute analyses such as these are people like Laurence Kotlikoff (a Boston University professor who moonlights as a well-paid shill for the FairTax).
3) Although one must always consider the dynamic effects of any tax policy change, I have serious concerns about major disruption of certain key industries. What would happen, for instance, if you suddenly slapped a new 30% sales tax on new cars and light trucks? Obviously, the market for vehicles would be hyperstimulated in the run-up period before the tax was implemented, but would be depressed for quite some time thereafter. Same thing for the housing industry, as the FairTax would apply to new homes (but not pre-owned ones).
4) I think one reason the negative impact on revenues would be very high is that evasion would be at least as large a problem as it is today. Note that income tax collections fall well short of what analyses of effective tax rates, brackets, and US personal income as estimated by most economists would suggest. Although an aggregate estimate of unreported income is anybody's guess, I don't think many people doubt that it's several hundred billion dollars per year. And there's no reason to expect that it would be any less under the FairTax. Large portions of the incomes of small business owners and service providers would no doubt take a detour around the cash register if you imposed a 30% sales tax.
5) FairTax supporters are loathe to release any data supporting their claims involving "embedded taxes," and I think it's pretty easy to see why.
For starters, although this may in some instances, of course, depend on elasticity of certain labor markets, economists seem to be in virtually full agreement that the incidence of the employer portion of the payroll tax falls wholly, or at least almost wholly, on the employee, not the employer. If that's true, and I believe that it is, one may expect that in the event the payroll tax were completely eliminated, most workers' paychecks would settle at an amount approximately equal to their current gross pay, less both the employee's and employer's "side" of the former payroll tax. Thus the employer's cost of hiring a worker would remain constant across the transition.
Although it's been a while since I was involved with VC and private equity deals, I believe the
average taxable profit margin across a broad range of industries is more like 6% rather than 10%. Of course, it's higher in a few industries and much lower in others. As a very rough guess, and assuming a 17% average corporate
effective tax rate, I doubt seriously that "embedded" corporate income taxes amount to more than about 1% of gross sales. And that doesn't take into account the obvious fact that costs attributable to "embedded taxes" borne by many service providers are little, if any, greater than zero.
Another thing to remember here is that the FairTax features a "prebate," which FairTax supporters describe as a payment to every household designed to reimburse lower-income families for the tax levied on basic necessities such as food and clothing. (I suppose we're supposed to forget the obvious fact that they also claim that prices won't go up after the 30% tax is added on, since all those "embedded taxes" now disappear, and that the "prebate" should therefore be completely unnecessary!)
I'm too lazy to go look it up in one of their tables, but I think the annual "prebate" averages something like $6K for a typical family, and varies according to the number in your household. That suggests that the prebate alone would run somewhere around 3.5% or 4% of GDP.
Assuming that the estimates offered by Robert Barro and others are in the ballpark, one may reasonably expect that the FairTax, as presented by its supporters, would raise about 15% of GDP, and perhaps 11 or 11.5% after subtracting the "prebate."
Doesn't sound very "revenue-neutral" to me!