Would the FairTax Raise or Lower Marginal and Average Tax Rates

National Bureau of Economic Research ^ | December 2005 | Laurence J. Kotlikoff

[ancient_geezer]

Would the FairTax Raise or Lower Marginal and Average Tax Rates

Laurence J. Kotlikoff, David Rapson NBER Working Paper No. 11831 Issued in December 2005 NBER Program(s):   PE ---- Abstract ----- This paper compares marginal and average tax rates on working and saving under our current federal tax system with those that would arise under a federal retail sales tax, specifically the FairTax. The FairTax would replace the personal income, corporate income, payroll, and estate and gift taxes with a 23 percent effective retail sales tax plus a progressive rebate. The 23 percent rate generates more revenue than the taxes it replaces, but the rebate’s cost necessitates scaling back non-Social Security expenditures to their 2000 share of GDP. The FairTax’s effective marginal tax on labor supply is 23 percent. Its effective marginal tax on saving is zero. In contrast, for the stylized working households considered here, current effective marginal labor taxes are higher or much higher than 23 percent. Take our stylized 45 year-old, married couple earning $35,000 per year with two children. Given their federal tax bracket, the claw-back of the Earned Income Tax Credit, and the FICA tax, their marginal tax is 47.6 percent. The FairTax imposes a zero marginal tax on saving meaning that reducing this year’s consumption by a dollar permits one to increase the present value of future consumption by a dollar. In contrast, the existing federal tax system imposes very high marginal taxes on future consumption. For our stylized working households foregoing a dollar’s consumption this year to uniformly raise consumption in all future years raises the present value of future consumption by only 45.8 to 77.4 cents, i.e., the effective marginal tax rates on uniformly raising future consumption via saving facing our households ranges from 22.6 percent to 54.2 percent. The FairTax also reduces most of our stylized households’ remaining average lifetime tax rates ? and, often, by a lot. Consider our stylized 30 year-old, single household earning $50,000. The household’s average remaining lifetime tax rate under the current system is 21.1 percent. It’s 16.2 percent under the FairTax.

[ancient_geezer]

You seem to be caught in static analysis. You cannot see that reducing property tax and increasing sales tax will affect the decisions of economic participants.

You misread the statement my friend.

If government gets the same amount of money under one tax law as it would under another tax law, that is economically equivalent.

For a given set of conditions if both systems return the equivalent revenues, they will do so in a dynamic sense as well.

By the way, what you are overlooking is the impact of decisions made by economic participants in the choices of investing vs spending. Today we are on the path of disaster where net savings is rapidly headed for a net debt scenario, a bubble economy looking to implode.

 

 

It is time to reverse that trend.

The only difference is that a sales tax has destructive consequences at transition due to the necessary increase in money supply.

That is foolishness. Since government takes no more from the money supply under the FairTax, than it would under an equivalent "Flat Tax" or even the income/payroll tax. After all, they all are supposed to be equivalent taxes according, at least to Flat Tax authors, your presumed necessary increase in money supply has no basis. The same money is available for expenditure on goods, services and investment in both cases. No adjustment is necessary.

[groanup]

...sales tax and a flat income tax are economically equivalent.

Correct. Actually I was misinterpreting your post.

[ancient_geezer]

Thank you for recognizing that the FairTax is not revenue neutral. It is a tax increase.

It is as written, and revenue neutality will require a reduction in rate during Ways & Means Committee markup. I definitely grant that. The rate to be neutral with the temporary Bush tax reforms should be around 19%.

Interestingly most opponents would disagree with you saying that the FairTax does not collect enough and the rate is too low.

Personally I recognize the rate as too high, and push for the lower rate since the legislation is to be revenue neutral by design and plan of its proponents and authors.

[SolidSupplySide]

If government gets the same amount of money under one tax law as it would under another tax law, that is economically equivalent.

No, if the government gets the same amount of revenue under two different tax schemes, they are REVENUE NEUTRAL.

For a given set of conditions if both systems return the equivalent revenues, they will do so in a dynamic sense as well.

Tax system 1:
0% rate on income $0-80,000
50% rate on income in excess of $80,000 Income = $100,000
Tax Revenue = $10,000

Tax system 2:
10% flat rate on income
Income = $100,000
Tax Revenue = $10,000

These two systems are revenue neutral in that they raise the same amount of revenue. But they are not economically equivalent. The worker under tax system 2 has more incentive to keep working because his next dollar of income is taxed at 10%. Under tax system 1, he would be taxed at 50%. They are revenue neutral but the dyanmics are different.

Do you see the difference between "revenue neutral" and "economically equivalent"?

A sales tax and a flat income tax (at the same rate with the same deductions) are "economically equivalent".

[SolidSupplySide]

Interestingly most opponents would disagree with you saying that the FairTax does not collect enough and the rate is too low.

Well, I am ignoring the massive evasion a sales tax north of 10% would create. The underground economy would flourish under a sales tax that high. No jurisdiction in the world has sustained a sales tax rate more than 14-15% due to evasion. Because of the increase in the underground economy, the tax rate for a national sales tax would have to be greater than the theoretical one.

[ancient_geezer]

"one tax law as it would under another tax law" = "under two different tax schemes"

I see you like to play word games.

A sales tax and a flat income tax (at the same rate with the same deductions) are "economically equivalent".

Only problem is no-one is proposing a flat income tax with the same taxbase as a retail sales tax replacing both income and payroll taxes.

No if you want to compare apples with apples and real proposals out there, I am interested in doing so. However, what I am not interested in is perpetuating the income tax in any form, whether it be flat or otherwise. We have already been there and done than and a century of experience tells us what a flat income tax becomes.

"A hand from Washington will be stretched out and placed upon every man's business; the eye of the federal inspector will be in every man's counting house....The law will of necessity have inquisical features, it will provide penalties, it will create complicated machinery. Under it men will be hauled into courts distant from their homes. Heavy fines imposed by distant and unfamiliar tribunals will constantly menace the tax payer. An army of federal inspectors, spies, and detectives will descend upon the state."
-- Virginian House Speaker Richard E. Byrd, 1910, predicting the consequences of an income tax.

[ancient_geezer]

Well, I am ignoring the massive evasion a sales tax north of 10% would create.

And ignoring the massive evasion an income/payroll tax system north of 40% does create. Once again you fail to compare apples with apples and oranges with oranges

[SolidSupplySide]

We have already been there and done than and a century of experience tells us what a flat income tax becomes.

There is also plenty of evidence from every single continent on what a sales tax becomes when its rate gets too high: A VAT!

[SolidSupplySide]

And ignoring the massive evasion an income/payroll tax system north of 40% does create. Once again you fail to compare apples with apples and oranges with oranges

One of the benefits of income taxes is the cross-reporting which reduces evasion to a great degree. There is no cross-reporting in a sales tax. That's why they turn into VATs.

[ThinkDifferent]

23% of GDP is a whole lot of money!

Um yeah, government spends too much, we know. But given that government needs to exist and spend some amount, it needs a way to collect taxes. The income tax is a spectacularly bad way to do that; the FairTax, while not perfect, would be a substantial improvement.

[ancient_geezer]

There is also plenty of evidence from every single continent on what a sales tax becomes when its rate gets too high: A VAT!

Not all sales taxes are equal my friend. The "sales tax" you refer to is the European business turnover tax that was replaced VATs. A sales tax on business purchases as opposed to retail only tax, as such taxes cascade throughout an economy causing extreme economic problems.

The dominate reason many other countries have gone to a VAT is it is a requirement for European Union membership in order to create a uniform tax sytem, a basis not related to "retail sales tax" evasion.

You should note that retail sales taxes were expressly not replaced by the VAT in the EU where VAT became the tax system of choice:

 

http://europa.eu.int/eur-lex/en/consleg/pdf/1967/en_1967L0227_do_001.pdf

FIRST COUNCIL DIRECTIVE
of 11 April 1967
on the harmonisation of legislation of Member States concerning
turnover taxes
(67/227/EEC)
THE COUNCIL OF THE EUROPEAN ECONOMIC COMMUNITY,

Having regard to the Treaty establishing the European Economic Community,and in particular Articles99 and 100 thereof;

Having regard to the proposal from the Commission;
Having regard to the Opinion of the European Parliament;
Having regard to the Opinion of the Economic and Social Committee;

Whereas the main objective of the Treaty is to establish,within the framework of an economic union,a common market within which there is healthy competition and whose characteristics are similar to those of a domestic market;

Whereas the attainment of this objective presupposes the prior application in Member States of legislation concerning turnover taxes such as will not distort conditions of competition or hinder the free movement of goods and services within the common market;

Whereas the legislation at present in force does not meet these requirements;

Whereas it is therefore in the interest of the commom market to achieve such harmonisation of legislation concerning turnover taxes as will eliminate, as far as possible, factors which may distort conditions of competition, whether at national or Community level,and make it possible subsequently to achieve the aim of abolishing the imposition of tax on importation and the remission of tax on exportation in trade between Member States;

Whereas, in the light of the studies made, it has become clear that such harmonisation must result in the abolition of cumulative multi-stage taxes and in the adoption by all Member States of a common system of value added tax;

Whereas a system of value added tax achieves the highest degree of simplicity and of neutrality when the tax is levied in as general a manner as possible and when its scope covers all stages of production and distribution and the provision of services;whereas it is therefore in the interest of the common market and of Member States to adopt a common system which shall also apply to the retail trade;

Whereas,however,the application of that tax to retail trade might in some Member States meet with practical and political difficulties; whereas,therefore,Member States should be permitted,subject to prior consultation,to apply the commom system only up to and including the wholesale trade stage,and to apply,as appropriate,a separate complementary tax at the retail trade stage,or at the preceding stage;

Whereas it is necessary to proceed by stages,since the harmonisation of turnover taxes will lead in Member States to substantial alterations in tax structure and will have appreciable consequences in the budgetary,economic and social fields;

*** SNIP ***

 

In fact, the original reason for a VAT was due to the cascading effect of transaction/turnover taxes on all business operations (a VAT without purchase credits) that created devastatingly high tax burdens on business and economies. The creation of the VAT had little if anything to due with evasion rates of retail sales taxes.

http://www.uq.edu.au/economics/johnquiggin/news/GST9806.html

"The VAT was introduced in France in 1954, to replace a system which relied a highly distortionary turnover tax on sales to supplement a rather ineffectual income tax system. The problem with a turnover tax is the 'cascade' effect arising from the fact that goods are taxed every time they change hands. The effective rate of tax on a good therefore depends on the length of the marketing chain from producer to final consumer. At even modest rates, cascade taxes are highly distorting. The VAT solves this problem elegantly, by allowing firms to credit the tax already paid on their inputs against the tax imposed on their sales. The net tax payable is therefore a fixed proportion of value-added. ..."

"Like the metric system, the VAT was adopted by other European countries, and the use of a VAT was made a condition of membership of the European Union. Once again, the English-speaking countries had less need to make the change, and were slower to do so. Their income tax systems were more effective, and their wholesale and retail sales taxes were less distorting than cascade taxes. ..."

[ancient_geezer]

There is also plenty of evidence from every single continent on what a sales tax becomes when its rate gets too high: A VAT!

And what do you say of a tax system that its authors note is a VAT with income tax from its very design?

 

http://waysandmeans.house.gov/fullcomm/106cong/4-11-00/4-11kotl.htm

"Robert Hall, one of the originators of the proposal(Flat Tax), who describes his Flat Tax as, effectively, a Value Added Tax. A value added tax taxes output less investment (because firms get to deduct their investment.)"

"The Flat Tax differs from a VAT in only two respects. First, it asks workers, rather than firm managers, to mail in the check for the tax payment on that portion of output paid to them as wages. Second, it provides a subsidy to workers with low wages."

 

The Flat Tax; Chapter 3, by Robert Hall and Alvin Rabushka

• Here is the logic of our system, stripped to basics: We want to tax consumption. The public does one of two things with its income—spends it or invests it. We can measure consumption as income minus investment. A really simple tax would just have each firm pay tax on the total amount of income generated by the firm less that firm’s investment in plant and equipment. The value-added tax works just that way. But a value-added tax is unfair because it is not progressive. That’s why we break the tax in two. The firm pays tax on all the income generated at the firm except the income paid to its workers. The workers pay tax on what they earn, and the tax they pay is progressive.

• To measure the total amount of income generated at a business, the best approach is to take the total receipts of the firm over the year and subtract the payments the firm has made to its workers and suppliers. This approach guarantees a comprehensive tax base. The successful value-added taxes in Europe work this way.

• The other piece is the wage tax. Each family pays 19 percent of its wage, salary, and pension income over a family allowance (the allowance makes the system progressive). The base for the compensation tax is total wages, salaries, and retirement benefits less the total amount of family allowances.

[groanup]

a sales tax and a flat income tax are economically equivalent.

Actually that is arguable. In most analyses I have seen the sales tax would create a boom economically. Jorgensen put the GDP spike at upwards of 10%. The "tax haven" effect is enormous as well. Jobs, jobs jobs.

The flat tax would be simulitive also, assuming the rate is low enough, but nowhere near the amount the fair tax would be.

[Conservative Goddess]

"One of the benefits of income taxes is the cross-reporting which reduces evasion to a great degree."

It is also a system that penalizes hard work and investment, eviscerates the 4th Amendment, results in lien and levy of private property for failure to pay, results in countless hours of lost productivity, instills fear and loathing into otherwise perfectly rational adults. The Founding Fathers are spinning in their graves. Why do you defend the indefensible?

[SolidSupplySide]

Actually that is arguable. In most analyses I have seen the sales tax would create a boom economically. Jorgensen put the GDP spike at upwards of 10%. The "tax haven" effect is enormous as well. Jobs, jobs jobs.

I see that you employee an appeal to authority by referencing Dr. Jorgensen. Perhaps you should read what he writes. On pages 22-23, Jorgenson declares a flat income tax and a sales tax as being equivalent.

[ancient_geezer]

a flat income tax and a sales tax as being equivalent.

Yep as they generate the same revenue to government.

But as he shows in that same paper, their respective effects on the economy are quite different:

 

http://www.economics.harvard.edu/faculty/jorgenson/papers/baker.pdf

Revised April 12, 1999.
THE ECONOMIC IMPACT OF FUNDAMENTAL TAX REFORM
by
Dale W. Jorgenson Harvard University
and
Peter J. Wilcoxen University of Texas, Austin

This paper was prepared for presentation at the
Baker Institute Conference
on Tax Policy Reform
Rice University Houston,
Texas November 6, 1998

---

 

We have simulated the impact of implementing two different versions of a consumption tax at the beginning of 1996. The first is the Armey-Shelby Flat Tax. The Armey-Shelby proposal levies taxes on the difference between business receipts and the sum of business purchases and business payrolls. Labor income is taxed at the individual level. An important feature of the proposal is the system of personal exemptions at the individual level that we have described.

The second proposal we have considered is the National Retail Sales Tax. The tax base is the same as in our simulations of the Flat Tax. However, the method of tax collection is different. The Arrney-Shelby Flat Tax preserves the existing structures of the corporate and individual income taxes, but alters the tax base. The National Retail Sales Tax eliminates corporate and individual income taxes; retail establishments would collect the taxes. This would require a broad definition of these establishments to include real estate developers and providers of services, such as medical, legal, and personal services. Most important, no personal exemptions are provided.

---

PDF page 25-27:

2. Figure 4 compares the consumption tax rates for revenue-neutral substitution of the Armey-Shelby Flat Tax (FT) and the National Retail Sales Tax (ST) for existing income taxes. The Flat Tax rate is 25.1 percent in the year 1996 and remains virtually constant through the year 2020. The National Retail Sales Tax rate rises from only 15.7 percent in 1996 to 21.4 percent in the year 2020. Only the Flat Tax includes a system of personal exemptions, so that the tax rate is considerably higher, especially at the initiation of the tax reform. Second, the consumption tax base for the Flat Tax grows at nearly the same rate as government expenditures, while the tax base for the Sales Tax grows more slowly, reflecting the increased importance of investment.

3. Figure 5 compares the impacts of the Flat Tax and the Sales Tax on GDP. Under the Flat Tax the GDP is only 0.6 percent higher than the Base Case in 1996; the impact of this tax reform on GDP gradually rises, reaching 1.3 percent in 2020. Under the Sales Tax the GDP jumps by 13.2 percent in 1996, but the impact gradually diminishes over time, falling to 9.0 percent in the year 2020. The short-run differences between these two tax reforms are due mainly to the impacts on labor supply, while the long run differences also reflect the impacts on capital accumulation.

4. Figure 6 compares the impacts of the two tax reform proposals on consumption. The impact of the Flat Tax in 1996 is to increase consumption by 3.5 percent, relative to the Base Case. This impact gradually diminishes over time, falling to 1.3 percent by 2020. While it may seem paradoxical that consumption increases with a rise in the consumption tax, the marginal tax rate for low-income taxpayers is reduced to zero, stimulating consumption. By contrast the Sales Tax curtails consumption sharply in 1996, resulting in a decline of 5.6 percent, relative to the Base Case. However, the level of consumption overtakes the Base Case level in 1998 and rises to 5.5 percent above the Base Case in 2020.

5. Figure 7 compares the impact of the two tax reform proposals on investment. The impact of the Flat Tax in 1996 is to depress investment by 8.6 percent, relative to the Base Case. Investment recovers over time, eventually reaching a level that is only 1.7 percent below the Base Case in the year 2020. Substitution of the Sales Tax for existing income taxes generates a dramatic investment boom. The impact in 1996 is a whopping 78.5 percent increase in the level of investment that gradually gives way by the year 2000 to a substantial increase of 16.5 percent, relative to the Base Case.

---

6. Figure 8 compares the impacts of the tax reforms on exports, while Figure 9 compares the impacts on imports. It is important to keep in mind that net foreign investment, the difference between exports and imports in nominal terms, is exogenous in our simulations, while the exchange rate is endogenous. The Flat Tax results in a very modest decline in exports of 0.5 percent in 1996, relative to the Base Case, but exports recover rapidly and exceed Base Case levels in 1997, rising eventually to 4.6 percent above these levels in 2020. Imports initially rise by 2.0 percent, relative to the Base Case, in 1996, but this impact declines to only 0.3 percent by 2020. The Sales Tax generates a substantial export boom; the level jumps to 29.2 percent about the Base Case level in 1996, but declines by 2020, reaching 18.9 percent of this level. Imports in 1996 exceed the Base Case level by 2.5 percent, but fall to 1.3 percent below this level in 2020.

---

7. The inter-temporal price system provides the mechanism for re-allocations of resources in our simulations. Figures 10 and 11 give the impacts of the tax reforms on the prices of investment goods and consumption goods and services. Under the Flat Tax the price of investment goods drops by more that 6.8 per cent in 1996 and the price decline continues, falling only modestly to a little over six percent by 2020. The Sales Tax produces a reduction in investment goods prices exceeding twenty percent in 1996, rising gradually to between twenty-five and thirty percent over the period 2000-2020. Under the Flat Tax prices of consumption goods and services decline by more that 4: 5 percent in 1996, but this price reduction falls over time to around three percent in 2020. The Sales Tax reduces the price of consumption by a little over three percent in 1996, but this price decline increases to more than ten percent by 2020.

8. The implied subsidy to leisure time is equal to the marginal tax rate on labor income and would drop to zero when the individual income tax is abolished. Individuals sharply curtail consumption of both goods and leisure under the Sales Tax. Figure 12 shows that labor supply (and demand) jumps initially by thirty percent in 1996. This labor supply response recedes to a level of around fifeen percent by 2020. By contrast the Flat Tax generates an increase in both consumption and labor supply. The labor supply response is only two percent in 1996, but gradually rises to more than five percent by 2020.

9. Since producers would no longer pay taxes on profits or other forms of income from capital and workers would would no longer pay taxes on wages, prices received by producers under the Sales Tax, shown in Figure 13, would fall by an average of twenty percent in 1996. Figure 14 shows that prices received by producers would fall by an average of twenty-five percent by 2020. The impact of the Flat Tax on prices received by producers is much less dramatic. Prices decline in the range of six to eight percent for most industries in 1996 and five to seven percent by 2020.

[groanup]

on pages 22-23, Jorgenson declares a flat income tax and a sales tax as being equivalent.

Maybe so. But you shouldn't have stopped reading on page 23.

On page 24 he puts the GDP increase under a flat tax at 1.3% while under a National Retail Sales it jumps by 13%. If that is economic equivalency I'm Alan Greenspan.

[groanup]

Thanks. You beat me by three minutes. :-)

[n-tres-ted]

This is a useful report, and it's very good that it's coming out at this time. The points made in the abstract will catch the eye of Secretary Snow, who is working on recommendations for tax reform to be given to the president in January. Those reductions in marginal tax rates for common households are highly significant to accumulation of capital by those working to raise their standards of living (i.e., just about everybody).

[Kellis91789]

"One of the benefits of income taxes is the cross-reporting which reduces evasion to a great degree."

Really ? One shudders to think how bad it would be if not for all those 4th-Amendment-violating cross-checks. The current IRS "tax gap" is $350B -- more than 40%. And that doesn't even count criminal activity.

On the other hand, 85% of retail purchases are made through 15% of businesses. These are the Wal-Marts, etc. which are not going to assist consumers in evasion of a Sales Tax. They have too much to lose. So even if the other 15% of purchases all evaded the FairTax, it would be much less than under the current income & payroll taxes.

Keep in mind, the current tax system requires only a single person to fail to evade it -- they just don't report it. That would be the self-employed in any number of businesses. Under the FairTax, it requires at least two people -- the seller and the buyer.