Skip to comments.JORGENSON EXPLODES FAIRTAX MYTH (FR Exclusive)
Posted on 08/24/2005 9:40:44 PM PDT by RobFromGa
August 24, 2005
U.S. Representative John Linder
1026 Longworth House Office Building
Washington, DC 20515
Copy: Neal Boortz, WSB Radio,
Dr. Dale Jorgenson, Harvard University
Dear Representative Linder:
I wrote to you two days ago regarding what I consider to be serious misrepresentations of the Fair Tax plan contained in your book, The FairTax Book. On page 2, you state Lets agree up front that this book is about honesty and I intend to hold you at your word. Since that time, I have been in contact with Dr. Jorgenson in an attempt to clarify his understanding of this Plan and his calculation of expected price declines.
On pp. 22-23, your book states: An extensive study of tax costs was completed a few years ago by Dr. Dale Jorgenson, then chairman of the Harvard Economics Department. On average, Jorgenson concluded, 22 percent of the price paid for a consumer product represents embedded taxes.
You then went on to show a Chart (Fig 5.1) which shows the expected price decline without embedded costs for various goods and services as prepared by Jorgenson during his study.
On page 55, you go on to explain that these embedded taxes are in addition to the money taken out of your check in income and payroll taxes.
On page 59, you again invoke Dr. Jorgensons study: If youre looking for scholarly support for the proposition that prices will fall once the embedded taxes are removed, we can check back with [Jorgensons] The Economic Impact of the National Retail Sales Tax and you quote his report:
Since producers would no longer pay taxes on profits or other forms of capital income under the NRST and workers would no longer pay taxes on wages, prices received by producers would fall by an average of twenty percent
In this statement, Jorgenson seems to say that one of the reasons for the price drop at the producer level was the elimination of the tax on wages paid to workers. So, naturally if the business is going to realize this benefit it must reduce the workers gross pay be the amount that is currently being paid in the form of income and payroll taxes. This only makes sense because how can the business reduce costs if it gives the worker tax savings to the worker?
Later on page 59, you state: Once the FairTax takes effect, youll be receiving 100 percent of every paycheck, with no withholding of federal income taxes, Social security taxes, or Medicare taxes and youll be paying just about the same price for T-shirts and other consumer goods and services that you were paying before the FairTax.
Dr. Jorgensons report clearly showed that under his study the worker would not get their complete paycheck, because if he/she did, there would be no cost savings to the business and therefore no price drop associated with worker taxes.
You continue this theme on page 83: Remember that the poor, along with everyone elsewill no longer have Social Security taxes or Medicare taxes removed from their paychecks. Whatever they earn, they get on payday. For most of those we categorize as poor, this would mean an immediate 25 to 30 percent increase in their take-home pay.
On page 84, you make it clear though that even though the workers will keep all of their paychecks for a big raise, you still believe that because of the disappearance of the embedded taxes, the total price paid for consumer goods will remain very nearly the same.
By assuming these two things together, you are misrepresenting Jorgensons report and double-counting the tax savings, first by giving them to the worker as a pay raise, and then at the same time assuming that there was a cost savings to the business.
On page 85 you make it clear the worker will get the pay raise.
And then on page 111, you tie it all together with a Quick Review in which you erroneously assert that Heres what happens when we pass and implement the FairTax plan:
We start collecting 100 percent of our earnings on our paycheck.
We all get virtual raises, since payroll taxes are no longer siphoned from our checks.
The prices of consumer goods and services remain essentially the same, with the removal of the embedded taxes compensating for the added consumption tax.
Dr. Jorgensons report seemed pretty clear to me, but I felt it was necessary to ask him directly what he meant so I sent him this e-mail:
At 09:29 AM 8/24/2005 -0400, you wrote:
Dear Dr. Jorgenson,
I am a private US citizen who is concerned that the FairTax proponents are misrepresenting your conclusions. Would you please comment on the attached letter I sent to Mr. Boortz and Rep. Linder? I think that they are being dishonest to imply that the wage earner will keep his entire paycheck, while at the same time businesses will be able to reduce costs? Your March 1996 testimony stated, in part:
5.Since producers would no longer pay taxes on profits or other forms of capital income under the NRST and workers would no longer pay taxes on wages, prices received by producers, shown in the sixth chart, would fall by an average of twenty percent
Are you expecting business to reap a benefit from the taxes that that the worker no longer pays? It certainly sounds like that is part of where you see the business reducing its costs.
Dr. Jorgenson responded:
From: Dale Jorgenson [mailto:email@example.com]
Sent: Wednesday, August 24, 2005 10:28 AM
To: Rob xxx
Re: Fair Tax- Is your 1995-6 Testimony being misrepresented by Boortz/Linder book?
A more reasonable interpretation of my 1996 testimony is that workers would keep that after-tax pay; producers' prices would fall, but retail prices would be increased by the national retail sales tax. Any gains by workers and investors would be the result of increase economic efficiency.
[He then went on to recommend his book called LIFTING THE BURDEN, about another tax reform plan he calls Efficient Taxation]
I wanted to be perfectly clear what he was saying, so I asked him to clarify his email:
At 06:41 PM 8/24/2005 -0400, you wrote:
Excuse me for my lack of understanding of your answer, when you say "workers would keep that after-tax pay" are you saying that if they are making $1000 a week now, and paying $200 payroll+income taxes now, that under the FairTax you were assuming that workers would get paid $800 and keep all of that? Or are you saying that you meant they would make $1000 under the FairTax?
Dr Jorgenson responded:
I am saying that the worker would continue to receive the after-tax amount of $800. Prices received by producers would decline to cover the cost of after-tax wages to workers and after-tax dividends and interest to investors. However, taxes paid at the retail level would include the Fair Tax.
So, Dr. Jorgenson, whose report you are relying on to support your calculation of embedded taxes, is stating that in making those embedded tax calculations he was not assuming that the worker would keep his current after-tax amount, NOT that the worker would keep all of his current gross pay-check. By reducing the gross pay of the worker to the current after-tax amount, the producers would see a cost reduction that would allow them to reduce selling prices. There would be no increase in take-home pay.
I think you need to carefully review the misrepresentations in your book and offer a retraction and modify subsequent printings to remove these errors. You have spent a large amount of time on this plan, and it is still a viable option for debate even without the bug windfall pay raise for everyone. I would enjoy the opportunity to discuss this with you further if you have questions.
We have a massive black market now. We always will- it will just shift.
By the way, in the State of Florida, where we are funded 100% by sales tax, I can tell you confidently that the Dept. of Revenue is nothing like the IRS in terms of intrusiveness. Their tactic is to audit sales receipts, but that's nothing compared to the info needed to determine income.
excellent work, Rob. The books should be removed from the shelves due to this HUGE error.
Thank you for a decent, civil reply.
The only thing I have ever been looking for from FairTax proponents is an honest discussion.
You are so focused on the specific numbers that you seem to have missed a vital point in Dr. Jorgenson's first response to you:
Your analysis of employee income, producer costs, and consumer prices is based on a static view of the world that does not take into account the dynamic impacts of the changes to the tax system. Without taking those effects into account, your numbers aren't going to make sense no matter how you apply your assumptions.
I'm not sure what they should do at this point, but I plan to call Mr. Linder today.
you miss the point, I am not debating whether the actual FairTax is a good or a bad thing for the econoy and for Americans in the long term through economic growth.
I am attempting to expose a $1.3 Trillion misrepresentation in the way the plan is sold in The FairTax Book, and this is being accomplished. Once the dust settles on this correction, we can debate away on the relative merits of the actual plan.
But the fair tax assertion that prices immediately come down 20% can no longer be made.
As far as this specific issue, and whether or not it is a misrepresentation, I will reserve judgement until I hear either a rebuttal or an admission from the FairTax folks -- it is possible that something is being missed.
My interest in the FairTax has never been the economics anyway (though the discussion threads always seem to get dragged that way). Let me repeat something I posted on a different thread:
Most of the recent discussions and arguments about the FairTax here on FR have been of the economics variety, and have basically boiled down to "how many angels can dance on the head of a pin" arguments. Nobody really knows what the impact will be due to the dynamic effects of changes to the tax code (even tax cuts under the current system are hard to predict the effects of accurately), though guesses can be made by using certain assumptions -- and its these assumptions that appear to be the main point of contention in the arguments.
While it may be worthwhile to have these discussions, in my opinion, they miss the most important point of all with regards to the FairTax.
Imagine having no IRS to pour over your financial records.
Imagine not having to report your personal finances (income and certain expenditures) to the federal government.
Imagine not having to make investment decisions based on what will or won't subject you to additional taxes.
Imagine a tax system in which your total liability is simple, straightfoward, and doesn't require an accountant or computer software to calculate (especially when different accountants come up with different answers).
Imagine a tax system that doesn't play games with whether or not you're rich or poor, black or white, male or female, or any other social or economic factor.
That is the freedom that the NRST/FairTax will bring. That is the major reason why all of the other schemes advocated (flat tax, transaction taxes, etc.) are unacceptable.
Another BIG advantage is that Ministers can preach for or against candidates or any social issues without loseing their tax exempt status (there being no taxes).
Obviously, politicians won't stop spending more and more money so the pressure has to come from outside. I want people to explicitly pay ALL their taxes, not have them hidden in a receipt or be funny money at pay time. I want people to deposit their FULL salary into their bank account and then have to write checks to the IRS quarterly to pay taxes. No withholding, etc.
Only if you subscribe to a static model of the economy.
That's basically my reason for supporting the FairTax too.
Oh, and by the way, you have it completely backwards -- if Rob's analysis is correct, Jorgenson still maintains that the prices will drop by 20% or so, but that employees would not receive their currently withheld income and payroll taxes.
Of course, that would violate a large body of contract law, but that's probably because Jorgenson just makes an assumption to make modelling the changes easier, not that this will necessarily be the case in practice.
What's to stop the politicians from placing "special" taxes on expensive items, like a luxury tax? For example, a car that's over $20,000 has a luxury tax of 100%.
What stops them now? The last time they did something that stupid, they practically destroyed the yacht-building industry in this country.
No kidding, we have only been debating this point for 6 years
I'm oughta here bump
Your forgetting (for some reason) the 1/4 - 1/5 of the current (untaxed) economy that avoids paying social security, Medicare, and income tax entirely.
But anytime ANY of these people makes a purchase after the Fair Tax begins, that exchange is taxed.
Now ole Rob claims that almost all of the current "underground" (untaxed) purchases (he makes a incorrect assumption that the underground econmy is only drug dealers and prostitues!) are used goods and from pawn shops that would not be taxed, but that is wrong.
I never made that assertion, and haven't made a single reference to undergroung purchases, nor am I commenting on the potential black market that would result from a 30% tax on every retail sale.
And yet, you still managed to be completely wrong. How did you manage that? Were you not following the thread?
Watch what happens as more people do business out of their homes.
Not as big as ending the tax advantage of leftist foundations making "contributions" to lawyers who sue to control the price of resources using environmental law.
It's been a few years, but when I went to the publick library to look at the income tax title of the U.S. code of law; I found that the Tax code books were larger than all the other U.S. codes put together! Larger than the Law on Customs, Maritime, Judicial etc,
It is a swollen monster that needs to be beheaded!
The economic boom from the fair tax would not really come from taxes that Americans pay. As demonstrated, that would be basically a wash. The boom comes from imports. The US imports a huge amount. As the system is today, the import competes price wise with the domestic product which has the embedded taxes. When the import item is sold, that embedded tax equivalent is shipped out of the country as an added bonus to the overseas producer. With the Fair tax the imported product must compete with the domestic product at a price that does not include embedded taxes and the importer losses the bonus while still incurring the added costs of transportation and handling.
The net effect would be to spur domestic production of goods and services. Since we realistically would still import heavily, stopping the flow of embedded tax equivalent out of the country would be like "tax gravy" to the federal government. Just look at our current trade imbalance and picture 22% of that flowing into the Federal government. Goodbye budget deficits. I was a flat tax man until I carefully examined the system and came to this realization. This aspect of the Fair tax must be hammered home to people because it has such a potential impact on our domestic economy and is the real way to protect jobs in America.
Maybe not, but imagine if your local minister could FREELY talk about your political candidates!
I CAN see what a positive impact it would have on those liberal tax exempt foundations influence on litigation. Thanks.
How can you guys always twists your gross errors and exaggerations into us being wrong?????? I was not wrong. There is no legal mechanism to get wages to come down to keep take home pay constant. Since wages will remain where they are, prices of goods will have to reflect the additional $1.3 Trillion that is now being pocketed by workers. End prices to consumers will have to go up around 15%. Rents and other contractual obligations, will immediately go up 30%. You can talk about the dynamic forces that may eventually bring wages down and prices down, but that will take years. In the meantime, our economy will be in chaos.
"There is no reason to believe that employers would decrease anyones pay."
Well, sorta. Dr. Jorgenson said, in his e-mail to RobFromGa:
"I am saying that the worker would continue to receive the after-tax amount of $800."
Dr. Jorgenson is saying that the reduction in the general price level will occur because employees will continue to get their net pay (not their gross pay), and thus will not suffer a decline in take-home pay.
However, after the NSRT goes into effect, their pre-NSRT pre-tax gross wages will be reduced to their pre-NSRT after-tax net wages. Thus, no less money goes home with the worker, but the worker does not receive in his paycheck the amounts formerly paid for his side of payroll taxes, the employer's side of payroll taxes, or his personal income taxes.
The businesses will then be able to reduce prices by the amount that was being paid by and on behalf of wage earners: payroll taxes (both sides) and personal income taxes.
So, prices fall because businesses reduce prices by the amount of these taxes, and workers keep their same AFTER TAX pay, not their gross PRE TAX pay.
However, then the 30% NSRT is applied to the economy, and workers are about back to where they were (at least on average - however, I have to think about the implications of folks paying significantly different rates of effective taxes).
The real upshot of this is that all the talk about reducing price levels in the economy by 20% or more is NOT coming through "cascaded" corporate business taxes, etc. The savings, at least according to Dr. Jorgenson, come primarily from reducing the gross pay of workers so that their gross pay will be equal to their old after-tax net pay.
"I believe labor contracts are for gross pay, not after tax income. By what mechanism does the Fair Tax eliminate every labor contract in the country?"
However, we now know that the underlying basis for the assertion that general price levels will fall 20+% is a result from reducing gross wages to net wages, and doing away with personal income and payroll taxes (and passing the savings on to the consumer).
I guess this makes the whole issue of the NSRT a lot more theoretical and involved (at least in the implementation). To accomplish what Dr. Jorgenson suggests would take a lot of highly-technical, hard-bargained legislation to override labor contracts, to accomplish this result.
However the means of achieving the result, though, the relevant point is that Dr. Jorgenson believes that bringing down general price levels would be by lowering workers' gross pay (which would also be their net pay under the NSRT) to their current net pay, after-tax, under the existing system.
Hogwash. You completely ignored what RobFromGa and Jorgenson said, and posted the exact opposite as being what they "proved". For what it is worth, I agree that Jorgenson's model is flawed in that there are legal issues involved (which I even said in the post you replied to!) but the discussion is on Jorgenson's model, complete with the assumptions that went into it.
As far as whether Rob's analysis is even correct is still open for debate -- if this were an article for publication, it would have been grossly irresponsible to not have even attempted to get a rebuttal before publishing.
"What's to keep this 23% tax from increasing the minute we switch to the national sales tax?"
The goodness and decency of our politicians.
By the way, if you look at the National Retail SALES Tax from the perspective of a SALES tax, it's actually about a 30% exclusive tax on all new goods and all services. So, you buy a cigar that the business wants a buck for, you pay a buck thirty. Thirty cents goes to Uncle.
Thirty cents is also 23% of the overall cost to you, the consumer, of a buck thirty.
That is what the analysis says, but there is no way to make that happen. What realistically will happen is prices to the consumer will have to go up significantly. To make the fair tax work and not create economic havok, wages would have to adjust, but I don't see how that can be done legally and practically.
I'm not sure Jorgenson is actually advocating doing that in the first place. The tax savings has to be applied somewhere (either all for the employer, all to the employee, or some mix), and I think Jorgenson chose this method in order to simplify his model. The net effects should be the same regardless -- purchasing power should be roughly equivalent since the same amount of taxes are taken out of the economy.
Personally, I think it would be better than that, because there's additional overhead and wasted effort and money that goes into tax compliance and avoidance that could be freed up for productive use and/or cost savings.
Ignored what they said???? I have embraced it. It is exactly what I have been saying for 6 years and being called a liar and disrupter for. If take the employee pockets all his taxes prices can not go down 20%.
No suprise to me ... I I raised that very question on this thread four years ago:I went back and read that thread a few months ago. You should be commended for your reasoned argument that was rejected out-of-hand by the FairTax proponents. You had this nailed years ago.
Like I said, I don't know about this particuar plan. If they are saying that the business owner gets a windfall of 20% because he doesn't have to withold taxes, then that is just silly. However, there certainly WOULD BE savings if we went to a tax system where I am not forced to be the collection agent for the fed, as a small business owner.
Well that is what fair taxers have been saying for years and that is what Boortz book claims. And you must remember, the 7.5% payroll tax is just on wages, not on gross sales. The savings businesses will see will be under 10%.
Income tax is in the embedded tax, too. Did your numbers include inocome tax?
Dear Always Right,
"That is what the analysis says, but there is no way to make that happen."
Yes, that's true.
I'm just trying to explain Dr. Jorgenson's theory.
If there were a way to achieve a steady state with an NSRT without trashing the economy during a transition, it would be a far more interesting proposal.
I'm still very leery about taxing away 20% of GDP through consumption taxes, as I think the direct effect on consumption will be highly negative.
However, we could at least debate stuff worth debating if some of the NSRTers around here would give up the idea that price savings of 20+% are going to magically appear out of the sky from "cascaded" corporate income taxes (LOL), rather than the source the actual theoretician cites: Loss of that part of gross wage to the worker that currently comprises payroll and personal income taxes.
There in lies the rub. Fair Taxers have been maintaining that workers could keep the whole paycheck AND prices would come down 20%. Since income tax workers paid was in fact part of the 20% of embedded taxes, that claim has been exposed as fales.
It is not unusual for email systems to allow multiple versions of email addresses. Doesn't look bogus to me.
You may be right about Dr. Jorgenson's intentions. It's tough to get inside folks' heads.
However, I'm inclined to think he chose this model for a different reason. I haven't had time to work it all out in my head, but my initial intuition tells me that doing it Dr. Jorgenson's way might be better vis-a-vis imports and exports.
I gotta think about it more.
"Personally, I think it would be better than that, because there's additional overhead and wasted effort and money that goes into tax compliance and avoidance that could be freed up for productive use and/or cost savings."
Well, I've owned my own businesses for 20 years, and my own personal experience is that this would save me little, if anything. I'm sure it would save some people more, but my own experience with other business owners is that they wouldn't save much, either.
And Dr. Jorgenson clearly views the price level reductions being fueled primarily by saved payroll and income taxes that are not passed back to the worker.
Allegedly exposed as false. It's a bit premature to be celebrating since we haven't seen the AFFT rebuttal yet.
You are certainly correct that the employer's total cost of an employee is greater than the employee's gross pay. And all of the employer's portion of payroll taxes would be repealed by the Fair Tax Act.
Thanks so much for your time spent on this. While the fair tax has good points, it needs critical study and dissection (as you demonstrate) to see if it is indeed worthwhile.
?????????? Just how does this happen? Under the current system, assuming no state or local witholding of any type, two employees each have a gross salary of $1000 per period. One has a wife and three kids, claims M-5 on his W-4 and has a "take-home" of $800 after Income & FICA. The other is single, claims S-1 on his W-4, and has a take home of $750.
Are you saying that with the Fair Tax, they keep getting 800 and 750 respectively? Who makes that call?
All I know, is that from listening to Mr. Boortz on the radio, I don't trust him a bit...
No one is making the call. It was just the analysis which supports the reduction of prices by 20% assumed the savings from employee taxes would be passed to the business. There is no mechanism to have it done. The way the law is, take home pay would go up but end prices to the consumer would have to go up accordingly.
dimples was correct in post #27. Economist assume that there will be one of two outcome with the transition to a sales tax. They are:
- Assumption 1: That nominal (pre-income tax) wages will stay the same (i.e., take-home pay increases) and consumer prices increase by the amount of the sales tax. In short, that take-home pay and consumer prices increase.
- Assumption 2: That nominal wages will decrease by the amount of payroll and income tax the worker was previously paying (i.e., take-home pay stays the same) and consumer prices stay the same even with the sales tax. In short, that take-home pay and consumer prices stay the same.
In his study, Dr. Jorgenson made Assumption 2 - that take-home pay and consumer prices stay the same. This is not wrong, it is just one of the possible outcomes. What was wrong was how this was presented by Boortz and the FairTax supporters. They took the assumption that take-home pay would increase (from Assumption 1) and paired it with the assumption that consumer prices will stay the same (from Assumption 2). They mixed the best of both worlds and came up with a windfall, that take-home pay would increase while consumer prices stayed the same, that could not possibly happen. Much of the proported benefits of the FairTax come from this erroneous assumption made by Boortz and the FairTax supporters.
While Dr. Jorgenson's use of Assumption 2 was not wrong, most economists believe that, because wages are difficult to lower (economists call this "sticky wages"), Assumption 1 is the most likely outcome from a transition to a sales tax.
Below is a complilation of quotes from various economists (including, ironically, the authors of the FairTax bill) that explain these assumptions in greater detail:
by C. Alan Garner
Federal Reserve Bank of Kansas City
in Economic Review - Second Quarter 2005
Wages and prices. Replacing the income tax with a flat tax poses smaller challenges for wage and price adjustment than either a national sales tax or a VAT. Because the structure of the flat tax is similar to the current income tax, large adjustments in consumer prices or wages would probably not be necessary After-tax and before-tax wages would be similar before and after the tax reform, and nominal prices would be roughly unchanged (Zodrow 2002).
A national sales tax or a VAT, in contrast, would require the average price of consumer goods and services to rise relative to production costs and wages.15 A national retail sales tax is the simplest case to understand because the tax is imposed entirely at the retail level. Consumers would pay a substantially higher price for goods and services after adding in sales taxes at a rate that could easily be 30 percent or higher. Because wages are a large fraction of production costs, the price paid by consumers would increase relative to the wage rate received by workers. However, in the case of a revenue-neutral tax reform, the decline in the income-related taxes paid by households would offset the rise in consumption taxes, leaving households with the means to purchase the higher-priced goods and services. Under a VAT, consumer prices would increase relative to wages because of taxes imposed at various stages in the production process rather than just the final retail sale.
An important question from the standpoint of short-run macroeconomic adjustment is how the increase in consumer prices relative to wages occurs. One possibility is that the after-tax consumer price level would rise by the full amount of the consumption tax while wages remain constant. Another possibility is the after-tax consumer price level would be constant while wages decrease. Most discussions of transitional tax-reform issues assume the first case.16 When a VAT has been introduced abroad, authorities typically permitted an upward adjustment in the after-tax consumer price level, although efforts were generally undertaken to ensure that this one-time adjustment did nor become a sustained inflationary process (Tait).
Alternatively, the necessary increase in consumer prices relative to wages could be accomplished by holding the price level constant and reducing the wage level. Many economist, however, believe that wages are "sticky" in the downward direction. Workers are reluctant to take a wage cut, and efforts to reduce the wage rate might cause many workers to leave their jobs. The result could be a large temporary increase in the unemployment rate and lower levels of spending and output. Gravelle cites simulations with large-scale econometric models that do not assume the economy always operates at full employment. In three of the four simulations cited, real output decreased initially in response to fundamental tax reform. Although other economists have criticized such models and might not accept their conclusions, the simulations emphasize the need for further research on the short-run employment and output effects of fundamental tax reform.
Moreover, replacing all federal income taxes with a national sales tax or VAT would require much larger price and wage adjustments than other countries experienced when adopting VATs. Foreign VAT rates have typically been no more than 10 percent because the countries kept other revenue sources, such as an income tax. In most cases, the country also eliminated other consumption-type taxes, which offset some of the upward price-level pressures. Thus, the price adjustments required by fundamental U.S. tax reform would be outside the range of historical experience.
- This discussion focuses on fundamental tax reform in which a national sales tax or VAT replaces all federal income and payroll taxes. The adjustment issues would be smaller if a low consumption-tax rate were enacted to replace a small part of the current tax system or to supplement existing revenue sources.
- The increase in consumer prices could account for part of the decline in the real value of existing assets during the transition to a consumption tax. Nominal assets such as bonds and bank accounts would lose real value as the price level rose. With no increase in consumer prices, the decline in the real value of existing assets would occur through other channels. For example, the decrease in wealth would fall on equity owners as corporations lost expected depreciation allowances and the prices of tax-free investment goods declined relative to taxable consumer goods and services (Zodrow 2002). In practice, the increase in the price of consumer goods and services relative to wages could occur through a combination of consumer price increases and nominal wage decreases.
Professor of Economics, Boston University, and Research Associate, National Bureau of Economic Research
Testimony Before the House Committee on Ways and Means - Hearing on Fundamental Tax Reform
April 11, 2000
This sentence and the one preceding it assume the price level will rise with the adoption of the Fair Tax. If the Federal Reserve used its monetary policy to maintain the consumer price level, the adoption of the Fair Tax would entail a decline in the level of producer prices and, thus, the nominal wages and capital income received by productive factors.
by Dan Mastromarco and David Burton
[authors of the FairTax]
Memorandum, March 16, 1998
Federal income and payroll taxes either are or are not incorporated into the prices of goods and services. If they are embedded in prices, their removal will reduce prices. If they are not, then their removal will not reduce prices but instead returns to labor and capital will go up. If returns to labor go up, people will see their after-tax wages increase and asset values will increase since the present discounted value of the new, higher returns will be higher.
The replacement sales tax could be incident on the factors of production or it could be incident on consumers through higher prices. It cannot be both. If it is incident on the factors of production, then wages and the return to capital will fall but sales tax inclusive prices will not be any higher, on average, than they are today. If the sales tax is fully incident on consumers, then prices will increase by the amount of the sales tax but returns to labor and capital will be higher.
by Dan R. Mastromarco and David R. Burton
[authors of the FairTax]
Tax Notes, June 29, 1998, p. 1779
Footnote #13: The degree to which after-tax wages will increase is a function of the incidence of both the sales tax and the repealed taxes. If the income tax and payroll taxes are incident on income recipients and the sales tax is incident on consumers, then after-tax wages and returns will go up quite considerably as will tax inclusive prices. If the sales tax is incident on the factors of production, then after-tax wages and the after-tax return to capital will not go up to any considerable degree (at first) but producer prices will fall and retail prices, even including the sales tax, will remain roughly comparable. The real purchasing power of wages will undoubtedly increase considerably over time because of a larger capital stock (increasing productivity), microeconomic efficiencies caused by a more efficient allocation of scarce resources, and higher productivity from lower compliance costs.
The Price Level
Switching to an indirect tax such as a valued-added tax (VAT) or national sales tax will probably cause a one-time jump in the price level, with no permanent change in the inflation rate. By contrast, any consumption-based tax that levies taxes directly on households will probably have little or no effect on the price level.
A VAT or sales tax is likely to boost the price level because each one collects the tax on labor income from the firm or retailer. That treatment represents a change from the current income tax system, which collects tax on labor income directly from the worker. Because the cost of labor to the firm would include the new tax, real compensation paid to workers would initially have to fall to match the value of their so-called "marginal product" and keep them fully employed.
Real compensation can fall in two ways: nominal compensation can drop or the price level can rise. What happens will ultimately depend on the Federal Reserve. If it fixes the price level, nominal compensation will have to fall--an event that workers might accept because they would no longer have to pay income tax and hence would take home about the same pay as now. Most analysts note, however, that workers have resisted cuts in nominal compensation in the past. Those analysts expect that firms fearing morale problems or facing union contracts will hesitate to make such cuts. In that case, nominal compensation may fall slowly to its new level, leading to higher unemployment rates in the interim. To prevent that outcome, the Federal Reserve is expected to allow the price level to rise. For example, a VAT or sales tax of 10 percent would lead to a one-time jump of 10 percent in the price of consumer products.
Further price increases may ensue if compensation is indexed to inflation. In that case, the price rise will cause a corresponding rise in compensation, and real compensation will not drop enough to maintain full employment, requiring a further price rise--that is, a wage-price spiral. That problem occurred in the United Kingdom when it adopted a VAT in 1979, although the extent of indexing there was greater than it is in the United States.
Setting aside for a moment temporary inflexibilites in contracts for wages, bonds, and so forth (we address these later), whether ther overall level of prices changes or not does not materially affect this story.16 Even if prices do not rise at all, moving to a consumption tax would cause the purchasing power of both wages and existing wealth to decline by an average of 20 percent relative to a situation with no taxes. Nominal wages would be forced down because firms would be earning 20 percent less, after taxes, from the output produced by workers. The nominal value of existing capital assets - in the form of, for example, share prices - which constitute much of old wealth, would also decline because the output they produce provides 20 percent less in after-tax revenues.
- Whether in fact consumer prices would rise in the event of tax reform depends on the monetary policy set by the Federal Reserve Board.
Source: Slemrod, Joel and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate over Tax Reform, MIT Press: Cambridge, 2004.
Transition Costs and Macroeconomic Adjustments
One of the most difficult issues to address in considering a shift to consumption taxes is the transition from the current system to the new tax regime.5 While all shifts to a consumption tax cause some common transitional disturbances and windfall gains and losses, the most serious problems arise from a shift to a national retail sales tax or to a value added tax. In these cases, a tax formerly largely collected from individuals is now collected at the firm level -- either from retailers on total sales or from both final and intermediate producers' value added. Flat taxes avoid this problem but can result in confiscatory taxes on existing assets.
Price Accommodation and Short-run Contractions Under a Retail Sales Tax or VAT
Holding prices fixed, these firms would need to reduce payments to workers to retain profit levels. In fact, many firms would not have enough of a profit margin to pay the tax without something else -- either prices or wages -- adjusting. Consider, for example, a grocery retailer that may have a 1% or 2% profit margin now owing a tax equal to 20% of receipts. This firm simply does not have the cash to pay the tax. If it is difficult to lower wages (and presumably it would be), a significant one-time price inflation, to allow these costs to be passed forward in prices instead, would be required to avoid a potentially serious economic contraction. Note that the price increase, were it possible to implement correctly and precisely, would solve the transition problem because although prices would rise, individuals would have more income to purchase the higher priced goods -- and demand would not fall. It is difficult, however, for the monetary authorities to engineer such a large price change. Moreover, even with the monetary expansion in place to do so, the imposition of such a tax would be disruptive if firms are reluctant to immediately raise prices, again leading to an economic contraction. That is, firms could contract their business, or even close down, until output had contracted enough to raise prices.
These disruptions are not minor in nature -- imagine the difficulties of engineering and absorbing a one-time price increase that is likely to be close to 20% (the level, approximately, that might realistically be needed to replace the income tax).6 Even if such an inflation could be managed, there are always concerns that any large inflation could create inflationary expectations -- it's hard to manage a single one-year price increase. In fact, economists who judge a consumption tax to be superior to an income tax may nevertheless be skeptical about the advisability of making the change because of these transition effects.
- See CRS Report 98-901, Short-Run Macroeconomic Effects of Fundamental Tax Reform, by Jane G. Gravelle and G. Thomas Woodward for a more detailed discussion of these issues.
- The rate would depend on whether and the extent of any family exemption. A 20% tax exclusive rate would correspond to a tax inclusive rate between 16% and 17%.
- 7 U.S. Congress, Joint Committee on Taxation, Tax Modeling Project and 1997 Symposium Papers, committee print, 105th Cong., 1st sess., Nov. 20, 1997, JCS-21-97 (Washington: GPO, 1997), p. 24.
Prices for consumer goods and services quickly rise by the amount of the tax, and then some. The portion of the price increase in excess of the tax is due in part to the higher cost of imports (from the weaker dollar) coupled with the ability of some domestic producers of competing goods to hike their price to that of imports. Consumer prices similarly rise 25 percent -- roughly the nominal rate of sales tax, unadjusted for any exemptions or transition rules -- by 2002 and gradually drop from that peak to a level that remains about 18 percent above the pre-change baseline.
Examined on a year-over-year basis, these price increases generally amount to a large, one-time hike in prices as the NRST is imposed, with some moderation of this increase in the longer run. Due to a weaker dollar, merchandise import prices increase by nearly 4 percent shortly after the NRST is imposed and are 6.5 percent over baseline levels in 2010. Merchandise export prices are also above baseline levels. In 2001 and 2002 they are nearly 3 percent above the baseline. However, due to lower interest rates, which reduce business costs, export prices are only slightly greater than baseline levels for most of the remainder of the forecast period. The overall impact on prices is measured by the change in the GDP deflator, which initially rises 20 percent above the baseline price level before settling back to a 13 percent price rise relative to the baseline.
The notion espoused by some that pre-tax prices would drop some 20-30 percent under a NRST (so that after-tax prices would not rise and may even decline) is a peculiar one. This could only happen if all of the personal income tax, the corporation income tax and payroll taxes are currently embodied in retail prices. Tax incidence -- that is, who actually bears the ultimate tax burden -- is an elusive question that has been the focus of many economic papers, because the answer is not clear. However, the general consensus among economists is that perhaps a portion of the corporate income tax may be passed on to consumers in the form of higher prices, but that the majority is ultimately paid by corporate owners in the form of lower after-tax profits and by employees in the form of lower compensation. Most economists concede that personal income taxes and payroll taxes are ultimately borne by labor and are not passed on to consumers in the form of higher prices.
Transitional Issues in Tax Reform
Price Level Effects
Because the flat tax is similar in structure to the existing income tax system, its implementation would have relatively little effect on the absolute price level. Both before- and after-tax wages would be roughly similar before and after reform, so that nominal prices remain roughly constant.
In contrast, the effect of implementing an NRST on the absolute price level is less certain. One possibility is that the tax could be fully shifted forward in the form of higher prices for consumption goods, with no change in the price of investment goods, which are untaxed under the NRST. At the other end of the spectrum of possible responses, nominal prices could remain constant. Under this scenario, before-tax real wages would have to fall roughly to the level of prereform after-tax real wages in response to the elimination of the income tax. Intermediate responses between the "full price adjustment" and "no price adjustment" scenarios are of course also possible.
Choosing between these various scenarios requires making necessarily speculative assumptions about the response of the monetary authorities to the imposition of the NRST. However, most analysts assume that the monetary response would be sufficiently accommodating that the full price adjustment scenario would obtain.
The primary rationale underlying this assumption is the view that the downward flexibility of nominal wages is quite limited, in part because most wage contracts and agreements are specified in nominal terms. Thus, a tax reform that required wage reductions to reach a new equilibrium would be quite costly as these wage reductions would initially be distributed unevenly across industries. This in turn might result in considerable unemployment in sectors characterized by rigid wages, as well as misallocations of labor, at least in the short run. Proponents of the full price adjustment view assume that monetary policy would be expansionary to avoid these costs.
Most observers fall into the full price adjustment camp. For example, McLure (1996, p. 23) concludes that it would be "hard to imagine the monetary authorities not accommodating such an increase in prices." Gravelle (1995, p. 59) argues that full price adjustment is likely because a "national sales tax would tend to produce an economic contraction if no price accommodation is made." In its analysis of the distributional implications of implementing consumption taxes, the Joint Committee of Taxation (1993, p. 59) concludes that, "Unless there are convincing reasons to assume otherwise, the JCT staff assumes the Federal Reserve will accommodate the policy change and allow prices to rise." Finally, Bradford (1996a, p. 135), in discussing the same issue in the context of a value-added tax, observes that, "It is commonly believed that introducing a value-added tax of the consumption type will bring with it a monetary policy adjustment that would result in a one-time increase in the price level ;and no change in payments to workers in nominal terms."
Nevertheless, opinion on this issue is certainly no unanimous. For example, the alternative assumption [that wages will fall] is implicitly made by Jorgenson and Wilcoxen, who argue that implementing a national sales tax would reduce producer prices on average by 25 percent. Auerbach (1996) takes a compromise position by assuming partial price adjustment. In addition, European experience with the introduction of the VAT is mixed, generally suggesting partial price adjustment. On the other hand, Besley and Rosen (1999) find full (or even more than 100 percent) forward shifting of state sales taxes in the United States.Source: Zodrow, George R. (2002). "Transitional Issues in Tax Reform." In United States Tax Reform in the 21st Century, George Zodrow and Peter Mieszkowski, Editors. Cambridge University Press.
Monetary Implications of Tax Reforms
Does it matter how the central bank responds when the tax system is reformed? Some economists would argue that in a very general sense it does not. Many would argue that the central bank's response would have little long-run effect, because what really matters is the productive capacity of the economy and because there could be no money illusion in the long run.
And, in the short run, the standard relation between prices and money makes it clear that, under limiting assumptions, the central bank need not change monetary policy. Consider the transition from our present tax system to a consumption tax. Ignoring any incentive effects caused by the tax reform, velocity and output are unchanged. With a revenue-neutral tax reform, aggregate after-tax income is unchanged, so there need be no demand-driven effects on consumer prices. Under these conditions, v, y, and q remain unchanged as a result of the tax reform, and thus maintenance of the status quo implies that the central bank need not change its policy. Assuming that output is constant, the central bank could eliminate any transitory price changes in the long run by leaving monetary policy unchanged.
But things may not be that simple. The implied changes to wages and producer prices require a degree of flexibility in the economy that many might find unlikely. Specifically, for the consumer price to stay constant, the producer price must fall by the amount of the tax. And because a drop in the producer price means that the business revenue produced by hiring another worker drops, the before-tax wage must drop by a corresponding amount. Many have argued that such price and wage changes are implausible and that the central bank should "accommodate" a transitory change in the consumer price level by adjusting monetary policy so that it is consistent with constant producer prices and wages.
Source: Bull, Nicholas, and Lawrence B. Lindsey. 1996. "Monetary Implications of Tax Reforms." National Tax Journal 49.3 (September): 359-79.
The Price Level
When Britain adopted consumption taxation in 1979, the price level rose by the amount of the new tax. This jump in prices caused substantial disruption in the economy, partly because it stimulated further rounds of wage and price increases through indexation formulas that failed to exclude consumption taxes from the measured cost of living. Standard macroeconomic analysis suggests that the underlying cause of such a price effect is the contractual determination of wages in money terms. Under an income tax, the wage is set in pretax terms. Workers finance consumption out of what remains of their wages after paying taxes. Under a sales tax or a value-added tax (VAT), the wage is set on an after-tax basis. Workers use their entire wages for consumption and pay their consumption taxes as they consume. When an income tax is replaced by a sales tax or VAT, the wage bargain should be revised to lower the purchasing power of wages or by raising the prices of consumption goods. As a practical matter, the second always occurs.
One of the advantages of a flat tax or a personal cash-flow consumption tax is that both leave the wage bargain in pretax form. There is no disruptive jump in the price level. Unlike other effects I have discussed, the increase in the price level is not intrinsic to a consumption tax, but is the result of a particular choice about how to administer the tax.Source: Potential Disruption from the Move to a Consumption Tax, by Robert E. Hall. The American Economic Review.
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