Thursday, September 13, 2007

A Tax Cure All?

During a Presidential debate, Gov. Huckabee referred to the “Fair Tax”, and I didn’t know what it was so I looked it up. I came across, which has done research for its plan to make the tax code more efficient and fair.

Generally, this approach is a consumption tax. The “fair tax” charges a sales tax of 23% on all final goods and services. Used items would have no sales tax. There would be no income tax or any other kind of federal tax. Each person would receive a “prebate” (an early rebate) each month so that all spending up to the poverty line would be tax-free. If the poverty line were set to $15K, the prebate checks would total $3,450 during the year.

Supporters claim the plan is more efficient than the current tax code, which I believe is true. Obviously, if the tax code shrank from over 9,000,000 words down to the 130 pages they suggest this would save a lot of money on tax compliance. The group also states that this plan could eliminate the IRS, and end Congress’ love affair with lobbyists. Unfortunately, the devil is in the details.

A glaring problem is crossing borders to buy big-ticket items in Canada and Mexico. I live several hours from Mexico, but if I were going to buy a $25K car that had a 23% tax on it ($5,750), I would definitely buy it in Mexico. People living further away from the border could still save thousands by flying there to purchase a car, boat, jewelry... Only a fool would buy any big-ticket item inside the U.S.

The phrase “final goods and services” may be short, but the definition of “services” could run as long as the current tax code. The definition of “services” is vague and left up to interpretation. A link to their definition is here.

Would a company that currently provides services now have to pay a 23% tax on all the services it performs? Let’s say ABC Services Inc. earns $10 million in revenue per year, and makes $1 million profit. Currently they would pay 35% tax on $1 million, which yields $350K in taxes. If they had to pay 23% tax on their services that would mean $2.3 million in taxes ($1.3 million more than their profits). This means a whopping 757% tax increase that would drive the company into bankruptcy. Maybe this type of “service” does not count as a taxable service, but that would be up to Congress and an army of helpful lobbyists to decide.

Because of the high tax rate, every industry would constantly be lobbying to remove all or part of their output from the definition of “Final Goods and Services”. The “FairTax” would not end the IRS nor would it end lobbying.

This is not to say that a simple tax code is not a noble cause. The Tax Foundation projects that tax compliance for 2007 in the United States will cost around $305 Billion. A study by them on a Flat Tax proposal by then Texas Congressman Dick Armey in 1996, predicted it would reduce tax compliance costs by 94%. Adding up all the government workers, private tax accountants, and the corporate attorneys who work to calculate and avoid taxation it adds up to hundreds of thousands of workers. All of these people could be doing much more productive things.

However, this presents the last and greatest problem with enacting a simplified tax system. The massive upheaval of changing the system would cause many problems. Those whose entire career depends on a complicated tax code do not want to see it go away overnight. If you were 50 years old and all you knew how to do was give advice on the tax code what other kind of job could you hold? Would people give to charity as much if they did not have that pull of a tax deduction? Our current tax code affects our behavior in many ways and completely dropping it might change it in ways that we do not like.

Even though I am a big fan of the Flat Tax, the move to a simplified tax system should be a gradual one. We should have a series of what I dub “Tax Switches”. Those in the highest income brackets who own most corporate stock indirectly pay corporate taxes, which is a 35% tax on profits made by corporations. This tax should be eliminated and switched to an increase in the marginal income tax rates.

If done right, the average person would be no better or worse, and it is one less tax to have to fool with. The countless hours companies spend coming up with ways to reduce taxes are less productive for society as a whole. By doing it slowly and in one sector of the tax code, mass layoffs are avoided.

This may be oversimplified and if someone sees some holes in my logic let me know. I am suggesting this general idea.

Over say ten to twenty years, other taxes would be eliminated in the movement towards a flat tax. Tax deductions would also be eliminated while lowering the marginal income tax rates across the board.

A radical switch in the tax structure sounds good, but it is not feasible when everyone starts to realize how much stress it will cause in the short run. It is also not enough to complain about the size of the tax code and hope Congress does the right thing. We need specific policies that will help us take steps towards a simplified tax code like a Tax Switch.


Ian said...

As for "crossing borders" to buy big-ticket items: Those would bear the tax upon entry into the U.S. All imported goods bear the tax.

As for comparable taxes: Right now, based on research by Dale Jorgenson, there exists (on avg) 22% price inflation due to the business costs of complying with income and payroll taxes - higher for some industries, lower for others. Thus, using the average on $10 million, the hidden tax - paid by consumers - is $2.2 million + $350 k paid by the business (which is really passed along to consumers) equals $2.550 mil, or 25.5% of revenues.

The effect of the FairTax - because it is revenue neutral - is to "externalize" this embedded tax factor. The business builds collection of the tax into reduced-cost services, and is granted an administrative credit against the tax remittance. Based on page 11, Figure 1 of the "plain english summary" of H.R. 25, on $7.8 million in reduced-cost sales, this would amount to $2.33 mil in tax, plus an administrative credit total of ~47,000.

So, $2.33 mil + ($47K) = $1.86 mil, or 23.8% of revenues. Keep in mind that the company now has the full use of all of its income, and cheaper costs for doing business. Plus, it isn't punished for hiring people, nor will it have politicians in Washington cutting deals with its competitors - or competing sectors! (Not to mention the money IT will save by not having to pay for lobbyists to protect its interests against tax activism by others - which now accounts for 53% of the lobbyists in Washington!)

The FairTax is not only feasible, but URGENT, if one takes to heart the concerns of an economic meltdown detailed by Dr. Laurence Kotlikoff. Indeed, the system is uncorrectably corrupt because of invisibility and the lack of political accountability it fosters. Tom Frey, of the DiVinci Institute, foresees the coming collapse of the income tax system.

What must be done is that you, and me, must ACT to demand our legislators scrap the tax code and pass the FairTax Act.

Brian Shelley said...


Good points. I felt rather sheepish after someone e-mailed me and explained why enforcing cross border sales would be pretty easy, with the possible exception of jewelry and other small items.

I still have some concerns over bleeding hearts lobbying to get certain "necessities" to be tax free. Who would win an argument to eliminate consumption taxes on baby formula? Sure it opens a can of worms, but I can't imagine that it wouldn't pass.

I also have some concerns about the perceived regressive nature of the tax. I probably need to do more research, but that was my first reaction to it and I'm guessing for others as well.

The links are right on about the fact that international competitiveness will force us to do something as we start to fall behind.

Ian said...

First, keep in mind that prices after FairTax passage would look similar to prices before FairTax - not "30% higher" as opponents contend - competition would see to it. So, the FairTax rate (figured as an income-tax-rate-non-comparative, sales tax) on new items would be 29.85% (on the new, reduced cost of items because business isn't taxed under FairTax - thus lowering retail prices by 20% to 30%), or 23% of the "tax inclusive" price tag - this is the way INCOME TAX is figured (parts of the total dollar).

To address your concerns about "regressivity," the effective tax rate percentages, that different income groups would pay under the FairTax, are calculated by crediting the monthly "prebate" (advance rebate of projected tax on necessities) against total monthly spending of citizen families (1 member and greater, Dept. of HHS poverty-level data; a single person receiving ~$200/mo, a family of four, ~$500/mo, in addition to working earners receiving paychecks with no Federal deductions) Prof.'s Kotlikoff and Rapson (10/06) concluded,

"...the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.

"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."

Further, per Jokischa and Kotlikoff (circa 2006?) ...

"...once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."