FAIR TAX BLOGBURST 10-04-06

by Jonathan Garner of Publius Rendezvous

It has been interesting lately to observe just what the critics of the Fair Tax have to say. Lately, much of what has been said has centered around percentages. Clever as it may be to confuse people with cleverly worded assertions that tend to fool the average American when it comes to these issues. If anyone in the audience is similar to me, it takes focused attention lest my eyes glaze over at the thought of following someone's lessons involving percentages, statistics and numbers in general.

Succinctly, what has been asserted that I have seen generally resembles something such as this:

Remember, even the proponents admit they'd need a 23 percent tax rate to fund the current size of the federal government. However, they are starting out their new "fair" tax system with highly deceptive language.

H.R. 25, Section 101(b)(1) states "FOR 2005- In the calendar year 2005, the rate of tax is 23 percent of the gross payments for the taxable property or service." Note the phrase "of the gross payment."

Here's how it works: You buy a candy bar for a total price, including tax, of $1.30. One dollar of that price pays for the candy bar; $.30 goes to the federal government.

One dollar purchase + $.30 in tax sounds like 30 percent to you and me (and to every state that currently has a sales tax). But the "FairTaxers" don't calculate it that way. They say: $1.30 total price. $.30 = 23 percent of $1.30, therefore the tax is 23 percent.

Many critics have pointed out that this is a deceptive way to calculate a sales tax. AFT rebuts the critics by saying (we paraphrase for simplicity), "If you made $1.30 in income and paid $.30 of it in tax, you'd call it a 23 percent tax rate." The 23 percent figure is what AFT refers to as the "tax inclusive" rate.

But a sales tax is not an income tax, and when we see national sales tax advocates and uncritical journalists promoting the 23 percent figure without giving the underlying explanation, we can only think that some very thick wool is being pulled over people's eyes.

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

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

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

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

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

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

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

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

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

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

The FairTax Blogburst is jointly produced by Terry of The Right Track Blog and Jonathan of Publius Rendezvous. If you would like to host the weekly postings on your blog, please e-mail Terry. You will be added to our mailing list and blogroll.