A HARDER LOOK AT THE FAIR TAX
by James M. Bennett
Mr. Bennett is the volunteer state Co-Director for New Jersey of Americans for Fair Taxation, a non-partisan grassroots group to educate the public about the Fair Tax
Professor Adler, in his opinion piece "A Hard Look at the Fair Tax," from November 22, 2007, is the first critic I have seen to make some founded criticisms of the Fair Tax, none of which however is a deal-breaker. Adler's most fundamental oversight, however, is to view the tax statically and ignore dynamic benefits of the change, for example, the removal of tax costs that are embedded in the prices of goods and services sold today (although Adler does discuss briefly high-volume low-margin businesses. He also does acknowledge that his piece does not address the macro-economic benefits of the tax). The following comments will pull topics together that are scattered throughout his opinion piece.
PURCHASING POWER.... 1
UNFORSEEN CONSEQUENCES....... 2
STATE ADMINISTRATION. 3
STATE AND LOCAL GOVERNMENTS....... 3
SOCIAL SECURITY 4
LEGAL UNCERTAINTY 4
IRS "SAFETY NET" AND INCENTIVES... 5
EVASION.. 6
TRANSITION.... 6
CONCLUSION.... 6
PURCHASING POWER
Contrary to Adler’s assertion that purchasing power would decrease, the combined effect of eliminating income tax and embedded tax costs in the prices of today’s goods and services would actually increase consumer purchasing power. Adler offers charts purporting to demonstrate decreased purchasing power following the Fair Tax. The flaws begin with the disregard of the effect of elimination by the Fair Tax of payroll, FICA, taxes on take-home pay for those who work. The retiree analysis claiming a 3.74% reduction in purchasing power overlooks the indexing of Social Security benefits, Title III, Section 303, and the effect of removing tax costs from today’s prices for goods and services.
An interesting question is the effect of the Fair Tax on those who live from the corpus of savings, such as "trust babies." One would have to acknowledge that prices would rise somewhat for this group of people, on a one-time basis, as a result of the Fair Tax - however nowhere near the 30% Adler contends since there are substantial tax cost savings. To the extent that people go into savings corpus and cannot live from income, which becomes untaxed, there would be some disadvantage. Thus the Fair Tax truly is a wealth tax.
Groups that in fact would sacrifice purchasing power under the Fair Tax would include crime figures and foreign tourists. They would become taxpayers to the relief of the rest of us.
UNFORSEEN CONSEQUENCES
Adler raises concerns about unforseen consequences of changing from a system we know to a new one. However several considerations make the chance one worth taking. The tax code today punishes productivity, thrift and effort. Comptroller General David Walker warns of a fiscal crisis if Americans do not raise their personal savings rate, and Adler acknowledges that the Fair Tax removes the marginal tax on savings. Foreign business, through lower corporate taxes and abatement of the VAT, competes in our own market at an unfair tax advantage. American business makes tax-motivated decisions, often at the expense of business-motivated decisions, and becomes uncompetitive. Dollar-denominated investments abroad amount to over $12 trillion, which under the Fair Tax will be repatriated and infused into the American economy. Social Security and Medicare, which the Fair Tax stabilizes, are headed for insolvency under today’s state of affairs.
Perhaps the most significant punishment of savings is the Earned Income Credit, which disappears with the Fair Tax. Instead, the Fair Tax gives the same pre-bate to everyone and never takes it away. The pre-bate gives low-income people a substantially greater incentive to improve themselves and at the same time demonstrates fairness to them. Adler’s point about the absence of assurance that the pre-bate will be used wisely, and not for drugs, alcohol or chocolate bars, applies equally to today's Earned Income Credit and other tax advantages intended to help the poor.
All reputable economists agree that the economy would benefit from the Fair Tax. Even the American Retail Association, that opposes it, acknowledges that the United States economy would benefit long-term from the Fair Tax. The President’s Mack/Breaux Tax Panel, in their conclusion that the Fair Tax rate was inadequate, ignored $23 million worth of Fair Tax research and came up with a flawed analysis - it used the wrong tax base. Adler, in calling for additional micro-economic study, also did not consider a study performed by Harvard Professor and Economics Department Chair Dale Jorgenson which examined embedded tax costs in 35 branches of the economy. The average embedded tax cost over the entire economy is 10% before consideration of tax compliance costs and additional efficiencies through increased capital spending brought on by the Fair Tax. When one factors these components in, the savings begin to approach 20%.
STATE ADMINISTRATION
Adler argues that the ¼% administration credit to the states would be an insufficient incentive for the states to agree to sign on to a cooperative agreement. He overlooks two benefits states would have from signing on. The first is the short-term use of substantial sums of money. The second is federal cooperation in reaching internet sales, projected at $33 billion for 2008.
Adler states that the administration fees paid to the states and merchants would exceed the IRS budget, which misses the main issue. Although the IRS today costs $10 billion, the real cost to our economy of the tax code is compliance, whose direct cost is estimated at $350 billion. If we double that amount to consider the lost opportunity costs the result from devoting resources to tax compliance, we approach 6% of GDP annually.
If most of the 45 states who already have sales taxes sign onto the cooperative agreement, most of the tax-collection infrastructure already would be in place. The principal task would be to register service businesses who previously were exempt from the state sales tax.
States furthermore will probably elect to conform their tax schemes to the federal pattern. There is a mild incentive in the Fair Tax for states to have "conforming state taxes," as defined in the bill. Without the federal spur, states may be reluctant to go it on their own (although Michigan and Florida are well on their way) because of the risk of cross-border shopping. Price hikes would be modest because businesses would save their own embedded tax costs at the state level. A study by Dr. Karen Walby, citing other studies, indicates that New York and California could eliminate their income taxes by expanding their state sales tax bases and increasing the rate by only a couple of points.
STATE AND LOCAL GOVERNMENTS
Adler argues incorrectly that state and local governments would see a jump in borrowing costs, to which there is a two-pronged answer. The contention that loss of their interest rates advantage on bonds will raise rates goes against economic analysis. First, the delta between taxable bond yields and tax-free bond yields is primarily due to taxes. Take away taxes, and interest rates drop to their true market level. After all, the after-tax cost of borrowing money to a profitable corporation, that can deduct bond interest, is little different from that to state and local governments. Thus, consumers of capital are on nearly equal footing.
Second, the state and local government bond market today is limited to high-income individuals whose tax brackets justify the lower yields. The Fair Tax will open up state and municipal issues of bonds to middle-income investors. Further it will open up the market to IRA's and pension funds, who today do not want to waste their tax shelter on these securities because of their relatively low yields. Thus, rather than government bond rates rising to today's corporate levels, corporate bonds will drop to the present government bond level. All may drop further.
The other point about state and local governments is that the Fair Tax will force high-tax states to pay more attention to their residents' pockets. New York and New Jersey today do not mind taxing their residents at high levels because these states know that their residents do not feel the full impact of state taxes. Residents can deduct state taxes from their federal income tax base. Under the Fair Tax state and local politicians will pay more attention to fiscal issues.
Adler argues that the taxation of government should be removed, and the government budget reduced correspondingly. For several reasons, this suggestion should be rejected. We do not want to give government, at any level, a purchasing advantage over non-governmental parties. Governments can formulate more realistic budgets and fiscal decisions when they pay market prices for goods and services they consume. Finally, we want to eliminate the distortion that would take place when nominal government purchases conceal non-governmental interests behind them.
SOCIAL SECURITY
Perhaps Adler raises a legitimate concern over the administrative cost and fraud potential to the Social Security Administration's management of the pre-bate. This concern would be substantial but for the fact that 70% of American households today depend on the federal government for one benefit or another. The incremental cost of ramping up the Social Security Administration would be less than the cost of dismantling the IRS.
LEGAL UNCERTAINTY
Adler overstates several potential legal issues. If the Fair Tax is said to be unconstitutional, one would have to reconcile the fact that state governments today have to withhold FICA and income taxes from the paychecks of their employees. The fact is that the Fair Tax is not imposed directly on the state government but on the transaction. A retail merchant must withhold sales tax no matter who the customer is. Interestingly, the federal government presumably would also have to pay a state's Fair Tax tax on purchases made in a given state.
Adler makes further arguments about the uneven treatment of legal and illegal residents, citing a Ninth Circuit decision that is inapplicable. There is no right of a government benefit to illegal immigrants as long as the federal government honors equal protection and due process. As long as the intent of Congress is to allow the pre-bate only to legal residents, the policy will be defensible in Court.
Adler's argument about trade violations is not clear. Under the Fair Tax the United States treats all goods in its own domestic market equally, regardless of origin. If goods from another country are subject to higher business taxes at the point of origin, that is not the affair of Congress. The United States is not affirmatively subsidizing American business with the Fair Tax. It is merely choosing not to tax domestic business with the Fair Tax. If another county chooses to penalize American goods entering its market, the United States, which still has the world's largest economy, should exercise its retaliatory clout. Such an exercise would force other countries to adopt their versions of the Fair Tax and contribute to the world’s standard of living.
IRS "SAFETY NET" AND INCENTIVES
Adler discusses various contemplated impacts of the Fair Tax. The most difficult to understand is his comment number six about the "safety net provided by the Internal Revenue Code." If the tax code creates the burden in the first place, there is no act of heroism in exempting certain taxpayers or activities from it. There would be more transparency in giving affirmative aid to those who still need government help once they are no longer taxed.
Adler later goes into detail about "incentives" and "benefits" of the current tax code. Without dismissing any of them in a facile way, the story comes to mind of the lady who goes into a bakery. The baker gives her a loaf of bread for free, and she complains to him that he did not give her his usual 20% discount. The best incentive and benefit that a tax code can provide is to impose no tax in the first place.
The loss of the home mortgage interest deduction (and also the local property tax deduction) requires some discussion. Home ownership under the Fair Tax will continue to be attractive. Although one could argue that mortgage interest payments should be subject to the Fair Tax, they are not taxed. Rent however is. Second, because income is untaxed, one saves for a house and pays down mortgage principal more rapidly. Because of the capital-creating and tax-eliminating effect of the Fair Tax, mortgage rates drop 20-40%. Finally, when one sells or bequeaths the house, there is no tax on the gain.
The mortgage interest and local property tax deductions are income-tax deductions, not payroll-tax deductions. If one pays mortgage interest and local property taxes out of wage income, the income is after-tax income as far as the payroll tax is concerned. The Fair Tax eliminates both income and payroll taxes.
Adler argues that the advantage of an investor purchasing a house over a family seeking to move in is unfair. The business purchaser does benefit, from a business use conversion credit when he buys the property, according to the provisions of Title II, Section 202, as long as that property either existed at the dawn of the Fair Tax or paid the Fair Tax previously. However the lower price paid by the investor permits the business to charge lower and more competitive rents. When the investor sels the property to a consumer, the Fair Tax is recaptured.
Adler's argument that there is a self-employment anomaly does not withstand scrutiny of the bill. Adler argues that proprietors of wholesale businesses would never have self-employment income as defined in Title II, Section 903. It is correct that only sales of taxable property count in the calculation of self-employment income, but taxable property under Title II Section 2 is not limited to property sold at retail. Taxable property exists at the wholesale level but is taxed only when sold at retail.
Perhaps the most significant incentive and safety net represented by the Fair Tax that does not exist under the present code is the incentive for people of all income groups to scrutinize government expenditures. Under the Fair Tax, government expenditures become transparent, and people participate in the cost of government in a way that is fair every time they go to the cash register. People are put in control of when they pay tax and how much tax they pay through their purchasing decisions.
EVASION
Adler discusses evasion at length but overlooks the fact that the underground and shadow economy today is $1.5 trillion. If the IRS could close the so-called "tax gap," the federal government would be able to balance its budget.
While no one is claiming that the Fair Tax will eliminate evasion, there are two main reasons to believe that evasion and non-compliance will be far less rampant. First, the Fair Tax is simple and transparent, in contrast to today's IRC. While the Fair Tax is not the Flat Tax, the two share simplicity in common. When Russia implemented its version of the Flat Tax, compliance increased 47%.
Second, the number of collection points under the Fair Tax drops from 155 million individuals and businesses to 20 million businesses. This number makes it easier for tax authorities to focus. A business will be loath to risk its status as a registered seller, representing its livelihood, to avoid collecting and remitting taxes.
Another consideration is that it takes only one person to cheat on income taxes. Cheating on the Fair Tax requires two people, a seller and a purchaser. The chances that two people will risk criminal prosecution and civil sanctions is exponentially lower.
TRANSITION
Adler contends that the prices of goods and services would jump 30% without considering the smoothing effect of the inventory credit of Title II, Section 902 and the continuing effect of the un-taxing of business, the removal of tax compliance costs, and the price-damping effect of efficiencies gained through capital spending. Generally those who accelerate purchasing on the evening before the Fair Tax will be disappointed.
To be sure there will be tax-planning in the year prior to implementation through acceleration of tax-deductible expenses under the current code and deferral of income. Because these are short-term developments, their effect soon will disappear.