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Sunday, July 30, 2006



Thanks for highlighting the FairTax. You missed the major point, though, on embedded taxes. Embedded taxes aren't those corporate income taxes you pay - it's the cost of the taxes payed on the labor to produce a good. Let's say Wal-Mart sells something for $5.00. It's cost to purchase that good is $2.50. Its cost to sell that good is $1.50, and its profit margin is $1.00. The cost to sell the good itself, the $1.50, includes wages and FICA, keeping out admin. Take FICA out and you've saved 7.65% on the $1.50. But, lo!, the cost to produce it goes down, too, by some number. It is estimated that the cost of goods includes 15-25% embedded taxes. You may assume any amount in that range, but on the whole, prices will drop before going back up.

I'm not as optimistic as the authors on the range of embedded taxes, but I assume at least 15%, just accounting for FICA (both halves). Other taxes, including the corporate income tax, go away, too, but so do compliance costs, which are staggering.

As to your house example, you are simply wrong. You need to read the book before coming to your conclusions, especially if you're going to blog on it. Again, housing is labor intensive. Assuming only a 15% drop in cost-os construction, that leaves you at 85 cents to the dollar. 30% of 85 cents is 25.5 cents. Assuming the low end rise, your house now costs $1.105 per dollar of "old" house. That premium is not far beyond the "new" house premium now anyway. And what's wrong with "old" houses becoming more valuable? If you own one, you're sure going to be happy. But the bump will be one-time only. Once existing houses have appreciated due to the transition, the FairTax will be built in.

First-time homebuyers will have more in their pockets, so buying that new home or first old home won't hurt any more than it did before.

Be careful before you decry something you don't fully understand, and I mean that in the sincere sense, not the "you aren't smart enough so be quiet" sense. I know you're smart enough, but the ripples in the pond on this one are big, and a glimpse just doesn't allow enough understanding.

And the 30% number isn't fair, either. Unless you're going to describe the 25% income tax bracket as the 33% bracket, or the 35% bracket as the 54% bracket, use the inclusive 23% number. If you spend a dollar, 77 cents go to the retailer, and 23 cents goes to the government. If you earn a dollar, 25 cents goes to the government and 75 cents goes to you. Apples to apples.

I say, "Jump on that bandwagon!"


Thanks for the point about FICA, I missed the boat on that issue.

A few additional remarks:

The savings to a company from eliminating FICA would actually be more like 7.11%, not 7.65% (tax-inclusive rate and all... only 7.11% of the total payroll expense to a company now is FICA, exclusive of benefits of course). Sure, it's only a little more than half a percent difference, but that does add up.

And while the embedded tax savings in the cost of goods might possibly be 15%, it wouldn't be due to eliminating "both halves" of FICA. The company would only save its half of FICA, unless it cut employee salaries by the other half (which supporters of the FairTax insist will not happen). So, as above, the FICA savings would be only 7.11% of payroll costs, which presumably do not make up 100% of current sales price of goods, so the actual price savings on a given item due to the elimination of FICA will by definition be no greater than 7.11% (and in many cases, much less).

Other taxes come into play, of course, but let's continue with our hypothetical Wal-Mart example, adjusted a little closer to reality and normalized to an original product sales price of $1.00.

The most recent data I found show a net profit margin for Wal-Mart of 3.6% in 2005 (up from under 3% a few years ago). So on our $1 item, we've got a net cost (materials, labor, and overhead) of 96.4 cents, and net profit of 3.6 cents. Wal-Mart's corporate income taxes on that 3.6 cents would be about 1.1 cents.

As demonstrated above, the maximum impact that payroll taxes could have on the cost of a product is if 100% of the product cost is in labor. Thus, at most the amount that Wal-Mart would pay in FICA on our $1 product is about 6.9 cents.

So, by eliminating corporate income taxes and payroll taxes, Wal-Mart might save at most 8 cents on the dollar, nowhere near the 15% savings claimed as a "low end".

That assumes the most favorable mix of labor/materials for this specific hypothetical, of course, so the actual savings might well be less than that. On the other hand, the amount of overhead that is related to "tax compliance" would also need to be taken into account. However, I find it difficult to believe that compliance costs that are directly and solely related to payroll and income taxes are "staggering", as a percentage of total overhead costs. Perhaps, for mega-corporations, there may be substantial savings found there. But of all the small businesses that I've worked with (or for), not a single job would be eliminated by eliminating payroll and corporate income taxes. Those taxes are handled by employees with other job responsibilities which would not go away (payroll staff, accounting staff, etc.). The workload for such employees would be reduced somewhat, but the actual cost savings to the companies I'm familiar with would be minimal.

In fact, the total estimated cost of compliance for the federal tax system, according to a GAO report on the subject, including both individuals and businesses, was (on the high end) $200B in 2005. That is a pretty big number, but put in context of the $2,100B collected that year, it represents only about a 9.5% premium above the direct cost of taxes. So if you were to take that 8% direct cost for our Wal-Mart example, and apply even double the GAO compliance premium as additional cost, you'd still have less than 10% total tax expense on product pricing.

So basically, I'm suggesting that there's an upper limit to the average cost savings from the FairTax to be expected in the economy, and that upper limit is probably substantially less than 15%. By the way, as I demonstrated above, the more labor-intensive an industry is (such as housing), the closer to that 7% limit you'll get for savings.

And we still haven't talked about the market incentive for companies to actually cut prices by the amount of tax savings enjoyed, whatever that amount might be.

On another subject, it really doesn't much matter whether you try to standardize quoted percentages as tax-inclusive or tax-exclusive... because the basis for the income tax is completely different from the basis for the sales tax. Your example isn't "apples to apples" either, because you switch from spending a dollar to earning a dollar, regardless of percentages.

In fact, the "fairest" way to compare the change in taxes is to look at actual dollar amounts paid by an individual under both plans. And while it's difficult to estimate what the actual change in base price for goods and services might be (as noted above), we can make some assumptions and then draw some general conclusions from that.

Taking my own most recent paycheck as an example, my federal withholdings for income tax, social security, and medicare work out to 27.5% of my gross income (yeah, I get hosed... single middle-class male with no wife, no dependents, and no mortgage... I'm nobody's idea of a "target" for tax cuts! :-D )

So to compare equivalence of tax revenues to the federal government, we can ask how much would I need to spend on taxable goods and services, for the feds to get the same amount of money from me as they currently get?

Accounting for the $188 monthly "prebate" I'd be entitled to under the FairTax plan, by my calculations I would ultimately need to spend almost 129% of my gross income on taxable items (tax-inclusive) in order for the feds to get as much money from me as they do today.

Obviously, spending 29% more than I make is not a sustainable behavior. So even if I wanted to, there's just no possible way that I could pay as much to the feds under the FairTax plan as I do now. As I said in my original article, it's actually a great deal for me personally!

But here's the general question I have... if businesses are no longer providing tax revenue for the feds (either corporate income or employer FICA), and people like me aren't providing anywhere near as much revenue for the feds (can't spend enough to make up the difference)... but the feds are guaranteed by the plan's supporters to collect just as much in the first year under the new system as they do under the current system...

Where's the money coming from?

By definition, if some entities that are currently being taxed will pay less in the future, then some other entities must pay more in the future for everything to balance out.

But I strongly suspect that this is where the promise of the FairTax falls flat. Proponents claim that by allowing people to keep their income for themselves, this will spur economic growth, and the extra growth will make up the difference. But they also claim that the government won't be short-changed by this plan; federal revenues will remain the same as under the current system.

And the bottom line is, if the feds are taking money out of the economy, whether they do it directly out of your paycheck or they take it out at the cash register, the money is coming out of the economy. The promised massive economic growth from all of this untapped capital seems like a lot of smoke and mirrors, because the same exact amount of capital freed up by eliminating the income and payroll taxes must be taken again in the form of the replacement sales tax, if federal revenues are to remain the same. The remaining capital in the system may get shifted around, but it won't necessarily grow.

Certain individuals will benefit greatly from this plan. But for them to do so, while still extracting the same amount of money out of the economy, will mean that other individuals will pay.

And what the FairTax proponents have failed to adequately explain, in my opinion, is exactly who the net losers are going to be.

So as I said before... it's an intriguing idea.

But the plan seems to make promises that it can't possibly keep, using unrealistically optimistic economic forecasts. I remain highly skeptical, but willing to listen. ;-)

ARgh. I just typed a long post and accidentally closed the window. I'll try to recreate it as best I can. It was probably too long, anyway.

Where to start (again)?

OK, first, the money comes from:

a) visitors to the US, who spent over $100B here last year,

b) tax evaders of all stripes, including drug dealers and corporate raiders, each time the buy an Escalade or a Lear Jet, and

c) the repatriation of offshored money currently evading taxation.

Obviously, if receipts were ~$2TT last year, and these account for at least $300BB in new spending, our net tax burden, for those who paly by the rules, drops 15%. This doesn't even account for soft tax cheats, people who take a little bigger deduction than they should or pay landscapers cash, or whatnot.

On the whole, though, most people will wind up about the same, with one exception - the poor will be completely untaxed. Completely. There is no ambiguity on this. No FICA, no income tax, nothing. And no tax is more regressive than the payroll tax.

As for Walmart, their profit margins are so skinny, that the embedded taxes are smaller than most businesses. I think it's probably not representative to use them as a hypothetical. I know that's a bit of a dodge on the question, but most businesses don't operate on 4% margins. Soooo, Wal-mart's prices will be relatively higher, allowing Mom and Pops to be more competitive, which we all would assume is a good thing.

Let's go to a dollars scenario. You make $20/hour. Your employer pays you $21.422 an hour with your 7.11% FICA. You are in the 27% bracket with everything. Meaning you get to keep $14.6 an hour.

You would like to buy a widget. Today, the widget costs $14.60. You have to work one hour to pay for that widget.

Tomorrow, the FairTax goes into effect. Assuming your employer pays you $20/hour, but keeps the 7.11% so he can simply make more profit, prices soar 30%. Your widget now costs $18.98. 23% goes to the Feds and the employer keeps $14.60. You only have to work 57 minutes now to earn that widget.

And you get the prebate. And we haven't factored in any price drop for embedded taxes. And we haven't factored in any increase in economic activity due to the reduction in burden on business. And you still have an extra $1.02 in your pocket.


Not really. It just highlights the real math involved. Most people don't know what they pay now ("I got money back this year!"), so they see this new tax as worse. But it's not. Prices go up 30% (worst-case scenario), but you got a 37% raise! If you're poor and your tax burden was low, the prebate would be a bigger contributor to your bottom line, thus offsetting the price increase. The rich, who pay a lot in tax, will pay a lot in sales tax, because they tend to buy more. If they scrimp and save, they'll pay less, but Paris will spend it for them once they die, so the government will get theirs eventually.

Been there (losing a lengthy post)... very frustrating, eh?

OK, so I think perhaps you missed a bit of my point... I fully realize that most people who play by the rules now will see a net decrease in federal taxes paid. In my own case, I'd be almost guaranteed at least a 25% reduction in federal tax burden and very likely more than that (but then, that's likely because I pay so much in income taxes now relative to others in my income range). So you're preaching to the choir as far as the sales tax being a better deal on an individual basis. The 30% rate doesn't scare me at all.

My bigger question is, with most people paying less to the feds, in some cases substantially less (such as the working poor many of whome, as you say, would be completely untaxed), who is making up the difference in federal revenue?

Your answers are helpful, but I still question whether those sources will completely make up the difference. And, they represent a mixed bag for the economy as a whole. There are downsides to consider as well, it's not all positive.

For example, the tax that would be captured from foreign visitors. You are correct that this represents an all-new federal revenue stream. Assuming continued spending around $100B, that would make for $23B in new federal tax revenues (we're assuming that the visitors have the same total spending budget, of course, since they didn't have their income taxes eliminated). So that would recover about 1% of current federal tax revenues (in very round numbers).

But, that $23B comes at the expense of the travel industry. That money gets absorbed as taxes rather than hotel rentals, airline travel, tickets to Disneyland, etc. It's less income for somebody in the supply chain, which means less money available for consumer spending somewhere along the line. How big an impact this will have, I can't say. But the point is that we wouldn't get the full benefit of that $23B in "new" revenue because we'd be paying for it in reduced consumer purchasing (thus less sales tax revenue) to some extent.

That also assumes that the new 30% premium placed on travel to the U.S. doesn't deter some foreigners from visiting in the first place. This would immediately make the U.S. a less-desirable travel destination, so one has to assume that overall foreign travel would decrease by some amount. I don't know how much that would be, but it's safe to assume that $23B in new tax revenue is a ceiling, and the $23B reduction in travel-related revenue for the economy is a floor.

Then consider the newly-captured taxes from the "underground economy". Fair enough, yes we will start taxing people who weren't paying taxes before, so there's some new revenue involved there. How much? Do we have decent figures on how many mob bosses are out there evading taxes right now? This may be a substantial amount of new tax revenue, so that could be a very good thing.

But keep this in mind... to the extent that those people are not paying taxes on their income now, and thus represent potential new federal revenue, the sales tax will reduce their spending. So while the average Joe no longer pays income taxes and is thus able to afford to buy the same goods and services as before even with the 30% sales tax added in, Anthony Soprano wasn't paying income taxes in the first place, so he just saw a 23% reduction in his purchasing power.

I'm not about to cry for Mr. Soprano... but the same economic downside exists in this case as for foreign visitors. The more you claim we can capture from this new source, the worse it will be for the economy as a whole, as every previously-untaxed dollar taken out in new sales tax is a dollar that can no longer be spent on goods and services. While I don't cry for Mr. Soprano, I do have sympathy for Cadillac and Bombardier as the sales of Escalades and Lear Jets will take a hit to some extent under this plan.

Also, as to the soft underground economy... people who pay the landscaper under the table, for example... what is to stop me from continuing to pay the landscaper under the table with this plan? If anything, this system creates a bigger incentive for underground exchange of goods and services, because of the added sales tax burden. Right now, I have no real incentive as a buyer to pay for things under the table, because I'm paying with after-tax dollars anyway. It's the seller who benefits by that arrangement, as he doesn't claim the income. Under the FairTax system, I have a major incentive to pay for things under the table, because I'm paying with pre-tax dollars. And there's really no reliable system to catch either the buyer or the seller when evading the sales tax, so there's no real disincentive for the seller to accept payments under the table either.

Anyhow, I guess my point is still that while the feds will certainly derive revenue from previously-untapped sources, there will be some offsetting damage to the economy as they do so. Income taxes are a drag on the economy, that's very true. But taxes, period, are a drag on the economy in whatever form they take. The claims of dynamic economic growth as a result of the FairTax proposal remind me an awful lot of claims for perpetual motion machines. It may appear that you're getting something for nothing, but everything has a cost.

And, to make an adequate public policy decision between two plans, we need to know what the actual costs and benefits of each will be. So far, we hear nothing but benefits from the FairTax supporters, while the discussion of real costs has been less than forthcoming. It's definitely been an interesting discussion... believe me, I really want to be able to get behind a plan that would be better for me personally... but so far the FairTax plan has been long on promises and short on proof. ;-)


You're right. There isn't any proof that the FairTax would be better. But there isn't any proof that the income tax is better, or that the rate required to fund the government isn't 20% or 18%, either.

Read the book. Challenge their assertions, back the math out, and let's talk again. But at this time, I don't see how the FairTax is a risk. 85% of the sales of goods and services in this country are through major retailers (>50 employees). Those major retailers have no incentive to help people cheat, so the tax-avoidance market will be relatively smaller than it is today, where multi-billion-dollar industries thrive on providing tax avoidance services (HR Block, insurance agents, bankers, tax attorneys, etc.). Will other multi-billion-dollar industries crop up to promote barter services? Sure, but that will just replace the money avoided now.

Most of the criticism of the plan is based on speculation that it won't be passed as written, or is just flat-out dishonest. (Taxes the poor harder! etc.)

This debate has been honest and informative, and for that I thank you. I would encourage you to look into the details before writing it off, because you're still assuming a 30% bump in prices, without accounting for the embedded taxes, or people's increased purchasing power. Tony Soprano may not like it, but Average Joe will see little change to his bottom line. I've always taken Fairtax supporters to task for saying that prices will stay the same and your wages will go up. That's as dishonest as saying its a regressive tax.

The truth is, most people will see little change in their cash flow, except the very poor, who will see a great change, upwards. Their contribution to the tax base, however, is such a small percentage, that it's negligible. I'll probably see a net increase in my tax burden, you'll see a net decrease, but it's fair. It's a fair system, promotes privacy, reduces the power of government (lobbyists hate the FairTax because it means no more monkeying with favored credits or deductions), and fully funds the social security and medicare nightmares.

I'll tell you who's going to get hit is the rich old guy who gets his max social security pension and pays no tax, but lives for forty years after he retires. He'll get his prebate, but his consumption above the poverty limit will get taxed, as it should. Kids buying candy will pay tax. Unemployed people working under the table will be taxed if they consume more than the poverty level. If you live off the grid and don't bother anybody, grow your food, etc., you won't pay any tax, and you shouldn't because you aren't one of society's problems. If you don't want the government to know who you are or where you live, don't file for the prebate. You'll pay tax on everything you buy, but you can live in total anonymity from the federal government. (Idaho loves the FairTax)

The figure 23% might be high, might be low. but the plan is Fair, transparent, unmanipulable, and the time is right. Society is ready for the privacy age. Progressives should love the plan - no taxes for the poor, and the rich get soaked. Conservatives should love the plan - no deductions to steer favor or behavior. Libertarians love the plan - it's voluntary. Don't buy much if you don't want to pay much. Authoritarians hate it, but they aren't about fairness.

As for taxes being a drag, I'm not saying they aren't. But if you look at the reasons they claim a dynamic growth model, they're sound. Less offshoring, drastically reduced compliance costs, and the removal of tax implications from business decisions WOULD make the US a massive economic enterprise zone that would dramatically boost the US's attractiveness as a place to do business. We still have the most productive labor force in the world; imagine what it would be like if we had the best tax system in the world, too.

I'll check out the book. And you're right, there's no reason to claim that our current system is the best possible system. I'm not opposed to change just because it's change. ;-)

But I just don't see at this time how the FairTax is not a risk. It's a completely unproven, untried system, which pretty much by definition introduces some level of risk. It may have fewer benefits and more costs than advertised -- and, in fairness, the reverse is true too -- but I'm not one generally to buy into anything after only reading the marketing literature. Again, not a reason to write it off entirely, but the burden of proof must lie with those who which to introduce change rather than those who wish to maintain the status quo.

Anyhow, I'll post again on the subject after I've had a chance to really dig into the gory details. Thanks for the discussion, it's been quite interesting!

What happen to health care coming with your tax payment as other country's already have ??

I'm a little late to the party, about 2 months late, but Paul's comment popped this thread into my awareness again and I re-read it. I went and read the FAQ too and I have to say that the claims on their face seem incredible. The idea that we could tax people less while getting the same or more tax revenue seems impossible.

"But we will stimulate the economy without causing inflation and make up the difference." If freeing up capital could stimulate the economy without causing inflation, why wouldn't the fed just set the prime rate at 1% and leave it?

"And we'll capture new taxes from foreigners and people who currently avoid income tax." That is true. But how much and at what cost. You start taxing people who were not taxed before and they WILL change their behavior.

Extraordinary claims require extraordinary proof. I have no doubt that there are tax systems more fair that what we have, but you can't get something for nothing.

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