The Fair Tax Problems and Possibilities

1
The Fair Tax Problems and Possibilities

• It is fairer to tax people on what they extract
  from the economy, as roughly measured by their
  consumption, than to tax them on what they
  produce for the economy, as roughly measured by
  their income
• -- Thomas Hobbes in Leviathan

2
Current System - Personal Income

• Personal Income tax depends on the total yearly
  income less possible deductibles.
• Collected on a pay as you earn basis.
• Corrections are made at the end of the tax year.
• After corrections are made, taxpayer may owe in
  taxes or may qualify for a refund.

3
Current System - Business Income

• Corporate tax generally refers to a direct tax on
  the profits made by a company.
• Earnings are considered gross revenue less
  expenses.
• Corporate expenses that relate to capital
  expenditures are usually deducted in full.
• These expenses are deducted over the useful life
  of the asset purchased.

4
Current System - Payroll

• Payroll tax usually refers to two different tax
  systems.
• First is where employers are required to withhold
  earnings from employees check.
• Known as Pay As You Earn system.
• Other payroll taxes are paid from employers own
  funds.
• Gets paid into government programs such as social
  security, disability, health care, and
  unemployment.
• Either a fixed charge per employee or a
  percentage of each employees pay is what
  determined this tax.

5
Current System - Inheritance

• The inheritance tax, estate tax, and death duty
  are names given to various taxes which arise on
  the death of an individual.

6
Current System - Capital Gain

• A capital gains tax is levied on the profit
  released upon the sale of a capital asset.
• Capital gain is treated as income and is subject
  to the marginal rate of income tax.
• In an inflationary environment, capital gains may
  be to some extent illusory if prices in general
  have doubled in five years, then selling an asset
  for twice the price it was purchased for five
  years earlier represents no gain at all.

7
Fair Tax - Sales Tax Rate

• Fair Tax legislation would apply a 23 federal
  retail sales tax.
• Tax would be levied on all U.S. retail sales for
  personal consumption.
• Savings, Investments, and Educational tuition
  would be considered investments and will not be
  taxed.
• Personal services such as health care, legal
  services, auto repair, haircuts, etc. would be
  taxed.

8
Fair Tax - Effective Tax Rate

• Effective tax rate for a family household would
  be variable due to fixed monthly tax rebate.
• The rebates would have the greatest effect at low
  spending levels, where they could lower a
  households effective rate to zero or a negative
  rate.
• At higher spending levels, the rebate has less
  effect, and a households effective tax rte would
  approach 23 of total spending.

9
Analysis of Fair Tax burden

• There is a large concern about keeping taxation
  progressive
• A straight up sales tax is regressive
• If everyone paid a high percentage tax on what
  they purchased, the tax burden would shift to the
  poor
• Examples
• 1. College students.
• Low tax burden now
• High tax burden under straight up sales tax
• 2. The wealthy.
• Higher tax burden now
• Lower under straight up sales tax

10
What the presidents panel says

• The Presidents Advisory Panel on Tax Reform
• Created by executive order 13369 by President
  Bush in 2005 to study different tax proposals
• Basic goals of American Tax reform
• 1. Simplify tax code
• 2. Keep tax code appropriately progressive
• 3. Long term job growth
• Replacing the income tax with a retail sales
  tax, absent a way to ease the burden of the
  retail sales tax on lower and middle-income
  Americans, would not meet the requirement in the
  Executive Order that the Panels options be
  appropriately progressive.

11
Easing the Burden A prebate

• How to ease the burden on low and middle income
  Americans?
• Fair tax proposal removes tax burden for income
  earned under the poverty level (determined by
  family size)
• There is an additional problem with smoothed out
  consumption
• The checks would be issued once a month
• Examples
• A college student with an income at the poverty
  level (10,400)
• 2,392 a year
• 199 a month
• A family of four with an income at the poverty
  level (28,000)
• 6440 a year
• 537 a month

12
Prebate and Progressivity

• The prebate makes the Fair Tax more progressive
• If everyone spent all of their income, the more
  that people make and spend, the higher the
  effective tax rate

13
Philosophical Questions

• American political thought rallies around
  independence and freedom
• The prebate would make large amounts of people
  dependent on the American government for their
  monthly checks.
• Does this harm our independence?
• Counter point A lot of us wait for our Income
  tax refund every year, or alter our purchasing
  behavior due to tax breaks, are we really all
  that independent?

14
Transition Problems

• Encouraging Savings
• If you were receiving more money from the
  government than you pay in taxes just what would
  you be buying?
• If people are inclined to retain their money
  rather than spending it, will that reduce
  consumption enough to cause a recession?
• If you saved your money rather than spent it, you
  would be able to do so without income taxes,
  making dangerous credit card debt and over
  spending much less appealing than our current
  system

15
Transition Problems

• Impications of Transition
• The Fair Tax is going to be regressive by age
• If you already have your home filled with items,
  you will not be spending as much as someone who
  is buying a house and things for their house
• This means that the older generations of
  Americans will be more inclined to support this
  than younger people who use more of their income
  on goods and services
• At the same time however, people who have saved
  and collected money while suffering the income
  tax would be double taxed by the Fair Tax\
• Example if you paid a 30 of your income so in
  order to save 1000 you would have to earn 1428.
  After paying 428 in taxes you would then be
  taxed again on what you consume with that 1000.
  

16
Revenue Neutrality

• What is the right tax rate?
• Currently there is estimated a 15 evasion rate
  of federal income taxes
• The evasion rate is why people question if the
  proposed 23 sales tax would be enough, many
  speculate that the actual tax may have to be
  30-40
• On the flip side, because people traveling to
  America would be spending money here that they
  would never pay income taxes on, there would be
  some positive inflow of foreign money by the Fair
  Tax

17
Black Market Growth

• Historically black markets emerge wherever there
  is an incentive to avoid the laws placed on
  people
• Prohibition created a huge black market for
  alcohol
• Drugs and Narcotics are entirely black market
  itemsthe market does exist despite it being
  against the law and relatively easy to trace

18
Black Market

• If the sales tax in the United States on all
  purchases of physical goods and services was
  23-40 there would be a huge incentive to
  purchase things on the black market
• In Iowa where fireworks are illegal there is a
  market beyond the borders of this state at every
  major highway where fireworks are legal
• We could expect similar markets to border the
  United States in Canada and Mexico,
• We could also expect many people would bring
  items into America and illegally sell them
• If you bought 50 laptops that cost 1,000 each
  and haul them to Minneapolis, normally they would
  have 230 in taxes placed on their purchase, but
  if you only charged a 100 premium from people,
  you would easily be able to cover the costs of
  the trip with the 5000 you collect, at the same
  time people who save 130 on a new laptop
  purchase would also be very inclined to seek the
  black market

19
Effects of FairTax on Economy

• Impact of new tax system on the economy
• Variables Real GDP, Investment, Labor
  compensation, Consumption, Employment
• Necessity of an accurate model
• Computable general equilibrium model
• Study by BeaconHill Institute
• Constructed in 2006

20
Model Details

• Analysis of variables in economy such as prices,
  employment, savings, interest rates, and exchange
  rates
• Used by CBO and US Treasury
• Details
• Economic relationships among producers,
  households, government, and the rest of world
• Equilibrium model (assumes demand equals supply
  in every market)
• Dynamic model (accounts for secondary effects of
  tax changes)

21
Model Details

• Assumptions
• House holds are assumed to maximize their utility
• Accounts for future policy changes
• Producers are assumed to maximize their profits
• Government taxes, Government spending

22
Circular Flow in a CGE model
Source BeaconHill Institute
23
Elasticities

• Behavioral Elasticities of Substitution in
  Consumption and Production
• Inter-temporal Elasticity of Substitution
• Intra-temporal Elasticity of Substitution between
  Consumption and Leisure
• Intra-temporal Elasticity of Substitution between
  Consumption Goods
• Armington Elasticities

24
Results

• Effects on economic performance

Table 1. Effects of the FairTax Relative to
Current Law ( change)
Source BeaconHill Institute
25
Results

• Effect on GDP

Source BeaconHill Institute
26
Results

• Effect on Investment

Source BeaconHill Institute
27
Results

• Effect on Employment

Source BeaconHill Institute
28
Results

• Effect on comsumption

Source BeaconHill Institute
29
Results
Table 2. Index of Change in Real Output Relative
to Benchmark of 100, by Sector
Source BeaconHill Institute
30
Results

• Effects on specific economic indicators

Table 3. Summary Effects of the FairTax on Income
Groups Relative to Current Law, 2007-2031 (
change)
Source BeaconHill Institute
31
Results

• Indicator of well-being
• Income
• Consumption
• Leisure
• Utility

Table 4. Lifetime Utility under the FairTax
Relative to Current Law (static household
mobility)
Source BeaconHill Institute
32
Results
Table 5. Distribution of Household Units by
Income Group
Table 6. FairTax Impacts on Instantaneous and
Lifetime Utility of Households (relative
to current law, change)
Source BeaconHill Institute
33
Personal Conclusions

• Prashanth
• Ken
• Mike
• Will