James Leroy Wilson's blog

Monday, August 04, 2008

More on the Fair Tax

I missed a key point in my Fair Tax piece below. I imagined that any household that spent less than the poverty line would have an incentive to have a Fair Tax rate of 100%.

But I was wrong, because it is impossible for the Fair Tax rate to be 100%.

You see, in the Fair Tax plan, the tax rate is "tax-inclusive." What if a sales tax doubled the price of a good? In tax-exclusive terms, it would be a tax rate of 100%. But in "Fair Tax," tax-inclusive terms, it would be a tax rate of 50%. If the tax doubles the price from $20 to $40, Fair Tax logic would say that it's a 50% tax, because 20 is 50% of 40.

So what if the tax doubles the prices of goods and services? If the Smith Family makes and spends the poverty line of $28,000, and a 100% tax rate is imposed (or 50% in Fair Tax logic), their expenses would rise to $56,000, but their "prebate," being 50% of the poverty line, would be $14,000, leaving them with combined income and prebates totaling $42,000 and a $14,000 shortfall.

And if the Smiths were frugal and spent just $20,000 of their $28,000 income, and the Fair Tax doubled their expenses, their expenses would increase to $40,0000 and their income plus prebate would be $42,000. In other words, they would be saving $2,000 instead of the $8,000 they had been, amounting to a 75% tax on their savings.

Indeed, if taxes increased the price a thousandfold, under "Fair Tax" logic the tax rate would be 99.9%, and the "prebate" the Smiths would get would be 99.9% of the poverty line, or $27, 972, even as their expenses go up to $2 million.

Under the proposed Fair Tax, the price of a good would rise by 30%, but the tax "rate" would be 23%. In other words, the Smiths, if they spent all their $28,000 income, would see prices rise by 30% but their prebate would only be 23%, a shortfall of $1,960. If they were frugal and were spending just 77% of their income would they come out even on the deal, or come out ahead if they spent an even lower percentage.

It is probable that the repeal on all taxes on the cost of production will lower the cost of goods substantially, offsetting the Fair Tax taxes to some degree. This may have to be the case, because otherwise consumer purchasing will fall substantially and, contrary to claims, the Fair Tax would be quite regressive.

Indeed, this could only really fly if the poverty line was re-calculated to reflect the Fair Tax price inclusion. They should calculate what the poverty line would be if all costs of production would be removed, and then add 30%. Only at this new line would a 23% prebate actually make the Fair tax progressive.

And even so, my point from the last post still stands about how, once the Tax is in place, many people will be disadvantaged by tax rate cuts. The benefit of reduced taxes seems predicated on prices falling proportionally to tax rate cuts, benefiting consumers. But it is more than likely that prices will not fall, or at least not fall so far as the rate cut. Instead, sellers are more likeley to keep the difference as profit. So people making up to twice the poverty line will see their rebate checks fall, but not see a corresponding fall in prices. Therefore, it will still be in their interest to keep the tax as high as possible.

7 comments:

  1. I can't quit follow your math but the Fair tax plan is easy to understand.

    Most people don't realize that corporate taxes add an average of 22% (16% to 25% depending on the product) to the cost of producing goods in America. These taxes are just passed on to consumers through higher prices. So not only are we paying taxes on our own incomes, we're paying all the corporate taxes too. Average middle class families pay about 15% personal income and payroll taxes. With the 22% hidden taxes factored in, we're actually paying about 37%.

    The Fair tax plan offers to eliminate income taxes and replace them a simple 23% sales tax AND a monthly rebate in advance! Now explain to me how anybody (besides the crooks in W.D.C.) could possibly loose anything on this deal. -_<

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  2. I explained it in two posts. The poor and middle class, having received a 23% prebate, will have no incentive to see it ever reduced, and every incentive to see it increased.

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  3. I see what you're saying. If the tax rate is cut, it would automatically increase revenue for retailers (they would get to keep more of what consumers pay) but, it would also cut the prebate percentage and, unless retailers pass the buck by cutting prices, consumers would see a net loss in spending power.

    Notice that a cut in the tax rate would be necessary before prices can be lowered at all. Some stores may cut prices by a fraction of the cut in the tax rate but there would be a strong reluctancy among most retailers to cut prices at all and this would have an immediate inflationary effect.

    The most effective way to deal with this would be to automatically increase the spending allowance, assuming zero price cuts, whenever the tax rate is reduced and then adjust it down over time as pre-tax prices normalize with inflation. A few examples:

    With a tax rate of 23%, a household living at the spending allowance of $28,000 would pay sales taxes totaling $6,440 in and would recieve prebates totaling $6,440- no net gain or loss.

    If the tax rate is reduced by 1%, the household's prebate would drop to $6,160- a loss of $280. In order to preserve their prebate of $6,440, the spending allowance would need to be increased by 4.5% to $29,272.73 ($6,440/.22).

    If the tax rate is reduced by 2%, the household's prebate would drop to $$5,880- a loss of $560. In order to preserve their prebate of $6,440, the spending allowance would need to be increased by 9.5 to $30,666.66 ($6,440/.21).

    If the tax rate is reduced by 3%, the household's prebate would drop to $5,600- a loss of $840. In order to preserve their prebate of $6,440, the spending allowance would need to be increased by 15% to $32,200 ($6,440/.20).

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  4. Your mistake is presuming that the prebate represents additional income, like a welfare check. It's NOT. It's nothing more than an advanced refund of taxes that haven't been paid yet. They can cut the tax rate to 1% and we would still spend the same amount of money on the same amount of goods. Nobody would loose anything from a reduction in the tax rate or the prebate amount. The only difference is how the money is split after it's been spent.

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  5. The problem is incentives. If people believe they will not actually spend up to the poverty line, then they will want to maximize the prebate amount and come out ahead.

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  6. Which, I should add, means they will have an incentive to demand higher taxes.

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  7. If you're earning less than the poverty level, you wouldn't waste your time advocating a tax hike that would hardly improve your standard of living when you could easily find a good paying job and dig yourself out of poverty.

    If you're earning more than the provery level and spending less, you're still not going to support a tax hike because the inflation it would cause would reduce the purchasing power of your savings far more than what the prebate would contribute.

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