public finance – econ 344, iowa state university the fair tax problems and possibilities “it is...

Public Finance – ECON 344, Iowa State University Public Finance – ECON 344, Iowa State University

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


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.


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.


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 employer’s 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.


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.


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.


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.


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 household’s effective rate to zero or a negative rate.

• At higher spending levels, the rebate has less effect, and a household’s effective tax rte would approach 23% of total spending.


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


What the president’s panel says

• The President’s 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 Panel’s options be appropriately progressive.”


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


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


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?


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


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.


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


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 items…the market does exist despite it being against the law and relatively easy to trace


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


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


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)


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


Circular Flow in a CGE model

Source: BeaconHill Institute


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


Results

• Effects on economic performance


Table 1. Effects of the FairTax Relative to Current Law (% change)


Results

• Effect on GDP



Results

• Effect on Investment



Results

• Effect on Employment



Results

• Effect on comsumption



Results


Table 2. Index of Change in Real Output Relative to Benchmark of 100, by Sector


Results

• Effects on specific economic indicatorsTable 3. Summary Effects of the FairTax on Income Groups Relative to Current Law, 2007-2031(% change)



Results

• Indicator of well-being• Income

• Consumption

• Leisure

• UtilityTable 4. Lifetime Utility under the FairTax Relative to Current Law (static household mobility)



Results

Table 5. Distribution of Household Units by Income Group

Table 6. FairTax Impacts on Instantaneous and Lifetime Utility of Households (relative tocurrent law, % change)



Personal Conclusions

• Prashanth

• Ken

• Mike

• Will

public finance – econ 344, iowa state university the fair tax problems and possibilities “it is...

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