Taxing Sales Under the FairTax: What Rate Works?

Transcription

1 Taxng Sales Under the FarTax: What Rate Works? By Paul Bachman, Jonathan Haughton, Laurence J Kotlkoff, Alfonso Sanchez-Penalver, and Davd G Tuerck Paul Bachman s the drector of research at the Beacon Hll Insttute, Suffolk Unversty, Boston Jonathan Haughton s an assocate professor of economcs at Suffolk and a senor economst at the Beacon Hll Insttute Laurence J Kotlkoff s a professor of economcs at Boston Unversty and a research assocate at the Natonal Bureau of Economc Research, Cambrdge, Mass Alfonso Sanchez- Penalver s an economst at the Beacon Hll Insttute Davd G Tuerck s a professor of economcs and char of the economcs department at Suffolk and executve drector of the Beacon Hll Insttute They are ndebted to Davd Burton and Karen Walby for very valuable comments and to Douglas Guffre for hs excellent research assstance HR 25 and S 25 would replace the federal personal ncome, corporate ncome, payroll, captal Table of Contents I Introducton 663 II The FarTax Base 664 A Personal Consumpton Expendtures 664 B Government Consumpton Spendng 666 C The Sze of the FarTax Base 666 III The FarTax Rate 666 A Replacng Tax Revenue 666 B The Prebate 668 C Tax-Inclusve Versus Tax-Exclusve Rates 668 D Determnng the FarTax Tax Rate 668 IV Federal Spendng Wth a 23 Percent Rate 673 V Effects on State and Local Government 674 VI Concluson 677 Appendx A: The Mathematcs of State and Local Fnance Under the FarTax 678 Appendx B: Method Used to Estmate 2007 Baselne 680 References 681 gans, alternatve mnmum, self-employment, and transfer taxes wth a sngle-rate federal retal sales tax known as the FarTax The FarTax also would provde a prebate to each household based on ts demographc composton The prebate s set to ensure that households pay no net taxes on spendng up to the poverty level Wllam G Gale (2005) and the Presdent s Advsory Panel on Federal Tax Reform (2005) have suggested that the effectve (tax-nclusve) tax rate needed to mplement the FarTax s far hgher than the proposed 23 percent rate Ths study, whch bulds on Gale s analyss, shows that a 23 percent rate s emnently feasble and suggests why Gale and the panel reached the opposte concluson Copyrght 2006 Paul Bachman, Jonathan Haughton, Laurence J Kotlkoff, Alfonso Sanchez-Penalver, and Davd G Tuerck All rghts reserved I Introducton The Far Tax Act of 2005 (HR 25 and S 25), would replace most exstng federal taxes wth a comprehensve consumpton tax n the form of a natonal retal sales tax leved at a tax-nclusve rate of 23 percent, effectve January 1, 2007 The act would repeal the federal ncome tax (ncludng the captal gans tax and the alternatve mnmum tax), the corporate ncome tax, federal payroll taxes, the self-employment tax, and the estate and gft tax The act s ntended to be revenue neutral HR 25 calls for revenue, rather than spendng, neutralty Revenue neutralty commonly means usng dfferent taxes to generate the same number of nomnal dollars But most tax changes have lttle potental to change prces, so nomnal revenue neutralty generally equates to real revenue neutralty, whch n turn equates to real spendng neutralty The FarTax has the potental to sgnfcantly change both the prces pad by consumers and those receved by producers Consequently, focusng on nomnal revenue neutralty would rase the queston of what would happen to those prces and thus to real spendng levels TAX NOTES, November 13,

2 Table 1 GDP and Consumpton, Unted States, ($ bllons) Gross Domestc Product 10,128 10,470 10,971 11,734 12,494 Personal Consumpton Expendtures 7,055 7,351 7,710 8,214 8,746 Government Consumpton Expendtures 1,502 1,617 1,737 1,843 1,963 Total Consumpton (personal + government)* 8,557 8,968 9,447 10,058 10,709 Asa%ofGDP Source: US Bureau of Economc Analyss, Natonal Income and Product Accounts [accessed 2006] US Congress, Congressonal Budget Offce, Budget and Economc Outlook for Fscal Years 2007 to 2016 (2006) Note: * Totals may not add due to roundng 1 See Gale (2005) and Presdent s Advsory Panel on Federal Tax Reform (2005) 2 The dfferent fndngs stem, n part, from the mstaken assumpton by Gale and, we presume, by the presdent s tax reform panel (whch has not dsclosed ts method) that state and local governments should be compensated for havng to pay the FarTax, n part from our use of updated data, n part from the focus on dfferent years, n part from other methodologcal refnements and choces, and, n part, from our decson n ths study to gnore (other than some passng remarks) ssues of tax evason, expanson of the tax base due to general equlbrum effects, and captal gans on outstandng government debt In ths report, we focus on real revenue/real spendng neutralty To be precse, we determne what FarTax rate s needed, not only for the federal government but also for state and local governments, to mantan ther real spendng levels after the swtch to the FarTax Focusng on real rather than nomnal neutralty has the decded advantage that one can determne the revenue-neutral FarTax tax rate wthout havng to pn down what happens to the prce level As Gale (2005) ponted out and as our math confrms, the formula for the FarTax rate needed to acheve real revenue/real spendng neutralty s ndependent of the prce level 1 Some crtcs of the FarTax argue that the rate needed for ths purpose would be far greater than 23 percent; Gale (2005) argues that t would be at least 31 percent The most mportant fndng of ths report s that only a 273 percent cut n non-socal Securty federal expendtures would be needed to accommodate a 23 percent rate 2 That s a remarkably small adjustment when set aganst the more than 30 percent rse n the real value of those expendtures snce 2000 It s mportant to note that those calculatons are based on the statc assumpton that mplementaton of the FarTax would have no effect on the tax base; n so dong, they gnore the expansve effect that the FarTax could be expected to exert on the base as t elmnates the bas aganst savng nherent n the exstng tax system Those calculatons gnore: general equlbrum feedback (supply-sde and demand-sde) effects that could sgnfcantly rase the FarTax base (see, for example, Kotlkoff and Joksch, 2005, or Tuerck et al, 2006b); the possblty that tax evason would exceed the consderable amount of evason automatcally ncorporated n our calculatons gven our use of Natonal Income and Product Accounts (NIPA) data, whch undercount consumpton expendtures due to evason under the current tax system; and the roughly $1 trllon real captal gan the federal government would secure on ts outstandng nomnal debt, were consumer prces to rse by the full amount of the FarTax The next secton measures the sze of the FarTax base Secton III determnes the tax rate requred to mantan the level of real non-socal Securty federal spendng under the FarTax Secton IV consders the level of real non-socal Securty federal spendng cut needed to accommodate a 23 percent FarTax rate Secton V ndcates that f state and local governments contnue to collect the same real revenues from ther taxpayers, they wll be able to mantan ther real spendng levels, despte the requrement that they pay the FarTax on ther purchases Secton VI concludes wth bref dscussons of general equlbrum feedback effects, tax evason, the huge potental captal gan accrung to the federal government from mplementng the FarTax, and what may be the FarTax s most sgnfcant feature ts potental to enhance budgetary dscplne II The FarTax Base HR 25 calls for a tax on all consumpton of goods and servces n the Unted States That conssts, for the most part, of what the NIPA defnes as personal consumpton expendtures and government consumpton expendtures Table 1 shows that consumpton, so measured, comprsed approxmately 86 percent of gross domestc product n Although Table 1 provdes a rough sense of the base on whch the FarTax would be leved, a number of further adjustments are requred As ndcated n Table 2, the most mportant of those have to do wth the treatment of housng and educatonal expendtures A Personal Consumpton Expendtures The FarTax has specal provsons for taxng housng, educaton, fnancal ntermedaton servces, and travel We also need to make an adjustment for state and local sales taxes 3 The remanng 14 percent conssted of gross prvate domestc nvestment and net exports, nether of whch s part of the FarTax base The FarTax treats exports and mports on a destnaton tax bass It exempts exports and taxes mports 664 TAX NOTES, November 13, 2006

3 1 Housng Explct rental payments are subject to taxaton under the FarTax Implct rents on exstng owneroccuped housng and farms are not However, the Far- Tax mplctly taxes mputed rent on newly constructed housng va a prepayment approach that leves the FarTax on ther ntal sale 4 Thus, we remove the value of mputed rent for housng and farm dwellngs from the base Because purchases of new homes are counted as nvestment n new structures n the NIPA accounts, we add those fgures to the base Under the FarTax, mprovements to sngle-famly homes and realtors fees, whch represent payments for servces provded, are also taxable Those expendtures are counted as nvestment and not consumpton n the NIPA tables, and they are added to the FarTax base It should be noted that, under the FarTax, there s no tax on the resale of houses or any other property that was prevously subject to the FarTax or that was owned by a consumer on the changeover date 2 Educaton Tuton and job tranng expendtures are treated as an nvestment n human captal and, as such, are excluded from the FarTax base 3 Fnancal ntermedaton The FarTax calls for the taxaton of both explct and mplct fnancal ntermedaton servces that consumers pay to fnancal servces frms Explct fnancal ntermedaton servces nclude fees for brokerage, bankng, loan orgnaton, mutual fund management, and other fnancal servces; and are counted n personal consumpton expendtures n the NIPA tables Implct fnancal ntermedaton servces are defned by HR 25 as the dfference between the basc nterest rate (as defned n secton 805) and the rate pad on an nvestment, account, or debt The dfference between actual nterest payments (for example, new home mortgage nterest) and basc nterest payments (the 10-year bond yeld) s taxable Thus, for example, a taxpayer wth a mortgage rate of 7 percent would have 29 percent of the mortgage nterest payment subject to tax f the Treasury rate were 5 percent Implct fnancal ntermedaton servces are not ncluded n the accountng of personal consumpton expendtures n NIPA Consequently, we have calculated our own values for mplct fnancal ntermedaton servces for home mortgage, nonproft, and personal borrowng 5 4 Accordng to the Natonal Assocaton of Realtors, approxmately 23 percent of newly constructed homes are purchased for nvestment purposes Those homes would not be subject to the FarTax when they are newly bult, but the payments made by the renters of those unts would be subject to the FarTax We make an adjustment to account for those purchases If the houses are later sold by the busness to a consumer (that s, converted from a busness or nvestment purpose to a consumpton purpose), the sales would be taxed under the FarTax We do not attempt to estmate the revenue from ths provson It could, however, be substantal over tme 5 In Table 2, lne 9, mplct fees are mputed as follows: the excess of the basc nterest rate (as defned n secton 805 of HR 25) over the rate pad on such nvestment The value for mplct fees for home mortgages s derved by estmatng the prncpal ($64819 trllon n 2007) by dvdng the total nterest payments (Footnote contnued n next column) 4 Travel As a destnaton-prncple sales tax, the FarTax apples to all retal purchases wthn the Unted States regardless of the natonalty of the purchaser or the orgn of the goods Adjustments to the accounts are necessary to capture purchases made by nonresdents vstng the Unted States and to subtract overseas purchases made by US resdents 6 5 Adjustng for state and local taxes The porton of state and local sales taxes that apples to sales at the retal level s deducted to avod cascadng or levyng the FarTax on top of state and local sales taxes Because the FarTax does not apply to ntermedate transactons (busness-to-busness sales), the state and local sales taxes that apply to those transactons are automatcally excluded from the base We have adjusted our calculatons to reflect an estmate that 40 percent of state and local sales taxes apply to busness transactons 7 6 Other adjustments Food produced and consumed on farms never reaches retal markets and s not subject to the FarTax We subtract the amount of that consumpton from the base Fnally, nonproft nsttutons are treated as persons by the NIPA tables, so ther consumpton expendtures are ncluded n the prvate tax base The consumpton expendtures of nonproft nsttutons consst of ther operatng expendtures, ncludng wages and salares of nonproft workers, but do not nclude ther sales of goods and servces to ndvduals The FarTax taxes nonprofts sales of goods and servces to ndvduals and ther purchases of goods and servces that are not sold on to ndvduals, ncludng captal goods However, the Far- Tax does not tax the salares and wages of nonproft workers, so an adjustment s needed We remove the salares and wages of nonproft workers that are not nvolved n the producton of goods and servces sold to lsted n NIPA Table 711, lne 16 ($4654 bllon n 2007) by the new home mortgage nterest rate lsted n Table B-73 of the 2006 Economc Report of the Presdent (EROP), whch was 718 percent n 2007 We apply the basc nterest rate defned as the 10-year bond rate lsted n Table B-73 of the EROP to the prncpal ($64819 trllon x 520% = $3371 bllon) The dfference between total home mortgage payments and the basc nterest payments ($4654 bllon - $3371 bllon = $1283 bllon) s the taxable mplct fnancal ntermedaton fee Ths calculaton s repeated for nonproft nterest usng the new-home mortgage rate The mplct fee for personal nterest pad s calculated by applyng the basc nterest rate (three-year US Treasury securtes rate) from Table B-73, EROP to the Federal Reserve estmate for total outstandng consumer credt (for 2007: $2,4149 bllon x 37% = $8935 bllon) That fgure s subtracted from the total nterest pad by persons lsted n NIPA Table 711, lne 17 ($244 bllon n 2007) to arrve at our estmate of the mplct fnancal ntermedaton servce for personal credt that s subject to the FarTax (for 2007: $244 bllon - $8935 bllon = $1546 bllon) 6 Accordng to offcals from the Bureau of Economc Analyss, NIPA Table 255, lne 112: expendtures n the US by non-resdents ncludes travel to the Unted States by nonresdents 7 Rng (1999) TAX NOTES, November 13,

4 ndvduals 8 We also remove the captal consumpton allowance to avod double countng B Government Consumpton Spendng Government consumpton s ncluded n the FarTax base to put personal and government consumpton expendtures on an equal footng 9 Government consumpton expendtures nclude payroll taxes pad by governments and ncome taxes and payroll taxes pad by ther employees on government wages They also reflect payroll and ncome taxes pad n the course of producng consumpton goods bought by government from prvatesector frms The ntent of the FarTax s to substtute a sales tax for all of those taxes Falng to tax government consumpton, whle taxng only prvate consumpton, would make government consumpton expendtures artfcally cheap n comparson wth prvate consumpton expendtures and could cause the provson of some goods and servces to mgrate from the prvate sector to the government sector Actvtes such as trash collecton and transportaton servces are taxed under the FarTax, whether provded by government or the prvate sector C The Sze of the FarTax Base Snce the effectve date of HR 25 s January 1, 2007, we estmate the tax base for the FarTax and the federal tax revenues that would be replaced by t for calendar year 2007 The CBO provdes estmates of several mportant economc statstcs and tax revenues for the major federal taxes (see Table 3) 10 As detaled n Appendx B, we use the latest avalable CBO data to form 2007 projectons of tax-base components We fnd the 2007 FarTax base to be $11244 trllon Startng wth personal consumpton expendtures of $9772 trllon, we make adjustments for housng by addng the purchase of new homes and the mprovement of exstng homes The mputed rent for owner-occuped housng and farm dwellngs s removed because the tax 8 The personal consumpton expendture (PCE) wthn the NIPA accounts ncludes the fnal consumpton of nonproft nsttutons servng households (NIPA Table 29, lne 57, $1837 bllon) and ther sales to households (NIPA Table 29, lne 64, $6768 bllon) We estmate and remove the wage and salary porton of the fnal consumpton expendtures of nonproft nsttutons Frst, we remove the porton of nonproft fnal consumpton expendtures that s attrbutable to educatonal nonproft nsttutons, snce they have already been removed from the base nsttutons (NIPA Table 29, lne 61 mnus lne 67, $52 bllon) That leaves the fnal consumpton expendtures at $1317 bllon Next we estmate the rato of wages and salares to total expendtures of nonprofts by takng NIPA Table 113, lne 51 and dvdng t by the sum of NIPA Table 29, lnes 58 and 70; the result equals 5165 percent We apply ths rato to the $1317 bllon to get $68 bllon That represents our estmate of the salares and wages of nonproft employees that are not nvolved n the producton of goods and servces that are sold to households 9 Gale et al (1998) 10 US Congress (2006) due on the mputed rent wll become prepad when the property s sold as a new dwellng 11 We also adjust for educaton tuton (excluded under the FarTax), taxable nterest and fnancal ntermedaton, foregn travel, and other tems 12 The net effect of those adjustments s to reduce the prvate consumpton base to $9235 trllon, as Table 2 shows Next, we add government consumpton at the state, local, and federal levels to the base We subtract wages pad to government employees who provde educaton and tranng, and we subtract captal consumpton allowance 13 We add spendng for new buldngs and equpment to the base State and local government consumpton, thus adjusted, equals $1093 trllon; federal government consumpton equals $916 bllon Those amounts sum to $11244 trllon dollars, representng 81 percent of 2007 US gross domestc product as projected by the CBO 14 We note that when calculatng the FarTax rate we do not dscount the amount we estmate the federal government would save because of the reduced tax admnstraton and enforcement dutes that t would have under the FarTax That reduced spendng would mply a lower tax burden on the prvate sector as well as state and local government, whch would then ncrease ther respectve consumpton levels, leavng the FarTax base unchanged III The FarTax Rate Gven the base, we can calculate the rate at whch the FarTax must be leved once we know how much tax revenue needs to be rased Two man tems need to be computed: the 2007 revenue to be replaced and the revenue needed to cover the prebate A Replacng Tax Revenue Table 3 detals the amount of revenue rased by ndvdual and corporaton ncome taxes, socal nsurance and retrement contrbutons, and estate and gft taxes on a calendar-year bass taxes that would be (Text contnued on p 668) 11 Table 2, lne 2, accordng to the Mar 2005 report by the Natonal Assocaton of Realtors, 23 percent of homes purchased n 2004 were for nvestment purposes Also, 79 percent of homes purchased for nvestment purposes are sngle-famly homes Those numbers provde a bass for ths estmate 12 Table 2, lne 8 ncludes Other (see NIPA 255, lne 110), whch conssts of (1) fees pad to busness schools and computer management tranng, techncal and trade schools, and so on, and (2) current expendtures (ncludng consumpton of fxed captal) by nonproft research organzatons and by grantmakng foundatons for educaton and research Gale (1999) ncludes t whle Burton and Mastromarco (1997) exclude t We have chosen to nclude half of ts value 13 Accordng to BEA, government consumpton expendtures nclude the consumpton of fxed captal; to avod double countng of the consumpton of captal, we have removed captal consumpton allowance from the base 14 US Congress (2006), p TAX NOTES, November 13, 2006

5 Table 2 Computaton of the FarTax Base, 2007 ($ bllons) Lne Taxable Consumpton Categores 2007 Source Prvate Consumpton Spendng 1 Personal Consumpton Expendtures 9,772 NIPA 115, lne 2 Housng 2 Purchases of New Homes 394 NIPA 545B, lne 36 3 Purchases of New Moble Homes 9 NIPA 545B, lne 40 4 Improvements to Sngle-Famly Homes 176 NIPA 545B, lne 42 5 Brokers Commssons on Housng 121 NIPA 545B, lne 43 6 Less: Imputed Rent on Housng -1,067 NIPA 245, lne 49 7 Less: Imputed Rent on Farm Dwellngs -15 NIPA 245, lne 51 Educaton 8 Less: Educaton Expendture -221 NIPA 245, lnes 95, 96, and 50% of 97 Fnancal Servces 9 Plus: Taxable Home Mortgage Interest 128 NIPA 711, lne 16, EROP, Table B Plus: Taxable Nonproft Interest 5 NIPA 711, lne 18, EROP, Table B Plus: Taxable Personal Interest 155 NIPA 711, lne 17, EROP, Table B-73 Travel 12 Plus: Expendture n US by Nonresdents 115 NIPA 255, lne Less: Expendture Abroad by US Resdents -8 NIPA 255, lne 111 (nondurables) 14 Less: Foregn Travel by US Resdents (servces) -54 NIPA 255, lne 110 (50%) Other 15 Less: Food Produced and Consumed on Farms -06 NIPA 255, lne 6 16 Less: State Sales Taxes -263 NIPA 33, lne 7 (60%) 17 Less: Salares and Wages of Nonprofts -68 NIPA 29, lne 62 mnus lne 68, multpled by 52% (% of nonproft wages to total expenses) 18 Plus: Captal Spendng by Nonprofts (net of captal) 58 NIPA 67, lne 8, mnus NIPA 75, lne Subtotal, Prvate Consumpton Base 9,235 Government Consumpton Spendng State and Local Government 20 State and Local Government Consumpton 1,333 NIPA 33, lne Less: Current Educaton Spendng (Wages and -403 NIPA 63D, lne 94 Salares) 22 Less: Captal Consumpton Allowance -163 NIPA 33, lne 38 State and Local Government Investment 23 Gross Purchases of New Structures 263 NIPA 395, lne Gross Purchases of Equpment 63 NIPA 395, lne Subtotal, State and Local Tax Base 1,093 Federal Government Spendng 26 Federal Government Consumpton 845 NIPA 395, lne 7 27 Less: Captal Consumpton Allowance -108 NIPA 32, lne Subsdes 60 NIPA 32, lne 31 Federal Government Investment 29 Gross Purchases of New Structures 17 NIPA 395, lne 9 30 Gross Purchases of Equpment and Software 102 NIPA 395, lne Subtotal, Federal Government Tax Base Gross FarTax Base 11, Asa%ofGDP 81% 34 Untaxed Federal Government Spendng (GN) 272 NIPA 32, lne 28 (5723%), IRS, SOI Table 14 Note: Totals may not add due to roundng TAX NOTES, November 13,

6 Table 3 Revenue From Income, Payroll, and Estate/Gft Taxes, ($ bllons) Actual Estmates Descrpton Indvdual ncome taxes ,019 1,101 Corporaton ncome taxes Socal nsurance and retrement recepts Estate and gft taxes Total 1,685 1,825 2,059 2,185 2,288 GDP 10,971 11,734 12,494 13,262 13,959 Memo: Taxes as % of GDP Sources: NIPA Table 115 Estmates from US Congress, CBO, Budget and Economc Outlook for Fscal Years 2007 to 2016 (2006) Note: Totals may not add due to roundng repealed and replaced by the FarTax 15 In calendar year 2005, those taxes yelded $2059 trllon or 165 percent of GDP In 2007 those taxes are expected to yeld $2288 trllon or 164 percent of GDP Those fgures are based on CBO estmates that assume that all tax provsons scheduled to expre before 2016, ncludng the tax cuts enacted between 2001 and 2004, do not expre 16 It s worth notng what the FarTax rate would be were t not for the prebate To calculate the rate before the prebate s ncluded, we would dvde the gross FarTax base (lne 32 n Table 2) by the unadjusted revenues to be replaced, as lsted n Table 3 under the total for 2007, to get 2035 percent (= 2,288/11,244) In the absence of the prebate, the FarTax rate would be 2035 percent, well below that called for n HR 25 B The Prebate As dscussed n Kotlkoff and Rapson (2005) and Tuerck et al (2006a), the FarTax s prebate makes the FarTax hghly progressve when measured relatve to the economcally meanngful bass of lfetme ncome The prebate s based on the federal poverty gudelnes adjusted to remove any marrage penalty The prebate may be thought of as a rebate, except that t s pad at the begnnng of each month n advance of that month s consumpton expendtures The sze of the monthly prebate provded to a gven household s set at the amount of FarTax that household would pay over the course of the month, were t consumng at the federal poverty lne More precsely, the prebate equals the FarTax rate multpled by the famly consumpton allowance dvded by 12, where the famly consumpton allowance s based on the sze of the household 17 An addtonal adjustment s made for marred couples to prevent a marrage 15 Snce the federal fscal year begns Oct 1, calendar year 2007 contans the last nne months of fscal 2007 and the frst three months of fscal 2008 We adjusted the fscal year revenue numbers to calendar year 2007 by addng three-fourths of the fscal 2007 total revenues to one-fourth of the total revenues for fscal US Congress, Congressonal Budget Offce (2006), p The famly consumpton allowance s the US Department of Health and Human Servces poverty level gudelne plus an addtonal amount to elmnate a marrage penalty penalty because the poverty level for a famly of two s not twce the poverty level of a sngle person lvng alone Take, for example, a famly of four Its 2007 famly consumpton allowance s projected to be $26,981, resultng n an annual prebate of $6,205 (023 x $26,981) The total famly consumpton allowance or prebate base was estmated by usng the US Department of Health and Human Servces Poverty Level Gudelnes for 2006 and US Census Bureau estmates for the number and sze of households n the Unted States The famly consumpton allowance computed for each famly sze/martal status combnaton was multpled by the number of households n each sze category to compute the total value of the prebate for that category Those totals were summed to arrve at the base on whch the prebate would be calculated C Tax-Inclusve Versus Tax-Exclusve Rates We now need to clarfy the dfference between taxnclusve and tax-exclusve sales tax rates An example wll help Suppose a worker named Joe earns $125 and spends all of hs earnngs Suppose further that he pays a tax of $25 If he were subject to an ncome tax, he would earn $125 before tax, $100 after tax, and spend $100 at the store Thus, he would need to earn $125 to spend $100 In the case of a sales tax, he would earn $125 and pay $125 at the store Of the $125 pad by Joe at the store, the store would remt $25 n sales tax, meanng that Joe ends up wth just $100 worth of goods and servces We may thnk of the tax rate as $25/$100 = 25 percent, whch s the tax-exclusve rate (t e ); alternatvely, we may report the tax rate as $25/$125 = 20 percent, whch s the tax-nclusve rate (t ) The 23 percent FarTax rate n HR 25 s a tax-nclusve rate, as s the current personal ncome tax, whereas most state-level sales taxes are quoted on a tax-exclusve bass For ease of comparson, we report tax rates n both ways n Table 5 D Determnng the FarTax Tax Rate In ths secton we determne the rate at whch the FarTax would need to be leved n 2007 To repeat, we assume that the FarTax would be neutral n the sense that t would permt the same real expendtures by federal, state, and local government as well as cover the costs of the prebate 668 TAX NOTES, November 13, 2006

7 Table 4 Computng the FarTax Base Reducton Due to the Prebate for 2007 Household Sze Famly Consumpton Allowance Number of Households (Thousands) Base Reducton (Thousands) I Sngle Households 1 $10,016 29,858 $299,049,690 2 $13,490 12,719 $171,584,833 3 $16,965 6,645 $112,727,257 4 $20,440 3,233 $66,092,706 5 $23,915 1,441 $34,464,747 6 $27, $13,406,258 7 or more $30, $12,179,087 Subtotal, Sngle Households 54,781 $709,504,577 II Marred Households 2 $20,031 24,991 $500,599,437 3 $23,506 11,489 $270,055,951 4 $26,981 12,980 $350,222,029 5 $30,456 5,775 $175,871,370 6 $33,930 2,009 $68,177,390 7 or more $37,405 1,006 $37,636,330 Subtotal, Marred Households 58,250 $1,402,562,508 Total Prebate Base Reducton $2,112,067,084 Prebate as % of GDP 188% Under current law, the federal budget balance for 2007 may be wrtten as: (1) R1 + R2 + DEF G + TR + GN Here: R1 07 s the revenue from taxes to be elmnated under the FarTax (ncludng ncome and payroll taxes); R2 07 s the revenue from federal excse and other taxes that wll contnue to be leved after the FarTax s enacted; DEF 07 s the federal budget defct; G 07 s taxable federal government spendng on goods and servces; TR 07 measures federal transfer payments to ndvduals, ncludng most Socal Securty payments, Medcad and Medcare subsdes, and socal programs such as food stamps, for whch the recpents are not taxed under current law; and GN 07 represents federal spendng and transfers for whch the recpents would not be taxed under the FarTax, but for whch they would be under current law essentally, wage and salary costs of educaton, plus nterest payments on the government debt held by the publc plus currently taxable Socal Securty benefts C 07 : Personal consumpton at market value n 2007 GS 07 : Taxable state and local government consumpton at market value n 2007 Now consder what happens wth the ntroducton of the FarTax Under the FarTax, equaton (1) becomes: (2) R + R2 + DEF = G + TR + GN + PRE + AC FT FT FT FT FT FT FT FT In equaton (2) the FT subscrpt ndcates values under the FarTax, and the components that have the same basc names as n equaton (1) R2, DEF, G, TR, and GN represent the same revenue or expendture components as n equaton (1) The three new terms n equaton (2) are: R FT : The tax revenue to be rased by the FarTax n 2007 PRE FT : The prebate Ths s a new expendture to be fnanced by new tax revenue rased by the FarTax AC FT : The admnstratve credt that the federal government wll pay vendors and states for collectng the FarTax Unlke the terms n equaton (1), the terms n equaton (2) are not drectly measurable Two ssues that arse n the determnaton of the FarTax values are the reacton of monetary authortes to the swtch to the FarTax and the amount of revenue needed for the FarTax to cover the real expendtures that had prevously been fnanced by the exstng federal taxes Because the FarTax falls on consumpton, there s a queston of how ts mposton would affect the prces of consumer goods 1 Accountng for changes n consumer and producer prces At a macroeconomc level, prces depend on how the monetary authortes react to changes n tax polcy, macroeconomc condtons, and other varables affectng prces In smple terms, the overall prce level must be consstent wth the quantty theory equaton, whereby MV=PY Here M s the money supply, V s the velocty at whch money crculates, P s the prce level, and Y s real ncome For the purpose of ths analyss, we assume that under the FarTax, V and Y would reman unchanged Therefore, a rse n the prce level would be TAX NOTES, November 13,

8 possble only f accommodated by an ncrease n the money supply 18 Put another way, wthout monetary accommodaton, prces faced by consumers under the FarTax would not rse Any changes to the level of monetary accommodaton that s, ncrease n the money supply would cause prces to ncrease n the same proporton Let us desgnate α as the percentage by whch market prces under the FarTax would exceed market prces under current law n 2007 We assume that the monetary authortes determne ths percentage through ther control of the money supply, such that 0 α t e where t e s the tax-exclusve FarTax rate Wth no change n real ncome or the velocty of money, the maxmum amount that prces could ncrease when the FarTax s mposed s the amount of the tax, so the prce would go up by a factor of t e when there s full monetary accommodaton In general the relatonshp between pre- and post-fartax consumer prces, P 07, and P FT, s gven by: (3) P FT =P07 (1 + ) Consumer prces have two components: Producer prces (PP) the prces producers receve Ths component ncorporates all unt costs of producton, ncludng unt proft margns Other federal commodty taxes (PR2) mport dutes, excse taxes, and the lke Revenues from those taxes form the R2 component of the federal government revenue mentoned above Under current law ths means that consumer prces are: (4) P07 = PP07 + PR207 Because the FarTax s leved on producer prces as well as on top of other federal commodty taxes, consumer prces under the FarTax satsfy: (5) PFT = ( PPFT + PR2 FT)(1 + te) Now consder how producer prces pre- and postmposton of the FarTax are related Ths relaton s gven by: (6) PPFT = PP07 (1 - T)(1 + ), where T s the rate by whch producer prces under current law would fall wthout any monetary accommodaton Note that ths rate s not necessarly equal to the FarTax rate due to the presence of other commodty taxes 19 Assumng the government adjusts the level of these other commodty taxes to mantan ther real purchasng power, we have: (7) PR2 = PR2 (1+ ) FT 07 Lettng t be the FarTax nclusve rate: 18 In fact, Y would not reman constant, but would rse, owng to the dynamc effects that would arse from replacng the exstng tax system wth the FarTax We dscuss ths further below n connecton wth the evason ssue 19 As we wll see later, the fact that PR2 s also taxed causes T to be greater than the tax-nclusve FarTax rate, t (8) 1 + t e = 1 1-t Now, substtutng (3), (6), and (7) n (5): P07 (1 + ) = [ PP07 (1 - T) + PR2 07](1 + te)(1 + ) P07 = [ PP07 (1 - T) + PR2 07](1 + t e ) P07 (1- t)=pp 07 (1- T)+ PR207 P07 (1 - t) = PP07 + PR207 - PP07T P07 (1 - t) = P07 - PP07T PP T = P t, we get: P07 (9) T = t PP 07 Lettng = P 07 we have: PP07 (10) T=, t To calculate γ we use consumpton and R2, whch we estmate at $147 bllon n 2007 Hence, we have: C07 + G07 + GS07 = C + G +GS - R Thus, (10) becomes: (11) T = t 11,244 = = , Dealng wth government purchases of goods and servces Let us now consder the ndvdual components of equaton (2) We start wth nomnal government expendtures G (on the rght-hand sde of the equaton) of goods and servces Those expendtures must buy the same real goods and servces under the FarTax as they would under current law, except for IRS servces that would no longer be needed because of the removal of dfferent taxes vald under current law Callng those IRS real savngs IRSS: (12) GFT = ( G07 - IRSS) (1 + ) Nomnal federal transfer payments TR that are not taxed under current law must reman hgh enough to command the same goods and servces under the FarTax as they do under current law Thus: (13) TR = TR (1 + ) FT 07 3 Treatment of taxable transfer payments and FarTax tax-favored purchases Now let us consder transfer payments to ndvduals that are subject to ncome taxes under current law Examples nclude government nterest payments and Socal Securty benefts Mantanng the real purchasng power of those transfer payments before and after the FarTax requres takng nto account that the payments wll no longer be subject to ncome taxaton A smlar ssue arses n the case of government purchases of educatonal servces and other commodtes that would not be subject to the FarTax Assumng the 670 TAX NOTES, November 13, 2006

9 tax break s passed on to purchasers of those commodtes, the government s requred real spendng on such goods and servces wll be reduced Denote by GN the sum of taxable transfer payments plus federal purchases of goods and servces not subject to the FarTax, then: (14) GNFT = GN07 (1 - T)(1 + ) Substtutng (11) we can wrte: (15) GN = GN ( t ) (1 + ) FT 07 It s possble that some elements of GN would not undergo the once-and-for-all adjustment assumed by equaton (15) For example, HR 25 requres the ndexaton of Socal Securty benefts, whch mght be nterpreted to mean that the porton of those benefts fallng nto GN would, n practce, be adjusted upward by α but not downward by T For our purpose of mantanng government overall spendng constant n real terms, the ndexng of the Socal Securty payments ncluded n GN would cause the real value of G and/or TR to decrease correspondngly Because we are nterested n the FarTax rate and not the actual values of G, GN, and TR, we consder ths approach to be vald 4 The prebate Nomnal prebate expendtures are calculated by multplyng the total famly consumpton allowance or prebate base, denoted B 07, by the tax-nclusve rate (t ) and the ncrease n the prce level Hence: (16) PREFT = B07t (1 + 5 The FarTax s admnstratve credt The admnstratve credt that wll be pad to vendors and state government for collectng the FarTax, AC FT, s set n HR 25 at a quarter of 1 percent (025 percent) of the revenue collected by the retaler, and another quarter of 1 percent of the revenue collected by the state and local government The federal government gets no admnstratve credt for collectng any FarTax revenue To calculate the admnstratve credt, we must dentfy the sources of collecton, and for that purpose we separate purchases done at the vendor level predomnantly retalers and professonals from those done at the government level The latter are wages pad by the dfferent governments to ther employees Sales tax revenue collected at the vendor level ncludes all prvate and government retal purchases That amount comprses prvate consumpton, C 07, and the nonwage porton of G 07 and GS 07 That revenue s frst collected by the vendors, who clam a credt equal to 025 percent of revenues collected and send the remanng 9975 percent (100 percent percent) to the state government The state government then takes ts 025 percent of the amount remtted by the vendor, sendng the remander to the federal government The total admnstratve credt for ths type of revenue, as a porton of the revenue, s therefore % (= 025% + 025% x (1-025%) 50%) It s mportant to consder that federal wages are 32 percent of federal government purchases, and state and local government wages are 41 percent of state and local government purchases That means that the nonwage porton of government purchases relevant to ths type of revenue s 68 percent of G 07 and 59 percent of GS The FarTax on state and local government wages s collected only at the state government level and therefore would earn a credt of only 025 percent That means that for the admnstratve credt we also have to apply a 025 percent factor to 41 percent of GS 07 At the same tme, because the federal government wll not clam an admnstratve credt for collectng the FarTax on ts own wage payments, we do not nclude an admnstratve credt for ths porton of FarTax revenues Fnally, the prvate sector ncreases ts consumpton by IRSS on the assumpton that ths reducton n federal government spendng s passed on to taxpayers n the form of a reduced tax burden: (17) ACFT = { 050% [ C07 + IRSS ( G07 - IRSS) GS07] + 025% 041 GS07} t (1 + 6 Revenue collecton under the FarTax We now consder the revenue sde of equaton (2) and begn wth R FT, the revenue rased by the FarTax We know that the tax s leved on consumpton: personal consumpton and the consumpton of federal, state, and local governments Therefore: (18) RFT = ( CFT + GFT + GSFT) t In the above equaton we have two new terms: C FT : Personal consumpton at market value n 2007 under the FarTax GS FT : Taxable state and local government consumpton at market value n 2007 under the FarTax Assume there s no monetary accommodaton The FarTax would cause producer prces and, therefore, the tax base for state and local governments to fall Unless some measure s taken, state and local government revenue would fall That would be the equvalent of state and local governments provdng a tax cut to ther taxpayers We assume that state and local governments take the necessary measures to mantan the real value of ther revenues, whch, n ths settng means rasng ther tax rates or expandng ther state sales tax bases by conformng to the FarTax base 21 And that assumpton mples that those governments wll mantan the real value of ther consumpton purchases 20 For the federal government, NIPA Table 62D, lne 87 (salary and wages) s dvded by the federal government tax base (G) to gve the porton of the tax base that comprses wages and salares That percentage s subtracted from 100 percent to obtan the value of nonwages n the tax base The process s repeated for state and local governments, NIPA 62D, lne 92, except that wages and salares for educaton, lne 94, ($403) are subtracted from total wages and salares snce ths s subtracted from the state and local government tax base 21 States wll have an ncentve to conform ther state sales tax base to the FarTax base because HR 25 provdes that conformng states are allowed to collect state sales taxes on Internet and remote sales to resdents of ther state Other studes have estmated ths to be a potental revenue gan of between $215 bllon and $337 bllon for 2008 TAX NOTES, November 13,

10 Table 5 Computaton of the 2007 FarTax Rate ($ bllons) Revenues to be Replaced Gross Revenue to be Replaced $2,288 Less: Earned Income Tax Credt and Chld Tax Credt -52 Total Revenue to be Replaced (R1 07 ) 2,236 IRS savngs (IRSS) -8 Adjusted Revenues to be rased (R IRSS) 2,228 Adjusted Tax Base (Inclusve of Tax) Components Personal Consumpton Adjusted for Admnstratve Fee (09950C 07 ) 9,189 State and Local Government Consumpton Adjusted for Admnstratve Fee (09960GS 07 ) 1,089 Federal Government Consumpton Adjusted for Admnstratve Fee (09966G 07 ) 913 Taxed Federal Government Transfers (10132GN 07 ) 276 Less: IRS Savngs Adjustment (00016IRSS) -001 Less: Prebate Base (B) -2,112 Adjusted Tax Base $9,355 Therefore tax rate (t ) s 2,228/9,355, whch equals 2382% Tax-exclusve rate (t e ) s 2,228/(9,355-2,228), whch equals 3127% Note: Totals may not add due to roundng We extend that assumpton to the cost savng enjoyed by the federal government n the form of reduced expendtures on the IRS The cost savng s fully passed on to consumers Therefore: (19) CFT = ( C07 + IRSS) (1 + (20) GS = GS (1 + FT 07 Substtutng the relatonshps n equatons (12), (19), and (20) nto equaton (18): R =( C + IRSS + G - IRSS + GS ) t (1 + FT ) (21) RFT = ( C07 + G07 + G07) t (1 + ) Now consder R2 FT The revenue n ths category s rased by excse taxes, mport dutes, and the lke As we have mentoned prevously, the revenue must buy the same goods and servces for the government as t dd prevously Therefore, the real revenue from those sources under the FarTax must be the same as t would be under current law Hence: (22) R2 FT = R2 07 (1 + ) Let us now consder the defct We assume the defct to be fnanced by prvate savng We contnue to assume that household purchasng power remans fxed In partcular, we assume that wages wll adjust to keep purchasng power constant n real terms Therefore, we further assume savng to be constant n real terms That means that the defct n 2007 wll be the same under the FarTax, wthout monetary accommodaton, as t would be under the current law Thus: (23) DEFFT = DEF07 (1 + ) 7 The FarTax rate formula Substtutng expressons (12), (13), (15), (16), (17), (21), (22), and (23) n equaton (2) gve the equaton for budget balance under the FarTax: (24) ( C + G07+ GS07) t (1 + ) + R207(1 + ) + DEF07(1 + ) = 07 G07- IRSS) (1 + ) + TR07(1 + ) + GN07( t) (1 + ) + B07t (1 + ) + {050% [ C + IRSS ( G - IRSS) GS ] + 025% 041 GS } t (1 + ) We note that (1 + α) accompanes every term n equaton (24), so t drops from the equaton That s mportant because t mples that the FarTax rate s ndependent of the level of monetary accommodaton Smplfyng equaton (24): [09950C IRSS G GS07] t + R207 + DEF07 = (25) G + TR + GN ( t ) + B t - IRSS We now group the terms that are multpled by t to get: [09950C IRSS G GS GN07 - B07] t = G + TR + GN -R2 -DEF - IRSS G07 + TR07 + GN07 -R207 -DEF07 -IRSS t = 09950C IRSS G GS GN - B Usng (1): (26) t = R107 -IRSS 09950C IRSS G GS GN - B Insertng values from Table 5 and solvng gves: (27) t = 2,228 9, , ,112 = 2382% The nformaton requred to determne the FarTax rate s set out n Table 5 The FarTax calls for the replacement of federal taxes on personal and corporate ncome, the gft and estate taxes, and the payroll tax We estmate that the revenues rased by those taxes would be $2288 trllon n 2007 under the current law We subtract 672 TAX NOTES, November 13, 2006

11 the cost of the earned ncome tax credt and the chld tax credt, whch the federal government counts as spendng and whch represents revenue that would not be rased under the FarTax HR 25 also calls for abolshng the IRS, snce the states would admnster the FarTax The federal agency that would take responsblty for workng wth the states to coordnate FarTax collectons would need far fewer resources than the IRS now needs Therefore, we estmate that the federal government would be able to cut $8 bllon from the FY 2007 IRS budget of $1101 bllon 22 Those adjustments reduce the revenues replaced by the FarTax to $2228 trllon As set out n Table 5, the FarTax base needs some adjustments to match equaton (26) We have to adjust personal, state, and local government and federal government consumpton by the deducton of the admnstratve credt fees We must add the base for the reducton n GN We reduce the base by the net effect of the IRSS n the admnstraton credt Fnally, we must deduct the prebate base We thus calculate the adjusted base to be $9355 trllon To rase revenue of $2228 trllon from a base of $9355 trllon, the rate that must be mposed s 2382 percent n tax-nclusve terms, or 3127 percent n tax-exclusve terms IV Federal Spendng Wth a 23 Percent Rate In the prevous secton, we showed that the FarTax rate requred to keep exstng federal government spendng constant n real terms s 2382 percent However, HR 25 calls for a rate of 23 percent Although there s only a small dfference between the two rates, t would be necessary for the federal government to undergo a reducton n real spendng were the 23 percent rate to be mplemented Alternatvely, the FarTax could enhance economc growth enough to ncrease the FarTax base by 3 percent, n whch case 23 percent would be suffcent to avod any spendng reducton (As prevously explaned, ths report provdes a purely statc analyss that gnores the expansve effect that the FarTax could be expected to exert on economc actvty as t elmnates the exstng bas aganst savng In practce, therefore, t would probably be possble to mplement the FarTax at the 23 percent rate wthout any reducton n federal spendng In the absence of that expansve effect, however, some reducton n spendng would be necessary) Whle that reducton s also necessarly small, there s a queston of just how large a reducton would be requred The answer s n part poltcal, nasmuch as every government program has some consttuency that would resst even small budget cuts 22 BHI estmates the followng IRS appropratons for fscal 2007 could be cut: flng and account servces ($1,619 mllon), shared servces support ($1,504 mllon), complance servces ($4,497 mllon), offsettng collectons-rembursables ($183 mllon), exstng user fees ($100 mllon), and new user fees ($135 mllon) See US Department of Treasury, Department of Treasury Budget n Bref FY 2007, Internal Revenue Servce, avalable at nbrefpdf Here we estmate the percentage reducton n federal government spendng that would be requred under a 23 percent rate; all spendng that would be n place under the FarTax, except for Socal Securty benefts, s avalable for reducton We must take nto account a number of complextes that arse n makng ths calculaton Frst, we must recognze that the avalable pool of spendng depends partly on the rate tself Some spendng (expendtures that fall under the categores of GN, AC, and PRE) would be dfferent under a 23 percent rate than under a 2382 percent rate Second, we must recall that Socal Securty spendng falls under the TR as well as the GN category Socal Securty payments would make up 2412 percent of TR and 4796 percent of GN n 2007 We defne: NSS FT : The amount of non-socal Securty spendng that would be n place under the FarTax δ: The percentage of the non-socal Securty spendng (dentfed as NSS FT ) under a 23 percent rate that would need to be cut We let: (28) NSSFT = GFT TRFT GNFT + ACFT + PREFT Substtutng ths defnton n equaton (2): (29) RFT + R2 FT + DEFFT = NSSFT TRFT GNFT From secton 34 we know ths equalty wll hold only when a rate of 2382 percent s mposed Note that R FT, NSS FT, and GN FT are all a functon of the tax-nclusve rate Those values wll be dfferent when we mpose a 2382 percent rate than when we mpose a 23 percent rate Callng the values of these categores under a 23 percent rate R FT, NSS FT, and GN FT, respectvely, the correspondng equaton to (29) under a 23 percent rate s: (30) R FT + R2 FT + DEFFT = (1 - ) NSS FT TRFT GN In equaton (30) we ntroduce δ because we know that the mposton of the 23 percent rate wll brng n less revenue than would be needed, and we want to know what share of NSS FT that s We now solve for δ: (31) = 1 - FT R R DEF TR GN FT + 2 FT + FT FT FT NSS Usng the approprate values from Table 6 n equaton (31): (32) = 1-2, ,782 FT = 0273 Table 6 shows the values of the dfferent revenue and spendng categores that would be n place under the FarTax wth a rate of 23 percent It also estmates the necessary spendng cut to be $76 bllon, whch s smply the dfference between the spendng that would be necessary wth a 23 percent rate and the revenue that would actually be rased The $76 bllon represents 273 percent of the non-socal Securty spendng that would be n place f no cut were needed wth a 23 percent rate TAX NOTES, November 13,