Taxing Sales under the FairTax: What Rate Works?
About This Event

The FairTax proposal, which now has fifty-four sponsors in the U.S. House of Representatives, would institute a national retail sales tax to replace individual and corporate income taxes, payroll and self-employment taxes, and estate and gift taxes. The question of what sales-tax rate would be needed to replace the revenue Listen to Audio


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now raised by other taxes has been the subject of much controversy.

At this event, economist Laurence J. Kotlikoff of Boston University, who coauthored a recent study about this issue, will present his findings. Jane G. Gravelle of the Congressional Research Service and William G. Gale of the Brookings Institution will respond. AEI resident scholar Alan D. Viard will moderate.

Agenda
9:45 a.m.
Registration and Breakfast
10:00
Presenter:
Laurence J. Kotlikoff, Boston University
Discussants:
Jane G. Gravelle, Congressional Research Service
William G. Gale, Brookings Institution
Moderator:
Alan D. Viard, AEI
11:30
Adjournment
Event Summary

February 2007

Taxing Sales under the FairTax: What Rate Works?

The FairTax proposal, which now has fifty-four sponsors in the U.S. House of Representatives, would institute a national retail sales tax to replace individual and corporate income taxes, payroll and self-employment taxes, and estate and gift taxes. The question of what sales-tax rate would be needed to replace the revenue now raised by other taxes has been the subject of much controversy.
 
At this February 28 AEI conference, economist Laurence J. Kotlikoff of Boston University, who coauthored a recent study about this issue, presented his findings. Jane G. Gravelle of the Congressional Research Service and William G. Gale of the Brookings Institution responded. AEI resident scholar Alan D. Viard moderated.

Laurence J. Kotlikoff   
Boston University

The FairTax proposal is both feasible and beneficial. With a simple retail sales tax and rebate system, the FairTax should be attractive to both Republicans and Democrats. The revenue-neutral tax rate, expressed as a tax-inclusive rate, is estimated to be 23.8 percent. (At this tax rate, sales tax of $238 would apply to an item that costs $762 pretax, so that the tax would be 23.8 percent of the $1,000 after-tax price.) The revenue-neutral tax rate does not depend on how consumer and producer prices adjust to the introduction of the sales tax.

State and local governments will not need to be compensated for the fact that their purchases are subject to the FairTax. These governments can continue to provide the same real services if they continue to impose the same real tax burdens on their residents.

If the tax rate is set at the 23 percent value proposed in the FairTax bill rather than at the revenue-neutral 23.8 percent value, only modest spending cuts will be required. The government will need to reduce non-Social Security spending by a mere 3.5 percent.

Compliance would not be an issue with the FairTax proposal, because evasion rates would be similar to the income-tax evasion rates of today. The National Income and Product Accounts (NIPA) consumption data used in the estimation contain only a 2 percent adjustment for evasion. The Internal Revenue Service will have 100,000 employees that could enforce the FairTax, possibly through undercover operations. Even if the revenue-neutral rate needed to be adjusted upward to reflect evasion, that would be more than offset by a downward adjustment due to the economic growth that the tax will cause.

The Federal Reserve Board would probably allow the consumer price level to rise, devaluing the federal government’s medium- and long-term debt, giving the government a $770 billion capital gain. There would, however, be a $184 billion revenue loss from the Transitional Inventory Credit. Under the FairTax, it would be easier to block increases in federal spending, because spending increases would push up the sales tax rate, a highly visible rate that would apply to all sectors of the country.

William G. Gale
Brookings Institution

The required FairTax rate for the year 2007 would be 28.2 percent, almost 5 percent higher than Kotlikoff’s measurement. The difference in estimation is due to variations in the detailed calculation of the tax base rather than the use of a different basic formula.

Kotlikoff's 23.8 percent number is out of line with past estimates--it is almost as low as the 23 percent estimate initially made by the proposal’s supporters in the 1990s, an estimate now agreed to have been artificially reduced by inconsistent assumptions about how consumer and producer prices adjust to the tax (“the Mistake”). Other authors who have avoided the Mistake have obtained estimates of 28 percent or higher under favorable assumptions and have obtained far higher estimates under more realistic assumptions about erosion of the tax base and evasion. It is puzzling that Kotlikoff’s study, which avoids the Mistake, obtains such a low estimate. His estimate is also out of line with well-established estimates of the revenue-neutral rate for the Hall-Rabushka Flat Tax, a similar proposal.

The tax rate will need to be increased due to legal erosion of the tax base. For example, it will be politically impossible to apply sales tax to a portion of mortgage and credit-care interest payments, as the FairTax plan proposes. As these and other items are exempted from the tax, a vicious cycle will ensue; the erosion of the base will require higher tax rates, which will intensify the pressure for still more erosion.

Under some circumstances, a move to consumption taxation could expand the economy 7 to 10 percent. When transition effects and adjustment costs are included, however, the impact on growth could be as little as 0 to 3 percent.

Debt repudiation, through inflation or otherwise, is not a smart move for the world’s biggest debtor. Also, there is no guarantee that moving to a retail sales tax would result in government spending cuts. In many instances, spending cuts have been achieved in combination with tax increases.  

Jane G. Gravelle
Congressional Research Service

Many problems are associated with switching to a national retail sales tax, the foremost being administration issues and avoidance by taxpayers. Adjustment requirements for underreporting from NIPA are significant enough to merit concern and attention. The 2 percent number cited by Kotlikoff seems too low.

Avoidance networks involving underreporting, misuse of rebates, selling under fair market prices, and relocation abroad will reduce the effectiveness of a FairTax. Studies show that many states have alarmingly high avoidance rates even with the relatively low sales taxes imposed today. A much higher tax rate, like that under the FairTax plan, would only inflate these numbers. Administrative problems that have arisen on the state level, such as consumption of inventories and consumer/employee discounts, will raise countless issues under this plan. Evasion is likely to be even greater than under value-added tax systems, such as Great Britain’s.

The effects on economic growth are uncertain. Long-run gains may be modest. In the short run, the tax will cause consumption to fall unless labor supply increases. Transition will be a big problem with the tax. Consumer price increases of 30 to 50 percent will be extremely disruptive for the economy.

AEI intern Douglas Wigley prepared this summary.

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