Sunday, January 13, 2008

The Huckatax: How Fair Is It?


I am urban. I am white-collar. I am tolerant on social issues. I am Jewish. In Mike Huckabee's "us-vs.-them" identity politics, I am a poster child for "them."

Nonetheless, when it comes to evaluating Huckabee's signature domestic proposal, the FairTax, I want to try to be, well, fair. Neither its supporters nor its detractors are providing a clear perspective on the concept.

The basic idea is to replace the existing Federal taxes with a national sales tax. Potential advantages include reduced complexity, weaker incentives to lobby for tax breaks, and stronger incentives to save. Potential drawbacks include difficulty raising revenue and major shifts in the tax burden relative to the current system.

A Consumption Tax

Over four years ago, I described a consumption tax to replace our existing tax system. I proposed that the tax be levied on personal consumption expenditures as defined in our National Income Accounts, without saying how the tax would be implemented. The FairTax is implemented as a sales tax, which means that it taxes goods and services at the point of purchase. As I understand it, the tax would apply even if the goods and services were purchased by someone other than consumers -- by government agencies, for example. Thus, the scope of the FairTax appears to be somewhat larger than the scope of my consumption tax proposal. Both proposals treat spending on health care as subject to tax, but the FairTax exempts spending on education. The FairTax also has the oddity of taxing the purchase of a new home but not taxing the purchase or the implicit rent on existing homes.

I proposed a tax rate of 40 percent, with a personal exemption of $5000 per person per year. The FairTax has a rate of 30 percent*, with exemptions of $2352 per adult and $792 per child. For a family of two adults and two children, my proposal would create a personal exemption of $20,000. With the FairTax, the exemption is $6288 per year, which for a family of four is not even enough to pay for health insurance.

(*The FairTaxers quote a 23 percent rate. If a boombox costs $100 and I pay a $30 sales tax, then to me that is a 30 percent tax. What the FairTaxers are saying is that if I have to lay out $130 for the boombox and $30 of that is taxes, then I am paying $30/$130 = 23 percent in taxes. This is consistent with the way we think of income taxes--if you earn $130 in income and pay $30 in taxes, then you think of your tax rate as 23 percent. However, it is not the way we typically think of sales taxes.)

I proposed using the consumption tax to cover spending at all levels of government, but I proposed eliminating 2/3 of government spending, including Social Security, Medicare, Medicaid, and public education. The FairTax does not pay for any state and local government spending, but it is supposed to pay for all existing Federal spending, including Social Security and Medicare.

There are transition problems and implementation problems galore with moving toward a consumption tax. For the purposes of this essay, I want to set those aside.

Arithmetic Issues

William Gale questions the FairTaxers' arithmetic. He thinks that they fail to account for:

(a) the need to finance the exemption (which I did account for in my tax proposal); and

(b) the fact that if government pays sales tax on its purchases it will need more revenue

After correcting this arithmetic, Gale concludes that the tax rate would have to be 44 percent. That is, on the boombox that costs $100, you would pay an additional $44 in sales taxes.

Something Drastic

The moral of the story is that if we want to abolish the income tax and shift to a consumption tax, we will have to do something drastic. In my scenario, the drastic policy is to eliminate Social Security, Medicare, Medicaid, and public education. The only redistributive mechanism in my plan is the personal exemption, which you will recall I set at $20,000 for a family of four.

Under the FairTax, we keep all of the big government programs, but there is a puny personal exemption of $6288 for a family of four. Furthermore, we sock the middle class (and everyone else) with a 44 percent Federal sales tax that, unlike most state sales taxes, covers health care and housing.

For years, economists have been saying that a consumption tax would be a good idea. Why, then, does the FairTax seem so drastic and implausible?

To understand why a consumption tax is a radical idea, study the following table (source) showing the share of U.S. income taxes paid by the various income brackets.

Minimum IncomeIncome BracketShare
$365 Ktop 1%39%
$145 Ktop 5%60%
$104 Ktop 10%70%
$62 Ktop 25%86%
$31 Ktop 50%97%
< $31 Kbottom 50%3 %

What the table shows is how dependent the government is on income taxes from the rich in order to pay for national defense, agriculture subsidies, and all sorts of other wonderful programs apart from Social Security and Medicare. The non-entitlement Budget is largely financed with taxes on the top 5 percent of earners.

The problem with a consumption tax is that the top 5 percent of earners do not consume at the same rate that they earn income. As a result, the government cannot abolish the income tax without sacrificing hundreds of billions in revenue from the subset of high earners who also are high savers. To make up for this loss, the middle class has to be socked with either higher taxes or fewer entitlements.

An argument can be made that a progressive tax would be a tax whose burden falls most on the people who spend the most, not on the people who earn the most. This argument could be used to justify cutting taxes for high-income savers, with a corresponding tax increase (or entitlement benefit cuts) for middle-income spenders. The philosophical justification for this position is actually fairly sound.

However, the political reality is that there are a lot more middle-income spenders than there are high-income savers. The fact that we have a system that steals from the latter to give to the former ought to be no surprise. In fact, one of our major political parties is dedicated above all to attempting to increase the amount of such stealing. That party characterizes any reduction in income tax rates as "tax cuts for the rich."

Semi-Fair Tax

I do not think it would be prudent to go "full Monty" with the FairTax. However, I believe there is some potential for reforms along the following lines:

1. Abolish the income tax for households with incomes under $100,000. Tax 10 percent of income between $100,000 and $150,000 and 35 percent of income over $150,000. Index these brackets for growth in nominal wages, but otherwise put in mechanisms that freeze the income tax.

2. Abolish the payroll tax.

3. Institute a national sales tax of about half of the FairTax plan. In the future, implement all tax cuts and tax increases through the sales tax, not the income tax.

Roughly speaking, the income tax provides 1/2 of Federal revenues, and the payroll tax accounts for 1/3 of Federal revenues. If we cut income tax revenues by 1/3 and abolish the payroll tax, we would lose in total 1/2 of Federal revenues. Thus, the national sales tax would have to be about half of what it would under the FairTax plan. If Gale's estimate is correct, then the national sales tax would have to be between 20 and 25 percent.

The idea of freezing the income tax while leaving the sales tax up for grabs politically is to try to increase the public's sensitivity to the cost of Federal programs. Right now, politicians can treat high-earners as an ATM machine, always there to dispense cash for "targeted tax cuts" or foolish spending programs.

Instead, the idea would be to fix the amount of "soak-the-rich" taxation permanently, with all of the variation at the margin coming in the sales tax. Thus, if a politician wants to raise spending or institute some form of "targeted" tax cut, the sales tax rate has to rise, and everybody has to feel it.

Compared with the FairTax, the semi-Fair tax would not reduce taxes on high earners--some of them might even face higher taxes. However, it would reduce taxes on work and increase taxes on consumption. That combination might encourage more saving. In addition, if the rules about keeping the income tax invariant and paying for new spending with sales tax increases could be made to stick, the bias toward higher government spending might be greatly reduced.

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