May 10, 2007

The "Fair Tax"

If you've been following the internet love that Mike Gravel has been getting after the democrat candidate debate, then you know he's something of a radical. One idea that he espouses is the abolition of the income tax. It would be replaced by a national sales tax. The particular plan he is behind is in the House of Representatives now. According to its website, the resolution received 60 co-sponsers. The fact that they named the resolution "Fair tax" instead of something more informative is an interesting peek into the hyper-politicization of everything, but that's another issue.

I'm not sure how I feel about the whole thing, but there are definite question marks which the website fails to mention. I wish they would just list the advantages and disadvantages of the current and proposed system and leave and let the individual decide. The day someone in Washington acknowledges that everything has its costs will be the day people begin to trust politicians again. But again, that's an issue for another day.

What I really want to write is my knee-jerk reactions. Admittedly, I haven't done any real research into the subject other than reading a few statements on their website. However, I have some immediate questions. The first is about the instant inflation that the change would cause.

First of all, this inflation would be different than the kind you're used to hearing about. Normally, we think of inflation as constant, but this would be a one time, anticipated inflation. Therefore, the effects are somewhat different. The main problem with constant inflation is the uncertainty about what prices will be in the future, making it difficult to plan ahead. This one-time, anticipated inflation will mainly have one time effects. One effect, I would think, would be that all of the money in the system would lose value. Normally, the textbook says that if the rate of inflation changes and it's anticipated, then banks will increase their rates to offset it. But this wouldn't change the rate at all. I think it would be a one time loss of value of all of the current supply of money. Just how bad that would be I don't know, but I think it would be a negative for anyone with a substantial amount of money saved. I can't think of any way to counter this than to print money and distribute it to everyone to maintain a constant level of purchasing power. The logistics of doing this fairly would make it unprobable, though not impossible.

Another issue is how it affects the government. One of the main talking points is that the lifetime tax burden of individuals will decrease. This may be true, but keep reading. This assumes that the government itself will pay this tax when they purchase things. The government (national, state, and local) spends about $2 trillion a year to buy things. says that their plan of a 23% sales tax will equal the current receipts from the income tax and other taxes. It doesn't mention the $500 billion cost to the government and the necessary reduction in total spending. This may be a good thing depending on your ideology, but there's no doubt the effect would be significant. Also what about state and local governments paying taxes to the federal government?

The government also uses the current system to influence behavior, which again is good or bad based on your ideology. I'm no expert, but i would think that the deductions that businesses can take for certain expenses encourages their growth. Taking that away might slow the development of new businesses and, in turn, the economy itself.

There's a 41-page paper about how this proposal would influence the macroeconomy that I need to read sometime. Maybe some of my questions will be answered there. The only thing I'm sure of is that such a massive change is going to have very significant changes on how the country will function.

Posted by chupathingy on May,10, 2007 at 5:41 PM | Comments (4)

Just to start, I'm not on the Gravel bandwagon. I think he's arrogant and hot headed, and though he has a different point of view he would be no less stubborn than our current president. He's also got no chance (the Internet base is tiny, no matter what Digg and Reddit like to think and he's raised an ASTOUNDING $498 in campaign financing), so he's only serving to tear down the real candidates.

Anyway, with respect to a national income tax, it seems odd that it would be backed by Democrats...From what i remember (and it's been 5 years since AP Econ so bear with me), isn't a national sales tax regressive? If man with $1000 and a man with $10000 each buy 100 loaves of bread at $3.00/ea, they are each spending $69 in taxes. For the poor man, that is a 6.9% income tax, for a rich man, that is only a 0.69% income tax. It would seem that the poor bear the burden of a sales tax...I realize the rich spend more, but they also save and invest a LOT. They also get many gifts, so i'm not sure how this is a good idea. Maybe I should read the site, but it seems fishy, and maybe its my belief that gravel is a kook. I know Ron Paul, the other unknown internet celebrity candidate (who at least has some campaign finance) also wants to get rid of the income tax, but he's a libertarian, so i understand his position.

Comment by: mallio at 9:39 AM, May, 11, 2007

You're completely right about a straight sales tax. However, I forgot to mention that this plan being pushed now involves a "prebate," where the government sends you a check at the beginning of each month to cover spending up to the poverty level. Beyond that, the argument is that since the prebate is a smaller percentage of higher incomes, than their rate is smaller.

For example, suppose one person spends $20,000 and another spends $100,000 (notice income is irrelevant except as a means to consume) and the prebate is for taxes spent on the first 10,000 spent at 20% so the prebate amount is $10,000*20% = $2000. The total taxes paid are then $20,000*20%=$4000 and $100,000*20%=$20,000. After the prebate, the net tax burdens are then $4000-$2000=$2000 (10% of $20,000) and $20,000-$2,000=$18,000 (18% of $100,000).

Think about it like the system now with two tax brackets, $0 to the poverty level is 0% and anything above the poverty level is 20% so the average rates are different. I would also like t point out that until 1913, there was no national income tax, so its not like this would be a new idea.

Comment by: neil at 11:09 AM, May, 11, 2007

Oh i see, the prebate does seem to make sense. but i think it would also offset your inflation argument. When places list their prices, taxes don't figure into the display price, and since everyone receives a big fat government check at the beginning of the month, the burden of paying the extra taxes is barely felt.

a problem that this does expose though is how will this effect american goods in foreign markets? will they become more expensive too? this could make people stop buying american products if the tax makes it cheaper to have things shipped from foreign countries.

Comment by: mallio at 3:13 PM, May, 12, 2007

In a practical sense, I think the prebate would help mitigate the effect of the increase in prices due to the tax. However, this would only apply to spending up to the poverty level, and would only be nominal. $1 would still be worth less in terms of the amount of goods it could buy. Imagine that an apple costs 10 cents before the tax and 12 cents after a 20% tax is levied. Before the tax, $1 could buy you 10 apples. After the tax, you can only buy 8.33 apples. If someone gave you 20 cents (so you have $1.20 total) to offset the 20% tax, you can still buy 10 apples, but it takes more dollars to do it. In other words, before the tax, $1 was worth 10 apples, and after the tax, that same $1 is only worth 8.33 apples. This means that any money lying around, say in a savings account, will be worth less after the tax is levied.

You do raise an excellent point about the interplay between American and foreign goods. A large sales tax would make foreign goods relatively cheaper (after tax) before transaction/transportation costs are taken into account. My guess would be that the government's answer would be similar in nature to the answer to the current question of how to deal with differences in sales tax between states within the U.S.

Obviously, foreign goods sold in the U.S. would still be subject to the tax, but foreign (or even American) goods sold in foriegn countries bring up an interesting question.

Comment by: neil at 1:03 AM, May, 14, 2007