Um . . . no

I'm no fan of the Fair Tax. But this from Kevin Drum is just wrong:

The issue isn't so much Social Security benefits, which are currently tax-free for nearly all retirees but would end up being subject to a sales tax. The "prebate" feature of the FairTax proposal would, in theory, take care of most of that. Rather, it's retirement savings, which would end up getting taxed twice. Say you earn $1000 at age 64, pay taxes on it, and then stick the remaining $800 in the bank. The next year you turn 65. Under current law, that retirement money is yours free and clear because you've already paid taxes on it. But if a sales tax is in place, that $800 isn't worth $800. It's only worth about $600. Surprise! All that money you've saved for retirement is suddenly worth a whole lot less than you thought it was. Better not plan on taking any of those Caribbean cruises you've been dreaming about.

This is transitionally true--once. (And could be fixed in a variety of ways, such as boosting Social Security checks). But on average, it is not.

Assume for simplicity's sake that we are choosing between a fair tax of 20% and an income tax of 20%.

Income tax Worker gets paid $2,000, loses $400 to tax, consumes $800, saves $800. 10 years later, retires and spends the other $800.

Sales tax Worker gets paid $2,000, pays no income tax. Buys $1000 worth of goods, 20% of the value of which is tax. Saves $1,000. 10 years later, buys $1000 worth of goods, 20% of the value of which is tax.

The senior pays the same amount of taxes, no matter what. It gets more complicated when you add time preference for money, interest, investment and growth. There is no reason, however, to claim that the Fair Tax results in double taxation. Broadly speaking, the reason a fair tax hits seniors harder is that they don't save; they run down savings. And the Fair Tax is structured to benefit those who save.

Politically, this is probably a killer. But economically, it might well actually be good, encouraging seniors to delay the date at which they retire and start drawing down savings.

Comments

Aren't you and Kevin missing a more obvious boon to savers from the Fair Tax? Let's say you're a 65 year old to your 401(k) for decades and you decide to start taking distributions from it. Under our current income tax system, you'd pay taxes on these distributions as ordinary income. Under a Fair Tax, those distributions would be tax-free withdrawals. That would be a huge benefit to most seniors.

Posted by Fred | January 16, 2008 5:34 PM

That second sentence should read:

"Let's say you're a 65 year old and you've been making contributions to your 401(k) for decades and you decide to start taking distributions from it."

Posted by Fred | January 16, 2008 5:36 PM

Actually, given the lifestyles of retirees, wouldn't the more realistic result of the FairTax be that the retirees would:

1) Draw retirement income tax-free
2) Take extended vacation in different country
3) Spend retirement income tax-free in that country

So, it looks like it they would have avenues through which to dodge the consumption tax. Expect the rich to do something similar. And expect Canada and Mexico to raise their sales taxes...

Posted by Person | January 16, 2008 5:39 PM

I think Kevin's point is that while the distributions are now income tax free, the Fair Tax would be paid on any purchases made with those distributions. In many cases, the 23%(30%) Fair Tax would be more than what the previous income tax rate would have been on those distributions.

Posted by PaulK | January 16, 2008 5:41 PM

Perhaps I am missing something, but isn't the concern some one who is already retired. And thus is spending their 800 in savings on goods that now, because of the tax, cost 20% more?
It may not make a difference if we started from scratch, but we have to get from to there from here, which means you need to do something for the retired people who made savings decisions based on the assumption that the principle saved would not again be taxed.
The prebate helps some, but I think it assumes poverty line spending, I want to retire at a standard of living substantially higher than that.

Posted by OGTom | January 16, 2008 5:42 PM

Fine, so it's a one-time transitional problem. What remedy do the Fair Tax boosters have in mind? All I've seen is Larry Kotlikoff's answer: Screw 'em.

Posted by Paul Zrimsek | January 16, 2008 6:03 PM

It's a one time transitional problem that's ALWAYS going to be a problem pre-transition. Which means it's ALWAYS going to piss off a whole lot of likely voters, whether we do it next year, in five years, or in 25 years. They may not be the same voters, but there's always going to be a sizable block of people who are going to be affected, and those people vote. Good luck with that.

Posted by Seitz | January 16, 2008 6:32 PM

I don't understand Megan's opposition to the Fair Tax. She has herself advocated shifting from taxing capital to taxing consumption. And that's exactly what the Fair Tax would do.

It isn't likely to be enacted, but as a theoretical matter, it would certainly contribute to economic efficiency.

Posted by rwe | January 16, 2008 7:16 PM

What in Kevin's post suggests this his point is not transitional? In the quote, he talks about the person paying income taxes at 64 - clearly under the old tax regime, and then paying sales tax after the regime switch.

Boosting Social Security checks seems an ineffective solution as those most harmed will be high net worth individuals with large taxable retirement savings.

In related news, I am totally wrong to be upset that Boston sport teams are so dominant right now. On average for the 21st century, they probably will not be so no problem for this New Yorker.

Tom

Posted by Tom G. | January 16, 2008 7:18 PM

"In many cases, the 23%(30%) Fair Tax would be more than what the previous income tax rate would have been on those distributions."

Could be, but retirees pay income tax on 100% of their 401(k) distributions, whereas they only would pay the Fair Tax on what they spend (here).

Posted by Fred | January 16, 2008 7:43 PM

This is transitionally true--once.

Yeah, and that's clearly what Drum is talking about, right? He obviously knows that once the tax is in place, people wouldn't be paying income tax.

Still, it's kind of off to say it's transitionally true just once. It would be true for all the money people have saved which was earned while there was still income tax, which would last something over 60 years, unless you propose to hike the new sales tax high enough to pay for tax rebates on every dollar that was earned and saved before the switch occurred. Which kind of sounds like a lot of money, to me.

Posted by brooksfoe | January 16, 2008 8:26 PM

The effective marginal rate on the amounts drawn down form 401K would generally be lower than 23%. And with the dollar sinking faster than Lizzy Borden's axe, taking "vacations" abroad is not such an alluring proposition.

Kevin points out that the "transitional" period would last several decades--this is an essential point of the argument. Whatever savings and pensions 30-60 year olds have right now would suddenly become reduced by a quarter if the UnFair Tax were implemented.

But there are far bigger problems with the proposal than pissing off future retirees. What is this going to do to the trade balance? And if the 23% is meant to reflect the average federal income tax rate, what are the FairTaxers going to do for Medicare and Social Security? The claim here is that a (relatively ineffective) way of addressing the transition pains is boosting Social Security income, but where is this money going to come from? Thin air, like most idiotic conservative proposals?

European VAT is 19%. And it is hidden--that is, the prices you see in stores include the VAT. On small goods and most food items, the impact is not particularly noticeable--the weekly price fluctuations on most small goods and food are well over 19%. But this is not the case on large-ticket items, such as computers. A 19% difference in price appears substantial--it's not nickel-and-diming you to death, even though it's the same amount no matter how the money is spent. So guess where the Europeans are buying their laptops and peripherals today? That's right--in the US! With 30% VAT, this hidden export will die. Damn, even iPod sales in the US will drop by 20% easily.

The point is that this kind of proposal sounds plausible in theory, as long as you don't try to see which strings will get pulled. If you take a closer look, the proposed change suddenly becomes insane.

Let's not forget that any consumption tax is regressive for two reasons--first, lower and middle-income population spends far greater portion of their income on "consumption"; second, the upper economic strata will have a greater opportunity to spend their supposedly increased income abroad. That results in another problem--it takes a significant portion of currency out of circulation within the US. Oops! Now not only the jobs go oversees, but the income as well.

Posted by buck | January 16, 2008 8:36 PM

"That results in another problem--it takes a significant portion of currency out of circulation within the US. Oops! Now not only the jobs go oversees, but the income as well."

Yeah, but that currency ends up back here eventually anyway -- this is where foreigners can spend the U.S. dollars they got from American tourists.

Posted by Fred | January 16, 2008 8:43 PM

I appear to be with Kevin on this one.

While it's true this is a "transitional" effect, the taxed savings that the consumption tax will hit have been built up over careers. And the Roth IRA is contributing to larger 'transitional' costs even as we speak (for many savers, Roths are taxed on the way in and no *income tax* on the way out..)

Posted by "Mindles H. Dreck" | January 16, 2008 9:54 PM

Megan,

Once again you completely miss the point: Kevin's saying that the national sales tax is a non-starter today (or in 2009 or whenever) because the people who saved money in 2007 or 2002 or 1995 or whenever had already paid income tax before they put the money in the bank. The reason people save for retirement is to ensure they have money to spend on things they need notwithstanding the fact that they no longer have a job. If we instituted a national sales tax today in 2008, every one (including yourself) who saved money in the past (and already paid income taxes on the earnings) would be taxed twice when they spend their savings.

Say I made $2,000 in 2007 and paid $400 in income tax that year. I put $800 in the bank. In 2009 a national sales tax is enacted. I cash out my savings account and spend the $800. Now I pay an additional $160 under the national sales tax (over and above the $400 I paid in 2007). If that's not double taxation, I don't know what is.

I think you think "retirement savings" means money to pass along to the children. Kevin understands that working people save money (after paying income tax on it) so they will have money to spend after they retire.

This is very, very simple.

P.S. I understand what a 201(k) is.

Posted by Mortimer Madler | January 16, 2008 10:35 PM

I agree with most of the ther commenters above. Megan is confused. The Fair Tax would indeed shift the burden of taxation toward retirees. Indeed, Larry Kotlikoff, one of its most prominent supporters, argues that this is one of its merits, since the current tax system is rigged against the young.

This is not one of Meg's better moments. It's almost as bad as the time she told us that a depreciation of the dollar has no effect on the dollar price of oil.

Posted by rwe | January 16, 2008 11:26 PM

I specifically said it would shift the tax burden towards retirees, but not for the reason Kevin says.

The kind of savings that Kevin is talking about are only a small percentage of almost anyone's assets. Chief sources of incomes for retirees:

1) SS (taxed @ 50% of normal rate)
2) Private pension (taxed)
3) 401(k) (taxed)
4) Interest and dividends (taxed)
5) Capital gains from sale of house
6) IRA (taxed)

Interest bearing accounts, Roth IRAs, Keoghs, mutual funds held outside of tax-advantaged savings vehicles etc. are not generally a large part of their income. This is a concern of maybe a couple of percent of the population.

The tax burden shifts more broadly because a) they don't get special tax breaks on social security and b) they don't save much. The effect of the double taxation will be very, very small for almost any senior, because almost all of their income currently comes from Social Security, private pensions, and 401(k) saving.

Posted by Megan McArdle | January 17, 2008 7:23 AM

"In abolishing inexcusable governmental practice X, there would be transition costs. Ergo, X should stay forever."

Posted by Person | January 17, 2008 9:27 AM

I feel like it should be pointed out (if it hasn't already) that the 'transitional problem' isn't just a problem for retirees or near-retirees. It's a problem for anybody with savings whatsoever. If you have any form of after-tax savings you will find it's worth 30% less after the 'FairTax' than it was before.

At any rate it's a purely academic discussion, because as others have mentioned, it's a political non-starter, for this very reason and a host of others.

Posted by JD | January 17, 2008 9:42 AM

I haven't studied the composition of retiree savings, so I can't say whther this is right:

"The effect of the double taxation will be very, very small for almost any senior, because almost all of their income currently comes from Social Security, private pensions, and 401(k) saving."-MM

I know alot of retirees with substantial savings outside of 401k's and IRA's, and that money was saved from taxable income. But anecdotal evidence isn't proof. But then, Megan didn't offer any proof either. She could be right, but I suspect that "very, very small for almost any senior" really overstates things.

Importantly though, even that is a modification of what she said initially.

"There is no reason, however, to claim that the Fair Tax results in double taxation."

Well, for those seniors who have saved after tax income there is reason to complain that the Fair Tax results in double taxation. I myself think the Fair Tax has a lot of merit, but I could understand why someone who had significant savings (from taxable income) would feel that it was "unfair."

Stated in such a strong form: "There is no reason...," Meg's assertion is clearly wrong. So that's why I wrote that "This is not one of Meg's better moments."

Actually, this proclivity for overstatement gets her in trouble frequently.

Posted by rwe | January 17, 2008 9:50 AM

One of the advantages of a consumption tax over an income tax is that it encourages people to save. All of those people who are currently not saving would hopefully begin saving more under a consumption tax. The current system actually discourages saving to some extent.

We really should be having two debates. The first is whether we want to switch to a consumption tax and what kind we want to switch to. The second is how we handle the transitional problems. The existence of transitional problems is not a reason to abandon the whole idea.

Posted by Earnest Iconoclast | January 17, 2008 11:09 AM

The transition period is non-trivial and I think pretending it doesn't count is massively silly. Not only are people nearing retirement age votes, but they are PEOPLE and they would be royally screwed during the transition. And just as we have reason to be skeptical that FairTax could even be implemented in its proposed, simple, loophole/exception-free condition, we should be skeptical that any transition-smoothing could be accomplished well, or at all. The bottom line is that a large cohort of individuals would take it in the shorts for the remainder of their lives, which might be 5 or 10 or 20 years and that counts for a lot, we can't just dismiss that as "transitionally true--once".

Posted by Noah Yetter | January 17, 2008 12:54 PM

McArdle:

"... Chief sources of incomes for retirees"

As was pointed out above retirees don't just spend their income, they spend down their capital. This capital would now buy less.

") Capital gains from sale of house"

The first $250000-$500000 of such gains are currently tax free, not to mention the return of capital.

Posted by James B. Shearer | January 17, 2008 1:07 PM

What Does the Fair Tax Really Do for You?
The implementation of the Fair Tax is predicated upon four assumptions:

Assumption #1 - All active businesses entities in the US, including US corporations, sub-chapter S corporations, limited liability corporations, sole proprietorships, trusts, and partnerships have embedded costs that average 23% and prices for all services and new products will decline by 23% if the Fair Tax is implemented.

Assumption #2 – A Federal sales tax of 30% will be imposed on all consumers, Federal, State, and Local governments, and non-profit organizations on the purchase of all services, such as medical, legal, loan interest, and insurance, and all new products (including houses, food, and prescription drugs).

Note: Business entities and investors will be exempted from paying the Federal Sales Tax on any new products or services constituting part of the business activity.

Assumption #3 - The Fair Tax proposal is defined as being "revenue neutral" in that it is expected take in the same approximate amount of Federal sales tax revenues as comes in from the existing Federal business income taxes, FICA payroll taxes and Federal personal income taxes.

Assumption #4 - The Fair Tax proposal assumes that the IRS will be replaced with 45 individual state sales tax collection agencies and a U.S. Treasury sales tax collection agency to represent the states that don’t have a sales tax or don’t want to be responsible for collecting the 30% Federal sales tax and forwarding it to the U.S. Treasury.

The Fair Tax assumptions have major shortcomings which will adversely affect all Americans, including children, working, and retired not in the top 5% of the income brackets as shown below.

(1) THERE IS NO GUARANTY OF PRICE REDUCTIONS: It appears intuitively obvious to the casual observer that most of tax savings, reduced costs and increased profits resulting from the elimination of the estimated 23% embedded cost will flow to the bottom line and be passed onto executives and investors and not to the customers or employees.

There is no legal requirement for businesses to reduce prices by the amount of any embedded cost elimination savings and no way to measure what they actually do.

Examples of windfall profits by US corporations in the past have a dismal track record. Look at the deregulation of the electric power generation and distribution industry that generated record profits and obscene long-term price increases to consumers; and Healthcare industry advocates stating that the "free market" healthcare HMOs were more efficient but required a 12% bonus to offer Medicare Part C over and above what Medicare was already obtaining from the healthcare industry for beneficiaries using Medicare Parts A and B.

The US pharmaceutical industry manufactures prescription medications around the globe, is given Federal government protection from allowing people to purchase prescription drugs outside the US, and gives Americans the highest prescription drug prices in the world.

Most of the profits resulting from savings for any purpose (elimination of “embedded costs”, moving jobs off shore, reducing employee wages and benefits, and importing manufactured products) went straight to executive perks (bonuses and salaries, stock option plans, and executive retirement programs) and investors with very little to none to employee salaries or reduced customer prices for products or services.

Anyone who seriously thinks a 23% reduction in costs will not disappear long before it hits the consumer prices or employee wages doesn't understand the current implementation of capitalism, business organization and tax regulations, and corporate protectionism existing in the US.

(2) IMPACT ON MOST AMERICANS: The Fair Tax program is a reverse “Robin Hood scheme” that shifts the raising of tax revenues to finance the US Government operations from the business community (reduced to zero) and higher income Americans to the working Middle Class, retirees, and children not in the top 5% income bracket.

(3) IMPACT ON RETIREES - The Fair Tax proposal works directly against the needs and contribution of tens of millions of current retirees and increasing numbers of baby boomer retirees approaching retirement.

The Fair Tax proposal elimination of the payroll tax (Social Security and Medicare) and Federal personal income tax also eliminates the very reliable system used to report earnings and calculate Social Security benefits.

The Fair Tax proposal will put retirees, most of whom have a Federal Tax obligation of less than 10% of their gross income and no payroll tax to now pay a sales tax of 30% on all their purchases of services and new products. The 30% tax rate will apply to purchases of services and new products made with Roth-IRA income which was supposed to be tax free, and a 30% tax on services and new products made with Social Security income.

Note: Social Security is currently tax free for many retired individuals and couples, and partially taxed for the rest.

With no defined commitment to maintaining the Social Security and Medicare programs and no way to calculate individual Social Security benefits, the door will be wide open for politicians looking to “reduce taxes” to simply declare that the Social Security and Medicare programs are “wasteful” and “no longer required”? In its place, they will most likely propose a means-tested charity program.

The next step may be to propose the elimination of the Social Security Trust Fund that has loaned the Federal Government approximately $1.8 Trillion Dollars and the Medicare Trust Fund that has loaned the Federal Government approximately $400 Million Dollars, turn the proceeds over to the US Treasury and not return of the Trillions borrowed from the working Americans who provided them via the payroll taxes they paid.

(4) WHAT IF PRICES DO NOT DROP BY 23%? If the average cost of ALL new products and services does not decline by 23%, then the 30% Federal sales tax on the allegedly reduced prices from elimination of embedded taxes will increase the costs/prices of new goods and services over and above the current costs/prices for new goods and services.

(5) WILL INDIVIDUALS PAY MORE TAXES? The Fair Tax proponents allege that it will raise the same amount of Federal Revenue as the current tax code. This means that the revenue from Federal business income and payroll taxes currently paid by business entities will have to be paid by individuals and State and Local governments under the Fair Tax. By default, individuals will pay more in taxes over their lifetime under the Fair Tax, not less.

Also, the Fair Tax will result in everyone (children, everyone in the work force, and retirees) that is not in the top 5% of income brackets to pay the 30% Federal sales tax on every service and new product they buy from “cradle to grave”. Since this group spends just about all their available lifetime income on goods and services subject to the Fair Tax, their effective tax rate will be close to 30%.

(6) ELIMINATING THE IRS DOES NOT SAVE ANY MONEY - It is also important to realize that the proponents of the Fair Tax have already conceded the costs of collecting the proposed 30% Federal sales tax are the same as the current expenditures for the IRS to collect and process Federal tax revenues. While the Fair Tax eliminates the IRS, it does not reduce the costs for Federal tax revenue collection expenses.

Other impacts of the Fair Tax mean that nationwide or regional businesses will be dealing with up to 45 separate tax collection agencies (the states currently collecting sales taxes) depending on the number of states they operate in as well as a new Federal tax collection organization that the Fair Tax proposes to establish to monitor and collect the new Federal sales taxes.

Each of the individual states sales tax collection agencies has different organizations, business processes, and penalty determination and assessment policies. Businesses operating on a nationwide basis or large regional basis could find the tax compliance work increasing by having to report to up to at 20 – 46 agencies on a monthly basis.

If you think the IRS can be heavy-handed, you don't realize that state sales tax penalties can start at 25% for being one day late, and quickly climb to 100% penalties. Many state sales tax agencies can come directly into a business to monitor the business and revenue activity and seize cash if they suspect the business of not paying all taxes due.

CONCLUSIONS: Great for business (taxes go to zero), great for high income earners (top 5%) who do not spend the bulk of their income and disastrous for the remaining 95% of Americans. It will be onerous for Federal, State, and Local Governments; and non-profit entities (now exempt from all sales taxes), and an administrative nightmare to deal with dozens if individual state sales tax collection agencies regarding collection of the 30% Federal sales taxes.

In addition, State and Local governments will have to increase taxes to offset the Federal Sales taxes they pay, and non-profit entities will have less income available to provide services.

Pay particular attention when any candidate or politician talks about “Means-Testing” or “Entitlement Reform”. These are generally buzz words that really mean reducing health or retirement benefits while leaving the potential beneficiary with the responsibility and requirement to continue paying for them.

In closing, I have grave reservations that any savings achieved by corporations from not paying the business portion of the Federal payroll taxes and business Federal income taxes will result in wage increases or reduced prices for the products and services they sell.

I also have serious concerns about rampant avoidance and cheating by consumers (under the table cash payments, etc.) and businesses failing to remit the collected 30% Federal sales taxes to the appropriate agencies.

Posted by Alan Lidstone | January 25, 2008 10:21 PM