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Replace All Federal Taxes on Income with the Fair Tax Act , HR 25

Phil Hinson Answers Congressman Shuler's FairTax Concerns

FairTax Concerns
Rob Ellsworth
Staff of Reps. Heath Shuler (D/NC) and Walt Minnick (D/ID)

1. How would you prevent the States from raising their income and sales taxes as a response to abolishing the federal income tax?
2. How would you prevent local governments from raising property taxes as a response to abolishing the federal income tax?
I will respond to these two together. Here is what we believe will happen at the state level when (not "if") the FairTax is passed at the federal level. There will be considerable pressure to "harmonize" state tax systems with the federal government's. That pressure will come primarily from two factors:
(a) Any state wishing to continue taxing their residents' incomes will have to build an income tax system from the ground up, since they will no longer have a federal system to "piggy-back" onto. Almost every state income tax form uses AGI or taxable income from the taxpayer's 1040 as the starting point. The preparer is then able to make certain adjustments to convert this numerical starting point to taxable income for that particular state. With no federal return to provide a much simplified starting point, any state wishing to continue taxing income would have to codify an entire set of income tax legislation from the ground up. That would be a daunting task for a part-time legislature.
(b) When citizens from each state are no longer required to file federal income tax forms, there will be considerable political pressure on states to eliminate theirs, also. That pressure will only build as more Americans realize what an economic drag an income tax is compared to a consumption tax and what a colossal waste of human and financial resources it is. Citizens of a particular state are going to resent having to file an income tax annually (along with all the other attendant inconveniences) when surrounding states do not put that requirement on their citizens. The more states drop their income taxes, the greater the pressure will build on the remaining states to drop theirs.

When we say that a state "harmonizes" its tax system with that of the federal government, we mean primarily that it eliminates its income tax if it has one (as about 45 of them do currently), it broadens the tax base of its sales tax by adding services (if it does not already) and it uses a rebate, rather than exemptions, to alleviate regressivity. When I testified before a joint committee on tax reform of state legislators here in Georgia a few years ago, an economist from Georgia State University here in Atlanta also testified. She said that the current set of exemptions in our sales tax legislation costs the state 50% of the revenue that it would otherwise collect. I suspect that Georgia is not atypical compared to other states in this regard. A rebate mechanism would be a far less costly, and, I would argue, fairer way to address regressivity.

Therefore, we believe that many states can eliminate their income taxes and reform their sales taxes in such a way as to minimize any rate increases of those sales taxes. We have even seen states that can eliminate income taxes and keep the rate on their sales taxes the same. Many states have a problem with property taxes and this would provide an opportunity to address this issue at the same time. The key is to reform the design of their sales tax system so that it brings in more revenue.

Relative to concerns about raising the rates of the sales taxes, the same dynamics would be in play at the state level as would be the case with the NRST (National Retail Sales Tax). Namely, when the same sales tax rate applies to everyone, and we remove legislators' abilities to play various groups of taxpayers off against each other and obscure tax increases with an arcane system that no one understands, the downward political pressure on the one rate that every one pays will be very substantial. One of the founders said it better than I:

"It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty, that, 'in political arithmetic, two and two do not always make four.' If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them."
Alexander Hamilton in Federalist #21

3. Would completely eliminating tax deductions for charitable and municipal giving, reduce the incentive to give? (I do realize that all citizens - especially wealthier Americans - would have more disposable income to contribute to charities if we abolished the federal income tax; however, if the built-in advantage of giving is taken away, coupled with higher state and local taxes and a 23% tax on goods and services, could that 'giving' dry up?)
We believe that charitable contributions would flourish in a FairTax world and we have economic studies which bear this out.

First of all, let's remember that the purpose of all deductions against an income tax are so that you can pay those items with pre-tax dollars. However, these incentives only function for the 30% (app.) who choose to itemize on their tax returns. With the FairTax, citizens would pay everything with pre-tax dollars. In a FairTax world, there would be no AGI floors that have to be met for deductions to be deductible and none of the other limitations of the Internal Revenue Code would be applicable. Every dollar you donate, regardless of who you donate to, would be paid with pre-tax dollars.

Perhaps even more important, with no more involuntary deductions from your paycheck, you would have more disposable income. This is by far the biggest variable in determining charitable giving levels. In addition, the FairTax would stimulate the economy very significantly which would also increase the capacity for giving. Americans would give more because they would have more to give.

4. Are there any studies that project what our federal revenues would be for the next fiscal year under the national sales tax?
a. CBO and OMB currently project what our federal revenues will be based off of projected growth and income rates - and all other taxable receipts. They project what our deficit will be by subtracting all expenditures from those expected receipts.
b. What would the projected revenue for the U.S. Government be under the sales tax for FY 2011 and would that be higher or lower for FY11 than we're estimating under the current tax code?
c. Is the goal of the Fair Tax to increase Federal Revenues? Or is it to reduce Federal Revenues and shrink the overall size of government?
i. If the goal is to reduce revenues and the size of government, how would you address the increased annual deficits?
ii. What "Pay-Go" offsets would you propose with the Fair Tax so that you comply with House and Senate Rules to only pass mandatory spending/tax changes that are "deficit neutral"?
The FairTax has been carefully calculated to be revenue neutral, meaning that it raises enough revenue to replace the taxes that it eliminates plus pay for the rebate that is part of the proposal. Some of our critics have argued that our rate would have to be significantly higher to be revenue neutral. We have rebutted these positions in writing and have had the rate calculations scored by separate economists using the design of the proposal as written. Without getting too technical, the critics typically change the design of the proposal, then score their modified version. They may say, for example, that the rebate won't work and they replace it with exemptions such as the states with sales taxes use. By the time they reduce the tax base by putting in all the exemptions, they have to raise the rate to compensate. The interesting thing is that the critics do not support this version of tax reform and neither do we. Thus, they spend their time scoring a version that has no support whatsoever, rather than the version which has more political support than any other tax reform proposal in congress. We consider this a very disingenuous approach.

When we say that the FairTax rate is calculated to be revenue neutral, we have to also point out that this is based on a static analysis, which is the way that bills are required by congress to be calculated. As I am sure you are aware, there has been a controversy surrounding static vs. dynamic scoring going on in congress for some time now. This issue is particularly germane to the FairTax, since all of our economic studies indicate that economic growth would be higher under the FairTax than under a continuation of the current system (or under any alternative proposal, for that matter). Economists do not agree on many things, but one thing that most do agree on is that economic growth would be higher under a consumption tax than under an income based system. Several of our economic studies have forecast GDP growth rates initially in the double digits and even many years after initial implementation, growth would still be slightly higher than under the status quo. Think about that - Chinese type growth rates in an economy the size of ours, where 4% is considered strong economic growth. No living American has experienced double digit growth rates in the US economy. Even if the FairTax only created 7 - 8% growth for a few years, it would still be well worth it to pass this important piece of legislation.

For this reason, we strongly believe that the FairTax would bring in more revenue to the federal government, even though it has been carefully scored as revenue (and spending) neutral. It would increase revenues not by raising rates, but by stimulating the economy which, we believe, is the best approach to the deficit problem. We have seen two trends which are crucially important in converting federal budget surpluses into deficits when you compare the decade of the 90s to this past decade:
(a) Spending has increased dramatically, and
(b) Economic growth has slowed down from a consistent 4% to less than half of that
The FairTax would not address (a), but it certainly would address (b) and, in fact contribute to growth rates which would be, at least initially, much higher than what we experienced in the 90s. This would make a balanced budget much more achievable in combination with specific spending cuts than merely using spending restraint alone.

The goal of the FairTax is not to increase or reduce revenues, although a by-product f the economic expansion it would create would be to increase them. The goal of the FairTax is to enable the federal government to raise the revenues that it requires in a less intrusive and economically destructive manner.

Answering the question in a little more depth, I would say that the goals of the FairTax are to:
(a) address the adverse economic trends which the current tax system exacerbates, such as
(i) the trade deficit and erosion of our manufacturing sector
(ii) the federal budget deficit, to the extent that slower economic growth is a contributing factor,
(iii) the crisis in SS & Medicare (discussed below),
(iv) our low personal savings rate, a source of concern of every serious economist,
(v) the ongoing spiral of complexity and higher and higher compliance costs of the current system,
(vi) the AMT (Alternative Minimum Tax)
(b) Serve as an essential element of reforming the system of tax preferences and earmarks for campaign cash, aided and abetted by an army of extremely well paid lobbyists. Many polls have shown that the American people increasingly feel that they are not being represented in congress and that their interests are being pushed aside by that of the big-money special interests. The FairTax may address only one part of that problem, but it is a critical part.
(c) Better position this country to be able to compete in an increasingly global market place. Globalization is THE megatrend of the 21st century. This country will face a level of global competition that it never has in its history. Most Americans realize neither the magnitude of the challenge that we face, nor the extent to which our tax system places us at a disadvantage in this increasingly competitive environment.

5. How long would you estimate needing to transition from the current tax code to the Fair Tax? What about long-term obligations?
(Former) Fed Chairman Greenspan has suggested a six month time span between the time that the FairTax is passed into law and the time it is implemented. He believes this would be an appropriate amount of time for the capital markets to adjust to this new tax regimen. Implementation itself would be immediate - income taxes would be due and payable probably through the end of a calendar year, and the FairTax would be implemented on January 1. Americans would still file their returns on April 15 of that year for the very last time (assuming they are current with their filings).

The only transition rule is that inventory held over on the implementation date would be eligible for a credit against sales taxes paid, or if it is a business which only sells business to business (and therefore won't collect the sales tax), they could receive a cash rebate. The intent of this rule is so that businesses could pass along the lower (pre-tax) prices to their customers immediately upon the FairTax going into effect and not wait until old inventory was flushed through the supply chain.

6. Would the FAIR Tax eliminate the Estate Tax and Capital Gains taxes?
Yes. The FairTax replaces these taxes plus income taxes at the individual and corporate levels, employer and employee portions of federal payroll taxes - all current federal taxes except excises, which account for less than 5% of federal revenues.

Inheritances would be taxed as spent - which we believe is a much fairer way to levy.

7. How does the FAIR Tax account for Social Security, Medicare and Medicaid? Since they are entitlements with explosive growth, wouldn't reforming entitlements need to be a key component of overhauling our income tax code? How would you recommend reforming the key contributors to our national debt?
The FairTax is itself one of the most effective ways to reform SS & Medicare. By that, I mean that the essential problem with these two social safety net programs is demographic in nature - we will be adding proportionately fewer people to the labor pool (who are the ones paying into the system if we stick with a payroll tax base) than we will have people retiring (and drawing funds out of the system) over the next several decades. We find ourselves in a box because of a combination of
(a) these systems were not set up on an actuarially sound basis to begin with, with no assets set aside to pay for the promised benefits,
(b) a payroll tax was used to fund them ,with current taxes collected paying for current benefits, and
(c) the demographic bubble I referred to, as the baby boomers retire over the next approaching years.
If we switch from a payroll tax basis to a broader tax on the entire economy (such as a broad based sales tax), we go a long ways towards freeing these systems from the demographic straight-jacket they are in. For example, if we grow the US economy enough to double its size over the next 15 years (as has been suggested as a goal with fundamental tax reform a critical element), then we double the base from which to withdraw those tax revenues. If we stick to a payroll base, there is no way that we double that base (or anything close to that) over the next 15 years.

It has been suggested that passing the FairTax would be enough to stabilize these systems and make other reforms unnecessary. I am not an economist and I won't make that claim, since we don't have studies to back that up. What I will say is that if we don't pass the FairTax, then we are left with either (a) tax increases, or (b) benefit reductions, that either individually or in combination are of such a magnitude that some have suggested that social unrest (riots) are inevitable. At the very least, there seems to be a lack of political will to tackle these problems effectively with only those two options on the table.

It cannot be overemphasized that the FairTax is the only proposal that we are aware of which addresses the core problem of SS & Medicare, which is demographic in nature.

8. Where would the money come from for the "Prebate"? Would every American get a check? How much is the "prebate" check for?
a. Since America does not have a trust fund, would we have to just print the money to send the Prebate checks?
b. Would an unemployed person and Bill Gates get a Prebate Check?
c. Would this money need to be borrowed from overseas to write the first check?
As indicated earlier, the sales tax rate has been calculated to replace the revenues lost from other eliminated tax forms, as well as to pay for the rebate. The rebate is, in effect, a refund of taxes paid at the register. Because it is paid at the first of the month, whereas consumption occurs throughout the month, some of it will be paid out as rebates in advance of its receipt through the sales tax collection system. This is a very short term cash flow issue (less than 30 days) and I'm not knowledgeable enough in terms of the federal government's treasury operations to know how they would address that short term need. However, I find it hard to believe that it would be difficult to accommodate.

9. How would shifting to the Fair Tax affect the ratings of U.S. Treasuries? What affects could it have on the fragile dollar if new uncertainties about U.S. tax revenue were to cause China, Japan, Canada, Mexico and the Arab Oil states to dump U.S. Treasuries in the open market? (my concern is that this uncertainty (if not calculated properly) could trigger a serious decline in the dollar and potential inflation)
A shift to the FairTax should strengthen the dollar over the medium to long term because it would address the twin deficit problem (trade deficit and federal budget deficit), as well as the other adverse economic trends that the current system contributes to referenced in the answer to #4 above.

More specifically, it has been argued that adding a border adjustment element to our tax system would be ineffective in addressing the trade deficit, since "currency adjustments" would offset. That argument has been rebutted by some of the leading international economists because, even though trade flows are a factor in currency valuations, they are only one of a number of factors. Furthermore, we are the only one of 30 OECD countries without a border adjustment element and we are the only one with a massive trade deficit - in fact, the other 29 have a net trade surplus, even though China is not in the OECD. In this case, "currency adjustments" means that the USD is strengthening. Neither FairTax proponents nor critics dispute that the USD would be strengthened by adding a border adjustment element to our tax system, only what its effectiveness would be in reducing the trade deficit. The more sophisticated economists in international trade believe that it would be very effective in that regard.

As you also pointed out, basing the federal government's revenues on consumption, rather than income, would be a move to a more stable and predictable revenue base. That should not be a cause for concern among the holders of US treasuries. Neither would the fact that this is a move which would lead to faster economic growth within the US and the elimination of several hundred billion dollars in wasted compliance costs.

For all the above reasons, we believe that holders of US treasuries would welcome reforming the US tax system along the lines of the FairTax and that the USD would be strengthened significantly over the medium to long term.

10. Would the pre-bate come in the form of a card? Would it only work on food and clothing?
The prebates would be in the form of cash and most of them would probably be sent via electronic bank transfers. The Social Security Administration has a lot of experience sending out large volumes of monthly payments and they would probably do it. Since it is in the form of cash, it would work on anything, including food and clothing.
11. What would the sales tax be? Could states raise their sales tax on top of it?
If you are asking what the rate would be of the new NRST (National Retail Sales Tax), the answer is that it would be 23% tax exclusive or 30% tax inclusive. That is, if you purchased something at the store which had a pre-tax price of $1.00, you would pay $1.30 for it. The reason we have to get into the complication of two different ways of measuring the rate is that sales taxes and income taxes have traditionally been calculated on different bases. If you ignore that complexity, you introduce a bias in favor of income taxes in any comparison based solely on the different ways that the two types of taxes have their rates measured.

States would still be free to design their tax systems as they please, just as they are now. However, for the reasons explained in depth in response to #1 and 2 above, we believe that the effects on state taxes would be quite positive.

12. How would the increased sales tax affect new autos and other big-ticket items like private jets and yachts? While those customers are already wealthy, the construction of one yacht (for example) supports 1,000 jobs in the yacht building industry in the gulf coast. When President Clinton created his "luxury tax" on high end autos, cars, jets, etc. - it crushed those industries and we lost tens of thousands of good paying jobs in those areas because wealthy people decided not to purchase new products - they either fixed up their current product or bought a year-old product.
I am not aware of any economic studies which look specifically at the luxury items that you reference. However, at least some of the studies do indicate that there would be some initial decrease in overall consumption. We regard this as a benefit, since economists almost universally regard our low savings rate as a source of concern and an increase in savings also equates to a decrease in consumption. However, two things must be kept in mind in this regard:
1. At least one of the studies has shown that the reduction in consumption would be composed entirely of a decrease in imports. In fact, that study shows an increase in the consumption of domestically produced goods - but not enough to totally offset the decline in imports, so that you would see a net decrease in total consumption. This is due to the elimination of the bias that the current system provides to foreign producers over and above our own domestic producers. The FairTax puts all producers - domestic and foreign - on a level playing field and domestic producers would benefit from that relative to continuing with the current system. This is how you arrive at the finding that, even with a decrease in consumption, GDP growth is higher than under a continuation of the current system.
2. The studies which show a reduction in overall consumption in the short term also show faster consumption growth rates (due to a faster growing economy) than under a continuation of the current system, and they also show that by about the 4th or 5th year after implementation, consumption levels would have caught up to where they would have been under a continuation of the old system, and from that point forward, consumption levels would be positive.

What we believe will happen, therefore, is as follows:
1. A small initial decline in consumption, followed by faster rates of consumption growth, consumption catching up to where it would have been by the 4th year, and higher levels of consumption thereafter.
2. A faster growing economy, as measured by GDP growth
3. A healthier mix between savings and investment
4. A healthier mix between imports and consumption of domestic production.

I'm sorry that I can't answer your question about big ticket items more precisely, but our best guess is that those items will track the pattern of the other consumption categories discussed above. In other words, there may be some initial reduction in the purchase of these items, but the longer term trend is that a faster growing economy leads to faster rates of consumption growth and the elimination of the current system's bias toward foreign producers means a healthier mix of domestic production vs imports.

13. What affects would this have on individuals who earn under $20,000 a year (who currently pay $0 in federal income tax)? And how would it affect individuals who earn under $33,000 who pay a thousand or two thousand dollars a year in federal income taxes before their refund? Do you have a breakdown for a typical family of four with a combined income of say 50 or 60 grand or less?
Almost all Americans at the low end of the economic ladder pay more in payroll taxes than they do in income taxes. Payroll taxes, because of the ceiling on earnings, are the most regressive element of the current tax system. Getting rid of that component and replacing it with a broad based tax on the entire economy in which the only taxes that are paid on a net basis are for consumption above the poverty level would be very beneficial to those at the low end of the economic ladder.

More specifically, here is how the prebate would work. The prebate is calculated as the sales tax rate times the poverty level for a given family size. Please note that the poverty level is already calculated annually by the Department of Health and Human Services. The rebate calculation would not require any additional calculation of the poverty level itself. If the poverty level for your family size is $2,000 per month and the sales tax rate is 23% (tax -inclusive), then you would receive a check (or direct deposit) for $460 at the beginning of each month. If you bought exactly $2,000 worth of "stuff", you would be charged that same $460 at the register and you would be even. To the extent that you bought more, you would become a net taxpayer. However, even if you bought $4,000 worth of "stuff", your effective tax rate would only be 11.5%. That is 23% divided by 2 - because half of the taxes you paid at 23% would have been rebated.

However, it must also be remembered that the elimination of the old tax system, which gets embedded at each step of the domestic supply chain, would enable pre-tax prices to drop because of competitive pressures. We believe, therefore, that pre-tax prices of domestically produced goods would decline by 8 to 12%. That means that a family consuming at exactly the poverty level would see an 8 - 12% increase in their purchasing power - assuming that they purchased all US produced goods. To the extent that they purchased imports, their purchasing power increase would be less than that.

Another way to look at it is that a family purchasing 1.5 times the poverty level for their family size would break even on what they paid for their consumption, when the pre-tax price decreases and the rebates are netted against the imposition of the sales tax at the register:
Rebate (assuming poverty level of $2,000/mo) ($460)
Sales taxes paid
(assume consumption of 1.5 times poverty rate or $3,000) $690
Pre-tax price decrease (assume 10%) ($231)
Net decrease in cost ($1)

This assumes that 100% of consumption is from domestic production. However, this does not even count savings from the elimination of SS & Medicare taxes. The analysis comes out the same for any assumed poverty level you wish to use, so long as you keep the other parameters the same. Therefore, an American citizen spending up to 1.5 times the poverty level will far quite well under the FairTax

I went through everything I like about the fair tax in our last meeting: 1) I think it will lead to greater productivity, 2) I think it will lead to higher savings rates and lower interest rates, 4) I like the idea of taking a wrecking ball to the IRS, 5) I like the idea of keeping more of my own money, 5) I think pegging our federal revenue to consumer spending is less volatile than incomes because consumers continue to spend during recessions while incomes may drop by as much as 20%
We are in agreement.
(my concern here is that the increased Sales tax may reduce consumption - especially in early stages - additionally, what about when someone loses their job and burns through their prebate?)
I think that I discussed the consumption issue fairly thoroughly above. If any questions remain on this issue, or any other, please advise and I will do additional research. We want you to feel very comfortable - as comfortable as all the constituents who met in Congressman Shuler's office in mid-April are. As to the issue of someone losing their job, let's remember that the purpose of the rebate is not to replace unemployment insurance or other forms of assistance in that regard. It is to make sure that Americans struggling at the low end of the economic ladder do not bear the burden of the tax system.
I will also include a graph of the effective rate of the FairTax when measured against consumption. What it shows is how effectively the FairTax makes the FairTax progressive - meaning that the effective rate increases as consumption levels increase. For a household consuming at exactly the poverty level, the effective rate is zero because the rebate offsets dollar for dollar the taxes paid at retail checkout counters. As consumption rises, so does the effective rate, but very gradually, and the effective rate approaches, but never reaches 23%.

Last, I will leave you with a quote from a very highly respected economist from here in the Atlanta area.

"Where we now use government tax treatment to alter behavior, use direct subsidies. Virtually all economic studies show that the cost of behavior alteration is lower through direct subsidies than through tax advantages."
Former Regent's Professor of Economics Emeritus at Georgia State University, Donald Ratajczak is a nationally known economist and one of the leading econometric forecasters in the country.

Philip L. Hinson
Volunteer Regional Director - SE
Americans For Fair Taxation

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