Comparing Tax Systems: Reconsidering Refundable Credits

When looking at the previous post comparing the effective tax rates of current system to the Fairtax system, you may have noted that there are a few examples for large 'single/head of household' very low income households where the difference between the Current System Effective Tax rate and the FairTax Effective Tax rate is negative, indicating that such households would be better off under the current system than the FairTax.

If you took the time to look closely, you would notice that in all such cases, the reason is that some combination of the current system refundable tax credits ( earned income tax credit, or additional child tax credit) were leading to a large negative income tax for that household. A refundable tax credit is a credit against taxes paid, such that if a household owes no taxes, the remaining credit will be refunded to them.

So if a household only owes $1000 in taxes, but is eligible for a $2000 refundable tax credit, the IRS would send them a check for $1000. Effectively, they would have paid -$1,000 in income taxes.

Refundable tax credits are basically anti-poverty programs. The Congressional Budget Office (CBO) even classifies them as such in their outlays for mandatory programs table. They note for the 'Income Security' category: 'Includes unemployment compensation, Supplemental Security Income, the refundable portion of the earned income and child tax credits, Food Stamps, family support, child nutrition, and foster care.' This is an important point. The refundable part of these tax credits are budgeted as outlays. If we move to the FairTax, the budget for them as outlays remains. Since the FairTax is revenue neutral, the revenue for them remains (to the degree it's there now). So if we wish to spend those moneys on anti-poverty programs we are free to do so without abusing the tax system to accomplish that end.

Because of this, I felt it might be useful to see how the FairTax compares to the current system, in the absence of refundable credits. Please note, whether you believe the money currently budgeted for refundable tax credits will be spent on equivalent anti-poverty programs or not is up to you. If you don't then continue to refer to the previous comparison tables. But if you believe they will be, then the outcome for the poor looks much rosier under the FairTax than under the current system in all cases, as shown in the tables below, where the refundability of tax credits has been disabled (in other words, no one pays less that $0 income tax):

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Why FairTax Revenue Neutrality works

The reason the FairTax is revenue neutral at the relatively low rate of 23% compared to the much higher rates in the current system is entirely because of the breadth of the tax base.

The FairTax taxes $9246.2 billion out of our $10,971.2 billion 2003 GDP, or about 84%.

The current system taxes about $4500 billion dollars, or about 41% of our 2003 GDP.

It's all about the tax base :)

FairTax Estimated Revenue And Revenue Neutrality

We have already estimated the tax base for the FairTax (using 2003 data) as $9246.2 billion dollars.
Computing the revenue for the FairTax is then fairly straight forward.

23%*$9246.2 billion = $2126.6 billion dollars.

We have previously figured the cost of the prebate at $502.4 billion dollars.

So the net revenue from a 23% FairTax (with 2003 data) is:

$2126.6 - $502.4 = $1624.2 billion dollars.

We have previously figured the amount of revenue the FairTax must replace (using 2003 data) as $1660.5 billion dollars.

So our back of the envelope calculation of estimated FairTax revenue using 2003 data is within $36 billion dollars, or 2% of the actual amount of revenue we need to replace. Given the somewhat crude nature of our figuring, this is not unexpected. However it should show clearly that the 23% FairTax rate being revenue neutral rate is plausible.

So what would the FairTax rate have to be to be exactly a revenue replacement for the 2003 data? Well, the revenue we are seeking to replace is $1660.5 billion dollars. The prebate adds another $502.4 billion dollars. So we need to raise a total of $2162.9 billion dollars from the FairTax, on a tax base of $9246.2 billion. $9246.2/$2162.9 = 23.4%. So you can clearly see, that the 23% FairTax rate is in the right ballpark for revenue neutrality.

Estimated Prebate Costs

The FairTax provides a prebate to each household each month to reimburse the amount that household would pay in tax if it spent up to the poverty level for a household of it's size. When trying to compute the revenue neutral rate for the FairTax, you MUST take into account the cost of providing this prebate.

The Department of Health and Human Services Poverty Guidelines for 2003 defines the poverty line as $8,980 per household, plus $3,140 for each additional dependent in that household. Due to the FairTax's anti-marriage penalty clause however, it is reasonable to expect that the Family Consumption Allowance under the FairTax will effectively be $8,980 for each adult, and $3140 for each child (using 2003 data). This yields an annualized prebate cost of 23%*$8,980 = $2065.4 per adult and 23%*$3140 = $722.2 per child.

According the the US Census Bureau's Population Estimates, in 2003 there were 73,050,146 people in the US under 18 and 217,738,830 adults over the age of 18.

So the total cost for the prebate using 2003 data would be:

$722.2 * 73,050,146 + $2065.4 * 217,738,830 = $52.7 billion + $449.7 billion = $502.4 billion

So the estimated prebate cost using 2003 data is $502.4 billion dollars.

The Tax Base under the FairTax

Under the FairTax, all consumption of new goods and services (except tuition for education) is taxed at the same uniform rate.

The Bureau of Economic Analysis (BEA) keeps data on aggregate national personal consumption expenditures (PCE) as part of its National Income and Product Accounts (NIPA). If you are curious you can see how the BEA defines Personal Consumption Expenditures.

For 2003, the total PCE was $7709.9 billion dollars, of which $200.4 billion was for education and research. So the PCE contribution to the FairTax tax base is $7709.9 - $200.4 = $7509.5 billion.

The FairTax also taxes government consumption. The BEA keeps data on government consumption as well. For 2003, government consumption was $1,736.7 billion dollars.

So the total FairTax tax base is $7509.5 + $1736.7 = $9246.2 billion dollars.

The Tax Base under the Current System

One of the important things to understand when comparing the FairTax to the current system, is how narrow the tax base for the current system is. The 'Tax Base' is the money over which we apply taxes. When your tax base is a small percentage of your GDP, that means that very little of the money in your economy is being taxed at all.

The IRS provides us with a good summary of the tax base for personal income and corporate income taxes for 2003 (the most recent year for which the data is available).

The Social Security administration provides us with data about the social security and medicare tax base in 2002 (the most recent data currently available). Since 2002 Social Insurance revenues according to the CBO where $700.8 billion, which makes the $713 billion revenues for Social Insurance about 1.7% higher, and since the Social Insurance revenue is almost entirely Social Security and Medicare payroll tax, and since the Social Security and Medicare tax rates have not shifted, I will scale up their 2002 numbers by 1.7% for a 2003 estimate.

Tax Base 2003 (billions of dollars)

Source	Taxable Income
Personal	$4,200
Corporate	$261.4
FICA	$4271.4
Medicare	$5186.7

So to put it simply, the tax base for our current system is around $4.5 trillion dollars ($4.2 trillion personal income and FICA + $0.261 trillion corporate net income).

By way of comparison the US GDP in 2003 was $10,971.2 billion. So the tax base in our economy is relatively narrow. $4.5 trillion is only about 41% of our GDP. So about 41% of our GDP is currently subject to taxation by federal income, corporate income, and payroll taxes.

The Revenue from the Current System we need to Replace

The Congressional Budget Office (CBO) does a wonderful job of keeping and publishing historical budget data. In particular, they publish tables of government revenue by major source. If you look at the 2003 numbers in this table you will find (in billions of dollars):

Government Revenue by Source (billions of dollars)

Year	Individual Income Tax	Corporate Income Taxes	Social Insurance Taxes	Excise Taxes	Estate & Gift Taxes	Customs Duties	Miscellaneous Receipts	Total Revenues
2003	793.7	131.8	713.0	67.5	22.0	19.9	34.5	1,782.3

The FairTax repeals the taxes for the columns highlighted above in green. So the FairTax must replace the $793.7 + $131.8 + $713.0 + $22.0 = $1660.5 billion dollars in revenue. I will not discuss in detail the source of the $22.0 billion in gift and estate taxes, because it is so small.

Towards Demonstrating Revenue Neutrality

One of the things that people frequently question about the FairTax is whether the 23% inclusive rate is sufficient to raise sufficient tax funds to leave the government with as much revenue as the current system is generating. FairTax proponents will line up the economists who have studied the issue and found the revenue neutral FairTax rate to be between 22% and 24%.

But if you are like me you feel much better if you can *see* the numbers, and follow the calculations. So, I'm going to make a go at making similar calculations to show that the 23% FairTax rate is plausibly revenue neutral. Please note, I am not an econometrist, nor do I play one on TV. My calculations on this matter will be somewhat rough, but hopefully will be sufficient to demonstrate that the 23% FairTax rate is plausibly revenue neutral, and also to show why it is, since this point is so counterintuitive to many people.

To do this I'll:

1. Start with the current system and show where, in aggregate, our current tax revenue comes from.
2. Demonstrate how much revenue one could expect to generate from the FairTax at a 23% rate given the current personal consumption data.
3. Make an estimate of the cost of the FairTax prebate.
4. Compare the revenue generated by the FairTax, less the prebate cost, with the revenue generated by the current system.

Effective Tax Rate: Current System vs Fairtax System

Since we computed the Effective Tax Rate of the Current System and the Effective Tax Rate of the FairTax, it makes sense to put the two side by side so they can be compared.

Pay particular attention to the green 'Diff' column. It represents how greater an Effective Tax rate would a person would pay under the current system than under the FairTax if a person spent 100% of their income.

Once again you will see an explaination of exactly how a cell value is computed if you click on it.

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Current System Effective Tax Rate

The current tax system also creates an effective tax rate, but unlike the FairTax, it is not an easy or straight forward thing to compute. One should be able to compute the effective tax rate for a taxpayer by taking the amount of taxes they pay and dividing by their income. Unfortunately the amount of taxes paid depends on a huge array of factors. The same income earned different ways is taxed differently. The same income earned by two different households is taxed differently. It is very complicated and confusing.

To try to make this simpler I will take as my model a household where all income is earned wages. I will take into account the payroll taxes, income taxes, standard deduction, and personal and dependent exemptions. I will also take into account the earned income tax credit and the child tax credit, as these are major benefits for poor and middle class taxpayers which depend only on income and number of children. I will only consider Single, Married Filing Jointly, and Head of Household, filing types. Married Filing Seperately is more complicated than I can face.

Below are tables showing the Effective Tax Rate of the Current System. Please note, once again, that you will be able to see the details of the calculations by clicking on the table cell you are interested in.

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FairTax Effective Tax Rate

In order to fully understand the impact of the FairTax on various spenders you must speak about the effective tax rate. The FairTax is applied at the cash register at a uniform rate of 23% inclusive on all retail sales of new goods and services. However, because of the Family Consumption Allowance the effective rate on each dollar you spend will vary depending on how much you spend and how large your household is.

The effective tax rate is the total amount in FairTax that you pay divided by the number of dollars that you spend. Since the Family Consumption Allowance refunds to you the amount of tax you would be charged if you spent up the the poverty line for your household the effective tax rate for the FairTax will always be lower than the 23% rate. To compute the effective tax rate:

s = spending
a = family consumption allowance
r = FairTax Effective Tax Rate
r = (0.23*(s-a))/s

You can look up the amount of Family Consumption Allowance by household size and marital status here.

If you examine the tables of the Effective FairTax Rate below for single and married households you will notice that the FairTax is quite progressive. Please note these tables reflect effective tax rates on spending on new goods and services, not income. The FairTax doesn't care home much you make, only how much you consume. (Note: if you click on a table cell you will see a detailed explanation of the calculation that produces the contents of that cell displayed below the table.)

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The FairTax and Education Spending

The FairTax replaces all income, payroll, capital gains, dividend, interest, and business taxs with a 23% national retail sales tax on all new goods and services. It does not in general tax investment. If you invest $100 in stocks or bonds or your business and at the end of the year that investment has earned $10 you get to keep all $10. In keeping with this spirit of not taxing investment the FairTax does not tax educational spending. The rationale for this is that education is investment in human capital and should not be discouraged.

So if you have to pay a $10,000 tuition bill for your childs education, you only need to earn $10,000 under the FairTax.

Please note, HR25 Title II SubTitle A Section 2 Subsection a Paragraph 4 defines education spending as:

The term `education and training' means tuition for primary, secondary, or postsecondary level education, and job-related training courses. Such term does not include room, board, sports activities, recreational activities, hobbies, games, arts or crafts or cultural activities.

By not taxing spending on education the FairTax dramatically increases the affordability of college education. Today a family wanting to send their child to college has basically three choices:

Coverdale IRAs

Coverdale IRAs allow parents to put aside up to $2,000 dollars a year for their childs education. The money put aside may grow with no taxes, and if used for qualifying educational expenses is not taxed on withdrawl. The money put into the Coverdale is not tax deductible however. The IRS has more information on Coverdale Accounts. Suffice it to say the rules are a little complicated.

529 Plans

Each state has a 529 college savings plan that you can invest money in for your childs college tuition. You get no tax deduction for money contributed. The money put aside grows tax free and isn't taxed on withdrawl if spent on qualifying educational expenses. Unfortunately you have to be a pretty savy shopper to not get ripped off as administration fees from the state, and management fees from the institutions managing the fund can greatly reduce returns. Additionally these plans are usually marketed through brokers who charge hefty commisions to move your money into them. You also have very limited control over how the money is invested.

Just Save

In this senario you pay taxes on the money you save, and then you pay taxes on the earnings on the money you save. Ick

With a Coverdale Plan or a 529 plan at least 25.3% of each dollar you save is taxed away by income tax(minimum 10% bracket) or payroll tax (%15.3) before you even put it in the accounts. If you save outside these accounts then you're earnings get eroded each year by taxes on capital gains, dividends, and interest. Additionally the ins and outs of Coverdale and 529 plans can be quite involved.

With the FairTax you pay no taxes on dollars you save for your child college tuition (or any other purpose) at all. When you go to spend those dollars on educational costs you are once again not taxed on them. Thus the FairTax makes it not only much easier to save for your childrens educational expenses, but also much more effective.

Update: An article on Yahoo news about how broken 529 plans are.

The FairTax and Investment

The FairTax proposal not only eliminates all income and payroll taxes in favor if a 23% national retail sales tax, it also eliminates all taxes on capital gains, dividends and interest. What this means is that if you buy a stock at $10 and sell it at $15 you will reap all of the $5 in profit, and may reinvest it without any tax. Only when you choose to spend that $5 of profit (on a new good or service) will you be taxed on that profit.

There are a lot of folks who will look at this and see a big tax break for the rich. Think of it this way though: capital investment is what creates higher paying jobs. If an investor lends a business man $100,000 to buy a bulldozer, he can afford to pay that bulldozer driver a lot more than he can afford to pay someone moving earth for him with a shovel. This is because one man driving a bulldozer can do as much in a day as 10 guys with shovels can in a week. If you tax the interest he pays the investor, then it takes longer for the investor to be able to lend to another business man to buy another bulldozer to create another high paying job. Taxing investment income that is reinvested is purely a means of slowing the creation of higher paying jobs. Now this is NOT to say that the investor shouldn't pay his Fair Share(tm). But the FairTax moves his fair share to the point at which he turns those profits to selfish ends by consuming goods and services with them.

After all, if two investors both make $100,000 dollars in the market and one reinvests it all in creating more highing paying jobs for others, and the other buys a couple of Rolexes and a Mercedes, does it really make sense to take the same $40,000 cut from both of them? Isn't that punishing the virtuous behavior of investing in making a more productive economy in the same way as punishing hedonistic consumption?

The FairTax does not allow the rich (or anyone else) to escape taxation, all it does is tax you for what you consume, not what you contribute. Investment is a contribution to society, and thus the profits from investment are not taxed until they are used for consumption.

Tax what people consume, not what they contribute

One of the interesting things about the FairTax is the way it recasts taxation ethically. For most people their income is a measure of what they contribute to society. One can clearly point to instances where this is not so, but on average it's much closer to true than to false. The current income tax system therefore taxes people on what they contribute to society. The FairTax, as essentially a consumption tax, taxes people on what they take from society.

It just somehow feels more right to be taxing taking rather than contributing.

Family Consumption Allowance

When you speak of the impact of taxes you tend to talk about whether they are progressive or regressive. Progressive taxes tend to tax the rich more than the poor, regressive taxes tend to tax the poor more than the rich. Sales taxes are usually seen as regressive because the poor must spend a greater percentage of their income on necessities than the rich, and thus have a greater portion of their income subject to taxation. In the past state governments have tried to overcome the regressivity of sales taxes by exempting necessities (like food). This inevidibly has led to market distortions and political manuevering for businesses to get their goods in a 'necessity' category. The FairTax takes a different approach to eliminating the regressivity of a sales tax.

The FairTax introduces a Family Consumption Allowance (FCA). The FCA is a check sent each month to each household registering to receive it (registration is voluntary) to reimburse the amount of sales taxes paid if that household spent up to the poverty level as specified by the department of Health and Human Services. This is how the FairTax 'exempts' necessities. It presumes that every household must spend up to the poverty line in order to purchase necessities and then refunds that portion of tax. The FCA would be administered by the Social Security Administration, which is quite proficient at sending out monthly checks. Complete details on the FCA can be found in the bill HR25 Chapter 3.

Below is a table showing how the FCA would work for household of various sizes:

2004 Rebate Calculations

Family size	HHS annual poverty level	FairTax annual consumption allowance (single person)	Annual rebate (single person)	Monthly rebate (single person)	FairTax annual consumption allowance (married couple)	Annual rebate (married couple)	Monthly rebate (married couple)
1	$9,310	$9,310	$2,141	$178	N/A	N/A	N/A
2	$12,490	$12,490	$2,873	$239	$18,620	$4,283	$357
3	$15,670	$15,670	$3,604	$300	$21,800	$5,014	$418
4	$18,850	$18,850	$4,336	$361	$24,980	$5,745	$479
5	$22,030	$22,030	$5,067	$422	$28,160	$6,477	$540
6	$25,210	$25,210	$5,798	$483	$31,340	$7,208	$601
7	$28,390	$28,390	$6,530	$544	$34,520	$7,940	$662
8	$31,570	$31,570	$7,261	$605	$37,700	$8,671	$723