Tuesday, October 19, 2004

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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Thursday, October 14, 2004

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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Sunday, October 03, 2004

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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Saturday, October 02, 2004

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.