Sunday, August 21, 2005

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):

Loading table...

Loading table...

Loading table...

Loading table...

Saturday, August 20, 2005

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)
SourceTaxable Income

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)
YearIndividual Income TaxCorporate Income TaxesSocial Insurance TaxesExcise TaxesEstate & Gift TaxesCustoms DutiesMiscellaneous ReceiptsTotal Revenues

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.