JORGENSON EXPLODES FAIRTAX MYTH (FR Exclusive)

U.S. Representative John Linder
1026 Longworth House Office Building
Washington, DC 20515
Phone: 770-232-3005
Fax: 770-232-2909
Copy: Neal Boortz, WSB Radio,
Dr. Dale Jorgenson, Harvard University

I wrote to you two days ago regarding what I consider to be serious misrepresentations of the Fair Tax plan contained in your book, “The FairTax Book”. On page 2, you state “Let’s agree up front that this book is about honesty” and I intend to hold you at your word. Since that time, I have been in contact with Dr. Jorgenson in an attempt to clarify his understanding of this Plan and his calculation of expected price declines.

On pp. 22-23, your book states: “An extensive study of tax costs was completed a few years ago by Dr. Dale Jorgenson, then chairman of the Harvard Economics Department. On average, Jorgenson concluded, 22 percent of the price paid for a consumer product represents embedded taxes.”

You then went on to show a Chart (Fig 5.1) which shows the expected price decline without embedded costs for various goods and services as prepared by Jorgenson during his study.

On page 55, you go on to explain that these embedded taxes are “in addition to the money taken out of your check in income and payroll taxes.”

On page 59, you again invoke Dr. Jorgenson’s study: “If you’re looking for scholarly support for the proposition that prices will fall once the embedded taxes are removed, we can check back with [Jorgenson’s] “The Economic Impact of the National Retail Sales Tax” and you quote his report:

Since producers would no longer pay taxes on profits or other forms of capital income under the NRST and workers would no longer pay taxes on wages, prices received by producers… would fall by an average of twenty percent”

In this statement, Jorgenson seems to say that one of the reasons for the price drop at the producer level was the elimination of the tax on wages paid to workers. So, naturally if the business is going to realize this benefit it must reduce the workers gross pay be the amount that is currently being paid in the form of income and payroll taxes. This only makes sense because how can the business reduce costs if it gives the worker tax savings to the worker?

Later on page 59, you state: “Once the FairTax takes effect, you’ll be receiving 100 percent of every paycheck, with no withholding of federal income taxes, Social security taxes, or Medicare taxes and you’ll be paying just about the same price for T-shirts and other consumer goods and services that you were paying before the FairTax.”

Dr. Jorgenson’s report clearly showed that under his study the worker would not get their complete paycheck, because if he/she did, there would be no cost savings to the business and therefore no price drop associated with worker taxes.

You continue this theme on page 83: “Remember that the poor, along with everyone else—will no longer have Social Security taxes or Medicare taxes removed from their paychecks. Whatever they earn, they get on payday. For most of those we categorize as poor, this would mean an immediate 25 to 30 percent increase in their take-home pay.”

On page 84, you make it clear though that even though the workers will keep all of their paychecks for a big raise, you still believe that because of “the disappearance of the embedded taxes, the total price paid for consumer goods will remain very nearly the same”.

By assuming these two things together, you are misrepresenting Jorgenson’s report and double-counting the tax savings, first by giving them to the worker as a pay raise, and then at the same time assuming that there was a cost savings to the business.

And then on page 111, you tie it all together with a Quick Review in which you erroneously assert that “Here’s what happens when we pass and implement the FairTax plan:”

“We all get virtual raises, since payroll taxes are no longer siphoned from our checks.

“The prices of consumer goods and services remain essentially the same, with the removal of the embedded taxes compensating for the added consumption tax.”

Dr. Jorgenson’s report seemed pretty clear to me, but I felt it was necessary to ask him directly what he meant so I sent him this e-mail:

I am a private US citizen who is concerned that the FairTax proponents are misrepresenting your conclusions. Would you please comment on the attached letter I sent to Mr. Boortz and Rep. Linder? I think that they are being dishonest to imply that the wage earner will keep his entire paycheck, while at the same time businesses will be able to reduce costs? Your March 1996 testimony stated, in part:

5.Since producers would no longer pay taxes on profits or other forms of capital income under the NRST and workers would no longer pay taxes on wages, prices received by producers, shown in the sixth chart, would fall by an average of twenty percent

Are you expecting business to reap a benefit from the taxes that that the worker no longer pays? It certainly sounds like that is part of where you see the business reducing its costs.

From: Dale Jorgenson [mailto:djorgenson@harvard.edu]
Sent: Wednesday, August 24, 2005 10:28 AM
To: Rob xxx
Re: Fair Tax- Is your 1995-6 Testimony being misrepresented by Boortz/Linder book?

A more reasonable interpretation of my 1996 testimony is that workers would keep that after-tax pay; producers' prices would fall, but retail prices would be increased by the national retail sales tax. Any gains by workers and investors would be the result of increase economic efficiency.

[He then went on to recommend his book called LIFTING THE BURDEN, about another tax reform plan he calls Efficient Taxation]

I wanted to be perfectly clear what he was saying, so I asked him to clarify his email:

Excuse me for my lack of understanding of your answer, when you say "workers would keep that after-tax pay" are you saying that if they are making $1000 a week now, and paying $200 payroll+income taxes now, that under the FairTax you were assuming that workers would get paid $800 and keep all of that? Or are you saying that you meant they would make $1000 under the FairTax?

I am saying that the worker would continue to receive the after-tax amount of $800. Prices received by producers would decline to cover the cost of after-tax wages to workers and after-tax dividends and interest to investors. However, taxes paid at the retail level would include the Fair Tax.

So, Dr. Jorgenson, whose report you are relying on to support your calculation of embedded taxes, is stating that in making those embedded tax calculations he was not assuming that the worker would keep his current after-tax amount, NOT that the worker would keep all of his current gross pay-check. By reducing the gross pay of the worker to the current after-tax amount, the producers would see a cost reduction that would allow them to reduce selling prices. There would be no increase in take-home pay.

I think you need to carefully review the misrepresentations in your book and offer a retraction and modify subsequent printings to remove these errors. You have spent a large amount of time on this plan, and it is still a viable option for debate even without the bug windfall pay raise for everyone. I would enjoy the opportunity to discuss this with you further if you have questions.

You should look at the example in #311 a bit more carefully since it is not at all like the earlier post of mine from four years ago.

While not precisely the same, your example from four years ago shares one major flaw with the table you posted in #311:

both use an exceedingly high number for profit as a percent of revenue. The old table used 18%, the current table uses an even more unreasonable 33%.

US corporations average a profit of between 5% and 6% of revenue (before income taxes.)

The old table added tax to input cost to get price (curiously ignoring the rest of profit as a component of price.) The new table also adds tax to input cost, but also adds the entire profit on top of that. That, my friend, double counts the tax (FairTax folks seem to favor double counting ;-) Under any standard accounting procedure, tax is deducted from gross profits (PBT) to get net profit. Tax is never added to profit to get price!

This table uses the marginal tax rate ...

Nobody is suggesting a problem with the marginal tax rate, it your choice of profit at 33% of cost that is the problem (nobody who does accounting the way you have would be an accountant for very long!)

In fact the numbers reach a very conservative level asymptotically.

Not possible. The algorithm at the heart of the table you posted is a "compound interest" algorightm. It does not converge; it does not approach an asymptote. It expands indefinately and infinitely as the number of periods (levels) grows. And, most importantly it does NOT even come close to modeling the impact of tax on price!

It is the mechanism that is the thing of interest here rather than the numbers themselves.

Nice dodge; but, actually, BOTH are of vital interest:

First you have to get the algorithm right. Both tables (the one in #311 AND the one four years ago in #147) have incorrect algorithms.
Second, you have to use numbers that reflect the situation you are attempting to model. Your numbers greatly exagerate the problem you are trying to illustrate.

While I agree that taxes are indeed embedded in the price of goods and services, the level of these so-called "hidden taxes" is not nearly as great as you would lead us to believe.

For that reason insisting on using only corporate taxes...

Who insisted on WHAT? What thread, what posts are you reading anyway? I have taken issue with YOUR table: it's hogwash. You appear to be the one insisting on using selecive data (incorrectly at that) and bogus reasoning.

That is well over twice the total amount of Federal tax collected from all sources.

Dimples, from what I am gathering from the example given is that tax related costs are accumulating, not just federal tax collected. It is clear that in the view of many economists across the board that the cost bearing on businesses related to the income tax system actually exceed the amount of revenue the government receives.

You appear to see this example of one of cummulative or cascading tax where what is portrayed is how total costs increase throughout the chain.

That having been said however, the discussion in light of Dr. Jorgensons work, regarding the percentage decrease in producer prices, such tax related overhead cost do not appear to even be a factor in his calculations. His model is a simplified view of taxes per-se from what I can put together, and he allows gross income (before tax) to fall for labor as well as for business allow a decline in overall prices of 22%. The net result is essentially constant purchasing power on the part of the consumer modified for gains in productivity that result from higher efficiencies achievable in going from an income tax system to a consumption tax system.

My analysis after reviewing both RobFromGa's representations of Jorgenson's statements and Jorgenson's NRST studies of where I am at on this issue are as follows:

It seems to me, for lack of description or explainations in Dr. Jorgenson's papers concerning the simplifying assumptions made, I know I have made significant errors in interpretation of his results in assuming his calculations took business tax related overhead costs into account and gross wage would be what the employee would receive under any real world scenario involving contracted compensation for labor.

It appears that the impact of tax planning, compliance, and litigation costs were not a factor taken into account in Dr. Jorgenson's studies. Something that I, for one felt ,that any useful study would account for. Apparently Dr. Jorgenson did not address that level of detail in his IGEM.

It appears the net effect of the IGEM study was to aggregate all federal taxes per-se, as they reflect in price of goods, discounting individual income for individual part of the taxes (lowering the tax component of pricing for that factor) and discounting business sales revenue (i.e. aggragate of prices) for the total of business and individual taxes replaced by the NRST proposal. I do not see where he indicates that he did take any tax related overhead cost into account per-se in his studies, only the effects of adjusting price to the producer by the total amount of taxes replaced.

A simple check on that conclusion is to simply divide 1996(base year) federal tax revenues from corporate, SS/Medicare & personal income taxes by PCE,

NIPA Personal Income and Its Disposition:
1996 PCE = $5258.6 billion

NIPA Federal Government Receipts & Expensitures:
1996 corporate taxes = $ 190.6 billion
1996 SS/Medicare payroll taxes = $ 542.8 billion
1996 Personal Income taxes = $ 663.4 billion
=================================
Total replaced revenues = $1396.8 billion

Federal tax revenue replaced, as a percentage of PCE (retail price of goods and services purchased) = 100*1396.8/5258.6 = 26.56%

I know I had over analyzed Jorgenson's results assuming he took more into account regarding business and individual costs than he apparently did and by my assuming that gross wage would remain constant using sticky wage view of how wages respond in the real world as a consequence of contract requirements most folks receive their wage under.

In re-evaluation of Jorgenson's work:

In his email response to RobFromGa, Dr. Jorgenson describes his IGEM simulation results as:

"A more reasonable interpretation of my 1996 testimony is that workers would keep that after-tax pay; producers' prices would fall, but retail prices would be increased by the national retail sales tax. Any gains by workers and investors would be the result of increase economic efficiency."

In response to RobFromGa's query for clarity:

"Excuse me for my lack of understanding of your answer, when you say "workers would keep that after-tax pay" are you saying that if they are making $1000 a week now, and paying $200 payroll+income taxes now, that under the FairTax you were assuming that workers would get paid $800 and keep all of that? Or are you saying that you meant they would make $1000 under the FairTax?"

Dr. Jorgenson responds:

"I am saying that the worker would continue to receive the after-tax amount of $800. Prices received by producers would decline to cover the cost of after-tax wages to workers and after-tax dividends and interest to investors. However, taxes paid at the retail level would include the Fair Tax."

The bottomline in reviewing his papers; Jorgenson's simulation appears to have not taken tax related overhead costs into account at all!! It merely addresses the replacement of income, payroll and gift/estate taxes one for one and then applies it to price decline with the simplying assumption that personal gross income would fall to 1996 net(after tax) income.

Tax related overhead costs appear not to be a factor entering into Jorgenson's calculations and as such overhead cost due occur in the real world, real world would actually do better than the simulation provides in that aspect.

As far as I see it any tax related overhead costs saved by business becomes a plus to the bottom line purchasing power of the individual whether it be realized as increasing net personal income(wage and investment), in additional decline in prices or a combination of both.

You appear to see this example of one of cummulative or cascading tax where what is portrayed is how total costs increase throughout the chain.

Well, the table has four core rows: Input (cost), Profit Margin, Tax Rate and Selling Price. It also includes two rows that show running totals: Accumulated Tax, Tax as a percentage of Price. So, yes, I see the table exactly as it is labeled and subsequently portrayed by its poster: an example of how taxes cascade and accumulate throughout the chain. It attempts to show nothing else. It does not attempt to include "compliance costs" or any "tax-related" cost that is not a direct tax levied on profit.

Unfortunately as I and others have repeatedly pointed out, and as the poster and his allies have yet to address, the table is flawed in both its algorithm and its fundamental input data.

As for Dr. Jorgensen's work, I'm glad you now realize that he did not model what many are claiming he did. Many have and continue to represent things about the models and outcomes that are simply not true.

Please do not misinterpret what I am saying: I do NOT say that the cost to business resulting from the implementation of the current tax scheme is insignificant. I AM saying that the table and supporting arguments posted by pigdog and others does not model those costs at all, and what the table does attempt to model is done so incorrectly.

Other threads have attempted to include discussions of compliance costs, etc., (to little common ground), but THIS thread is principally about whether the magnitude of take home pay increases and price decreases as represented by the FairTax proponents are possible. As you apparently now agree, Dr. Jorgensen's work does not support the claims that have been made.

As you apparently now agree, Dr. Jorgensen's work does not support the claims that have been made.

What I agree with is that Dr. Jorgenson's work is incomplete on the subject as regards the effect of tax related overhead cost effects on wages and prices equally.

The Dr. Jorgensons work indicates little change in purchasing power of the individual citizen once NRST is included with the price received by the producer as consumer price the customer pays.

I agree that Dr. Jorgenson held takehome pay constant with respect to the income/payroll tax baseline as a simplifying assumption for implmenting his model, thereby saying nothing about where actual pay received in the real world will goes. As has been pointed out it is unlikely that contracted wages (i.e. gross wage on pay slips) can actually change in the real world outside Jorgenson's implementation.

Bottom line, assume gross pay will become takehome in any real situation, producer prices can fall by whatever proportion the business side of income & payroll taxes make up current prices.

Additionally it should be noted that producer prices can fall or gross income can climb by what ever tax related overhead costs (not accounted for in Jorgenson's simulation) are saved in going to a retail sales tax system would effectuate a net increase in consumer purchasing power to that degree.

What cannot be said definitively, is that Jorgensons IGEM results preclude the claims of NRST supporters as regards receiveing full contracted pay, and lower producer prices. The question that remains is how much is the gain from any full accounting of tax related business costs, and that remains a question for further studies on the bottom line thier.

What I agree with is that Dr. Jorgenson's work is incomplete on the subject as regards the effect of tax related overhead cost effects on wages and prices equally.

It's also incomplete on the effects hydro-dams have on salmon migrations ...

But, come on. It was never meant to model either one of those!. Let it go. You act like Dr. Jorgenson was the personal economist for the FairTax movement. He wasn't then; he isn't now. He never even attempted to model the thing you guys call the FairTax, and certainly didn't intend it to be the difinitive work on the subject.

I agree that Dr. Jorgenson held takehome pay constant ...

Actually, he didn't do that either. You're falling prey to the presumption that the model intended to hold wages at some particular level (the one you want, or the one he did) as an INPUT to the structure of the model. He didn't. His model simply takes taxes OUT of the employers line items of cost (in bulk) and re-inserts the same number (in bulk) as a direct consumer cost to model the growth impacts on the overall economy (he does this with several tax schemes one if which is a generic sales tax scheme.) The impact on wages is an incidental effect, not a cause.

Bottom line, assume...

Well, see, that's the problem ... there's too much assumin' goin' on! Assume all you want. Just don't try and make conjecture look like fact by trotting out an authoritative source unless the authoratitive source used the same assumptions.

What cannot be said definitively, is that Jorgensons IGEM results preclude the claims of NRST supporters ...

NOW were getting somewhere! Moving from "Jorgensen PROVES what we say" to "Jorgenson doesn't PRECLUDE what we say" is a MONUMENTAL move!

Thanks for your support.

You act like Dr. Jorgenson was the personal economist for the FairTax movement. He wasn't then; he isn't now. He never even attempted to model the thing you guys call the FairTax, and certainly didn't intend it to be the difinitive work on the subject.

Testing of the Fair Tax Act provisions specifically, was done by Jorgenson in '97 applying his inter-temporal equilibrium models with the Fairtax provisions that include both replacement of income and payroll taxes as well as addressing progressivity on the expenditure side of the budget through a demogrant as HR25 does with its FCA.

Here is the text of summary results of that testing, the specific report is available on email request from AFFT in pdf format.

THE ECONOMIC IMPACT OF THE NATIONAL RETAIL SALES TAX
ByDale W.Jorgenson
May 18, 1997
Final Report to Americans For Fair Taxation

INTRODUCTION AND SUMMARY

The purpose of this report is to analyze the economic impact of substituting the National Retail Sales Tax (NRST)for individual and corporate income taxes,the Medicare,Social Security, and FUTA payroll taxes,and the estate and gift taxes.1 I consider a revenue neutral substitution-one that leaves the government deficit unchanged. Finally,I focus on the impact of this fundamental tax reform on economic growth over the next quarter century.

I have summarized my conclusions in a series of charts:

1.The revenue neutral substitution of the NRST for existing taxes would have an immediate and powerful impact of the level of economic activity.The first chart gives a projection of GDP under current tax law. The second chart shows that GDP would increase by almost 10.5 percent in the first year.This increase would gradually decline to a little under 5.4 percent over the next twenty-five years.

2.Taxation of consumption would induce a radical shift in the composition of economic activity-away from consumption toward investment. The third chart shows that real investment would initially leap by a staggering 76.4 percent and then gradually fall to about 15 percent higher than under existing taxes. The third chart reveals that real consumption would initially decline by 9.1 percent. However,consumption would overtake the level under existing taxes within five years and grow rapidly under the NRST.

3.Holding net foreign investment constant,the fourth chart shows that exports would jump by 26.4 percent under the NRST, while imports would rise only modestly. This is the consequence of excluding exports from the tax base while including imports. The initial export boom would gradually subside, but exports would ultimately remain more than 13.3 percent above the level under the current tax system, while imports would fall a modest 0.9 percent below this level.

4.As a consequence of the elimination of taxes on capital income,individuals would sharply curtail consumption of both goods and leisure. In addition,the implied subsidy to leisure time would drop to zero under the NRST; under the existing tax system this is equal to the marginal tax rate on labor income. The fifth chart shows that the NRST would generate dramatic growth in the capital stock and a sharp initial rise in the labor supply that would gradually decline over time.

5.Since producers would no longer pay taxes on profits or other forms of capital income under the NRST and workers would no longer pay taxes on wages, prices received by producers, shown in the sixth chart,would fall by an average of twenty percent.The seventh chart shows that industry outputs would rise by an average of twenty percent with substantial relative gains for investment goods producers.

6.In the long run producers’ prices, shown in the eighth chart,would fall by almost thirty percent under the NRST.In addition,the shift in the composition of economic activity toward investment and away from consumption would drastically redistribute economic activity among industries.The ninth chart shows that production would rise in all industries,but the increase in production of investment goods would be relatively greater.

7.The imposition of the NRST would produce a sharply higher tax rate on consumer goods and services, but the tenth chart shows that the initial consumption tax rate would be twenty-three percent at both federal and state and local levels or only 18.4 percent at the federal level. This would gradually rise over time,but remain below thirty percent or 23.8 percent at the federal level.

IMPLEMENTATION OF A CONSUMPTION TAX

In Hearings on Replacing the Federal Income Tax, held by the Committee on Ways and Means in June 1995, testimony focused on alternative methods for implementing a consumption tax.The consumption tax base can be defined in three alternative and equivalent ways. First, subtracting investment from value added produces consumption as a tax base,where value added is the sum of capital and labor incomes. A second definition is the difference between business receipts and all purchases from other businesses,including purchases of investment goods. A third definition of the tax base is retail sales to consumers.This is the definition that underlies the NRST.

*** Snip ***

3. National retail sales tax.Like existing state sales taxes,a national retail sales tax would be collected by retail establishments,including service providers and real estate developers.The actual collections could be subcontracted to existing state agencies. Enforcement procedures would be similar to those now used by the states. To defray the costs of collection at the retail and state government levels,the NRST would rebate 0.25 percent of the tax base to retailers and another 0.25 percent to state agencies.

*** Snip ***

DISTRIBUTIONAL IMPACT

Daniel Feenberg,Robert Mitrusi,and James Poterba (1996) have shown that the “demogrant ” feature of the NRST produces greater progressivity in the distribution of the tax burden.This makes it unnecessary to consider additional policies to enhance progressivity as part of a shift to NRST. However,a very important limitation of this finding is that the impact is purely “static ” and does not include the dramatic gains in the level of economic activity and changes in the composition of this activity.

Footnotes:

¹ The NRST is described in detail by Laura Dale (1996)

His model simply takes taxes OUT of the employers line items of cost (in bulk) and re-inserts the same number (in bulk) as a direct consumer cost to model the growth impacts on the overall economy (he does this with several tax schemes one if which is a generic sales tax scheme.) The impact on wages is an incidental effect, not a cause.

You care to find that anywhere in his IGEM description, or in any report he has ever done on his IGEM model. I haven't and I have been looking continuously for such an inclusion or even the hint of such to determine the magnitude of the costs he might have used. He doesn't mention business tax related cost factors, only tax per-se anywhere in any of his model input descriptions.

Sorry here you are the one making assumtions just as you did about Jorgenson attempting to model the FairTax provisions.

Well, see, that's the problem ... there's too much assumin' goin' on! Assume all you want. Just don't try and make conjecture look like fact by trotting out an authoritative source unless the authoratitive source used the same assumptions.

I certainly agree there has been a lot of assumin' goin on!! On all sides. And therein lay the problem.

That is why I have been reviewing the details of his models and his works. None address or even mention business tax related overhead cost inputs anywhere in his models. In fact the only adjustment to wage is for changes in tax per-se that I can find anywhere in the IGEM model functions.

NOW were getting somewhere! Moving from "Jorgensen PROVES what we say" to "Jorgenson doesn't PRECLUDE what we say" is a MONUMENTAL move!

Glad you see the potential for business tax related overhead making room for substantive purchasing power gains for the individual and buisiness.

I've always felt something didn't quite add up with this. I mean, if the government is taking in a certain amount of money via the current tax system, and after the FairTax they are still taking in the same amount of money, how can everyone be paying less taxes?

The Fair Tax plan has never claimed to be a tax cut. Individuals, who are the only ones who pay taxes, will still pay the same amount of taxes, but at the register instead of a paycheck deduction.

The benefit comes from the elimination of the IRS. It also comes from the fact that companies do not have to waste precious productive time contemplating the tax implications of every business decision. This frees up time and money for new product development, purchases of equipment, hiring of more employees,and improvement of production and marketing techniques.

Individuals will see the embedded taxes disappear from the retail price, and be transferred to a sales tax. This means prices stay about where they are now. There is no tax on savings, capital gains, or the sale of used products. Additionally, now foreign citizens who shop in America will pay taxes. Participants in the underground economy, who pay no taxes, will be forced to pay them when they buy a loaf of bread, a new car, a dishwasher, etc.

So, prices remain the same, taxes remain the same, The IRS vanishes, and businesses free up time and money to improve their business. It's a winning deal for everyone.

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