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.

Who is James Payne

A 1996 Bradley Fellow at The Heritage Foundation

Search James L. Payne

voluntaryist.com

"Editor's Note: Political scientists James Payne has taught at Yale, Wesleyan, Johns Hopkins, and Texas A&M. He wrote his first book (published by Yale University Press) while an undergraduate at Oberlin College and now has over a dozen books and monographs to his credit.. Disappointed with the irrelevance and left-wing orientation of the academic political science discipline, Payne resigned his tenured professorship (at Texas A&M) in 1985, and became an independent, free-lance scholar living in Sandpoint, Idaho. His recent works include an analysis of Congress and the budget (The Culture of Spending: Why Congress Spends Beyond Our Means), an evaluation of the tax system (Costly Returns: The Burdens of the U.S. Tax System), and an examination of social assistance policies (Overcoming Welfare: Expecting More From The Poor - And Ourselves)."

and what hole did he pull these numbers out of?

refer: The Flat Tax; Hall & Rabushka, '95:

Notes & References:

A comprehensive review of all the studies that attempt to measure the costs associated with the federal income tax appears in James L. Payne, Costly Returns: The Burdens of the U.S. Tax System (San Francisco: Institute for Contemporary Studies Press, 1993). Payne summarizes the estimates of compliance costs that appear in the following studies: Joel Slemrod and Nikki Sorum, "The Compliance Cost of the U.S. Individual Income Tax System," National Tax Journal 37 (December 1984): 462–65; Arthur D. Little, Inc., Development of Methodology for Estimating the Taxpayer Paperwork Burden (Washington, D.C.: Internal Revenue Service, 1988), pp. III–23; James T. Iocozzia and Garrick R. Shear, "Trends in Taxpayer Paperwork Burden," in Internal Revenue Service, Trend Analyses and Related Statistics, 1989 Update (Washington, D.C.: U.S. Government Printing Office, 1989), p. 56; Annual Reports of the commissioner of the Internal Revenue Service; and a variety of other IRS memoranda

...24 percent compliance costs, 33 percent disincentive costs, and 8 percent other costs...

Thanks for the pointer. I do have a couple of questions though:

Compliance Costs

Aren't the "compliance costs" entirely equal to labor cost (2.9 million people working 5.4 billion hours)? Not to suggest that we should preserve such jobs (I don't think we should) but to save the cost, you have to eliminate the jobs; not just from any particular company, but you eliminate that type of job from the entire economy. It seems to me (after growing up in a former mill town in Western Pennsylvania) that it can take a generation to eliminate the local effects of wiping out an industry ... even if it is good for the economy in general.

Disincentive Costs

Aren't disincentive costs really an accounting of the production that could have taken place had there been no negative incentives to hire additional labor or invest additional money? As such, isn't calling them a "cost" a bit misleading since eliminiation of this "cost" makes available no addition bottom line dollars? Isn't the positive effect of eliminating this cost called "growth." Isn't the stimulus aspect of tax policy accounted for in the the economic impact assessments of these various studies rather than in the cost accounting part of these studies?

Other Costs

Aren't these costs really a smattering of costs associated with audits, enforcement, tax-shelter overhead, and somesuch? Doesn't that make them really subcatagory of "compliance costs"? Do you have any studies that actually break out and differentiate that time spent by the accountant managing the Cayman Tax Shelter vs filing the quartly 10Q?

You might find these interesting:

A 1976 study in the Journal of Political Economy by Professor Edgar Browning found that the cost of taxes on labor was between 9 percent and 16 percent of each additional dollar collected.
A 1984 study by Professor Charles Stuart, published in the American Economic Review, found that the U.S. tax system as a whole costs 24.4 percent of each additional dollar collected.
A 1985 study by Charles Ballard, John Shoven and John Whalley, published in the National Tax Journal, estimated that economic distortions cost between 13 percent and 24 percent of revenue collected.
Another study that same year by the same economists, published in the American Economic Review, concluded that the cost of the U.S. tax system was between 15 percent and 50 percent of each additional dollar collected.
A 1987 study by Edgar Browning, published in the American Economic Review, found the cost of the U.S. tax system was between 31.8 percent and 46.9 percent of revenue.
A 1991 paper by Professors Dale Jorgenson and Kun-Young Yun in the Journal of Accounting, Auditing and Finance put the cost at 18 percent.

Given all this, the consensus seem to suggest a cost burden of far less than 65%, though the total economic burden (counting growth effects) are certainly higher ... but then growth stimuli are not costs in the cost accounting sense.

As with all these discussions, the devil is in the detail; it's not a question of whether such costs exist, it's a question of how big they really are, and much really flow directly into product pricing.

Is it fair to say you don't have a cost accounting background?

Follow the tax dollar. In today's system, the dollar goes from the customer to the business. The business uses that same dollar to pay workers, buy equipment, make profit, and pay tax, etc. The part of that dollar that pays the worker is further split into money the worker takes home and money paid on the workers behalf to others (payroll and wage taxes, benefits, etc.)

Follow me so far? ... good

Now take the part of the dollar that the business used to pay the employee and eliminate the taxes the business pays on the worker's behalf. What happens to that part of the dollar under your scenario? Though it moves from the taxman to the employee the business still has to pay it out. Because the business now gives that part of the dollar to the employee to take home, the business cannot use that part of the dollar for any other purpose (like expanding production, or profit, or reducing cost.) The only part of the dollar coming from the customer that becomes surplus to the business is the profit tax it used to pay. That amounts to roughly 33% (tax rate) of 10% (profit margin) of the dollar that the business got from the customer. That's three cents.

Now the business might what to pass that on in the form of a 3% price reduction, might want to reinvest it to grow his production capacity, might want to keep it for profit ... what the business does depends many, many factors that are particular that business' circumstances.

Of course since it no longer needs one, the business might fire its tax accountant and pass those saving along.

But, under no circumstances does the business get the abilty to give the same part of that same dollar to BOTH the employee AND the customer.

Just for completeness sake, Let's agree that the part of the dollar the business got from the customer that the business used to pay the employee part of the FICA taxes is NOT given to the employee (even though it is not part of the employees gross wage statement, some have argued that the employee should get that amount anyway). Since the business no longer pays any taxes, that amount also becomes surplus and is subject to disposal at the needs of the business as discussed in the prior post.

If the business is a labor intensive business it might have 80% of its costs tied up in labor, 10% tied up in capital, investment, and other misc. costs, and the same 10% profit as before. In addition to the 3% savings on profit tax elimination, the business has another surplus part of the dollar received from the customer because the payroll tax is eliminated (that's wages + employer paid payroll tax = 80% of the dollar from the customer.)

Doing the requisite math puts the employer payroll tax at 5.7% of the customer dollar. Add the two together and the total ELIMINATED direct tax cost is 8.7% (not quite near the 23% you keep claiming is in there.) The only way to get to 23% is by the elimination of some of the labor cost (eg. firing the tax accountant.)

Realizing the missing 14.3% means that labor costs, remembering we already eliminated the cost of the employee part of the payroll tax, have to drop to 60% of the customer dollar (With the original labor cost at 80%, the employee part of the payroll tax represented 5.7%, leaving 74.3% for gross wages. 74.3% less the need 14.3% yields 60%)

That translates into a 20% labor force reduction.

Now I'm not saying that is good or bad, I'm just pointing out that the price reductions through cost reductions and tax redirection will come with another kind of price tag: there is no free lunch.

Aren't disincentive costs really an accounting of the production that could have taken place had there been no negative incentives to hire additional labor or invest additional money?

Actually that more describes "oppertunity costs" more than disincentive costs.

Disincentive cost include the costs of alternatives chosen for their tax sheltering and avoidence as opposed to productivity improvements possible were resources applied to their most productive use without tax concerns, it is the choice of doing a thing to create a deduction to shelter income or minimize taxes rather than produce product.

A fair run down of what comprises Overhead costs as opposed to opportunity cost can be found here.

http://www.taxfoundation.org/compliance2002.html

Overhead Compliance Costs

The complexity generated by the growth and constant change of the tax code creates two general types of economic cost: overhead and opportunity cost. Overhead can be divided into three principal activities: the economically sterile exercises of tax planning, compliance, and litigation, all of which act like tax surcharges on taxpayers.

• The first type of overhead is tax planning, which in this context refers to all the economic decisions that individuals and firms make to maximize their benefits in the tax code.

• The second type of overhead, tax compliance, refers here to the basic actions required to file the federal income tax, including record keeping, education, form preparation and packaging/sending.

• The third type of overhead is tax audits and litigation, referring to the cost of the IRS and the Tax Court, as well as all the legal costs that taxpayers incur while dealing with these two government institutions.

Of these three costs, the second, tax compliance, is the only one estimated in this report. It is for this reason that the data presented here should be viewed as extremely cautious estimates of the federal income tax compliance burden on taxpayers.

*** snip ***

The Burden of Compliance Costs

As shown in , and , the Tax Foundation estimates that in 2002 individuals, businesses and non-profits spent over 5.7 billion hours complying with the federal income tax. Using an hourly cost of $29.98 for individuals and $37.26 for businesses and non-profits, the estimated cost of compliance in 2002 is $194 billion (See Methodology section for details about how the hours and wages were determined)—Individuals bear a cost of $86.1 billion, businesses bear a cost of $102.5 billion and non-profits bear a cost of $5.4 billion. Therefore, the overall compliance cost surcharge alone amounts to nearly 20.4 cents for every $1 collected by the federal income tax.

Given all this, the consensus seem to suggest a cost burden of far less than 65%, though the total economic burden (counting growth effects) are certainly higher ... but then growth stimuli are not costs in the cost accounting sense.

As far as your cites broader and more uptoday estimates exist beyond those you cite, for each study is highly dependant upon how much is included in the authors scope of his study and what is included into his determinations.

Payne is actually a more central figure among many.

http://www.heritage.org/Research/Taxes/hl565.cfm

An American Economic Review study found that every dollar of taxes could impose as much as $4 of lost output on the economy, with the probable harm ranging between $1.32 and $1.47
Edgar K. Browning, "On the Marginal Welfare Cost of Taxation," American Economic Review, Vol. 77, No. 1 (March 1987), pp. 11-23.

"Another study in the Journal of Political Economy estimated that the corporate income tax costs more in lost output than it raises for the government."Jane G. Gravelle and Laurence J. Kotlikoff, "The Incidence and Efficiency Costs of Corporate Taxation When Corporate and Noncorporate Firms Produce the Same Good," Journal of Political Economy, Vol. 97, No. 4 (1989), pp. 749-780.

Killing the IRS, By Daniel J. Pilla, Reason Magazine July 1995

"There is little about a flat-tax system that will trim the staggering cost of tax law compliance. At present, this burden is estimated at $700 billion annually. Much of the cost is associated with recordkeeping and tax law enforcement, neither of which is reduced by a flat tax. A flat tax certainly involves a simpler tax return, but return preparation is the smallest component of tax law compliance.
The solution to our tax problem is to adopt a national retail sales tax in place of the personal and corporate income tax. Only a sales tax can eliminate the invasiveness of the IRS, since one's income and lifestyle are irrelevant."

Chief Executive, The New directions in tax reform -
May 1995.

Tax expert Ernest Christian Jr., a partner with Washington's Patton, Boggs & Blow, reckons these are low estimates or at best incomplete. Citing a U.S. Treasury study which indicates that 6 billion man-hours are consumed each year just in the record keeping for income and payroll tax returns alone, Christian says the true burden on the U.S. economy is probably closer to $1 trillion. For example, Jane Gravelle of the Congressional Research Service estimates that economic loss from the corporate income tax is equal to about 97 percent of the corporate tax revenue collected.

STATEMENT OF REPRESENTATIVE DICK ARMEY
HEARING ON THE IMPACT ON
INDIVIDUALS AND FAMILIES OF REPLACING THE FEDERAL INCOME TAX
Committee on Ways and Means, Full Committee, 4-15-97 Testimony

Hinders Economic Opportunity
According to a study by Jane Gravelle, an economist with the Congressional Research Service, and Larry Kotlikoff, an economist at Boston University, the corporate income tax costs the economy more in lost production than it raises in revenue for the Treasury.
Dale Jorgenson, the chairman of the Economics Department at Harvard University, found that each extra dollar the government raises in revenue through the current system costs the economy $1.39.

Economic Burden of Taxation
William A. Niskanen
Presented October 2003
Friedman Conference
Federal Reserve Bank Dallas page 6.
www.dallasfed.org/news/research/2003/03ftc_niskanen.pdf

"Given that the elasticity c implicit in recent U.S. fiscal conditions is about 0.8 and the average tax rate is about 0.3, the marginal cost of government spending and taxes in the United States may be about $2.75 per additional dollar of tax revenue. One wonders whether there are any government programs for which the marginal value is that high. Given the estimate of the long-term elasticity c from the U.S. time-series data, the marginal cost of government spending and taxes may be as high as $4.50 at the current average tax rate. "

As with all these discussions, the devil is in the detail; it's not a question of whether such costs exist, it's a question of how big they really are, and much really flow directly into product pricing.

And also highly dependant upon by whom and when any particular study was done, and the root purpose of the study. Which is why Payne's number is useful, because it is a compliation of the results of many economic studies by manny different researchers not just one source.

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