National Retail Sales Tax - You gotta be kidding!

GOPNATION.COM ^ | January 31, 2005 | Steve Pudlo

[groanup]

...as well the employer's SS/Medicare excise taxes on payrolls paid are repealed releasing those taxes and costs associated with them.

Agreed. And compliance costs would diminish greatly. But if a company makes say a 15% rate of return (net) and is taxed at 35% on that return the effect of eliminating income taxes is 5.25% of that corporation's income statement. Add another, what is it, 7% of its payroll which is say 50% of its expenses and you get another 3.5% in savings. That's just 8.75%. Add another 1% in compliance cost and we're up to 9.75% of savings, which is significant but how does that translate into lowering prices by 23%? I know there are companies that are well over and under these numbers. I'm just using hypo's.

[ancient_geezer]

And he's paying the VAT on all his costs.

Just to expand, he's paying the VAT on all his inputs but not taking the credits.

Home production and service business have few inputs. The participants use barter, cash and trade with each other for their inputs often to the total exclusion of the formal markets altogether. Once the single/selfemployed individual is driven out by red-tape that ends the participation in the tax system as far as business dealings go.

Under an NRST, if that small entrepeneur wants to avoid haggling with NRST and the state tax collection systems he has the option of selling produce and services to other businesses without the tax system intrusion. A factor totally missing under the VAT.

With the NRST the small busines can gain the foothold it needs to grow and enter full market particpation that is discouraged under VAT systems.

VAT in practical implementation simply does not fulfill the false promise of enforcibility. What it does do is create a intrusive environment that fosters government regulations and ever extending complexity in attempts ot "make fairer", "increase enforcibility", etc. that do no more that make sure that more participants evade the formal market all together.

That in a nut shell is what all these articles and reports are saying about economic conditions that ubiquitous VAT systems encourage.

 

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[ancient_geezer]

I know there are companies that are well over and under these numbers. I'm just using hypo's.

And the study's 20% first year fall in the price that producer receive for there products is an average across many business sectors as well:

The numbers cited in any study can only be taken as average unless presented in an explicit distribution table or in a graphical form as above.

In your hypo by the way you must also take into account that a business' inputs drop in cost as well as the direct reductions from tax repeal he sees in his own operations.

[SCALEMAN]

"at least until they run out of used stuff to sell each other, and have to run out an buy some more new stuff "

I have contended for years that the 'goods' in the flea markets and garage sales is continuously recycled... these people buy 'crap' at the sales and markets and then sell it in their booths or garage sales. I believe that nothing new is added.. it is all just moving from booth to booth .. garage to garage..

[ancient_geezer]

Hmmm, maybe that why all the oldest stuff is cast iron and dented up stainless steel??? ;O)

[SCALEMAN]

"Most businesses are local,"

That's probably true, but I'm located in Stl and do business in Mo, Il, Ar, and Ky and operate an 'apportioned' truck (54,000 gvw). The paperwork my small (5 employees) business has to put up with is enormous and onerous.

[OHelix]

The break even point is obviously 23% of gross receipts.

If a RETAIL company would pay 23% gross receipts in taxes under the existing system, it would be able to drop his prices by 23%, and keep wages, profit, and the total salesprice (after tax) the same as it was before.

If a RETAIL company pays more than 23% of gross receipts in revenue, then they would be able to have extra money to apply to profits or even further price decrease. If it is less than 23%, then they could not reduce their price by 23% without either losing profit, or reducing wages.

Presuming the 15% net company of your example is representative of an average company:

It's costs are 85% of gross receipts
Half of its costs are payroll, half other goods and services. (42.5%)

You could expect all of the other goods and services they spend on to also reflect the 9.75% reduced price. 42.5% x 9.75% = an additional 4.14%, added to the 9.75% would bring the total up to 13.89%.

So with the total savings being 13.89, you would be able to expect the same to apply again, so we'll have to recalculate how much savings on other costs would be. 42.5% x 13.89% = cost savings of 5.9%, added to the 9.75 for a total of 15.65% total savings.

So, we recalulate again, 42.5% x 15.65% = 6.65, plus 9.75 is a new cost savings of 16.4.

Run it through again and it's 16.72... Run it thourgh again and...

I don't remember how to run the calculus on it, but I keep recalculating the sum and it's limit is right around a 17% savings for the company in your example.

Someone who uses calculus everyday can maybe put up what the limit of the sum would be.


I asked earlier if anyone knew the national average for (tax paid/gross receipts). If it is around 23% I think the wages must drop argument is not true. If it's significantly lower, then it would seem valid.

[OHelix]

I think that only the corporate and payroll taxes are removed to bring down prices. The tax on gross wages would not effect prices unless gross wages were removed.

But in the example above, you can see that the actual amount of potential price decrease keeping gross wages and profit the same, would yield slightly more than the national average of:

total corporate taxes paid (including payroll, but not SS and personal income tax) divided by gross receipts.

[Badray]

Imbedded taxes include the taxes paid by a deliveryman who delivers to Wal-Mart. His imbedded taxes could have no effect on the system unless his wage falls. Do we all agree? I can see no way that removing his embedded taxes will allow prices to fall unless his wage falls.

Maybe I'm dense, but why wouldn't his gross wage fall? Why would his falling gross wage be a bad thing?

Whether as an employee or as an independent contractor, the lower cost of making deliveries to the retailer will help lower prices, right? Am I missing something?

[Your Nightmare]

Whether as an employee or as an independent contractor, the lower cost of making deliveries to the retailer will help lower prices, right? Am I missing something?

It's a matter of scale. If you keep prices the same with tax (lower sticker price) and lower my wages, I don't have much higher purchasing power. If you let prices rise with tax (sticker stay the same) and let my take home rise, I would have roughly the same purchasing power as the other scenario. The question becomes, which is easier to do, lower wages or make prices rise? In the end, this is really the decision of the Fed's monetary policy. Every (literally, every - including the authors of the FairTax) economist I've read whose has commented on the subject has suggested that the Fed would work to keep wages the same and raise prices.

[Your Nightmare]

I'm beginning to agree with the economist YN cited. I know it is heresy. I still think the FT would be better than the current fiasco but what would really be the net effect on price levels?

Ya know, groanup, this is all I've been trying to do, have a reasonable discussion about these issues. This is serious stuff we are contemplating. We could really screw things up, but good. I say "question assumptions and bust the myths."

In the end, from an economist's viewpoint (which ignores enforcement issues), the FairTax would probably have good benefits for the economy. Would my purchasing power increase by the amount of taxes previously withheld from my check plus what I get for the FCA? Of course not. That's not reasonable. That's a sales job to get the suckers on board. Would my purchasing power increase some, probably.

[Your Nightmare]

Hate to tell you but under the VAT red tape there are more of them and they don't deal with businesses. They operate out of home and are generally barter, service and home manufacture/grown produce oriented.

What VAT red tape? How is a VAT much more difficult to comply with than a NRST?

They operate out of home and are generally barter, service and home manufacture/grown produce oriented.

This person could just as easily evade a NRST. Actually, easier. He is paying some inputs, even if it's gas to deliver his goods or a hoe for the garden.

[Your Nightmare]

Let's think about one of YN's posts where an economist suggested that wages would have to fall in order for prices to fall with the FT.

Actually, it's more than one. For reference, here is the list of quotes (note who the first one is from).

Criticism of the Sales Tax for Residential Real Estate Isn't Built on a Solid Foundation

by Dan R. Mastromarco and David R. Burton
[authors of the FairTax]
Tax Notes, June 29, 1998, p. 1779

Footnote #13: The degree to which after-tax wages will increase is a function of the incidence of both the sales tax and the repealed taxes. If the income tax and payroll taxes are incident on income recipients and the sales tax is incident on consumers, then after-tax wages and returns will go up quite considerably as will tax inclusive prices. If the sales tax is incident on the factors of production, then after-tax wages and the after-tax return to capital will not go up to any considerable degree (at first) but producer prices will fall and retail prices, even including the sales tax, will remain roughly comparable. The real purchasing power of wages will undoubtedly increase considerably over time because of a larger capital stock (increasing productivity), microeconomic efficiencies caused by a more efficient allocation of scarce resources, and higher productivity from lower compliance costs.

The Price Level

Switching to an indirect tax such as a valued-added tax (VAT) or national sales tax will probably cause a one-time jump in the price level, with no permanent change in the inflation rate. By contrast, any consumption-based tax that levies taxes directly on households will probably have little or no effect on the price level.

A VAT or sales tax is likely to boost the price level because each one collects the tax on labor income from the firm or retailer. That treatment represents a change from the current income tax system, which collects tax on labor income directly from the worker. Because the cost of labor to the firm would include the new tax, real compensation paid to workers would initially have to fall to match the value of their so-called "marginal product" and keep them fully employed.

Real compensation can fall in two ways: nominal compensation can drop or the price level can rise. What happens will ultimately depend on the Federal Reserve. If it fixes the price level, nominal compensation will have to fall--an event that workers might accept because they would no longer have to pay income tax and hence would take home about the same pay as now. Most analysts note, however, that workers have resisted cuts in nominal compensation in the past. Those analysts expect that firms fearing morale problems or facing union contracts will hesitate to make such cuts. In that case, nominal compensation may fall slowly to its new level, leading to higher unemployment rates in the interim. To prevent that outcome, the Federal Reserve is expected to allow the price level to rise. For example, a VAT or sales tax of 10 percent would lead to a one-time jump of 10 percent in the price of consumer products.

Further price increases may ensue if compensation is indexed to inflation. In that case, the price rise will cause a corresponding rise in compensation, and real compensation will not drop enough to maintain full employment, requiring a further price rise--that is, a wage-price spiral. That problem occurred in the United Kingdom when it adopted a VAT in 1979, although the extent of indexing there was greater than it is in the United States.

Source: U.S. Congressional Budget Office. (1997). The Economic Effects of Comprehensive Tax Reform. Washington DC: Government Printing Office.

Setting aside for a moment temporary inflexibilites in contracts for wages, bonds, and so forth (we address these later), whether ther overall level of prices changes or not does not materially affect this story.¹⁶ Even if prices do not rise at all, moving to a consumption tax would cause the purchasing power of both wages and existing wealth to decline by an average of 20 percent relative to a situation with no taxes. Nominal wages would be forced down because firms would be earning 20 percent less, after taxes, from the output produced by workers. The nominal value of existing capital assets - in the form of, for example, share prices - which constitute much of old wealth, would also decline because the output they produce provides 20 percent less in after-tax revenues.

16. Whether in fact consumer prices would rise in the event of tax reform depends on the monetary policy set by the Federal Reserve Board.

Source: Slemrod, Joel and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate over Tax Reform, MIT Press: Cambridge, 2004.

Transition Costs and Macroeconomic Adjustments

One of the most difficult issues to address in considering a shift to consumption taxes is the transition from the current system to the new tax regime.⁵ While all shifts to a consumption tax cause some common transitional disturbances and windfall gains and losses, the most serious problems arise from a shift to a national retail sales tax or to a value added tax. In these cases, a tax formerly largely collected from individuals is now collected at the firm level -- either from retailers on total sales or from both final and intermediate producers' value added. Flat taxes avoid this problem but can result in confiscatory taxes on existing assets.

Price Accommodation and Short-run Contractions Under a Retail Sales Tax or VAT

Holding prices fixed, these firms would need to reduce payments to workers to retain profit levels. In fact, many firms would not have enough of a profit margin to pay the tax without something else -- either prices or wages -- adjusting. Consider, for example, a grocery retailer that may have a 1% or 2% profit margin now owing a tax equal to 20% of receipts. This firm simply does not have the cash to pay the tax. If it is difficult to lower wages (and presumably it would be), a significant one-time price inflation, to allow these costs to be passed forward in prices instead, would be required to avoid a potentially serious economic contraction. Note that the price increase, were it possible to implement correctly and precisely, would solve the transition problem because although prices would rise, individuals would have more income to purchase the higher priced goods -- and demand would not fall. It is difficult, however, for the monetary authorities to engineer such a large price change. Moreover, even with the monetary expansion in place to do so, the imposition of such a tax would be disruptive if firms are reluctant to immediately raise prices, again leading to an economic contraction. That is, firms could contract their business, or even close down, until output had contracted enough to raise prices.

These disruptions are not minor in nature -- imagine the difficulties of engineering and absorbing a one-time price increase that is likely to be close to 20% (the level, approximately, that might realistically be needed to replace the income tax).⁶ Even if such an inflation could be managed, there are always concerns that any large inflation could create inflationary expectations -- it's hard to manage a single one-year price increase. In fact, economists who judge a consumption tax to be superior to an income tax may nevertheless be skeptical about the advisability of making the change because of these transition effects.

5. See CRS Report 98-901, Short-Run Macroeconomic Effects of Fundamental Tax Reform, by Jane G. Gravelle and G. Thomas Woodward for a more detailed discussion of these issues.
6. The rate would depend on whether and the extent of any family exemption. A 20% tax exclusive rate would correspond to a tax inclusive rate between 16% and 17%.
7. 7 U.S. Congress, Joint Committee on Taxation, Tax Modeling Project and 1997 Symposium Papers, committee print, 105th Cong., 1st sess., Nov. 20, 1997, JCS-21-97 (Washington: GPO, 1997), p. 24.

Source: CRS Report for Congress: The Flat Tax, Value-Added Tax, and National Retail Sales Tax: Overview of the Issues. Esenwein, Gregg A. and Jane Gravelle.

Prices.

Prices for consumer goods and services quickly rise by the amount of the tax, and then some. The portion of the price increase in excess of the tax is due in part to the higher cost of imports (from the weaker dollar) coupled with the ability of some domestic producers of competing goods to hike their price to that of imports. Consumer prices similarly rise 25 percent -- roughly the nominal rate of sales tax, unadjusted for any exemptions or transition rules -- by 2002 and gradually drop from that peak to a level that remains about 18 percent above the pre-change baseline.

Examined on a year-over-year basis, these price increases generally amount to a large, one-time hike in prices as the NRST is imposed, with some moderation of this increase in the longer run. Due to a weaker dollar, merchandise import prices increase by nearly 4 percent shortly after the NRST is imposed and are 6.5 percent over baseline levels in 2010. Merchandise export prices are also above baseline levels. In 2001 and 2002 they are nearly 3 percent above the baseline. However, due to lower interest rates, which reduce business costs, export prices are only slightly greater than baseline levels for most of the remainder of the forecast period. The overall impact on prices is measured by the change in the GDP deflator, which initially rises 20 percent above the baseline price level before settling back to a 13 percent price rise relative to the baseline.

The notion espoused by some that pre-tax prices would drop some 20-30 percent under a NRST (so that after-tax prices would not rise and may even decline) is a peculiar one. This could only happen if all of the personal income tax, the corporation income tax and payroll taxes are currently embodied in retail prices. Tax incidence -- that is, who actually bears the ultimate tax burden -- is an elusive question that has been the focus of many economic papers, because the answer is not clear. However, the general consensus among economists is that perhaps a portion of the corporate income tax may be passed on to consumers in the form of higher prices, but that the majority is ultimately paid by corporate owners in the form of lower after-tax profits and by employees in the form of lower compensation. Most economists concede that personal income taxes and payroll taxes are ultimately borne by labor and are not passed on to consumers in the form of higher prices.

Source: Statement of John G. Wilkins, Managing Director, Barcroft Consulting Group, on behalf of National Retail Federation. Testimony Before the House Committee on Ways and Means. Hearing on Fundamental Tax Reform. April 11, 2000.

Transitional Issues in Tax Reform

Price Level Effects

Because the flat tax is similar in structure to the existing income tax system, its implementation would have relatively little effect on the absolute price level. Both before- and after-tax wages would be roughly similar before and after reform, so that nominal prices remain roughly constant.

In contrast, the effect of implementing an NRST on the absolute price level is less certain. One possibility is that the tax could be fully shifted forward in the form of higher prices for consumption goods, with no change in the price of investment goods, which are untaxed under the NRST. At the other end of the spectrum of possible responses, nominal prices could remain constant. Under this scenario, before-tax real wages would have to fall roughly to the level of prereform after-tax real wages in response to the elimination of the income tax. Intermediate responses between the "full price adjustment" and "no price adjustment" scenarios are of course also possible.

Choosing between these various scenarios requires making necessarily speculative assumptions about the response of the monetary authorities to the imposition of the NRST. However, most analysts assume that the monetary response would be sufficiently accommodating that the full price adjustment scenario would obtain.

The primary rationale underlying this assumption is the view that the downward flexibility of nominal wages is quite limited, in part because most wage contracts and agreements are specified in nominal terms. Thus, a tax reform that required wage reductions to reach a new equilibrium would be quite costly as these wage reductions would initially be distributed unevenly across industries. This in turn might result in considerable unemployment in sectors characterized by rigid wages, as well as misallocations of labor, at least in the short run. Proponents of the full price adjustment view assume that monetary policy would be expansionary to avoid these costs.

Most observers fall into the full price adjustment camp. For example, McLure (1996, p. 23) concludes that it would be "hard to imagine the monetary authorities not accommodating such an increase in prices." Gravelle (1995, p. 59) argues that full price adjustment is likely because a "national sales tax would tend to produce an economic contraction if no price accommodation is made." In its analysis of the distributional implications of implementing consumption taxes, the Joint Committee of Taxation (1993, p. 59) concludes that, "Unless there are convincing reasons to assume otherwise, the JCT staff assumes the Federal Reserve will accommodate the policy change and allow prices to rise." Finally, Bradford (1996a, p. 135), in discussing the same issue in the context of a value-added tax, observes that, "It is commonly believed that introducing a value-added tax of the consumption type will bring with it a monetary policy adjustment that would result in a one-time increase in the price level ;and no change in payments to workers in nominal terms."

Nevertheless, opinion on this issue is certainly no unanimous. For example, the alternative assumption [that wages will fall] is implicitly made by Jorgenson and Wilcoxen, who argue that implementing a national sales tax would reduce producer prices on average by 25 percent. Auerbach (1996) takes a compromise position by assuming partial price adjustment. In addition, European experience with the introduction of the VAT is mixed, generally suggesting partial price adjustment. On the other hand, Besley and Rosen (1999) find full (or even more than 100 percent) forward shifting of state sales taxes in the United States.

Source: Zodrow, George R. (2002). "Transitional Issues in Tax Reform." In United States Tax Reform in the 21st Century, George Zodrow and Peter Mieszkowski, Editors. Cambridge University Press.

Monetary Implications of Tax Reforms

Does it matter how the central bank responds when the tax system is reformed? Some economists would argue that in a very general sense it does not. Many would argue that the central bank's response would have little long-run effect, because what really matters is the productive capacity of the economy and because there could be no money illusion in the long run.

And, in the short run, the standard relation between prices and money makes it clear that, under limiting assumptions, the central bank need not change monetary policy. Consider the transition from our present tax system to a consumption tax. Ignoring any incentive effects caused by the tax reform, velocity and output are unchanged. With a revenue-neutral tax reform, aggregate after-tax income is unchanged, so there need be no demand-driven effects on consumer prices. Under these conditions, v, y, and q remain unchanged as a result of the tax reform, and thus maintenance of the status quo implies that the central bank need not change its policy. Assuming that output is constant, the central bank could eliminate any transitory price changes in the long run by leaving monetary policy unchanged.

But things may not be that simple. The implied changes to wages and producer prices require a degree of flexibility in the economy that many might find unlikely. Specifically, for the consumer price to stay constant, the producer price must fall by the amount of the tax. And because a drop in the producer price means that the business revenue produced by hiring another worker drops, the before-tax wage must drop by a corresponding amount. Many have argued that such price and wage changes are implausible and that the central bank should "accommodate" a transitory change in the consumer price level by adjusting monetary policy so that it is consistent with constant producer prices and wages.

Source: Bull, Nicholas, and Lawrence B. Lindsey. 1996. "Monetary Implications of Tax Reforms." National Tax Journal 49.3 (September): 359-79.

The Price Level

When Britain adopted consumption taxation in 1979, the price level rose by the amount of the new tax. This jump in prices caused substantial disruption in the economy, partly because it stimulated further rounds of wage and price increases through indexation formulas that failed to exclude consumption taxes from the measured cost of living. Standard macroeconomic analysis suggests that the underlying cause of such a price effect is the contractual determination of wages in money terms. Under an income tax, the wage is set in pretax terms. Workers finance consumption out of what remains of their wages after paying taxes. Under a sales tax or a value-added tax (VAT), the wage is set on an after-tax basis. Workers use their entire wages for consumption and pay their consumption taxes as they consume. When an income tax is replaced by a sales tax or VAT, the wage bargain should be revised to lower the purchasing power of wages or by raising the prices of consumption goods. As a practical matter, the second always occurs.

One of the advantages of a flat tax or a personal cash-flow consumption tax is that both leave the wage bargain in pretax form. There is no disruptive jump in the price level. Unlike other effects I have discussed, the increase in the price level is not intrinsic to a consumption tax, but is the result of a particular choice about how to administer the tax.

Source: Potential Disruption from the Move to a Consumption Tax, by Robert E. Hall. The American Economic Review.

[Your Nightmare]

I'm beginning to agree with the economist YN cited.

The technical term for what we are discussing is "marginal product of labor," how much output does a business get from an additional unit of labor. Falling prices reduces the marginal product of labor and changes the wage bargain (I'm paying you $X for $Y amount of output). If I'm paying you $8 for $10 worth of output and prices drop where your output is only worth $7, I can't keep paying you $8 and make money. Our informal wage bargain needs to be renegotiated.

This works perfectly efficiently and instantaneously in full-employment computer models like Jorgenson's, but of course, in the real world, wage bargains can't be renegotiated that easily and without great displacement of labor (ie, unemployment). So the prevailing thought is the Fed will work with the money supply to keep prices from falling and keeping the marginal product of labor consistent.

[Your Nightmare]

Ï„est

[Your Nightmare]

Here is a technical explanation of what could happen to prices and wages with tax reform (the paper is also interesting in it's discussion of assets):

The Transition to Consumption Taxation, Part 2: The Impact on Existing Financial Assets

by Alan D. Viard, senior economist and policy advisor in the Research Department of the Federal Reserve Bank of Dallas.

...[snip]...

COULD TAX REFORM INDUCE AN INCREASE IN CONSUMER PRICES?

The above analysis assumes the consumer price level is unchanged by tax reform. The asset pricing implications are different if the consumer price level rises in response to tax reform. Some argue that the labor-market effects of adopting a sales tax or traditional VAT may prompt a monetary policy response that raises the consumer price level.

Labor Markets under Alternative Tax Systems

To understand this argument, I consider a simple perturbation to the circular flow between firms and workers (Table 5). A firm purchases one additional unit of labor from a household and produces additional consumption. Let MPL and MPL* denote the marginal product of labor under a consumption tax and the income tax, respectively. For the firm to be indifferent to this perturbation, its after-tax receipts from selling the additional consumption must equal its wage payment. After paying any applicable taxes, the household consumes its additional wages.

Under the sales tax and the traditional VAT, the firm pays an additional tax of t_cMPL on its additional consumption output. For the firm to be indifferent to the perturbation, the equilibrium value of its wage payment to the household must be (1 - t_c)MPL. Since the household pays no tax, its consumption increases by this amount.

Under the two-part VAT (which taxes the firm on value added minus wage payments), the perturbation does not change the firm's tax liability because its value added and wage payments rise by the same amount. For the firm to be indifferent to this perturbation, the equilibrium value of its wage payment must be MPL. However, the household pays tax of t_cMPL on its wage income, so its consumption increases by only (1 - t_c)MPL.

Under the income tax, this perturbation does not change the firm's tax liability because its receipts and wage expenses increase by the same amount. For the firm to be indifferent to the perturbation, the equilibrium value of its wage payment must be MPL*. However, the household pays tax of t_pMPL* on its wage income, so its consumption increases by only (1 - t_p)MPL*.

Each of the three consumption tax designs distorts the labor-leisure decision by driving a wedge at rate t_c between the marginal product of labor and the after-tax wage rate. The income tax also distorts this decision by driving a similar wedge at rate t_p.

To consider the transitional impact of tax reform on labor markets, I make a few simplifying assumptions. Although tax reform is likely to greatly increase the marginal product of labor in the long run by significantly expanding the capital stock, the short-run change in marginal product should be small because (as discussed above) the capital stock expands only gradually. So I assume the marginal product of labor is initially unchanged, MPL = MPL*.²⁰ I consider a worker with a marginal product of twelve consumer goods per hour, who earns $12 per hour when these goods sell for $1 each, and I assume the consumption and personal income tax rates are both 25 percent.

The replacement of the income tax with a two-part VAT has little impact on labor markets because these taxes are similar in form as well as substance. Table 5 implies that under either tax, the firm pays the worker $12 and the worker pays $3 tax. Under the current income tax, firms withhold the worker's wage tax, so the paycheck is actually $9, with a stub noting that the worker is being paid $12, $3 of which is withheld for taxes. Hall and Rabushka (1995, 145) propose similar withholding under a two-part VAT.

The treatment of wages under a sales tax or traditional VAT differs in form, but not in substance, from that under an income tax because the tax is imposed on the firm rather than the worker. In accordance with Table 5, the firm now pays a wage rate of only $9 because it retains only 75 cents after tax for each of the twelve goods the worker produces. The paycheck amount is still $9, but the stub is now different, showing $9 as the wage with no tax withheld. The worker owes no additional tax, and disposable income is still $9. This wage-rate adjustment illustrates the public-finance principle that imposing a tax on the seller rather than the buyer has no real economic effect because the equilibrium price adjusts by the amount of the tax.

Potential Nominal-Wage Rigidity and Monetary Accommodation

Some argue that this adjustment may not easily occur. They note the longstanding literature suggesting that workers resist nominal-wage reductions and argue that this resistance applies to reductions in the wage rate listed on the paycheck stub, not reductions in take-home pay.²¹ Even if such resistance does not exist, they note that the Fair Labor Standards Act (FLSA) prohibits the necessary adjustment for lower-paid workers. This law prescribes a minimum value (currently $5.15 per hour) for the wage rate shown on the paycheck stub.

If the listed wage rate remains rigid, the adoption of a sales tax or traditional VAT has problematic labor-market consequences. After paying sales tax or VAT, firms retain only 75 cents for each unit produced and they can profitably hire workers at a $12 wage rate only if their marginal product is fifteen units, rather than the twelve units possible before reform. The implied hiring reduction and unemployment could be substantial.

The literature on nominal-wage rigidity generally assumes workers do not resist real-wage reductions achieved through inflation. Similarly, since the FLSA minimum wage is not indexed, its real value can be reduced through inflation. If nominal-wage rigidity otherwise impedes the necessary adjustment, a possible response is a monetary policy that rapidly increases the consumer price level by a factor of 1/(1 - t_c).²² I refer to this policy as "full accommodation" of the consumption tax and to a smaller price increase as partial accommodation.

Full accommodation raises the price of consumer goods to $1.33. Since firms retain $1 after paying sales tax or VAT, they can profitably hire workers at a $12 wage rate if their marginal product is twelve units, the same as before reform. The necessary real-wage adjustment occurs without any reduction in nominal wages.

It is unclear whether nominal-wage rigidity poses a problem. Workers who resist isolated reductions in their nominal wage rate may accept an economywide reduction made in response to a highly visible change in tax policy, particularly when take-home pay is unaffected. Congress can also amend the FLSA when it adopts tax reform. Accommodation may be unnecessary.

I make no prediction about whether monetary policy would accommodate all, some, or none of a sales tax or traditional VAT. Instead, I compare the asset-price effects of tax reform under the different possibilities. I have already described the effects without accommodation and now describe them with full accommodation. Intermediate effects occur under partial accommodation.

ASSET PRICE EFFECTS WITH FULL ACCOMMODATION

With accommodation, the nominal interest rate (and the inflation rate) is extremely high during the brief period when the price level is rising. If r = r*/(1 - t_p) thereafter, full accommodation reduces the real value of debt by factor t_c.

As the top panel of Table 6 shows, bond values fall from 100 to 75 at each firm. At the first firm, as total value falls from 400 to 300, stock values fall from 300 to 225, which is also a 25 percent decline. At the second firm, however, as total value declines from 400 to 360, stock values fall only from 300 to 285, a mere 5 percent. At the third firm, where total firm value is unchanged at 400, stock values actually rise, from 300 to 325. Overall, bondholders now bear heavier burdens than stockholders, reversing the pattern seen in Table 3.

The value of the household loan also falls from 100 to 75. As the bottom panel of Table 6 shows, the household lender suffers a 25 percent wealth decline while the household borrower enjoys a 25 percent decline in the value of its liability.²³

Although this analysis generally ignores consumer-owned capital, it should be noted that accommodation benefits homeowners with mortgages at the expense of mortgage lenders, in the same way it benefits stockholders of leveraged firms at bondholders' expense. Consider a homeowner with a $120,000 house and an $80,000 mortgage, and assume that tax reform reduces the home's real value to $110,000.²⁴ If the consumption tax is not accommodated, the real value of the mortgage is still $80,000 and the homeowner suffers a 25 percent decline in home equity, from $40,000 to $30,000. But if the tax is fully accommodated, the real value of the mortgage falls to $60,000 and the homeowner's equity rises from $40,000 to $50,000, as the mortgage lender bears more than the full burden of the decline in value. (Of course, accommodation is irrelevant if the homeowner does not have a mortgage.)

Some believe an accommodated consumption tax would be too harsh on bondholders and household lenders and too favorable to stockholders and household borrowers, the opposite of the concerns expressed with no accommodation. If accommodation is considered undesirable, it can be avoided by adopting a two-part VAT. Or if a sales tax or traditional VAT is adopted, steps can be taken to facilitate rapid nominal-wage adjustment. Or if nominal-wage rigidity is considered inevitable, the need for accommodation can be avoided by phasing in the sales tax or VAT and phasing out the income tax over an extended period. With a smooth ten-year phase-in, for example, nominal wages need fall only 2.5 percent per year from their prereform path; if they had been growing 4 percent per year, they can still grow 1.5 percent per year during the phase-in, avoiding outright reductions. However, since firms have an incentive to delay investment while a consumption tax is phased in, it may be better to immediately replace the income tax with a two-part VAT and then phase in a sales tax or traditional VAT and phase out the two-part VAT.

 

NOTES

20. With endogenous labor supply, tax reform may initially reduce the marginal product of labor. See Huffman and Koenig (1998, 25), Auerbach (1996, 57-58), and Kotlikoff (1996, 175).
21. Taylor (1999, 1013-21) surveys the literature on nominal-wage rigidity.
22. Bradford (2000, 100-102), Congressional Budget Office (1997, 65-66), Gillis, Mieszkowski, and Zodrow (1996, 752-53), Hall (1996, 77-78), Auerbach (1996, 44 fn. 29), Gravelle (1996, 1441-42), and Viard (1994) discuss these issues. Most, but not all, of these authors suggest that nominal-wage rigidity will require some accommodation of a sales tax or traditional VAT.
23. Accommodation also lowers the real value of the $3 trillion of nominal debt the U.S. Treasury owes to the public, thereby lowering the tax rate required for long-run budget neutrality.
24. Tax reform is likely to reduce the value of consumer-owned capital, such as owner-occupied homes, along with the value of business capital, but for different reasons, reflecting the distinctive tax treatment of consumer capital. See Viard (2000, 11-13), Bradford (2000, 107), and Congressional Budget Office (1997, 66-67).

[phil_will1]

"Take a look at post #1041 and tell me that he is an honest debater and not a disruptor who is disengenuous."

Good point, Ray. You can add 1048 to that. He has studied the FairTax extensively, can cite chapter and verse from the bill itself, posts extensive exerpts from sources such as Brookings, the National Retail Federation and other staunch guardians of the status quo.

He says that he thinks there are other better proposals out there, which is why he constantly attacks the FairTax. When you ask him what proposal he likes better, his response is not a specific proposal, but a generic type of tax: "flat tax or VAT". When you ask him for a link to the proposal that he favors, he insultingly says there are many studies out there on the generic tax forms that he favors. Ask him a specific question, such as the rate that he would use, and he evades the question. He criticizes the economic studies which have been done on the FairTax, but offers none in support of his preferred alternative.

I have to agree with badray on this one.

[phil_will1]

"LOL - I don't know what the DJI is."

DJI = Dow Jones Industrials

[phil_will1]

"Do you think that a study that has the labor supply increasing 30% in one year should be thought of as accurate?"

As previously posted, with outsourcing, the labor supply is not a limiting factor.

Ohelix, watch this exchange and tell me that YN isn't disengenuous. Also, you credited him for making a mistake earlier on this thread and then admitting it. Want to bet that he sticks with his ridiculous unfounded assertion that "outsourcing isn't part of the labor supply"?

[CSM]

I like using these types of questions to find out if someone is a true conservative or a convenient conservative. Of course, I'm still waiting for an answer from the person I posed it to.....I'll give them some time given that life does exist outside of FR.