JORGENSON EXPLODES FAIRTAX MYTH (FR Exclusive)

self | August 25, 2005 | RobFromGa

[RobFromGa]

August 24, 2005

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

Dear Representative Linder:

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.

On page 85 you make it clear the worker will get the pay raise.

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 start collecting 100 percent of our earnings on our paycheck.

“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:

At 09:29 AM 8/24/2005 -0400, you wrote:

Dear Dr. Jorgenson,

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.

Rob

Dr. Jorgenson responded:

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?

August 24

Dear Rob,

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]

Best,
Dale

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

At 06:41 PM 8/24/2005 -0400, you wrote:
Dr. Jorgenson,

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?

Regards,
Rob xxx

Dr Jorgenson responded:

August 24

Dear Rob,

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.

Best,
Dale

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.

Sincerely,

Rob xxx
xxxxxxx

[woodbeez]

Maybe the prostitute forgot too...

[Kellis91789]

Notice I didn't account for any "embedded tax costs" that reduces her buying power under the current system. I also didn't account for any increase in buying power due to price drops under the FairTax.

I was addressing only Dimples' assumption that an illegal nanny would continue as illegal.

If we admit any "embedded tax cost" currently or allow for any "price drop" under FairTax, then this nanny is much better off with the FairTax and being legal than she would be as an illegal under the current system.

By being legal, she is getting herself an $1,163/mo future SS benefit in today's dollars.

[Always Right]

That seems like it would offer less incentive to be illegal than under the current system. Am I missing something ?

Yes, if a nanny is earning $24K per year, the odds are she is paying very little federal income tax. Her personal exemption and standard deduction add up to about $8000, the her next $7200 is tax free. The remaining $9000 or so is taxed at 15%, or about $1300. You overstated her income tax liability by about $900, and that is at the higher single rate.

[lewislynn]

It isn't a tax on the business.

Who said it was?

The point is if the business owner is to realize the same "assigned salary" as before the fairtax then the original service price or retail price would have to have the tax added..It can't be reduced..

Get it?

Do I have to wait untill you get to work tomorrow to use their computer before I get your reply?

[pigdog]

I believe you're probably correct about the non-concurrent price effects. I certainly recall no such claims and I'm not sure The FairTax Book authors made such a claim. I think it may have been assumed in by some wishing to do so perhaps (for whatever reason).

I've tried to caution several on the thread that they shouldn't be making a mountain out of a molehill and should wait for more information. The present contretemps-in-a-teacup amounts to what I see as a difference of opinion between differing interpretations of some of the economic analysis. More detailed data should straighten that out, I'd think.

Your BofA analysis is quite interesting and similar ones could be made for other firms no doubt, but the thing of great interest to me is that in your example I would think that removal of the cascading embedded business income tax costs (not payroll/withholding or compliance costs which you address - and not just the removal of the income taxes themselves but their downstream effects after they have buit into costs/prices), it will probably well surpass 20%. The poster Dimples and I are debating cascading embedded taxes - now onto another thread - and I'm trying to help him understand them better, but it's a long, slow slog. There is a light at the end of the tunnel, I think, though.

[Always Right]

Does FairTax.org or Linder and Boortz actually attribute these simultaneous claims to Jorgenson ?

The fairtax orginzation attributes the 22% embedded tax to Jorgenson and then make the leap that prices would fall 22% and take home pay would go up. There is no other site there except for Jorgenson.

[Dimples]

To which of my replies are you referring?

I don't think I ever used the terms "nanny" and "incentive to be illegal" in the same post or even in the same context.

My belief is that, human nature being what it is, the less scrupulous amoung us value the risks and rewards differently than you or I do (they less fear the consequences of being caught than they value the opportunity to make an additional buck.) The increased incentive to be "off the books" derives from the ability to make an under the table retail transaction at a substantial discount to the customer with both the customer and the provider getting a better deal than executing the same transaction "on the books." That's why folks do it today despite the presence of the all knowing, all seeing, oracle of TaxLand: the IRS.

Today, the nanny is already off the books. That's why Zoe Baird withdrew her name from nomination for Attorney General some years ago. You see, she didn't pay the "nanny tax" for her domestic help ... and SHE was in line to be Attorney General!

Do you really think the illegal Mexican Gardener, working for cash, is going to set himself up with SS system and report their wages? Of course not.

How about the House Painter that says: "I'll tell you what, I'll paint the garage AND the house if you just pay me an additional $550 cash. Otherwise, I have to charge you $650 (because of the Tax) He's otherwise "on the books", but winds up with 10% more in his pocket and a paper trail for a job to keep the auditors at bay. The homeowner saves $100. (Normal, above board price for Garage and House: $650 = $500 cost plus $150 FairTax).

I believe the important aspect of such deals is simple: people will not analyze the risk/reward in any situation based on whether the old tax system would have left them ahead or behind (as you suggest in your example.) People will maximize their immediate opportunity. It there a dose of illegality in it, they'll decide whether they are likely to get caught.

The reason I believe there is more opportunity AND incentive to cheat under the Fair Tax is that people are faced with more consumption options than income options. That, on its face, suggests that there is more opportunity to execute an illegal, tax free transaction under the FairTax.

As for incentive, a retailer could offer up to a 23% discount on an "off the books" transaction to entice a sale, and not loose a dime in income. Like the House Painter, it's quite likely he'll never be caught, especially when the tax-free transaction is buried in a larger above-board transaction.

[Always Right]

Then I eliminate some employees that might be doing nothing but tax-related tasks.

I take in over $7 million a year, and there is not one employee I could even cut their time if we eliminated all federal income tax. My book keeper must still pay all the bills and balance the books. Maybe 40 hours is a year is spent on tax compliance.

[Dimples]

I see you're back. Perhaps you missed this from another thread: Since it has come up again in this thread, let's take in indepth look at this "cascading taxes" assertion.

Here's the way one really calculates embedded (cascading, hidden, pick-your-favorite-term) taxes. 

	Levels	1	2	3	4	5	6
Initial Cost	Revenue	$2.01	$4.05	$8.15	$16.40	$32.99	$66.39
$1.00	Cost	$1.00	$2.01	$4.05	$8.15	$16.40	$32.99
Tax Rate	PBT	$1.01	$2.04	$4.10	$8.25	$16.60	$33.40
34.40%	Tax	$0.35	$0.70	$1.41	$2.84	$5.71	$11.49
	NetProfit	$0.66	$1.34	$2.69	$5.41	$10.89	$21.91
	Net Profit %	33.00%	33.00%	33.00%	33.00%	33.00%	33.00%
Accumulated Tax Paid		$0.35	$1.05	$2.46	$5.30	$11.01	$22.49
Tax cost as a % of Revenue		17.30%	25.90%	30.18%	32.30%	33.36%	33.88%

Intial Cost: Initial cost to the first level for the widget ($1.00)
Tax Rate: The Percentage of Profit Before Taxes owed as Tax
Revenue: The amount received by a business from the sale of a widget to the next level (sale price)
Cost: The amount the business paid to the previous level for the widget
PBT: Profit before Taxes: The amount of Revenue in excess of Cost at each level
Tax: The amount of PBT that is Tax  (@ the Tax Rate of 34.4% of PBT)
Net Profit: The amount of PBT that remains after taxes are removed
Net Profit %:  Net Profit expressed as a percentage of Revenue
Accumulated Tax Paid: The cumulative amount of tax paid by the current and all previous levels
Tax Cost as a % of Revenue: The Accumulated Tax Paid expressed as a percentage of current-level Revenue

So,  using pigdog's inputs (since we're after the MECHANISM!, not the VALUES!), after the 6th level, "Accumulated Tax Paid" grows to a whopping $22.49. Even more eggregious is the "Tax Cost as a % of Revenue" which grows 33.88%!!.  Compared to the original table offered by pigdog, these numbers are even worse...

...or are they?

Let see what happen when a new retailer jumps into the frey, except, he is smart enough to buy the widget at the Initial Cost of $1.00 and sell it at the 6th level sale price to generate revenue of $66.39:

	Levels	1
Initial Cost	Revenue	$66.39
$1.00	Cost	$1.00
Tax Rate	PBT	$65.39
34.40%	Tax	$22.49
	NetProfit	$42.90
	Net Profit %	64.61%
Accumulated Tax Paid		$22.49
Tax cost as a % of Revenue		33.88%

It turns out that after only ONE level, the "Accumulated Tax Paid" is exactly the same as it was when SIX levels handled the widget before!  Even more amazingly, "Tax Cost as a % of Revenue" is also EXACLY the same as the six level example. How could that be? I thought taxes "cascaded"!

Well, it turns out that the amout of Accumulated Tax is proportional ONLY to the amount of accumulated PBT.  Whether you take all the profit at one level or chunk it up and divide it among many levels, you wind up paying the same cumulative amount of tax: a percentage of cumulative PBT.

So pigdog is right: the numbers don't matter, its the MECHANISM that is of interest, BUT since pigdog got the MECANISM wrong, he drew the wrong conclusion.

As you can see Taxes don't multiply, they add.  And they only add up to an amout proportional to cumulative profit: accumulate less profit, pay less tax. And it doesn't matter how many levels of accumulation there are, the tax is only proportional to the accumulated profit. 

Now let's say that the last three levels of the chain extract NO profit. If pigdog is right, all that "Cascading" tax from levels 1, 2, and 3, should keep on growing.
Let's see:

	Levels	1	2	3	4	5	6
Initial Cost	Revenue	$2.01	$4.05	$8.15	$8.15	$8.15	$8.15
$1.00	Cost	$1.00	$2.01	$4.05	$8.15	$8.15	$8.15
Tax Rate	PBT	$1.01	$2.04	$4.10	$0.00	$0.00	$0.00
34.40%	Tax	$0.35	$0.70	$1.41	$0.00	$0.00	$0.00
	NetProfit	$0.66	$1.34	$2.69	$0.00	$0.00	$0.00
	Net Profit %	33.00%	33.00%	33.00%	0.00%	0.00%	0.00%
Accumulated Tax Paid		$0.35	$1.05	$2.46	$2.46	$2.46	$2.46
Tax cost as a % of Revenue		17.30%	25.90%	30.18%	30.18%	30.18%	30.18%

Hmmm.... Everything stopped growing.  Why?  Because there is no additional profit to tax.  The tax is levied only on the new profit at each level; NOT on ANY portion of the tax embedded in the Cost from prior levels.

Now, of course, if you want to argue that 33.88% is way too high a level of  tax embeddes in price, then the numbers DO matter.  You see, as you lower your profit expectation by reducing your price, far less profit (and tax) accumulate.  Let's see what happens when the chain lowers its Net Profit % expectations from 33% to 10%:

	Levels	1	2	3	4	5	6
Initial Cost	Revenue	$1.18	$1.39	$1.64	$1.94	$2.29	$2.70
$1.00	Cost	$1.00	$1.18	$1.39	$1.64	$1.94	$2.29
Tax Rate	PBT	$0.18	$0.21	$0.25	$0.30	$0.35	$0.41
34.40%	Tax	$0.06	$0.07	$0.09	$0.10	$0.12	$0.14
	NetProfit	$0.12	$0.14	$0.16	$0.19	$0.23	$0.27
	Net Profit %	10.00%	10.00%	10.00%	10.00%	10.00%	10.00%
Accumulated Tax Paid		$0.06	$0.13	$0.22	$0.32	$0.44	$0.58
Tax cost as a % of Revenue		5.24%	9.69%	13.46%	16.65%	19.35%	21.65%

Profit and Tax still accumulate, but at a much slower rate. The accumulated tax after six levels is far less than was accumulated after TWO levels in the 33% NPAT% example.

Conclusion: Taxes are indeed embedded in price BUT they only accumulate in proportion to PROFIT.  Extract no incremental Profit, pay no additional tax. So, regardless of Cost, regardless of the number of levels, regardless of the tax rate, regardless of how much was already paid by prior levels in a chain of transactions:

the tax paid at any level is only proportional to the profit extracted at that level
the cumulative tax paid is only proportional to the cumulative profit extracted
the tax from prior levels is not taxed in subsequent levels

The "magic of compound interest" (called "cascading" by pigdog and others) does not apply here.

Please feel free to repost this anywhere you may encounter the infamous "cascading taxes" table posted by pigdog

[Always Right]

Notice I didn't account for any "embedded tax costs" that reduces her buying power under the current system. I also didn't account for any increase in buying power due to price drops under the FairTax.

that is because once a 30% tax is added (23% inclusive) her buying power is less and prices will have gone up. There is no way around it, unless employees take pay cuts.

[Always Right]

I've tried to caution several on the thread that they shouldn't be making a mountain out of a molehill and should wait for more information. The present contretemps-in-a-teacup amounts to what I see as a difference of opinion between differing interpretations of some of the economic analysis.

You are one of the most delusional posters on this forum if you still insist this is just a matter of differing interpretations.

[Kellis91789]

You must not have actually read the example. Re-read the part about her buying power under the FairTax being 77% of spending. There is the 30% tax-exclusive number you like so much.

My later post was only that most reasonable people do expect SOME price reduction and do admit SOME embedded tax costs. It is only a question of how much of each.

Note that Jorgenson did not reply to Rob that ALL of the price reduction would come from reduced gross wages. That would be silly, since there are definitely non-wage costs that would be eliminated for the producer.

[Kellis91789]

Really ? Gee, my company has only 75 employees and $100M sales, but I could cut 1 person out of my HR/Accounting department if they didn't need to manage the tax-related documents and payments for those 75 employees. Witholding, 401K, depreciation of assets, tax planning, 1099's, W2's, etc. This is activity that happens all year long due to staff turnover. It isn't just about preparing the tax return the last 4 weeks of the year.

[lewislynn]

Under the fairtax a "nanny" would be domestic help and the person who hires a nanny (as well as any government) is a "taxable employer". The "taxable employer" is responsible for remitting any tax on the nanny's service and reporting her earnings to SS.

It cost the household she works for $3000 income to pay her $2000.

---

Am I missing something ?

One of us is. Where and why did the $3000 income to pay her $2000 come into play.

Here is what you're missing.

Supposing a nanny is working for $2000/mo, she would owe $306 self-employment tax and $200 income tax. She takes home $1494.

Her after tax (spendable) income is 75% of her gross...

Under the FairTax, she charges $2400/mo gross, of which $552 is FairTax and she takes home $1848 and gets the prebate of $190 for a total $2038.

----

Her buying power is 77% of what she spends, so legal is $1569

Using your numbers. Her after tax (spendable) income is only 65% of her gross (13% less than under the income tax) INCLUDING THE phoney REBATE and her gross (not including the rebate) under the fairtax is 20% MORE than under the income tax...

So, once again, using your numbers, she has a higher gross but smaller percentage of disposable income INCLUDING THE phoney REBATE under the Fairtax...

That's a double whammy!

[lewislynn]

For some reason you gave the nanny a 20% raise and it still isn't a favorable outcome...

[Kellis91789]

If you look at the bottom of any post, it will tell you the post that is being referenced. In this case it was your post 423.

"Does anybody really think that those same households that now employ underground nannies, housecleaners and gardeners and don't NOW pay FICA taxes, or withhold income tax from these employees' pay are going to become "in the game" taxable employers and pay the required tax under the FairTax scheme???

I didn't think so."

My post was to show an example of a case where there was sufficient benefit to the nanny to be legal rather than illegal.

My post was not a reference to the "cash economy" that exists amongst contractors such as your painter that are already participating in the system but doing cash work on the side. A similar argument exists, however, in that those people would be cheating themselves of SS credits. So it still decreases the benefit to evasion compared to the current tax system.

These people would not be comparing the current system to the FairTax on a transaction-by-transaction basis. I didn't mean to suggest it. Their decision was simply legal vs. illegal under whichever system exists.

If the "illegal Mexican Gardener" is your point-man for the underground economy, then that is a separate issue. Toss 'em all back over the fence and be done with it ! But as long as he is here, he can't benefit from SS and can't collect the prebate, so he has more incentive to work illegally. Has no choice, in fact. Then it does become up to the employer to reject him.

[Kellis91789]

The $3000 income required from the household is because they had to pay the nanny out of after-tax income -- income and payroll taxes taken out of $3000 leaves $2000. Somebody paying $2000/mo for a domestic servant is obviously in a high tax bracket.

"So, once again, using your numbers, she has a higher gross but smaller percentage of disposable income INCLUDING THE phoney REBATE under the Fairtax..."

This is the same BS argument that liberals like to use. Switching to percentages or amounts -- whichever favors their argument more. Her buying power is $1569 FairTax vs. $1494 Current. She comes out ahead.

If I offer you a job with two salary options:
a) $100K gross, take-home $60K
b) $70K gross, take-home $50K

Would you take option (b) just because your "percentage" take-home was higher ?

[Dimples]

What "prices" will BofA be reducing? their account fees? their lending rates?

BofA makes money by making loans and charging interest to their customers. Is obtaining a home mortgage loan from BofA a taxable retail transaction under FairTax?

If so, is the tax paid at funding on the entire amount of the loan? or is it paid monthly as an adder to the interest rate?

If not, you've just eliminated a pretty significant portion of the GDP from the tax base.

You might want to try your simple approach on a GM or IBM kind of company: corporate, non-financial.

[lewislynn]

Her buying power is $1569 FairTax vs. $1494 Current. She comes out ahead.

Nice try. Is her service worth $2400.00 dollars a month under either tax or just under the Fairtax because you thought it helps skew the numbers?

[lewislynn]

If I offer you a job with two salary options:
a) $100K gross, take-home $60K
b) $70K gross, take-home $50K

This is the same BS argument that liberals like to use. Switching to percentages or amounts -- whichever favors their argument more