Fixing America’s Tax System: What About the Fair Tax?

Tax policy and income distribution have been pretty heated debates in public policy in recent years. Do the rich pay their fair share? How do we stop the growing inequality among wage earners? These are questions I am sure many of you have heard if you paid attention to the 2008 and 2012 presidential elections. The question is how to fix it. One of the proposed solutions is called the Fair Tax. In this blog I will explain what the Fair Tax is, how it differs from our current system, and the pros and cons of it.

The Fair Tax is a national sales tax that proposes a 23% tax on the sale of goods and services (this would include the purchase of food, clothes, and other non-durable goods) and this would replace the current tax system of income taxes, corporate income taxes, payroll taxes, and excise taxes. In order to not penalize low-wage earners, the Fair Tax would have a “prebate” where each month a check is given to families based on how much they spend and how many people they have in their family unit. The idea behind the Fair Tax, and any consumption tax, is that it is a more “fair” tax as it taxes individuals based on how much they spend versus how much they make. Under this system, it encourages people to save as they could put earned income into investments and thus have more money to spend in the future rather than today. Under traditional economic theory an increase in savings leads to an increase in investment and this would lead to higher GDP in the future. Also, this would eliminate the corporate taxes and payroll taxes, thus giving the United States a comparative tax advantage over foreign countries and help bring businesses to the United Sates (note: businesses would have to pay consumption taxes as well). This is a progressive tax based on consumption.

The current tax system is progressive based on based on income that has a negative tax rate for low income earners. The Earned Income Tax Credit (EITC) pays low income earners a check to reduce their tax burden and is a form of income redistribution. The current system of taxes hurts businesses (note: the United States has the highest corporate tax rate in the world) as it gives other countries a comparative tax advantage, encourages consumption today and discourages saving and allows for ways to evade taxes as wealthy individuals tend to consume out of savings and investment earnings (that would be captured in a consumption tax).

There are several problems I find with a Fair Tax. One is that is is regressive on income, that means that people who earn less have a higher tax burden because a 23% sales tax on food, clothes, and other necessities hurt low wage earners much harder than high wage earners, thus it is a regressive tax and gives advantages because someone making a million dollars a year has a high range of possibilities to consume whereas lower wage earners have a small range which penalizes the low wage earner. Also, with the “prebate” system it makes families heavily dependent on monthly checks from the government, which essentially sets up a massive welfare system and makes individuals heavily dependent on the government. Also I believe that the Fair Tax would discourage spending, which is the largest component of GDP.

It is hard to fully estimate how a consumption tax will affect the economy as the assumption is that consumption will remain at the same level it is today, which I think is an unfair assumption as when prices increase it discourages spending. The average consumer will look at it as prices are higher and use more discretion with spending, and this will lowers spending on the middle and lowers classes.

In 2006, the Presidential Advisory Panel did a study on the Fair Tax and estimated that it would hurt middle class families by increasing their tax burden and lower that of the upper class (see the below figure)

To be fair, I must note that there have been studies done that show the opposite of this in support of the Fair Tax, however as I stated earlier this assumes that consumption and income remain at the current levels given the income tax, which is a large assumption.

As I have stated in previous posts, I believe that reforms are needed to the current tax system that that create a separate tax code for small businesses, drastically reduce the corporate tax rate, and smooth out the tax code to have less of a penalty for earning more money (see previous blog post).

Another point to be added is that if a Fair Tax is to be proposed, you would have to amend the constitution so that the Federal Government cannot still collect income taxes as you risk the possibility in the future of the government reinstating the income tax and then consumers would be taxes both on income and consumption, and the possibility of an amendment of this sort is highly unlikely.

There are some benefits to the Fair Tax that have potential to help the economy through supply side economics. However when Supply Side Economics was tried in the 1980s the increases in investment spending were far smaller than they though would happen and I would bet the same would be true for the Fair Tax. The bulk of GDP comes from consumption spending and instituting a tax that potential hurts that does not make sense for future economic growth.

I can't believe I just found this blog. This is amazing.

Glad to be able to help

Food and energy are rather volatile and their prices can be affected drastically by short term work events and natural disasters which can cause large swing in inflation. Economists use core inflation as a central measure because it ignores short term swings in those volatile prices.  If food and energy prices actually go up as a result of inflation that will be shown in the prices of other goods as well. Inflation is a measure of the aggregate goods and services, so if energy prices go up permanently then so will the price of everything else. You can see that core inflation follows the same trend and inflation but lacks the large swings.  This gives us a better idea as to what is happening at the aggregate price level.

Food and energy are rather volatile and their prices can be affected drastically by short term work events and natural disasters which can cause large swing in inflation. Economists use core inflation as a central measure because it ignores short term swings in those volatile prices. If food and energy prices actually go up as a result of inflation that will be shown in the prices of other goods as well. Inflation is a measure of the aggregate goods and services, so if energy prices go up permanently then so will the price of everything else. You can see that core inflation follows the same trend and inflation but lacks the large swings. This gives us a better idea as to what is happening at the aggregate price level.

Hello! I've been assigned to do a report about Lorenz Curve, but I don't know how to start. How does it even work? I read a post about it on your page but I can't seem to understand some parts of it.
Anonymous

Imagine you take all the income for every individual earned in the United States and you ordered them from highest to smallest. Then you take that list and break it into five equal groups. Each one of these groups is called a quintile, and in each quintile you have the exact same number of wage earners.

On the X axis you would have the five quintiles, or more specifically you would order your list from smallest to largest. On the Y axis you would have the percent of the cumulative total of the income they earned. So the lowest quintile may account for say 10% of the total income. Then the first and second quintiles may account for 20% of the total income. The first, second, and third may account for 35% of the income. The first second, third, and fourth may account for 60% of the income, and then all five quintiles together would be 100% of the income. That gives your the lorenz curve. In some countries the curve has weird bows and shapes as they have income skewed way to the top. If the Lorenz curve was a straight vertical line, that would mean that 1 individual held ALL the income for the entire country. If the line were a straight line with a slope of 1 going through the origin, then that would mean that every individual in the country had exactly the same income. The bigger the bow of the curve, the more unequal the distribution of incomes.

One of the problems the US economy has faced since 2008 is that wages have not increased to meet productivity.  It has typically been the trend that as productivity increases so does worker compensation.  Looking at the graph you can see that since the recession wages have pretty much been stagnant.  Productivity is at an all time high because people have been laid off so the existing workers are being asked to do more work than they normally would.  

Going forward, eventually businesses will have to compensate their workers more if they want to continue to see increased productivity.  Eventually the growth of productivity will decline.  Typically, as a business recognizes that it has reached a productivity ceiling, it will higher more workers and compensate better, that is a sign that a company is doing well and making sound enough profits to expand.  One thing to note is that corporate profits are very high, but yet we see this trend continue which is alarming.  One explanation is that there is a structural problem in the labor force (see a more detailed explanation here from an earlier blog).  Until we can fix this structural problem in the labor force, where people are not adequately trained and located in the right places for the jobs, there is a chance we will continue to see this trend of stagnant wage growth, and the fear from that is that eventually there will be a drop in productivity.  Addressing the structural change in the labor force is key if we want to see real progress in economic growth.

One of the problems the US economy has faced since 2008 is that wages have not increased to meet productivity. It has typically been the trend that as productivity increases so does worker compensation. Looking at the graph you can see that since the recession wages have pretty much been stagnant. Productivity is at an all time high because people have been laid off so the existing workers are being asked to do more work than they normally would.

Going forward, eventually businesses will have to compensate their workers more if they want to continue to see increased productivity. Eventually the growth of productivity will decline. Typically, as a business recognizes that it has reached a productivity ceiling, it will higher more workers and compensate better, that is a sign that a company is doing well and making sound enough profits to expand. One thing to note is that corporate profits are very high, but yet we see this trend continue which is alarming. One explanation is that there is a structural problem in the labor force (see a more detailed explanation here from an earlier blog). Until we can fix this structural problem in the labor force, where people are not adequately trained and located in the right places for the jobs, there is a chance we will continue to see this trend of stagnant wage growth, and the fear from that is that eventually there will be a drop in productivity. Addressing the structural change in the labor force is key if we want to see real progress in economic growth.

GDP was revised downward for the second quarter today from 1.7% to 1.3%.  This graph shows the potential GDP of the United States if there were perfectly stable economic growth (full employment GDP), which is about 3% per year.  The red line shows actual GDP growth and you can see the fluctuations around it.  The latest recession really hit GDP hard, and in the past after a dip we see some sort of boom that propels GDP back to around potential GDP.  Right now given the pace that we are going, unless we see GDP over 3% we will always run parallel or below.  We need to see growth greater than 3% to catch up, however that could take a very long time, so ideally it would be nice to see GDP rise at 4% or more to make that catch up quicker.

Just a reminder that GDP is defined two ways:

1) The Market Value of all final goods and services produced in the United States for a given year
2) The sum of all the income for every individual and company in the United States for a given year

So as long as GDP is below the potential, the United States is not using its labor and capital efficiently and therefore we will continue to see higher unemployment than normal.  As more goods and services are consumed companies will be forced to hire more labor and expand current operations.  In turn that will generate higher income for workers and more income for companies.

Low GDP growth = Low growth in wages, Low Growth in Jobs.  Bad for everyone.

GDP was revised downward for the second quarter today from 1.7% to 1.3%. This graph shows the potential GDP of the United States if there were perfectly stable economic growth (full employment GDP), which is about 3% per year. The red line shows actual GDP growth and you can see the fluctuations around it. The latest recession really hit GDP hard, and in the past after a dip we see some sort of boom that propels GDP back to around potential GDP. Right now given the pace that we are going, unless we see GDP over 3% we will always run parallel or below. We need to see growth greater than 3% to catch up, however that could take a very long time, so ideally it would be nice to see GDP rise at 4% or more to make that catch up quicker.

Just a reminder that GDP is defined two ways:

1) The Market Value of all final goods and services produced in the United States for a given year
2) The sum of all the income for every individual and company in the United States for a given year

So as long as GDP is below the potential, the United States is not using its labor and capital efficiently and therefore we will continue to see higher unemployment than normal. As more goods and services are consumed companies will be forced to hire more labor and expand current operations. In turn that will generate higher income for workers and more income for companies.

Low GDP growth = Low growth in wages, Low Growth in Jobs. Bad for everyone.

New research from Sentier Research shows that household income has dropped 8.2% in the last 4 years.  Note that income is the primary factor in both consumption and savings, seeing a lower income for households means that people are spending less and saving less. Since the recession we have seen gross private saving in the US remain flat.  Personal savings directly ties into investment spending in the economy in new capital goods and buildings.

Basically in a nut shell, lower household incomes means that on the aggregate level people are worse off then they were four years ago and have less money to spend and get the economy going again.

New research from Sentier Research shows that household income has dropped 8.2% in the last 4 years. Note that income is the primary factor in both consumption and savings, seeing a lower income for households means that people are spending less and saving less. Since the recession we have seen gross private saving in the US remain flat. Personal savings directly ties into investment spending in the economy in new capital goods and buildings.

Basically in a nut shell, lower household incomes means that on the aggregate level people are worse off then they were four years ago and have less money to spend and get the economy going again.

See how each sector of the economy contributes to overall GDP growth in the United States.  You can see that manufacturing took a slight dip but seems to be on the rise, healthcare is steadily increasing year after year, but real estate and the financial sector has been in decline

Keys to look at going forward :- Construction as construction picks up, that is usually a good sign of a recovering economy, right now it is trending downward.  This means that people are in demand for new houses, expanding their business, and have a favorable view of the economy moving forward.  New construction also means that other sectors will benefit as consumers will be furnishing new houses and buildings and companies will be hiring new employees to staff.- Manufacturing  as the manufacturing sector continues to increase that is a good sign for economic recovery, it means that people are buying and that products are in demand.-Real Estate/Finance  As you can see that this section is one of the most important parts of the economy.  This sector, along with manufacturing, was hurt very badly by the latest recession.  In the past this sector has lead the US economy out of recessionary periods, this time is a little different because this is the primary sector that was hurt.  As this sector improves it will feed into many other areas of the economy as well.  This area has been a problem for policy makers and they could probably do a better job at finding ways to help this sector.

See how each sector of the economy contributes to overall GDP growth in the United States. You can see that manufacturing took a slight dip but seems to be on the rise, healthcare is steadily increasing year after year, but real estate and the financial sector has been in decline

Keys to look at going forward :
- Construction as construction picks up, that is usually a good sign of a recovering economy, right now it is trending downward. This means that people are in demand for new houses, expanding their business, and have a favorable view of the economy moving forward. New construction also means that other sectors will benefit as consumers will be furnishing new houses and buildings and companies will be hiring new employees to staff.
- Manufacturing as the manufacturing sector continues to increase that is a good sign for economic recovery, it means that people are buying and that products are in demand.
-Real Estate/Finance As you can see that this section is one of the most important parts of the economy. This sector, along with manufacturing, was hurt very badly by the latest recession. In the past this sector has lead the US economy out of recessionary periods, this time is a little different because this is the primary sector that was hurt. As this sector improves it will feed into many other areas of the economy as well. This area has been a problem for policy makers and they could probably do a better job at finding ways to help this sector.

A Better Way to Understand the Problems in the US Labor Market

In the midst of the current presidential election both candidates talk about how they are going to fix the economy and turn the job market around. The one thing they are both missing is that there has been a structural change in the US labor force and more than the traditional methods of stimulating employment are needed. We have seen the Fed take a very accommodative stance with multiple rounds of quantitative easing, low interest rates, and operation twist. Monetary policy has done about all it can to stimulate the economy. We saw a major stimulus bill passed, which did have some positive effects to slowing down the rate of job losses earlier in the recession but it did not focus on areas of long term growth, it put money into short term growth and we are seeing those effects now. I have said before that this recession has had structural changes to the economy and has had some pretty large effects on the labor market which is why we have had unemployment above 8% for so long.

The following graph shows the number of job openings (in thousands) since 2008:

Looking at this graph, you can see that the number of job openings in the United States is on the rise, so why have we not seen a corresponding change in the unemployment rate? The next graph I am going to show you is called the Beveridge Curve. It is a curve that relates the number of job openings to the unemployment rate.

When the economy enters a recession, the curve will slide down, as you can see from the picture above. As the economy recovers and jobs open up and get filled we should see that curve turn around and move back in a similar trend. When you see the curve move to a new position following a recession, it is the result of a structural change in the labor market. These changes can be seen in the form of geographical mismatches of job openings to available labor or job-skill mismatches. When seen with real data, that graph can take on a funky shape, but it plots movements and trends, and that is very important in understanding what is going on real-time in the economy.

The first graph I am going to show you is the Beveridge Curve following the 2001 recession:

This plots the job vacancy index against the unemployment rate (data taken in making this and following graphs comes from the Bureau of Labor Statistics). You can see that as the economy turned around the Beveridge Curve went back and followed along the same path, showing the economic recovery that took place in the early 2000s. Next I will show you the current Beveridge Curve:

As you can see it looks like the curve has shifted and there are several periods of vertical movement in the curve as oppose to moving leftward, which should be a sign of economic recovery.

The latest recession really devastated the manufacturing and financial industries in the United States. I believe that the reason we are seeing a shift in the Beveridge Curve is that we have a mismatch of skills to needs in the labor force. One of the things that must happen is that people that lost jobs in industries that got wiped out must find a new niche in the economy, and that will require job re-training and re-tooling. Currently, people are seeking work in the same sector they were laid off in and that is not where the job openings are. A good investment in the future would be to look at these sectors and see how we can assist in getting these displaced workers better suited for the jobs that are available. We can look to bring back manufacturing jobs to the United States, but that will require a very large change in several policy areas. A good fiscal policy or stimulus would be to look at ways to invest in getting this section of the labor force better equipped to become a part of the structural change in job market. This is a better use of government funds than propping up companies and industries (e.g. Solyndra and other green technology companies) that could not survive on their own.

Both Presidential candidates will tell you they can create millions of new jobs. However, both candidates are failing to address the true problem behind unemployment in the United States.