Topic: Tax and Budget Policy

Unfair Criticism of the Fair Tax

Regular readers know that I think the flat tax is the more astute tax reform option, but I admire the Fair Tax because it has the same pro-growth features as a flat tax (low tax rate, no double-taxation of saving and investment, no special loopholes, etc). As such, I feel compelled to offer a partial defense against Bruce Bartlett’s anti-Fair Tax column in the Wall Street Journal. Bruce notes some of the political obstacles to a national sales tax, and I largely agree with those observations, but Bruce also says that Fair Tax advocates are wrong to advertise the “tax-inclusive” rate. It is true that ordinary Americans think of “tax-exclusive” rates when looking at state sales taxes, but the Fair Tax people are seeking to compare their proposal to the current income tax, which is calculated on a “tax-inclusive” basis. So while it’s true that sales tax advocates should not let people assume that the Fair Tax is calculated the same way as a state sales tax, this does not mean the “tax-inclusive” rate is not an appropriate measure when looking to overhaul the tax code. Bruce also cites the revenue estimates of the Joint Committee on Taxation as if they were carved on stone tablets, but the JCT has a long track record of inaccurate predictions because of their assumption that tax policy has no affect on economic growth. Using the JCT as an authority is akin to letting the other side serve as both player and umpire:

In reality, the FairTax rate is not 23%. Messrs. Linder and Chambliss get this figure by calculating the tax as if it were already incorporated into the price of goods and services. (This is known as the tax-inclusive rate.) Calculating it the conventional way that every other sales tax is calculated, with the tax on top of the price, yields a rate of 30%. (This is called the tax-exclusive rate.) The distinction is confusing, but think of it this way. If a product costs $1 at retail, the FairTax adds 30%, for a total of $1.30. Since the 30-cent tax is 23% of $1.30, FairTax supporters say the rate is 23% rather than 30%. …professional revenue estimators have always concluded that a national retail sales tax would have to be much, much higher than 23%. A 2000 estimate by Congress’s Joint Committee on Taxation found the tax-inclusive rate would have to be 36% and the tax-exclusive rate would be 57%. In 2005, the U.S. Treasury Department calculated that a tax-exclusive rate of 34% would be needed just to replace the income tax, leaving the payroll tax in place. But if evasion were high then the rate might have to rise to 49%. If the FairTax were only able to cover the limited sales tax base of a typical state, then a rate of 64% would be required (89% with high evasion).

Soak the Rich with Lower Tax Rates

Ever since the supply-side tax rate reductions of 2003, the economy has prospered and this has generated a windfall of tax revenue for the Treasury. The Wall Street Journal notes [$] that the lion’s share of this new revenue is from upper-income taxpayers.

There are many factors that influence the economy’s performance, so this does not necessarily prove that the 2003 tax cuts “paid for themselves.” But the windfall certainly bolsters the argument that the right types of tax cuts (lower marginal tax rates) have a positive impact on growth and that this means at least some revenue feedback.

Writes the WSJ:

Since the Bush tax cuts of 2003, the budget deficit has fallen by $217 billion mostly because of a continuing torrid pace of revenue growth. …For the Bush tax cuts to have been a give-away to the rich, people paying the higher marginal tax rates would have to be carrying a smaller share of the income tax load. But the IRS data indicate that they are not paying less. Instead, they are paying more — lots more. More surprisingly, the richest 1%, 5% and 10% of the taxpayers are shouldering a larger percentage of the income tax burden at the federal level than the tax estimators said they would had the Bush tax cuts never materialized. …The amount of tax paid by those earning more than $1 million a year increased to $236 billion in 2005, up from $132 billion in 2003, the year of the tax cut. This was a 78% increase in taxes paid by millionaire households.

…[L]ower tax rates on capital gains and dividends also caused a huge jump in reported income. The National Bureau of Economic Research found an “unprecedented surge in regular dividend payments after the 2003” Bush tax cut. Likewise, the lowering of the capital gains tax was followed by a 150% increase in the amount of capital gains unlocked by the 15% tax rate. Lower tax rates expanded the tax base.

…The supply-side revenue effects on the rich are remarkable: Tax rates on higher incomes have been halved, but the federal tax share of the top 1% has nearly doubled.

Finally, Some Not-So-Bad News on the Budget

The big surprise in the Congressional Budget Office mid-year budget estimates released today isn’t that the year-to-year deficit shrank again.  Or that the long-term liabilities in Medicare and Social Security continue to impend. 

The surprise is that federal spending will only grow about 3% in the current fiscal year that ends this October.  That’s a big improvement over the annual average 7% growth we’ve seen since the first day of the George W. Bush presidency.

How did that happen?  Those familiar with my previous research will probably not be surprised to hear that the new political reality – divided government – has something to do with it.

True, agriculture subsidies are lower this year as a result of higher crop prices.  And the run-up in spending on a variety of programs in 2006 – like the payouts on flood insurance policies after Hurricane Katrina – was temporary.  The most remarkable factor in the trends, however, is that non-defense discretionary spending has been frozen for the first time since the maiden budget of the “Republican Revolution” Congress.  (If the trends CBO estimates hold for the remainder of the year, such spending might actually decline by $1 billion.) 

Sure, part of this is also the result of a decline in spending on federal Katrina relief.  But there’s something else going on, too.  Earlier this year, the new Democratic Congress decided to put the federal budget on auto-pilot until October.  Instead of passing new appropriations bills to fund the government for the entire year, they passed what is called a “continuing resolution” to keep the government operating. 

This didn’t happen because the Democrats were all that interested in spending less money.  They just wanted to get the old budget work left to them by the outgoing Republican Congress off the table so they could get on with more ideological-base-friendly legislation, like the minimum wage increase.  And the Democrats knew that the president might finally start vetoing legislation, too.  A protracted battle over the budget wasn’t something they wanted to spend their energy on in the first half of the year.  Thus, the auto-pilot continuing resolution: a piece of legislation that keeps the government running at basically the inflation-adjusted level of the previous year. 

With the White House veto strategy finally a credible threat*, it looks like we might have a similar sort of outcome on spending this year, too.  Isn’t divided government wonderful? 


* As I told David Jackson of USA Today a few weeks ago, George W. Bush “dislikes Democrats more than he likes big government.”

More Thoughts on Trade Enforcement

In addition to the sock safeguard action against Honduras, the U.S. government recently requested arbitration over alleged violations by Canada of the 2006 Softwood Lumber Agreement.  (We’ve written about this long-running dispute here, here, and elsewhere). Under the SLA, Canada is required to restrict the volume of its exports or impose an export tax (or some combination of the two) when the prevailing monthly price falls below U.S. $355 per million board feet.

The deal, which the Canadians signed with guns to their heads, was agreed during a period of a robust housing market and relatively high lumber prices.  With the decline of the U.S. housing market, lumber prices have gone south, and the stipulation that Canada intervene in the lumber market has kicked in.

Enforcement in this case, then, means that the housing market slump will endure longer than it has to.  Builders will be less capable of offsetting rising mortgage rates with lower priced homes, as the cost of their most important input remains artificially high.

Even the cost of nails should be expected to rise and for the same reason –  enforcement.  On Tuesday, the U.S. International Trade Commission determined preliminarily that imports of certain steel nails from China and the United Arab Emirates (co-winners of the 2006 Congressional Pinata of the Year Award) are being sold at less than fair value in the United States and causing material injury to domestic producers.   Additional duties are likely to be formalized by the end of the year. 

Thus, the administration’s indulgence of Congress’s demands for more trade enforcement will have the noble effect of making life more difficult, in particular, for Americans at the lower end of the income spectrum, who will need to devote more of their limited resources to housing and socks.  More often than not, trade enforcement is just another term for regressive taxation.

Denmark’s Meager Tax-Cut Package

The good news is that Danish politicians have announced that taxes will be reduced. This is welcome news in a nation with the world’s highest income tax rate. Indeed, the tax burden is so onerous that even the OECD suggested it might not be a good idea to subject 40 percent of workers to marginal tax rates of more than 70 percent. Unfortunately, the tax cuts that have been proposed are akin to putting a band-aid on a compound fracture. Instead of reducing the top tax rate, the government merely intends to adjust the income level where the top bracket takes effect. While this surely is better than nothing, the government also is raising taxes on energy and increasing an already bloated welfare system. Tax-news.com reports on Denmark’s less-than-exciting reforms:

The Danish government has announced its intention to cut taxes by DKK10 billion (EUR1.34 billion) per year in 2008 and 2009 in a bid to stimulate the labour market, and improve incentives to work. Under the proposed reforms, announced by the government on Tuesday, the income ceiling for the middle and top income tax brackets will be raised to DKK353,000 per year from DKK304,100, and to DKK381,300 per year from DKK365,000, respectively. …In the same announcement, the Danish government also promised that a broad economic plan for the next eight years would not raise any taxes between now and 2015. The economic package also promises DKK50 billion in extra spending to improve Denmark’s welfare system between 2009 and 2018. …To help offset the tax cuts, the government also announced that green taxes on energy consumption would increase from 2008 to match inflation. This would increase taxes on heating, water and electricity.

Czech Republic Joins the Flat Tax Club

Following up on Marian’s earlier post, it’s time to cue up the unofficial theme song of the flat tax revolution and review one of the first English-language news reports about the Czech Republic becoming the 20th jurisdiction to adopt a low-rate flat tax. The Prague Daily Monitor reports that the vote in the Chamber of Deputies clears the only real obstacle to a low-rate tax system:

The cabinet’s package of public-finance reforms passed the final vote in the Chamber of Deputies yesterday thanks to two unaffiliated opposition MPs who voted with the governing coalition. Starting next year, the legislation will gradually reduce corporate and personal-income taxes, cut social spending and introduce cash fees for health care. It still requires Senate approval and President Václav Klaus’s signature, but no resistance is expected from either. …

The reform package will gradually lower the corporate tax rate from today’s 24 percent to 21 percent next year, 20 percent in 2009 and 19 percent in 2010. The existing progressive taxation of personal income at 12 to 32 percent will be replaced by a flat tax of 15 percent in 2008 and 12.5% in 2009. The personal income tax will be calculated from super-gross income, including social and health insurance contributions paid by the employee and the employer. This means effective taxation will be 23.1 percent of gross income in 2008 and 19.4 percent in 2009.

The Czechs Adopt a Flat Tax

The lower house of the Czech parliament passed legislation earlier today implementing a 15 percent flat tax on personal income. The new tax system will take effect on January 1, 2008, and the rate is then scheduled to drop to 12.5 percent in 2009. The legislation also reduces the corporate tax rate from 24 percent today to 19 percent by 2010.

The reform, which was narrowly passed by 101 members of the 200-member parliament, now goes to the upper house, where the government has a massive majority and no obstacles are expected. Once the reform clears that hurdle, it will then be signed into law by the Czech President Vaclav Klaus, who is a free-market economist. That act would make the Czech Republic the 20th country to adopt a flat tax. (The Bulgarian government has agreed to introduce a flat tax by January 2008, but the measure has not yet passed through the Bulgarian parliament.)

The opposition socialists have stated that they will repeal the law if or when they return to power and may even raise constitutional objections to it. For now it seems, however, that the legislation will come into force.

The Czech flat tax is a big step in the right direction, and another sign that tax competition is having a positive effect. But the legislation is not perfect. One of the salient features of a pure flat tax is the elimination of tax exemptions, deductions and loopholes. The Czech legislation is less ambitious and many of the bad features of the current system will remain in force. Also, the 15 percent tax rate will be levied on gross income, including payroll taxes. This means the tax rate is not directly comparable to nations that impose the flat tax only on net income, such as Slovakia.