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March 04, 2005

Toward the Fair Tax: Greenspan Endorses Move to Consumption Tax

Federal Reserve Chairman Alan Greenspan weighed in on tax reform yesterday, endorsing a move toward a consumption tax, while cautioning against rapid, wholesale change.

"Many economists believe that a consumption tax would be best from the perspective of promoting economic growth - particularly if one were designing a system from scratch - because a consumption tax is likely to favor saving and capital formation," Mr. Greenspan said.

That should provide a boost to the Fair Tax bill introduced and championed by Georgia Congressman John Linder, a member of the House Ways and Means Committee. Congressman Linder (R-GA), reintroduced his personal consumption tax proposal, H.R. 25, also known as the “FairTax.” on the first day of the 109th Congress.

There are several Republican lawmakers who recognize that tax reform and social security reform need to be considered together.

A total tax overhaul will take enormous political effort, but Linder sees good momentum in Congress. It’s time to get behind this commonsensical tax bill that lives up to its name—“fair tax.”

Posted by Jim at March 4, 2005 09:10 AM

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Amen! I'd love to see the consumption tax come to pass. plant gardens to avoid taxes (and make my wife happy!). no taxes on most used items. get your full paycheck. who wouldn't like it?

oh, yeah. the Democrats.

Posted by: truth peddler at March 4, 2005 01:00 PM

I agree and add that both are long past due. The good Dr. is right a consumption or sales tax *in place of* the Income Tax would provide better motivation to workers.

Posted by: Rod Stanton at March 4, 2005 01:36 PM

Jim, I've heard about the fair tax, but have a concern/question that I'd really like to read up on. I'm not sure how Greenspan reaches his conclusion that a consumption tax would "be best from the perspective of promoting economic growth." Isn't that a bit counter-intuitive?

I've heard that the consumption tax would be on the order of .37 per $1, and the cognitive profile of the tax would be so great, that the short-term impact could jar our economy, no? People SOOO aware of the taxes that they are paying, that they "over correct" and curtail spending to a degree that the consumption of most services and discretionary commodities comes to a halt in the short-term. How many jobs are in these industries? How many jobs will be lost in the short term? What impact will this have on not just the economy, but families?

In other words: True the tax would encourage saving, but wouldn't a tax on consumption also decrease the incentive to consume and therefore result in a decline in productivity and therefore a decline in jobs/wages and therefore the ability to consume/save?

I tend to be a supply-sider, so I'm not sure how this jives with what I know about economics (which is not much).

Perhaps you or one of our readers can point to a couple point-counter point articles on the consumption tax?

Posted by: Rick Brady at March 4, 2005 01:40 PM

Here's a document that includes a Wall St. Journal article and a Fox interview of Rep. John Linder by Bob Novak.,FoxNews&CNN.pdf

Linder and talk show host Neal Boortz are working a a book on the fair tax. It's probably a couple of months away from being completed, though.

Posted by: Jim Jewell at March 4, 2005 02:52 PM

Thanks Jim, I read the information at the link with great interest. I remain unconvinced however; not opposed, but unconvinced. I'll take a "wait and see" approach to this one. :-)

Posted by: Rick Brady at March 4, 2005 03:11 PM

After a few more bites of lunch and some thought...

I favor raising the cognitive profile of taxation in almost all circumstances. Income tax witholding is pretty clever as taxpayers got used to looking not at their gross income, but take home pay as their income. This is evident in how excited many people get if they get a refund check from the IRS.

The consumption tax would certainly raise the cognitive profile of taxation, which would be a good thing in the long run. As Linder wrote,You would become a voluntary taxpayer paying taxes when you choose, as much as you choose, by how you choose to spend."

I am primarily concerned with the potential for short-term, near/mid-term, and long-term unintended consequences.

Short-Term Consequences:

I recall an article (don't know if it was true) about an 85 year old man driving on tha autobahn in Germany. He had a navigational system that told him to "make a U-Turn NOW!" He did. The car flipped. He died.

First of all, I don't buy the 23% consumption tax. We pay ~8% in CA and we also have income tax AND property tax and we still can't fund our schools and transportation adequately. I suspect that the 23% figure is a purposeful low ball (like Bush's Medicare proposal) to gain intial support. But, that's a side note.

Let's say the tax is 23%, then you add the state or local tax (I know this doesn't apply in all states), and you get somewhere around 30%. All of a sudden that $15,000 new car you had your eyes on becomes $20,000. In the near-term, people will see the $20K price tag relative to the $15K perceived value. It doesn't take many changes from from "yes, I'll buy it" to "no, I'll wait and see" to force companies to cut production, close plants, terminate manufacturing and sales positions, which equals fewer people making money to "spend" on other items.

Linder thinks that the eliminated payroll taxes will largely offset this effect, presumably because the reduced costs will allow the automobile manufacturer to offer lower prices to customers to get the car back down to that $15K perceived "value." But these adjustments take time and in the short-term, having managed a pizza business, the response is to: 1) cut labor hours; and 2) postpone capital expenditures. I'm most worried about these short-term ramifications.

Near- and Mid-Term Consequences:

The sales tax is a highly volatile source of revenue. California provides a perfect case in point. Pre-Proposition 13 (1978), CAs revenue was derived largely from property taxes derived from property value increments. The government's revenue stream was very stable and predictable, making it easier for long-term planning of expenditures. I don't know where they are now, but when I was writing an article on a related fiscal issue (published in the Journal, "Planning Forum"), I saw a series of charts depicting the annual State revenue stream before and after Proposition 13. It showed steady and measured rise in revenue for decades through 1978. Post 1978, into the 1990s, it was all over the place. Makes it very difficult to govern under those circumstances (I'll come back to that).

The bi-cameral Congress was created in part to cool the passions of the majority of a population-based Congress. Senators have 6-year terms, while Representatives have 2-year terms. Not subject to all the passions of the Congress, but not as insulated as the Senate, the President has a 4-year term.

When thinking about "stability" v. "accountability," I think of the property tax as the Senator, the Income tax as the President, and the sales tax as the Representative.

I think the property tax tied to increments in property value is by far the most "stable" revenue source for a government, but it is not responsive enough to economic downturns. If property values rise faster than income, you could find yourself out of your home simply because you couldn't keep up the property tax payment.

On the other hand, the sales tax is highly responsive to the economy. If you don't have much income, or anticipate cash flow problems, you curtail spending and, as Linder said "become a voluntary taxpayer paying taxes when you choose, as much as you choose, by how you choose to spend."

Imagine the consequences of a bearish economy where people have lost their jobs and those who have jobs are not spending money. At that time, there is a higher than usual demand for public "safety net" services, the government is cash-strapped. If you think we should never provide these "hand up" (not hand out) services to begin with, I guess you don't have a problem here; but, most Americans do want a safety net.

A volatile revenue source would force lower-income, perhaps younger or senior families into a precarious situation. They would be forced to walk a tightrope without a safety net (unless taking on debt is part of the solution, which it could very well be).

That leaves us with the income tax - not perfect, but not all that bad. One way to increase the cognitive profile of the income tax is to slowly eliminate witholdings (again - don't want to be like the old man who made the u-turn on the autobahn), and move towards requiring an annual lump payment. Maybe then the citizens would demand more accountability from the government for our tax rates and their spending levels.

Another idea would be to simply the tax code by charging three flat taxes (off the top of my head for example, say, 0.25% property tax, a 10% sales tax, and a 5% income tax).

Potential Long-Term Unintended Consequences:

Proposition 13 restricted property taxes to about 1.25% of the value at the time of the last sale of the home. In post Prop 13 fiscal regime, you have two retired CA couples who live next door to each other. One couple bought their home in 1975. The other couple bought their home in 2004. The first couple's property tax is calculated with the value of the property in 1975 as the base. The second couple's property tax is calculated with the value of the property in 2004 as base. The result is that although the two couples have the same impact to municipal and state services and infrastucture, they pay drasitically different levels of property taxes. We're talking up to 500% differences in some 30 year old middle- and upper-middle class neighborhoods.

I bring this up because Prop 13 had a long-term unintended consequence. The instability and inequity in the distribution of the property tax forced the State and local governments to rely for a while on the sales tax as a primary source of revenue - so much so that they alter land use patterns around big box/sales tax generating giants, in many cases against the expressed will of local consituents. Would the Feds get into the Land Use business? We should consider lessons of land use fiscalization in California.

Even as the State and local governments grew dependent on the sales tax, they could not force residents to spend; so, rather than curtail spending in Sacramento or City Hall, they got VERY creative in applying various "fees" and "assessments," each with very low overall cognitive profiles. It's a situation of concentrated cost with diverse benefits for all you poli sci students. It's easy to do when the costs are concentrated, but not sustained - that is, CA residents pay a $15 registration fee here, a $60 licensing fee there, etc. etc. and what happens is CA residents end up paying MORE for public services than they would have had Prop 13 not passed.

Anyways, lunch is over, so back to work. That was fun...

Posted by: Rick Brady at March 4, 2005 04:14 PM