This paper titled “A Comparison Of Governor Romney’s Middle-Income Tax Proposals Vs. The FairTax Legislation” written by Kerry D. Bowers on 9 June 2012 will explain whether he was or not. No cheating now, I read the entire paper to find out, I expect everyone else to as well.
During the 12 September 2011, Republican Presidential debate, Governor Romney made the following statements in response to a question about the FairTax.
“But the way the fair tax has been structured it has a real problem and that is it lowers the burden on the very highest income folks and the very lowest and raises it on middle income people. And the people who have been hurt most by the economy are the middle class. And so my plan is for middle income Americans, no tax on interest, dividends or capital gains. Let people save their money as the way they think is best. We’re taxing too much, we’re spending too much and middle income Americans need a break and I’ll give it to them.”
The claim made by Governor Romney, that the FairTax would lower the tax burden on the lowest and highest incomes while raising it on the middle-income wage earner (current tax code implied), is inconsistent with the preponderance of information that may be accessed from multiple sources comparing the FairTax with the current tax code. That being so, I will refrain from further comment on this point made by the Governor and defer to the reader to present argument to the contrary. As to the Governor’s implication that his tax proposals will be less of a burden on the middle-income earner than that anticipated with the FairTax legislation, I have not, as of this writing, discovered a study that would either directly support or discredit the Governor’s claim. Therefore, it will be the intent of this document to present the specifics of the Governor’s proposals with that of the FairTax legislation for the purpose of conducting a comparative analysis that will either substantiate or refute the Governor’s claim.
Below, and attached in PDF format, is a spreadsheet I have prepared to facilitate an analysis of the Governor’s proposals vs. the FairTax legislation. The sheet is divided into two sections. The first section is a side-by-side comparison of the details proposed by Governor Romney vs. the details contained in the FairTax legislation. The specifics of the Governor’s proposals were obtained from his website and from other web-based media sources which reflected the same information. Where changes from the current tax code were not specifically addressed in the Governor’s proposals, I used IRS 2012 rates, deductions, exemptions, and credits to complete the comparison.
The second section of the sheet is an application example in which the specifics of the Governor’s proposals and that of the Fair Tax legislation were applied to similar conditions for a comparison of their effective tax rates. In my example, I present effective tax rate as it relates to the “sacrifice” in purchasing power as described by David G. Tuerck, PHD, who serves as the Executive Director for the Beacon Hill Institute and Chairman of the Department of Economics at Suffolk University. Dr. Tuerck, in general terms, describes sacrifice as the ratio of products surrendered to the government vs. the quantity that could have been purchased by the taxpayer were individual taxes excluded. In other words, if the taxpayer’s earned income is $50,000 and the federal income and payroll tax consequence is $10,000, then there is only $40,000 left (net income) from which 40,000 widgets, each priced $1, could be purchased from a total possibility of 50,000 widgets. The sacrifice is the 10,000 widgets that the government can purchase with the $10,000 tax revenues surrendered by the taxpayer to the government. The effective tax rate, in this case, would be the ratio of 10,000 widgets/50,000 widgets = 20%. Dr. Tuerck further describes this measure of effective tax rate as how much the government “impinges upon the taxpayer’s standard of living”, which is reduced in the foregoing example by 20%. For additional information about effective tax rates, I refer the reader to Dr. Tuerck’s BHI paper Memo To Bruce Bartlett: Do the Math.
The example I have prepared in part 2 of the sheet is based on a middle-income family consisting of 2 parents and 2 children with a combined earned income of $50,000. Given the similarity of the Governor’s proposals to that of the existing system, I was able, with appropriate changes to the tax rates, standard deduction, personal exemptions, and child tax credit, use a tax-year 2011 Form 1040 to calculate the amount of federal income taxes due. To complete the individual income-tax consequence, I added the employee Social Security tax, $3,100 (6.2% of earned income ) and another $725 (1.45% of earned income) for the Medicare tax. Not included in this filing example is the average individual tax compliance costs of approximately $182 as reported in H&R Block’s 2011 Annual Report. (It should be noted that the reported costs likely include a combination of both federal and state filing fees.) To further substantiate the impact individual compliance could have on the effective tax rate, I noted from the company’s annual report that an estimated 61% of all individual tax filers used a retail filing service in 2011. Such average compliance costs could add another 0.5% to the Governor’s effective tax rate as presented in this paper and 0% to the FairTax since no filing is required of the individual taxpayer.
To begin the process of determining the effective tax rate under the Governor’s proposals, I subtracted the applicable standard deduction, exemptions, and credits from the earned income amount to obtain the taxable income. Next, I calculated the amount of income tax due on the taxable income as determined from a 20% reduction to the 2012 marginal rates, i.e., the 10% bracket becomes 8%, 15% becomes 12%, and so on. I then calculated the employee’s share of the Social Security and Medicare taxes, which was added to the income tax to determine the total individual taxes due for this example. The sum of the combined income and payroll taxes was subtracted from the earned income amount (wages, salaries and tips) to obtain the net income, the amount of income remaining for purchases, investments or savings. In this example, 100% of the net income will be used for purchases as described by Dr. Tuerck for determining the effective tax rate.
The next step was to establish a product and price and one inclusive of embedded taxes for comparative purposes. I restricted my approach to one that I believe will present the least potential for argument from the Governor’s perspective. In this example, I chose a fictitious product (widget) with a single manufacturer and separate retailer to sell the widgets to consumers. The manufacturing costs per widget was set at $.25 (25 cents) with a 100% markup prior to distribution to the retailer, making the total manufacturing price $.50 (50 cents). The retail price was set at 100% over the manufacturing price, thus the price to the consumer is $.50 + $.50 = $1.00 (1 dollar).
Next, I focused on the embedded tax consequence to the price of the widget, which will occur partly as a result of the Governor’s intent to assess a 25% corporate tax on manufacturing and retail businesses. This cascading tax, in addition to the cascaded employer’s share of payroll taxes, 6.2% for Social Security and 1.45% for Medicare, will be embedded in the price of every widget sold to a consumer under the Governor’s proposals. In developing the widget price, I chose to use only the Governor’s corporate tax and existing employer payroll tax, because both can, within a reasonable degree of certainty, expect to be eliminated in their entirety from product and service prices soon after implementation of the FairTax and subsequent to the expiration of the transition credit and its possible effects. Other embedded taxes that exists in all products and services sold today and that will continue under the Governor’s plan, such as the existing amounts for income taxes, employee payroll taxes, and compliance costs, will arguably remain in the price of products and services under the FairTax, though differing in application and amounts. Those embedded taxes that will continue under both the FairTax and the Governor’s proposals include tariffs, duties, imposts, excises and tax code compliance costs, though compliance costs will be significantly reduced at the manufacturing level and even more so at the retail level due to the administrative credit.
To calculate the corporate tax embedded by the manufacturer, I first multiplied the manufacturer’s markup, $.025, by the suggested manufacturing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of 7.9% as reported by Inc.com. The product from this equation was then multiplied by the Governor’s proposed 25% corporate tax rate. The resulting manufacturer’s embedded tax consequence was then calculated as, $0.25 x 0.079 x 0.25 ≈ $0.005 (½ cent).
The same process was accomplished for retail corporate taxes. In this case, the retailer’s $0.50 markup was multiplied by the average EBITDA for retail sales, 4.5% as reported by Inc.com. This product was then multiplied by the proposed retail corporate tax of 25%. The embedded tax consequence for retail sales was calculated from this process to be, $0.50 x 0.045 x 0.25 ≈ $0.006 (again, about ½ cent). The total embedded corporate-tax consequence is calculated as, $.005 (manufacturing) + $.006 (retail) = $.011 (about 1 cent). This $.01 is included in the widget retail sale price of $1.00.
The last embedded taxes to include in this example is the employer share for both Social Security and Medicare. To determine the appropriate amount added to the widget retail price, I had to examine what actually constitutes payroll and, of that amount, what percentage may be taxed. The percentage of gross sales that payroll can consume varies widely among manufacturing, distribution, and retail businesses, sometimes amounting to 40% and more for labor-intensive operations. For this example, I again turned to the representative measures provided by Inc.com, which reflected the percent of gross sales attributable to payroll to be 15% for manufacturing and 13% for retail. However, and as eluded to earlier, payroll is not just pay distributed to the employee but, as reported by CFO.com, includes an average of 40% attributable to benefits, leaving 60% as a representative wage and salary figure. To calculate the manufacturer’s share of payroll taxes embedded in the product price, I used, $.50 (sales) x .15 (payroll) x .60 (pay vs. benefits) x .0765 (Tax) ≈ $.003 (approx. ½ cent). The retail embedded payroll tax was figured as, $1.00 (sales) x .13 (payroll) x .60 (pay vs. benefit) x .0765 (tax) ≈ $.006 (approx. ½ cent). The total payroll tax consequence is then $.01 ( 1 cent).
As can be seen on the spreadsheet, the total embedded tax used for this example was $.02 (2 cents). The embedded tax consequence to the price was then, $.02 / $1.00 = 2% (inclusive). The product price exclusive of the embedded taxes is figured as, $1.00 – $.02 = $.98. For purposes of calculating the effective tax rate under the Governor’s plan, I used the embedded tax inclusive price of $1.00. Please note that my examples are not meant to be representative of the actual aggregate of embedded taxes in the pricing of products and services, but to serve as a standard that is well within reason for application in this one, simple, comparative example.
The last steps I used to calculate the effective tax rate under the Governor’s plan began with determining how many widgets from among a pool of 50,000 could be purchased with the remaining individual net income, $44,363 (Net) / $1.00 (Price) = 44,363 widgets. Next, I determined how many of the 50,000 widgets were sacrificed to the government as calculated by, 50,000 widgets – 44,363 widgets = 5,637 widgets. The final step in this last series of computations reveals the effective tax rate, 5,637 (government’s widgets) / 50,000 (available widgets) = 11.27%.
Turning next to the FairTax, I began the simple process of inserting the applicable elements of the legislation to calculate the net income. As can be seen, this required only 2 elements, the earned income (wages, salaries and tips) and the annual rebate amount based on family composition. The net income was then calculated by adding the two inputs, $50,000 earned income + $6,960 rebate = $56,960 net income.
Next, I calculated the widget price exclusive of the embedded taxes by removing the corporate and employer payroll taxes imposed under the Governor’s plan, $1.00 – $.02 = $.98. This remainder was then multiplied by the full 30% exclusive sales tax to calculate the amount of tax assessed on the sale of each widget, $.98 x .3 ≈ $.29. This amount, plus the widget price, is defined in the FairTax legislation as the gross amount, which, in this case, is $.98 + $.29 = $1.27. This is the price then used to calculate the effective tax rate under the FairTax. Before leaving this section, I want to emphasize again that the least arguable amount of embedded taxes were used in the Governor’s example, and the removal of these from the widget price before adding the sales tax does not detract from the intended advantage to the Governor’s proposals.
To complete the last steps in the process of determining the effective tax rate under the FairTax, I first divided the net income by the gross amount to determine how many widgets could be purchased, $56,960 / $1.27 = 44,708 widgets. Next, I subtracted the amount of widgets that can be purchased using net income from the total amount of available widgets which renders the amount sacrificed to the government, 50,000 widgets – 44,708 widgets = 5,292 widgets. Lastly, the effective tax rate equals the number of widgets sacrificed divided by the total number available, 5,292 (government widgets) / 50,000 (available widgets) = 10.58%.
Governor Romney’s Tax Proposals, Effective Tax Rate: 11.27%
FairTax Effective Tax Rate: 10.58%
Governor Romney’s implication that his tax proposals will give middle-income Americans greater tax relief than that which will result from the FairTax legislation is REFUTED.
The Governor’s tax proposals in this analysis produced an effective tax rate 6.5% greater than that of the FairTax, ((11.27% – 10.58%)/10.58%) ≈ 6.5%.
Governor Romney misrepresented the FairTax vs. the current tax rate for middle income earners as evidenced by the results of this analysis which used his proposed tax rates that are lower than those of the current tax rates.
Governor Romney’s proposals would have produced a significantly greater effective tax rate had the example focused on a self-employed filer responsible for both the employer and employee share of payroll taxes.
Had the example been exclusive to services, which may include embedded taxes of 40% or more, the gap between the Governor’s plan and the FairTax would have been significantly more pronounced in favor of the FairTax.
Had the example included all the stages of product development, from a raw resource to a final product sold at retail, the embedded tax consequence would likely have been significantly greater and further widened the gap between the Governor’s tax rate and that of the lower effective tax rate identified with the FairTax.
Were we to examine the entire range of middle-income wages, we would find the Governor’s marginal tax-rate plan to impose increasingly greater taxes on individual incomes, thus expanding the gap between the Governor’s plan and the FairTax.
Had the example allocated expenditures and distributions to items under the FairTax that are excluded from the sales tax, such as education, job training, gift distributions, and investment purchases, among others, the division between the Governor’s rate and that of the FairTax would have further widened.
Governor Romney’s tax plan, with its similarity to the existing income, payroll, and corporate tax system, will likely retain the same breadth of problems, inefficiencies and ineffectiveness identified with the current system.
Lastly, the Governor’s plan, as evidenced and reasonably assumed from the first part of the chart, will unlikely achieve any of the 7 requisites identified for an effective tax system – Simple, Fair, Neutral (no impact on business decisions), Visible, Stable (requiring infrequent changes), Efficient, and Fosters Economic Growth.
Kerry D. Bowers
9 June 2012