Simulating the dynamic macroeconomic and microeconomic effects of the FairTax.

INTRODUCTION

This paper uses a life-cycle general equilibrium model developed in Fehr, Halder, Jokisch, and Kotlikoff (2003), Fehr, Jokisch, and Kotlikoff (2004a, 2004b, 2005a, 2005b) and Jokisch (2006) to study the dynamic macroeconomic and microeconomic effects of replacing all federal taxes with a progressive, broad-based consumption tax, namely the FairTax. The FairTax combines a federal retail sales tax, levied at a single rate, with a rebate the size of which depends on the household's characteristics. Businesses would be exempt from the FairTax on their purchases, since such purchases do not represent consumption. The FairTax also increases Social Security benefits to maintain their real purchasing power. Finally, the FairTax reduces non-Social Security federal expenditures to help pay for its introduction of a major new transfer (equivalently, tax expenditure), namely the FairTax rebate.

As specified in HR25, the legislation that would implement the FairTax, the FairTax would be levied at a 30 percent nominal rate and a 23 percent effective rate. The nominal rate refers to the rate one would pay at the store in purchasing a good or service. To see the relationship between the nominal and effective rates, consider spending one dollar at a retail store. With a 30 percent sales tax rate, one ends up with only 77 cents in actual consumption, since 23 cents (which is 30 percent of 77 cents) goes to taxes. So paying a 30 percent retail sales tax when one spends one's income or wealth is the same as facing no retail sales tax, but having one's income and wealth reduced by 23 percent.

Households finance current and future consumption with their current wealth and their current and future labor earnings. Taxing consumption expenditures is, thus, effectively equivalent to taxing what is used to pay for consumption, namely existing wealth as well as today's and tomorrow's labor income. In the case of the FairTax, every dollar of existing wealth as well as every dollar of current and future earnings would be effectively taxed at a 23 percent rate.

Under the current U.S. federal tax system, total effective marginal tax rates on labor supply are higher than 23 percent for almost all American households. Indeed, as shown in Kotlikoff and Rapson (2005), typical middle-aged and middle-income earners face total effective federal marginal tax rates on working of roughly 30 percent. For these and most other households, the FairTax would dramatically improve labor supply incentives.

Since the FairTax taxes consumption at the same rate no matter when it occurs, it imparts no incentive to consume now as opposed to later and, thus, no disincentive to save. In economic terms, the FairTax's marginal effective tax rate on saving is zero. In contrast, the existing federal tax system imposes very high marginal effective tax rates on saving. This point is also documented in Kotlikoff and Rapson (2005), who report marginal taxes on saving for stylized households ranging from 20 percent to 54 percent.

In addition to imposing, in almost all cases, much lower marginal taxes on working and, in all cases, dramatically lower marginal taxes on saving, the FairTax imposes lower average taxes on low- and middle-income working households than does the current system. It does so, in part, by broadening the tax base from what is now primarily labor income to the sum of labor income and current wealth and, in part, by reducing non-Social Security real federal expenditures to help pay for the FairTax rebate. In particular, the reform implies a real reduction in federal purchases of goods and services, which many Americans may view as desirable. In this regard, it should be noted that federal purchases of goods and services, measured as a share of GDP, have risen by over one-fifth since 2000.

Would switching to the FairTax enhance or undermine progressivity? The implicit taxation of wealth under the FairTax is certainly a highly progressive element of the proposed reform. So too is the elimination of the highly regressive payroll (Federal Insurance Contributions Act, or FICA) tax and the implementation of the FairTax's highly progressive rebate. On the other hand, the personal income tax is progressive, albeit less progressive than many seem to believe (see Gokhale, Kotlikoff, and Sluchynsky (2002)). Understanding the FairTax's net impact on progressivity is one of this study's goals. What about the FairTax's treatment of the elderly? Well, HR25 would increase Social Security benefits by 30 percent to maintain the purchasing power of those transfer payments. In addition, it provides the rebate to all American households, including the elderly. In so doing, it overcompensates the poor elderly who live either entirely or primarily off of Social Security; i.e., the poor elderly receive the rebate even though the purchasing power of their Social Security benefits remains unchanged.

In contrast to the poor elderly, the middle class and rich elderly finance much or most of their consumption from their accumulated wealth. The purchasing power of this wealth is reduced by the FairTax. Hence, the FairTax imposes a higher fiscal burden on the middle-class elderly and the rich elderly than does the existing tax structure. In the life-cycle model, the elderly have a higher propensity to consume out of their remaining lifetime resources than do young and certainly future generations. Hence, shifting the burden of taxation from young and future generations to initial older generations reduces aggregate private consumption and increases national investment. Increased investment means, in turn, more capital per worker and, thus, higher labor productivity and real wages.

A key question about the FairTax is its real revenue neutral rate, i.e., the rate needed to preserve real spending by both federal and state governments. Gale (2005) suggests that the FairTax's proposed 23 percent effective (tax inclusive) rate would fall significantly short of achieving real revenue neutrality. Bachman, Haughton, Kotlikoff, Sanchez-Penalver, and Tuerck (2006) conclude the opposite. Although we find Bachman et al. (2006) persuasive, our highly stylized model is not the U.S. economy. Sustaining a 23 percent rate in our model requires an 18 percent cut in federal discretionary spending as a share of national income. Alternatively, maintaining real discretionary spending levels in switching to the FairTax requires a 26 percent effective rate. Since the FairTax proposal specifies a 23 percent effective rate and no cuts in discretionary spending, we simulate two alternative policies. The first is implementing the FairTax at a 23 percent rate, but cutting discretionary spending by 18 percent. The second is maintaining discretionary spending as a share of national income, but implementing the FairTax at a 26 percent effective rate.

The two alternative simulations yield very similar results. Relative to maintaining the current pay-as-you-go policy of financing entitlements, either manner of switching to the FairTax will precipitate a very major increase in the U.S. capital stock and real wages over the course of the century, prevent what would otherwise be a doubling to the highly regressive payroll tax, and effect very major welfare gains, particularly for the poorest current and future members of society. Indeed, once one moves to generations postdating the baby boomers, there are positive welfare gains for all income groups in each cohort.

Take, for example, the policy of shifting to a 23 percent FairTax rate and cutting the scale of discretionary real spending by 18 percent. This policy raises marginal labor productivity and real wages, over the course of the century, by 25.0 percent and long-run output by 16.1 percent. It also reduces by half the long-run increase in the effective rate of wage taxation needed to pay the Social Security and healthcare benefits of an aged country. These macroeconomic gains have important microeconomic welfare implications. In the long run, low-income households experience a 26.3 percent welfare gain, middle-income households experience a 12.4 percent welfare gain, and high-income households experience a 5.0 percent welfare gain. This is a very progressive long-run outcome. But progressivity marks the entire transition. Low-income households who are initially alive at the time of the reform, whether they are young, middle age, or old, all experience welfare gains ranging from 4.7 percent to over 20 percent. Who pays for these substantial welfare gains? The answer is hardly anyone. The initial rich elderly and middle aged as well as some middle-age middle-income households are made worse off, but their welfare losses are quite small compared to the welfare gains experienced by the current poor and future generations. One reason the FairTax offers such significant welfare improvements for winners and such small losses for losers is that it significantly improves economic incentives, particularly the incentive to save, and, thereby, reduces economic distortions, i.e., excess burden.