Addressing the FairTax Critics … Again

Missourinet reports on the recent back and forth between supporters and detractors of a change in Missouri tax code. The change, proposed by House Joint Resolution 56, would eliminate the current income tax and replace it with a broad 5.11-percent sales tax. Detractors — specifically, the Missouri Budget Project — have claimed that this policy would be disastrous for businesses and consumers alike. To address some of their longstanding concerns, the Show-Me Institute recently released a study written by Dr. Joseph Haslag and I, in which we computed the necessary rate for a broad sales tax to maintain revenue neutrality after replacing the income tax. We then proceeded to demonstrate how this rate would not have the disastrous effects on standard of living and private-sector vitality that critics claim. Our arguments have yet to be fully engaged.

In Missourinet’s piece, Amy Blouin, executive director of the Missouri Budget Project, claimed:

“Childcare … that’s going to be taxed,” said Blouin. “Educational services, tutoring, private K-12 education if your kids are in a private school – a Catholic school – you’re going to pay this on those schools.”

Former Missouri Budget Director Jim Moody echoes Mrs. Blouin’s concerns and worries about the effects of the expansion of the tax base:

“That [includes] hospitals, doctors, everything in medical care,” said Moody. “So you’re going to tax, at 5.11 percent, things you’re not currently taxing – prescription drugs, medical care, hospital visits, nursing homes.”

They’re right. It’s true, all those goods and services will be taxed under the change, along with several others that have historically been exempt from taxation. Unfortunately, Blouin and Moody fail to appreciate that tax changes do not happen in a vacuum. This is a subtle point, but — as we have argued before — although the prices of these newly taxed goods would increase by the sales tax rate, several changes would simultaneously occur elsewhere in the economy to make consumers better off.

To begin with, its important to understand that a change in the tax code implies a change in incentives. People and firms alike respond to these changing incentives in many ways, including altering their supply and demand of goods and services. With that in mind, the claim that the prices on all goods and services would increase by the tax rate is misleading. In the long run, prices would increase at most by the tax rate, but this increase would be dampened by microeconomic changes.

Prices would indeed increase, but consumers would also become richer following the repeal of the income tax, and some of that reclaimed wealth would be used to protect against price increases stemming from the sales tax. Meanwhile, lower corporate and personal income taxes would create strong incentives for the inflow of people and investment funds to the state. In the long run, this translates to higher employment, higher incomes (which shield against price increases), and, ultimately, greater revenues from sales tax receipts.

In the process of presenting her case against the tax change to the state legislature, Blouin has suggested that 95 percent of Missourians would be hurt by HJR 56. It’s difficult to follow her reasoning. It is clear that 100 percent of Missourians would be affected by this policy change, but the claim that 95 percent would be hurt is unsubstantiated by the evidence. In the study I cowrote with Dr. Haslag, we presented a model that we used to compare tax burdens under both the current income tax rate and the proposed sales tax rate. We even used our own computation of the sales tax rate, 5.96 percent, which is higher than that suggested in the bill. We found that the break-even point was $60,000. At this income level, the burden under both tax systems was comparable. Because only 28 percent of Missouri tax filers in 2008 earned incomes higher than $60,000, the 95-percent figure that Blouin cites seems highly suspect. Hopefully, she will clarify her arguments and engage our own.