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Ok, there’s another assumption being made by many of the less experienced or knowledgeable proponents of the so called “Fair Tax”. That is that, freed of the onerous burden of the Federal corporate income tax, the corporations who are in competitive markets would all then reduce the prices of their products by an amount sufficient to balance the new cost added by the national sales tax. Let’s take a look at a hypothetical, to see just how incorrect this assumption is.
We’re going to start with a privately held corporation, run by yours truly (this is a hypothetical, remember, and if I have to imagine it, at least I can imagine a company with me as the big boss[1]). Let’s suppose that my company, which I will with typical modesty, call “Shapero Systems Incorporated” – hey, remember, I said this was a hypothetical). We sell Widget X, and that’s our only real product right now. Each unit of Widget X costs us $100 to produce and ship to our retail stores (yes, we’re a vertically integrated corporation). That $100 covers the cost of materials, manufacture, maintenance and depreciation of plant facilities, office space, advertising and salaries of employees – the works. We produce 1 million units a year, and we sell every unit we make. We have four hundred employees, and we’re incorporated in Delaware[2]. The market for Widget X is, however, extremely competitive, and while we are able to sell every unit we make, every penny counts so if I can cut the price without hurting profits, I will.
Over the last few years, We’ve been selling Widget X for $110 per unit in our retail stores. This is a hefty 10% profit after expenses. But, of course, there’s the Federal government taking its cut of our profits – and let’s say that for one reason or another, SSI has to pay a 30% corporate tax on all profits. Note: This is a tax on profits not on gross income. SSI’s gross income from sales is $110 million, but our profit after expenses is only $10 million (making us, to be honest, a solid mid-size business – we’re not a Mom & Pop, but we are not another Microsoft or a Boeing by a long shot). The Fed charges us 30% of that $10 million, or $3 million in taxes – which, of course, we pay without any serious complaint.
Now, suppose the Fed changes the rules and says, “you no longer need to pay corporate income tax”. I jump for joy, and immediately call up our head of sales and tell him, “We are cutting the price on our Widget X’s by $3 per unit immediately! Make it so!” Ok, the consumer in one of our stores sees the announcement that afternoon, and all the units are now selling at $107 per unit instead of $110.
Now does the consumer get to buy a unit for $107, saving himself not 30% on the price but rather only ~2.73%? No. Because along with the same announcement that the Fed is no longer collecting income tax from the corporation, is the announcement that they will now be collecting a 30% sales tax on all retail sales and services. So our stores now have to charge 30% sales tax and add it to that $107 base price. Widget X now sells for $139.10, including tax. So while I, the sole owner of the privately held SSI company have lowered my price as much as I can without lowering the net profit, the price that the retail buyer pays at the register has gone from $110 (assuming we’re selling in a state with no sales tax) to $139.10, an increase in cost to him of $29.10, or roughly a 26.45% increase in cost.
Now, you say, it won’t mean that because everyone will get a cut in their personal income taxes, so they’ll have more money to spend. Well, let us assume for the moment that I am a really nice guy, and all the employees of SSI are going to get the same rate of pay after the changeover as they did before the Fed dropped income taxes. Say that each of those employees is making the same kind of money that I make now as a consultant (so that I can use the same basic numbers). They no longer have to pay Federal income tax, so they end up not paying the 13.8% total rate on their Federal income tax any more. Their income, instead of being 86.2% of salary is now 100% of salary (modulo other taxes). But they just live on Widget X’s – that’s nearly their sole expenditure (I said this was a hypothetical, remember). Before, if they wanted to buy lots of Widget X’s – say spending 50% of their salary on Widget X’s, they could buy what 43.1% of their salary would buy in Widget X’s at the retail level (we’re assuming a state with no local sales tax for the moment, as well). Now, without that Federal income tax, they are able to buy what 50% of their salary will buy in Widget X’s. But wait a moment – each Widget X now costs 26.45% more at the retail level than it did before. What’s the result? If Y is the number of Widget X’s that an employee could buy before the “great change”, then Y*(50/43.1)*(1/1.2645) = 0.9174 * Y is the number of Widget X’s that an employee can buy after the “great change”.
So even assuming that their salaries are not reduced by this, the 30% “Fair Tax” would represent an immediate loss of roughly 8.26% in the purchasing power of their time. What does this mean? It means that it costs them 9% longer to earn the dollars (1/1.0826) to earn a Widget X than they did before the change. There’s been an automatic 8.26% inflation in a single day.
And if you think I’m being conservative by producing a hypothetical with a 10% gross profit before taxes – if you think that major corporations have larger profit margins – then I’m afraid that you are wrong. Retail furniture stores typically have net profit before income taxes in the 3-4% of sales range. The median of Fortune 500 companies is 3.1% profit (based on income). Granted, there are companies with higher than these numbers – drug companies fall closer to the 17% net profit based on sales, but a 10% gross profit before taxes would be a quite healthy company. And since the Fed taxes based on profit, not on just gross sales, this represents a company for which the cut in Federal taxes would produce the greatest incentive to cut prices (hence the least effect on the consumer of the national sales tax).
And these calculations, simple though they are, are the very calculations that the proponents of the “Fair Tax” either cannot perform, or do not want their readers and listeners to perform, lest the Potemkin village nature of their claims become obvious.
Footnotes
[1] “A man’s reach must exceed his grasp, or what’s a heaven for?” – Milton.
[2] A state with very favorable business and corporation related law, to my understanding.
We’re going to start with a privately held corporation, run by yours truly (this is a hypothetical, remember, and if I have to imagine it, at least I can imagine a company with me as the big boss[1]). Let’s suppose that my company, which I will with typical modesty, call “Shapero Systems Incorporated” – hey, remember, I said this was a hypothetical). We sell Widget X, and that’s our only real product right now. Each unit of Widget X costs us $100 to produce and ship to our retail stores (yes, we’re a vertically integrated corporation). That $100 covers the cost of materials, manufacture, maintenance and depreciation of plant facilities, office space, advertising and salaries of employees – the works. We produce 1 million units a year, and we sell every unit we make. We have four hundred employees, and we’re incorporated in Delaware[2]. The market for Widget X is, however, extremely competitive, and while we are able to sell every unit we make, every penny counts so if I can cut the price without hurting profits, I will.
Over the last few years, We’ve been selling Widget X for $110 per unit in our retail stores. This is a hefty 10% profit after expenses. But, of course, there’s the Federal government taking its cut of our profits – and let’s say that for one reason or another, SSI has to pay a 30% corporate tax on all profits. Note: This is a tax on profits not on gross income. SSI’s gross income from sales is $110 million, but our profit after expenses is only $10 million (making us, to be honest, a solid mid-size business – we’re not a Mom & Pop, but we are not another Microsoft or a Boeing by a long shot). The Fed charges us 30% of that $10 million, or $3 million in taxes – which, of course, we pay without any serious complaint.
Now, suppose the Fed changes the rules and says, “you no longer need to pay corporate income tax”. I jump for joy, and immediately call up our head of sales and tell him, “We are cutting the price on our Widget X’s by $3 per unit immediately! Make it so!” Ok, the consumer in one of our stores sees the announcement that afternoon, and all the units are now selling at $107 per unit instead of $110.
Now does the consumer get to buy a unit for $107, saving himself not 30% on the price but rather only ~2.73%? No. Because along with the same announcement that the Fed is no longer collecting income tax from the corporation, is the announcement that they will now be collecting a 30% sales tax on all retail sales and services. So our stores now have to charge 30% sales tax and add it to that $107 base price. Widget X now sells for $139.10, including tax. So while I, the sole owner of the privately held SSI company have lowered my price as much as I can without lowering the net profit, the price that the retail buyer pays at the register has gone from $110 (assuming we’re selling in a state with no sales tax) to $139.10, an increase in cost to him of $29.10, or roughly a 26.45% increase in cost.
Now, you say, it won’t mean that because everyone will get a cut in their personal income taxes, so they’ll have more money to spend. Well, let us assume for the moment that I am a really nice guy, and all the employees of SSI are going to get the same rate of pay after the changeover as they did before the Fed dropped income taxes. Say that each of those employees is making the same kind of money that I make now as a consultant (so that I can use the same basic numbers). They no longer have to pay Federal income tax, so they end up not paying the 13.8% total rate on their Federal income tax any more. Their income, instead of being 86.2% of salary is now 100% of salary (modulo other taxes). But they just live on Widget X’s – that’s nearly their sole expenditure (I said this was a hypothetical, remember). Before, if they wanted to buy lots of Widget X’s – say spending 50% of their salary on Widget X’s, they could buy what 43.1% of their salary would buy in Widget X’s at the retail level (we’re assuming a state with no local sales tax for the moment, as well). Now, without that Federal income tax, they are able to buy what 50% of their salary will buy in Widget X’s. But wait a moment – each Widget X now costs 26.45% more at the retail level than it did before. What’s the result? If Y is the number of Widget X’s that an employee could buy before the “great change”, then Y*(50/43.1)*(1/1.2645) = 0.9174 * Y is the number of Widget X’s that an employee can buy after the “great change”.
So even assuming that their salaries are not reduced by this, the 30% “Fair Tax” would represent an immediate loss of roughly 8.26% in the purchasing power of their time. What does this mean? It means that it costs them 9% longer to earn the dollars (1/1.0826) to earn a Widget X than they did before the change. There’s been an automatic 8.26% inflation in a single day.
And if you think I’m being conservative by producing a hypothetical with a 10% gross profit before taxes – if you think that major corporations have larger profit margins – then I’m afraid that you are wrong. Retail furniture stores typically have net profit before income taxes in the 3-4% of sales range. The median of Fortune 500 companies is 3.1% profit (based on income). Granted, there are companies with higher than these numbers – drug companies fall closer to the 17% net profit based on sales, but a 10% gross profit before taxes would be a quite healthy company. And since the Fed taxes based on profit, not on just gross sales, this represents a company for which the cut in Federal taxes would produce the greatest incentive to cut prices (hence the least effect on the consumer of the national sales tax).
And these calculations, simple though they are, are the very calculations that the proponents of the “Fair Tax” either cannot perform, or do not want their readers and listeners to perform, lest the Potemkin village nature of their claims become obvious.
Footnotes
[1] “A man’s reach must exceed his grasp, or what’s a heaven for?” – Milton.
[2] A state with very favorable business and corporation related law, to my understanding.
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