Estate Tax Compromise?

You always knew that the Bush plan for the estate tax couldn't possibly be allowed to happen: it first called for estate tax to fall a little, bit by bit, with the exemption raised bit by bit, over a decade, until it got down to 45% in 2009, with a $3.5 million exemption, where it in fact is now. Then it's supposed then to be zero in 2010. Not just lower, not just a higher exemption, but zero, nada, no estate tax at all. But only for people who die in 2010! Then it's supposed to snap back to the old rate of 55% with a $1 million exemption for anyone who dies after that.

Talk about your death panels! The Bush estate tax plan has wealthy parents hiring bodyguards and cancelling plans to invite their kids over for the holidays next year.

Just kidding -- I hope -- but it's certainly true that the plan creates the most perverse economic incentive ever. If your parents are wealthy (and are leaving their money to you), then if they die in 2010, you keep it all, but if they live one extra day, it could cost you millions.

Anyway, that's why I've been saying all along that the estate tax will never go to zero, but neither will it ever snap back to the old rates, which were too high. And now the House has voted to keep the 2009 rates on a permanent basis. Personally, I thought the best answer was a lower exemption and a rate of about 30%, but I'll live with the House proposal -- and hopefully, my parents can now keep living too!

More on "Fair Tax"

One of the comments on yesterday's entry made a good point (actually, several good points but I'm just going to highlight one of them).

The comment by Kipesquire points out that the claim by Fair Tax proponents that the Fair Tax would impose a federal sales tax of 23% is somewhat misleading. To their credit, the Fair Tax people at least acknowledge this point on their website (they don't acknowledge the regressivity point anywhere that I can see). Under the Fair Tax, if you spent $1 at a store, 23 cents of that dollar would be paid by the store to the federal government as tax. This is the basis for the Fair Tax people's statement that the Fair Tax rate would be 23%.

But as even they acknowledge, sales taxes are usually quoted on a "tax exclusive" basis; that is, they are quoted as a percentage of the cost of the underlying goods, not as a percentage of a price that includes the tax itself. What's really happening in this example is that you are spending 77 cents on some item and paying 23 cents in tax on that item. If you went to a store today and bought a 77-cent item and paid 23 cents in tax, we would normally say that the tax rate is 23/77 = 30%, not 23/100 = 23%. So it would be more straightforward (although less politically appealing) to present the "Fair Tax" as a 30% sales tax.

So when I said yesterday that my hypothetical couple Alice and Bob earned $100,000, saved $10,000, spent $90,000, and paid 23% of $90,000, or $20,700 in taxes, it's important to realize that the $20,700 is part of the $90,000 they spent. They got $69,300 worth of goods and paid $20,700 in taxes on those goods. On the more normal "tax exclusive" basis, one would say they paid a tax of $20,700/$69,300 = 29.87%. After their $6,297 rebate, their tax would be 20.78% of their spending. The richer C&D paid 29.70% of their spending (after rebate), and the even richer E&F paid 29.83% (after rebate).

Thus, under the Fair Tax, one's tax, quoted on a "tax exclusive" basis, would asymptotically approach 30% of one's spending, the more one spent.

But yesterday's main point was that it's extremely misleading to call a tax "progressive" when the rich would in all likelihood pay less of it as a percentage of their incomes. As noted yesterday, rich people can save a much higher percentage of their incomes than middle-class people. (Indeed, my hypothetical Alice and Bob's ability to save 10% of their $100,000 income while raising two kids is prodigious, given that real Americans often save less than nothing.) Because the "Fair Tax" would tax only spending, not savings (and it also taxes only consumer spending, not spending that represents business investment), rich people, as shown yesterday, could easily pay a lower percentage of their incomes in tax than middle-class people, thus piling up savings on which they could earn even more income on which to pay an even lower tax rate. I just can't trust people who fail to acknowledge this basic point.

The "Fair" Tax

Republican Presidential candidate Mike Huckabee recently endorsed the "Fair Tax." The "Fair Tax," which you can read in detail about here, is a proposal to repeal federal income tax, payroll tax, estate tax, and a bunch of other taxes, and replace them all with a 23% federal sales tax. The IRS could be abolished, and people would pay taxes only on what they spend, not on what they save.

Everyone would also get a "prebate" of the tax equal to the amount of tax that a poverty-level household would pay. The prebate is determined solely by household size, not by income -- for example, every married couple with two children would get an annual prebate of $6,297. The alleged advantage of the prebate is that it would, supposedly, make the Fair Tax progressive -- poor people would pay hardly anything, and middle-class people would pay a lower percentage of their spending in tax than rich people.

I'm not really expert enough to evaluate the Fair Tax in all its detail, but I can tell you one thing: the whole concept is based on a big, fat lie. The Fair Tax website prominently states and many times repeats that the Fair Tax is "progressive." Nonsense.

The website makes this claim because, under the Fair Tax, the wealthier you are, the more tax you would pay, when the tax is considered as a percentage of your spending. But they hide the fact that they wealthier would be likely to pay less when the tax is considered as a percentage of income.

The wealthy generally spend less of their income than the poor or middle class, and the Fair Tax taxes only spending, not saving. Therefore, under the Fair Tax, the wealthy would likely pay less tax as a percentage of income. Maybe a lot less.

Let's do an example. Alice and Bob are a two-earner couple with two children. Between them, they make $100,000 per year. Because raising kids is expensive, they have to spend most of their income. Let's imagine they manage to save $10,000 and spend $90,000. They pay 23% x $90,000 = $20,700 in tax. After their rebate of $6,297, their net tax is $14,403. That's 16.00% of their spending, and it's 14.40% of their income.

Now, Carol and David are also married with two kids, but Carol is a partner at an investment bank and makes $10,000,000 per year. David doesn't work. Living rich is expensive, but they've got so much money they manage to save $5,000,000 of their income and they spend $5,000,000 (I could live pretty well spending $5,000,000 per year, couldn't you?). They pay a tax of 23% x $5,000,000 = $1,150,000. The get the same $6,297 rebate (a trivial sum for them), after which their net tax is $1,143,703.

Now, the Fair Tax people want you to focus on how much tax Carol and David pay as a percentage of their spending. And yes, as a percentage of spending, Carol and David pay 22.87% -- notably higher than Alice and Bob. But look at their tax as a percentage of income. Because they can save half their income, Carol and David's tax is just 11.44% of their income! That's substantially lower than Alice and Bob's tax as a percentage of income.

And if Ellen and Frank, another married couple with two kids, are super-rich, make $100,000,000, and spend $25,000,000 (saving $75,000,000), they'd pay 23% x $25,000,000 = $5,750,000 in tax, or $5,743,703 after their rebate. That's 22.97% of their spending but just 5.74% of their income!

So it seems to me that the "Fair Tax" is likely to be highly regressive. The Fair Tax website touts the tax as progressive many times based on tax paid as a percent of spending. But I don't see a word about tax paid as a percent of income.

In my opinion, that's fundamentally dishonest. It causes me to distrust the whole website. When people are promoting a highly regressive tax as progressive, I would say, stop right there. The whole thing is immediately suspect.