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October 14, 2008
A FairTax Primer: Part 2
Filed in: Current Affairs, Politics, Tax Policy

Part 1

In the last 12 days since I started this, we have seen continued intervention by the government in the markets coupled with the largest market declines in history. And while I agree that correlation is not causality, it is instructive to take rhetorical consideration:

If, instead of injecting massive liquidity - the Fed and Treasury perhaps committing in the last few months as much as an entire year of federal tax revenues - had the Congress somehow become possessed with the imponderable temerity to act with correctness and passed the FairTax legislation - i.e. abolished the progressive income tax, payroll tax, capital gains tax, death tax - all federal taxes, and replaced them with a voluntary consumption tax, would the markets have behaved any differently?

Let's see, instead of encouraging a debtor nation - encourage a saving nation, instead of banishing tax haven capital, encourage the trillions and trillions of ex-pat offshore dollars to come home, instead of motivating businesses to export jobs out of the country with the backbreaking tax code, encouraging them to employ in country, and instead of making our products too costly for overseas consumption, making it possible to export competitively again - just to name a few benefits that would result.

Do you think the markets might find such news favorable?

Even if you take the point of view that enacting the FairTax legislation might not meet expectations, is it not reasonable to assume that any miscalculation about its implementation would pale in comparison to the various bailout, finger-in-the-dike, activities that we've observed recently?

Can it be more clear that economic stimulus, not intervention, is the direction to take? Will we shuffle along for years before we collectively realize it? Or will our markets crash in short order under the pall of interventionist action?

Let me move to the key issue for this post which I referred to obliquely in Part 1: Compliance.

(For backup and references to what I assert here - unless I confess that it's my own idea - please read the books).

Compliance with the federal tax code is a part of the embedded cost of the goods and services that we all consume. Economists that have attempted to analyze these costs have estimated that individuals and businesses spend somewhere between $300 billion and $500 billion annually to comply with the tax code. Yes, that's $300 billion to $500 billion.

Comprising some 67,000+ pages, and featuring some 16,000+ changes in the last twenty years, the tax code is so complicated that a recent study demonstrated that if you contact the IRS with a question, you are guaranteed to get a wrong answer about 60% of the time.

Candidates and pundits regularly throw around ideas about tax cuts and acts of stimulus for the economy. How many of them would result in a cost reduction to the economy of $3 trillion to $5 trillion over ten years? No? That's what removing compliance with the tax code would deliver.

What kind of stimulus would that kind of capital injection make in our economy?

It's pretty obvious: enacting the FairTax legislation is justifiable for this reason alone.

Let me offer some of my own ideas as well. I'm not a spokesperson for the FairTax organization - I'm just a citizen volunteer. I just happen to think the the FairTax legislation is the only currently available mechanism to reverse the financial decline that we find ourselves in.

So here's my opinion on this matter: I think that the estimate of compliance costs is wrong. I don't know how much wrong, but I think it may be huge. The estimates are far too low.

Why? A couple of reasons: 1) Sarbanes-Oxley, 2) Efficiency costs - the intangible cost of the tax code.

Sarbanes-Oxley was designed to prevent the sort of corporate corruption exemplified by the likes of Enron and Worldcomm - so preventing public entities from defrauding the public (which, of course, begs the question, How could Fannie and Freddie have happened in the age of SarbOx? It's something like, "if guns are banned only criminals will have guns" I suppose). The result has been that compliance costs for public companies has soared. But that's hardly the story. The real story of SarbOx as it relates to business is that it has trickled down to small business.

You might wonder how that is possible. Here's how: the entire accounting industry has been pressed into a kind of hostage situation - part of the SarbOx regulations have to do with holding the public accounting industry to public company reporting standards. The threat is, that if a public accountant puts signature to incorrect reporting - their license to practice can be revoked. The practical application of this, is that the public accounting industry has therefore applied public company standards across the board - including the small businesses for which they practice. In terms of their work product, there is very little difference today between a compiled financial statement (which most small businesses employ) and an audited one (which public companies are required to file). A compiled financial statement is the representation of the principals of the business - and since there are typically no securities involved there are really no shareholder issues of importance, and there's no legerdemain involved in demonstrating the financial activities of a small business with a single checking account. An audited financial statement is certified by the public accountant which means they have examined pretty much every aspect of the financial matters of a firm so that they can, with reasonable certainty, certify the state of a business firm. The sad result of SarbOx for small business is that the former method of producing a financial statement has now become pretty close to the latter - and that includes the cost.

I know these things first hand. My cost of compliance with the tax code and the trickle down of SarbOx on my small business - which has caused my accountant to spend increasing, fear based billing time to do a compiled statement for my firm - has increased by over 500% in the last ten years. You read that correctly.

The US Small Business Administration determined in 2004 that small employers (less than 20 employees) had an average compliance cost of more than $1,300 per employee. Small businesses pay significantly more in compliance costs on average than they pay in actual taxes. The 'average' business taxpayer pays about $500 less per employee than small business and fairly large corporations pay only a small fraction of their tax burden in compliance costs (because they pay significantly more taxes).

So tax compliance costs are another regressive tax - small businesses are hit far harder than larger businesses by the cost of complying with the tax code.

Finally, the efficiency impact - though somewhat intangible - I believe is much larger than the compliance costs of the tax code. What's this efficiency impact?  It is the fundamental distortion of business strategy and behavior because of the impact of the tax code. I've often joked over the years that after running my company for a decade I was no longer able to do much useful work because I spent most of my time with attorneys and accountants. Unfortunately, that is largely true. It is almost unimaginable how much time is spent - by small businesses and large businesses - contemplating the tax impact of choosing which things to consume and which things to invest in, how to recognize revenues, and prepare to defend such recognition, contemplate the hundreds of changes to the tax code that happen each year and make a determination how that might affect the behavior of the company. Modify operational activities in terms of time billing, expense management and reporting, etc., etc., etc.

In 2005, the Government Accountability Office (GAO) estimated that this business efficiency cost was somewhere between 2 and 5% of the GDP! That's somewhere between $250 billion to $700 billion in annual cost.

There are a number of critics of the FairTax - mostly they seem to attack the determination of what the embedded federal tax should be - and whether is should be quoted as embedded or not.

But, there is really no argument against the elimination of these compliance costs if we remove the tax system that is responsible for them. A reasonable case can be made that the annual cost of compliance is nearly half of the annual tax revenue.

Can we consider our society financially viable if we continue to live with such a dysfunctional system?


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