The Fair Tax Will Hurt The States

June 17th, 2008 · No Comments · Subscribe to this feed

Before the Fair Tax advocates attack me as being uninformed, first let me tell you I am actually for the Fair Tax, or at least some form of consumption tax instead of the current income tax system. Unfortunately, the Fair Tax proposal in its current incarnation has a few serious flaws, some of them unintentionally insideous that could have grave consequences for our nation. Sadly, nobody seems to be talking about the inner workings of the tax proposal. Rather, they focus on ideological issues such as “consumptions taxes favor the rich” and “no it doesn’t, it encourages savings and income taxes discourage work.” I don’t particularly care who it favors so much as whether or not it will work without unpleasant unintended consequences.

The Fair Tax Shifts Responsibility From The Federal Government To The States

In my mind, the biggest argument against the Fair Tax is that it shifts a heavy burden from the federal government to the states. Fair Tax advocates often claim the tax is revenue-neutral. I agree: to the Federal government. Unfortunately, one of the mechanisms it uses to accomplish this is to shift many expenses to state governments while keeping all the revenue for itself. What results is a net loss in tax revenue for society. The way it does this isn’t obvious at first, but is entirely logical once you think about it: municipal bonds.

Municipal Bonds

There are approximately $1.7 trillion worth of municipal bonds outstanding, which is a huge market by any standards. Muni bonds are a major way that states and local governments finance public works such as bridges, roads, water systems, and the like. Just like anybody else wanting to borrow money, local governments are at the mercy of interest rates. The lower the interest rate, the more they can afford to borrow. Municipalities are greatly helped in this regard due to the fact that municipal bonds are exempt from federal income tax. Since investors don’t have to pay tax on the interest received, they are willing to accept a lower yield in return. This is a significant advantage. To make a casual comparison, the Vanguard Intermediate-Term Muni Bond (VWITX) fund currently yields 3.55% while their taxable Intermediate-Term Bond fund (VBIIX) yields 4.82%, a margin of 1.27%. While not a perfect comparison since the average duration, maturity, and risk profile of these two funds doesn’t match up perfectly, it does mean that local governments get a significant discount when borrowing money compared to what they would have to pay otherwise thanks to the tax-free status of their interest payments. Applied to the $1.7 trillion size of the municipal bond market, we can see the Federal Government is subsidizing state and local governments to the tune of approximately $20 billion per year thanks to their generosity in not taxing their interest payments. That isn’t chump change and will have to be made up for in some other way if the Fair Tax were implemented. Since there is no income tax, municipal bond yields would rise and taxable bond yields would fall until they reached equilibrium. Either way, the shortfall wouldn’t simply disappear. If the Federal Government stopped paying for state and local projects, the money would be raised somewhere else, probably in a way nobody could have anticipated ahead of time. Perhaps property taxes would go up or maybe even state income taxes. Either way, it’s something to think about.

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