Special Studies, February 28, 2008

Robert D. Dietz, Ph.D.

Report available to the public as a courtesy of HousingEconomics.com

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In recent years, increasing numbers of tax policymakers and analysts have called upon Congress to undertake fundamental tax reform. The motivations behind these calls include the growing complexity and compliance costs associated with the current tax code, the number of expiring tax provisions, the expanding reach of the Alternative Minimum Tax, the increased awareness of the connection between tax policy and economic growth, and the long-term national budget challenges associated with entitlement programs such as Social Security and Medicare.

Economists have developed a number of options for fundamental tax reform that may be considered in any potential tax reform effort. These include the flat tax, the value-added tax, the Bradford X-tax, and the President’s 2005 Tax Reform proposal. Another option, and the subject of this article, is a national retail sales tax (NRST), as proposed in H.R. 25, the “Fair Tax Act of 2007,” which was introduced by Georgia Congressman John Linder and is championed by political talk show host Neal Boortz and economists such as Laurence Kotlikoff.

Fundamental tax reform efforts offer possibilities and dangers to the economy as a whole, as well as to specific sectors of the economy, including home building. This article examines the FairTax proposal, its rules concerning housing, and estimated economic impacts on homeowners and home builders. It finds that replacing the present-law income tax with a national retail sales tax, like the FairTax, while increasing economic growth, would have negative economic effects on home building and housing.

The Fair Tax

A NRST offers a dramatic change in tax policy with respect to the existing income tax. Under the FairTax, as defined by H.R. 25, almost all existing federal taxes would be repealed, including individual and corporate income taxes, the Alternative Minimum Taxes, payroll taxes for Social Security and Medicare and estate and gift taxes. Only excise taxes on products such as alcohol and tobacco would remain in place. The Internal Revenue Service would be effectively eliminated over a three-year period, although new or existing government agencies would be required to collect excise taxes, distribute the FairTax “prebate,” and monitor sales tax compliance.

To replace the federal tax revenue lost by the elimination of these taxes, H.R. 25 establishes a 23% sales tax rate for all sales or exchanges of new goods. Proponents of H.R. 25 claim that this rate is sufficient to achieve revenue neutrality with no cuts in government spending. To produce a progressive system of taxation, the FairTax would establish a “prebate” or “demogrant.”  The prebate is an amount of money payable to households from the government each year. The amount represents a rebate for a certain amount of sales tax to be paid during the year. In effect, the prebate defines the sales tax equivalent of a 0% income tax bracket, for which a certain amount of consumption (or income for an income tax) would not be subject to tax. For an income tax, the larger the zero-bracket, the more progressive the tax is. The same principle applies to the FairTax. The FairTax’s prebate is equal to the 23% rate times the applicable poverty rate income level, adjusted for certain family composition variables. For 2007, the poverty rate for a single person is $10,210. Thus, the prebate for this individual would equal approximately $2,350 per year. A married couple would receive a prebate of about $4,700.

The 23% rate cited in H.R. 25 is subject to some confusion. The statutory rate cited in the legislation is the “tax-inclusive” rate. When most people think of a sales tax, they think in terms of the “tax-exclusive” rate; that is, the tax rate is assessed against the retail price, with the retail price plus the sales tax yielding the final after-tax price. The FairTax rate of 23% is a tax-inclusive rate, meaning that 23% of the final after-tax price is tax and the tax-exclusive rate is equal to 29.87%. [1] 

With the rate specified, the next important issue is the definition of the tax base. H.R. 25 would in general tax all sales transactions from a business to an individual. Individual to individual sales would be exempt. Note that this would exclude sales of existing homes. Sales from an individual to a business, such as labor, would generally be exempt from tax. Investment and payments to capital would be exempt. By not taxing investment and productive business activities, a national retail sales tax encourages economic growth.

FairTax Policies Concerning Housing and Home Building

However there are specific policy elements of H.R. 25 that would be harmful to housing. Under H.R. 25, all new home sales would be taxable. H.R. 25 taxes all sales from a business to an individual, thus new home sales are part of the tax base. Note that this would include home improvements and remodeling services as well. In this regard, the FairTax treats housing like a durable good and not as an investment.

Other types of services would also be subject to the FairTax. For multifamily rental property, all rental payments made by tenants to property owners would be subject to the sales tax. While it is true that such payments would be made from the tenant’s now untaxed income, the relative price of housing costs (whether mortgage payments or rental payments) would be higher relative to other purchases or investments, such as stocks, and this would reduce the overall demand for housing and housing improvements.

Another service that would be subject to the FairTax under H.R. 25 would be financial intermediation, or the service provided by a bank or other financial institution in making a loan, which is a business to individual transaction. The proposed legislation requires that a portion of interest payments on all loans (except student loans) that possess an interest rate above a benchmark interest rate (most likely the 10-year Treasury bond interest rate) would be subject to sales tax. [2] The proportion would be equal to the proportion of the interest rate in excess of the benchmark interest rate.

For example, suppose the 10-year Treasury bond interest rate is 5%. If a home buyer obtains a 7% mortgage, then 2/7 (the portion of interest payments above the benchmark) of the mortgage interest payment would be subject to the sale tax. Thus, under the FairTax, most mortgage interest payments would be in part taxable.

Furthermore, other financial services would also be subject to the sales tax. These services include brokerage fees, realtor fees, mutual fund management fees, loan origination fees, and others. The FairTax would thus increase the cost of selling or buying a home for both new and existing housing.

Finally, the required sales tax rate for H.R. 25, 23% in tax-inclusive terms, is too low to produce the same revenue as the current system according to even economists who support the FairTax. A higher tax means diminished growth effects, and a higher tax on housing.

Estimated Impacts on Housing and Home Building

In order to understand the full implications of the FairTax, NAHB contracted with Tax Policy Advisers (TPA) to analyze the complete set of impacts, including the positive effects associated with greater economic growth and the potential negative effects specific to the housing sector. [3] TPA is regarded as having non-partisan tax expertise, and their models’ results provide a glimpse into what government tax economists would report if studying the FairTax proposal.

TPA examined the effect of replacing the current income tax system with the FairTax, including determining what tax rate would be required for the proposal to achieve budget neutrality. TPA found that it would need to be higher than the rate specified in H.R. 25: 27.7% (38.3%) to 26.1% (35.3%) depending on the year. Using this range of rates, TPA found the following impacts on the economy, homeowners, builders and developers.

 
Macroeconomic Impacts

Replacing the income tax with the FairTax produces faster economic growth for the economy as a whole. In the first year after the change, Gross Domestic Product (GDP) is 2.1% higher and remains higher in the long-run. After five years, GDP is 3.1% larger than it would have been under the income tax. For the non-residential sector (all business not connected to housing), the benefits are stronger. In the year of the reform, GDP allocable to rest of the economy is 2.3% higher, and 5 years after the reform, it is 3.3% higher.

Because there is no income tax, after-tax wages are higher. In the year of the change, after-tax wages are on average 17.4% higher (notice that because the average income tax rate is 21%, this estimate reflects a before-tax wage decline). After five years, after-tax wages are 20.6% higher because faster economic growth and a more efficient allocation of investment capital have increased the demand for labor, pushing wages up. Accordingly, labor supply also increases. After the reform, labor supply is 2.8% higher and remains approximately 3% higher five years later; i.e. more of the population works and/or workers work more hours.

Investment in non-housing business benefits due to the adoption of the FairTax. In the year of the reform, the dollar volume of investment in such businesses is 8.9% higher. Five years later it is 8.3% higher than the baseline. The increase in investment and savings slightly decreases the before-tax interest rate. After five years, interest rates are lower by 1.1 percentage points. However, the after-tax interest rate (accounting for a tax on financial intermediation) remains approximately the same.

Before-tax prices of non-housing goods fall due to the FairTax. In the year of the reform, prices are on average lower by 0.2%. After five years, prices are lower 0.5%. However, the value of existing assets and wealth falls significantly. After the reform, non-housing related assets prices fall by 14.6%. After five years, there is some offset but pre-reform assets are still worth 12.1% less in real purchasing power terms.

Finally, the non-housing capital stock – the total value of productive business assets – is unchanged in the year of reform because of the offsetting effects of the declining value of existing assets and the increased flow of new investment. However, after five years the aggregate value of the non-housing capital stock is 4.8% higher.

Owner-Occupied Housing Impacts

Due to the adoption of the sales tax, the user cost (the ultimate cost of owning including tax benefits and expected appreciation) of owner-occupied housing increases by 4.6% five years after the reform. This estimate reflects the combined effects of repealing the present-law income tax housing preferences and the effects of those parts of the FairTax levied on housing, including mortgage payments. Because the after-tax cost of owning housing is higher, the demand for owner-occupied housing as a form of investment is lower relative to other forms of investment.

Lower demand implies lower average housing prices. The TPA model finds that prices are on average lower 10.1% in the year of reform. Over time, this price decline dissipates because of higher after-tax income due to the FairTax. The TPA model predicts a six-year transition for this to occur.

The investment in owner-occupied housing, that is home building activity representing new construction and remodeling, suffers due to the adoption of the NRST. In the year of the reform, investment in owner-occupied housing falls 18.6%, a decline of $94 billion in home building economic activity. After five years, investment in owner-occupied housing is still lower by almost 2%.

Due to the sales tax on new housing sales, sales fall by 18.6% from 1.053 million in the baseline to 857,000. Sales remain lower 5 years later, with total volume equal to 1.006 million.

Rental Housing Impacts

The sales tax also has strong negative effects for owners of rental housing. Due to the sales tax on rental payments, the before-tax price of rental housing falls due to declining housing demand. In the year of reform, before-tax rents fall by 0.2%. After five years this price is lower by 0.5% and it continues to fall thereafter.

The value of existing rental housing business is among the worst hurt by the move to the FairTax. The average value of rental housing businesses falls by 25.7% in the year of the reform. After five years, the value of these businesses remains lower by 21.8%. However, the investment in rental housing – home building for rental property –increases as a result of the tax policy change. In the year of the reform, investment in residential rental property increases by 12.9% and is 10.5% higher after five years.

Aggregate Housing Sector Impacts

In terms of aggregate investment in housing (the Bureau of Economic Analysis measure of residential fixed investment [RFI]), home building activity declines after adoption of the FairTax. In the baseline, RFI is 32.4% of total investment in the economy, totaling $672 billion. After the tax policy change, RFI falls to 28.2% of total investment ($600 billion). The share then grows to 30% two years after the reform and 30.6% after five years. Thus, RFI declines as a share of total investment due to the FairTax. Total housing starts decline by 13% in the year of the reform with single-family starts down by 18.6%. Multifamily starts increase by 12.9% as noted above.

The homeownership rate declines due to the move to a NRST. In the baseline the homeownership rate is 68.8%.  Due to the reform, the rate falls to 68.6% after two years and to 68.1% after five years. In the theoretical long run, the rate falls to 67.7%. This is a function of the relatively higher user cost of owner-occupied housing. The decline in the homeownership translates to a less favorable market for new home sales.

The sum of these changes reduces the net-of-tax profit for the average home builders. According to the estimates from TPA, profits for home builders are on average 9% lower due to the change in tax policy. This estimate includes lower revenue due to lower housing sales, but also reduced costs due to the elimination of embedded-tax price effects, as well as the elimination of income taxes on the home building business. According to the estimates, it takes at least three years for the stylized home builder to recover to the profits it obtained before the change in tax law.

Conclusion

The analysis discussed in this article indicates that transitioning to the FairTax would produce negative effects for housing and home building. The replacement of the income tax with a NRST would produce some positive effects, including faster economic growth. However, the degree of this growth effect is dependent on the sales tax rate required. The results from TPA indicate strong negative effects on home building, and these modeling efforts use a sales tax rate (27.7% to 26.1% over the time period) that lies at the low range of economists’ estimates for the necessary budget neutral rate. A higher rate would produce lower economic growth and reduce the benefits offered by a NRST.

More importantly, there are fundamental aspects about the particular policy details of H.R. 25 that would be damaging to housing.  This is not to suggest that some type of NRST could not be beneficial to housing and home building. For this to be the case, at the very least sales tax exemptions for new home sales and mortgage interest payments would be required. However, this is unlikely to be offered because the estimated revenue from such taxes is necessary to keep the sales tax rate low. TPA estimates that for a 28% sales rate, exempting new home sales and rental housing payments from the base increases the required tax rate to 30.4% or 43.7% on a tax-exclusive basis.

Further, other observers have noted the importance of taxing new homes sales and rental payments because these transactions are unlikely sources of sales tax evasion. As the sales tax base narrows, the required rate increases, and the incentive for evasion increases. This in turn requires a higher rate and so forth. For these reasons sales taxes associated with housing are likely an important part of the tax base for any NRST. And for these reasons, it is difficult to construct a NRST that would not harm housing and home building.

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Footnotes:

[1] Mathematically, suppose the tax-exclusive tax rate (the “normal” sales tax rate used by most local governments) is equal to t and the consumer pays an after-tax price of p (1 + t), where p is the before-tax price. It can be shown that the tax-inclusive rate, s, is equal to t / ( 1 + t ) and correspondingly t is equal to s / ( 1 - s).

[2] Yin, George (2006). “Is the Tax System Beyond Reform?”  Florida Law Review 58:977-1041.

[3] TPA is run by George Zodrow, an academic economist at Rice University, and his colleague at Rice University, John Diamond, a former Congressional Joint Committee on Taxation macroeconomist. The economic models developed by TPA are used under contract throughout the Washington tax policy community. TPA’s clients include the Department of the Treasury and the Congressional Joint Committee on Taxation.