Deconstructing the Cain Nines

I like almost everything about Herman Cain.  He is as solid a free-market supporter as any of the candidates.  He is a staunch supporter of Israel.  He is a true believer in the Constitution and is 100% pro-life.  His instincts reflect those of the Tea Party.  But I cannot embrace his 9-9-9 plan.  It is too close to the fair tax, and too far from a flat tax.  But consider something like 18-0-0.  Read on.

The best comment so far on the now-famous 9-9-9 plan was Michele Bachmann's "The devil is in the details."  Indeed, it is not easy to flesh out all the details.  I will stick my neck out and try to infer some important details from what has been published.  First, look at some OMB figures representing tax revenues from various sources in FY 2010. These were used in my recent article in AT.

Table 1: FY 2010 Tax Revenue

            Revenue Source                                              Revenue ($)               Revenue(%)

Personal Income Tax                                                      $956B                         44%

Payroll Taxes (Social Security, Medicare)                     $746B                         34%

Corporate Income Tax                                                    $198B                           9%

Other                                                                               $273B                         13%

Total Receipts                                                               $2.174T                        100%

The current corporate tax is set nominally at 35%.  Yet the amount collected is only about 11% of corporate profits.  There are thousands of pages of tax regulations on the topic of how to define corporate revenue and expenses for tax purposes.  The Cain plan sets the new rate at 9%.  Will there be changes in the accounting rules?  Will only 3% be collected?  Those are important details, and if the rules continue to require thousands of pages, there will be no transparency.

The new 9% payroll tax replaces the old FICA.  That includes both employer and employee contributions totaling approximately 15% of all ordinary income (not capital gains, interest, dividends, etc.) up to around $100K.  The reason the percent is approximate is that it depends on taxpayer status and type of employment and on the profitability of employers.  Since the Cain payroll tax would have no ceiling, it is reasonable that it can collect the missing 6% from the amount paid by higher income taxpayers on their earned income above $100K and all of their unearned income.  The exact relationship is unstable in any case.  Whatever the rules are, they will be gamed by taxpayers to minimize receipts.

All versions of tax reform are likely to require a change in the laws governing the so-called trust funds for Social Security and Medicare.  These are merely bookkeeping entries, but the rules involving how the entitlements are funded rely on them.

The new 9% corporate and payroll taxes will bring in about the same as FICA and the corporate income tax do now.  That leaves the 9% sales tax to replace the personal income tax.  The details are too far from being clear to enable even a close estimate of the revenue raised.  I think used goods don't count.  But you would pay 9% of a commission to buy an old house or a used car.  Or maybe on the difference between the seller's and buyer's cost?  Services get taxed, yet we are assured that cheating will be impossible?  Kids, if you shovel snow or mow lawns, beware!

The Cainsians seem to think that the sales tax will bring in about a trillion dollars to cover the defunct income tax.  But please -- just like the fair-taxers they are shilling for, intentionally or not, they pretend that no new bureaucracy will be needed.  Who wants the under on a thousand pages at a dollar a page?

The point is that the numbers seem not to add up in theory, and are likely to fall shorter in practice.  Only a die-hard fair-tax believer could think this is a good idea.  Indeed, the Nines are really just a stepping stone to all sales tax all the time, except for one thing.  The sales tax Nine will double or triple, and the other Nines will gain another digit.

The 9-9-9 plan suffers from being driven by a catchy description that fails to capture all the moving parts of the tax code.  As Table 1 shows, there are currently four slices in the revenue pie: personal income tax, payroll taxes, corporate income taxes, and other taxes.  The last category covers various excise taxes, tariffs, and fees which are not based on income.  Cain and the fair-taxers would add a new category of sales tax or value added tax or some combination thereof.  There may be some provisions for other corporate taxes, but I confess to not understanding those at all.  Even the basic flat 9% payroll tax has already been revised by Cain himself to ease the burden on lower income earners.

Suppose we keep all of the old categories.  Leave the "other" category aside for now, as it has little to do with the main categories.  Divide the payroll tax into two pieces, employee and employer, and add the new sales tax category.  Consider each income tax bracket a separate category. Designing a new system simply requires assigning percentage rates to the two FICA pieces, the personal income tax pieces, and the corporate pieces.  The huge hidden complexity then resides in the definitions of income, deductibles, and the details of the sales tax.  Some of these have obvious effects, but most are too subtle for simple calculations.  It would be desirable to simplify the rules and to lessen their impact.  All plans to be discussed eliminate the alternative minimum tax (AMT).

Every plan put forward by economists, politicians, includes filling in the following charts.

The column labeled "Rules" refers to all the revenues less expenses and deductions allowed by law.  The fewer rules, the simpler and more transparent the code will be.  Examples of rules in the current code are brackets, capital gains, wages, exemptions, itemized or standard deduction, and charity.  In the sales tax category, the rules could be quite complicated.  The column labeled "Tax Rates" lists the current statutory tax rates on income in each category.  The rules are such that the "True Rate" depends on special circumstances pertaining to each taxpaying entity.  The "Notes" are just short remarks to point out something interesting.

Table 2: Current System

Tax Category

Rules

Tax Rates

True Rate

Notes

 

Corporate Income

Highly complex

0%-35%

11%   profits

Strange, but true

 

Employee Payroll

        simple

        7.15%

7.15% wages

 

Up to a ceiling of around $100K

 

Employer Payroll

simple

7.15%

6.4%  wages

Effective rate varies

 

Income Tax

complex

10%-35%

18% wages

IRS

 

Sales Tax or VAT

complex

0%

 0% sales

 No federal bureaucracy

 

Table 3: Caine 999 Plan 1.0

Tax Category

Rules

Tax Rates

True Rate

Notes

 

Corporate Income

Highly complex

9%

Hard to say

 

 

Employee Payroll

        simple

           9%

   9% wages          

No ceiling

 

Employer Payroll

simple

0%

   0% wages

 

 

Income Tax

none

0%

0%

Sounds great

 

Sales Tax or VAT

complex

9%

Even harder to say

         New        bureaucracy

 

The secret to designing a "fair" or "simple" system is to balance nominal rates, true rates, and enforcement costs.  If corporate earnings are taxed and then capital gains and dividends are taxed to individuals, that is double taxation, which discourages investment.  If sales are taxed, it discourages consumption, which indirectly encourages savings.

The costs incurred by corporations just to comply with the tax code are enormous.  What would be the consequences of eliminating the tax on corporate profits?  All the compliance costs go away.  All double taxation goes away, lessening the need for special treatment of gains and dividends for individuals.  On the other hand, there is no marginal compliance cost to the employer's share of payroll taxes.

A national sales tax is an invitation for out-of-control federal spending.  It is zero now.  Let it be zero forever!

This suggests a modification to the Cain-Nines.  Eliminate the 9% corporate profits tax but re-institute the employer's share of payroll taxes at 9%.  Table 4 summarizes the effect of this change.

Table 4: Caine 999 Plan 2.0

Tax Category

Rules

Tax Rates

True Rate

Notes

 

Corporate Income

none

0%

0%

Zero can be beautiful

 

Employee Payroll

                simple

                 9%

   9% wages          

No ceiling

 

Employer Payroll

simple

9%

   9% wages

No ceiling

 

Income Tax

complex

0%

0%

Really?

 

Sales Tax or VAT

complex

0%

0%

     No new         bureaucracy

 

There are a few important details which must be addressed.

The first detail is how to treat the self-employed.  The fairest way I can think of is to treat the income of a self-employed individual as if it was flowing through a fictional corporation.  With the corporate tax gone, there is no double taxation involved.  A total of 18% would be owed.

With the corporate tax out of the picture, investment is favored over consumption. But does it go too far?  Corporate owners might use corporations to shelter what are now dividends, capital gains or corporate taxes. A corporation could be a kind of super IRA, with taxes postponed indefinitely. Actually, this is already the case to some extent.  Since capital gains taxes are only due when stock is sold, and since the tax on gains is lower than on ordinary income, corporations are currently sheltering a lot of individual income.  If high economic growth is the goal, this is a good thing.  Still, it is a reasonable point to consider.

Those issues should not take away from the essential simplicity of Cain 2.0.  But how much revenue does Cain 2.0 capture?  According to the Census Bureau, total personal income in Fiscal 2010 was $12.5T.  This includes ordinary income and capital income.

If Cain 2.0 is used with zero income tax, and a total of 18% in payroll tax, the revenue would be around $2.25T.  The OMB Table 1 at the beginning of this article shows revenue of only $1.9T.  That is a tax increase of $325B!  If the 9% rate was reduced to 7.5%, that would cut revenue by 20% to $1.8T, just slightly below current revenue. Raise it to 12%, and it brings in $3T. The individual and corporate shares of the payroll tax don't even have to be equal; only the total matters.

All the current arguments about tax levels and deductions would be reduced to fighting over the single number 9%.  There would be full transparency, and all taxpayers would have skin in the game.  Of course this is a pure flat tax.  The main difference with Cain 1.0 is that the 9% corporate income tax is replaced by a 9% corporate payroll tax.

It is remarkable that merely by applying the payroll tax to all income and removing the ceiling, so much revenue is raised.  That is some measure of the impact of thousands of pages of rules.

If the progressive income tax were retained for individual, the payroll tax rate could be reduced further, while keeping revenue constant.  In any case, the brackets could be set very low and even then, deductions would be worth much less than now.  The hybrid tax referenced earlier in the article is an example of this.

Finally, suppose the quoted national income figures are wrong, or that they change unexpectedly in the future.  Just do a simple calculation and reset the 9% rates accordingly.

I like almost everything about Herman Cain.  He is as solid a free-market supporter as any of the candidates.  He is a staunch supporter of Israel.  He is a true believer in the Constitution and is 100% pro-life.  His instincts reflect those of the Tea Party.  But I cannot embrace his 9-9-9 plan.  It is too close to the fair tax, and too far from a flat tax.  But consider something like 18-0-0.  Read on.

The best comment so far on the now-famous 9-9-9 plan was Michele Bachmann's "The devil is in the details."  Indeed, it is not easy to flesh out all the details.  I will stick my neck out and try to infer some important details from what has been published.  First, look at some OMB figures representing tax revenues from various sources in FY 2010. These were used in my recent article in AT.

Table 1: FY 2010 Tax Revenue

            Revenue Source                                              Revenue ($)               Revenue(%)

Personal Income Tax                                                      $956B                         44%

Payroll Taxes (Social Security, Medicare)                     $746B                         34%

Corporate Income Tax                                                    $198B                           9%

Other                                                                               $273B                         13%

Total Receipts                                                               $2.174T                        100%

The current corporate tax is set nominally at 35%.  Yet the amount collected is only about 11% of corporate profits.  There are thousands of pages of tax regulations on the topic of how to define corporate revenue and expenses for tax purposes.  The Cain plan sets the new rate at 9%.  Will there be changes in the accounting rules?  Will only 3% be collected?  Those are important details, and if the rules continue to require thousands of pages, there will be no transparency.

The new 9% payroll tax replaces the old FICA.  That includes both employer and employee contributions totaling approximately 15% of all ordinary income (not capital gains, interest, dividends, etc.) up to around $100K.  The reason the percent is approximate is that it depends on taxpayer status and type of employment and on the profitability of employers.  Since the Cain payroll tax would have no ceiling, it is reasonable that it can collect the missing 6% from the amount paid by higher income taxpayers on their earned income above $100K and all of their unearned income.  The exact relationship is unstable in any case.  Whatever the rules are, they will be gamed by taxpayers to minimize receipts.

All versions of tax reform are likely to require a change in the laws governing the so-called trust funds for Social Security and Medicare.  These are merely bookkeeping entries, but the rules involving how the entitlements are funded rely on them.

The new 9% corporate and payroll taxes will bring in about the same as FICA and the corporate income tax do now.  That leaves the 9% sales tax to replace the personal income tax.  The details are too far from being clear to enable even a close estimate of the revenue raised.  I think used goods don't count.  But you would pay 9% of a commission to buy an old house or a used car.  Or maybe on the difference between the seller's and buyer's cost?  Services get taxed, yet we are assured that cheating will be impossible?  Kids, if you shovel snow or mow lawns, beware!

The Cainsians seem to think that the sales tax will bring in about a trillion dollars to cover the defunct income tax.  But please -- just like the fair-taxers they are shilling for, intentionally or not, they pretend that no new bureaucracy will be needed.  Who wants the under on a thousand pages at a dollar a page?

The point is that the numbers seem not to add up in theory, and are likely to fall shorter in practice.  Only a die-hard fair-tax believer could think this is a good idea.  Indeed, the Nines are really just a stepping stone to all sales tax all the time, except for one thing.  The sales tax Nine will double or triple, and the other Nines will gain another digit.

The 9-9-9 plan suffers from being driven by a catchy description that fails to capture all the moving parts of the tax code.  As Table 1 shows, there are currently four slices in the revenue pie: personal income tax, payroll taxes, corporate income taxes, and other taxes.  The last category covers various excise taxes, tariffs, and fees which are not based on income.  Cain and the fair-taxers would add a new category of sales tax or value added tax or some combination thereof.  There may be some provisions for other corporate taxes, but I confess to not understanding those at all.  Even the basic flat 9% payroll tax has already been revised by Cain himself to ease the burden on lower income earners.

Suppose we keep all of the old categories.  Leave the "other" category aside for now, as it has little to do with the main categories.  Divide the payroll tax into two pieces, employee and employer, and add the new sales tax category.  Consider each income tax bracket a separate category. Designing a new system simply requires assigning percentage rates to the two FICA pieces, the personal income tax pieces, and the corporate pieces.  The huge hidden complexity then resides in the definitions of income, deductibles, and the details of the sales tax.  Some of these have obvious effects, but most are too subtle for simple calculations.  It would be desirable to simplify the rules and to lessen their impact.  All plans to be discussed eliminate the alternative minimum tax (AMT).

Every plan put forward by economists, politicians, includes filling in the following charts.

The column labeled "Rules" refers to all the revenues less expenses and deductions allowed by law.  The fewer rules, the simpler and more transparent the code will be.  Examples of rules in the current code are brackets, capital gains, wages, exemptions, itemized or standard deduction, and charity.  In the sales tax category, the rules could be quite complicated.  The column labeled "Tax Rates" lists the current statutory tax rates on income in each category.  The rules are such that the "True Rate" depends on special circumstances pertaining to each taxpaying entity.  The "Notes" are just short remarks to point out something interesting.

Table 2: Current System

Tax Category

Rules

Tax Rates

True Rate

Notes

 

Corporate Income

Highly complex

0%-35%

11%   profits

Strange, but true

 

Employee Payroll

        simple

        7.15%

7.15% wages

 

Up to a ceiling of around $100K

 

Employer Payroll

simple

7.15%

6.4%  wages

Effective rate varies

 

Income Tax

complex

10%-35%

18% wages

IRS

 

Sales Tax or VAT

complex

0%

 0% sales

 No federal bureaucracy

 

Table 3: Caine 999 Plan 1.0

Tax Category

Rules

Tax Rates

True Rate

Notes

 

Corporate Income

Highly complex

9%

Hard to say

 

 

Employee Payroll

        simple

           9%

   9% wages          

No ceiling

 

Employer Payroll

simple

0%

   0% wages

 

 

Income Tax

none

0%

0%

Sounds great

 

Sales Tax or VAT

complex

9%

Even harder to say

         New        bureaucracy

 

The secret to designing a "fair" or "simple" system is to balance nominal rates, true rates, and enforcement costs.  If corporate earnings are taxed and then capital gains and dividends are taxed to individuals, that is double taxation, which discourages investment.  If sales are taxed, it discourages consumption, which indirectly encourages savings.

The costs incurred by corporations just to comply with the tax code are enormous.  What would be the consequences of eliminating the tax on corporate profits?  All the compliance costs go away.  All double taxation goes away, lessening the need for special treatment of gains and dividends for individuals.  On the other hand, there is no marginal compliance cost to the employer's share of payroll taxes.

A national sales tax is an invitation for out-of-control federal spending.  It is zero now.  Let it be zero forever!

This suggests a modification to the Cain-Nines.  Eliminate the 9% corporate profits tax but re-institute the employer's share of payroll taxes at 9%.  Table 4 summarizes the effect of this change.

Table 4: Caine 999 Plan 2.0

Tax Category

Rules

Tax Rates

True Rate

Notes

 

Corporate Income

none

0%

0%

Zero can be beautiful

 

Employee Payroll

                simple

                 9%

   9% wages          

No ceiling

 

Employer Payroll

simple

9%

   9% wages

No ceiling

 

Income Tax

complex

0%

0%

Really?

 

Sales Tax or VAT

complex

0%

0%

     No new         bureaucracy

 

There are a few important details which must be addressed.

The first detail is how to treat the self-employed.  The fairest way I can think of is to treat the income of a self-employed individual as if it was flowing through a fictional corporation.  With the corporate tax gone, there is no double taxation involved.  A total of 18% would be owed.

With the corporate tax out of the picture, investment is favored over consumption. But does it go too far?  Corporate owners might use corporations to shelter what are now dividends, capital gains or corporate taxes. A corporation could be a kind of super IRA, with taxes postponed indefinitely. Actually, this is already the case to some extent.  Since capital gains taxes are only due when stock is sold, and since the tax on gains is lower than on ordinary income, corporations are currently sheltering a lot of individual income.  If high economic growth is the goal, this is a good thing.  Still, it is a reasonable point to consider.

Those issues should not take away from the essential simplicity of Cain 2.0.  But how much revenue does Cain 2.0 capture?  According to the Census Bureau, total personal income in Fiscal 2010 was $12.5T.  This includes ordinary income and capital income.

If Cain 2.0 is used with zero income tax, and a total of 18% in payroll tax, the revenue would be around $2.25T.  The OMB Table 1 at the beginning of this article shows revenue of only $1.9T.  That is a tax increase of $325B!  If the 9% rate was reduced to 7.5%, that would cut revenue by 20% to $1.8T, just slightly below current revenue. Raise it to 12%, and it brings in $3T. The individual and corporate shares of the payroll tax don't even have to be equal; only the total matters.

All the current arguments about tax levels and deductions would be reduced to fighting over the single number 9%.  There would be full transparency, and all taxpayers would have skin in the game.  Of course this is a pure flat tax.  The main difference with Cain 1.0 is that the 9% corporate income tax is replaced by a 9% corporate payroll tax.

It is remarkable that merely by applying the payroll tax to all income and removing the ceiling, so much revenue is raised.  That is some measure of the impact of thousands of pages of rules.

If the progressive income tax were retained for individual, the payroll tax rate could be reduced further, while keeping revenue constant.  In any case, the brackets could be set very low and even then, deductions would be worth much less than now.  The hybrid tax referenced earlier in the article is an example of this.

Finally, suppose the quoted national income figures are wrong, or that they change unexpectedly in the future.  Just do a simple calculation and reset the 9% rates accordingly.