999: Right but Mostly Wrong

GOP Presidential Candidate Herman Cain is to be commended for issuing his "999 Plan". Mr. Cain's plan is "Right" in that he is the only candidate who is - so far - beginning the discussion of tax reform with a complete scrapping of the current tax code. I agree with him. The current system is completely broken and, whether it can be fixed or not, should not be fixed but replaced.

Several prominent economists, notably Dr. Arthur Laffer, have come out in favor of 999. I have come to the conclusion however that the 999 Plan is not the solution. My main problem with the plan centers around the second "9", which Mr. Cain characterizes in his public statements and on the plan's page as a "9% Business Flat Tax" on "gross income less all purchases from U.S. located businesses", or simply as a "9% business income tax". Trouble is, it isn't. It's a value-added tax (VAT), and therefore I have to judge it as "wrong".

In an op-ed published today by Dr. Laffer in the Wall Street Journal, the mis-characterization of 999 as a "9% flat-rate tax on net business profits" persists.

I encourage everybody to look at the supporting documents for 999, both the "9-9-9 Scoring Report" and the "9-9-9 Scoring Tables". I'll be citing page numbers from the report below.

In the scoring report, the business tax is properly called a "Business Transactions Tax" (page 7).

Each business would pay tax on gross receipts less payments to other businesses. Allowing the subtraction of payments for intermediate goods yields the value added by the company. Subtracting investment as well yields a subtraction method value-added tax." (my emphasis)

So, there it is in black and white, a VAT. It is not what I'll call a compound VAT since business purchases of materials and resources for production are deducted, but there is one important cost of production that is not deductible from revenue: labor costs.

Also on page 7, the basis for this levy is clearly stated: "The tax base...would be the gross compensation paid to employees." How is this justified? Well, that is spelled out on page 4 of the report:

Finally, fringe benefits paid by employers count as part of personal consumption even though they are not directly purchased by individuals. These employer-related purchases amounted to $581 billion (4.5% of GDP) in 2008. Employer contributions for health and life insurance accounted for over 96 percent of these purchases. These expenditures must be specifically accounted for in the design of a retail sales tax or as much as 7 percent of the tax base could disappear. In this case the payments made by the employer must be deemed to have paid by the employee to conform to taxing the purchases of individuals.

So, 999 as written will tax both salaries and benefits at the business level, and then tax wages again through the 9 percent personal income tax! So much for getting away from double taxation; another indication that this is the wrong approach.

999 probably looks attractive to enterprises for whom materials or other business-to-business transactions such as rent are their primary cost of production. But what of enterprises that add value by reselling human capital, that is, professional services?

I am in consulting, and have been since 1999. The value I add to my customers is my professional expertise, and the portion of my services that involve purchasing products from other businesses is a very minor component of what my services cost the customer. The lion's share is my own compensation, and the profits my employer earns for being able to resell my expertise. How would 999 affect the taxation applied to a professional services organization?

Let me give a somewhat simple example. An enterprise provides professional services to a customer for $1,000 with a pre-tax margin of 20% - for each $1,000 billed, the enterprise profits by $200. The $800 in costs are wholly that of human capital - wages, benefits, and other compensation. Under the current tax code, the enterprise pays taxes on $200. Under 999, the enterprise would pay taxes on $1,000. On the surface, this looks like a benefit. 9% of $1,000 is $90. Seems fair...until you realize that to get to the same $90, the $200 profit under the current code would have to be taxed at 45%, whereas if this was a corporation filing under the corporate tax code (35%), $200 in profit results in taxes of $70. 999 produces a 28.57% tax increase.

If we look at a small business selling professional services filing their taxes as a S corporation under the individual rules, 999 is simply a disaster. Such a tax filer that reports income at the 28% bracket ($174,400)
with the same pre-tax margin (i.e. revenue is $581,333.33), pays $25,424 under the current code (24.34% effective rate) and would pay $52,320 in taxes under 999 - a business crushing tax increase of $26,896 or 105.79 percent!

This effect will strike at the heart of every business for whom labor is the major component of their cost of sales. I can come to no other conclusion that 999 will plague all consultants, doctors, accountants, home handymen, etc. who generate their livelihood from service delivery and not from producing physical goods and therefore, can not support Mr. Cain on the substance of the 999 plan.

Now, I will provide my own disclaimer to this analysis. It does not factor in the tax reduction from businesses no longer paying the payroll taxes that are implicitly factored into the example of profit/cost under the current tax code, but on the surface I do not believe that such a reduction would come anywhere close to reducing the effective increases on service-related businesses that I have calculated under 999.

999 is only a starting point for an open discussion on a complete overhaul of our taxation system and nothing more. I do not want it as a solution. If Mr. Cain is the last conservative standing in the GOP primary he will get my vote but the flaws of 999 combined with his lack of solution depth (the response to all economic questions is 999) and glaring shortcomings when it comes to foreign policy means I cannot support him as our standard bearer until such an eventuality.

I'd enjoy comments to my analysis, particularly if you think I've gotten it all wrong.

UPDATE 10/20 1341EDT: Alex Kaufmann was gracious enough to link back to my analysis in his blog post at For the Republic! Please give him some clicks!