The FairTax is a tax reform proposal which would eliminate all federal taxes including estate, social security, medicare, income and corporation taxes. It would replace these taxes with a national sales tax. One of the points of discussion concerning the FairTax is what businesses will do with the money formerly deducted for taxes from their employee’s paychecks. It seems clear the employee’s share of the taxes would have to go to employee. Under the current system when Congress reduces the tax rate or when an employee changes her withholding the employer has no right to retain any of that money. It would be no different when the FairTax reduced the rates to zero. The more difficult question is what will happen to the employer’s share of the social security taxes. One point of view is because the employer currently considers this tax as an employee cost when determining the price of labor, the employer will continue to count the money as a labor cost and pass it on to her employee. The other point of view is because the employer’s share of the Social Security tax was never part of the original agreement to be paid to employee, the employer will keep the money she formerly paid for her share of the social security tax. Because the employer’s share has never appeared on the employee’s pay stub it seems likely the employer will not pass their share to the employee.
Obviously the employee would receive a more direct benefit if her employer passed on her share of the Social Security taxes instead of keeping it. Assuming the employer keeps her share, will the employee receive any indirect benefits from the elimination of the employer’s share of the social security tax through reduced prices both from her employer and from other businesses? If the employer is able to keep the money and add it to her profits, then in general the employee will not benefit from the money. If the employer uses the money to reduce prices, either directly or by reinvesting it into her company to improve her productivity, the employee will receive an indirect benefit.
In order to determine the most likely scenario, it is necessary to understand the role of prices in a free-market economy. As Thomas Sowell points out in his book “Basic Economics”, businesses cannot set the price of their product wherever they want. The fact every business would like to charge more and every consumer would like to pay less provides a tension which determines the price through supply and demand. Prices are like a thermometer not a thermostat. High prices relative to cost tell investors the best place to invest their money. If a business is able to charge a high enough price to make exceptional profits, other investors will see the money making opportunity and invest in the market and provide competition until the prices fall enough to remove the incentive for other investors to increase investment in the industry. This process puts pressure on businesses to lower prices.
Examples of this process abound. After the deregulation of gasoline prices in 1981, the high price of gasoline encouraged massive investment in the industry. Inflation adjusted prices of gasoline dropped the next several years and did not return to the 1981 levels until 2008.
Similarly, after the airline industry was deregulated in 1978, the high prices for airfare encouraged new investment in the field and new, lower fare airlines spring up resulting in much lower airfares and greatly increased the number of people who could afford to fly. Everyone is familiar with how the price for computing power has dropped over the last three decades in the computer industry. A scientific calculator which cost around $15 today sold for over $100 back in the late 1970s. If prices are artificially fixed with a ceiling or floor, they can no longer serve as a signal to investors to increase or decrease investment in the industry. For example, price supports for sugar in the United States cause an oversupply of sugar to be produced in the United States. Price ceilings like rent control in cities like New York and San Francisco cause a shortage of rental apartments. In both cases the normal process of prices dictating where investment is made has been tampered with.
Removing the employer’s share of the social security taxes through the FairTax would send a signal to investors to increase their investment in any industry which didn’t either reinvest the extra money in their industry or reduce their prices. Businesses could invest in new technology to make current workers more productive which would reduce prices. Businesses could use the money to reduce the prices directly. Or businesses could hire one extra worker for every 15 workers they currently employ (assuming the historical 7% employee contribution) which not only would increase employment but it would also improve productivity which would reduce prices. Clearly employees as a whole would benefit in one way or the other from the elimination of the employer share of the Social Security taxes through the FairTax.