1.  What are embedded taxes?

Under our current income tax system, every business or individual involved in the manufacturing of a product, or in the provision of a service, pays taxes.  Not only do they pay income taxes on their profits, they also pay the employer portion of the payroll taxes for each one of their employees.  And they have whatever other forms of taxes that may apply to their business as well; sales taxes, property taxes, excise taxes, etc.

And these taxes are included in the price of the product or sevice when it is sold.

For instance, a minor operator who digs coal includes the taxes they pay in the price of the coal they sell to the power plant owner.  And the power plant owner includes not only the taxes that came in with the coal, he adds the taxes he pays into the price of the electricity he sells to his customers.

So the final customer is paying for part of the taxes levied on the coal miner and on the power plant operator.  These are what are called embedded taxes.  They don't show up on the bill, but they are there, and are paid by the final consumer of every product and service produced in this country.

2.  How much of the price of goods and services is due to embedded taxes?

It varies with different products, but the total embedded taxes varies from 15% to as high as 25% of the retail price.  This means that if ALL the embedded taxes were removed, the costs of goods and services could drop by as much as 25%!!

A study was done by Dr. Dale Jorgenson of Harvard University that provides an excellent analysis of embedded taxes.  In the study, Dr. Jorgenson included all sources of embedded taxes in making his analysis, which means his results for embedded taxes are higher than those addressed by the FairTax, but the type of analysis is the same as used in developing the FairTax legislation.

3.  How does the FairTax "remove" embedded taxes?

Under the FairTax, businesses no longer pay income taxes on their profits or the employer portion of the payroll tax.  This allows them to reduce the cost of the goods or services they produce.  And when those goods and services are sold to other businesses, the FairTax is not applied to the sale.

At each step in the production process, the cost of raw materials is less, the costs of services purchases by the business as part of their manufacturing operations is less, and their own operating costs are less because the employer portion of the payroll taxes and the income taxes on their profits are eliminated.

4.  Under the FairTax, how many of the embedded taxes will be removed?

Under the FairTax, businesses will not have to pay the employer portion of the payroll tax, nor will they have to pay any income tax on their profits.  In addition, they will not have the cost of complying with our current, complicated, income tax code.

The employer portion of the the payroll tax is 7.65% of labor costs, and studies have shown that the cost of compliance averages about 2.5% of total cost of production.  The income taxes levied on profits may be as high as 35%, but most average about 15% of total cost of production.

For an average company earning a 10% profit under the current income tax system, the FairTax would result in a reduction in costs of about 16%.  The number may vary based on the ratio of labor to raw materials needed to produce the product or service, and with the actual profit of the company under the current income tax system.

5.  What will the overall effect of removing embedded taxes be under the FairTax?

Under the FairTax, embedded taxes will be removed, to be replaced by the FairTax.

It should be noted that the FairTax will be applied to the now lower price of the good or service, and not to the old price which included the embedded taxes.  And don't forget, workers will have their whole paycheck with which to make their purchases, and the prebate to take care of some of the FairTax they will be paying.

6.  Won't companies just keep the profits when embedded taxes are removed?

There is nothing forcing companies to pass along the savings realized  under the FairTax in the form of lower prices, except market forces.  However, history has shown that, in a free market, those forces are extremely powerful and quick to act.  For example, several years ago, an airline industry tax was removed, and airlines tried to keep the additional profits for themselves.  But within 72 hours, one of the airlines had dropped their price slightly in an attempt to gain market share, and within a week, all airlines had dropped their prices to reflect the removal of the expired tax.

Most recently, a similar situation developed in the summer of 2011 when Congress failed to renew FAA funding before it expired.  As a result, airlines saw a reduction in costs due to the suspension of airline ticket taxes.  While some airlines tried to keep the windfall profits, others did not and within a few days, all airlines were in the process of dropping prices when Congress finished the FAA re-authorization and the taxes were re-imposed.

Had the taxes remained in suspension, airline ticket prices would have reflected the new, lower, cost structure within a couple of weeks at most.

With a free market, companies respond to changes in cost structure very quickly, but we have to recognize that not all markets are free.  Where one company has a monopoly, or a small group of companies operate as a cartel, prices may not respond as quickly.  But, as we know, such actions are illegal and relatively rare.  The one "legal" monopoly is of government services.  For instance, Public Utility Commissions may respond quickly to changes in the cost structure of utility companies, or they may not.  Unfotunately, there is little customers will be able to do outside the political arena since alternative utility services are not readily available.