NOTE: I am reproducing a number of essays on taxes which originally appeared in my now defunct blog Random Notes. I will also be reproducing articles on the FairTax in the next few days. I hope these essays will provide a good background for my planned essay examining the current state of the FairTax, as well as summarizing all my objections to it, those which have been answered and those which were not. Those interested in the topic may also find useful material in a number of essays printed in this blog (many reproduced from Random Notes), including: "Passing Thoughts on Taxes", "Two Thoughts on Taxation", "Government by Emotion", "Minimal Reforms", "Simplicity", "Reframing the Debate", "A Partial Reply to yt_knight", "Another Reply to yt_knight", "The Runaway Stagecoach", "The VAT Versus the FairTax", "Ch-Ch-Changes", "Gardasil and Logical Errors", "What is Wrong with a Prebate?", "Making Taxes Hurt", "Reply to FairTax Comments", "Reply to FairTax Comment II", "Reply to FairTax Comment III", "Short Reply to Doctor Adams", "Revisiting the FairTax", "If we must...", "What We Need", "The Consequences of Bad Laws" and "Truths About Taxation".
With the recent popularity of the FairTax, it seems sales tax has received a new lease on life, with conservatives, previously not particularly fond of any taxes, becoming noisy boosters for one of the more intrusive and messy types of taxation. Now, i have spent a lot of time talking about the FairTax and its many failings ("An Interesting Analogy, "Why I Dislike the FairTax ", "The Best Argument Against the FairTax ") as well as the many authoritarian assumptions underlying it ( "The FairTax's Liberal Assumptions"), so I won't go into a lengthy analysis of the FairTax here. If it continues to appear in the news, then I may revisit the FairTax again in greater detail, but for now I will leave the FairTax alone, unless it relates directly to our discussion of sales taxes.
I suppose the first place to start is to briefly explain what I consider to be good or bad when it comes to taxation, or, to be more technical, what the purpose of taxation is and what features make for an efficient tax system without too many externalities. (I hate that bit of jargon, but it is easier than saying "negative consequences, unexpected costs or other unforeseen problems." So, for once, I will use a bit of technical jargon as it does have a very clear and useful meaning and saves a lot of words. Or would have, had it not elicited this lengthy aside.)
At least the first element should be easy to answer. The purpose of taxes should not only be obvious, but hopefully something upon which all sides can agree. The primary purpose of taxation is to raise revenues to fund government operations. We may differ on what those operations might be, and some may hope to use taxation to achieve secondary purposes, but I think there is not a political philosophy in existence which sees taxes as serving anything other than the purpose of generating revenue.
However, as soon as we move beyond that very simple purpose, I fear the beliefs about taxation become quite different. Even among those nominally supporting the same end of the spectrum, there is quite a bit of room for disagreement, as can be seen in some of my past debates about the purpose of taxes, and what would make an ideal system ("Truths About Taxation", "A Partial Reply to yt_knight", "The VAT Versus The FairTax", "What we need", "Making Taxes Hurt", "The FairTax's Liberal Assumptions") That being the case, I know it is unlikely my definition of a good system will match the preconceptions of anyone reading this post, but hopefully I will make my case well enough that, whether they accept my definition or not, readers will understand the reasons for my arguments and, with a little luck, find them to be true.
To keep this simple, I am going to start by using the rules I established in "Truths About Taxation" to define an ideal system of taxation:
1. Minimizes the individual harm doneAs I said, these may not meet everyone's idea of the best possible system -- fans of progressive taxation, or using the tax system to modify behavior will despise rules #2 and #3 -- but I think I can justify them as we go along, and so, for the moment, let us move along to look at the sales tax itself. When the time comes to support my choice of these rules, I will give them as much support as I can.
2. Treats all individuals and all types of income and wealth similarly
3. Does not target specific acts or assets for favorable or punitive treatment
4. Has the lowest total administrative cost per dollar of revenue
5. Taxes only enough to cover needs, not more
6. Produces consistent results
So, moving on to the sales tax.
The sales tax is an odd beast as everyone believes they know what it is, yet there are so many variations that everyone's assumptions are different, creating a situation where apparent agreement often masks a welter of dissimilar assumptions. For example, does the tax cover only consumer spending, or are wholesale goods covered too? If only consumer, then are "big box" stores consumer or producer? How do we define the two? What defines a sales transaction? If we include purchases of producers' goods, then do transfers between corporate divisions count as sales? (If so, we are discussing a variety of VAT, in all probability.) Does the tax cover food? Clothing? Used goods? Are transfers in kind covered or only cash sales? Does it cover out of state sales or in state only (for state taxes)? Is the tax paid by an added amount at time of sale, or taken out of the stated price? That is, does the burden of payment fall on the seller or buyer? (Though in both cases, the seller ends up collecting the tax.) Are services taxed or only goods? If only goods, how are combined goods and services (such as private chef services) handled? If only goods are taxed, and someone is hired to produce a finished product, how is that taxed? Is the entire cost of hiring considered the sale price of the product? Or is part of the fee considered a service? I could go on, but this should make obvious all the variations that exist in sales taxes -- as well as how the sales tax can merge into a form of VAT. When discussing sales taxes it is good to keep these differences in mind, as it seems everyone speaking on the topic assumes the sales tax exists only in the form with which they are familiar, with much resulting confusion.
For our purposes, let us define sales tax in the most general terms possible, using the tax most often thought of as a "sales tax" by the general public, the consumer sales tax, which adds a fixed percentage of the retail price at time of sale to consumer goods -- however defined. We will ignore all the specific details and nuances of this tax for now, dealing with them only as necessary to understand the differing impact of various solutions. For the moment, all we need to understand is that it is a tax which is applied solely to consumer goods and is assessed as a percentage of the sale price1.
Obviously, there are other variations, taxes which include producers' goods, some VAT systems, which are sales taxes in as much as the tax is applied at sales, and is assessed on the increase in sales price, and other systems. However, as the consumer sales tax is the most common type, and is the version which is advocated -- in a very specific form -- by the FairTax advocates, let us keep our analysis limited tot hat particular tax.
My first objection to the sales tax is unusual in that it is an argument often advanced by liberal critics, yet it is a valid concern. And that concern is that a sales tax is regressive, and extremely regressive. The poor, or rather the lower class, spends almost all of their income on consumer goods, and thus will experience taxation of 100% of their income. On the other hand, much of the middle class saves at least some part of their income, and many have small businesses in which they invest, and thus a portion of their income will remain untaxed. As a result, the tax rate will be quite regressive, with the poor paying the full rate on their income, while many in the upper class will pay less than half the rate, perhaps much less2.
There are some schemes which try to ameliorate this regressive nature, such as those which exclude various items designated necessities. This usually means at least foodstuffs are excluded, though some are rather inconsistent even in this regard, excluding some foodstuffs, but not prepared foods. Some exclude clothing as well. Whatever they exclude or do not, it does function to make the sales tax less regressive, in almost the same way a more comprehensive sales tax makes the tax regressive. As the poor spend a large percentage of their income on such necessities, they receive a much larger tax break from this exclusion than those who are more wealthy. Obviously it varies from individual to individual how much money is spent, and on what category, so, once we incorporate these exclusions it varies form individual to individual what percentage of income is taxed via the sales tax. Still, even with exemptions, there is certainly a bias toward those with high incomes and considerable investment, though considerable exclusions, including food and clothing, may favor the lower and upper classes at the expense of the middle, and especially the lower middle class. Of course, some would argue that encouraging investment and discouraging nonessential spending is a good thing, but we shall discuss using taxes to enforce policy later.
Ignoring the regressive nature of sales taxes, there are still a number of issues, including the question of using taxes to enforce policy, which we just mentioned.
The first issue is a revenue issue. Unlike capitation taxes, property taxes, and even income taxes to a degree, the sales tax is a highly unpredictable source of revenue. Of course during periods of consistent economic conditions, be they prosperous or recessionary, the numbers tend to remain relatively constant, but even then there are large seasonal cycles, including the increase in consumer spending during holiday months, vacation spending during summer months -- or winter months in some locations -- and the drop of spending for seasonal workers when their jobs dry up. Thus, even in the best of conditions, sales taxes are inconsistent revenue sources. Worse still, they are highly sensitive to not just economic changes, but fears of economic changes. Rumors of a recession can bring on a huge decline in discretionary spending, dropping revenues unexpectedly. Even good news can harm state revenues, for instance a particularly strong stock market can divert money from vacation and luxury spending into investments, reducing sales tax revenues. Sales taxes are also tied to consumer prices, which can be volatile to say the least. Should weak numbers result in a large number of sales, the prices upon which taxes are based can decline quickly, once again causing revenues to drop.
The bigger problem, I believe, is the one I mentioned earlier,t eh use of taxes to enforce policy. Look at those rules I created, and you will see that they are inconsistent with policy driven taxes. be it the ability to deduct mortgage interest, capital gains taxes intended to punish the rich or anti-consumption measures such as sales taxes.
And the sales tax, though it is not explicitly described as such, is an anti-consumption measure. By making consumption more costly, it encourages the reduction of spending for consumer goods. In fact, the FairTax makes of this a virtue, advocating for the ability to encourage savings and investment. However, that is not the purpose of a tax system. Tax systems are intended to generate revenue. By trying to discourage those actions which bring in revenue, be it using cigarette taxes to discourage smoking or sales taxes to discourage spending, we are fighting against ourselves. of course taxes will slightly discourage the activities taxed, but that is to be worked around, not enhanced. We should find tax rates which produce the best revenue when taking that discouragement into consideration, we do not want to set them even higher to try to stop the activities bringing in revenue.
There are many, no doubt, who will ask why not use taxes to enforce policy? After all, it is only my assertion that taxes should not be used for policy purposes, so what is the harm? And that is a valid question, so allow me to make the case against policy driven taxes in general, and the sales tax as an anti-consumption measure in particular. After that, I will try to wrap things up by looking at the tax concepts I find most feasible, and show why they are so, and why the sales tax is not among them. (As well as make an argument for ignoring all of these in favor of voluntary funding schemes, when the reduced scope of government makes them possible, if it ever does.)
There are any number of ways to encourage or discourage a behavior the government wishes to modify. The most forthright, and most effective, is certainly the explicit law. As most people do not wish to be fined or jailed, this is remarkably effective. Of course, as we see with laws against prostitution, drugs and other behaviors which can be carried on out of the public eye, many times such laws simply force the activity underground, but that is often the best result possible without using an absurd amount of resources.
Explicit laws may work, but they also have several problems. For example, they are subject to judicial review. And while it may work to make teen pregnancy a crime, the courts are unlikely to allow such a law to stand for long. Even when there is no review, many activities simply seem absurd to ban through the law. To return to our teen pregnancy example again, even if the courts slept through that one, an failed to notice the new law, doubtless many activist groups would mock the politicians enacting such a law tirelessly, and the opposition party would use it to great effect. While many issues may be important to the government, and using explicit laws may work, there is something in us that still sees some matters as outside the real of those things about which we can legislate. It is one of the few hopeful signs I ever see about our state. We still think something are either too small for government, or just not proper subjects for legislation.
And that leaves the state with two choices, social or economic pressure. I discussed both in an incomplete fashion in "The Carrot and the Stick - Or How to Create a Fat, Lazy, Surly Donkey", but let us give them a brief look here.
The government is pretty bad at social pressure. They like to think PSAs and educational campaigns and presidential or congressional commissions and all the rest work, but anyone old enough to recall "Just Say No" -- or the incredibly laughable "cigarette mash" advertisements -- can attest that government's version of peer pressure elicits more laughs than success. It is not just that the government is out of touch with their target audience, or that "message by committee", the default government method, inevitably produces amusingly incompetent approaches, the fact is, if an issue mattered, then individuals would already be advocating it, and if it doesn't matter, then all the government money in the world will not spark interest. So the state either ends up putting out "me too" advertisements making them look a few months behind the curve, or else appear to be taking on issues about which no one cares. It is a formula destined to create laughs or yawns, but not much success.
Which is why bribery is becoming more popular, and tax policy is nothing but a form of bribery, well bribery and fines. When the government wishes to encourage something, the most effective means falling short of actual laws is to either offer rewards for action, or penalties for inaction. As individuals tend to respond to financial incentives, this is probably the best solution the government has. Of course, given my view of government, I find all such actions invalid, as the few functions I see as valid for the government, all fall within the criminal law, and all these efforts at behavior modification strike me as outside the scope of state action. But, as we are discussing taxes only, for the moment I will act as if such goals and methods were valid, and ask how to make them work best3.
And that is where I argue the sales tax, or any tax, is a bad choice.
Some, reading my discussion of financial incentives might draw the conclusion tax incentives, or penalties, are a good idea. After all, I said financial incentives were the most effective means short of explicit laws, that being the case, why would not tax policy be the best solution for situations where explicit laws are not possible?
The problem is, taxes are not a universal solution, and often have differing impact on different individuals. For example, that $5000 deduction per child is very valuable to people earning a certain amount, but once you earn enough, that deduction becomes trivial. Not to mention those who earn little or nothing, to whom that deduction is meaningless as well. The same applies to deductions or allowances offered for many activities. As many are capped, or allow only a certain percentage, for the poor and the rich, they are irrelevant, and even the middle class seems them offering varying degrees of incentive.
Which brings me back to the sales tax. As I said, in a way the Fair Tax folks are right, it discourages consumption, but only for some. For the poor, it can;t, as they have to spend most or all their income on necessities, and cannot choose to spend less. All the sales tax does is reduce the amount of those necessities they can obtain, or whether there is a small amount left over for luxuries of any kind. Likewise, for the very rich, the added amount is trivial when it comes to small purchases. For large purchases it may act as a slight disincentive, but they can likely avoid that by buying outside the markets covered by the sales tax. In that way it acts like a luxury tax, mainly hurting domestic producers and sellers by pushing business offshore.
The group most effected by the sales tax is the middle class. They must buy necessities like everyone else, and so must pay so much tax to survive. Beyond that, the tax is trivial in some respects, when buying very small items, but it does have an unseen impact by reducing the amount left to spend on other large purchases, luxuries and vacations. The remaining impact depends on the specifics of the tax. If the sales tax is limited in scope, then it would probably serve to favor large purchases being made among those things without tax, such as trips or education, while discouraging taxed purchases, such as homes and boats. (Assuming that was the specific policy.)
The problem here, is that the tax strikes unevenly, is felt quite differently by different people, is an incentive for some, but not for others, especially those who need to try to save, like the poor and lower middle class, as they pay little or no tax. As an incentive, the policy is so muddy in the message it delivers, and so hit or miss in its incidence, it fails to be an effective incentive at all. It ends up costing just as much as a similar policy of explicit fines or incentive payments, but at the same time, its impact is weak and uneven. And thus I would argue it is a poor means to change behavior4.
There is another consideration, though it is not an issue now with state sales taxes at 3%, %, even 8%, and that is the issue I discuss in "Symmetry and Asymmetry in Government", "Misunderstanding Democracy" and "Power and Disorder". When a group feels it is being unfairly singled out by the state, it looses interest in supporting or defending the state. Should sales taxes rise into the mid double digits, as the FairTax suggests, and should they be recognized as regressive, hitting the poor and lower middle class inordinately, as they must consume all or most of their income to survive, while the more affluent can avoid spending and thus taxes, then it is possible that ideologues might be able to sway those disaffected classes and convince them they have nothing to lose in a sudden change of regime. It sounds absurd, but throw in inflationary pressures, maybe declining employment, and it is not too different from situations which have historically produced unrest in other lands. Just because it is "only a sales tax" doesn't mean it can't happen. The Stamp Act was only a sales tax as well.
1. There are taxes which are fixed fees, and others which are tied to volume or unit count, such as many state cigarette and alcohol taxes. It is arguable whether or not these are sales taxes. For our purposes, I have defined sales taxes as only those which are assessed as a percentage of the sale price, and so these are not true sales taxes. However, as that is an arguable point, we will look at them as well, when it is relevant to the discussion. (As we will see, these flat fees are often less harmful than sales taxes, though to a degree that depends on the size of the fees and the nature of the goods in question.)
2. It is rather embarrassing to hear FairTax advocates talk about how the FairTax allows you to "choose how much tax to pay" by "choosing how much you spend". Nothing points to an elitist upper class origin more -- and to supporters among college students who do not support themselves -- than the idea that spending is optional. For almost all of the lower class, and even a significant part of the middle class, spending most of their income is called survival and is not optional. Of course, this is a silly argument anyway. As I argued elsewhere ("The FairTax's Liberal Assumptions", "Another Reply to Yt_knight", ""), you could say the same of the income tax, you can choose how much tax you pay by working less or taking a lower paying job. That does not make either tax voluntary, despite the efforts of FairTax sophists.
3. I find the discouraging of consumption particularly absurd, as consumption is the end goal of production. We work so that we can consume. Granted, we need to invest (or save -- which is investing, just indirectly) in order to expand our economy, to improve our conditions and so on, but we can only do so once we have satisfied some wants. And we only want to expand our economy because it satisfies even more wants. With satisfaction of wants being the cornerstone of the economy, it seems counterintuitive to make a policy of stopping people from satisfying wants. The truth is, with a stable economy, once enough wants are satisfied that future consumption of the fruits of investment seem more pleasing than more present consumption, people will save. We do not "save too little" right now because we are short sighted, but because our currency policies make overspending, and borrowing to consume, economically sound concepts. (See "Nation of Debtors", "Living Beyond Their Means " and "To Correct Debra Saunders".)
4. The FairTax, with its prebate, is even worse, as it waters down the disincentive to consume to a degree, while leaving the rest of this discincentive in place, sending mixed messages at an even higher cost, and at the same time making us all comfortable seeing the government as a source of regular monthly payments. But I said I would not take on specific details of the FairTax.
I know I promised more in this essay than I delivered, I avoided a few topics I said I would discuss and stopped before I reached some other issues. The reason for that is twofold. First, it is late and I wanted to get this posted eventually. Second, I realized I was drifiting far from the original topic, and would do better to save some topics for a more broad survey of the topic of taxes in general, which I will probably try to write soon. I will obviously want to explain and justify my rules for a good tax once again, s well as ask what taxes can and cannot do, and then look at all types of taxes, including my ideas for voluntary taxes, and finally reach some conclusions about where we should head in terms of government sources of revenue.
Originally posted in Random Notes on 2012/02/11.