How a Progressive Consumption Tax Works

Yesterday Gary Becker proposed switching to a consumption tax, one which could be made progressive. Since a progressive tax has higher rates for higher incomes, it's a bit hard to think how this is possible. If I buy milk, how will the government (or the store for that matter) know how much I make?

A progressive sales tax is progressive in an indirect way. We know that wealthy people tend to buy certain goods (superior good), middle-class people buy certain goods (normal goods), and poor people buy certain goods (inferior goods). Note in this case, an inferior good is not a good of poor quality. It's just one where people buy more of it when their income falls. College is an example (few wealthy people go to college).

Under progressive consumption taxes, restaurant food should be at a high tax rate, fast food at a moderate level, and little-to-no tax on food bought in a grocery store. Concerts should have a high tax and board games a low rate. The internet should be moderately taxed or not taxed at all.

The only issue with this kind of tax is its implementation. As you can guess, cataloging all these different goods would be incredibly time consuming. It's tempting to divide goods into large segments but selecting something as broad as "cars" becomes problematic. There are luxury cars and basic cars. In some places (e.g. NYC), many low income people don't have cars since public transportation is sufficient to meet their needs. In rural areas or in western states, this is less the case. It gets even more complicated considering some low income people need their car to operate a small business, regardless where they live.

Of course, we will have to accept some imperfections in a progressive consumption tax system. Imperfections are inevitable. But it's worth thinking about how it might work in practice.

The Bush Tax Cuts

I was largely agnostic when it came to the Bush-era tax cuts. But I had no idea how much taxing the rich taxed small business.

From what I gathered (via this video), all revenue from a privately held company (which small businesses are) counts as income for the owner. If the efforts of dozens of people bring in half a million, that's the legally the same as a CEO of a big company making half a million. In the former case, that money goes to employ the people to keep the business afloat. In the latter case, it's not. The narrator in the video underlines how risky it was for him to hire more people since it's unclear if the tax cuts will expire or not.

The video's produced by the Small Business & Entrepreneurship Council, so I assume they're correct that the tax system works as described, but of course there could be many exceptions that exclude most small businesses and the narrator's just in a bad place. Still, I think when most of us think "the rich's income" we're not thinking small business revenue.

That's not to say that small business is the "key" to economic recovery...I don't think it is. But it's not insignificant, either, and allowing the cuts to expire look less and less like a good idea.

The Madness of the Many

Daniel Indiviglio suggests taxpayers have discretion over where their funds go. I love this idea. In fact, I considered it a while ago (though I called it "taxpayer earmarks" and was less ambitious than Indiviglio, thinking only a fraction of the tax payment would be available for discretionary spending). I can't find a post about me talking about it, so you'll just have to take me at my word.

I am concerned that the payments are just another form of cheap talk, but more directly destructive. In Indiviglio's example, he increases his share to the DEA from $3.14 to over $160. I think many Americans would applaud that increase despite the efficiency (and ethical) problems of arresting people for enjoying drugs. I'd expect subsidies and make-work jobs to rise, as well, depressing the economy.

You might wonder why politicians don't have to worry about this trade off (pleasing the people at the expense of the economy). Well they do, but its weakened compared to the average taxpayer. If the politician's in charge when the economy sinks, he's (rightly or wrongly) punished for it by losing his job. Moreover, he has business interests (and their campaign contributions) which help keep him in line. But a single taxpayer's virtually unaffected by slightly increasing a subsidy for a feel-good industry. Even if they don't send money that way, most will and that's what makes the difference. It's the cheap talk of voting but without the (and I can't believe I'm wording it this way) rational filter of the politician.

The Shape of Things (Well, Just Taxes)

The Laffer curve is an inverted U-shaped curve which dominates the economic and policy discussions of taxes. It illustrates the relationship between tax rates (x-axis) and tax revenue (y-axis): as tax rates increase, the government gets more money until rates are so high, people leave the formal sector altogether and stop paying taxes. At both 0% and 100%, government gets no revenue.

The discussion about increasing or lowering taxes often reverts to where we are on the Laffer curve. If we're to the left of the peak, raising taxes raises revenue while on the right of the peak, lowering taxes lower revenue. Brad DeLong recently posted this graph of OECD countries' tax rates and revenue, claiming the peak is pretty far to the right.

What's bizarre about these discussion is that there's so much incentive to operate the peak. Raising taxes on everyone by just a bit (or raising taxes on unpopular people by a bit more) gives lawmakers a huge chunk of change to hand out to constituents. From the politician's perspective costs are low and benefits are high. In lowering taxes even more so: you get to lower taxes, raise revenue, and tell the truth! No politician would give up that option. So it seems pretty obvious to me that most countries operate at more or less the peak of the curve.

So why does DeLong have this graph with a clear upward sloping relationship? Because each country has a different peak. Operating in the extralegal sector means you can't operate in the legal sector. Therefore, the opportunity cost of going extralegal is higher in some countries than in others based on the quality of the legal sector. This is why developing countries, with an awful legal sector, have to depend on inflation to make ends meet. It's also why Sweden keeps a high tax rate: its government functions very well (for various demographic and cultural reasons). If you want to make a claim in favor or against taxes efficiency is much firmer ground.

Tax Rates in Economic Development

Bruce Bartlett comments on the 2010 release of the African Economic Outlook which notes that African developing countries have low tax rates compared to developed countries when they were at a similar level of development.

[A]lmost every country in Africa has a low tax/GDP ratio. If low taxes were the primary key to growth then Africa would be far richer than it is.

I'll agree with Matthew Yglesias: this highlights the importance of a well-functioning government. It doesn't mean that low taxes don't help development. Recent work suggests that low taxes are a symptom of a bigger problem: a poorly-functioning formal sector. If taxes are at even a moderate level, then people in the formal sector will leave because the formal sector doesn't add much to their bottom line, anyway. Governments have to keep them low to get any tax revenue at all and they make up that difference is massive amounts of inflation. Show me a low inflation, low tax country and we'll talk if the role of low taxes in development is overrated.

Should We Tax Happiness?

A new study suggests that a good part of income (for cricket players) comes from luck. Home field advantage matters a lot in cricket (apparently), scout show up randomly, and a good debut has a lasting impact on your career. If you happen to be on your home turf when the scout shows up, you're be in a better long-term position than your opponents. (The study was able to separate out performance from the field and performance from skill.) Matthew Yglesias argues that this is evidence for "Progressive taxes and more and better public services."

This leads to an intriguing question: should we tax happiness? The goal of public services (in this context) to the help the worst off and we use progressive taxes to fund those services, ethically justified because the wealthy didn't "earn" 100% of what they made. And because taxing someone because they got something by luck is justified in the area of salary, then taxing someone because got something else by luck must be equally justified.

Before I go further, two points. One is that this is not a serious policy proposal. Measuring happiness is very hard to do, made even more so since you'll be taxing people based on information that's completely subjective. I have no idea how you would do it nor do I care to figure it out. It's just a discussion to check for consistency. Second, yes generic happiness and wealth are functionally the same thing. Yes, the happiness research disagrees with me on this, partly because of issues with happiness research and the difficulty of measurement. All I'm saying is that when you take money away from people, you make them less happy and when you give them money they are more happy. The two are, on the margin, interchangeable (so no comments about how taxing income takes away what people didn't earn but taxing happiness doesn't collect "happiness" for the government to consume).

With that out the way, consider your own happiness. Most notable in my happiness is my relationship with my girlfriend, Tanya. I love her a great deal and she's by far the most serious relationship I've had. We met somewhat by chance, via match.com. (I call this is by chance because I was thinking about leaving the site having gone on so many dead-end dates and she had recently joined it.) According to Yglesias, this is grounds for a tax on my happiness. Most happiness that comes from social interaction is very similar to the cricket story: if you happen on a good opening conversation (performance) with the right person (scout), it can scale into something truly astounding. The question becomes, is this a stupid idea because it's impractical or because the whole notion of taxing happiness inequalities is silly? My vote is the latter as, I wager, it would be for most people.

The True Cost of the Soda Tax

Monica Potts argues that a soda tax isn't regressive even though lower income families spend more of their money (as a percent) on groceries compared to higher income families:

But that assumes lower-income families won't substitute something else, or just stop buying soda...If lower-income families are drinking a lot of soda, it's only because it's disproportionately cheap compared with healthier foods and drinks.

I really doubt that last statement's true since water's far cheaper and healthier than soda.

People buy soda for the same reason they buy anything else: it's the best value given the price. Yes, I'm sure if you increase the price people will buy less of it but they will shift to options that, when you consider costs and benefits, are less desirable. Even if they end up spending the same amount of money on groceries they are worse off than before the tax, by definition. They can only be made equally happy if they spend more.

This point deserves stress. The standard cannot be "if people are spending the same amount as before, then they are largely unaffected." That's a nonsense comparison. You must weigh the costs (including not just money but time, risk, etc) and the total benefits. Or, if you can, hold everything else equal.

Mankiw on Taxes

Greg Mankiw proposes we re-think measuring tax burdens. We generally measure them by calculating taxes, adjusted for GDP.

Looking at taxes as a percentage of GDP may mislead us into thinking we can increase tax revenue more than we actually can. For some purposes, a better statistic may be taxes per person, which we can compute using this piece of advanced mathematics:

Taxes/GDP x GDP/Person = Taxes/Person

Here are the results for some of the largest developed nations:

France: .461 x 33,744 = 15,556.
Germany: .406 x 34,219 = 13,893.
UK: .390 x 35,165 = 13,714.
US: .282 x 46,443 = 13,097.
Canada: .334 x 38,290 = 12,789.
Italy: .426 x 29,290 = 12,478.
Spain: .373 x 29,527 = 11,014.
Japan: .274 x 32,817 = 8,992

The bottom line: The United States is indeed a low-tax country as judged by taxes as a percentage of GDP, but as judged by taxes per person, the United States is in the middle of the pack.

Brad Delong and Matthew Yglesias says this implies that North Korea is a wonderful tax haven and Slovakia could stand much higher tax rates.

There's a reason why Mankiw focused on the countries he did: institutions. Japan, Italy, US, and the UK have similar economic systems (similar compared to the rest of the world). Mindlessly treating North Korea as the same as South Korea makes the same mistakes economists made decades ago when we wondered why all countries weren't converging to the same GDP. But the Solow model's predictions only work when countries are institutionally similar: "conditional convergence." Comparing Solvakia and Spain about tax revenue misses the point.

Tea Party History

With the "Tea Party protests" so popular among some Americans as a way to defy big government, a history lesson from one of my favorite books seems appropriate.

Most believe that the original Boston Tea Party was a protest against taxes on tea. In reality, the Americans weren't drinking that much British tea; local merchants have been boycotting it for five years, relying on smuggled Dutch tea instead. So, the British decided to remove some of the taxes on British tea in an attempt to make it competitive with Dutch tea.

Loyal British merchants would be granted the right to sell this cheap tea, effectively running the American merchants out of business. That's what the tea party was all about and why those merchants threw their competition into the ocean. (Granted, this would grant a monopoly on British tea to Loyalists, but the problem with monopolies is they increase price and restrict outputs which wouldn't be an issue here, given it has to compete with Dutch tea.) The famed party wasn't a protest of tariffs, it was a protest for a lack of tariffs, as bootleggers supported Prohibition and drug dealers benefit from the DEA.

The Tea Party wasn't celebrated in the colonies, either. The systematic destruction of private property highlighted Massachusetts' reputation as a place for warmongers and Benjamin Franklin demanded that the protesters pay full restitution to the owners of the destroyed tea.

As much as I empathize with the concerns of the modern protesters, this probably isn't the thing you want to be referencing to get your point across.

The Law of One Strange Price

Tyler Cowen at Marginal Revolution is rightly skeptical of macroeconomic explanation that rely on one strange price, including interest rates, tax rates, and the price of T-bills compared to cash. But it's only partly true. Yes, one screwy price is unlikely to mess with the whole economy (even for systematic prices such as interest rates and taxes). But it can if it's screwy enough. If the minimum wage was $100 an hour, there would be a major macroeconomic downturn thanks to that law alone.

The question becomes what is likely to be so out of whack. Interest rates and T-bills are traded on the market, checked and rechecked every day. If there is a systematic error, it's either short lived or relatively small. Taxes are checked as well (by voters), but that happens only every couple of years, if at all. They're also checked in a political process where the "right" tax is determined and spent by lawmakers acting on the voters behalf, instead the voters themselves. Most prices aren't so strange to mess up an economy by themselves. But if one is, I bet it's a tax.

The Forgotten Charity

Amity Shlaes recalls the last great act of banker, industrialist, and art collector Andrew Mellon in The Forgotten Man:

By giving largely, generously, completely, and entirely, he would demonstrate that the private man could be as good a servant to the public as the government official was...Mellon's gift would show the value of leaving art--or capital--to accumulate and compound in the shadows, untaxed. The National Gallery would be an object lesson that the high taxers could not forget.

One of the finest collections of Western art in the world, and the main building which houses it, was originally the gift of a "robber baron" who gave so selfishly that it doesn't even bear his name. And so, alongside the monuments to presidents and memorials to wars, among the lawmakers and tourists, in the shadow of the Capitol building, rests a silent dedication to low taxes.

First Kentucky and Now Egypt

When I saw this, I nearly fell over laughing. Copyright the pyramids? Ridiculous! The fact that every little kid is amazed by pictures of pyramids in history books is probably the only reason why they later visit Egypt and spend gobs of American money there as tourists. Please tell me that their copyright laws won't hold up here in the US.

Demand Curves Still Slope Down

Paul Krugman argues (January 7) that increasing taxes on the wealthy will not hinder the slowing US economy. It's a strange argument considering the wealthy invest much more and this investment is a key input into how economies grow. If you tax people more, especially on investment, they will be less likely to invest. Krugman cites the high growth rates in the Clinton era but it isn't, as he implies, due to high taxes. The plethora of possibilities was due to the dotcom boom. Krugman is mistaking coincidence for logic.

Of course if you do want to play this game, Herbert Hoover sharply raised taxes in 1932 and it didn't fix the problem.

Hustle and Woe

While driving home tonight DJs on a local radio station sparked a massive discussion on various "hustles," or ripoffs, people encounter in our daily lives. Listeners called in with example after example: cell phones, bottled water, condos, computers, cable/internet, parking, college tuition, stadium tickets, casinos. The great paradox is that even as people say these are ripoffs, they buy them. The DJs bemoaned the price of cable and internet, claiming cable in their age could be paid with a paper route. What they ignored is that such service included far fewer channels, no internet, and no On Demand service (the last of which one of the DJs praised).

These things are not really ripoffs, as evidence that people keep buying them. What sort of person buys somethings he knows he doesn't want? Most of these examples are really opportunities for people to wish stuff was cheaper, but that's nothing special.

Granted, some products are truly ripoffs--some things are not worth the price you pay for it. But such products don't hang around for long. Nobody called in claiming New Coke was a ripoff. The only true hustle out there are taxes, money that generally goes to those you don't know and probably don't care about it. The very fact that most of these groups can't make money through donations demonstrate that. And there's no way to opt out (short of leaving the country). If you don't buy a cell phone, your life is a little less easy. But if you don't pay your taxes, you go to jail. Woe is me.

Texas Holdup

Since I am back in Iowa visiting the folks, my blogging has been very sparse lately. However, when I saw this new Texas law going through the legislature, I had to comment.

The Texas government plans to start taxing patrons of strip clubs five dollars to fund sexual assault prevention programs. Their logic is that people who frequent such establishments are more likely to go on to attack women. If that's true--and it may or may not be--I'm not sure why the state wants to discourage them from going there. If, for example, murderers liked to hang out in pool halls then we'd expect police officers to also go to pool halls to find crimminals. They certainly wouldn't want to shut them down.

It's not that the government wants to prevent sexual assualts, they just don't like strip clubs. Oh they cloak such selfishness in nice motivations like "helping battered women" but what they really care about is getting rid of the things they, personally, don't like. Sen. Dan Patrick said it all:

I don't want the fact that the government is making money from them to make them harder to close. I would rather see the businesses close down,

Yes, Senator, because it's really all about you.

Subsidizing Dropping Out of High School?

Gary Becker and Kevin Murphy have an interesting article on income inequality. They go through various stats, discussing how returns to education is driving the increase in inequality. Then they bring up the political desire to create an increasing progressive tax code to reduce the inequality. They offer this as a rebuttal:

For many, the solution to an increase in inequality is to make the tax structure more progressive-raise taxes on high-income households and reduce taxes on low-income households. While this may sound sensible, it is not. Would these same individuals advocate a tax on going to college and a subsidy for dropping out of high school in response to the increased importance of education? We think not. Yet shifting the tax structure has exactly this effect.

HT Greg Mankiw

The Opportunity Cost of Going Flat

This week on EconTalk Russ Roberts interviewed Alvin Rabushka. author of The Flat Tax. I haven't heard the whole podcast (having misplaced my earphones) but one virtue is worth emphasizing: the elimination of jobs.

Even if the bureaucratic process allows all those thousands to keep their job at the IRS despite many of them being useless, the economy will still see legions of tax preparers, software makers and lawyers go out of business, or at least that section of the company. And entire industry would be rendered obsolete overnight! The savings to the taxpayer would be immense, even if everyone ends up paying the same amount.

"But David," you might say, "aren't jobs good?" It depends on what they add to the economy. Digging wholes only to fill them up is a job but it adds nothing. Making buggy whips in a world of cars doesn't do much either--nothing eliminates jobs like technology. If we can get the same thing (an adequately funded government) for less, then why wouldn't we want it? The saved resources (time and money) would allow us to do so many things, making society even richer.

Supporters of our current tax system will note that we don't get the exact same thing with the flat tax and that's true. (We don't get the exact same thing swapping buggies for cars either, but very few stick to traditional horsepower; just because it's not strictly better doesn't mean we shouldn't move.) Some people will pay more and some will pay less. But the point here is that everyone will save a lot on preparation.

Adam Smith on Taxes

Adam Smith gave four signs of bad taxation:

1. If it requires a large bureaucracy for administration.
2. If it “may obstruct the industry of the people, and discouraged them from applying to certain branches of business which might give maintenance and employment to great multitudes. While it obliges the people to pay, it may thus diminish, or perhaps destroy, some of the funds which might enable them more easily to do so.”
3. If it encourages evasion.
4. If it puts people through “odious examination of the tax-gatherers, and expose them to much unnecessary trouble, vexation, and oppression."

In conclusion, “It is in some one or other of these four different ways that taxes are frequently so much more burdensome to the people than they are beneficial to the sovereign.”

(From Charles Adams’ For Good and Evil: The Impact of Taxes on the Course of Civilization)

William Tell, Tax Revolter

The story of William Tell is well known, but not the reason for his actions. In 1273, the Austrian Hapsburg family refused to acknowledge the independence of the communities of Schwyz and Uri and attempted to tax them. The Swiss rebelled against paying the Hapsburgs, including one William Tell. For his punishment, he had to shoot an apple from his son’s head with a crossbow, and became famous for his tax evasion. The revolt against oppressive taxation gained traction in 1291 when three communities formed a mutual assistance league against Austrian taxes. Other communities joined, and Switzerland came into existence. In 1315 the Austrian troops entered Switzerland, outnumbering the Swiss about ten to one. The Swiss won the battle and subsequent ones, and currently has one of the best tax systems in the world (and by best I mean least burdensome).


(From Charles Adams’ For Good and Evil: The Impact of Taxes on the Course of Civilization)

The Rosetta Stone and Tax Immunity

In ancient Egypt (prior to 200 BCE) Egyptian soldiers returned from war and found they had to pay more in taxes. Greeks ruled the country and were the best at collecting them. The soldiers initiated a civil war that lasted for more than a decade.

To restore peace, the king Ptolemy V issued a “Proclamation of Peace.” It granted amnesty to the rebels, tax debtors were freed from prison, tax debts forgiven, no more conscription for the navy, and confiscated property was returned. Also, tax immunity was granted to the temples and their vineyards and crops, as was the tradition under the Pharaohs. Peace was restored to Egypt.

The priests were great beneficiaries. They had lost their tax immunity beginning in 700 BCE. In order to commemorate this, the priests decided that an honorarium be made in a “stele of hard stone in sacred and Greek letters, and set up in each of the … temples at the image of the everlasting king.”

This stele of hard stone was found by Napoleon’s army and is known as the Rosetta Stone. It is almost four feet high at its tallest point, weighs over 1,500 pounds, and was written in three languages. The reason for its size and multilingual inscription is because it announced immunity from taxes.

(From Charles Adams’ For Good and Evil: The Impact of Taxes on the Course of Civilization)