Column: Sales taxes can have negative effect

Published 12:00 am Wednesday, May 22, 2002

It is a pity that the proposal by the City of Albert Lea to install a half percent local-option sales tax failed to pass the state legislature.

The death of the bill itself did not bother me. What disappointed me is the way it was killed: The argument at the Capitol seemed to be narrowed down to a local control issue rather than merit-based scrutiny of the proposal.

The domination of politics over public policy is a sad but irreversible reality. Yet, the advocates of the tax should not give up their efforts to persuade the decison makers with reasons, polishing up their own rationale.

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Sales tax is regressive

One thing the advocates and opponents should bear in their mind is the fact that a sales tax is a regressive tax.

It becomes clearer if we compare the sales tax with an income tax.

The federal income tax has an incremental schedule varying from 10 to 39.1 percent in accordance with the income level.

Person A whose annual taxable income is $400,000 pays $156,400, while Person B who has $20,000 in taxable income pays $3,000.

Person A earns 20 times more than Person B. But for the income tax, A is obligated to pay about 52 times more than B, which tells the income tax is progressive.

A property tax has a neutral nature. It is subject to the property value: If Person A owns a house that is 20 times more expensive than Person B’s house, he pays exactly 20 times more in the property tax.

What about a sales tax?

No doubt, Person A spends more on goods and services than Person B. But does he spend 20 times more than B?

When it comes to the consumption of necessities, say toilet paper, the point is clear. If Person B uses 10 rolls of toilet paper, does Person A need 200 rolls? Not likely. Person A may spend more on toothpaste, light bulbs, coffee mugs and garbage bags, but not as much as 20 times more than a household with a decent income.

The demand for necessities is very inelastic: Consumption is not responsive to price changes.

We can say intuitively that even if the price of a toilet paper roll surged from 50 cents to $2, a consumer still needs to buy more or less the same quantity.

The demand for luxuries has, on the contrary, elastic demand. A small increase in the price causes a major decline in the demand.

Person A is more likely to give up the purchase of a Mercedes or yacht if the sales tax is imposed, while both A and B keep the same level of consumption of toilet paper.

Thus, the sales tax widens the gap between the rich and poor.

Irreparable loss in economy

The equity issue is only a part of the problem. A more important issue for all of us is the damage on the economy the sales tax may inflict.

The sales tax, as many other forms of intervention in the market, inevitably increases the price of goods and decreases the produciton. And both the consumers and producers lose economic benefits they could have gained in the free market.

In a model shown in the graph, the original demand and supply creates the market equilibrium E1 where the price of the good is 10,000 and the output is 500.

In this market, all the transactions take place at this price. It means that a consumer who is willing to pay more than $10,000 only needs to pay $10,000. A consumer willing to pay $10,020 gains a $20 surplus. Likewise a producer whose willingness to sell is $9,990 gains a $10 surplus.

If a $50 sales tax is imposed, the equilibrium moves to E2 at $10,030 and 300 outputs.

In this state, the above-mentioned consumer can no longer make the transaction since his willingness to pay is below the newly established market price, and his $20 surplus is lost. In the same way, the producer loses his $10 surplus.

Every consumer whose willingness to pay is between $10,000 and $10,030 and producers whose willingness to sell is between $9,980 and $10,000 are driven out from the market due to the tax. If we aggregate the amount of all the losses, the amount equals the shaded area on the graph that equals $20,000.

Of this total loss, $15,000 ($50 x 300 units) is shifted to the government as the tax revenue. But the rest, which is depicted in the triangle E1, E2, A is not conpensated. The $5,000 surplus disappeared as the deadweight loss because of the tax.

Public goods/government role

It is true that the free market has difficulty producing the right amount of public goods because of the lack of incentives among the participants. Everybody wants a clean lake, but not so many are willing to share the cost. The creation of public goods is a prime raison d’etre of the government.

But that fact should not allow the authority to jump to the sales tax as a handy tool to fund public projects, which can result in screwing up the economy.

Consequently, the implementation of a sales tax requires very careful scrutiny to weigh what we could gain from the increased tax revenue and what would be lost.

It is also sensible for the government to explore every possible way to encourage the market to increase the production of public goods the community needs by facilitating a appropriate incentive mechanism before intervening into the market in such a direct way as the sales tax.