Income taxation as an inefficient mechanism

Carl Bearden has an interesting discussion about Missouri’s Fair Tax proposal today that I thought was worth commenting on.

Income taxation means that each eligible individual has to figure out that they are eligible to pay tax, what that tax is, and finally, how and when to pay it. Not all individuals, depending on income status and other variables, have to pay income tax, but at a bare minimum, there is a cost to figuring out that I need to pay taxes on my income. I identify this as inefficient; simply because of the existence of transaction costs, some people simply don’t file tax returns. Worse, some people deliberately don’t file, and a lot of people cheat. Some people simply make mistakes.


The system, however, cannot easily correct for free-riders and enforcement costs. You have limited resources to go after tax cheats and people who made mistakes filing, and at the end of the day, most people who keep money from Caesar never face any real penalty.


The sales tax is far more efficient. Instead of collecting from individuals, the tax is collected at the point of sale by businesses, a finite number of entities that are registered and (pervasively) regulated anyway. It is a far simpler thing to collect sales tax from the smaller number of businesses and firms than it is to collect income tax from millions of individuals. Moreover, the costs of enforcing compliance are minimized; you already have the regulatory apparatus in place, pretty much, and the tax is simple to calculate (you don’t need H&R Block to fill out a 50 page form for you).


From an efficiency criterion, this is a much superior setup. Free-riders find it much harder to escape taxation, and society does not have to be overly intrusive to ensure compliance.



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