Tag Archives: income tax

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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Experimenting with an earnings tax

Imagine a 2 period wealth maximization game. In period one, consumers receive unitless  endowment N and can choose to use that endowment to consume, invest (at some interest rate i) or do nothing. In period 2, consumers choose to consume or do nothing, payoffs are made, and the game ends. We can introduce an exogenous income tax on investments, and an exogenous sales tax on consumption and utilize Monte Carlo simulations to do comparative analysis on different regime states to analyze the hypothesis that taxation of income retards stimulative investment and that a sales tax mechanism is preferable to maximize economic growth.

The basic design seems sound to me. . But flaws are not always obvious. Thoughts?

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Rex Sinquefield on taxes

Patrick Tuohey at the Missouri Record has generously agreed to publish a piece I wrote on Rex Sinquefield and his political agenda in Missouri. The piece should come out tomorrow, but here is a selection of excerpts from the Show-Me Institute Quarterly clarifying Sinquefield’s advocacy on taxation. The excerpts are taken from the Fall 2008, Fall 2009, and the Winter 2010 issues of the Show-Me Quarterly.

On why a re-evaluation of Missouri tax policy is in order:

Missouri is chronically below average for economic development and growth. During the past 10 years, employment has grown 8.8 percent nationally, while Missouri has boosted jobs by a barely perceptible 0.23 percent. In their study for the American Legislative Exchange Council, titled “Rich States, Poor States,” Laffer and Moore offer one explanation for the state’s poor performance: Missouri’s personal income tax rates. The highest rate of 7 percent — which includes the state’s top marginal rate of 6 percent, plus a 1-percent earnings tax imposed in Kansas City and Saint Louis — places the Show-Me State at 32nd in the nation.

On the deficiencies of Missouri’s income tax:

We side with economists who say that an income tax is a huge drag on growth in two ways: First, an income tax lowers the net pay of workers, providing them with less of an incentive to work. The flip side of this argument is that Missouri workers are likely to demand higher pay in order to offset the higher after-tax income in other states. Second, the income tax is inherently unwise, because it’s relatively narrow in scope and cannot be avoided except by leaving the state. This is hardly the type of tax that makes sense in the face of cutthroat competition among states. Missouri needs business and job creation. We’re also impressed by another set of significant economic numbers. States with no income taxes have the lowest overall tax burdens, according to data compiled by the Tax Foundation. Indeed, the correlation is virtually one to one.

On the link between taxation, jobs, and economic growth:

We show that the state’s economic growth has been sluggish by national standards, but that the nine states without an income tax have added more than twice as many jobs as the national average. Not all of this extra growth can be attributed to differing tax systems, but some of it certainly stems from the fact that the lack of an income tax lowers business costs. States without an income tax also have lower overall rates of taxation; the eight states with the lowest taxation rates in the country are eight of the nine states with no income tax. Multiple studies have shown that lower levels of taxation also boost economic growth, so implementing a sales tax to replace the income tax could boost growth in more than one way.

A broad-based sales tax should exempt the poor and will provide Missouri with greater financial security:

It’s true that a sales tax can be regressive, which is why it’s important to exempt low-income families from paying such increased taxes. If Missouri were to eliminate the income tax in favor of a slightly higher and more comprehensive sales tax, we could eliminate the penalty that the state’s tax policy imposes on business investment, and instead spur economic growth while simultaneously providing a more stable source of revenue for essential government functions.

And replacing the income tax with a sales tax can be revenue-neutral:

n 2007, Missouri’s sales tax generated nearly $2 billion. To replace the income tax fully, the sales tax would have to produce another $4.9 billion, according to Joseph Haslag, executive vice president of the Show-Me Institute. (I would like to point out that because repeal of the income tax would stimulate growth, ultimately, a dollar-for-dollar increase in the sales tax won’t be necessary. But I’m willing to adopt a revenue-neutral approach for argument’s sake.) However, Missouri lawmakers over the years have voted to exempt more than 140 other items from the sales tax, according to research conducted for the Show-Me Institute. In addition, Missouri does not tax consumer services. If Missouri included in the sales tax all products and services purchased by individuals — which  would exclude business-to-business transactions and capital acquisitions by businesses — a general sales tax rate of about 5.7 percent would suffice, according to Haslag’s estimates.

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A quick bleg on the income tax and fraud

I argue that Missouri’s ‘Fair tax’ proposal to eliminate the income tax and implement a revenue-neutral, broad-based sales tax makes intuitive sense to me on the grounds that it is relatively more idiotproof. That is, sales taxes are relatively easy to implement and monitor and a lot less costly to enforce relative to income taxes. Sales taxes also are hard to get out of paying relative to income taxes; you don’t lose money when people forget to send them in (or they get lost in the mail), cheat on them, or  make mistakes.

Speaking of cheating on your taxes, here is a rather egregious story of tax fraud from CNN today:

Investigators say Monroe County jail inmates in Key West had been filing false tax return forms for jobs they never had as far back as 2004, and getting thousands of dollars a pop in refund checks.

Using a formula that kept their refunds to amounts under $5,000 per claim, inmates thought they would fly under the radar, investigators say. And they did for years, passing around cheat sheets that showed line by line how to fill out the complicated forms.

The scam however is not a local gig. Investigators and federal officials say it has been going on for decades in state and federal prisons around the country.

“These guys weren’t rocket scientists…They didn’t just wake up and come up with this great scheme,” Monroe County Sheriff Bob Peryam said.

Here’s how it allegedly worked: using names of defunct or made up businesses as places of work and a master cheat sheet for salary and other numerical information, inmates filled out 4852 tax forms — the ones you use if your employer didn’t provide you with a W-2.

The inmates sent the forms in and the IRS then issued refund checks, in some cases sending them directly to the county jail. But inmates didn’t just fill out the forms for themselves. For a $500 fee ringleaders at the prison filled out refund requests for other inmates, promising they would each get a return of about $4,500.

Some of the prisoners, homeless before their arrests, were unaware of the scam. They gave away their social security numbers for honeybuns, a sweet pastry that inmates can buy in prison. The scammers would then file more refund requests under those social security numbers.

Wow. Consider that without an income tax, this scenario is simply impossible.

I want to point out that I don’t have a philosophical objection to income taxes per se. Rather it seems to me a matter of pragmatism: how idiot-proof can we make our taxation and government mechanisms?

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