The seemingly common-sense view that a retail sales tax will readily be shifted forward to the consumer is totally incorrect, writes Murray Rothbard. In contrast, the initial impact of the tax will be on the net incomes of retail firms. Their severe losses will lead to a rapid downward shift in demand curves, backward to land and labor, i.e., to wage rates and ground rents. Hence, instead of the retail sales tax being quickly and painlessly shifted forward, it will, in a longer-run, be painfully shifted backward to the incomes of labor and landowners. Once again, an alleged tax on consumption, has been transmuted by the processes of the market into a tax on incomes. [Full Article]
Source link: http://blog.mises.org/3343/the-consumption-tax-a-critique/
The Consumption Tax: A Critique
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I will not say that I’ve read the entire article as I should, but the general gist of things is enough on this point -
Today I was thinking about illegal markets.. I would venture that if the legal markets buckle any harder – out of illegal markets alone, operated by ‘conscious objector’ types, who I could be one of — the illegal markets would “teach” the legal markets how to correct, case in point:
Suppose someone, for example me, decided to ignore norms upheld in say, a material reality. What would happen if what I did, while being culturally essential to me – touched the sphere of what was hurting in “society” which I don’t recognize as “existing” — and I noticed the other to be unhealthy, weak, abused:
Would this be a chance for me to help you, or you to help me?
As I’ve pointed out before ( http://blog.mises.org/blog/archives/003313.asp ) Rothbard is unfortunately wrong regarding his claim that consumption taxes do not hurt consumers.
Just about every case of increasing or lowering consumption taxes that I’ve seen in Sweden and other European countries has been associated with a instant similar increase or decrease in prices. In fact, it usually is the case that prices increase/decrease with the exact amount as the change in consumption taxes and they increase/decrease that amount from day one of the tax change.
And again, there is every reason to expect this turn of event from a theoretical point of view. Rothbard disregards the fact that the former price was optimal only given the former sales tax. Rothbard was right to write “Prices, at all times, tend to be set at the maximum net revenue point for each seller.”, but he curiously disregards the fact that the maximum net revenue price calculation changes dramatically if a consumption tax is imposed.
Take a company who has a 20% margin and who is hit by a 30% consumption tax. While the old price it had may have been profit-maximizing in the absence of a consumption tax, it will obviously not be profit-maximizing with a 30% consumption tax.as all sales will involve losses. While the likely decline in sales may have counteracted any gains from futher increases in margins in the absence of a consumption tax, with a consumption tax the firm will definitely
gain from restoring positive margins even with a sharp decline in sales.
This effect will be greatly enhanced by the fact that the fall in sales is likely to be a lot lower as a result of a price increase since now competitors will be unable to compete with lower prices as they would have been without the consumption tax.
The conclusion of this article is “The best scheme of [public] finance is, to spend as little as possible; and the best tax is always the lightest.” Surely given the excessive taxation, as well as its immoral use for distributing income, that is a worthwhile guide. However, it does not indicate the basis on which to bring it about. I aver that the basis is the proper functions of government, which include defending the rights of its citizens, a judicial system, and consequently the survival of the nation and government itself. There are wide latitudes as to how this is to be interpreted, but barring such concepts as “positive rights” the total tax should end up small. Note that only a generation ago, when taxes were far too high, they were a fraction of what they are today.
There are of course issues as to how to allocate these taxes. Here, I believe that the ideal is a head tax, where each citizen pays an identical amount, as is done for membership in any organization or institution. (One of its many benefits is that this would ensure that taxes do not become high.) I recognize the theoretical argument that taxes be proportional to one’s wealth, and the practical argument that a head tax is inconceivable politically. Consequently, there is a need to compromise with some form of proportionality. Yet it may be kept in mind that more important than how taxes are allocated, is the imperative to not collect them for purposes that are not imperative for survival.
I think it is right to point out that a consumption taxes are not a panacea, and they ultimately need to be paid out of income (or some other wealth creation), but too much is done to compare the current horror with an imagined horror – with most of the effort going to expanding the horror components.
Were the entire IRS and associated compliance system removed (and there is someone to fill out your 1040 in every strip mall, and more appearing even with the internet and tax prep software), and replaced with a piggyback on state sales taxes, it would be a good. Right now it too often costs more to comply with the system than it generates in revenue.
A light-hearted post on the same topic: http://blog.mises.org/blog/archives/003302.asp
It seems to me that all discussion of a consumption or sales tax eventually leads to an implementation plan whereby the national tax is bolted on to the current state sales tax collection schemes.
This leads me to wonder why we are not advocating a return to the the original taxing structure in this country. That is, that all taxes are indirect and apportioned among the states according to population. Each state imposes the tax upon their citizens that makes the most sense, be it sales tax, income tax or some combination. No need for a separate bureaucracy to collect the fed money. One small office could handle the 50 checks a year they would receive from the states.
One thing more to say about a national sales tax: it will promote the growth of the underground, or black, market. Once a sales tax is imposed, people will find ingenious ways to sell each other stuff without invoicing, just like we do it here in Mexico to avoid paying the VAT. The underground market is the last truly free market we have.
Brother! I am so glad to see the constructive use of high demand product, so much so it in itself seems like the best alternative to currency you can get really. I mean, when you ignore people like Einstein, with unenforcable laws – you’re bound to catch a good guy on the other side of the fence with some notes. Stuff like this activity seals the deal for me – alternate culture completely. It’s just a matter of time before I’ll be able to run for some county political position, or you could be a council person or a board member of a super flexible, solid state system setup to be synergistic in it’s force… OR The tax route –
Stefan: I don’t believe Rothbard said it didn’t hurt consumers, just that sellers can’t directly pass on the tax. It’s obvious that the tax will affect prices, though (Rothbards wording makes it sound like it won’t, but I read it as implied). This seems right to me: assume you sell widgets for $100 each, and then the government passes a 10% sales tax. Let’s say you buy or make widgets for a total cost of $70. Now, the tax is only on “consumer” sales, so your supplier costs don’t change; i.e., it still costs you $70 each to obtain widgets. There’s no reason why the aggregate demand for widgets should change, as Rothbard says, so, if you could ignore the tax for the moment, your profit-maximizing selling price is unchanged. So if you increase your price to $110 ($100+tax), your revenue falls; and you have to pay 10% of the now-reduced revenue to the government! If you just ate the increase, you’d make more after tax. Now, of course, since you’re making less money, you’re going to change your buying decisions, which will affect your suppliers (that’s what Rothbard means about pushing the tax back), which will affect your cost base, and move your maximum-profit point, and so it’s quite likely (certain?) that your selling price will go up due to the tax, but an immediate increase of the amount (percentage-wise) of the tax is a losing proposition. But of course the vast majority of uninformed business owners nevertheless believe that they can just pass it on, so naturally enough you see the immediate changes you talk about. (On the other hand, if you’re selling mostly to other producers/resellers, you can just add it on, because your customers don’t pay it anyway; they pay it to you, but it gets refunded, so they effectively don’t pay (much; they do end up giving the government a short-term loan, so I guess that’s worth something))
Peter, that was a very good reading of this article, in my humble opinion. I was scratching my head at Stefan’s post, but I wasn’t sure enough of the argument being made to say anything.
Thanks for clearing a lot of it up.
“There’s no reason why the aggregate demand for widgets should change, as Rothbard says, so, if you could ignore the tax for the moment, your profit-maximizing selling price is unchanged. So if you increase your price to $110 ($100+tax), your revenue falls; and you have to pay 10% of the now-reduced revenue to the government! ”
Well, yes that is of course true (although technically it would actually only be 9.1% (10/110)that would be payed ). That is why I certainly do not dispute that sellers (Including wholesale dealers and their suppliers)are indeed hurt by consumption taxes.
But it is also true that if you keep the selling price unchanged ,revenues would fall too . Net revenue would in fact fall some 30%. That is because if the selling price is still $100 then the government would take $9 (100-(100/1.1)) and you would be left with only $21 in net margin per widget. So unless the price elasticity is so high that sales volumes would fall more than 30% with a 10% price increase , the profit-maximizing price will be higher than $100.
It is of course possible that price elasticity is that high, but not very likely particularly considering that competitors (apart from black market dealers) and possible substitute products will also be hit by the tax and will be unable to compete on price.
To emphasize the point, assume the sales tax is 50%, a rate which is not uncommon (It is often even higher)for certain “sin products” in Europe, like alcohol, tobacco, gasoline and electricity. This would mean that if you kept the price unchanged at $100, your gross revenue would be $66.67 which given a price of $70 from suppliers would turn net revenues negative and make any decline in sales volume a lesser evil.
Peter,
…This seems right to me: assume you sell widgets for $100 each, and then the government passes a 10% sales tax. Let’s say you buy or make widgets for a total cost of $70. Now, the tax is only on “consumer” sales, so your supplier costs don’t change; i.e., it still costs you $70 each to obtain widgets….
Since the only consumption tax that makes sense is a retail sales tax that is combined with the elimination of the IRS, and all other taxes, including personal and corporate income, and payroll taxes, supplier costs will most certainly go down.
Rothbard, writing when he did, had to consider a much broader range of possibilities, and did not include the effect of things like the monthly prebates and the elimination of all income tax compliance costs for both companies and consumers.
The expectation of the originators of the RST plan was that prices would not rise to the extent of the sales tax, if at all, over time as supply chain tax costs would be eliminated. This is the hardest thing for the public to believe, and Rothbard effectively supports the non-rise of prices even for already produced goods with their already embedded taxes. Not taken into account is the increased buying power of workers as they no longer have income tax with-holding or payroll taxes deducted.
In the end, some prices would rise and some would fall, but there is no possibility that all prices will rise by anything like the amount of the sales tax rate increase. New products would come into existence that could not previosuly support the costs of income tax compliance.
Regards, Don
So-called “Green Tax Reform” (GTR) would tax pollution and virgin materials along with consumption (the “bads”), while leaving labor, investment income, and savings (the “goods”) untaxed, closing the loop on natural resource use and greening things up both environmentally and economically. Furthermore, as pollution abated, tax receipts would decline and the state would shrink as a result, all the more so as society’s continued enrichment obviated the need (not that there ever WAS a need) for welfare programs. All that would then be needed is for the state to stop subsidizing oil companies with taxpayer-financed protection abroad, forcing the pump price of oil to reflect its true cost — http://washingtontimes.com/commentary/20030722-093718-6082r.htm — and spurring investment in safer, cleaner alternatives.
Hey, I can dream, can’t I?
Rothbard seems to have addressed very well the circumstances of implementing a consumption tax; and it also appears that he forgot to take into account the idea that, if the income tax is eliminated at the same time the consumption tax is implememted, consumers will have more money to spend (no more withholdings). Consumers will accept the higher prices, figuring that they (ok: we) can now afford it, since we are taking home more money (assuming the consumption tax rate is not higher than their former income tax rate).
Ah, yes, Stefan is quite right of course. However, I think the new profit maximizing price is unlikely to be just the old price plus tax.
In fact, if you take my previous numbers: $70 cost, $100 original selling price, and let’s make up a demand curve such that the number of units sold is 10000 originally; say, the floor of (300000-(p-100)^2)/(p-70) — i.e., you sell 10344 units at $99, 10000 units at $100, 9677 units at $101, etc.; this puts the maximum profit point at $100 ($300000 profit) with no tax. Now, if I didn’t screw something up, adding a 10% tax moves the new maximum profit point all the way up to $180 (selling 2669 units for a net profit of almost $250000. At $100 the net profit is just over $209000, and at $110, just under $225000).
Of course, that’s assuming your costs remain at $70 when you reduce to only about 1/4 of the original output, which is unlikely, but I think it makes the point.
Actually, I don’t think demand curves can be said to function in the equation-type manner Peter described. There is no reason to believe that a increase from say $120 to $126 will necessarily lower sales by the exact same amount as a increase from $100 to $105. And this is in fact particularly unlikely in this context.
One of my points was that price competition is likely to be a lot more limited below the level of $110, since below that it will be nearly impossible to gain a profit which provides a adequate return on capital. If price competition intensifies, then price elasticity will increase, making it a bad idea to raise prices.
To clariffy I think there are two reasons why the profit-maximizing price rises with a tax. As you know, the profit-maximizing price is the point where any further price increases will lower sales volumes more than they increase margins and where any price cut will lower margins more than they increase sales volumes. And as a sales tax will both lower margins and decrease price competition ( and accordingly price elasticity) at the old price, it will push up the profit-maximizing price.
Pre-tax a price increase of $10 would increase margins by a third (33.3%) from $30 to $40. Post-tax it would increase margins by
43.5% (30/20.91), making it now (Which wasn’t the case before the tax increase) profitable to raise prices if the price elasticy is such that such a move would lower sales between up to 30.3%, whereas before the tax increase the tolerated sales decline was only 25%.
Moreover, with the tax it is far less likely that competitors would want to respond to a price increase from $100 to $110 with price competition. And the decrease in price competition will likely lower the price elasticity at the point of $100.
The combined result of the higher base effect in margins and the decreased price elasticity is likely to push up the profit-maximizing price.
I agree…of course it doesn’t work that way in reality. But if we want to play with actual numbers, you have to make up some sort of equation (or table of values) for it. The inverted parabola I used is just the simplest equation I could think of on the spur of the moment that had the desired shape; it’s not intended to reflect reality, just to provide some numbers to demonstrate that the new price is unlikely to be the old price plus the tax (in fact, I think it demonstrates that it’s impossible for the new profit maximizing price to be just the old price plus tax (and that it’s always higher than that) — if the actual demand curve is above my curve at any point (necessary to make the new profit-maximizing price lower than on my curve), then the pre-tax profit-maximizing price would move up as well)
But the lost sales going from $100 to $105 (1430 sales lost) is not the same as going from $120 to $126 (647 sales lost), anyway.
ALL taxes are taxes on individual income, even those less-discussed taxes like compliance costs, payroll taxes, and deficit spending. While the article correctly states that overall tax burden is THE primary concern, the method of taxation is VERY important.
Generally, taxes that are either easier to avoid, allow greater personal privacy, or both, are self-evident as the preferable forms of taxation from the citizen’s POV, regardless of their economic status. Similarly the State will favor those taxes which provide the least room for avoidance combined with the minimum of personal privacy. Freedom-lovers everywhere should back any true local impetus to shift the burden to taxes that encourage the underground economy and are less intrusive.
Property taxes are extremely hard to hide from, since EVERYBODY pays them. I hate them for that reason, even undocumented illegal aliens pay property taxes! Were I to retire inside the U.S., I would chose a state with a high income tax and both low sales and property taxes.
I’m surprised that there isn’t a single libertarian who came up with this tax reform: have zero tax. No income, no corporate, no sales, no tariff-nothing.
Rely on voluntary donations.
If people really need a new bridge and the government earns the trust to build the best bridge at the best price, then they will help pay for it. The government would be like any other non-profit organization trying to convince people it is a worthy cause.
I think Rothbard is just plain wrong on at least one point.
He writes that “we cannot conclude that savings in the long run [under a consumption tax] receives any tax exemption or special encouragement.”
But this is not correct. Let’s do an example based on Rothbard. Suppose the real interest rate is 3%, the income tax rate is 20%, and Jones saves 10% of his income under the income tax.
If Jones starts with $1 earmarked for savings, the first year’s tax brings it to 80 cents. Since interest is taxed every year, Jones effectively earns 2.4% rather than 3% (assuming either 0% inflation, or inflation not being taxed). After 20 years, Jones has about $1.29 after tax.
Under a consumption tax, Jones starts with his full $1, and earns a full 3%. After 20 years, he has $1.81. Assuming 10% saving, the consumption tax will need be no more than 22.22% (this assumes the saved money is NEVER spent – under more reasonable assumptions, 21% or so might be enough) to raise as much money as an income tax. After paying the 22.22% tax, Jones is left with about $1.41.
Rothbard writes that “There will therefore be no shift by Jones in favor of savings-and-investment due to a consumption tax.” This is surely false. If Jones was neutral between $1 today and $1.29 in twenty years, as he was with the income tax, he will certainly earmark more to savings-and-investment when the choice is $1 now or $1.41 in twenty years.
I think Rothbard has made the mistake of forgetting that the return on investment is not received (and taxed) in bulk just before consumption, but continuously between investment and consumption. That is, an income tax taxes the income, and the income on the income, and the income on the income on the income. The consumption tax taxes only the income, and only once.
This would seem to undermine a good portion of his argument.
Phil
P.S. One hidden assumption in this calculation is that the change from income tax to consumption tax does not result in a lower interest rate. This does not seem unrealistic to me, since most investment activity is done in within corporations, which would not be affected by this change.
OK, you sent me to the spreadsheet! Without an inflation time-value-of-money calculation, the score is “Phil 1, Rothbard 0″!
Assume 0% inflation, 3% interest, 10% income tax on income and investments. Jones gets paid $100 at the beginning of each year, takes 10% of post-tax income into savings, and reinvests the post-tax interest income each year. After 10 years, Jones has spent $810 dollars, paid $100 in direct income taxes, paid $1.61 in tax on interest income, and has a nest egg of $104.51 in savings, which he now withdraws and spends. His total taxes are $101.61.
Use the same assumptions, but zero tax. At the end of ten years, Jones has spent $900 and has a nest egg of $128.08 which he now withdraws and spends. If he had been subject to a sales tax, how high would it have to have been to generate the same revenue as the income tax of 10%???
Well, Jones will spend $1028.08 and we need to get $101.62 to make it revenue-neutral.
101.62 / [1028.08 - 101.62] = 0.1097 or an 11% sales tax. The revenue-neutral sales tax rate has an inverse relationship to the income tax rate (10% income tax leaves 90% income, 1 / 0.90 = 1.11).
Over the course of the 10 years, with an income tax Jones gets to spend $914.51 on goods, and with a sales tax, Jones spends $1028.08 but gets $926.47 of goods. Jones should like the consumption tax better, because the tax-free compounding allows him to generate (through investment) more total money after tax even though the state gets the same tax amount. The state is happy only because we assumed no inflation, because with an income tax they get more of the money earlier and with the consumption tax they get a larger portion later.
Consumption tax is definitely more favorable to investment than an income tax (assuming no inflation).
Also, consumption taxes are easier to avoid and provide the government with less snooping potential and should be favored for that reason as well.
“Also, consumption taxes are easier to avoid and provide the government with less snooping potential and should be favored for that reason as well.”
hmm not if the government decides to put a microchip in every dollar bill or eliminate paper money completely in response to underreporting of retail transactions.
Microchips in dollar bills? Run them through the microwave!
A 30% consumption is equal to around a 40% sales tax.
An interesting study for Your readers on this subject, with scientific proof of the effectivity of shifting taxes from income to consumption is discussed on following site:
ECONOMICS : SHOULD WE STIMULATE CONSUMPTION OR PRODUCTION?
Consequences for Employment and Prosperity of two Economic Strategies
http://landelijkwonen.bkln.net/SHOULD-WE-STIMULATE-CONSUMPTION-OR-PRODUCTION.html
(an abstract on following US site:)
http://www.techcentralstation.com/032805E.html
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