ECO 4113 FISCAL ECONOMICS

CHAPTER 11

TAXES ON SALES AND CONSUMPTION

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TAXES ON SALES AND CONSUMPTİON

The sales tax is always ranked high in popularity (or, more accurately, low in unpopularity) when compared in polls with the federal income and local property tax.

Why?

Perhaps because sales taxes are relatively painless; they are extracted on a daily basis in very small sums.

Economists may prefer that taxes be visible, but taxpayers seem to prefer those taxes that are less visible. 2

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WHY SALES TAX?

Sales or transactions are taxed for both theoretical and practical reasons. The most important practical reason is that transactions provide a “tax handle,” consisting of an activity in which a value is established on which to base the tax,as well as two parties each of whom provides a cross-check on the reporting of the other.

The oldest form of sales tax is the tariff, a tax on goods entering the port or the city from abroad. Where the number of points of entry was limited-airports, docks, city gates-that narrow funnel through which goods must pass created an opportunity for tax collectors to gather and levy the tax with relative ease.

As the number of buyers,sellers,and the locations grows, however,the sales tax becomes more difficult to administer.

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Most states do not attempt to include all retail transactions in their base because of the compliance and collections costs of extracting revenue from sporadic sellers or very small retailers.

However, sales and transactions, with all their limitations, still offer one of the most visible and accessible tax handles.

A second reason for taxing sales is that consumption spending along with ownership of real property and income, is a measure of ability to pay taxes.

The more one spends the more taxpaying capacity one has.

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It is easier to conceal income from the tax collector than it is to conceal purchases.

A sales tax is a way of extracting a contribution to the public treasury from those who are engaging in either legal tax avoidance (by the form in which they get their income) or illegal but undetected tax evasion.

A third reason for taxing sales is particularly important at the state and local level. This tax offers a way of capturing revenue from commuters,tourists,and business travelers who use the public services provided by state and local governments.

The sales tax is highly exportable for states that are major travel destinations and for cities that attract large numbers of commuters to work during the day.

Retail sales taxes are relatively responsive to short-run cyclical changes in income, less so to longer term growth.

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SALES TAXES, VALUE-ADDED TAXES, EXCİSE TAXES

The variety of taxes on consumption or transactions is almost endless, but only three basic types are in widespread use;

1. The retail sales tax (or sometimes the wholesale tax)

2. The value added tax

3. Selective sales taxes on specific items, such as gasoline, automobile tires, or cigarettes, known as excise taxes.

Tariffs are a special form of excise tax that apply only to certain imported goods. 6

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We can sort the various kinds of sales taxes in any of several ways.

1. One grouping is to sort them into multistage or single-stage taxes.

Tariffs, excise taxes, some kinds of wholesale taxes, and retail sales taxes are single stage.

The value added tax and its predecessor, the cascade tax are multistage taxes.

2. A second way to classify the tax is by the breadth of the base.

A universal base of all sales or purchases (value added taxes come close) would represent one extreme, whereas excise taxes or tariffs on specific items would represent the opposite end of the spectrum, but the breadth of coverage varies greatly from one jurisdiction to another.

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3. A third classification would be on the basis of who is legally liable to pay the tax,which often bears little relationship to actual economic incidence.

Retail sales taxes are an obligation of the buyer, althoıgh in practice they are collected mostly by the seller.

Value-added taxes in most countries are an obligation of the seller.

When goods are sold to nonresidents, the value added tax of the sending jurisdiction is rebated at export and the value-added tax of the receiving jurisdiction is imposed at import.

This practice not only implements the destination of the principle but also ensures nondistortion of choice between domestic and imported goods.

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EFFİCİENCY İSSUES İN SALES TAXATİON A primary objection to sales taxation is that the

sales tax tends to erode its own base over time, particularly if the base of the tax is anything less than total consumption or the tax rates are very different in adjacent jurisdictions.

People have been creative in finding ways in which to legally avoid the sales tax or reduce the amount paid, particularly in the long run.

One is to shop in markets where the tax is lower or nonexistent.

Some stores will (legally) waive the state and the local sales tax on items being shipped out of state.

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Another way to avoid the tax is to shift purchases from taxed to exempt items-more food and less clothing in states where food is exempt and clothing is not, more services and fewer tangible goods in almost every state.

Adding to the erosion of the base by the action of buyers is the tendency of state legislatures to add exemptions and exclusions.

Among the more popular exclusions for equity reasons are prescription drugs, food and purchases by charitable organizations.

All of these exemptionsmay have strong equity justifications, but they must also be evaluated as tax expenditures that reduce revenue and further distort choices.

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SHİFTİNG BETWEEN MARKETS

To minimize complications, assume perfectly elastic supply and a tax that is fixed in terms of physical units.

The price, Po, is initially the same in both markets in equilibrium.

It is also assumed that some buyers are willing and able to shift to other markets at little or no cost by taking advantage of mail-order, internet, or travel opportunities, while others lack the information or flexibility to shop outside the local market even with enough time to adjust.

Consequently, demand declines in the taxed market but does not shift entirely to the untaxed market.

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AVOİDİNG CASCADİNG Another efficiency issue in sales or consumption

taxes is ensuring that taxes do not accumulate so that some items are taxed only once and others two or more times, resulting in different tax burdens on different purchases and an unintended distortion of consumer choice.

The tax burden on each good depended less on the tax rate than the number of times it changed hands and caught the attention of the tax collector.

Most of the nations that had been using cascade taxes have replaced them with VATs or some other less distorting form of sales tax.

The retail sales tax is collected at the point of final sale from retailer or distributor to the final consumer.

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Ideally,each item would be taxed once and only once.

One reason for using a single-stage tax (either wholesale or retail) is to avoid cascading or accumulation of tax on tax, which distorts consumers’ choices between different products or services because those that pass through more taxable stages accumulate larger amounts of tax.

Cascading can occur in a single-stage tax if some business purchases at the taxable stage are incorporated into products or services also subject to the tax.

One source of this problem is the fact that many items are purchased both by business firms and individuals.

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If the business firm must pay retail sales tax on its inputs, that tax is reflected in the selling price, and the retail sales tax on the final purchase is compounded by the tax at this earlier stage of processing.

On the other hand, a case can be made on both efficiency and equity grounds for some amount of the sales tax in the state of origin being reflected in the price of the good and passed forward to consumers wherever they live.

To the extent that such sales taxes are used to pay for public services that benefit producersithese firms are purchasing inputs into the production process that might properly be considered a cost of production.

Unfortunately, there is rarely any close connection between the amount of sales tax paid on inputs and the amount of public services consumed by the firm.

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EQUİTY İSSUES İN SALES TAXATİON

The primary objection to sales taxes is that they tend to be regressive, except for certain excise taxes on luxury goods.

A broad-based tax on sales or consumption, whether a value-added tax, a wholesale tax, or a retail tax, excludes saving by definition.

Since saving rises with income (higher income households save a substantially greater fraction of their incomes), consumption and sales tax burden on that consumption becomes a smaller fraction of income as income rises.

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What can be done to make them less regressive?

1.Broden the base, primarily by including some services, to keep the rate low and include more of the consumption spending of higher income households.

2. Narrow the base by eliminating consumption that represents a large fraction of income for lower income households (especially food and clothing).

3. Fine-tune the retail, wholesale, or value-added sales tax with excise taxes or differential rates on certain items that are consumed more heavily by upper income classes (e.g.,luxury taxes, admissions and amusements taxes, travel and tourism taxes).

4. Rebate some of the sales tax through means-tested income tax relief.

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BRODEN THE BASE

Including more services should reduce the regressivity of a sales or value-added tax.

Brodening the base also makes it possible to raise the same amount of revenue with a lower tax rate.

Services are more likely to be produced and sold by very small firms, greatly increasing the collection costs for the state and compliance costs for firms.

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NARROW THE BASE For most low-income families ,the biggest item in

the budget is housing (rent), which as a service is exempt in most states.

Among tangible goods, the most common exemption is is food. The food exemption is appealing ,but difficult to administer because of the challenge of defining food.

Cash registers must be programmed to distinguish between taxable and nontaxable items, which increases both collection and compliance costs.

The food exemption significantly reduces the base of the tax and makes the revenue less stable.

The food tax exemption suffers the usual problem of tax expenditures in terms of not targeting a particular group very efficiently.

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FİNE-TUNE THE TAX

A third tactic for improving the equity of the retail,wholesale,or value added sales tax is to impose an excise tax or differential tax rate on certain items that are consumed more heavily by upper income households.

PROTECT THE POOR This approach has the advantage of giving

relief only to low-income households, sacrificing less revenue than the tax expenditure approach of exempting food for all state residents.

It can be used in combination with the other three strategies to significantly reduce the regressivity of a broad-based retail sales tax.

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EFFİCİENCY İSSUES

The retail sales tax can be administered as either an origin principle tax or a destination principle tax.

Arguments can be offered for either approach, but the fact that the incidence of a broad-based retail sales tax falls mainly on the consumer supports the choice of a destination principle, so that the person actually paying the tax will be consuming the public services that those taxes support.

The fact that the base of the retail sales tax is less than 100% of consumption is also a source of distortion in consumer decisions.

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The incomplete coverage raises the after-tax price of some items relative to others, encouraging consumers to shift their consumption over time to untaxed items such as food and many services as well as to out-of-state retailers through mail-order and internet purchases.

Retail sales taxes can also distort locational decisions for not only commercial facilities but also industrial firms, because some states tax a wider range of business purchases than others.

For firms that buy a large quantity of materials and supplies that are taxable in some states and not in others, there is an incentive to locate their facilities-or least their purchasing departments-in states that offer the most attractive tax situation.

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EQUİTY İSSUES The failure to tax most services is an equity as

well as an efficiency issue in as much as inclusion of services makes the tax less regressive.

The destination principle creates serious challenges for tax administrators in collecting sales or use tax on a large share of mail-order and internet sales, which often escape taxation in either the state of origin or the state of destination.

This loophole discriminates among consumers on the basis of the way they choose to shop.

Because the internet and mail-order methods tend to appeal more sophisticated buyers, it is likely that failure to tax a large share of mail-order and internet sales makes the sales tax more regressive.

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EXCİSE TAXES

An excise or selective sales tax is imposed on named goods, such as the tax per gallon of gasoline or pack of cigarettes.

Many excise taxes are specific; that is, they are stated in terms of the physical units, while others are ad valorem, expressed as a percentage of the price.

The drawback of a specific tax is that revenue only grows with population and sometimes income, but not with inflation.

Ad valorem tax revenue increases not only as more units are sold but also as the price per unit goes up.

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RATE AND BASE As the tax rate escalates, both the absolute and

percentage decline in Q accelerates (and so does the excess burden or deadweight loss).

An increasingly larger increase in the tax rate is required to generate the same increase in revenue (or the same increase in the rate will generate less revenue) because of base erosion.

Rate and base relationships always offer a challenging trade-off for tax policy of any kind, but particularly so far excise taxes, because the base is already narrowly defined.

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REVENUE,EQUİTY, SUMPTUARY GOALS Excise taxes serve multiple purposes.

1. revenue.2. to tax items consumed more heavily by upper

income groups, in order to offset the regressivity of a general sales tax at the wholesale or retail level.

3. to discourage consumption of goods or services as a way of reducing negative externalities (sumptuary taxes).

Revenue and equity goalscall for collecting more tax,while sumptuary goals are aimed at shrinking the base.

Governments can regard excise taxes on activities that are socially undesirable as a win-win situation.

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There are limits on the usefulness of taxes as a way to discourage consumption.

If the tax rate gets too high, it may be worth it to risk the legal consequences to supply this demand through the black (illegal) market.

Citizens have always found ways to evade excise taxes imposed “for their own good.”

Some excise taxes, like the tax on airline tickets, are not intended to discourage the activity.

The tax is levied on a luxury good for which demand is believed to be relatively price inelastic, so that the base will not shrink too much in response to the tax.

A tax that is very productive in terms of revenue in the short run may erode the base and reduce tax revenue in the long run. 26

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VALUE ADDED TAXES

The value-added tax (VAT) emerged from France to become the dominant form of sales tax in the European Community (EC) in the late 1960s.

As the EC grew, new entrants adopted the value-added tax.

With the aid and encouragement of the World Bank in many cases, this complex tax was a surprisingly popular revenue tool in South America, Asia, and Africa as well.

Most of these countries used the new tax to replace (or integrate) tariffs, excise taxes, cascade-type sales taxes, single-stage taxes at the manufacturer’s or the wholesaler’s level ,or other less satisfactory revenue sources in the sales tax category.

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Because income taxes are used in a much more limited fashion in most other countries, the VAT is not only the predominant form of sales tax but also a major source of central government revenue as well.

In most cases it is administered on the destination principle, although some of the formerly communist nations of Eastern Europe apply the origin principle.

The VAT is imposed on the value that a producer adds to his raw materials or purchases (other than labor) before selling the product or service.

The value added consists of labor costs (L) and profit (Π). 28

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The VAT can be computed in two different ways:1)As a tax on labor plus profit, calculated seperately or together: tL + t Π or t(L+ Π).

If the tax rates are the same on both wages and profits, the choice of a method is based only on relative ease of calculation.

2)As a tax on the difference in the value of output (Q) and the value of purchased inputs (I),which can be calculated seperately or together:

tQ – tІ or t(Q- І ).

The most popular method is tQ – t І, because it is the easiest one to compute.

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The tax rate is simply applied to the value of sales,with a credit for taxes paid on any taxable inputs purchased.

Because taxes paid on earlier stages of the production process are always credited against tax due, there is no accumulation or cascading of taxes,and the tax burden on the final product is the same percentage of the price as it was on raw materials and intermediate goods.

The multistage feature of the VAT is attractive from the standpoint of internatioanl trade, and particularly trade within a free-trade area, customs union, or common market.

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Some countries use a single rate, others multiple rates, but the central or basic rates range from 6% to 23% with many clustered in the 15% to 20% range.

Exemptions are often handled by zero rating; charging a tax rate of zero on the final taxable sale, which allows the final seller to receive a rebate for taxes accumulated to that point.

Multiple rates are a way of integrating excise taxes into a single system, but they also add greatly to the collection and compliance cost of the system.

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EFFİCİENCY AND EQUİTY İSSUES Value-added taxes share the same efficiency

and equity attributes as other broad-based sales taxes.

In many cases, they are an improvement in efficiency over the kinds of taxes they replaced.

Excises and tariffs are more distorting of decisions than broad-based taxes because they single out a few products on which to levy the tax,and usually involve higher rates, increasing the deadweight loss. 32

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While it is often appropriate on both equity and efficiency grounds to tax different products and services at different rates, the level of tax on any given product is somewhat random rather than reflecting intentional distribution of the burden among consumers, elasticity of demand, discouraging negative externalities, or other relevant economic and social considerations in tax design.

Like all sales taxes, it is regressive.

The high rates increase the deadweight loss or excess burden.

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It is also criticised in terms of its high collection and compliance costs.

VAT both requires and creates an extensive paperwork burden on both tax collectors and taxpayers.

However , some countries have found the paper trail useful in attempting to enforce other taxes and regulations, so there may be some benefits as well.

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