Tax Rates Matter; Smarter Taxes Matter More
It's been almost 30 years since the last major federal tax system overhaul, and the chances of real reform in the next year look grim. But as usual, there's some hope in the states, and reformers may want to direct their efforts there.
Reforms can greatly enhance a state's competitiveness. For example, when North Carolina simplified its tax code, it moved from 44th to 15th in the Tax Foundation's business-climate rankings in a single year.
Policymakers often look for the silver bullet when it comes to finding revenue sources, but the most effective solution may be more nuanced. In a new paper, we summarize the various tools available to state policymakers and the tradeoffs associated with different types of taxes. States must choose among income, consumption, and property taxes as their primary revenue sources — and regardless of which system a state picks, there are often small improvements that can be made to its tax structure.
Tax economists generally agree that a sound state tax system meets five key criteria: It must be economically efficient, equitable, transparent, collectable, and, of course, able to raise enough revenue to fund government services. To the average taxpayer, this translates into simpler taxes that leave more disposable income in their hands — while still enabling governments to pay for the things they need.
With these five criteria as guidelines, policymakers must weigh the pluses and minuses of each type of tax. Income taxes, for example, are what economists call "revenue-enhancing." Taxpayers react less to income-tax changes than to changes in consumption or property taxes. Income-tax withholding makes increases in tax rates harder to monitor than they are with property taxes, and often it is costlier to change jobs or work less than it is to purchase things from areas with a lower sales tax (or even to evade sales taxes altogether, which is sometimes easy to do with purchases over the Internet). In practice, this means that relatively small income-tax hikes can be an easy way to increase revenue.
But even income taxes can encourage problematic behavior if taken too far. Eventually, people do begin to work less, and some may move to areas with lower taxes (especially at the local level). Research shows that increases in state tax rates deter new migrants as well, and economists have found that increases in state income-tax rates slow income growth and lead to reductions in per capita income, which makes residents worse off.
In 2015, several states acted on the evidence and reduced their tax rates. The most notable changes to income-tax rates took place in Illinois, Indiana, Massachusetts, and North Carolina.
Although reducing tax rates can be a move in the right direction, there are other options available for improving tax policy. In fact, improving the state's tax structure is just as important, if not more so.
Consider consumption taxes, which are taxes placed on consumer purchases. Such taxes are often advertised as being economically efficient, but that depends on how they are administered. They can easily go from being simple and efficient to distorting decision-making and harming the poor. A consumption tax is more likely to be efficient when it's easy to understand and applies to a broad base of goods and services.
An example of a consumption tax that alters decision-making is the gross-receipts tax. As the name implies, this tax applies to all the revenue a business receives, regardless of the business's expenses — which is a problem for goods that go through multiple stages of production. For example, if one business sells parts to another, which assembles them and sells them to a retailer, which in turn sells the product to the consumer, each of these businesses will pay the gross-receipts tax separately and pass the accumulating burden along to the next buyer.
This can incentivize firms to consolidate or make a product in-house rather than purchase it from outside the organization, even if contracting with another firm would be more efficient absent the tax implications. This increases costs, reduces output, and drives up prices for consumers. It's why many jurisdictions instead tax consumption through a "value added" tax, which applies only to the improvements made at each stage, or through traditional sales taxes, which apply only when a product is sold to the final consumer.
Additionally, selective consumption taxes imposed on some goods — like tobacco, alcohol, and fast food — often fall disproportionately on low-income households. This is because the higher prices caused by these "sin taxes" eat into the budgets of the relatively poor more than those of the affluent. More general taxes on consumption, like a retail sales tax that applies to all goods and services, can help alleviate this problem by taxing all goods at a lower rate.
Generally administered consumption taxes also help to alleviate transparency and collectability issues. Since they are more straightforward, it is easier for taxpayers to calculate their tax burden. They are also easier for retailers to collect, which lowers the cost of doing business.
Clearly, there are many different subtleties involved in designing even just one type of tax. Similar tradeoffs need to be considered when designing income and property taxes.
Despite the myriad of tradeoffs facing policymakers, simplifying taxes is a good, universal rule of thumb. Many of the ills of bad tax policy are the result of trying to solve too many problems with one tool. By taking a more comprehensive approach that attempts to balance the five criteria — sufficient revenue generation, efficiency, equity, transparency, and collectability — policymakers can make more meaningful improvements to tax policy at the state and local level.
Adam Millsap is a research fellow and Olivia Gonzalez a research assistant with the Mercatus Center at George Mason University. They are the coauthors of "Economic Perspectives: State and Local Tax Policy."