PIERCING THREE STATE TAX MYTHS ENSHROUDING PUBLIC FINANCE REALITY

By Michael E. Caryl

(First Published by the Public Policy Foundation of West Virginia, May 3, 2017)

Introduction

 

        The bromidic adage, that “taxes are what we pay for civilized society,” [1] simply confirms the obvious necessity of having some system of public finance to enable the orderly functioning of a society organized around a private market economy and the rule of law.   However, what should be the fundamental features of that system must be approached as an entirely separate question.  Thus, though the quoted adage is chiseled for the ages into the limestone arch over the entrance to the headquarters of the Internal Revenue Service in Washington, D.C., the question of “how we tax and spend determines, to a great extent, whether we are prosperous or poor, free or enslaved, and most important, good or evil.” (emphasis added) [2]     

 

        There are many thorough studies of that issue which have identified certain widely accepted principles of an ideal tax structure.  They include simplicity, reliability in terms of revenue yield, efficiency in administration, certainty and ease of compliance, transparency, fairness based on both equitable treatment and ability to pay, neutrality in terms of economic resource allocation and being promotive of free market competitiveness.[3]

        Unfortunately, there are also at least three major doctrinal mythologies typically raised in opposition to the principled development of specific tax structures.[4]  One, often asserted under the banner of equitable treatment and ability to pay, is to view all tax policies only through the prism of a persistent wealth redistribution agenda.  A second, which asserts the familiar admonition against so-called tax pyramiding, and is often justified in the interest of transparency, actually has no more economic policy grounding than simply being a way to slightly narrow the array of structural means available for tax imposition in general.   Third are arguments against certain tax structures raised in the name of free market competitiveness (among taxing jurisdictions and within industries) which are, ironically, rarely founded on a holistic consideration of free market influences, common sense and actual experience.

Tax Reform in West Virginia, Circa 2017

        As policy-makers in West Virginia struggle to enact comprehensive tax reform, in the context of seriously constrained revenues needed to fund public expenditure demands, one proposal with a degree of traction has emerged.   Specifically, under the proposal, which is designed to stimulate economic growth and tax base expansion, income taxes would be significantly, if not entirely, displaced by an expanded consumption tax base with a higher rate.  Further, in a legally separate, but conceptually integrated measure, designated the Fair and Simple Tax Reform (FASTR) Amendment, the comprehensive reform proposal also contemplates the phasing out and ultimate repeal of the tangible personal property tax. 

 

        As explained in the Fair 55 Tax Reform Plan© which was, to a degree, the inspiration for the current legislative proposal (including FASTR), the replacement of the income tax and tangible personal property tax with broad-based consumption taxes rests on the view that that last tax concept scores far higher than the others in satisfying most, if not all, of the principles of good tax policy.[5]  Predictably, each of the foregoing three tax policy myths have been raised by opponents to challenge the subject proposal.

Myth No. 1: Wealth Must Be Redistributed While Revenues Are Maximized

        The redistributionists inappositely resist the proposal because, they say, due to the regressive effect of such a change, higher income taxpayers are known to spend a smaller portion of their total resources than those in lower income brackets.  Thus, they argue, the proposal would not only be unfair, but would likely reduce government revenues, the two outcomes they oppose the most.[6]  Of course, absent the provisions discussed below to mitigate its actual impact on low income people, the regressive nature of any consumption tax, as a matter of settled theory (not to mention simple mathematical certainty) is beyond question.

 

         Indeed, it hardly requires overt expression for one to realize that the imposition of any tax, stated in dollars, will constitute a higher portion of a low income than it does of a higher income.   Likewise, higher income people spend a smaller percentage of their total income than do those who have less to spend, but the former spend more dollars for the simple reason they have more to spend.  However, economic growth and state government budgets rely not on effective income tax rates, or escalating percentages of income, including those used in progressive income tax systems, but on particular sums of dollars.  Thus, in the context of this specific proposal, the generally regressive nature of any tax (or of any charge stated in dollars for that matter) is utterly irrelevant as to whether the principles of good tax policy, much less the objectives of growth and expansion of the tax base, would be well-served by it.  

 

        Well-regarded economist, Douglas Holtz-Eakin, often observes that income taxes are imposed on what our labor and investments contribute to society for its use, and consumption taxes are applied to the things we take from society for our own use.[7]   Unless you think, as do the redistributionists, that tax fairness can only be satisfied by imposition of heavier burdens on the productive, self-sufficient  members of society,  the legitimate societal concern, not to raise the price of the necessities of life when purchased by low income individuals can be, and in the proposal is, fully addressed with well-designed and targeted relief measures. 

        Specifically, under the proposal, purchases of necessities of life such as food by low income persons, and such as shelter, medicine and healthcare services by all, would be expressly exempt from the broader consumption tax.  In addition, there are existing measures, which if refined and actively enforced, could operate to reduce the cost of taxation by most public utilities for low income consumers.[8]  Further, by immediately eliminating the personal property tax on vehicles, and by equalizing the real property tax rate for rented dwellings with the low rate traditionally only applicable to owner-occupied residences, the FASTR Amendment would eliminate two of the most regressive aspects of West Virginia’s current tax system.

        Finally, and most importantly, both the Fair 55 Tax Plan© and certain versions of the legislative proposal would provide direct monetary relief for low income individuals which would fully mitigate (dollar for dollar) the economic impact on them from the proposed rate increase and broadening of the consumption tax base.  Indeed, that would be so, even if they spent their entire income on things other than food, shelter, medicine and healthcare.[9]   Thus, the aspect of a consumption tax’s regressive impact which is a legitimate policy problem, can be solved without punishing the self-sufficient with more heavy taxation of what they contribute to society.[10]

Myth No. 2: It Is Always Bad Policy To Tax Business Purchases

        Just as the first tax policy myth reflects the perspective of its proponents in the “public expenditure community” and among self-designated “working people” advocates within organized labor, the second myth about the purported folly of “tax pyramiding,” due to taxing business purchases (a/k/a “inputs”), is most vigorously advanced by major business associations.  The analytical basis for viewing “pyramiding” as a problem is not nearly as sound as those groups would presume.   

        First, doubtless, every member of those groups would agree that pyramiding of their respective profits within the price of finished goods is an economically healthy and appropriate outcome.  That is, from raw material extraction, to multiple stages of processing to wholesale and, finally, retail distribution of any product, there are many layers of profit embedded in the final price of the product, all of which are due to the contributions of the long line of players producing, adding value and bringing it to market.   Since each of those parties, and their activities, which add to the value of the product to the final consumer, enjoy the benefits of government protections, infrastructure, etc., the cost of those benefits and protections is as legitimate a part of the final product’s final price as are their respective profits.   

 

        That is precisely why no known scheme of taxation (certainly not this State’s) attempts to prohibit the embedding of multiple layers of excise (or property, income etc,) taxes in the price of the product paid by the final consumer.  Obviously, the people who make public revenue policy are well aware of the fact that, ultimately, individuals, not business entities, pay all taxes.  Indeed, recognition of that public finance reality is a large part of why the issue of how best to design a fair and efficient tax structure must be separated from the related, but distinct, issue of how much public revenue should be collected through that structure.  

        As to the anti-pyramiding forces’ great concern for the adverse effect of taxing business inputs on the lofty tax principle of transparency, a small dose of public finance reality can put such concern in proper context.  An example of the importance that transparency of tax imposition plays in the real world marketplace can be found in the experience many of us have had while pumping gas into our vehicles at a self-serve station.  Thus, although typically being keenly aware of the total price per gallon of the grade of gas you start pumping, have you ever abruptly stopped pumping short of your planned purchase quantity, and driven off in search of a lesser taxed price, because you happened to read the notice on the pump disclosing the amount of state and local fuel taxes embedded in that total price per gallon?[11]

 

        As long as there is no competitive disadvantage for a given business due to “pyramiding” (a level-playing-field outcome that effective and even-handed use tax enforcement is designed to assure), the individuals who bear all the taxes can, in the vast majority of instances, be expected to be the customers purchasing, for their own benefit and use, the produced good or service from the market which provided it.   Moreover, they do so with full knowledge of, and exclusive concern for, the amount of its full price (including taxes both overt and embedded). 

 

        It would only be from a lack of competitive balance within an industry that might cause the ultimate economic incidence of a consumption tax to be borne by the seller’s owners (through reduced profits) or employees (through reduced wages).  Of course, avoiding private (business vs. business) competitive disadvantages is the objective of effective use tax enforcement and of comprehensive reform which offsets any pyramiding by other major reforms (e.g. eliminating the taxes on income and capital).  Thus, it turns out that the only practical purpose, of the widely and sternly expressed admonitions against tax pyramiding due to the taxation of business inputs, is simply to slightly narrow the array of potential incidences of taxation. Yet, the only result is an oblique but utterly futile effort to limit the absolute overall level of taxation itself. The third and final major tax policy myth, about jurisdictional competitiveness, is, likewise, flawed in its narrow “silo” approach to policy analysis.

Myth No. 3: Shifting From Income Taxes to Consumption Taxes Hurts Border Counties

        Any consideration of the border competition issue must first include a focus on the powerful countervailing influence of convenience in mitigating the purported disadvantage of higher consumption tax rates and broader consumption tax bases here.  Thus, it is important to recognize that, to the extent it might exist, the border competition issue is actually limited to retail sales of goods (not business purchases due to use tax enforcement and not most services due to the convenience factor) and largely only applies to purchasing decisions made by those individuals falling within a specific range of individual income levels.  That range starts somewhere above the lowest and rises to somewhere in the middle to upper middle income levels.  That is so, in part, because low income customers can buy groceries (the primary commodity on which most studies about border competition are based) tax exempt with SNAP cards, and because, at a certain point not that far up the income scale, convenience (i.e. the value of one’s time) easily trumps minor incremental price savings as a purchasing decision factor for all retail commodities. 

        That there is an upper limit of the “bargain purchaser” demographic on the income scale is due, in part, to what the economists call the diminishing marginal utility of each additional dollar which is the policy principle on which progressive income taxes are entirely based.  Indeed, the strong desire for personal convenience, and the value one places on his or her own time, are also the factors underpinning the “backward bending supply of labor curve” which economists identified long ago.  Specifically, on a graph of studied labor supply data, where the vertical axis represents rising levels of compensation, and the horizontal axis reflects actual labor supply available in the market, there is a point well up the compensation level where the theretofore rising diagonal line, reflecting the growing supply of labor, starts to literally bend back toward the zero point on the horizontal scale.  That, of course, simply reflects workers’ decisions, at higher compensation levels, to withhold further hours of their labor in favor of leisure and other personal endeavors.

        Accordingly, while Walmart based its original success on low prices, the ubiquitous and long-standing presence and success of higher-priced “convenience” stores, on every other corner, which are patronized 24/7 by hordes of shoppers of all income levels, not to mention the mushrooming internet market place, both show how powerful a marketing influence convenience is in face of modest price savings “down the road” and across the state line.  Thus, convenience-favored competition is forcing even Walmart to stop putting all its efforts into fighting it and, instead, to join in the e-commerce fray so as to engage the threat to its customer base from Amazon’s growing dominance of the low middle to high end retail market place, all driven by the marketing power of convenience.  

 

        Turning to certain specific studies on the border competitiveness impact of first taxing, and then exempting, grocery purchases in West Virginia sales tax, I would note the following.  In the Tosun/Skidmore analysis, they preface the whole paper with the admission that though they “expect(ed) an inverse relationship between food sales and the after-tax price differential,” to do that they had to “assume that input costs are similar on each side of the border.” [page 6].[12]  Thus, in order to assess the impact of any tax policy change, it is essential to consider the entire structure and not just the expected effect of one aspect of it. 

 

        So, yes, under the legislative proposal, in the course of getting rid of two uncompetitive taxes (income and personal property) in this State, the rate of the fairer, more reliable and more efficient tax may be higher and may apply to more goods and services than it has during the generations in which we have suffered from the two economically harmful taxes.   However, it should not be surprising that there is strong evidence that states with low or no income tax (but, by default with broad and higher rate sales taxes) consistently out-compete economically adjacent states with a higher and broader-based income tax, but with narrower-based and lower rate sales taxes.[13] 

        It should also be noted that, on pages 13 and 14 of the Tosun/Skidmore study, the West Virginia counties bordering Pennsylvania actually saw an increase in food sales despite the imposition of the tax on such a major retail commodity.  In attempting to explain that outcome, the relatively stronger Monongalia County economy (vs. that in southwestern Pennsylvania at the time) was cited.  Also, the change in food sales vis a vis Maryland in West Virginia counties bordering that state (e.g. Berkeley, Jefferson) was found to be “statistically insignificant.”   Finally, to their credit, the final sentence in their analysis states that: “It may be that in the end the benefits of imposing the sales tax on food outweighed the costs, but information presented here and in the previous literature helps decision makers to make that assessment.”[14]  

 

        Thus, even in circumstances where major reforms, such as here, consisting of elimination of the personal property tax and lowering and ultimate elimination of the income tax, were not actively being taken into account, the economists readily acknowledged the importance of considering the big picture and of not confining one’s tax policy reform analysis to the silo of whether an expanded consumption tax causes harmful border competition.[15]  Indeed, not only is the threat of adverse border competition, related to the consumption tax aspects of the legislative proposal, almost certainly overstated,[16] but a solid case can be made that, when the totality of the proposal’s aspects are considered, being in a border county is likely to be an economic competitive advantage.

 

        Accordingly, rather than being concerned about the possible loss of some retail purchases of goods by those “bargain hunting” customers, whose representation on the income spectrum is constrained on both the low and high ends by those whose propensity to travel across the state line for shopping declines either as their income falls or rises, respectively, why not adopt a policy which, precisely due to a tax differential, will attract new permanent residents seeking to reduce the tax burden on all their income, whether expended or saved?   

 

        Indeed, the power of that attraction for both middle and higher income commuters is even greater in the border counties which are within a short distance of major metropolitan areas (e.g. Washington, Baltimore, Pittsburgh).   Likewise, given the large pool of both government and private sector retirees now living in those metro areas bordering those same counties, the proposal could, for those reasons, prove to be an economic retail boon to those localities.  Of course, in the case of retirees, being not bound to an employer’s location, the entire state, including those other border areas not near major urban areas, would be appealing because their income is not taxed as heavily as in their current home states or at all.

 

        Although, in the case of commuters, the power of the reduced/no income tax attraction would, to some degree, be diminished by the imposition of income tax on their earnings in the jurisdiction where they work, that factor does not apply to their other income or to retirees at all.  Collectively, many commuters’ and retirees’ greater spending levels (measured in dollars when compared to the spending levels of lower income natives, and powered by the convenience factor) cannot help but boost the instate retail economic activity, including major items such as home purchases. 

Conclusion

        The foregoing rebuttal to the “myths,” that good state tax policy must: (1) effect wealth distribution, (2) never allow taxation of business inputs and (3) keep consumption tax rates low and bases narrow to avoid economically ruinous border competition, is intended solely to keep them from shutting down (i.e. enshrouding) an intellectually honest debate.  Of course, before implementation of any major shift from reliance on taxation of income and job-creating capital to a broad-based consumption tax, both dynamic fiscal scoring and careful econometric modeling should be done to confirm revenue adequacy and to understand and mitigate any purported regressive or anti-competitive effects of such a change.   However, the current and long-standing system, based on heavy taxation of earnings, production and capital is, in West Virginia, clearly not working, and the defenders of that bleak status quo cannot creditably invoke those myths to, again, block the prospects of progress.

 

[1]  Oliver Wendell Holmes, J. dissent in Compañía General de Tabacos de Filipinas v. Collector of Internal Revenue. ___ F.2d ___ (2nd Cir. 1927). 

[2]   Charles Adams, For Good and Evil, The Impact of Taxes On The Course of Civilization. Madison Books, 1993.

[3]  See, e.g. “Principles of Sound Tax Policy,” The Tax Foundation, Inc.

[4] Fair 55 Tax Reform Plan, PP. 10-12.

[5]  Id., pp. 1-2, 9. 

[6]  Note:  The opposition to revenue reduction, as a subtext agenda for the redistributionists’ contention about regressive impacts, is the mirror image counterpart of the “anti-pyramiding” theme advanced by organized business groups attempting to restrain tax burdens by limiting the incidents to be taxed.  See, pp. 5-7, infra.

[7]  https://www.americanactionforum.org/experts/douglas-holtz-eakin.

[8] See, W.Va. Code §§ 11-13F-1 et seq., §§11-13G-1 et seq. §§24-2A-1 et seq. and §§24-2C-1 et seq.

[9]   In the Fair 55 Tax Plan© this would accomplished by a Fair Tax Credit Card exempting from tax up to $500/year/person for clothing purchases by low income persons.  In one version of the current legislative proposal, this would be accomplished by refundable earned income and fixed income credits for low income individuals. 

[10]    Despite the “[price paid] for civilized society” view stated at the opening, use of the term “punish” in the context of taxation is not inappropriate in the eyes of the law.  Specifically, because the taking of one’s property in the form of taxation is treated as comparable to a punishment, the meaning and intent of taxing statutes, like criminal laws, are strictly construed by the courts against the government and in favor of the taxpayer/defendant.  Hellerstein, State and Local Taxation, 7th Ed., p. 30.  Indeed, this rule of construction is immediately antithetical to the view of the redistributionists and others that the tax code should serve as an instrument of social engineering.

[11]   If transparency were the sacred principle the anti-pyramiding folks contend that it is, any legislation imposing a tax on business inputs should be accompanied by a requirement that all products bear a written notice to the effect that “In the price of this product, there are embedded multiple impositions of taxes used to fund the benefits of government enjoyed by the various up-stream entities contributing to the production and delivery of this product, as as are the profits of those same entities.  If that is not acceptable to you, do not purchase this product, and, instead, contact your legislative representative with a request to reduce the cost of government spending so that amount of the taxes embedded in the price of this product can be removed.  Forms for making such a request are available at the counter of this merchant or on-line at www.TEA.gov.”

[12]   Mehmet Serkan Tosun and Mark Skidmore, Cross-Border Shopping and the Sales Tax: A Reexamination of Food Purchases in West Virginia, Bureau of Business and Economic Research, West Virginia University (2005).

[13]    Joel Griffin, 1000 People a Day: Why Red States are Getting Richer and Blue States Poorer, The Heritage Foundation (2015).  Ironically, in addition to considering the economic impact of right-to-work labor laws, the adverse influence of state income taxes on a levying state’s economy was studied through a comparison of Nevada and West Virginia.  Id, at pp. 20-21.

[14] Tosun/Skidmore, p. 18.

[15]  The same can be said of proposals which would oppositely rely on reduced consumption tax rates and narrow consumption tax bases to promote economic development based on discredited border competition assumptions.

[16]  The Fair 55 Tax Reform Plan © even contains, for those still unconvinced that the border competition contention is overblown, a proposal for a Progressive Creditable Presumed Use Tax structure which would apply, based on a progressive income and family size schedule, to those above the federal poverty level and provide a dollar for dollar credit against the presumed use tax for consumption taxes paid in or outside of the State.  Indeed, with a few years’ implementation, such an arrangement, designed to block the ill economic and fiscal effects of purported border consumption tax competition, would yield a live fire sample of whether those ill effects are really manifested.  

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