Garett Jones  

The Wisdom of Prescott 2: Sales taxes=Labor Taxes

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You work in the market economy to buy stuff in the market economy, either now or later.  

So if sales taxes are permanently high that weakens your desire to work in the market economy.  That means leisure--which government is still bad at taxing--starts looking like a better alternative.  Let's make that dinner at home rather than going out to a restaurant. 

Good neoclassicals like Prescott keep an eye on sales taxes when thinking about the incentive to work.  High European VATs stand between Europeans and their ability to consume market goods--and according to Prescott high VATs helps explain low European employment.  Why work so much when it's so hard to turn work into goods?  

There are a lot of good things to be said about consumption taxes.  After all, they're not capital taxes, and Chamley and Judd (PDF offering counterargument) showed us that capital taxes are bad bad bad

But Prescott reminds us that consumption taxes and labor taxes are really two sides of the same coin: They both stand between your market labor and your ability to consume market goods.  So, administrative issues aside, any nice thing you'd like to say about one you need to say to the other.  

This idea isn't unique to Prescott.  I'd learned and forgotten this idea many times over the years, but after reading Prescott's model of why Americans work more than Europeans, I never forgot it again (yet). 

Technical Coda: Dirk Krueger, a Prescott student, works this result out starting on page 91 (big PDF). 

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CATEGORIES: Microeconomics



COMMENTS (11 to date)
LNewt writes:

But if you tax consumption instead of income you don't have to worry about the accounting headaches of separating out income due to capital accumulation (like 'carried interest'), even if both taxes affect savings in the same way.

David R. Henderson writes:

@Garett,
They both stand between your market labor and your ability to consume market goods.
Great line, Garett. You bring a nice fresh writing style to this blog.

Garett Jones writes:

Many thanks, David!

johnleemk writes:

This point is one which Scott Sumner makes frequently; his favoured tax plan is a progressive payroll tax, because this would be identical to a progressive consumption tax.

Bostonian writes:

A sales tax is in part a labor tax, but it is also a wealth tax. Raising sales taxes by 10% is similar to a one-time wealth tax of 10%. Both would hit retirees, whereas raising income taxes would not.

Doug writes:

The point that consumption taxes distort labor decisions is well-known in the public finance literature. Usually it's framed as income taxes distort labor choices and saving decisions, while consumption taxes distort only labor choices.

LNewt makes an important point. The best reason for adopting a progressive consumption tax is that it is administratively superior, which means not only that it is cheaper and easier to administer, but also that it is much easier to measure and tax consumption than "income," which is an accounting fiction. Many economists do not grasp this point.

Some good introductions to the subject include:

Daniel Shaviro, Replacing the Income Tax with a Progressive Consumption Tax, Tax Notes 103:91 (2004). http://www.americantaxpolicyinstitute.org/pdf/ShaviroPCT.pdf

David Bradford, A Tax System for the 21st Century, Toward Fundamental Tax Reform (2005). http://www.aei.org/files/2005/05/09/20050428_book820text.pdf

Edward McCaffery, Ten Facts About Fundamental Tax Reform, Tax Notes (2003). http://lawweb.usc.edu/users/emccaffe/fnf/pages/editorials/mccaffery.pdf

Doug writes:

@Bostonian

If the baby boomer generation (the one with almost all the wealth) has simultaneously (1) pumped for ever-increasingly generous entitlements and (2) continuing tax cuts, perhaps a one-time levy is jusitified.

In other words, if you spend your entire voting/political life rewarding politicians who vote to increase spending while decreasing taxes, you're pushing taxes onto future generations--you deserve to pay up before it's too late.

Sure, most readers of this blog weren't advocating for these sorts of policies, but most of the populace did.

David R. Henderson writes:

@Doug,
If the baby boomer generation (the one with almost all the wealth) has simultaneously (1) pumped for ever-increasingly generous entitlements and (2) continuing tax cuts, perhaps a one-time levy is jusitified.
As the only baby boomer who blogs on this site, I take objection. I've spent my whole adult life opposing these programs. I think you're being a little collectivist here, although, to your credit, you point out at the end that most readers of the blog were not advocating these policies and you did say "perhaps."

Ritwik writes:

If sales taxes are high, that opens up a gap between GDP and gross value added of an economy.

Monetary exchanges are larger than value added, and inter-country welfare comparisons trickier, but value added will find its equilibrium value nonetheless. Or at least it should in any neo-classical model that preserves the classical dichotomy.

Prescott's 'neoclassical' conclusions are surprisingly non-neoclassical.

Will engage with the proof by Krueger, but have a nagging suspicion that it will be similar to the Cagan proof you presented, where the critical condition is still a matter of assumption and is simply hidden away from sight due to algebra that's recursive instead of being linear.

Also, what are your views on labour taxation if labour is really human capital?

Methinks writes:

Well, pardon the sarcasm, but thank goodness for the government that the SCOTUS has blown open the door to tax leisure by allowing it to tax NOT doing things.

Doug writes:

Blame game aside, the more important point is that progressive consumption taxation (of the post-paid variety) is the best policy, and we shouldn't let transition problems prevent the enactment of this very beneficial change.

Some transition relief might be called for, but again, the fact that most consumption tax reforms would effect a one-time wealth levy on current wealth holders is not a reason to chain all future generations to subpar policy.

Finally, the wealth levy won't be as harsh as it seems, since the transition to a consumption tax regime would not be a surprise. There will likely be a lot of notice if the change ever occurred, allowing people to plan to minimize the impact of the tax (e.g. make large purchases before the new law goes into effect).

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