ICYMI: State Economy Better Off With Simpler Tax System
I’ll stand with Raúl.
An Op-Ed By Dr. Peter Crabb in the Idaho Press Tribune
The state legislative session is about to begin and Idaho lawmakers will likely follow the new tax law from Washington by considering proposals for changing our own tax system. When taking up this question, policy makers should keep in mind a few basic economic principles.
The government raises revenue using various taxes, including income, sales, and property taxes. Economic principles show we can best judge the efficiency of any tax by looking at the costs it imposes on taxpayers. Two key economic principles are at play here: (1) People respond to incentives, and (2) The true cost of any action is what you give up to get it.
The first principle shows that society loses when taxes alter incentives and distort the allocation of resources. Well-designed tax policies minimize the amount of economic distortion that occurs when businesses and individuals pay for their work and labor.
A good example is found with income taxes, both corporate and individual. Because interest income is taxed, the current state and federal tax laws discourage saving and encourage borrowing. This disincentive disappears with any consumption, or sales taxes.
The second economic principle shows us that the administrative burden of complying with the tax laws is a true cost of any tax policy. Well-designed tax policies will also minimize the amount of money spent complying with tax laws.
The US tax code is one of the most complex and burdensome systems in the world. Many resources are therefore taken out of other productive uses and paid to accountants and tax lawyers. By some estimates this amounts to $200 billion in foregone opportunities each year.
Our state income tax came about in 1931, when the Idaho State Tax Commission was established to administer a new tax “intended to offset property taxes levied for state purposes.” Over time, the complexity of this tax has grown. State law makers may find it agreeable to lower the overall corporate rate in exchange for eliminating exemptions, thus simplifying the tax code and the costs of complying.
The benefits of such reform of our income or sales taxes can be studied using the basic model of supply and demand. In this model a tax on any good or service reduces the welfare, or well-being, of the buyers and sellers in the market. The quantity sold and produced in the market is therefore lower than it would be otherwise.
Income taxes are a tax on labor, and place what economists call “a tax wedge” between the wage the firm pays and the wage that workers receive. Absent the tax, what the firm pays would be exactly what the worker receives.
Using this supply and demand analysis, we find that welfare or well-being in the labor market declines the more we raise taxes on working. The decline in well-being on both the buyers’ side (employers) and the producers’ side (workers or wage earners) is called the deadweight loss of the tax.
Taxes have deadweight losses because they reduce consumption and production. As behavior changes with the tax, the overall size of the market shrinks below its optimal output level.
How much below depends on another economic concept known as elasticity. The price elasticity of demand or supply is an economic measure of the responsiveness of the quantity in the market to a change in its price. It’s clear that taxes raise prices — the cost of buying and selling. The quantity demanded and quantity supplied respond accordingly.
Larger elasticities imply larger deadweight losses. The overall effect on society of an income tax, or any other tax for that matter, depends on whether or not demand and supply in the particular market are elastic.
In the labor market, the size of the deadweight loss depends on the elasticity of labor supply and demand. There is some disagreement about the magnitude of the elasticity of supply. Some economists argue that income and payroll taxes have only a small distorting effect on the economy because the labor supply is seen as fairly inelastic.
Others argue that all labor taxes lead to large deadweight losses because labor supply is responsive, or more elastic. Under this argument, more people would be working and earning a wage if we didn’t tax income.
The argument over labor supply elasticity says nothing about the burden of paying income taxes. The administrative burden of a tax (filing forms, sending payments, record keeping, etc.) is another measure of how well a tax is working.
This is why economists generally support sales taxes over income taxes, as the latter is too cumbersome and costly to administer. It is therefore best to simplify both.
In summary, basic economic principles and models show that our state economy would be better off with a simpler tax system weighted less towards income taxes. Idaho gubernatorial candidate Raul Labrabor has just such a proposal.
Labrador is proposing to “flatten and broaden the tax base” by reducing the individual, corporate, and sales tax rates to 5 percent while eliminating income tax loopholes. He also proposes eliminating the sales tax on groceries, which is more of a burden on lower-income households, and the elimination of personal property taxes charged on business equipment, a particularly costly tax to administer.
Lower and more easily understood taxes are the right choice. Lawmakers do well when they work to just keep things simple.
Peter Crabb is professor of finance and economics at Northwest Nazarene University.