Another Pointless Tax Reform

Fiscal conservatives are hopeless: they keep doing the same thing over and over again, expecting different results.

I am talking about tax cuts, of course. As I explained in my ebook Tax Cuts Don’t Work: A Libertarian Alternative to the Laffer Curve, what worked in the 1980s doesn’t work in today’s American economy. Our government is simply far too big for tax cuts to have any meaningful effect on either economic growth or the budget deficit.

Unfortunately, tax cutters don’t listen. Another state is about to make the same mistake as others before it. After the Governor of West Virginia announced his flak-drawing plan to end the state’s taxation of personal income, Mississsippi is lining up alongside the Mountain State to phase out its income tax. The Tax Foundation gives its analysis:

House Bill 1439, the “Mississippi Tax Freedom Act,” would phase out the individual income tax over a period of 10 years or more, contingent upon revenue availability. In the short term, the bill would dramatically increase the personal exemption so that an estimated 60 percent of Mississippians would not pay the individual income tax starting in 2022, offset by higher sales taxes. In future years, year-over-year revenue growth (after accounting for inflation) from recurring revenue sources would be used to continue increasing the personal exemption, culminating in complete repeal.

This, say the authors Jared Walczak and Katherine Loughead, is a good idea:

Broadly speaking, taxes on consumption are more economically efficient than taxes on income. The sales tax falls on consumption, while the individual income tax falls on consumption and savings, meaning that it taxes both labor and investment and reduces the return to both. Reducing reliance on income taxes can be a very good thing—and 20 states and the District of Columbia have cut individual income tax rates since 2008, often to considerable success.

It is an exaggeration to say that the tax cuts have been a success. Yes, there is a migration trend where states with income taxes lose population and those without income taxes gain, but that is a trend of people moving away from higher taxes in general. A state appears attractive because it does not have an income tax, but it is by no means a guarantee that taxes in general are going to be low in that state. To take one example: as we will explain in detail in a coming issue of our Economic Newsletter – sign up today and get instant access – the total cost of government is measured as all taxes, fees and charges, divided by personal income earned in the state. When measured accordingly, Wyoming, which has no state income tax, has one of the costliest governments in the country.

Part of the reason why the absence of an income tax is on guarantee for low-cost government is that many tax reforms are designed with the warped concept of “revenue neutrality” in mind. The idea behind the Mississippi reform is precisely that: to replace the revenue stream from one tax with a similarly sized revenue source from another tax.

This type of reform is popular among fiscal conservatives because it allegedly allows for an overall reduction in taxation. This, in turn, spawns more economic growth and thereby generates more tax revenue.

At least, that is what the Laffer curve tells us. The problem is that the Laffer theory does not work anymore. But before we get there, we need to make another observation pertaining specifically to the Mississippi reform. The Tax Foundation again:

Under House Bill 1439, Mississippi’s general sales tax rate would increase to 9.5 percent, bumping it up to the highest statewide sales tax rate in the country, followed by California at 7.25 percent. With a state sales tax rate of 9.5 percent, Mississippi’s combined state and average local sales tax rate would increase to approximately 9.57 percent, making it the highest combined rate in the country, followed by Tennessee at 9.55 percent.

They point to the elimination of the state income tax, again, as transferring the tax burden from one economic activity to another, from gainful employment to consumption.

This is what is known as a regressive tax reform, in other words it transfers the tax burden from higher-income households to those with lower incomes. The more progressive the income tax is, the more regressive this tax reform would be, the reason being that a progressive income tax places a disproportionately higher burden on high-income taxpayers. A sales tax, which is flat by design, is relatively more burdensome on lower-income households than those with higher incomes.

In the case of Mississippi, the regressivity of the reform is limited but not absent. It is limited by two factors, the first being the small “scale” in the Magnolia State’s income tax: for income of $1-5,000 the tax rate is three percent; for $5-10,000 it is four percent and five percent thereafter. Since the lower rates are more important to lower-income families – accounting for a larger share of their total tax liability – the elimination of the income tax is going to mean less to them, proportionately, than it does to higher-income taxpayers. Therefore, the expansion of the sales tax is going to hit them harder.

Consider a quick example. Family A makes $36,000 per year. After standard deductions (with two minor kids), using the calculator for the 2020 tax filing year, they owe $670 in Mississippi state income taxes. This comes out to 1.86 percent of their pre-tax income. Family B, on the other hand, makes $96,000 per year. All other things equal, they pay $3,670 to the state of Mississippi, equal to 3.82 percent of their pre-tax income. In other words, their effective tax rate is more than twice as high as it is for the low-income family.

Suppose, now, that we apply standard theory about consumer spending and assign a higher propensity to consume to the lower income family. In practice, Family A spends 100 percent of their net-tax earnings, which means $31,486 per year. Family B, on the other hand, has a propensity to consume of 90 percent, spending $69,188 per year.*

Suppose, now, that we raise the state sales tax as proposed in the Mississippi reform, from 7 to 9.5 percent. Theoretically, the sales tax impacts about half of private consumption in the Magnolia State:

  • In 2018 consumers spent $94.1 billion;
  • That same year the state collected just over $3.5 billion in sales-tax revenue.

This comes out to a 3.8-percent collection, which is just over half the current sales-tax rate. Hence, for our little experiment we can assume that the sales tax hits half of all private consumption. Thus, Family A pays $1,067 in sales taxes, equal to 2.96 percent of their pre-tax income, while Family B pays $2,421 per year, or 2.52 percent of their pre-tax income. In other words, the sales tax is regressive already in the first place.

Suppose now that we eliminate the income tax and raise the sales tax to 9.5 percent, as proposed in the reform.

  • Family A gains $670 and pays an extra $306 in sales taxes;
  • Family B gains $3,670 and pays another $671 in sales taxes.

How much more purchasing power does the reform leave each family with? When deducting the higher sales tax from the income-tax elimination,

  • Family A has $364 more in their pockets, equal to a 1.01 percent increase in their purchasing power;
  • Family B has $2,999 more in their pockets, equal to a 3.1 percent increase in their purchasing power.

In other words, the tax reform is regressive in its impact.

We arrived at these numbers under three key assumptions. The first is that high-income consumers have a propensity to consume of 90 percent. This is likely too high a rate; the lower it is, the stronger the regressive nature of the reform. The reason is simple: the income-tax elimination benefits 100 percent of their income, but the sales-tax hike only hits the part they spend. The lower the latter relative the former, the more they stand to gain.

Secondly, it is assumed that the sales tax applies to the same proportion of consumer spending for both our hypothetical families. This is not necessarily true: the higher the income, the more services people tend to consume. Since services are less often burdened with a sales tax than goods are, our Family B may be getting away even more leniently than estimated here.

Third, it is assumed that the state does not lower the sales tax on food. Such a cut is in fact included in the Mississippi reform; since groceries represent a larger portion of spending by low-income families than by others, this cut would benefit Family A more than Family B. The Tax Foundation disagrees, however:

While many proponents of a preferential sales tax rate on groceries view it as a way to reduce the regressivity of the sales tax, there is little economic justification for lowering the sales tax rate on groceries while raising the rates on other goods and services, with empirical research suggesting that the higher general rates necessary to offset a reduced or zero rate on groceries have more of an impact on lower-income consumers than does the inclusion of groceries at the ordinary rate. This counterintuitive finding is largely explained by existing policies in all states, driven by federal law, excluding SNAP and WIC purchases from the sales tax base. Above that threshold, grocery purchases tend to scale well with income.

In other words, if we take their word for it, the cut in grocery taxes would have no discernible effect on the outcome of the reform. We can therefore safely exclude the grocery-tax cut from our calculations.

The regressive nature of the Mississippi tax reform is problematic for two reasons, the first being moral: it is not fair for government to benefit some citizens over others. To do so is unfair regardless of it happens on the spending side of the budget, or on the revenue side.

The second reason is economic. There is no guarantee that a “revenue neutral” tax reform will leave taxpayers better off on the balance. It is neutral in terms of the amount of revenue that government expects after the reform; whether or not that neutrality translates into taxpayers paying more or less after the reform, depends entirely on what taxes are created or raised and which ones are cut or eliminated.

It is unlikely that the Mississippi reform will result in any net increase in the tax burden. On the contrary, our brief experiment suggests that taxpayers in general could be left with more money in the pocket. Even if we remind ourselves that we have made three key assumptions regarding consumer behavior and the grocery sales tax, this reform is still unlikely to generate a decline in economic activity across the Mississippi economy.

However, it is also unlikely to have any noticeable growth effect. The increased tax on consumer spending is likely to cool off household spending, even if they are left with somewhat better margins thanks to the elimination of the income tax. Consumers will stick to their budgets and spend as much as before, but because of the higher tax they will redirect some of their purchases to marginally cheaper substitutes. Relatively pricey Price Chopper and Kroger supermarkets may lose some customers to Walmart and Costco.

Again consistent with consumer theory in economics, higher-income families are likely to increase their overall savings, in other words put more than ten percent of their extra money into the bank. This also dampens the growth effect of the increased net balances in taxpayer pockets.

However, the real problem lies in that the reform completely lacks attachment to the spending side of the budget. Spending is allowed to grow uninhibitedly and can therefore throw a wrench into the rollback of the income tax. The Tax Foundation again:

The income tax phases out subject to revenue availability, not on a strict schedule. According to the bill sponsor, if revenue grows according to projections, the individual income tax would be phased out in its entirety after approximately 10 years, with fewer and fewer Mississippians paying individual income taxes over time. As Speaker Gunn has explained, starting in tax year 2022, almost 60 percent of Mississippians would be removed from the individual income tax rolls entirely

It is very likely that the GDP growth projections behind this tax reform does not take into account that state spending will increase independently of GDP. It is usually placed on an average, estimated growth rate that matches projected GDP growth – a habitual form of conventional-wisdom analysis that is too prevalent in economic analysis to even discuss here… However, the omission of the spending side sets the state of Mississippi up for a nasty wake-up call a couple of years into the future. If spending grows faster than the reform requires, then the reform will be slowed down or eliminated entirely.

The reform comes with a fiscal stop block that halts the reform if there is an adverse reaction in state government finances during the reform roll-out phase. This stop block is based on the following condition:

  • Revenue will have to grow at X percent per year;
  • spending will have to grow at Y percent per year; and
  • X>Y.

If this condition is not met, the fiscal stop block halts the reform roll-out, which de facto means that the income tax is not cut as required to generate the numerical results we discussed above. This stop-block scenario is actually likely, the reason being that the Magnolia State depends more on federal funds for its state spending than any other state: since 2010, federal funds have paid for an average of 43 percent of Mississippi state spending. Since the federal government increases its spending independently of state fiscal or economic conditions; since non-defense federal spending tends to outpace the federal tax base (hence a chronic and growing budget deficit); and since federal funds come with requirements that the state throw in money raised from its own taxpayers; it is likely that states with high dependency on the federal government will see faster growth in spending than states that, thanks to a lower dependency rate, can have more control over their own spending.

If spending outpaces revenue, in other words if “X>Y” does not hold, the tax reform will be halted and some of the income tax will remain. Depending on when this happens, a smaller or larger portion of the income tax will still apply. As a result, Mississippi taxpayers may very well see a net increase in taxation.

The omission of the spending side has gone unnoticed among proponents of the Mississippi reform. In addition to measured support from the Tax Foundation, the tax reformers in the Magnolia State get praise from Americans for Tax Reform (ATR). In a February 7 op-ed, ATR president Grover Norquist praises the reform but does not with one word touch the spending side of the budget.

Norquist, while a strong leader in the fight against higher taxes, has fallen for the same temptation as all Lafferistas: all you need is love and tax cuts. The problem with this approach is that there comes a point when tax cuts no longer yield the benefits that their proponents expect. Norquist and other Lafferistas could benefit from reading my ebook Tax Cuts Don’t Work: A Libertarian Alternative to the Laffer Curve, where I explained how our government has become far too big for tax cuts to be meaningful anymore. There is a statistically easily identifiable threshold for the size of government, above which tax reforms are no longer effective. Only spending reform works.

Mississippi is about to make the same Laffer-doctrinaire mistake as so many before them. Without attention to the spending side, their tax reform will run into the same ditch that the Kansas reform did a few years back. While they did not apply a formal “X>Y” condition as Mississippi does, it was de facto that condition that derailed the Kansas reform.

The fiscally conservative movement must stop focusing on taxes. It is high time for them to shift their attention to the spending side. My ebook explains exactly how that can be done: I outline a reform model for our welfare state that would make entitlement systems fiscally sustainable and thereby end endless budget deficits.

By my ebook now – only $2.99: Tax Cuts Don’t Work: A Libertarian Alternative to the Laffer Curve.

*) It is assumed that their savings are largely concentrated to mortgages. This is an unrealistic assumption for a variety of reasons, but a more detailed account of how higher-income families save in IRAs, college savings accounts, etc., would only reinforce the point made in this article. By keeping the example as low-key as possible, we give the benefit of the doubt to the Mississippi tax reform.

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