The state-government establishment has a problem.
Well, make that several hundred problems, but let me just focus on one for the purposes of today’s discussion. Over the past three years, as state budget deficits have plagued governors and legislators, the various scholars and former government staffers who make up the aforementioned establishment – populating organizations such as the National Conference of State Legislatures – have pointed to an archaic tax system as the leading culprit.
If you’ve been watching state politics lately, in North Carolina or elsewhere, you’ve heard the standard litany by now: how our current tax structure was created in the 1930s, how it no longer fits the economic realities of the day, how it insufficiently captures revenues from non-manufacturing businesses and from the retail purchase of services, and so on. In the abstract, the critique sounds plausible. Indeed, the tax system is archaic and fails to mesh with the current structure of business and industry.
Unfortunately for its proponents, the thesis doesn’t really lead anywhere when postulated in the abstract. It doesn’t serve as a basis for legislative action. And when advocates begin to get more specific about the problems they see and the solutions they propose, they start to contradict each other – and often themselves.
For example, there is an entire gaggle of analysts and journalists who quack incessantly about how outdated the sales tax is. One of their complaint is that it is “volatile,” as this Christian Science Monitor article suggests was a big problem for the state budget of California. On the other hand, another school of experts swims in a completely different direction: they argue (with pretty good supporting evidence) that states overly reliant on income taxes have experienced significant volatility in their revenues in recent years because of wide variations in capital-gains realizations and other mechanisms make income “lumpy,” particularly to higher-income taxpayers. Interestingly, they also cite the California experience to prove their point – and this makes more sense because California is less reliant than the average state on sales taxes (27 percent vs. 32 percent of revenues, respectively) and more reliant on income taxes (49 percent vs. 37 percent). North Carolina’s percentages are roughly equivalent to California’s, by the way.
Are these two explanations of states’ fiscal turbulence – 1) it’s the sales tax, stupid, and 2) it’s the income tax, stupid – compatible? Not on their face. Virtually every state derives the large majority of its revenue from one or both of these two alternatives. And few would argue that statewide property taxes would be a good substitute – that form of taxation is especially despised both by good-government types and the general public. So if both sales and income taxes lack reliability, what other option is there? A poll tax? Making smokers and drinkers pay more? Talking about ideas that would make good-government wonks gag.
More coherent proponents of reform don’t argue that either form of taxation should be diminished or abolished outright. They argue for balance and for reforming each tax to address its more obvious flaws. In the sales tax arena, they would expand the scope of the sales tax to include retail services and goods purchased from catalogs or web sites. On income taxes, the establishment’s proposals vary but the common denominator is to maximize the share of income taken from high-income taxpayers – precisely the group that is hardest to nail down and from which the greatest revenue-volatility flows.
If they really thought through the implications of what they were saying (and I’m convinced most have not and are just trying to turn public attention away from the real fiscal problems of states, which are primarily on the expenditure side) tax-reform advocates would realize that the solution to volatility and equity problems lies neither in “balancing” two inherently flawed taxes or simply trying to find new ways to soak the rich. Instead, they would recognize that a sensible retail sales tax and a sensible income tax would be essentially the same thing.
That is, a sensible tax on goods and services sold at retail would impose one rate on every such purchase. And a sensible tax on individual income would impose one rate only on household income that is spent during a given year, which is by definition spent on retail goods and services. In the first case, you wouldn’t be discriminating between goods and services or between different kinds of vendors. In the second case, you wouldn’t be discriminating between present and future consumption, the latter being the same thing as savings. Just to explain further, savings is nothing more than deferred consumption, so if you tax the amount a household saves you inherently tax the return on that saving. To tax the money going into a savings account or investment and then to tax the money coming out in the form of interest, dividends, or capital gains creates a double-taxation bias with serious fiscal and economic drawbacks.
There may be sound public-policy reasons for favoring one form of this “consumed-income tax” over another. Some might argue that taxing income at the point of retail sale is best because it imposes less cost on consumers (vendors bear the cost of collection and payment to the government) and because it allows for greater financial privacy. Others might argue that taxing income at the point of households is best because it would make citizens more aware of the actual tax burden they face and remove businesses from the role of tax collectors. I’m in the latter camp.
But as an economic matter, the best sales tax system and the best income tax system are identical and unitary. Duplicating them by retaining both collection devices is just wasteful. Let’s just choose one or the other and do it the right way. And while we’re at it, our goal should be to reduce the percentage of personal income taken by the government.
I’m sure I’ll get agreement on that.
Hood is president of the John Locke Foundation and publisher of Carolina Journal.