State Sales and Income Taxes: An Economic Analysis
Calia, Roland, Government Finance Review
Zodrow, George R.
College Station, TX: Texas A & M University Press (204 pages)
States facing increased revenue demands are usually forced to choose between two options: relying on a state income tax system or utilizing a state sales tax. Using a purely economic perspective, this book presents a comprehensive analysis of the advantages and disadvantages of using either type of tax. More specifically, Zodrow evaluates the two options in terms of economic efficiency, fairness, administrative simplicity, and tax exportability. He also considers two possible alternatives to the sales and income taxes--increased reliance on user charges and adopting a tax on consumption with minimally progressive features. In the final chapter, Zodrow applies his analysis to the current tax system in Texas, one of the last states without an income tax.
Drawing on the public-finance literature, Zodrow outlines a desirable tax system as one that fulfills the following criteria: 1) it exports tax burdens to outof-state residents; 2) it is efficient; 3) it is equitable; 4) it provides an adequate and stable revenue stream, and 5) it has low administrative, enforcement, and compliance costs. The book compares income and sales taxes based on the criteria listed above.
Chapters 3 and 4 analyze sales vs. income taxes using the criteria of exportability and efficiency. Exportability is the extent to which a state can shift its tax burden to out of state residents. There are two ways state tax burden can be exported to out-of-state residents: through deductibility against federal tax liability or by exporting tax burdens through price changes. Under current federal law, only personal income taxes are deductible from an individual's federal tax liability. Therefore, the deductible portion of the state tax burden is effectively exported to taxpayers in other states, and income taxes are clearly preferred over sales taxes.
Exporting tax burdens through price changes is far more difficult under either tax option. Most business taxes are borne by relatively immobile factors like land and labor or by in-state consumers. The owners of these immobile factors and consumers bear the burden of tax, that is the excess inefficiency cost that can be attributed to the outflow of capital promoted by the tax that reduces the productivity of the state's labor and land resources. Because of these factors, there is little potential for tax exporting through price changes.
Thus, the very limited potential for tax exporting through price changes does not provide a compelling argument for either the sales or income tax.
The criterion of economic efficiency requires that a tax system be designed to minimize tax-induced distortions of individual, firm, and government behavior. Because all taxes reduce economic efficiency the question really is, which tax is least inefficient. Benefit taxes, which correspond to the benefits received from public services and thus are roughly analogous to prices in the private sector, are viewed as desirable on efficiency grounds because they promote efficient decision making in the public sector since individuals bear the cost of funding services they utilize. However, in the absence of user fees and charges, the least inefficient tax is one that is highly visible, that is citizens can clearly see how much they are paying for public services and put pressure on government officials to moderate spending increases. Thus, as income taxes are more visible than sales taxes, they are the preferred option on efficiency grounds.
Applying the third criterion of equity produces mixed results. It is difficult to make equity arguments for either the income or sales taxes on business activities. The most compelling argument in terms of equity is that businesses should pay taxes in proportion to the benefits received, an argument which is better achieved by means of user charges. …