LESSON 18 Sales and Income Taxes

In this lesson you will learn:

• The general impact of government spending.
• The three ways government typically pays for its purchases.
• The specific impacts of sales and income taxes.

Government Spending

One of the most profound ways that the government alters the economy, relative to the free-market outcome, is through its spending programs. In this lesson we will examine some of the ways in which these activities cause economic distortions, in light of our knowledge of how a pure market economy works. Remember to keep in mind that economic analysis by itself cannot decide for us whether a government policy is good or bad. However, objective economic analysis can show us that the typical justifications for interventionist policies are invalid. This is because the interventions themselves lead to a worse outcome using the very criteria given by those who support the interventions.

Regardless of how the government obtains its funds, when the government spends the money it necessarily draws resources out of the private sector and devotes them to lines chosen by the political authorities. For example, if the government spends $100 million building a bridge, we know this is affecting the economy even if we don’t know where the $100 million came from. In order to physically construct a bridge, the government must hire workers and buy supplies such as concrete and steel. Once these scarce labor and materials are applied to the bridge construction, they are unavailable to individuals in the private sector. A particular worker is physically incapable of building a factory for a private corporation, during the hours when he is working on the government bridge contract. And obviously concrete and steel that are incorporated into the bridge, cannot be used in other buildings built by private entrepreneurs.

If the political authorities simply declared that they were going to spend government funds in order to make themselves as happy as possible, economics would have nothing more to say. After all, when the owners of Disneyland decide to build a bridge connecting two areas of the theme park, they too are using up resources and making them unavailable to the rest of the economy. So why is there a problem when the government does the same thing?

The crucial difference is that the owners of Disneyland are operating in the voluntary market economy and so are subject to the profit and loss test. If they spend $100 million not on personal consumption (such as fancy houses and fast cars) but in an effort to make Disneyland more enjoyable to their customers, they get objective feedback. Their accountants can tell them soon enough whether they are getting more visitors (and hence more revenue) after the installation of a new ride or other investment projects.¹ Remember it is the profit and loss test, relying on market prices, that guides entrepreneurs into careful stewardship of society’s scarce resources.

In contrast, the government cannot rely on objective feedback from market prices, because the government operates (at least partially) outside of the market. Interventionism is admittedly a mixture of capitalism and socialism, and it therefore (partially) suffers from the defects of socialism. To the extent that the government buys its resources from private owners—rather than simply passing mandates requiring workers to spend time building bridges for no pay or confiscating concrete and steel for the government’s purposes—the government’s budget provides a limit to how many resources it siphons out of the private sector. (Under pure socialism, all resources in the entire economy are subject to the political rulers’ directions.)

However, because the government is not a business, it doesn’t raise its funds voluntarily from the “consumers” of its services. Therefore, even though the political authorities in an interventionist economy understand the relative importance of the resources they are using up in their programs—because of the market prices attached to each unit they must purchase—they still don’t have any objective measure of how much their citizens benefit from these expenditures. Without such feedback, even if the authorities only want to help their people as much as possible, they are “flying blind” or at best, flying with only one eye.

For example, suppose the government decides to build a public library in order to make books and internet access free to the community. Because the government only has a limited budget, it won’t do something ridiculously wasteful such as coating the library with gold, or stocking the shelves with extremely rare first editions of Steinbeck and Hemingway novels. Suppose the government tries to be conscientious,² puts out bids to several reputable contractors, and has a modest library constructed for $400,000.

Yet even if outside auditors or investigative journalists could find nothing corrupt or shocking about the process, the question would still remain: Was it worth it to spend $400,000 on building this particular library, in this particular location? The crucial point is that we know one thing for certain: No entrepreneur thought that he could earn enough revenues from charging for book borrowing to make such an enterprise worthwhile. We know this, because the library didn’t exist until the government used its own funds to build it!

One way to think about government expenditures is that they necessarily call forth the creation of goods and services that people in the private sector did not deem worth producing.³ When the government spends money it directs resources away from where private spending decisions would have steered them, and into projects that would not be profitable if private entrepreneurs had produced them relying on voluntary funding.⁴

Thus the political authorities in an interventionist economy face one-half of the socialist calculation problem. Even if we dismiss the above considerations on the grounds that “the preferences of rich people over resource usage are irrelevant,” the political authorities still have a problem in figuring out the best way to help the poor, disadvantaged, and so forth. For example, is it better to spend the $400,000 on a public library, or would it do “more good” if used to buy free flu shots for every child under the poverty line? In cases such as this, the government in essence is a giant distributor of charitable donations. Even those citizens who welcome the concept should ask themselves: Why do we need to route our donations through the political process? Why not decentralize the decisions and allow each person to donate his or her funds to the various charities that seem most worthy?

To be sure, the proponents of government intervention could offer (somewhat technical) replies to these questions.⁵ Even so, at best the case becomes one of finding the least-bad solution. Regardless of its possible benefits, government spending suffers from the calculation problem afflicting socialism. The system allows a select group of political authorities to override the input of private individuals in how (some of) their property should be used to steer resources into various projects. This is a very serious drawback for anyone who favors interventionism as a way to increase the “general welfare,” however defined.

Why Bureaucrats Have Such a Bad Reputation

A bureaucrat differs from a non-bureaucrat precisely because he is working in a field in which it is impossible to appraise the result of a man’s effort in terms of money.

—Ludwig von Mises, Bureaucracy, p. 53

How Government Finances Its Spending

In addition to the economic distortion (relative to the pure market outcome) caused by government spending per se, additional distortions are introduced depending on the source of the government’s revenues. Traditionally there are three main vehicles through which the government raises money: taxation, budget deficits, and inflation. When the government levies taxes, it decrees that individuals and corporations must pay money to the government according to certain rules. When the government runs a deficit, it borrows money from individuals, corporations, or other governmental institutions, by selling bonds. The government is legally obligated to pay back these loans with interest. Finally, when the government raises funds through inflation, it creates new money (“out of thin air”) and uses it to finance its purchases.

Later in the book we will deal with government deficits and inflation. In the remainder of this lesson, we focus on two of the primary sources of tax revenues for the government: sales taxes and income taxes.

Before proceeding, we should emphasize again that the distortions we discuss below are in addition to the distortions caused by transferring resources out of the hands of private entrepreneurs (subject to the profit and loss feedback mechanism) to be directed according to the political process. What we show below is that the government distorts the economy not just when it spends the money, but when it raises the funds in the first place through taxation.

To see the difference, imagine an extreme case where the government imposes a 200% income tax, meaning that for every dollar you earn, you are legally required to send the IRS a check for $2! In that ridiculous scenario, it is clear that very few people would work, or at least very few people would work “on the books” and report their incomes to the government at tax time. Consequently, the government would collect very little revenue, and wouldn’t be able to spend much money pulling resources away from their most profitable uses. Yet surely it would be wrong to conclude that this hypothetical economy suffered from very little economic distortions due to government interventions. In this scenario, everyone would have quit his or her official job and would be forced to live off the land, or work in black market jobs that could be hidden from the authorities. The economy would be plunged into extreme privation because of the punitive tax code, even though it raised very little revenue and the government didn’t have a large budget.

In summary, governments distort economies (relative to the pure market outcome) both when they spend money and when they collect funds. We now examine the specific distortions caused when the government collects money through sales taxes and income taxes.

Sales Taxes

Under a sales tax, the government mandates that a portion of the payment on certain transactions is owed to the government. For example, if there is a 5% sales tax on all restaurant meals, then diners who order $100 worth of food and drinks—according to the prices on the menu—must pay $100 to the restaurant, but then an additional $5 to the government. In practice, the restaurant collects the entire $105 from the diners at the end of the meal, and sets aside the $5 to be sent to the government at periodic intervals.

Sales taxes distort the economy because they force consumers to face incorrect prices. In our example of the restaurant meal, the diners must ultimately pay $105 for the particular combination of food and drinks that they enjoyed, when in reality the restaurant only needed to charge $100 in order to cover the expenses of the labor, raw meat, soda syrup, and other resources used to produce the meal. This distortion is obvious if we consider a case where the government imposes a large sales tax on some items—such as alcoholic drinks—while exempting other items from a sales tax altogether, such as fruits at the grocery store. This imbalance in sales tax rates causes the penalized goods to appear artificially expensive, giving consumers an incentive to purchase less of the penalized goods and more of the exempt goods.

Of course many reformers would say, “That’s the whole point! We want to discourage people from drinking alcohol.” Such a judgment relies on the reformers deciding that their own preferences should be given more say than the preferences of the consumers spending their money in the marketplace. Economic science cannot say whether such paternalism is good or bad, but it simply notes that the consumers themselves would judge themselves worse off, at least narrowly conceived. The imposition of a high tax rate on liquor only takes away options from consumers. People who want to eat healthy always have the option of spending nothing on liquor, without the government artificially raising its price.

Many practical economists advise governments to adopt uniform sales taxes with low marginal rates, in order to minimize these types of distortions. For example, rather than levying a sales tax of 10% on half the items in the marketplace, most economists would instead suggest that the government levy a 5% sales tax on all the items in the marketplace. This switch would bring in roughly the same amount of revenue to the government,⁶ and it would eliminate the arbitrary disadvantages placed on particular sectors of the economy.

However, we should remember that in a pure market economy, prices mean something; they are indicators of real scarcity Consequently, even if the government levies a “fair” single-rate sales tax applied uniformly to all goods and services, nonetheless it will distort the economy, because consumers will still have the incentive to not earn as much income in the first place. To see this, let’s take a ridiculous example where the government levies a uniform 100% sales tax on every item in the market. Even though every sector is hit with the tax, it’s obviously not a “wash.” Consumers will end up buying fewer items in total, and will allow their monetary incomes to fall by working less (and enjoying more leisure). Besides this obvious impact, there is also the subtle point that it is impossible to levy a truly uniform sales tax. For example, a 100% sales tax on chewing gum would make a $1 pack turn into a $2 pack, whereas a $50,000 sports car would turn into a $100,000 car. The sales of chewing gum would probably fall less than the sales of sports cars.

Up until now, we have been assuming that everyone in the society obeys the government’s tax laws. But in reality, as a sales tax rate becomes higher and applies to more and more items, more merchants and consumers will conduct their operations in the black market, meaning they will engage in voluntary transactions without reporting them to the government, or sending in the legally required tax payments. This reaction is yet another distortion caused by sales taxes, because some items (e.g., cartons of cigarettes) are much easier to trade on the black market than others (e.g., cars).

Income Taxes

When the government levies an income tax, it requires individuals and corporations to transfer some of their income in a particular period to the government. Income taxes are usually expressed as percentages, and are often graduated meaning that different portions of someone’s (pre-tax) income are taxed at different rates. For example, suppose an income tax has two brackets with a rate of 10% for income up to $10,000, and 20% for income above $10,000. A person with a pre-tax income of $100,000 would thus owe the government (10% x $10,000 + 20% x $90,000) = $1,000 + $18,000 = $19,000.⁷

To the extent that the income tax exempts particular sources of income, it causes distortions between these sectors. For example, the interest income earned from buying municipal bonds (issued by local governments) may be tax exempt, whereas the interest income earned from corporate bonds will be taxed. This causes investors to lend more money to local governments and less to corporations, other things equal, and distorts the allocation of capital funds.

Another example of this type of distortion is related to the problems with health care delivery in the United States. Under the current U.S. income tax code, when employees receive health insurance as part of their job, this benefit doesn’t count as taxable income. However, if the employer took the money it otherwise would have spent on the health insurance premium for the employee, and handed this money directly to the employee in the form of a higher paycheck, then it would be taxed—meaning the employee wouldn’t get to keep the entire boost in the paycheck. In other words, it’s much cheaper (depending on the relevant income tax rate) for the employer to buy health insurance for the employee, than for the employee to buy it him or herself. This is a major reason that health insurance is so intertwined with one’s job, whereas people typically use their paychecks to go buy their own auto and fire insurance.

In addition to exempting certain sources of income, another major distortion from income tax codes comes from allowing particular expenses to be excluded (or deducted) from one’s taxable income. For example, homeowners can deduct the interest that they pay on their house mortgages from their federal income tax assessment. So someone with a pre-tax income of $100,000 but who pays $5,000 in interest on the loan that he got from the bank to buy his house, will only report to the IRS that he has $95,000 in taxable income. The appropriate bracket tax rates will then be applied to this lower amount, not to the true $100,000 in income. Such a “loophole” in the income tax code arguably brings the economy closer to the market outcome overall (by limiting the applicability of the distortionary income tax), but it clearly causes large distortions between individual sectors, especially if marginal income tax rates are high. In the case of mortgage interest deduction, the distortion gives people an artificial incentive to prolong the length of their mortgage, and to use their money in other investments rather than paying back the bank as quickly as they otherwise would have.⁸

The biggest of all distortions from the income tax code relates to the decision of how much income to earn in the first place. Most obvious, people will work less if the reward for working (i.e., monetary income) is taxed more heavily. College students may prolong their educations, and older workers may retire earlier. In the economy as a whole, the total number of hours worked—particularly “doubletime” hours during holidays—will fall, because of the change in incentives. This will occur both because people will truly work less (and engage in more leisure), but also because they will work “under the table” or “off the books” and not report their earnings to the government. Because some forms of income are easier to hide than others, this encouragement of black market activity will distort the economy too, relative to the pure market outcome.

Finally, we discuss an effect of the income tax code that many analysts overlook. Some people argue that a tax hike, so long as it is modest, won’t have a noticeable impact on economic activity, since “people still have to work.” For example, suppose the government originally has no income tax at all, but because it needs more revenue it creates a new tax bracket of 20% on all incomes above $80,000. Many observers would think that this would have little effect on the economy, since people who make over $80,000 surely aren’t going to stop working because of the new tax!

Yet this analysis ignores the fact that the monetary paycheck is just one component of a job’s overall appeal to a worker. Suppose someone is the top accountant working for a reputable firm in a sleepy town in the Midwest, making $80,000 per year. He has applied for a job in New York City at a much larger firm where the salary is $140,000 per year. However, the downside is that the man would have to go through the hassle of moving, he would have to pay much higher prices for housing or apartment rental, the job at the large firm would be far more stressful, and the man would spend an extra two hours commuting each day. Before the income tax, the man would have to decide whether the extra $60,000 in salary per year compensated for these drawbacks of the big city job.

After the new income tax goes into effect, the advantage of the New York City position has fallen significantly. Now if the man takes the job, his pretax salary will still jump to $140,000, but he will have to write the government a check for $12,000. Thus his after-tax income will only be $128,000, compared to his $80,000 salary at his current job (which falls just below the tax line). Now the man must decide whether an additional $48,000—not $60,000—per year compensates for the hassle of moving, more expensive housing, the higher stress, and the longer commute. Even if this particular man decides to move anyway, it is clear that in an economy with millions of workers, a high income tax distorts their decisions about which jobs to accept. Thus the income tax—especially as its top rate grows higher and higher—interferes with the market economy’s ability to attract workers into the appropriate channels through higher wages and salaries. The “signal” sent by entrepreneurs bidding more for labor encounters interference from the tax code.

Taxes Discourage Production

“There is a [discouraging] effect when personal incomes are taxed 50, 60 or 70 percent. People begin to ask themselves why they should work six, eight or nine months of the entire year for the government, and only six, four or three months for themselves and their families. If they lose the whole dollar when they lose, but can keep only a fraction of it when they win [because of taxes], they decide that it is foolish to take risks with their capital. In addition, the capital available for risk-taking itself shrinks enormously. It is being taxed away before it can be accumulated. In brief, capital to provide new private jobs is first prevented from coming into existence, and the part that does come into existence is then discouraged from starting new enterprises. The government spenders create the very problem of unemployment that they profess to solve.”

—Henry Hazlitt, Economics in One Lesson, p. 38

Lesson Recap...

• No matter how it is financed, government spending always diverts physical resources away from projects determined in the private sector, and into projects chosen by the political process.
• Government typically pays for its purchases through taxation, borrowing, and inflation.
• All taxes distort the economy, relative to the free-market outcome. Sales taxes favor some goods over others, if the rates are not applied uniformly. Even a uniform sales tax reduces the rewards from working, which artificially encourages people to opt for more leisure. An income tax penalizes work even more directly, and artificially encourages people to choose jobs that feature non-monetary advantages.

NEW TERMS

Taxation: The process in which the government takes ownership of portions of income or other assets from private individuals.

Budget deficits: The excess of government spending over tax receipts. The deficit is the amount the government must borrow to pay its bills in a given period.

Inflation: The creation of more money, which drives up prices.

Black market: The system of illegal transactions that violate government regulations.

Sales tax: A tax that applies to goods and services as they are sold to the customer. Sales taxes are usually applied as percentages of the pre-tax dollar amount.

Paternalism: Overriding the desires of someone else because he or she is not considered competent to make the right decision.

Income tax: A tax that applies to the earnings of an individual or a corporation. Income taxes are usually applied as percentages of the pre-tax dollar income.

Graduated income tax: An income tax that applies higher rates to higher levels of income.

Income Tax Brackets: The thresholds of income that are taxed at various rates. For example, the lowest tax bracket might include incomes ranging from $0 to $10,000, which is taxed at 3%, while the next bracket might include incomes ranging from $10,001 to $20,000, which is taxed at 5%.

Tax Deduction: A provision in the tax code that allows a particular expense (such as medical expenses or the purchase price of a new solar panel) to be subtracted from an individual’s taxable income. This means that tax-deductible items are paid for with “pretax dollars,” which allows an individual to buy more with his income.

Taxable income: The amount of income actually subject to the official tax rates for each bracket. Taxable income is the original income after all deductions and other adjustments have been made.

STUDY QUESTIONS

1. *Does economics conclude that government spending is bad?
2. How do we know that government spending diverts resources from the private sector? Does it matter how the government obtained its funds?
3. **If the government builds a library, do we know that the private sector wouldn’t have built a library instead?
4. If the government raises a modest amount of money through taxation, do we know that the tax burden is light?
5. As long as people continue working, does the income tax have little effect on the economy?