How a Consumption Tax Discourages Savings

In my criticism of Fareed Zakaria’s article two weeks ago, I pointed out a common fallacy of modern economics: that a consumption tax discourages consumption and encourages savings. I’ll explain more clearly in this post why this is not true.

Before beginning, I should explain the concept of tax shifting. Who actually pays the tax? Is it the person who directly pays the tax, or is there some way that person can shift the tax onto someone else? A good example of this is a payroll tax, where a business is forced to pay (let’s say) a tax of 5% of a worker’s wage every time it hires a worker. Assuming the worker would normally receive a $10.00 wage without the presence of the tax, the worker now receives a lower wage, a wage of $9.52. (a 5% tax on $9.52 is $0.48, adding up to approximately $10.00)

So in this case, the business shifts the tax to the worker. We can say that the business is the direct payer of the tax but the worker is the true, indirect payer of the tax.

A tax not only hurts the true payer of the tax, but it also hurts everyone that person interacts with. These are the indirect effects of the tax. To quote Rothbard, “Thus, if an income tax is levied on Jones at 80%, this will hurt not only Jones, but also — by decreasing Jones’ incentives as well as capacities — other consumers by reducing Jones’ work and savings. It is therefore true that the effects of taxation diffuse outward from the center of the target.” Note that this is not the same thing as shifting. The direct effects of the tax still affect specific individuals, while the indirect effects of the tax affect others who interact with those specific individuals.

Now we can move on to the example of a consumption tax and apply these two concepts correctly to clear the confusion.

First note the logic in the following situation: a 10% sales tax is imposed on the sale of a lawnmower that normally has a price of $100.00. At a very basic level, people might analyze the situation and say “Okay, so the price moves to $110.00 and the consumer has to pay the whole price. Therefore, consumption is discouraged and savings are encouraged.” However, the lawnmower retailer will always have the price at the profit-maximizing price, originally $100.00. The tax does nothing to change that. If the lawnmower retailer could have raised the price to $110.00 and received a higher profit, he would have done so without the tax.

So initially when the 10% tax is placed on the $100.00 lawnmower, the price to the consumer stays the same. The total price will be $100.00, and approximately $9.00 will go to the government in taxes and approximately $91.00 will go to the retailer.  The price is still the same for the consumer but the retailer now receives less of a profit, or even losses. So in this case, the consumer is the direct payer of the tax but shifts it to the retailer, who becomes the true payer of the tax. (I don’t know how lawnmowers are made so I’ll intentionally be vague) The retailer, now with lower profits or even losses, lowers his demand from the factory making lawnmowers, shifting the tax back to the factory. This process occurs again and again, until the tax is shifted backward to the original factors: the land, capital, and labor. The tax hits the income accruing to these factors. Therefore, we conclude, a sales tax is an income tax.

Now, to clear up another source of confusion. The total price of lawnmowers does indeed go up, just not in the way many would think. As explained before, the price cannot go up immediately upon the imposition of the tax, because the retailer is already selling at the profit-maximizing price. However, the indirect effects of the tax, after the shifting process above described, will be to lower the supply of the good. The supply curve of each good, starting with the land, capital, and labor, and ultimately reaching the lawnmower retailer, will increase, making the price of each successive good higher. So the indirect effects of the sales tax will be to raise the price of the lawnmower, reducing consumption. The resulting profit-maximizing price will likely be somewhere between $100.00 and $110.00, assuming the demand curve stays the same. Consumers are indeed hurt by the consumption tax, but by the indirect effects, not by the direct effects.

Meanwhile, the direct effects of the tax on income will discourage savings in two ways. Firstly, because the land, labor, and capital owners get less income, they will have an incentive to consume more. To explain this in another way, because the land, labor, and capital owners now have a lower return on savings/investment, they will choose to consume more and save/invest less. Secondly, the lower a person’s real income, the higher their time preferences. That is, the lower a person’s real wage is, the lower their ability to buy products, the higher their consumption to savings ratio will be.

So at its very heart, a sales tax is itself an income tax. Consumption and savings will both be hurt, but savings will be discouraged even more than consumption.

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Posted on December 16, 2011, in Economics and tagged , , , . Bookmark the permalink. 2 Comments.

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