Saturday, December 15, 2012

Sales Taxes: Incidence and Incentives

It is commonly said that the sales tax affects workers and non-workers alike, as opposed to payroll and income taxes which tend to fall on wage earners, because everybody buys things but not everyone workers.  The elderly, for example, are harmed more by a sales tax than by a wage tax.

There is some truth to this conventional wisdom, but it has been exaggerated because many income streams are automatically indexed to inflation (specifically, the CPI), and CPI inflation reflects sales taxes.  For example, UK unemployment benefits are indexed to the CPI.  When the UK increased its VAT, inflation was created and the unemployed automatically got a raise while workers did not.

Another example, US social security benefits are indexed to the CPI via the Cost of Living Adjustment.  Thus, if the U.S. were to implement a VAT, the CPI would go up and the elderly would automatically get a raise.  Workers would not.

On the other hand, newly retired people have their social security benefit indexed to wages, which would not automatically increase after a VAT.  So new retirees would, in effect, pay the VAT throughout their retirement.  Elderly people also have non-social-security income sources, which are sometimes not indexed to inflation.  To the extend that elderly relied on non-indexed income, they would pay part of the VAT too.

In terms of incentives, the VAT discourages work because people work in order to buy more.  But, as noted above, there is an addition work-discouraging effect of sales taxes: through CPI-indexation it reduces the income gap between workers and non-workers.

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