Two posts on the sales tax and work incentives

If you want to measure the incentive for working, the sales tax needs special consideration.

(A)  Arithmetic.  Think of it this way:

(Disposable income) = (Total income) - (income taxes) - (sales taxes)

Sales taxes are levied as a percentage s of one's disposable income: namely, when you buy a dollar's worth of items at the store you get an extra sales tax charge of s dollars. Income taxes are, for simplicity, a fraction t of income. We have:

(Disposable income) = (Total income) - t*(Total income) - s*(Disposable income)

Equivalently:

(Disposable income) = [(1-t)/(1+s)]*(Total income)

(B) Labor supply behavior.  In order to understand how labor supply behavior changes in response to tax rate changes, to a first approximation all we need to know is the percentage change in [(1-t)/(1+s)]. Over the past 10 years, U.S. sales taxes (levied at the state and local levels) have hardly changed, which means that the time series for t, which is what I showed in my WSJ article, is all we need to calculate the percentage change in [(1-t)/(1+s)].

John Cochrane explains this further on his blog. Today I gave an example, from the U.K., where sales tax rates were NOT constant.

The U.K. example also reminds us how the sales tax is included in the CPI so that, if you do have a marginal tax rate measure inclusive of the sales tax, you should NOT multiply it by a real wage deflated by the CPI because that would double-count the sales taxes. The MTR series that I showed in my WSJ article (and available here in excel format) does not include sales taxes, and therefore can be multiplied by wages deflated by the CPI.

Indeed, economists researching wages should make this multiplication more often than they do (which is hardly ever), because taxes are part of the functioning of prices in the labor market.

(C) Welfare analysis.  If you want to calculate the new deadweight losses from new income taxes, you have to consider the sales tax and any other other wedge between total income and disposable income, even if the sales tax were constant over time, because the behavioral changes avoiding the new income taxes have the side effect of reducing sales tax revenues.  That's what I do in the small section of my book (Appendix 4.3) that quantifies labor market deadweight losses.