Sales Taxes and Capital Goods
by Fred E. Foldvary, Senior Editor, 10 June 2013A general sales tax, including its implementation as a value-added tax (VAT), imposes a lesser burden on goods that endure relative to goods that are quickly used up. This is the basic proposition in the article “Europe’s Fatal Affair with VAT” by the geo-classical public-finance economist Mason Gaffney, published by GroundSwell in the January-February and March-April 2013 editions. It is also a working paper in the web site of the University of California at Riverside.
Gaffney’s theoretical proposition is that a general sales tax is not neutral among commodities, but has a different impact on goods with long versus short duration. This insight was recognized by the classical economist John Stuart Mill in his 1848 book, Principles of Political Economy with some of their Applications to Social Philosophy. Mill wrote:
“Now, equal capital in two branches of production must have equal expectations of profit; but if a greater portion of the one than of the other is fixed capital, or if that fixed capital is more durable, there will be a less consumption of capital in the year, and less will be required to replace it, so that the profit, if absolutely the same, will form a greater proportion of the annual returns.” (Book V, Chapter IV, Of Taxes on Commodities).
Economists also refer to the “period of production,” in which a long period means slow turnover. In the economics of the Austrian school of thought, capital goods with a short period are referred to as goods of lower order, in contrast to goods of higher order that have a long duration. This structure of capital goods depends on the interest rate, as low rates induce more investment in higher-order capital goods. But the Austrian school has not investigated the effect of taxes on the time-structure of capital goods.
A general sales tax has a greater negative effect on goods with a rapid turnover, since the tax is greater as a proportion of the invested capital. The tax reduces the net rate of return on investment for the goods with a quick turnover, relative to goods of long turnover. This skews investment more towards fixed capital goods relative to circulating capital goods. For example, there is more investment in buildings relative to household consumption goods.
The differential effect of sales taxes creates economic waste, as resources are skewed away from their most productive use. As Mill put it, this effect is “a disturbance of values ... owing to ... the different durability of the capital employed in different occupations.”
Taxing sales as well as wages and enterprise profits disturbs the economic space-time continuum. Space generates rent, and taxes reduce rent. Mill recognized that some of the sales tax is passed on to consumers, some is dissipated in economic waste or deadweight loss, and some of it replaces what would otherwise be paid in land rent. He wrote that the landowner pays a portion of the tax, as “the landlords will have a smaller rent. A part of the tax, therefore, will already have ceased to fall on the consumer, and devolved upon the landlord”.
Those who advocate a national sales tax instead of a land-value tax are fooling themselves, as they do not realize that much of the tax is indirectly born by landowners. Landlords pay sales taxes when they spend their rent income, but most of their burden comes from the general reduction of land rent caused by the reduction of profits. Thus much of the sales tax either is paid from rent or is at the expense of rent.
But by taxing land rent indirectly by the sale of goods, rather than directly on the rent or land value, the sales tax creates a deadweight loss by raising the price of goods, reducing consumption and production, by eliminating producers who cannot pass on the tax, and by shifting production towards goods with higher turnover. The waste of excessive construction was evident during the real estate bubble that resulted in the Crash of 2008. Part of the waste was cyclical, caused by the cheap credit policies of the Federal Reserve, and part of the waste is continuous as affected by sales taxes. Now with the push to tax mail-order goods bought from other states, the perverse effects of sales taxes will be even greater.
Gaffney points out that the United States is the only major country without a VAT or general national sales tax. Europe could increase its VAT rates to increase revenues, and the fact that it has not done so implies that raising the rates would create even more economic damage. The US also has economic woes, but its unemployment is less than that of Europe, and when funds flee to relative safety, the flows have been to the USA. The income tax has bad effects, but at least if a firm is making little profit, it pays little tax, whereas the sales tax and VAT applies to the value of goods regardless of profit.
The proposition of John Stuart Mill and Mason Gaffney, that sales taxes are more damaging to goods with a more rapid turnover, needs more discussion and research. The proposition adds another arrow to the quiver of arguments against sales and value-added taxes.
-- Fred Foldvary
Copyright 2010 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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