Taxing consumption, not income

Clemens is director of research and Murphy is a senior fellow with the Pacific Research Institute. They are co-authors of the California Prosperity Project series of studies.

Commission recommends changes to make state revenue less volatile

The report by the state Commission on the 21st Century Economy, delivered Tuesday after a number of delays, contains a fairly substantial package of tax reforms that deserves both praise and caution.

The governor tasked the commission to both modernize and stabilize the state’s tax system. The report’s main recommendations contribute to both goals by shifting the base of taxes from income to consumption, which is a more stable source of revenue. Specifically, the report calls for eliminating most of the state sales tax and the entire corporate income tax and replacing them with a new “net receipts tax” on business. Personal income taxes would also be reduced markedly; the number of statutory personal income-tax rates would fall from six to two but the “high-income” surtax would remain.

The shift to consumption taxes will also, thankfully, improve economic growth. This is based on the realization that some taxes impose higher costs on society than others because they create more serious distortions.

Research has consistently shown that consumption-based taxes impose much lower costs on society than personal and corporate income taxes. A study by Dale Jorgensen and Kun-Young Yun found that corporate income taxes imposed additional costs of $0.84 for one additional dollar of revenue raised. A dollar raised through sales taxes imposed costs of $0.26. The reason for this large difference is how these two taxes influence incentives.

Corporate income taxes create disincentives for investment and business development, which impose large costs on society and workers. Consumption taxes make consumption a little more expensive and savings a little more attractive. This creates incentives for more savings, which leads to higher levels of investment.

The commission, unfortunately, left a number of details regarding the new net receipts tax to others to research and fill in the blanks. The report is unclear, for example, whether the tax will be visible to consumers. This is key since evidence from Europe and Canada confirms that a tax visible to consumers will be constrained while an invisible tax will increase substantially over time.

Questions also remain about carve-outs and exemptions for the new tax. One can be sure that every industry and advocacy group will be lining up over the next few years for special treatment (reforms don’t take effect until 2012). The commission itself recommends exempting businesses with sales under $500,000.

The shift from income taxes to consumption taxes will help promote economic growth, but much more needs to be done to further savings, investment and entrepreneurship.

There is ample evidence that part of the state’s economic problems are rooted in our tax system. A recent study by the Tax Foundation ranked California’s tax system 48th out of 50 states in promoting business investment and development. While the commission recommends tax reform, it, unfortunately, was restricted from examining the overall tax burden. This is a critical oversight since California maintains the fourth-largest government sector (state and local) as a share of the economy. Modernization and reform aside, California’s overall tax (and spending) burden needs to be lowered, which, incidentally, some of the members of the commission agree with.

The compromises inherent in these commissions mean that some of the more necessary medicine for what ails our economy was either ignored or deferred. Even so, the commission should be congratulated for tackling a critical and difficult issue. Its report represents a positive first step but not a final destination. It is now up to the Legislature and the governor to convert the recommendations into policy that will reshape the tax system, stabilize revenue and, above all, boost economic growth in the Golden State.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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