Is the sales tax truly regressive?

Great Debates
1

Back in college, I took an economics class in which the instructor insisted, with almost rabid enthusiasm, that the sales tax was regressive. Her reasoning was as follows:

Everybody needs product X.
Product X costs $1000.
The sales tax is 5% (I’m making up the numbers to make the math easy).
Thus, the tax on product X is $50.
If a guy who makes $20,000 per year buys product X, the percentage of his income consumed by the tax is .0025%.
If a guy who makes $100,000 per year buys the same product X, the percentage of his income consumed by the tax is .0005%.
The guy who makes $20,000 per year paid a significantly larger proportion of his per annum income for the tax than the guy who makes $100,000 per year.
Therefore, the sales tax is regressive. It hits the poor much harder than the rich.

The logic is flawless. Being a man of relatively tender years at the time, I believed anything she said, and I truly believed that the sales tax is regressive for years thereafter. But, one day it hit me. That logic only applies when you consider the poor guy and the rich guy buying the exact same thing, one time only. It struck me that it might be better to think about the situation not in terms of one purchase of the exact same product, but rather in terms of all of the things the poor guy and the rich guy buy in a given time period.

For example, consider a hypothetical situation in which both guys need to buy a car. The one who makes $20,000 per year knows he doesn’t have much money to throw around, so he winds up buying a used car for $10,000. The 5% sales tax he pays is $500, which works out to .025% of his income. The guy who makes $100,000 per year, on the other hand, has a lot more money to spend, and so buys himself a car for $60,000. He pays the same 5% sales tax, and in his case, it works out to $3000.

Now, here’s the fun part. $3000 works out to .03% of the rich guy’s income. Lo and behold, the rich guy paid .005% more of his income on the sales tax than the poor guy. And they both walked out of it with a car (not the exact same product, granted, but they serve the same purpose, and realistically, this is how it works out). This clearly doesn’t fit the definition of regressive that my econonomics instructor gave us.

The picture looks cloudy already, but consider what might happen next. The poor guy, again fully aware that he doesn’t have much money, drives his newly acquired car straight home, not stopping off anywhere to buy anything else because he’s now strapped for cash. The rich guy, on the other hand, drives his new car to a local steakhouse and gets himself a filet mignon at $30 a plate. He pays sales tax on that too. Add the sales tax paid for the meal and sales tax paid for the car, and, due solely to the fact that he bought something that the poor guy never would, he pays an even greater percentage of his income toward the combined sales taxes.

How is that regressive? Granted, if a millionaire and a poor guy lived the exact same lifetsyle, the millionaire would make out like a bandit as far as the sales tax is concerned. But, as a group, millionaires seldom live the same lifestyle as the guy making 20 grand a year. Instead, they live it up, just because they can. And, as the above example hopefully illustrates, they pay the same (and quite possibly more) percentage of their incomes toward the sales tax, primarily because they buy more stuff (and the stuff they buy is more expensive). This does not strike me as regressive.

Thoughts?

2

It just depends what you are trying to tax. A slaes tax taxes spending. The more you spend, the more you pay. It does not matter how much you make. You spend, you pay. This seems reasonable as you enjoy money when you spend it and your enjoyment is in proportion to how much of it you spend. Since you pay when you spend, it encourages saving (investing).

OTOH, income tax, taxes income. You pay when you earn whether you spend it or whether you save it.

In practice governments try to get every penny they can get so you will have every tax they can think of and then some.

3

A sales tax is regressive, but that isn’t why.

If 1.)everything is taxed and 2.)everyone spends every penny they make, then a sales tax is essentially a flat tax. Most sales tax proposals exempt necessities, which adds a hint of progressiveness, since rich people intuitively spend a smaller percentage of their income on “necessities”.

The problem comes with the second part. Let’s say there is a 10% sales tax. Jack makes $20,000 a year, and is probably going to have to spend nearly all of it to make ends meet. We’ll say that $15,000 of that is spent on “necessities” that have been declared exempt from taxation. Jack will pay $500 in taxes for the year. Effective tax rate: 2.5% of his income.

Bob makes $10 million a year. However, he doesn’t have to spend it all–he can live on a meager $1 million, and add the rest to his net worth. We’ll give him the same $15,000 for necessities, even though far more of his purchases probably fall under that umbrella. He pays 10% on the remaining $985,000, or $98,500, in taxes. Effective tax rate: 0.985% of his income.

In short, a sales tax does encourage people to save money, but only if they have money to save.

Dr. J

4

I think the logic would usually run something like this.

A person’s income will usually be split into two parts – consumption expenditures and investment (either money put in the bank, or more traditionally invested in the markets). People have to spend a certain amount to live, but after that base amount, they will choose to invest some of their money. As long as it is the case that (at least after you have earned enough money to live on), out of each additional dollar, some of it goes to savings, AND all consumption is taxed, but all investment is not, it is a relatively easy task to prove that the proportion of your income that goes to taxes declines as you earn more money. This is strictly a mathematical proof, it depends on the assumptions about consumer behavior embodied in the economic model. It may be possible to come up with realistic sounding counter examples, and those are always situations that in some way violate the assumptions this proof starts with.

Since I haven’t done rigorous mathematics in a long time I will leave the proof as an exercise for the reader

In your example, the problem is that you have only accounted for these two guys expenditures on one day. Over the course of the full year, the poor guy is going to have spent all or more than his $20,000 (he may have bought the car on credit) - so he will have paid 5% of his income in taxes. The wealthy guy would have saved something (even if he lived an extravagant lifestyle, three times as expensive as the other guy, he still saves 40 grand), and only would have paid the tax on his expenditures.

I am sure someone has done tax incidence studies in real world situations (where many consumption expenditures may not be taxed, ala rent and, in many localities, food), but I cannot give any citations.

5

DoctorJ, I do see your point. However, I guess I disagree that rich people intuituvely spend a smaller percentage of their incomes on necessities. Far from it. For example, both food and transportation are necessities, no matter how much money you make. But, rich people will intuitively buy more expensive food and more expensive cars than poor people. It’s only because the rich people can afford it. It doesn’t matter that Bob could potentially survive on the same $15,000 worth of necessities that Jack survives on. The fact is that Bob, because he makes more money, is probably spending two, three, even four times as much as Jack on necessities. To use a trivial example, let’s say that beer is a necessity. Jack buys himself a 6 pack of Bud Light. Bob, on the other hand, buys himself a 6 pack of Bass Ale, which costs about twice as much (at least in my area it does). Both Bob and Jack bought a necessity, but Bob still paid a lot more in sales tax than Jack did.

You’re obviously pretty well informed about this stuff. Whaddaya think?

6

srwilkins: I totally agree. That’s why I said:

I left that detail out to help make my point. If you include that fact, the regression becomes even worse. (Of course, they could set a baseline of “necessity”–say, in your beer example, Milwaukee’s Best–and tax the difference between the cost of the Beast and the Bass. That would get really messy in a hurry, though.)

I’m not that well-informed–I was just a math major in a previous lifetime. I’d love to hear what some of our more economically-inclined people have to say about it.

Dr. J

7

Economist checking in.

Yes, sales taxes tend to be regressive because savings grow as a proportion of income a income rises.

Note that this relies on income being used as a proxy for economic position. If you use consumption as a proxy, sales taxes tend to be proportional.

Of course you can try to tax only relatively income-elastic commodities, but in general this creates a mess.

picmr

8

That is very well said picmr. Let me try to present an example:

One man makes 30K/year and spends it all. Another man makes 60K/year and spends 30K on living exactly like the other guy and saves the rest.

With only sales tax they pay the same because they spend the same (and therefore enjoy the same quality of life). A sales tax taxes you on what you actually spend and enjoy.

With income tax the guy with more income payes more.

In any case both taxes are here to stay. I cannot see any government letting go of any source of income.