Public Finance Seminar Spring 2013, Professor Yinger

1. Public Finance SeminarSpring 2013, Professor Yinger Sales Taxes

2. Sales Taxes Class Outline • Administration of the Sales Tax • Tax Incidence (Equity) • Tax Distortion (Efficiency) • Recent Research on the Sales Tax

3. Sales Taxes The Basics • The sales tax is really a sales and use tax. • States levy a tax on the purchase or use of a commodity or service within their boundaries. • States cannot levy a tax on the purchase or use of a commodity in another state. What counts is point of delivery. So wine shipped from one state to another is taxed where it is delivered.

4. Sales Taxes The Supreme Court Ruling • State A cannot force firms in other states to collect sales tax even when they deliver to customers in State A—unless the firm has “nexus” in State A. This is based on the Supreme Court’s interpretation of the Interstate Commerce Clause in the U.S. Constitution. • Alot of revenue is lost here, because this applies to catalogue sales and to internet purchases. • Taxing the internet is a different issue. Congress has placed a moratorium on taxing access to the internet, which is a totally different thing than taxing products purchased over the internet. • Any state can tax internet purchases delivered by firms in their state to people in their state—and require the firms to collect the tax.

5. Sales Taxes The Use Tax • A state can collect a use tax from its citizens once a product is delivered, even if the purchase is from an out-of-state firm, but this is virtually impossible to administer. New York has a line on the state tax forms requesting voluntary reporting of this tax. • In some cases, states can solve the use-tax enforcement problem through interstate agreements to trade credit card information.

6. Sales Taxes Plugging the Leak • The definition of “nexus” is in doubt. New York went after Amazon because its affiliates have nexus in New York. So far, New York has won in court. • Amazon has dropped its affiliates in some states to avoid collecting taxes. • But big states, Amazon discovered that a distribution center (=nexus!) quickened delivery times and gained customers. • There is an on-going effort to create standardized product definitions and even tax rates so that the “burden” identified by the Supreme Court disappears. • About 20 states have signed onto this Interstate Compact, but it would require Congressional action and is a long way off.

7. Sales Taxes Tax Incidence • Tax incidence has two meanings. • Legal incidence is about who has the legal obligation to pay a tax. With a sales tax, this is usually the seller. This is the meaning relevant for administration. • Economic incidence is about whose opportunities are constrained by a tax, that is, who bears the burden. This is the meaning relevant for evaluating the fairness of a tax.

8. Sales Taxes Analysis of Tax Incidence • An analysis of tax incidence has two steps. • Figure out which side of the market, demand or supply, bears the burden of the tax. • This is about tax shifting. Can the side on which the legal incidence falls shift it to the other side? If the legal incidence is on the seller, does P rise enough to compensate for the tax? • Given the answer to 1, figure out the distribution of the tax burden by income class.

9. Sales Taxes Market Analysis • Standard incidence analysis begins by looking at the impact of a tax on the market for the taxed good or goods. • This analysis does not apply to the market for one taxed good if other goods are being taxed, too. • This analysis is based on relative prices, which do not change for two goods that are both taxed

10. P P D S+tax P2 S+tax P2 S P1=P3 P1=P3 S D Q Q Sales Taxes Market Analysis, 2 • Possibility 1: Consumers Pay

11. P S+tax S P S P1=P2 P1=P2 D tax tax P3 P3 D Q Q Sales Taxes Market Analysis, 3 • Possibility 2: Firms Pay

12. P S+tax S P2 tax Burden on consumers P1 Burden on firms P3 D Q Sales Taxes Market Analysis, 2 • Possibility 3: The burden is shared.

13. Sales Taxes A Simple Model of Incidence • Now consider the simplest possible supply and demand equations: • Since QSmust equal QD in equilibrium, we can equate the two right sides and solve for P:

14. Sales Taxes Shifting • Now we can take the derivative of P with respect to T; i.e., we can ask how P changes as Tchanges. • From this it is clear that

15. Sales Taxes Shifting, 2 • This simple example refers to slopes. A more general version would refer to price elasticities. The degree of shifting depends on the relative price elasticities of demand and supply (in absolute value). • The intuition is about responsiveness. A more responsive curve, which suggests more alternatives, implies that a side of the market is better able to escape the tax.

16. Sales Taxes Incidence, 2nd Step • The second step is to translate to the distribution of income. This obviously depends on the incomes of suppliers versus demanders. Either one could be higher. • The result is usually summarized with a graph with T/Y on the vertical axis and Y on the horizontal axis. A flat curve indicates a proportional system; a rising curve indicates a progressive system, and a falling curve indicates a regressive system.

17. T Y Progressive Proportional Regressive Y Sales Taxes Incidence by Income • In a graph, these concepts are:

18. Sales Taxes Equity Principles • In a policy setting, the positive analysis of tax incidence is combined with judgments about what is fair. • The ability to pay principle says that people with a higher income should pay more, but does not necessarily support progressivity. • The benefit principle says that people who benefit from the funded service should pay, but this does not rule out progressivity within this set of people.

19. Sales Taxes Tax Distortion • Taxes affect behavior. This implies that taxes move outcomes away from the efficient level that is generated by a competitive private market (under some circumstances)—i.e. that taxes cause distortion. • As before, the basic analysis applies to taxes markets relative to untaxed markets—not to one of many taxed markets.

20. Sales Taxes Excess Burden • Consider an elastic supply curve. The initial equilibrium is (P1, Q1). Because the tax is fully shifted, the new price, P2, equals P1(1+t), or ΔP=tP1. • Now if we draw the picture, we see that consumer surplus drops because of the tax revenue that is collected and because of a lost triangle = excess burden.

21. Government Revenue P Excess Burden P2 S+tax ΔP = t P1 S ΔQ D Q2 Q1 Q Sales Taxes Excess Burden, 2 • In a graph: The Market for Taxed Goods

22. Sales Taxes Excess Burden, 3 • We do not consider the tax revenue as a loss of consumer surplus. Tax analysis usually compares the burden from alternative taxes, so this revenue will be lost no matter what we do. • Moreover, even if we were just evaluating a single possibility, the revenue collected presumably results in benefits in the form of public services. • The triangle, called distortion or excess burden or EB, equals (½)ΔQΔP = (1/2)ΔQ(tP1).

23. Sales Taxes Excess Burden, 4 • Now the absolute value of the price elasticity of demand, say e, equals (P1ΔQ)/(Q1ΔP). So ΔQ= (eQ1)(ΔP/P1) = (eQ1)(tP1)/P1 = (eQ1)t and EB= ½ (e)(t2)(P1Q1) • This is a central result in tax analysis. Remember it!

24. Sales Taxes Excess Burden, 5 • This result yields three important lessons in here: • 1. EB increases with the size of the market being taxed (PQ). • 2. EB increases with the price elasticity of demand. Lesson: tax products with a low price elasticity—that leads to minimal distortion (but may not lead to greatest fairness!). • 3. EB increases with the square of the tax rate. The lesson: Have a diversified revenue system.

25. P P3 S+(2×t) P2 S+t P1 S D Q3 Q2 Q1 Q Sales Taxes Excess Burden, 6 • Why the square of t?

26. Sales Taxes Excess Burden, 7 • An additional important result arises in a market with an externality. • An example is the market for gasoline. • People buy gasoline in order to drive, and when they drive, they cause highway deterioration, pollution, and congestion. • Generally, gas taxes are set to cover maintenance only. • Raising the tax further would actually reduce distortion (i.e. lower excess burden).

27. Government Revenue P Excess Burden Avoided with Tax = SMC P2 S + Tax = PMC+SMC ΔP = t P1 S = PMC ΔQ D Q2 Q1 Q Sales Taxes Excess Burden, 8 • Excess Burden with an Externality The Market for Taxed Goods

28. Sales Taxes Recent Literature on Sales Tax Shifting • Several recent studies regress P on T in some form or another to see if P goes up dollar for dollar with T. • Poterba (one of the stars of empirical public finance, an economist at MIT) does this for a few broad categories of goods in a few cities and finds approximately full forward shifting onto consumers. • Besley and Rosen (two more stars; one an editor of the American Economic Review, the other the author of a popular public finance textbook) conduct this analysis for many narrow categories of goods and find overshifting.

29. Sales Taxes Terminology • This research is a bit hard to get into because of terminology. • The key is to distinguish between marginal cost (MC), the price “inclusive of tax” (Q), and the price “exclusive of tax” (P). The price inclusive of tax is what one observes in a market once the tax is imposed. The price exclusive of tax is what the firm receives. • So with no taxes and competitive markets, P=Q=MC. With taxes, competitive markets, and full shifting: Q = P(1+t) = MC(1+t).

30. Sales Taxes Poterba • Poterba’sapproach is to take market prices, Q, divide by (1+t) to get P, and regress P on t. With full shifting, the coefficient of t will be zero: Q/(1+t) = P = MC • or, in regression form, P = MC + βt • The predicted value of β is zero; a value above zero indicates overshifting onto consumers.

31. Sales Taxes Besley/Rosen • The Besley/Rosen approach is to regress Q on the determinants of MC and t. Q = MC(1+t) or ln(Q) = ln(MC) + βln(1+t) ≈ln(MC) + γt • In this case, the expected value of γ is 1.0. A value above 1.0 indicates shifting. • How could there be over-shifting? The most plausible explanation is market power. With an elastic demand curve, a monopolist will raise the price by more than the tax.

32. Sales Taxes Poterba’s Results • Poterba uses data on categories of spending, namely, women’s and girl’s clothing, men’s and boys’ clothing, and personal care items. One data set is for 1947-77, another is for 1925-39. • He finds full shifting. • He estimates in difference form, with the dependent variable the “inflation rate” for the spending category in the city and a controls for the city and national “inflation rate.” Because it is in difference form, the key dependent variable is the change in the tax rate. • He has lagged values to pick up the phase-in of tax effects and finds small but significant lagged impacts. The total impacts imply full shifting.

33. Sales Taxes Besley/Rosen Results • They use data for the last 30 years for specific products (a Big Mac, a box of Kleenex, a Monopoly game, and a package of 3 boys cotton briefs.) Their regressions include city and time effects and measures of real rental, wage, and energy costs—to capture MC. • The find full shifting for some (including Monopoly, Big Macs, and Kleenex) and overshifting for others. • They also do some dynamic analysis and find that the impact of taxes shows up very rapidly. They also reject Poterba’s differencing approach.

34. Sales Taxes Young and Bielinska-Kwapisz • This paper is in the NTJ in 2002. • They find over-shifting of excise taxes on beer and wine. • So taxes are shifted and there is considerable evidence for market power!

35. Sales Taxes Hawkins • Finally, Hawkins, (NTJ, December 2002) provides some interesting results on the distortion caused by various forms of the sales tax. • Hawkins estimates a demand system for all broad categories of consumption (nondurables, services, alcohol, gasoline, tobacco, home food, utilities, and autos and furnishings). This is done by assuming a pretty general functional form that yields structural parameters, that is, the parameters of the underlying utility functions.--which makes it possible to the EB from various forms of the sales tax. • He looks at 8 cases. The base case has no exemptions and no taxation of business inputs (which he calls pyramiding). The other cases add exemptions and/or taxation of (non-exempted) inputs: Here they are, with the excess burden that results (as a percent of revenue raised):

36. Sales Taxes Hawkins’s Results

37. Sales Taxes Lessons from Hawkins • The exemptions do cause excess burden, as expected. Services and home food, which are usually exempted, have a significant burden. The equity gains must be worth it! • Adding pyramiding actually lowers EB (except in case 5)! This is a surprise. But it happens because the taxed inputs produce goods that have inelastic demands and that tend to be exempt themselves. So ironically, pyramiding actually boosts efficiency!