Sunday, December 23, 2007

Long-Term Stability of Sales Taxes - An Example

As I have said, the empirical evidence on sales tax volatility has shown sales taxes to be not significantly less volatile than income taxes in the short-run. These estimates come from deviations around a trend. So sales tax revenues seem to stray from their long-run trends about as much as income taxes do. Income taxes have steeper trends though, meaning they tend to rise faster then do sales tax revenues as aggregate incomes increase. The best estimates I have seen are about a 1.8 long-run elasticity for income taxes and a 0.8 elasticity for sales (see this post). Many public economists argue that short-run volatility is what we should be focusing on - how quickly to the revenues crash due to a sudden downturn in the economy - and I agree that this is an essential component. However, I also think the long-run elasticities are very important as well and have said so, but perhaps have been not as clear as I would have liked as to why. The basic point is that since income tax revenues grow faster in the long-run, they will slow down faster as well when income growth slows down.

To make this point more clearly using a real recent episode in Oregon's economic history, I did a quick little back-of-the-envelope calculation based on the actual State of Oregon quarterly personal income figures from the Bureau of Labor Statistics. First off, understand that, in general, aggregate personal incomes increase over time due to inflation, population increases, productivity improvements, etc. So long-run trends in incomes are always positive as are tax receipt growth figures. But in 2001 and 2002 Oregon experienced a very significant slow down of income growth, so I decided to see what receipts of the two types of taxes would look like using those national estimates of elasticities. Based on the average growth rate over the period 1987 to 2007 we could have expected personal income to grow by about 9.2% over that two year span (2001-2002), in reality it grew 3.6%. So from the estimates elasticities we find that based on these expectations v. reality figures, income tax revenue would have fallen about 10% below 'normal', while sales tax revenue would have fallen 4.5% short of 'normal'. This seems quite a significant difference. Of course you can make the opposite argument as well, that once personal incomes started growing at normal rates again the income tax would have more quickly regained the lost revenues than would a sales tax. But, it would have more ground to make up anyway. So though I think the short-run is quite important, I think this long-run differential is important too.

Finally, two comments on the previous post. First, a few people, I think, misunderstand the quote from the Feldstein and Wrobel paper. It does not say anything about whether a progressive tax structure is good or bad - it simply says that the US job market is quite fluid and so employers have to compensate for high taxes. Full stop. So if your aim is to reduce inequality in a state through a highly progressive income tax, it won't work. It has nothing to say on whether inequality reduction is a good goal, or on who should or shouldn't pay tax, or whether the relatively wealthy should pay more, etc. I found this an absolutely fascinating paper - who would have thought that the US job market is that fluid, or that employees respond so strongly to net incomes, not just gross? Wow. But I guess the fact that I find this so fascinating is why I am an economist that does not get invited to many parties...

Second, if you care about poverty and unemployment you should care deeply about economic growth.


darrelplant said...
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darrelplant said...
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Stevelle said...

Is it possible to capture the elasticity of income taxes with a rainy-day fund and achieve a similar degree of revenue stability? That clearly depends on having fiscal discipline in spending, but Oregon's forecasting system helps achieve that already.

I have a lot of questions left by the abstract of that paper by Feldstein & Wrobel in particular. (I should see if I can get access to it.)

But I tried (failed?) to keep my comment more general than that.

And maybe I'm entirely wrong and we need to achieve any progressivity of the tax structure at the federal level (where employees have less mobility), and stick at the state level to elbowing our neighbors out of the way to reduce income tax on the well-to-do.

Patrick Emerson said...


It seems pretty clear that there is no substitute for a rainy day fund, even if a sales tax could have some moderating effect (and I think the evidence is that we cannot count on that). The mechanics of a rainy day fund are very difficult to imagine, however, and the evidence I have seen is that such funds need to be large. So politically, I am worried that it might not be feasible. But in this blog I am trying to stick to the economics and let others discuss politics.

What I am going to try to do is figure out what the evidence says about how big are the distortions that come from a high income tax (or, more to the point perhaps, a high relative income tax). I will try and do the same for sales taxes. This may all end up being too small to worry about. Ditto concerns about being 'too progressive'. I shall have more soon I hope. I don't expect to have any concrete answers at the end - I don't think the obviously right choice will emerge, but I do hope to point out a number of factors we should think about when considering tax reform and how serious these are.

I think the last abstract is quite instructive (and the finding has been confirmed in another paper by UO economists): it is not just the tax itself, but how it is spent that matters. It also gets back to an earlier post I wrote about business not necessarily wanting lower taxes, they want good physical and human capital infrastructure and are willing to pay for it.

Stevelle said...

"I think the last abstract is quite instructive."

That one grabbed me as well. I clipped a few comments on that one in particular in editing, but one of the primary concerns I have is that externalities are not well captured by the economic growth metrics.

With both minimum wage levels and indoor smoking bans we have seen recent evidence that contradicts the expected impacts, reflecting an unanticipated (or unaccounted) good.

The balancing act of leveraging how government spends our money against how much it collects is a fascinating topic.

Sadly, I don't get to talk about it at many parties either.

darrelplant said...
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Jeff Alworth said...

A confounding factor that Oregon uniquely has to deal with relates to elasticities (I think).

Of course you can make the opposite argument as well, that once personal incomes started growing at normal rates again the income tax would have more quickly regained the lost revenues than would a sales tax

The problem is that these quick rebounds may not be predictable two years out. As was the case in '07, incomes grew, but we were unable to apply the gains to the budget--effectively making up for the losses in 02-03--because the state economist didn't foresee that level of growth. The $1 billion that should have gone to state services that have formerly taken cuts instead went back to taxpayers.