Wednesday, February 29, 2012

The Myth Of The Harmless Consumption Taxes

Most European countries are now trying to reduce their deficits, which is basically good since most of them have had excessive levels of deficit spending. The problem is that most of them have to a too large extent tried to achieve that with growth harming tax increases, instead of spending cuts.

The tax hike of choice has been the Value Added Tax (VAT) and/or excise taxes on various goods, usually diesel/gasoline, tobacco and/or alcohol. The idea behind this appears to be that because consumption taxes supposedly only targets consumption it won't affect the incentive to produce.

That is wrong for several reasons. While I disagree with Murray Rothbard's extreme assertion that consumption taxes will only reduce prices excluding taxes and not affect prices including taxes, it is clearly the case that it will reduce prices excluding taxes, having the same effect on these producers as an income tax would have had.

And furthermore, higher prices of consumer goods will reduce the real value of everyone's income, again having a similar effect as an income tax would have.

It is true that the incentive effect of consumption taxes will be less than an income tax on labor income assuming it won't affect the level of unemployment benefits and other non-labor transfer payments (which are usually not subjected to income taxation), but while that assumption may be applicable in the short term, in the long term consumption taxes will likely create a political pressure to raise these benefits.

Another difference between consumption taxes on the one hand and income/payroll taxes on the other hand is that while both taxes domestic production for domestic consumers equally, consumption taxes taxes imports but not exports while income/payroll taxes taxes exports but not imports, and so a shift from income/payroll taxes to consumption taxes could be seen as a "hidden" form of mercantilist import tariffs. But since there is no reason to believe that mercantilism promotes prosperity that is not an argument for consumption taxes.


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