Consumption taxes are among the least harmful for growth but they fall heavily on those with low incomes.  Analysis of their fairness must consider their role within an overall tax structure.

Consumption taxes come in several forms.  Sales tax is collected by retailers at the point of purchase.  Use tax is collected on items purchased outside a taxing authority’s jurisdiction, e.g., a vendor in another state.  Excise tax is paid by the producer or wholesaler, e.g., of gasoline or alcohol.  Value added tax (VAT) is collected step by step from every buyer in the value chain (see below).

Sales tax:  We have no federal sales tax but 45 states levy it at rates ranging  from 1% to 10% and many local governments collect an additional amount.  What goods and services are taxable varies.  Nearly all jurisdictions exempt some categories or tax them at reduced rates.  Most exempt food sold in grocery stores, prescription medications, and many agricultural supplies.  Raw materials and goods purchased for resale are always exempt.

Use tax:  US retailers with no physical presence in a state can ship goods to customers there without collecting that state’s sales tax.  Tax payers should in that case pay the tax directly but they often don’t.  Because online retail has greatly increased the lost revenue, the Senate recently voted for a Marketplace Fairness Act so states could compel online businesses to collect all applicable taxes.

Excise tax:  The US federal government and many states levy excise taxes on a few items, typically ones for which demand is not greatly impacted by income.  One does not buy a lot more gasoline, for example, if one’s income grows.   That means excise taxes are usually the most regressive.  State excise taxes on gasoline, cigarettes and beer take about 1.6% of the income of the poorest families, 0.8% of the income of middle-income families, and 0.07% of the income of the very best-off, which means they are 22 times harder on the poor than the rich.

Value Added Tax:  VAT is collected every time an item or its components is sold, e.g., by manufacturer to wholesaler, wholesaler to retailer and retailer to end customer.  Each seller pays VAT on the difference between his cost for the product or its components and his revenue from the sale.  When he collects VAT from his customers he keeps the VAT he paid on the inputs and remits the difference to the tax authority.  That means VAT is like sales tax in that ultimately only the end consumer pays but different in that some of it is collected by every business in the supply chain.

VAT was first introduced in France in 1954.   Governments like it because most of the collection cost falls on business and sellers have a direct stake in collecting the tax.  Value added taxes have now been adopted by more than 140 countries and provide an estimated 20% of worldwide tax revenue.  The US is one of the few to retain conventional sales taxes.

Consumption tax fairness:   The OECD research I referenced in Property Tax and Fairness analyzes the impact of different taxes on economic growth.  As noted there, property and consumption taxes are among the least harmful for overall economies.   They are also, however, the least fair since they fall most heavily on those with a low income although that can be mitigated by exempting “necessary” items, such as food, clothing and medicines and/or by providing Earned Income Tax Credits (EITC).

This Distributional Analysis of the Tax Systems of all 50 States assesses the fairness of every state’s tax system in terms of income groups.  “The main finding of this report” it begins, “is that virtually every state’s tax system is fundamentally unfair.”  That’s because when all state and local taxes are added up, most states tax wealthier families at a lower rate than low- and middle-income families.  Only two tax their wealthiest as much as their poorest and only one taxes its wealthiest at a higher effective rate than its middle-income families.  The primary source of unfairness is consumption taxes.

The average combined rate on the best-off 1% of families is 6.4% before federal deductions for state and local taxes.  After accounting for that “federal offset”, their effective tax rate is 5.2%.  The average rate on families in the middle 20%  is 9.7% before the federal offset and 9.4% after.  The average for the poorest 20% is 10.9%, more than double the effective rate on the very wealthy.

The average state’s consumption tax structure is equivalent to an income tax with a 7.1% rate for the poor, a 4.7% for the middle class, and a 0.9% for the wealthiest taxpayers.

Property taxes:  Also tend to be regressive, but much less so than sales tax.  A home represents the lion’s share of the total wealth of average families but only a small share at high income levels.  Because property tax usually applies mainly to homes not all assets, it applies to most of the wealth of middle-income families and a smaller share for high-income families.  Because the tax on rental property is passed through to renters as higher rent, it represents a much larger share of income for poor families.

Different states have very different tax structures with very different degrees of fairness.

Most regressive tax states:  The ten most regressive states collect six times as high a percentage  from their poorest 20% as their richest.  They either collect no income tax or collect it at the same rate for all income.  Washington, the highest-tax state for poor people, taxes its poor families 17.3% of their total income.  In neighboring Idaho and Oregon, the poor pay 8.6% and 8.7% of their incomes.  Florida, also a no-income-tax state, taxes its poor families at the second highest rate, 13.5%.  Illinois, which relies heavily on consumption taxes, ranks third in its taxes on the poor, at 13.0%.

Least regressive tax states:  Vermont has a highly progressive income tax, low sales and excise taxes and an Earned Income Tax Credit (EITC).  Delaware’s income tax is not very progressive but that is its main source of revenue and its very low consumption taxes result in a system that is only slightly regressive.  New York and the District of Columbia achieve a close-to-flat tax system through EITC and income taxes with high top rates.

Conclusion:  Consumption taxes are effective but if the tax structure is to be fair, their disproportionate impact on lower income families must be mitigated.  Ways that can be done include:

• Progressive income taxes that provide a balance by disproportionately impacting higher income families
• Earned Income Tax Credits (almost a quarter of states use them)
• Exempting necessities, food in particular, that account for a higher part of low income family spending
• Providing essential services such as healthcare at no or low cost because that most benefits those with low incomes

In a future series of posts I will explore services governments can provide and how public spending on them impacts fairness.  Next up in this series, everyone’s favorite, personal income tax and fairness.

Assessing the fairness of property taxes raises issues beyond perceived and actual fairness.  We must also start to explore the balance between local and centrally collected taxes, the economic impact of different taxes, and the optimum structure of the entire tax system.

The existing structure:  Income tax is levied chiefly at the federal level and is the primary source of funds to support federal spending, sales tax is the greatest source of state government revenue, and local government is funded chiefly by property tax.  Personal and corporate income taxes for FY 2013 totaled $2,078B (see What we Tax).  The federal government collected $1,707B of that but an additional $334B was collected by the states plus $37B at the local level.  Income tax at 37% of the total is by far the greatest source of overall government revenue.

Several sources of tax each account for around 2.5% of the total.  Corporate income taxes totaling $399B collected mainly at the federal level is one.  $334B of personal plus corporate income tax collected by the states is another.  Total sales taxes of $416B is a third, $321B of which was collected by the states.  Property taxes totaling $383B is a fourth, almost all of which ($370B) was collected at the local level.  The next largest contributor at $152B (setting aside social security contributions better thought of as insurance payments) is utility and liquor store taxes, which are also a form of sales taxes collected chiefly at the local level.

Relative perceived fairness of taxes:  Property taxes at 25% take third place in the “not at all fair” stakes and get the highest of all “somewhat unfair” rating at 30%.  Page 21 of the poll results I referenced in The Purpose and Performance of our Tax System shows estate taxes to be considered “not at all fair” by 38%, gas taxes and corporate income taxes by 29%, local property taxes by 25%, motor vehicle taxes by 21%, cigarette, beer and wine taxes by 20%, state income taxes by 19%, social security and federal income taxes by 18% and retail sales taxes by 15%.

In the fairness of estate taxes I found them to be among the fairest and most efficient of all.  In the fairness of corporate income taxes I speculated they may be better eliminated.  What about property taxes?

Property tax issues:  Property taxes might fall disproportionately on pensioners and others with relatively high value assets but relatively low income.  In response, many local governments provide “homestead exemptions” to reduce the tax on an individual’s home relative to second homes and investment property.  There are also exemptions for veterans.  Another category getting exemptions is religious institutions.  Finally, exemptions are frequently offered as an incentive for businesses to locate within a jurisdiction.

A big reason property taxes are felt to be unfair is they are relatively painful to pay.  They are typically collected in two annual installments, so the amount due is large and paying it requires action.  The least unpopular tax, retail sales, by contrast is mostly collected in small amounts and automatically.

Property taxes support local education, police and fire protection, and most local infrastructure.  Big spending in any of these areas can lead taxpayers to feel spending is out of control and they may revolt.  The most common complaint is about spending on education.

Proposition 13 passed 35 years ago that cut and capped property taxes in California was triggered by a change in education spending.   A lawsuit complained California’s way of funding public education “fails to meet the requirements of the equal protection clause of the 14th Amendment … [so some taxpayers] are required to pay a higher tax rate than [those] in many other school districts in order to obtain for their children the same or lesser educational opportunities afforded children in those other districts.”   The state Supreme Court agreed and equalized per-pupil school spending throughout the state.  Prop 13 was the response.  Higher than average taxes in wealthy communities no longer provided extra benefit to their children.

The main result of Prop 13 was the state became responsible for what local governments, because their tax revenues were lower, could no longer fund.  Decisions about tax increases and how the money will be used that were made locally are now made by the state.  What did not change was that California was before Prop 13 and still is now the fourth most heavily taxed state.  Incomes are now taxed more heavily than property.

That result and non-result of Prop 13 raise two questions.  Is central decision-making more or less fair?  Is California’s new tax structure more or less effective?

Equal opportunity:  What we mean by fairness in this context is a relatively equal opportunity to support ourselves and if we want to work for it, to become wealthy.  That is why the California Supreme Court equalized per-pupil spending.  Maps based on Census Bureau data at this link illustrate the rationale.

Those who do not graduate from High School are much more likely to live below the poverty line.  Unfortunately, I do not have the results of 35 years of central vs local decisions about education spending in California.  The map shows there are still great differences in results among localities there.  The big message from the maps is the disparity between Northern and Southern states.

Population over 25 without High School Diploma

The much larger percentage of people without a High School diploma in the South and the correspondingly greater percentage of people living below the poverty line suggests we must enhance educational opportunity and expectations in the South as an important part of providing a more equal opportunity for all Americans to succeed.  That means a shift in decision-making not just from localities to states but also from states to the federal level.

Population Living below Poverty Line

Growth friendliness:  The second question raised by Prop 13 is whether the new tax structure (lower property taxes and correspondingly higher income taxes) is more or less effective for the overall economy.  That question is better answered with a larger sample of data.

This report analyzes how tax structures affected economic growth in 21 OECD countries over the last 35 years.  The results are:  “Property taxes, and particularly recurrent taxes on immovable property, seem to be the most growth-friendly, followed by consumption taxes and then by personal income taxes.  Corporate income taxes appear to have the most negative effect on GDP per capita.  …  These findings suggest that a revenue-neutral growth-oriented tax reform would be to shift part of the revenue base towards recurrent property and consumption taxes and away from income taxes, especially corporate taxes. There is also evidence of a negative relationship between the progressivity of personal income taxes and growth.”

I will consider this information again in posts about consumption taxes, personal incomes taxes and a better overall tax structure and budget management system.

Conclusion:  The OECD analysis does not address whether property taxes are more or less fair than other taxes but it does indicate that we would get higher economic growth if property taxes generated a larger part of overall tax revenue.  Higher economic growth would facilitate investment to provide more equal opportunity throughout society.  This suggests property taxes could be fair and effective if collected and invested not at the local but the federal level.

To get a good tax system we must: (1) know the cost and effects of each tax, (2) know who pays which taxes, and (3) decide which groups will contribute how much of the total.

We first explored estate taxes.  They turned out to be cheap to collect, hard to evade and have low impact on economic activity  Now corporate income taxes.  They are costly to collect, quite easy to avoid or evade, and fraught with competitive issues.  We noted earlier that estate taxes paid by the heirs of those who built the asset are the most unpopular of all.  That suggests we hold the peculiar belief that those who earn money should be taxed while those who inherit what others earned should not.  The Walmart heirs, for example, own more than the bottom 40% of America.  Is that what we want?

In general, we want corporations to pay more income taxes while we pay less.  Taxes are taken directly out of what we earn, so they are highly noticeable.  It feels unfair that a significant amount of our earnings is taken away but corporate income taxes do not feel unfair because we feel corporations could afford more.  When we hear that some pay none at all, it feels outrageously unfair.  It also feels unfair that while we are taxed on gross income, businesses are taxed only on profits.

Who in fact does pay corporate income taxes; customers, workers or owners,?  It can’t be customers because prices are set by the market and the market is supplied not just by corporations but also sole proprietorships, partnerships and S-corporations that pay individual income tax.  That means corporations can’t raise prices to cover their taxes.  So, is it workers or owners?  When corporate income tax was introduced in 1909 it reduced profits, i.e. was paid by shareholders.  Later, it was paid in part by workers getting lower wages.  Treasury Department economists reckon 82% now falls on owners and 18% on labor.

Note that tax on the income of non-incorporated businesses is paid entirely by the owners and, as I noted in Business Tax, around two thirds of US businesses reporting profits of $1 million or more are not incorporated.

How much tax do corporations pay?  The top rate in the US at 39.1% (35% at the federal level) is the highest in the world.  The effective rate, what they actually pay, is less clear.  The Tax Foundation summarizing 13 studies reports rates ranging from 23% to 34.9%.  The US rates are among the five highest for all countries analyzed.  Another analysis found 30 Fortune 500 companies had paid no federal corporate income taxes at all for the 2008-2010 period and there was recent outrage that, by accounting for them overseas, Apple avoided taxes on $74 billion in profits over the last four years.  Less noticed is that Apple’s 14% effective tax rate is much higher than Ford’s 3%, Amazon’s 6%, Boeing’s 7% and Verizon’s 9%, and is in the same range as IBM 15% and Google 17%.  That is half the 29.1% average rate for 2007-2012.  This magnificent chart shows all the numbers.

Why such different rates?  Chiefly because US corporations can delay paying income taxes on overseas profits until they are brought back into the US.  $1.7T of profits is currently estimated to be offshore.  Corporations like Apple locate intellectual property and/or manufacturing in countries with low tax rates.   When an Apple product is sold in the US, Apple pays its patent-holding Irish subsidiary a royalty that reduces the profit Apple shows in the US and transfers it to low-tax Ireland.  Apple borrows in the US, deducts the interest here, and uses the funds to pay dividends to shareholders and establish manufacturing overseas.  PepsiCo relocated concentrate manufacturing from New York to Ireland.  Over half their soda sold worldwide is now based on concentrate manufactured there.  Coca-Cola opened a plant in Singapore to produce concentrate for 18B cans of soda a year.  The soda industry as a result paid not the 29% average tax rate but 19%.  But retailers, who among other things sell soda, cannot relocate offshore so most of them paid between 35% and 40%.  Even Wal-Mart paid 31%.

The closer you look, the more complicated corporate taxes become.  Large multinational corporations have great flexibility in where they locate production, incur costs and realize profits.   They can borrow in one country and take the interest deduction there, locate production facilities and employ workers in another country, and realize profits in a third country.  A change in taxes on overseas profits impacts only multinationals, a change in depreciation allowances mainly affects manufacturing companies, but many multinationals are manufacturers.  The existing tax code encourages moving jobs overseas.

How important is this?  The Joint Committee on Taxation estimates a bill introduced this February by Senator Sanders (I-Vt.), a member of the Senate Budget Committee, would yield more than $590B over the next decade.  US corporations would pay US taxes on all profits when and wherever earned.  “At a time when we have a $16.5 trillion national debt and an unsustainable federal deficit; at a time when roughly one-quarter of the largest corporations in America are paying no federal income taxes; and at a time when corporate profits are at an all-time high, it is past time for corporate America to contribute significantly to deficit reduction”, Sanders said.

By closing the gap between companies that now pay different rates, the bill would also result in the market, not the tax code, playing a bigger role in determining companies’ success and failure. 

Is that the only alternative?  Wouldn’t it price our corporations out of the global market or commit us to cut our corporate tax rate in a global race to the bottom where all countries keep cutting?  Taxes based on where customers are located is another option.  The state of California moved to a sales-based system last year because the States already are in a race to the bottom.  Maine, where I live, is considering a substantial cut in business taxes for this reason.  In California’s scheme, a company that gets 20% of its sales in California pays California taxes on 20% of its worldwide profits at the state’s corporate tax rate.  It makes no difference where the firm has offices or where its employees work.

The US could move to a similar system, though if we were the only nation that did, companies could be taxed twice.  Presumably, there would be changes to our existing tax treaties with countries that require non-US companies to pay tax here while US companies pay tax there.

But could it be there is no system in a global economy that’s fair for multinational vs domestic corporations, small vs large ones, corporations vs non-incorporated, advanced vs developing economies, and so on.  Should we just end corporate income tax?  As I noted in Business Tax, it has long been falling as a % of GDP and as we saw above, it is paid mostly by shareholders.  Since they tend to be wealthier than average, that results in greater income inequality.  It would at least be clearer if we simply decided what rates of tax those with higher and lower incomes should pay.

What to do about corporate income tax?  Eliminate deferral of the tax on profits held overseas and other exemptions while cutting our tax rate?  Switch to taxing worldwide profits based on the US percentage of worldwide sales?  Eliminate corporate income tax?  Or what?  That decision must be made along with decisions about personal income and other taxes, each forming part of a better overall tax system.

The research for this series of posts is proving a lot more interesting than I expected.  We value working for success but want to abolish estate taxes.  What we call “payroll taxes” are not taxes but savings and insurance.  Corporate income tax is paid chiefly by wealthy people, distorts competition and cuts personal income by encouraging jobs to be moved overseas.  What will we discover next?