Are Sales Taxes Fairer Than Income Taxes?

With an increase in VAT taking effect in Ireland today (Jan 1st 2012) it is worth taking a look at the comparative fairness of taxes on sales and those on earnings.

There is a widespread belief that those individuals who receive very high earnings should pay high rates of tax on at least that part of their income that is deemed excessive. There are a number of problems with this concept. First and foremost, who determines what is "excessive" against what criteria? €100k? €500k? and just how punitive should be the tax on the portion of income that exceeds the chosen threshold?

Then there is the effect on incentives; although it is wrong to attach too much importance to this in relation to high incomes. Too often when an individual's earned income is so low that he or she receives support from a variety of social welfare programmes the marginal rate of tax becomes close to - and sometimes even exceeds - 100%. This occurs when the amount of support withdrawn as a result of crossing a particular income threshold exceeds the additional income received. That certainly is a disincentive. No one ought to be placed in the situation of becoming worse off as a result of working harder, working longer or receiving a promotion. So it is not necessary to feel too much sympathy for high earners whose marginal rate of tax exceeds, say, 50%.

More than one tax is levied on incomes

I can remember when the marginal rate of income tax on high earners in the UK was 90%. Executives justified high salary increases on the basis that, in order to give someone a £100 increase in take home pay it was necessary to raise his (and in those days it was nearly always a man) headline salary by £1000. Logically, when marginal rates fell dramatically under a previous Tory government, these individuals should have had their salaries reduced. In fact they just continued to receive big annual increases.

In most jurisdictions the tax that goes by the official title of "income tax" is not the only tax levied directly on incomes. In the UK, for example, there is "National Insurance", originally intended to cover the cost of health and social programmes this tax long since ceased to be so hypothecated and simply went into the general pool of government income. The equivalent in Ireland is PRSI.

Often these levies are applied only to income up to a certain level, thus reducing the effective margin between basic rates of income tax and the next higher band. So, for example, the basic rate might be 20% and the next band 40%, but, if the person on basic rate is also paying an 11% "Social Insurance" levy that cuts off at the same level as that at which the rate of income tax increases to 40%, the margin might look like 20% but is actually only 9%.

It's all so complicated

All this is starting to get complicated and I have only scratched the surface of the many different taxes on incomes and the allowances that can be claimed against them. And that is the other problem with income taxes. The harder you try to make them fair the more complicated they get.

Having taken a portion of an individual's earnings before he or she even gets to see its colour the government next proceeds to take another chunk from every pound, dollar or euro he or she spends. Actually, not everything because certain goods deemed essential to living, typically food and children's clothing, are exempted from sales taxes. And this is where the sales tax as a concept starts to look fairer than income tax. These days it is not possible to survive without purchasing some things that are subjected to sales taxes but it can reasonably be argued that the sales tax levied against big ticket items that only those on high incomes can afford ensure that the rich contribute more to the state's coffers than do the poor.

It is argued that such taxes act as a disincentive to consumption and that is bad for an economy but this surely happens only at the margins. If you can't afford to pay an extra 2% on the price of an item you probably can't afford it anyway. On the other hand, if paying €10k for something is no problem increasing the price by €200 probably won't stop you.

Increase sales tax on luxury goods

I would go much further, as the late Roy Jenkins did back in the days when the UK sales tax was called purchase tax, and levy a higher rate of sales tax on luxury goods. Of course, we are then presented with the problem of defining "luxury goods". One way might be to look at the average price paid for a particular category of item, say motor cars or ladies' wear, and levy the higher tax on those items for which the recommended retail price was more than double the category average. Difficult but not impossible I would argue.

And it could have another benefit: many such items are imported. Ireland and the UK could both do with reducing their level of expenditure on imported goods so a tax that acted as a disincentive would be beneficial. And, because the tax was determined against the value of the item rather than its origin it ought not to be outlawed by trade agreements as being overly protectionist.

So, on balance I tend to favour sales taxes over taxes on income when it comes to assessing their relative fairness. Of course, the elephant in the room is the size of the overall tax burden. And that depends very much on what you believe should be included on the list of things best provided by the state. Views on that vary widely across the political spectrum and between this side of the Atlantic and the USA. But that is a whole different argument.