A current legislative proposal seeks to eliminate Missouri’s income tax and replace it with a higher sales tax rate. It may not seem obvious to readers that one form of taxation is clearly better than the other, but economics teaches us a valuable lesson about how income taxes in particular slow down economic growth and prosperity.
There’s a pretty straightforward correlation between taxes and economic activity. When you tax something, you usually encourage people to do less of it. Income taxes induce people to be less productive, because the financial return that people gain from work and entrepreneurial activities, which are difficult, are reflected in other things that are less costly at the margin. In short, the other things they could do with their time become a little more valuable in comparison. Similarly, sales taxes induce less consumer spending, because people receive fewer goods and services for their dollar. Each type of tax makes people a little worse off, but in different ways.
So, why should we be particularly concerned about the income tax? For more than half a century, economists have understood that people will realize higher after-tax returns when income tax rates are lowered. In simple terms, this means that when income is taxed less, aggregate effort and employment increase, on average, leading to more money in people’s wallets. In addition to the total pie increasing, there is an incentive to invest more in the future, because the returns to entrepreneurial activity also increase when income tax rates are lowered. People’s savings flow to new investment, and economic growth rates rise as a result. When the economic pie gets bigger, people’s individual slices also grow. This has been a consistent finding in economics, both in theoretical models and real-world observations.
People benefit directly when their income is taxed less, but if Missouri eliminates its income tax, the government still needs to maintain a source of revenue. In this case, the proposed source for that revenue is a higher sales tax rate, with fewer tax exemptions. This has drawbacks, true enough. When people have to pay more for the goods and services they purchase, they generally choose to consume less. It’s no secret that people like to consume, so higher prices are a cost. It’s important to realize, however, that this decrease in consumption is only a short-term effect. Remember that the elimination of a state income tax allows people to take home, save, and invest more money — growing the economy. So, consumption spending benefits from the increase in take-home pay. Moreover, as the economy expands, consumption grows at a faster rate.
With respect to consumer spending, the increase in the sales tax rate and the broadening of the base will have its effects. Whatever the immediate costs, though, it is important to recognize that the growth rewards are permanent. This comparison of current costs to future rewards holds true for any number of investments — things like plant expansion, education, and kitchen remodels. In each case, there is an initial cost, and rational people can decide whether the rewards are worth that cost. But the two points must be considered together. If we focus only on the near-term costs, we miss the gains of faster growth unleashed by the change in the tax structure.
Another potential drawback is that retailers might relocate across the state border if Missouri implemented a higher sales tax rate. It is true that a few retailers might make this decision, but there is another half to this story. Because income taxes would be simultaneously eliminated, there would be an incentive for many other out-of-state businesses to relocate here. Missouri’s economy would experience a change in its industry composition if the income tax were replaced with a higher sales tax. It is wrong, however, to ignore the growth benefits that go with eliminating the income tax. Some stores may cross the state line, but Missouri shoppers will be richer.
Other states have successfully implemented this revenue model. Our neighbor Tennessee, for one, has an economy that is outpacing Missouri’s growth. There’s more. From August 1998 to August 2008, the nine states without an income tax added more than 4 million jobs, a 16.3-percent increase that doubled the national job growth rate. Only one of those states failed to exceed the national job growth rate.
Some people may decide they do not want to give up some short-term consumption to achieve higher growth rates in the future, which is understandable. Ultimately, though, paying careful attention to the long-term effects of government policy helps to make the world a better place — not only for ourselves, but for our children. Eliminating Missouri’s income tax is one road to greater prosperity.
Joseph Haslag is an economics professor at the University of Missouri–Columbia and chief economist for the Show-Me Institute, an independent think tank promoting free-market solutions for Missouri public policy.