July 2008

“Security Against Excess”: A State Retail Sales Tax

By Justin Jenkins 

In Federalist No. 21, Alexander Hamilton wrote, “It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess.  They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue.”[1] Hamilton’s argument, in modern English, is that a primary benefit of the consumption tax is its self-regulatory nature.  Sales tax rates can only increase to a certain threshold before demand for the taxed goods and services falls, and significant revenue is no longer generated.  In short, consumption taxes utilize economic incentives to produce a cap on the tax rates that the state or federal government may feasibly set.

The term “consumption tax” encompasses several sorts of taxes that have one element in common: they tax consumption, broadly defined as income minus savings.[2]  However, some of the taxation methods that technically fall within the category of consumption taxes are actually only variants of taxes on personal income.  For example, the “cash flow approach” taxes earned income minus a percentage of funds set aside in savings, but it also taxes the balance of those savings when withdrawn.  The “tax prepayment approach” does not deduct taxes on saved earnings, but those savings plus interest are tax-free when withdrawn.[3]  While both of these methods partially exempt savings from taxation, they still constitute taxes on income.  The most recognizable form of consumption tax, the kind that keeps the government in check per Hamilton’s analysis, is the retail sales tax.[4]  Commonly known as the Fair Tax, the retail sales tax was a major policy topic at the 2008 Iowa Caucus.  

As opposed to the approaches noted above which tax consumptive earnings based on an annual income-less-savings formula, the retail sales tax is levied each time an individual purchases a good or service.[5]  When used in place of an income tax, such a system would place more control of taxable funds in the hands of the people earning them, and would help prevent the government from raising taxes above sufficient limits.

Not all free market economists are advocates of the retail sales, or consumption, tax. Mr. Llewellyn H. Rockwell Jr., founder and President of the Ludwig von Mises Institute, wrote that “The champions of the consumption tax . . . need to redirect their energies, away from the method of taxation to its level.  They need to adopt the general principle that whatever the existing tax, it should be lower.”[6]  Mr. Rockwell implies that the amount of taxation is more important than the method used to collect taxes.

However, the means by which taxes are collected can and do impact the rates imposed and, by extension, the resulting funds available to the government. The consumption tax exerts a moderating force upon tax rates because, as Hamilton pointed out, the government cannot raise the rate too high without the risk of reducing collectible revenue.  Mr. Rockwell actually states this principle as an argument against the consumption tax: “The degree to which the consumption tax discourages consumption is the same degree to which it does not raise revenue.  How does the tax-hungry state deal with that paradox?”[7]  The answer is that such a paradox forces the “tax-hungry state” to go on a diet by restraining tax rates.  Far from being a weakness, the principle of reduced revenue produced by inordinate rates is the primary strength of the consumption tax.

Mr. Rockwell also indicates that the sales tax is just as coercive as the income tax, since “Nothing is voluntary if I am not permitted to exempt myself.”[8]  While it is true that taxes are by definition coercive, the degree of coercion varies from tax to tax.  Even with a high income tax rate, a person’s incentive to receive some income is almost always greater than his incentive to receive no income at all.  His paramount need to earn income permits the state and federal governments to get away with excessive income tax rates.  A consumption tax, on the other hand, is not so secure — if the price of sports magazines gets too high, people will quickly choose to do without them.

Mere slashing of income tax rates may not solve every aspect of the problem of over-taxation. As observed in a September 2007 FACT SHEET published by the Public Interest Institute, total collected personal income tax revenues actually increased after the Iowa Legislature cut the tax rate in 1998.[9]  Even after the rate reduction, the state’s maximum income tax rate is still 8.98%, placing Iowa among the top five highest maximum income tax rate states in the nation.[10]

While reduced tax rates are a step in the right direction, a massive overhaul that replaces the state income tax with a statewide retail sales tax would be far more effective in curbing high tax rates. Food and prescription drugs are currently exempt from Iowa sales taxes and could remain so.[11]

Hamilton went on to say that the consumption tax “forms a complete barrier against any material oppression of the citizens, by taxes of this class, and is itself a natural limitation of the power of imposing them.”[12]  The first U.S. Treasury Secretary got it right: sales taxes erect barricades to hem in government spending, thereby removing control from government and placing it in the hands of the people.  That is why the Iowa Legislature should consider replacing its personal income tax with a better model — one that creates a “security against excess.”

Justin Jenkins in an Intern at Public Interest Institute. 

The views expressed herein are those of the author and not necessarily those of Public Interest Institute or Tax Education Foundation.  They are brought to you in the interest of a better-informed citizenry.

Endnotes

[1] Alexander Hamilton, “Federalist No. 21,” in  George W. Carey and James McClellan (eds.), The Federalist, Liberty Fund, Indianapolis, IN, 2001, p. 103.

[2] Annette Nellen, “Consumption Tax Information,” Tax Reform Information, April 25, 2003, <http://www.cob.sjsu.edu/nellen_a/ConsumptionTax.html> (June 3, 2008).

[3] Ibid.

[4] Non-income-based consumption taxes also include “excise taxes, and indirect consumption taxes such as oil import fees.” See Iowans for Tax Relief, Public Policy Position Statement, September 18, 1996, Section 9.1, p. 26.

[5] Nellen.

[6] Llewellyn H. Rockwell Jr., “A Consumption Tax or an Income Tax?,” November 13, 2002, <http://www.lewrockwell.com> (June 3, 2008).

[7] Ibid.

[8] Ibid.

[9] “After the Income Tax Cut: Iowa Personal Income Tax Collections,” FACT SHEET 07-02, Public Interest Institute, September 28, 2007.

[10] Federation of Tax Administrators, “State Individual Income Tax Rates,” January 1, 2008, <http://www.taxadmin.org/fta/rate/ind_inc.html> (June 3, 2008).

[11] Federation of Tax Administrators, “State Sales Tax Rates,” January 1, 2008, <http://www.taxadmin.org/fta/rate/sales.html> (June 3, 2008).

[12] Hamilton.