December 4, 2009

Master economist Bill O'Reilly last night proposed that, to shrink the federal deficit, President Obama adopt the Bill O'Reilly Bold Fresh Economic Recovery Plan: halt "runaway" federal spending, keep the Bush tax cuts, and best of all, institute a federal sales tax.

O'Reilly wants just a 2 percent tax to last only two years. He thinks that'll close the deficit and get the dollar back on solid footing.

He brought on Neil Cavuto afterward. And say what you will about Cavuto, he's not an economic dunce. Like some people. And he tried to explain to O'Reilly that sales taxes don't work that way; they actually would suppress economic demand at exactly the time it needs to be rising.

This went whistling right over O'Reilly's head (duh). What Cavuto left unmentioned, of course, is that a sales tax is one of the most regressive taxes known to man; the tax burden resulting from consumption taxes disparately falls on the lower and middle classes. Guys with big mansions like Bill O'Reilly, however, are perfectly fine coming up with more taxes for working stiffs to pay.

A "federal sales tax" is what's otherwise known as a "consumption tax." It's worth remembering that, back in 2003, George W. Bush floated a similar idea (the suggestion then was to replace the entire income-tax system with a consumption tax), it was shot down pretty quickly.

As Angry Bear explained back then:

There are a number of reasons, including social justice, why a regressive tax is not a good idea, but that's a topic for a later post. Instead, the question is why a consumption tax is worse than an income tax. First, it will surely cost more than it is expected to. Why? Because naively setting the target consumption tax in a revenue-neutral fashion will actually lead to a decline in revenue. A consumption tax increases the cost of the final good to the consumer, meaning that for any price that stores charge, consumers buy less after the tax is imposed than before. Most states have sales taxes around 8%. To replace all income taxes with consumption taxes would require a federal consumption tax of at least 15% on top of the states' 8%. So things will change from the scenario in which, when a store sells a DVD player for $100, the consumer pays $108 to a situation in which the consumer pays $123. Consumers care about price after tax, not before (question: can you buy a $100 DVD player with only a $100 bill?)! So what happens when the effective price to consumers goes up? They buy less DVD players! But the government can not collect sales (consumption) taxes on unsold DVD players. As an economic aside, some, but not all, of the impact of the tax would be borne by sellers. In the current example, the retail price might fall to $95 ($5 less for stores) and the after tax price to consumers would be $95*1.23=$116.85 (an $8.85 increase). Stores get less and consumers pay more, as a result the total volume of goods traded will fall. More generally, any move to a consumption tax that proposes a neutral tax rate, one such that

"(the value of all goods sold * proposed rate) = Income Tax Revenue"

will not generate the same revenue as under the income tax because it fails to account for the fact that the volume of commerce will fall (economists call this "dead weight loss").

Put simply: Consumption taxes drive down economic activity because people will spend less, necessarily. O'Reilly's 2 percent tax won't even cover the decrease in economic demand that would result.

Incidentally, O'Reilly still owes Paul Krugman an apology.

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