An Analysis of the Replacement of Missouri’s Income Tax
By Abhi Sivasailam
Policy Pulse Contest Winner
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Winning Entry, College Division This entry in the 2009 Policy Pulse News Coverage Contest was submitted to the Show-Me Institute on May 26, 2009. For more up-to-date information about the bills that this article covers, please visit the Policy Pulse pages for HJR 36. The author, Abhi Sivasailam, is a student at the University of Missouri-Columbia. |
While Missouri’s economy struggled through the worst recession in recent memory, legislators in the General Assembly attempted to revamp the tax structure by abolishing the state income tax in favor of a sales tax. House Joint Resolution 36, introduced by Rep. Ed Emery (R-Lamar) called for submitting to voters a referendum to choose between amending the state Constitution and maintaining current tax structure.
The referendum entailed replacing state revenue that would be lost by eliminating personal and corporate income taxes, estate taxes, and other state and local “sales and use” taxes, by establishing instead a revenue-neutral, universal sales tax rate of 5.11 percent. Additionally, provisions in the resolution granted legislators the power to enact a one-time adjustment of this rate, should it fail to produce the desired revenue-neutral condition.
Further, to ensure that this new system of taxation would not impose a regressive burden on the poor, the resolution called for a sales-tax rebate, up to the poverty level of consumption, to be determined annually and disbursed to legal residents of the state on the first business day of each month.
Proponents of the legislation, such as Rep. Chris Kelly (D-Columbia), have championed it as the best kind of panacea, capable not only of alleviating Missouri’s economic ills, but also of strengthening the state, leaving it more competitive and more attractive for employers, investors, and residents.
Sales tax systems in and of themselves have several immediate benefits. For one, they would more evenly distribute the existing burden borne by taxpaying residents by expanding the tax base to illegal residents, temporary visitors to the state, tax evaders, and residents who earn their income in the black market. The benefits of such legislation stem not only from the implicit advantages of a sales tax that empowers personal freedom, but also from the gains associated with removing the harmful effects of an income tax.
If passed, this legislation could have served as a crucial ingredient in an invigorated Missouri economy. Abolishing the corporate income tax would create powerful incentives for establishing and operating businesses in Missouri, transforming the state into a lightning rod for investment from all over the country.
This influx of funds would be a vital component in compensating for the lack of economic progress that has been caused by income taxes displacing ordinary market investment. Income taxes have long been considered to be a drag on the economy, distorting incentives while imposing downward pressures on growth. Joseph Haslag, professor of economics at the University of Missouri–Columbia and executive vice president of the Show-Me Institute, wrote in a late 2008 commentary that when income taxes are established, they ensure that “Either businesses must pay higher wages to compensate, or employees will work fewer hours, cutting into productivity.”
Haslag observes that there is a clear, positive, and empirical correlation between freedom from an income tax and employment growth, noting that states without income taxes have, on average, more than doubled the national job growth rate since the start of the decade. Further, empirical evidence linking income taxes to variables such as growth rate of real personal income show a striking negative correlation between the two.
A study conducted by American Enterprise Institute scholar Richard Vedder and financial journalist Stephen Moore shows that from 1957 to 1997, real personal income growth rates in the 10 states with the lowest state tax burdens were nearly double the growth rate of the 10 states with the highest average tax burdens.
“I’ve never seen such a powerful economic tool in my time in the legislature,” Rep. Ed Emery said.
Not only could such a policy play an important role in increasing individual welfare, but it could also help smooth the state’s turbulent revenue streams. Later in the same commentary, Haslag wrote, “The income tax is highly sensitive to the overall economy … [thus] income tax revenues are subject to great volatility … the greater revenue volatility associated with income taxes makes it harder for state and local lawmakers to govern.”
Inferring a correlation from four decades of economic data, Haslag concludes that income tax revenue can range up to a 50 percent greater volatility than sales tax revenue. The explanation for this is intuitive: Consumers’ spending patterns tend to be relatively stable and predictable in the long run, especially in contrast to consumer wealth, which can be destroyed easily and swiftly by macroeconomic forces.
Implementation of such a policy would not be devoid of problems, be they economic, administrative, or legal. Critics — particularly Bruce Bartlett, former executive director of the congressional Joint Economic Committee — argue that a universal sales tax will itself produce market distortions. These might range from consumer preference shifting toward used goods, thereby harming businesses that sell new goods, to economy-wide price hikes that could rise by a factor of the tax rate. These criticisms, like others, are almost entirely short-run concerns.
The economy’s incredible adaptability ensures that, in the long run, not only will such price wedges equalize, but real average economic conditions will also improve. Other critics, such as journalist Pat Regnier, argue that such systems are more regressive than income tax systems for the poor and middle classes.
This is true, to some extent, but these concerns can be largely remedied through what R.W. Hafer, chairman of Southern Illinois University-Edwardsville’s department of economics and finance, calls “means-testing [of] the sales tax [and] … exclud[ing] certain items or services — such as food, medicine, or medical services — from the sales tax.”
Still other critics question the practicality of collecting a consumption tax, and argue that those seeking to evade taxes will create a plethora of black markets to do so. Granted, such illicit markets would likely emerge, but those potential revenue leaks pale in comparison with the costs of more widespread evasion under the current system, as well as the costs of maintaining and collecting current revenue.
While H.J.R. 36 does entail some challenges and shortcomings, a thoughtful cost-benefit analysis will show that, in the long run, such policies would promote prosperity, economic growth, and a strengthening of our institutions. Looking beyond mere economic welfare, replacing the income tax would empower individual freedom, allowing Missourians to vote with their dollars, and indirectly reduce support to the state if officials fail to soundly uphold their economic and social values.
NOTE: Although Sivasailam is currently a Show-Me Institute intern, he was not affiliated with the Show-Me Institute when he entered and won this contest. He submitted both his contest entry and internship application at roughly the same time. Each contest entry was stripped of personally identifying information before being submitted to the board of Policy Pulse contest judges, who were also unaware of Sivasailam’s pending intern application.