Recently, I coauthored an essay with Grant Casteel that was published by the Show-Me Institute. In that paper, we specified a model of the state economy and conducted a simple experiment. Our ultimate goal was to compare two different tax structures. More succinctly, which tax structure would do the least harm while raising the same level of revenue? Our results are easily summarized: For most cases, the typical Missourian prefers a broad-based sales tax structure to the current structure that relies on income taxes and sales taxes. The reason is also pretty straightforward: In the absence of the income tax, the state’s economic growth rate increases. Our results indicate that the typical person is willing to forgo some consumption today for faster growth and higher consumption tomorrow, both for themselves and their children.
Our analysis compares the state economy under two different tax structures, holding revenue constant. Over time, the ratio of government revenue to state GDP is constant. The state government runs a balanced budget, so government spending is also a constant fraction of state GDP. It follows that future state government spending will be greater in correlation with a faster economic growth rate. Thus, for those who argue that Missouri needs to spend more on state goods and services, the answer is simple: Choose a tax structure that relies on a broad-based sales tax rather than one that combines an income tax and an exemption-filled sales tax.
In the model economy, in order to achieve revenue neutrality in the first year, the sales tax rate is computed to be 11.9 percent, a figure that several articles have cited. Taken in isolation, this may seem like a radical policy, but it’s important to remember that the people populating this model economy prefer the tax structure in which the broad-based sales tax structure is implemented, replacing the tax structure that combines both income taxes and sales taxes. As with most things, context is everything. In the context of the model economy, the sales tax rate is high — but, to be logically consistent, one must also cite the welfare comparisons. Our results indicate that there is a tradeoff between economic growth and the tax structure, and that the average person prefers a policy that increases the growth rate.
Just to answer the critics, let me explain why we calculated the sales tax rate at 11.9 percent in the baseline economy. In the model economy we created for our analysis, the typical person consumes only 48 percent of their income. In the real world, however, the average person consumes about 70 percent of their income — so, those people populating the model economy choose a tax base that does not match well with actual observations of real-world consumers. Because the tax base is so small in the model economy, the revenue-neutral sales tax rate is higher than it would be in our real economy. If, on the other hand, the person living in the model economy consumed the same fraction of their income that we observe in actual consumers, their revenue-neutral sales tax rate would be only 7.6 percent.
To summarize, then, the sales tax rate is higher in our simple model economy because the modeled savings rate is higher than what we observe in the real world. In this economy, and in various permutations, consumers as a group are better off without an income tax, with a higher sales tax instead, and with the resultant higher economic growth.
