Sales Taxes: Incidence and Incentives

It is commonly said that the sales tax affects workers and non-workers alike, as opposed to payroll and income taxes which tend to fall on wage earners, because everybody buys things but not everyone workers. The elderly, for example, are harmed more by a sales tax than by a wage tax.

There is some truth to this conventional wisdom, but it has been exaggerated because many income streams are automatically indexed to inflation (specifically, the CPI), and CPI inflation reflects sales taxes. For example, UK unemployment benefits are indexed to the CPI. When the UK increased its VAT, inflation was created and the unemployed automatically got a raise while workers did not.

Another example, US social security benefits are indexed to the CPI via the Cost of Living Adjustment. Thus, if the U.S. were to implement a VAT, the CPI would go up and the elderly would automatically get a raise. Workers would not.

On the other hand, newly retired people have their social security benefit indexed to wages, which would not automatically increase after a VAT. So new retirees would, in effect, pay the VAT throughout their retirement. Elderly people also have non-social-security income sources, which are sometimes not indexed to inflation. To the extend that elderly relied on non-indexed income, they would pay part of the VAT too.

In terms of incentives, the VAT discourages work because people work in order to buy more. But, as noted above, there is an addition work-discouraging effect of sales taxes: through CPI-indexation it reduces the income gap between workers and non-workers.

About Casey B. Mulligan 76 Articles

Affiliation: University of Chicago

Casey B. Mulligan is a Professor in the Department of Economics. Mulligan first joined the University of Chicago in 1991 as a graduate student, and received his Ph.D. in Economics from the University of Chicago in 1993.

He has also served as a Visiting Professor teaching public economics at Harvard University, Clemson University, and Irving B. Harris Graduate School of Public Policy Studies at the University of Chicago.

Mulligan is author of the 1997 book Parental Priorities and Economic Inequality, which studies economic models of, and statistical evidence on, the intergenerational transmission of economic status. His recent research is concerned with capital and labor taxation, with particular emphasis on tax incidence and positive theories of public policy. His recent work includes Market Responses to the Panic of 2008 (a book-in-process with Chicago graduate student Luke Threinen) and published articles such as “Selection, Investment, and Women’s Relative Wages,” “Deadweight Costs and the Size of Government,” “Do Democracies have Different Public Policies than Nondemocracies?,” “The Extent of the Market and the Supply of Regulation,” “What do Aggregate Consumption Euler Equations Say about the Capital Income Tax Burden?,” and “Public Policies as Specification Errors.” Mulligan has reported on some of these results in the Chicago Tribune, the Chicago Sun-Times, the Wall Street Journal, and the New York Times.

He is affiliated with a number of professional organizations, including the National Bureau of Economic Research, the George J. Stigler Center for the Study of the Economy and the State, and the Population Research Center. He is also the recipient of numerous awards and fellowships, including those from the National Science Foundation, the Alfred P. Sloan Foundation, the Smith- Richardson Foundation, and the John M. Olin Foundation.

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