Wednesday, April 14, 2010

Arguing the Sales Tax Increase

I ran across blog post on the proposed sales tax increase in Arizona that referenced an economic analysis done by Dr. Alberta H. Charney from the Eller School of Management at UofA. Since I like to read what other economists write, especially about Arizona, I thought I'd have a look.

I've read both the article and the referenced economic impact study and there are problems in both.

Specifically, both the article and the study make claims that are at odds with recent data.

First, from a macroeconomic model standpoint, it assumes that both government spending and taxes have a multiplier effect on the economy. That is, an increase (or decrease) results in an increase (or decrease) in other transactions that add to (or subtract from) the overall economic effect. From the study:

The cumulative effect of these purchases is referred to as the multiplier effect and the additional purchases and economic activity created as a result of the initial increased demand is referred to as the economic impact. The reverse of all these effects occurs if there is a decrease in the demand for the output of an industry.

Given the numbers of jobs they cite, their model apparently assumes that the government spending multiplier is greater than the tax multiplier. Their model shows that taxing away $918M costs 7,383 private sector jobs while reducing government expenditures by $867.6M costs 14,092 mostly public sector jobs. That means their model assumes that public sector spending is about twice as effective as private sector spending at creating (or saving) jobs.

While that's what their model assumes, it's not what economists have found when they actually tried to measure the multiplier. What they found was that the government spending multiplier was about 0.7 while the tax multiplier was between 1.3 and 3.0. In short a dollar of government spending results in a net of 70 cents of economic activity while that same dollar received as a tax cut results in $1.30 to $3 in net economic activity. (The flip side of a tax cut would be a tax increase that on net decreases economic activity by $1.30 to $3.)

Even adding in the "lost" federal funds won't make up for the private sector loss if we use measured multipliers rather than their model assumptions.

The study has some reasons that government spending will result in more jobs than letting people spend their own money.

First, the government is a service provider and, generally, services employ more persons per $1 million of expenditures than do non-services providers...

Since 80% or more of the economy is services, this won't make that much difference. Retail jobs are service jobs as are jobs in wholesale and distribution.

Second, from the taxation side, a portion of the sales tax is paid by out-of-state visitors, so only slightly under 90 percent of the tax is paid by Arizona residents.

So we will get to outsource about 10% of the tax. That raises the cost of visiting Arizona relative to other places which will decrease the number of visitors. While we'll get the benefit of taxing those that still come, we'll lose all of the economic activity of those that will now stay away due to the higher costs.

For most sales, only the retail margin (the difference between final sale price and the wholesale cost of the item) is retained in the state. Retail margins can be as low as 27 percent of the total sales price for purchases made at general merchandise stores.

Basically this is saying that only a portion of the tax will be paid out of the retail margin. The rest will be passed back to the out of state wholesaler or distributor. I don't know how you make this work. I don't know any wholesaler or distributor that will sell me stuff at a lower price simply because the state of Arizona has a higher sales tax rate. As a retailer, that means all of the tax will come out of either my margin or a higher price charged to Arizona residents.

Overall I find the model's analysis and Dr. Charney's arguments unconvincing. The multipliers their model uses are out of sync with our experience. The government isn't that much more service job intensive than the private sector, and I don't see a mechanism for outsourcing the taxes to other states.

Best I can tell, just based on the multipliers, this tax increase will cost the private sector at least twice as many jobs as it will save in the public sector.

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