ECONOMIC EFFECTS OF A FEDERAL
GENERAL SALES TAX
September 17, 1942
CONTENTS SUMMARY Price effects of a retail sales tax Initial price effects Long-term price effects Effect of the tax on producers' goods Nontaxable services Exemptions of foodstuffs and other necessities Price effects of a war-time retail sales tax Price effects of other forms of sales taxation Immediate shifting Long-term shifting "Loadage" Markup Multiple tax discrimination among commodities Effects on business structure Effect on consumption expenditure and saving Absorption of purchasing power Penalization of spending Consideration of aggregate spending and savings ratios Relative effect War effects of wartime sales tax APPENDIX A APPENDIX B
ECONOMIC EFFECTS OF A FEDERAL GENERAL SALES TAX
1. A retail sales tax is generally immediately embodied in a proportional price increases, particularly when tokens or purchase schedule are employed as administrative aids.
2. Subsequent slackening of consumer purchasing, varying according to differing elasticity of demand for various commodities and services, results in production readjustments, thereby affecting costs of production and distribution, which in turn produce a new price pattern. Some lowering of business profits occurs in the course of this readjustment.
3. Manufacturers' excises, gross sales taxes and value added taxes are not likely to be embodied in price increases as promptly as retail sales taxes. A considerable part of their immediate impact is on business profit.
4. Eventually, like retail sales taxes, these other forms of sales taxation produce a new, higher pattern of prices, with some lowering of business profit.
5. Sales taxes imposed below the retail level involve an "interest loadage" to cover the working capital investment in tax payments not yet recovered from consumer purchase payments. This adds slightly to the price and profits effects of these taxes.
6. Manufacturers' excises and gross sales taxes, impose differing tax burdens on commodities and services according to their chains of production and distribution. These differing tax burdens cause these forms of sales taxes to modify the price, consumption and production patterns more than do retail sales taxes.
7. Gross sales taxes discriminate against single-process concerns in competition with integrated enterprises and thus promote vertical integration.
8. General sales taxes reduce consumption expenditure more and saving less than any other form of major-revenue tax.
ECONOMIC EFFECTS OF A FEDERAL GENERAL SALES TAX
The term "general sales tax" covers several different types of levies -- retail sales taxes, manufacturers' excises, gross sales taxes, value added taxes. Exemption of foodstuffs and other items may produce still further differentiation. Each type and subtype of sales tax has its particular effect on the national economy. Any inquiry into the economic effects of a Federal sales tax, therefore, must resolve itself into a series of interrelated studies on the several forms of sales taxation.
PRICE EFFECTS OF A RETAIL SALES TAX
A retail sales tax generally has an immediate effect upon prices. subsequently, long-term factors come into operation and tend to modify this initial influence.
INITIAL PRICE EFFECTS /1/
Imposition of a retail sales tax tends to produce an immediate proportional increase of prices for three reasons:
1. The law or the regulations may provide for the collection of the tax through tokens, or its assessment by a schedule. IN such case market inertia tends to preserve the pre-existing prices, with the tax calculated as an independent superimposed charge.
2. Even where superimposition of the tax is not provided or permitted by the law or regulations, the imperfect competition which characterizes most retailing facilitates fairly consistent action in adding the tax immediately to prices.
3. Even where sharp competition exists in a retail field, imposition of a retail sales tax is likely to be an extraneous factor producing concerted action among competitors.
This tendency towards immediate shifting of a retail sales tax is qualified by several considerations:
a. In spite of the considerations favoring concerted pricing action by retailers subjected to a retail sales tax, individual sellers will for a time seek a competitive advantage by absorbing the tax. This is more likely to occur in the case of a low-rate tax than a high-rate one.
b. Various customary prices and price lines are difficult to readjust if no provision is made for separation of the tax from the price by means of tax tokens or tax schedules.
c. Where retail prices are determined by manufacturers' resale price agreements, there may be delay in readjusting these agreements to embody the tax, if the tax is not separated from price by means of tax token or tax schedule collection.
LONG-TERM PRICE EFFECTS /1/
In normal times the general increase in prices caused initially by a Federal retail sales tax must cause a reduction of consumption, measured in physical units. /2/ This reduction of consumption is not distributed proportionately among all commodities and services, but varies with the differing elasticities of demand for the various commodities and services.
This varying reduction of consumption necessarily has its repercussions on industry and business. Decline of retail sales because of the tax-induced prices increases results in reduced orders placed with wholesalers and manufacturers. During the period of readjustment, manufacturers' profits are generally reduced, with greatest loss to those lines for whose products demand has fallen most. Eventually, by exodus of marginal high-cost firms in some lines, by failure of the industry to expand in other lines, a new equilibrium of production and demand is established. Included in this readjustment are such changes in unit costs as are necessitated by the varying degrees of reduction and the varying cost situations of lines of production and distribution. These cost changes have their influence on prices, so that the original price pattern, initially raised with little change, is replaced by a new and different one.
The ultimate results of a peacetime retail sales tax thus are --
1. a varying reduction in the production and consumption of commodities and services,
2. a change in the price pattern
3. a higher general price level bearing some relation to, but not strictly proportional to, the tax rate.
EFFECT OF THE TAX ON PRODUCERS' GOODS
Unless special provision is made for the exemption of equipment and supplies purchased by producers, a retail sales tax adds to the cost of these items. This tax element is a minor, unevenly distributed business cost factor. As such, its effect is divided between profits and prices increases, according to the particular situations of the firms affected,
Retail sales taxes are generally not extended to service charges, such as rent, professional payments, etc., which are not the subject of store sale. Marginal utility of these untaxed services is increased relative to the marginal utilities of the taxed commodities. This circumstance does not necessarily result in an increased consumption of these services, since absolute capacity to purchase is reduced for some income classes by the tax's absorption of purchasing power. It is quite possible, given certain combinations of elasticities of demand, for the tax-induced reduction of consumption to be concentrated in major part of the untaxed services. But this is not likely. More probably any decrease in consumption of the untaxed services will be less than that of the taxed commodities.
EXEMPTIONS OF FOODSTUFFS AND OTHER NECESSITIES
Exemptions of foodstuffs and other necessities from a retail sales tax have a social effect of easing the burden of the tax on the lower income classes for whom such purchases are major budget items. In addition, such exemptions affect the economic pattern. To the extent that group demand for food in general (as distinguished from particular goods) and other necessities is relatively inelastic, neither their exemption nor any general reduction of propensity to consume would be likely to have a substantial effect of their purchase, except by individuals in the lowest income classes. But if there are any areas where substitution of exempt items for taxable items is possible -- and exemptions are always likely to give rise to such areas of substitution -- then the buying of certain taxes items may be substantially reduced, and buying of the substituted exempt items substantially increased. Profits in the affected lines will be influenced for a time, and upon eventual readjustment, prices in these lines will be influenced by the cost of factors involved.
PRICE EFFECTS OF A WAR-TIME RETAIL SALES TAX
The immediate price effect of retail sales taxation -- the general tendency of the tax to be incorporated in retail prices -- is the same whether the tax is imposed in peacetime or wartime. But, with entire sectors of production for civilian purpose discontinued, with many elements of consumption expenditure channeled by rationing and shortages, with prices under control, normal interactions of prices, consumption and production are blocked. Therefore, long-term readjustments of consumption, production and prices, such as would result from a peacetime retail sales tax, are not likely to follow a wartime tax if the rate is moderate. A tax that added a substantial fraction to all retail prices, however, might cause shifts in mass buying sufficiently great to overtop the war-produced market inertias, and so influence the economic patter.
PRICE EFFECTS OF OTHER FORMS OF SALES TAXATION
If a manufacturers' excise, or a gross sales tax, or a value- added tax, was shifted along the various chains of production and distribution with no "loadage" and in such a way that the tax element involved in retail prices was uniformly proportional to retail prices for all commodities and services, its price effects would be identical with those of a retail sales tax. But these conditions do not obtain. Therefore, somewhat different price effects must be anticipated from these forms of general sales taxation.
IMMEDIATE SHIFTING /1/
General immediate shifting f a sales tax collected from others than retailers in less likely than in the case of a retail sales tax. The token and tax schedule arrangements that facilitate immediate shifting of a retail sales tax are absent. And while monopoly positions, which permit immediate price action, are frequently present in industrial sectors of the economy, effective competition occurs in some sectors of wholesaling and in many phases of industry. Where competitive policy is truly effective in any business field, a sales tax should not immediately affect price. The first action if most competitive producers and sellers is to maintain their market by absorbing the tax themselves. Thus the initial tendency of the tax is to reduce profits, or convert profits into loss, rather than raise prices. In recession, when markets are shrinking and competition is most bitter, this transition effect of a sales tax on profits rather than prices may be particularly marked.
But this need not always be the immediate reaction to a manufacturers' excise or a gross sales tax. In the many business sectors where competition is imperfect, monopolistic or group action may accomplish an immediate shift of the tax into prices. Moreover, an extraneous factor like a sales tax, widely advertised as a levy on consumers, may produce unplanned but widespread group pricing action even in competitive lines; this is particularly likely in boom periods when prices are already under pressure to rise. A wartime sales tax would be particularly likely to be shifted immediately into prices, since price controls would have to be modified to take account of the tax.
LONG-TERM SHIFTING /1/
Where the first effect of a manufacturers' excise or a gross sales tax is to reduce the profits in certain manufacturing or distributive fields, new entry into such fields is discouraged, or actual exodus from the field may occur because of failure. The consequent reduction of output and of distributive service eventually produces shortages in the retail field in the face of an unchanged consumer demand. Price adjustments accordingly occur. The cost changes involved in the constriction of production and distribution, and the reaction of the varying elasticities of consumer demand to higher prices involve further price readjustments. In the long run, apart from the effects of "loadage" and commodity and competitive discriminations discussed below, the effects of manufacturers' excises, gross sales taxes and value-added taxes on consumption, production and prices are similar to those of retail sales taxes, already described.
Whatever may be the ultimate interactions of price, demand and production for various commodities, a sales tax collected prior to retail sale imposes a business cost not imposed by a retail sales tax -- the cost of carrying all tax payments from the time they are made, through the successive links in the chains of production and distribution, to the time when retailers are reimbursed for them through consumers' payments. All along the chains of production and distribution, these tax elements increase the costs of goods and materials purchased, and hence increase the values tied up in inventories. No matter how these inventories are carried -- on buyers' working capital, on sellers' credit, or on bank credit -- an actual or imputed interest cost is involved. This interest "loadage" is an added cost of production and distribution that must be covered ultimately by retail prices.
This interest "loadage" is not a simple interest charge on the tax computed from the time of its original payment to the time of its coverage at retail sale. It is compounded, pyramided, at each transaction in the course of production and distribution.
The practice of basing retail pricing on a fixed proportional markup from purchase costs is widespread. This procedure has an important implication for the price effect of sales taxes. Goods come to retailers with their purchase prices already increased by one or more tax impositions at earlier stages of their production or distribution, and by the element of "loadage." Proportional retail markup is based on this expanded purchase price. Hence retail prices embody not only the tax and "loadage" that has been passed on to retailers, but also the additional fraction is this amount covered by the markup.
If a heavy sales tax is in effect for a considerable period of time, retailers' markup proportions may be modified by the elements of competition none the less present in the relatively imperfect competition that characterizes the retail field. But for a transition period, retail markup procedures tend to exaggerate the effect of a sales tax on prices, and to yield retailers additional profit.
MULTIPLE TAX DISCRIMINATION AMONG COMMODITIES /1/
A value-added tax is so apportioned among the various stages of commodity production and distribution that the proportional tax burden embodied in final retail prices of all commodities is the same. /2/ Manufacturers' excises can be so framed that the sale of goods which require further industrial processing are exempt, thus preventing multiple taxation of a commodity in the course of its production. But elimination of multiple taxation under a gross sales tax would be possible only through a provision for rebate of taxes previously paid on resold commodities, and such a provision is not administratively practicable.
A gross sales tax, therefore, discriminates among commodities and lines of commodities as to the ratio of tax embodied in retail price to retail price itself. A commodity that passes through a succession of industrial processes and distributive transfers performed by independent concerns is taxed at each transfer, and so bears a cumulated tax burden by the time it reaches retail sale. An item that involves a short chain of production and distribution bears a much smaller sales tax burden when it reaches consumers.
The long-term effect of this discrimination in gross sales tax burdens on commodities is to raise prices, reduce consumption and reduce production of the repeatedly taxed items more than for commodities less frequently subjected to the tax. Thus the patterns of consumption and production are still further modified, in addition to the modification caused by the general tax-induced price increase.
EFFECTS ON BUSINESS STRUCTURE /1/
During the period of market readjustment to a sales tax, all concerns involved in the production and distribution of the taxed commodities and services must experience some contraction of demand for their output. For some concerns in a line, this would mean a temporary reduction of profits, or a temporary conversion of small profits to a loss. For others, previously just clinging to solvency, it might accelerate the advent of failure.
A gross sales tax had an additional effect on business structure that does not result from other forms of sales taxation. In some lines, chains of single-process independents compete with vertical integrations that cover, within the single business structure, the series of operations handled by their smaller competitors. The integration pays a single tax on its output. Each of the single- process competitors pays a tax, and the output of a chain of such single-process concerns is burdened by a multiple tax. Thus single- process independents are placed by the tax at a competitive disadvantage as against integrations. In general, an incentive is offered to the further creation of vertical combinations.
This element of discrimination in a gross sales tax can be eliminated by a system of rebates for taxes previously paid on materials purchased for subsequent processing or resale which will against give rise to tax liability. This rebate arrangement, however, is generally deemed administratively impracticable.
EFFECT ON CONSUMPTION EXPENDITURE AND SAVING
A sales tax, to the extent that it increases the prices of goods and services, influences consumption expenditure and saving in two ways:
1. It absorbs purchasing power that might be available either for consumption or saving.
2. It penalizes consumption spending, while offering no immediate discouragement to saving.
ABSORPTION OF PURCHASING POWER
Reduction of an individual's real income by a tax-induced price increase affects his spending and saving according to the relative elasticities of his spending and saving schedules. These vary with his income position.
Where income prior to a tax-induced price increase is devoted entirely to consumption expenditure, there is no choice but to reduce purchases (net of tax) by the amount of the tax-induced price increase. /1/ While many individuals and family groups through the middle income ranges are "living completely up to their incomes", this situation is most common in the lowest income ranges.
Saving by individuals in the lower and lower-middle income classes consists to a large extent of budgeted savings account deposits, insurance premium payments, amortizing mortgage repayments and installment repayments. Such saving embodies a high degree of rigidity. /2/ A tax-induced price rise will have little effect upon it. In this case also the price increase tends to exercise its major influence on consumption spending.
Not until we reach family groups with incomes over the $3,000 or $5,000 level do we find marginal saving becoming elastic. For the higher income groups, saving tends to be the flexible margin between their incomes and their established standards of living, which display considerable short-term inertia. Reduction of their purchasing power through a tax-induced price increase might exercise a disproportionate effect upon their savings.
On the basis of this analysis, we might expect a sales tax to reduce only slightly, if at all, the savings of the lower and lower- middle classes, but to exercise a substantial influence on the savings of the higher income classes. Since three-quarters of individual savings are made by people in the income groups above $5,000, /3/ it might seem as though the predominant effect of a sales tax would be to reduce saving. But three-quarters of the consumption expenditures that transmit the sales tax burden to consumers are made by people with incomes under $5,000. /3/ Most of the shifted sales tax burden, then, comes to rest upon people who cannot or will not reduce their savings to any substantial extent. This element of the sales tax burden reduces consumption spending. The remaining minor fraction of a sales tax burden is shifted to people who cover it in varying degrees by reducing their saving.
As a first approximation, based on absorption of purchasing power by a sales tax, we may conclude that most of the revenue from a general sales tax /1/ -- say, three-quarters or a somewhat larger fraction -- constitutes a reduction of consumption expenditure. The balance represents a reduction of saving.
PENALIZATION OF SPENDING
Price increases resulting from the shifting of a general sales tax penalize spending. Inclination to spend is discouraged. This can have little or no effect on the spendings of individuals who were previously spending up to the limit of their incomes, or whose saving commitments were fixed, and hence who have no choice but to reduce the physical volume of their spending as the purchasing power of their income is reduced. For them, the compulsory reduction of their purchasing presumably exceeds the reduction of their inclination to spend. But for individuals in higher income ranges with a flexible margin of saving, who otherwise might let a sales tax burden rest entirely or in major part on their saving, this reduction of inclination to spend may make a difference. If the tax rate is sufficiently high, and the penalization of their spending substantial enough, it may induce a contraction of their customary standard of living. In such case the influence of a sales tax on the savings of higher income classes is reduced, and its influence on their spending increased.
A second approximation of the influence of a sales tax on national spending and saving, taking this penalization of spending into account, would allow the greater reduction of spending and less reduction of saving than the first approximation.
CONSIDERATION OF AGGREGATE SPENDING AND SAVINGS RATIOS
The preceding analysis has dealt with the immediate influence of a sales tax on spending and saving. It might be argued that the relative rigidity of the fixed saving commitments of the lower income groups and of the spending standards of the higher income groups is a short-term phenomenon. The inertial of these elements is effective for a time, but in a longer run both saving commitments and spending standards are adjusted to the change of circumstances caused by the tax, and a return is made to customary ratios of spending and saving for all income classes. In time, the tax tends to reduce spending and saving for each income class roughly proportionately to their previous spending-saving ratio.
If this reasoning be sound, people in the lower-income classes might be expected in time to increase their spending somewhat above the level predicted in the previous approximations, and people in the higher-income classes would decrease their spending. The margin for change would be relatively narrow for the lower income groups, but substantial for the higher income groups. Hence, the net effect of this readjustment would be to cause a sales tax to reduce spending still more in the long run than initially. On the basis of recent calculations of the distribution of spending and saving by income classes, five-sixths of the receipts of a national general sales tax might eventually be expected to constitute a reduction of consumption expenditure and one-sixth a reduction of saving. /1/
The preceding discussion involved the assumption that the receipts from a general sales tax were employed in such a way as not to create any purchasing power to replace that absorbed by the tax. This could occur if the receipts were used to retire bank held debt. Under most other circumstances, however, expenditure of the tax funds by the Government would restore part or all of the purchasing power absorbed by the tax to the national economy, though not necessarily with the same income-class distribution as the original absorbed purchasing power. This restoration of purchasing power would offset and modify the effects of the tax as noted above, if the raising and expending of the tax funds were considered as interdependent.
A more useful interpretation is to deal with Government expenditure as the fixed element, and to consider the relative effects on saving and spending of the various taxes that might be employed to raise the funds. Relative analysis discloses that a general sales tax exercises more effect on consumption expenditure than any other major-revenue tax. Consumption expenditure, which determines the distribution of the sales tax burden among income classes, is more concentrated among the lower income classes than the distribution determinant of any of the other major taxes. Since this distribution of burden among income classes is a major factor in the effect of any tax on saving and spending, this consideration alone places the general sales tax in the forefront as a spendings deterrent. In addition, a general sales tax has the added effect of penalizing, and hence discouraging, consumption expenditures.
WAR EFFECTS OF WARTIME SALES TAX
If a general sales tax is levied in wartime as part of a general program of obtaining a large war revenue and substantially absorbing civilian purchasing power, it is not possible to isolate its separate effect on earning and saving. Shortages and rationing change the customary consumption patterns of people in the various income classes, and thus modify their relative inclinations to spend and to save. Reduction of civilian purchasing power by other war taxes and by war borrowing further influences the marginal elasticities of spending and saving for the various income classes. The wartime effects of a sales tax on spending and saving, therefore, should be treated s but a part of the general effects of the war finance program.
Treasury Department, Division of Tax Research
September 17, 1942