Idaho’s legislative session is underway and taxes are front and center. The first bill introduced this year considers the tax placed on businesses to fund unemployment insurance.
When taking up the question of what is the best tax policy, legislators should keep in mind a few basic economic principles.
The government raises revenue using various taxes, including income, sales and property taxes. Economic principles show we can best judge the efficiency of any tax by looking at the costs it imposes on taxpayers. Two key economic principles are at play here: (1) People respond to incentives. (2) The true cost of any action is what you give up to get it.
The first principle shows that society loses when taxes alter incentives and distort the allocation of resources. Well-designed tax policies minimize the amount of economic distortion that occurs when businesses and individuals pay for their work and labor.
The second economic principle shows us that the administrative burden of complying with the tax laws is a true cost of any tax policy. Well-designed tax policies will also minimize the amount of money spent complying with tax laws, so that we don’t have to give up doing other more productive tasks.
Our state income tax came about in 1931, when the Idaho State Tax Commission was established to administer a new tax “intended to offset property taxes levied for state purposes.” Over time, the complexity of this tax has grown. State lawmakers may find it agreeable to lower the overall corporate rate in exchange for eliminating exemptions, thus simplifying the tax code and the costs of complying.
The benefits of reforming our income tax code can be studied using the basic model of supply and demand. In this model a tax on any good or service reduces the welfare, or well-being, of the buyers and sellers in the market. The quantity sold and produced in the market is therefore lower than it would be otherwise.
Income taxes are a tax on labor, and place what economists call “a tax wedge” between the wage the firm pays and the wage that workers receive. Absent the tax, what the firm pays would be exactly what the worker receives. Taxes thus force losses on society because they reduce consumption and production. As behavior changes with the tax, the overall size of the market shrinks below its optimal output level.
In addition to this lost output we also face the burden of paying income taxes. The administrative burden of a tax (filing forms, sending payments, record keeping, etc.) is higher when taxes are more complex.
For this reason economists generally support sales taxes over income taxes, as the latter is too cumbersome and costly to administer. It is therefore best to simplify both.
Basic economic principles and models therefore show that our state economy would be better off with a simpler tax system weighted less toward income taxes. Idaho gubernatorial candidate Raul Labrador has just such a proposal.
Labrador is proposing to “flatten and broaden the tax base” by reducing the individual, corporate and sales tax rates to 5 percent while eliminating income tax loopholes. He also proposes eliminating the sales tax on groceries, which is more of a burden on lower-income households, and the elimination of personal property taxes charged on business equipment, a particularly costly tax to administer.
Lower and more easily understood taxes are the right choice. Lawmakers do well when they work to just keep things simple.
Peter R. Crabb is professor of finance and economics at Northwest Nazarene University in Nampa.