Back to Preface, Summary, and GlossaryFrom Financing State and Local Government
p. 1-14, published 2001
Tax policy usually reflects an uneasy compromise among conflicting objectives, no one of which can be the sole determinant of policy or of policy reforms. Efficiency and equity (or fairness) in taxation are two fundamental economic criteria by which tax reforms can be usefully evaluated. These are complex and many-faceted concepts that include many other important criteria for policy evaluation, such as simplicity and competitiveness. Tax reform proposals almost always necessitate difficult tradeoffs between efficiency and equity.
Tax policy is inevitably a contentious subject. Oliver Wendell Holmes famously declared that “taxes are what we pay for a civilized society,” a lofty sentiment indeed, and perhaps one that is widely shared. But most taxpayers nonetheless seem to feel that the cause of civilization might be still further advanced if its price were distributed somewhat differently, usually in any direction but theirs. Senator Russell Long, a veteran tax legislator, summed it up this way: “Tax reform means, ‘don’t tax you, don’t tax me, tax that fellow behind the tree.’” Moral and ethical principles are frequently invoked in tax reform debates, with advocates strenuously asserting the importance of “fairness” and “equity” in taxation—discovering, remarkably enough, that adherence to these moral principles usually necessitates “taxing the fellow behind the tree.”
Fairness in taxation is undoubtedly important to all citizens, and certainly no branch of government seeks an inequitable distribution of tax burdens. Meaningful discussion of tax reform must begin with a recognition, however, that there is wide disagreement about the meaning of “fairness” or “equity.” It must also begin with a recognition that the search for better tax policy always involves the balancing of competing principles, of which equity or fairness is one but never the only one. This balancing is no easy task, but constructive public discourse can be advanced by an awareness that tax policy does involve tradeoffs, and that policymakers, and the citizens that they represent, must make choices among competing goals.
Economists have been grappling with the problem of taxation at least since the time of Adam Smith’s Wealth of Nations (1776), and certain perspectives have gradually evolved during the past two centuries of attempts to systematize the analysis of tax policy.(7) Perhaps the most important perspective that economists bring to bear is that public policies, including tax policy, should be evaluated in terms of their impact on economic welfare, that is, the economic well-being of the members of society. Taxes harm the economic well-being of those who bear their burden, but some methods of raising revenue cause more harm than others. To quote another famous justice of the Supreme Court, John Marshall, “The power to tax involves the power to destroy.” As Justice Marshall saw clearly, taxes affect behavior. An industry, an occupational category, the economy of a region, and even the economy of an entire state can be hampered, discouraged, even destroyed by taxation because taxes create economic incentives that generally tend to discourage the taxed activity. These incentives sometimes work in a very direct and obvious fashion, as, for example, when taxes on particular items of consumption such as luxury goods, tobacco products, or alcohol cause consumers to reduce their purchases of taxed commodities—or to obtain those commodities from untaxed sources such as out-of-state suppliers. Sometimes the incentives are much less direct, as, for example, when taxes on energy cause an increase in the cost of production for certain industries, whose outputs then become more costly, resulting—perhaps through several further stages in the production process—in higher prices for goods or services purchased by households. The adjustment of economic behavior in response to tax and other fiscal incentives may occur rapidly in some cases and quite slowly in other cases, but at whatever rate they proceed and however indirect they may be, the responses of producers and consumers to changes in tax policy play a crucial role in determining the ultimate impact of tax policy both on the allocation of resources in the economy (that is, the levels of consumption and production of different goods and services) and on the economic incidence of taxes, that is, the distribution of the real burden of the tax system.
The free play of market forces tends to drive the allocation of resources in ways that reflect both the costs of production of different goods and services—the value of the labor, capital, land, raw materials, and other inputs used in production—and the valuation of these goods and services by consumers—the amount that consumers are willing and able to pay for them. The search for profits by firms leads them to attempt to match production with consumer preferences and to find the least costly ways of satisfying consumer wants. The search by consumers for desired goods and services at low prices, the search by workers for satisfying and remunerative employment, and the search by investors for profitable outlets for new investment are all examples of economic behavior through which markets mediate the complex process of allocating resources and, in the process, balancing the benefits and costs of different possible resource allocations. Markets do not always function perfectly, and government policies, including tax policies, are sometimes needed to ensure certain goods and services are adequately provided.(8) As a general proposition, however, freely functioning markets work to achieve an efficient allocation of resources, that is, one that promotes economic welfare by ensuring that the limited productive capacity of the economy is utilized in the satisfaction of the preferences of households. When taxes affect economic incentives and thus economic behavior, resource allocation becomes dependent not only on the underlying costs of production of goods and services and on the valuation of goods and services by households, but on the tax implications of economic decisions. Virtually all taxes do alter economic incentives, and thus give rise to economic inefficiencies. An important objective of tax policy should be to limit the economic harm that the tax system causes through these inefficiencies.
Several examples can help to illustrate the kinds of inefficiencies that taxes can create. A tax on a household’s income, such as Kentucky’s personal income tax, creates fiscal incentives for taxpayers to alter their behavior. An income tax creates incentives for taxpayers to have less taxable income, which they can do by working less and having less earned income, by saving less and having less interest, dividend, and other forms of income derived from the accumulation of wealth, or by receiving income in tax-preferred or tax-sheltered forms such as untaxed fringe benefits, tax-sheltered retirement savings, or tax-preferred capital gains, to name only a few possibilities. Kentucky’s sales tax does not fall equally on all categories of consumption, as described in Chapter 3, and it thus creates incentives favoring certain patterns of consumption over others. Because it reduces the effective purchasing power of household incomes, it also discourages work effort in much the same way as the income tax, even though it does not actually tax earnings directly or explicitly. Local property taxes increase the cost of residential housing, both for homeowners that pay these taxes directly and for renters who absorb some portion of the tax in the form of higher rents demanded by landlords who are liable for property taxes. Property taxes on commercial and industrial property affect the profitability of investment, the amount of employment, and the output of goods and services; business income taxes affect investment and employment incentives, and so forth.
Most state and local taxes are location-contingent, that is, they must be paid by taxpayers located within a taxing jurisdiction but are not paid by those outside. Kentuckians pay the state’s personal income tax, but could avoid this tax if they lived outside of the state. For the most part, they pay the state’s sales tax because many of their purchases occur within the state; households residing outside of the state may pay some of Kentucky’s sales tax if they happen to engage in purchases here, but nonresidents generally pay relatively little of Kentucky’s sales tax. A household or business can avoid the property tax collected by a particular municipality, country, or school district by locating in a different jurisdiction either within the state, in another state, or even in a different country. A business may build facilities and hire workers in Kentucky in order to sell goods and services to the state’s residents or for export, or it may instead locate in another state (or country), and its location will affect whether it pays taxes to the state. Location-contingent taxes affect the incentives of households and firms to locate in Kentucky, and in particular localities within Kentucky.(9) The phrase “fiscal competition” (or “tax competition”) is often used to describe the fact that individual states and localities “compete” for productive, mobile resources with other jurisdictions, and that taxes (along with other policies, including the provision of public services financed by taxes) help to determine whether and what types of investment, workers, and other resources are drawn to or repelled by these units of government. Concerns about the “competitiveness” of state and local tax systems arise from a recognition that taxes affect the locational dimensions of economic behavior—one of the many incentive effects that arise from taxes.
Almost all taxes cause some loss of economic efficiency. As a practical matter, then, the challenge for economic policy is to limit the extent of the efficiency losses (sometimes called the “excess burden” or “deadweight loss” of taxation). As a general principle, the efficiency losses from a tax are modest and even negligible if the tax rate is very low, but rise rapidly as the tax rate increases.(10) Another important principle is that taxes cause greater efficiency losses when levied on goods or services for which the level of consumption is very sensitive to price. For example, the consumption of movies is more price-sensitive than the consumption of food, and thus a 5 percent tax on the former would cause a greater efficiency loss, per dollar of revenue collected, than a 5 percent tax on food.(11) These considerations generally argue in favor of broad-based taxes, which allow a given amount of revenue to be collected at a lower tax rate, and which, because of their inclusiveness, limit the opportunities for taxpayers to switch away from taxed toward untaxed activities. A general sales tax would therefore be preferred, on efficiency grounds, to a tax on the consumption of just one commodity category, such as apparel. A tax on all earnings would be preferred on efficiency grounds to a tax limited to earnings from only one type of work, such as agriculture. The term “neutrality” is often used to characterize a tax system that does not favor particular kinds of economic activity (such as employment, consumption, or investment) over another. A “neutral” tax will apply uniformly to a broad set of activities, making it possible to collect revenue at a lower rate of taxation.(12) As will be discussed further below, the issue of “base broadening” is one that warrants close attention in the context of Kentucky’s sales tax.
As observed at the outset, differing conceptions of fairness or equity pervade tax policy debates. Several distinct notions frequently arise in this context.
According to one equity principle, a fair tax system is one that distributes tax burdens in accordance with ability to pay. Typically, “ability to pay” is interpreted as a household’s economic well-being, measured by the amount of income that a household has or the amount of consumption that it undertakes, and the ability-to-pay principle would require that a higher level of taxes fall on households with greater ability to pay. A proportional income tax could be viewed as generally compliant with this principle because a household with, say, twice as much income, would pay twice as much in taxes. A progressive income tax, under which a household with twice as much income would pay more than twice as much in taxes, could be argued to satisfy the ability-to-pay principle as well, or perhaps even more so. On the other hand, progressivity or proportionality are not required by the ability-to-pay principle: even with a somewhat regressive income tax––one under which a household with twice as much income would pay, say, one and one half times as much in taxes––the tax system could still attach higher tax burdens to households with higher ability to pay.
Aside from the question of how tax rates should vary with ability to pay, there is a real question as to whether income is the best measure of ability to pay for a household, and the measurement of income itself is far from straightforward. Should wealth (the net worth of a household, that is, the value of its assets net of any liabilities) be considered in determining a household’s ability to pay, for example? Households with high levels of wealth tend, on average, to have high levels of income, but the two are certainly not perfectly correlated. A farmer may own a substantial amount of land and other assets but in any one year may have high income, low income, or even negative income (i.e., a net loss). A young family with two earners may have high income but little accumulated wealth, whereas a retired couple or elderly widow or widower may have no earnings but a substantial amount of accumulated assets, including perhaps a house with little or no remaining mortgage debt. Taxes on real property, which are commonly used by local governments, including those in Kentucky, are not true wealth taxes since they are based only on one type of wealth (real property) and are assessed on the gross value of real property, not its value net of outstanding debt obligations. One could still argue, however, that the tax on real property does on average tend to impose higher tax burdens on households with greater ability to pay.
As an alternative to using income or wealth as a measure of ability to pay, many economists would prefer to use consumption, that is, the value of all goods and services consumed within a period of time. The retail sales tax is one example of a tax that is (or at least could be) closely related to consumption. Consumption taxes are often said to be “regressive” because the amount of income that is spent on consumption tends to diminish as a household’s income rises. If income is viewed as the correct measure of ability to pay, then consumption taxes are only imperfect approximations of ability to pay. It should be noted, however, that the personal income tax in Kentucky, like the federal income tax to which it is very closely related, actually has many features that make it like a consumption tax—so much so that most economists view the personal income tax, as presently implemented in the United States and in many other countries, as a “hybrid” form of taxation, a mix between a pure income tax and a pure consumption tax.(13) And the ethical basis for using consumption rather than income as an indicator of ability to pay, if debatable, is by no means indefensible.
It is important to note that the ability-to-pay principle concerns the distribution of tax burdens among individuals or families, that is, to “natural persons.” Businesses, properly speaking, have no ability to pay, even though they may be regarded as “persons” under the law. Business activities affect the ability to pay of natural persons, for example by creating real income for their owners, for their employees, or for consumers. As a practical matter of tax implementation, it may be very difficult to determine how much income a corporation is producing for its shareholders if its profits are not distributed in the form of dividends, and households with high ability to pay might escape appropriate tax burdens if corporate income is not separately subject to taxation. A corporation income tax may offer a practicable if imperfect means by which the tax system can reach some of the otherwise lightly-taxed income of individuals and it may thus contribute to an improvement in the distribution of tax burdens in accordance with ability to pay.(14) But under this view, the taxation of corporations and other businesses should be seen as one component of the overall fiscal system that imposes tax burdens on people. Businesses as such can never truly bear any tax burdens, they can only distribute tax burdens to natural persons.
Rather than attempting to relate tax burdens to ability to pay, one might take quite a different perspective on fairness in taxation by arguing that taxes should be related to the benefits that governments provide to taxpayers. This concept of fairness is related to the notion of “fair exchange,” as in commercial transactions: it is fair to tax those who, in exchange, receive something of value from the government.
As a corollary to the benefit principle, it would appear that those who benefit more from government should pay more in taxes. A practical obstacle to the application of this principle, however, is the difficulty of measuring the benefits received. For example, taxes on trucks and other highway users are frequently cited as “benefit” taxes, but these taxes are seldom based on any direct measurement of benefits. Similarly, the courts have used the argument that businesses should be taxable in a state because they benefit from the “protection of the courts” there, for instance in litigation involving contract enforcement. But what is the proper amount that businesses should pay for such protection?
A more sophisticated interpretation of the benefit principle distinguishes between total and marginal benefit. If highways or courts did not exist at all, trucks would be worthless and businesses could hardly exist. The total benefit of highways to trucking firms might be the entire income of those firms, and the total benefit of the courts might be the entire income of all businesses and households. However, in the context of practical policymaking, the issue is not whether to have highways or courts at all, but rather whether to spend somewhat more or less on highways and courts, and if so, how to finance those incremental or marginal expenditures. According to the benefit principle, taxes should be assessed in accordance with the benefits of the marginal expenditures. This concept is familiar from ordinary exchange transactions in the marketplace. Food is essential to life, but the price of food reflects not its total value, but rather the value of the last or marginal unit of food. For this reason, the income accruing to the agricultural sector of the economy is closer to 5 percent of national income rather than 100 percent. The same logic should apply in invocations of the benefit principle of taxation.
Understanding the difference between marginal and total benefit does not solve the problem of benefit measurement. Economic methods such as benefit-cost analysis could be used to shed more light on this question, but in practice this is rarely done. As a practical tool, therefore, the benefit principle remains difficult to apply.
The concepts of vertical and horizontal equity are sometimes useful in analyzing tax policy. The principle of “horizontal equity” states that similarly-situated taxpayers should pay similar amounts of tax, that the tax system should not differentiate tax burdens “arbitrarily” among taxpayers. In practice, this principle is often applied in favor of more uniform treatment of taxpayers, for instance in arguing against tax preferences (special exemptions, depreciation rules, or other “loop-holes”) for particular industries or types of income (capital gains, pension distributions, or in-kind compensation in the form of fringe benefits). Tax policies that promote horizontal equity, which is often briefly characterized as “equal treatment of equals,” often also promote economic efficiency. As described earlier, efficiency is often enhanced by broad-based and uniform tax policies. Special tax treatment for particular industries or for particular kinds of income creates fiscal incentives to change investment, employment, or other kinds of economic behavior at the same time that it treats similarly situated taxpayers unequally.
The principle of “vertical equity,” sometimes summarized as “unequal treatment of unequals” is a natural companion of horizontal equity. It requires that differently-situated taxpayers should be taxed differently. In practice, this principle is used to justify heavier taxation for households with higher levels of income, property owners with greater amounts of property, or consumers with higher levels of consumption.
Efficiency and equity are perhaps the two most fundamental desiderata for a tax system, but many other considerations are often promoted as important principles of taxation. Whether these are really different from equity and efficiency or simply aspects of these basic principles can be debated, but they certainly deserve mention.
Taxpayers and tax administrators alike express dissatisfaction with the complexity of the tax system. There are real economic costs associated with tax compliance, one part of which is the time and money devoted to filling out tax forms, maintaining tax records, the hiring of tax advisers, and the public resources devoted to tax collection, including the processing of tax forms, verification of tax information including the cost of audits, and the costs to tax authorities and to taxpayers of the costs of litigation. There are also real economic costs associated with tax planning. Firms may be taxed very differently depending on their organizational form (proprietorship, limited-liability company, partnership, or one of several different forms of corporation). There may be tax advantages from organizing different parts of a business in different forms, or perhaps from locating different parts of a business in different localities, states, or countries. Households may experience significant tax consequences in buying and selling a home; holding assets in bank accounts, stocks, or bonds; using credit-card debt or home-equity loans; working as an employee or as an independent contractor; or in living in one state or locality and working in another, but understanding these tax consequences is often very difficult.
Aside from the efficiency costs resulting from the use of scarce resources in tax compliance and tax planning, a complex tax system can be unfair because not all taxpayers are equally adept at structuring their activities so as to avoid unfavorable tax outcomes. This might be seen as a form of horizontal inequity: tax burdens should not be differentiated among taxpayers because some are more adept at exploiting legal and administrative technicalities than others. For all of these reasons, it is important for tax policies to be simple, to be enforceable at reasonable cost, and to be as transparent as possible.
The term “competitiveness” is often invoked, and perhaps misused, in discussions of tax policy. It appears to reflect a recognition that the tax policy of a state or local government affects the locational decisions of households and businesses. Kentucky, and localities within the state, must compete for capital, skilled labor, entrepreneurial talent, and other productive resources. Other things the same, heavy taxation of these resources will make Kentucky a less attractive location for them. If “competitiveness” means the creation of a more attractive fiscal environment for productive resources, it suggests that these resources should escape taxation, or, even more, that they should be subsidized. Competitiveness, in this sense, is not a principle of taxation that is justified by economic analysis. The fact that states and localities operate in competitive environments, however, does carry important implications for tax policy.
If the rate of return on investment, net of tax, is higher in Kentucky than elsewhere, capital will flow into the state. If the rate of return on investment is lower than elsewhere, capital will flow out of the state. The same is true for other productive resources, including both skilled and unskilled labor. From the viewpoint of economic efficiency, Kentucky’s fiscal policies should impose taxes on productive resources that reflect the costs of the public goods and services provided to them when they locate in the state, but should otherwise neither increase nor decrease their net return. From the viewpoint of equity, the potential flow of resources into or out of a state or locality means that there are limits on the ability of a government to use tax (or expenditure) policies to make one group better off at the expense of another.
For example, highly-skilled workers (those with professional training such as physicians, scientists and technical personnel, skillful managers and entrepreneurs, and others with high earnings) are potentially employable in states other than Kentucky. If Kentucky’s tax policy is highly unfavorable to these workers, and if the state does not offer offsetting fiscal advantages (for example, in the form of public services valued by these workers), then fewer of them will be attracted to Kentucky and some of those residing within the state will be attracted elsewhere. As this occurs, the services of those that remain will be increasingly scarce and costly, compensating them for the extra fiscal burden imposed upon them. The incomes of other residents in the state will suffer, even though they may benefit from reduced tax burdens. If skilled workers were relatively immobile, the imposition of heavy taxes on them would enable the state to reduce tax burdens on lower-skilled workers, but since Kentucky must compete for their skills, the state’s ability to use its fiscal policies to lower the net incomes of highly skilled workers is limited.
The same logic applies to the taxation of the return to investment. Investors seek to obtain the highest rate of return on their capital. If a state attempts to impose heavy taxes on investment, the owners of capital will have an incentive to move capital to other states (or countries), unless of course the taxes are used to provide public services that compensate, or more than compensate, for the burden of the taxes themselves. (Thus, for example, if taxes on business income are used to meet urgent demands for transportation improvements, thus increasing the productivity of capital investment, heavier taxation of businesses might attract rather than repel investment.) The mobility of capital limits the state’s ability to use fiscal policy to reduce the net rate of return on capital while raising the net incomes of others through more favorable tax treatment.
Thus, competition for productive resources limits the ability of a state or local government to pursue “vertical” equity objectives, if by this one means policies that aggressively redistribute income from one group to another. Such policies may be ineffective in achieving their goals, and in addition they impose efficiency costs. These considerations are most important in evaluating the fiscal treatment of highly mobile resources, and least important, or not important at all, in evaluating the tax treatment of immobile resources such as land or minerals.
The tax system must, of course, meet its fundamental objective of providing sufficient revenues for government expenditures. “Revenue adequacy,” however, is not a static concept. The desired level of public expenditure varies over time, both in response to changing attitudes and preferences about the proper role of state and local governments and in response to changing economic conditions. Recessions, changes in the pattern of consumption, changes in the age structure or employment patterns of the population, and the growth and contraction of different industries not only make it difficult to forecast revenue with precision, but also demand frequent reconsideration of tax policy.
Furthermore, the desired level of public expenditure cannot be determined in-dependently of tax considerations. As described above, the efficiency costs of taxation rise as taxes are exploited more heavily. When rates of taxation are low and the tax system is efficiently structured, the efficiency costs of taxation are modest. If higher levels of revenue are required, however, the efficiency costs of taxation also rise. From the perspective of benefit-cost analysis, these “indirect” efficiency costs of taxation need to be taken into account in deciding how much spending is to be financed.
While it is difficult to determine what amount of revenue is “adequate” in any one year or over a long planning horizon, the related concept of “revenue neutrality” is a helpful analytical tool. A “revenue neutral” tax reform is one that pre-serves existing or projected revenue flows, without prejudging whether this is or is not an appropriate policy goal in itself. Thinking about revenue-neutral tax re-forms simply allows discussion to focus on the tax structure proper, separately from the question of whether public expenditures should be higher or lower.
In concluding this discussion of basic principles for the evaluation of tax policy, it is important to appreciate that the fundamental goals of equity and efficiency are not relevant to issues of taxation alone. They are equally important in the evaluation of the expenditure side of the government’s accounts. Indeed, the separation of expenditure and tax policy, while sometimes helpful in organizing analysis and discussion, can be misleading. For example, government subsidies or transfer payments often give rise to efficiency effects very similar to those that result from taxation, and equity considerations are frequently of great relevance for these types of policies. Government debt policies also raise very similar issues; in fact, economists often regard debt policy as nothing more than the implementation of tax policy over time. In any one year, government expenditures must be financed either from tax revenues or from borrowing. The decision to borrow means that interest and debt repayments will have to be made in future years, requiring addi-tional taxation at that time. Thus, the decision to borrow is in effect a decision to impose lighter taxation now in exchange for higher taxes in the future. The same efficiency and equity criteria that are used to evaluate taxation at a point in time can be applied to the evaluation of taxation at different points in time.
We have now reviewed numerous criteria—many of the most important, but not an exhaustive list––by which tax policies can be evaluated. Each of these criteria has some appeal, at least to most observers. Unfortunately, these criteria frequently come into conflict, and sensible policy choice usually requires that they be balanced against one another.
One classic illustration arises in the analysis of tax progressivity. To many people, the ability to pay and vertical equity criteria mean that taxes should be assessed more heavily on higher-income households. As a corollary of this view, many people would also favor the use of tax revenues to provide public services or cash transfers to poor households, for example in the form of welfare benefits, health benefits, or other forms of means-tested public assistance. Kentucky, or a locality within Kentucky, might attempt to promote these policy goals by instituting a highly progressive income tax, with high rates of taxation, so as to finance generous social services for the poor. Even if we accept the notion that this policy would be attractive on equity grounds, it would give rise to at least two important types of efficiency losses. First, it would create fiscal disincentives for households to earn high levels of income, and it would thereby discourage work effort and the accumulation of wealth (or more precisely, the accumulation of wealth in non-tax-sheltered forms). On the expenditure side, the policy would discourage work effort and savings on the part of poor households, since, with means-tested programs, their work efforts result in benefit reductions, thus creating a fiscal incentive to devote less time and effort to the earning of income. Second, such a policy would create incentives for high-income households to reside in other states or localities, while making the state or locality a more attractive location for poor households.
Neither of these types of behavioral responses would necessarily occur instantly; in general, the incentive effects of fiscal policies become more pronounced over time. Nevertheless, a large body of economic research confirms the common-sense observation that people do respond to the economic incentives embodied in tax and expenditure policies, both with respect to the effort that they expend to achieve higher incomes and with respect to locational choices. The locational dimension is especially important for relatively small jurisdictions, such as cities or counties, since it is comparatively less costly for people to move over short distances. States can also experience significant movement of people across their borders as well, however.(15) The pursuit of equity goals in tax policy can thus come into conflict with efficiency goals. This type of conflict is the rule rather than the exception, and the challenge for public policy is to strike a satisfactory balance. There is usually no simple and unambiguously preferred solution to the vexing problem of taxation.
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* The author wishes to acknowledge the immense benefits of assistance from of many people in the preparation of this and the accompanying report. I am grateful to Michael T. Childress of the Kentucky Long-Term Policy Research Center for inviting me to participate in this project and for many helpful discussions. I received invaluable assistance from Thiess Buettner and Rick Graycarek, whose work, as the principal research assistants on this project, was supported at the Martin School of Public Policy by a Postdoctoral award and the Virgil Couch Scholarship. Numerous state and local government officials and colleagues at the University of Kentucky have helped in obtaining data or in providing guidance and insights into the workings of fiscal policy in Kentucky. With sincere apologies to anyone whose name has been inadvertently overlooked, I thank Fred Bassett, Bob Cox, Richard Dobson, Tom Dobson, Debra Eucker, Richard Frymire, Susan Goins, Merl Hackbart, Greg Harkenrider, Nick Karney, Charles Martie, Charlotte Quarles, and Dag Ryen. The Martin School has provided an extremely supportive environment for the conduct of this research. None of the foregoing individuals or institutions bears any responsibility for any errors of commission or omission or for any opinions expressed here, which should be attributed solely to the author. Return to text.
7 The discussion in this and the following chapters relies heavily on many important scholarly and policy-analytic studies by many researchers in Kentucky and throughout the world. This work is aimed at a general audience, and citations to previous work are minimized in the interest of readability. Return to text.
8 For example, taxes can help to discourage pollution, excessive congestion of highways, and other forms of economic behavior for which markets do not force polluters, road users, etc. to take into account the costs imposed on the rest of society by their behavior. In such cases of so-called “negative externalities,” the discouraging effect of taxes may be precisely what is needed to improve economic incentives. Return to text.
9 Are any taxes not location-contingent? Yes, because some taxes are assessed against resources that cannot move from one place to another. Leading examples would be taxes on land and natural resources (including, for example, taxation of mineral resources like coal). The owner of a mineral deposit or parcel of land can escape tax. Return to text.
10 According to one simple rule of thumb, the efficiency loss rises with the square of the tax rate. This means, for example, that doubling the rate of tax causes the efficiency loss to quadruple. Return to text.
11 The logic of this statement is easy to understand. The efficiency losses from taxation result from its effect on the amounts of goods and services produced and consumed. When these amounts are not much affected by prices, taxes have a modest efficiency impact. For this reason, the efficiency losses from taxation are often larger in the long run than in the short run. For example, in the short run, a gasoline tax will affect gasoline consumption mainly through its impact on the amount of transportation undertaken with the existing vehicle fleet in carrying out customary travel. In the long run, a tax on gasoline would induce consumers to switch to more fuel-efficient vehicles and to alter travel patterns, for example, by living closer to work (or working closer to home) or by switching to public transportation. Return to text.
12 A truly efficient tax system would impose higher rates of taxation on those goods and services for which consumption is price-insensitive, but in practice it is difficult to obtain the information needed to implement this principle, and for that reason many economists favor a relatively uniform rate of taxation on efficiency grounds. Return to text.
13 A detailed explanation of this point, which has several facets, goes beyond the scope of the present report. As one important illustration, however, one need only remember that much retirement savings is tax-sheltered. By using 401(k) plans, IRAs, Keogh plans, SEPs, traditional pension plans, and other retirement-savings vehicles, younger taxpayers can shelter a portion of their income—a part that they save, rather than consume—until later in life, when they receive distributions from their savings plans. These distributions finance consumption during retirement. Thus, at least a portion of income not consumed when young escapes income taxation, while it is subject to taxation when it is consumed later in life, effectively converting the “income” tax into a tax on consumption. This observation incidentally illustrates the fact that one must not attach too much significance to the labels conventionally attached to taxes: calling a tax an “income” tax does not necessarily make it so, in substance. Return to text.
14 For a state government, a tax on the income of corporations with nonresident owners may be very attractive because it permits tax burdens to be shifted to nonresident individuals. This is not an application of the principle of taxation in accordance with ability to pay; rather, it represents the notion that a state can promote the interests of its residents by shifting or exporting tax burdens to nonresidents where possible. Using business taxes in this way again has nothing to do with imposing tax burdens on businesses proper, but rather on using business taxation as an administrative device to impose tax burdens on natural persons in a preferred manner. Return to text.
15 Of the approximately 270 million U.S. residents in 1999-2000, approximately 43 million changed locations in that year. Almost all of these relocations occurred within the United States; less than 2 million involved international migration. Of the nearly 42 million moves that occurred from one place to another in the United States, well over half involved moves from one location to another within the same county; about 8 million involved moves to another county in the same state, and about 8 million were interstate moves. (These are only the most recent statistics. Census data confirm that the phenomenon of frequent relocation has been a persistent feature of U.S. demographics for the past half-century.) No state is exempt from this pattern, though of course the extent of movement varies among the states and regions. Interestingly enough, as of the 1990 census, Kentucky stands out among the states as one that has experienced relatively little inflow from the rest of the country. In this year, 77 percent of the state’s residents were native Kentuckians, ranking fourth highest among the states in this respect. By way of comparison, only 62 percent of the 1990 U.S. population were residents in their state of birth. Pennsylvania ranked first in this dimension, with 80 percent native residents, and Florida was last, with only 30 percent natives. Unfortunately, the data from the 2000 census are not yet available. The 1990 data indicate that Kentucky had not attracted many new residents from other states or from abroad during the preceding several decades. Return to text.